11 making informed judgments part 4 risks and rewards navigating accounting, ® g. peter &...

11

Making Informed Judgments

Part 4

Risks and Rewards

Navigating Accounting,® G. Peter & Carolyn R. Wilson, © 1991-2009 NavAcc LLC. Modified by [Your Name].

22

Menu

Asset uncertainty and measurement dispersion

Asset risk

Risks and rewards

Risks and returns

Financial leverage and its consequences

Closing thoughts

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33

Asset Uncertainty and Measurement Dispersion

Asset uncertainty

Existence of more than one possible realization of the future benefits associated with an asset.

Things You Need to Know

Computer example:

You purchase a computer for $1,400 expecting that using it for its three-year expected life will help you increase your human capital’s value by $1,500.

At the time of the purchase, you believe a $1,500 increase in the value of your human capital is the most likely outcome; but it is possible that the benefits you actually realize could fall anywhere between $1,000 and $2,000 if the computer provides less or more benefits than expected.

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Measuring asset uncertainty

Assigning probabilities to possible future benefit realizations.1


1. Definitions presented here for asset uncertainty, measuring asset uncertainty, asset risk, and measuring asset risk are based on more general definitions in Wikipedia. “Risk." Wikipedia: The Free Encyclopedia. 3 April 2009 <http://en.wikipedia.org/wiki/Risk>.

Wikipedia attributes Douglas Hubbard "How to Measure Anything: Finding the Value of Intangibles in Business" pg. 46, John Wiley & Sons, 2007 and Douglas Hubbard "The Failure of Risk Management: Why It's Broken and How to Fix It, John Wiley & Sons, 2009.

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Continuation of computer example…

You believe the possible realized values of the computer’s future benefits could fall anywhere between $1,000 and $2,000 with the probabilities indicated below:


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Uncertainty associated with an asset depends on:

The range of possible realized future benefits

The pattern of probabilities assigned to them

You would be more uncertain about your computer purchase if the possible future benefits and probabilities followed the pattern on the right below:


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Answer the following question from the perspective of a representative student in your group:

How does uncertainty associated with the value of your assets compare to the dispersion of objective experts’ estimates of these values?

Questions

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The dispersion of objective experts’ estimates of an asset’s value reflects their collective uncertainty about possible future realizations and specifies the:

Range of possible realized future benefits and

Pattern of probabilities, where the probabilities depend on the percentage of experts predicting related realizations.

Take Aways

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Information is useful for prediction when it:

Helps measure uncertainty:

Helps specify a range of possible outcomes

Helps specify related probabilities

Reduces uncertainty:

Narrows the range of possible outcomes

Narrows the dispersion of the probability distribution

Take Aways

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Asset Risk

Asset risk

Asset uncertainty where some of the possible future benefit realizations result in losses, meaning the realized values of the future benefits are less than the asset’s current value.1


Measuring asset risk

Quantifying the probabilities and losses associated with asset uncertainty.1

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1. Definitions presented here for asset uncertainty, measuring asset uncertainty, asset risk, and measuring asset risk are based on more general definitions in Wikipedia. “Risk." Wikipedia: The Free Encyclopedia. 3 April 2009 <http://en.wikipedia.org/wiki/Risk>.

Wikipedia attributes Douglas Hubbard "How to Measure Anything: Finding the Value of Intangibles in Business" pg. 46, John Wiley & Sons, 2007 and Douglas Hubbard "The Failure of Risk Management: Why It's Broken and How to Fix It, John Wiley & Sons, 2009.

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Asset Risk

An asset has a possible loss when a possible realized value of its future benefits is less than its current value.

On the date you buy the computer, the current value is the purchase price.


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Asset Risk

The possible loss realizations are to the left of the current value—values below $1,400.


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Asset Risk

To measure the risk associated with the purchase, you need to estimate: the possible loss realizations and the related loss probabilities. The shaded region below represents this risk.


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Asset Risk

Suppose the figure on the left below represents everybody else’s beliefs about the future benefits they expect to get from the computer and the one on the right represents your beliefs about the expected benefits.

Should you expect to pay less than $1,400, more than $1,400, exactly $1,400 for the computer?

Questions

EveryoneElse

Your Expectations

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Asset Risk

The computer manufacturer just released a report that lead you and everyone else to conclude the possible realizations and probabilities on the right below are now more representative.

Should you now expect to pay less than $1,400, more than $1,400, exactly $1,400 for the computer?

Questions

You and Everyone Else

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Asset Risk

The same asset purchased for the same price can have different risks for different owners either because: they plan to use the asset differently or they otherwise have different beliefs about its future usefulness.

Take Aways

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Asset Risk

Generally, when buyers believe an asset will be less risky than previously thought, its price will increase, reflecting buyers’ willingness to pay more for less risk.

Take Aways

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Asset Risk

Generally, when buyers believe an asset will be more risky than previously thought, its price will decrease.

Take Aways

This will not be true when buyers can diversify the additional risk with other assets or liabilities, are risk seekers, or are not behaving rationally.

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Asset Risk

Caveat: Watch for different terminology

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2020

Compare the risks of Intel’s cash & cash equivalents and inventories. What are the sources of these risks?

INTEL CORPORATIONCONSOLIDATED BALANCE SHEETS

December 27, 2008 and December 29, 2007(In Millions--Except Par Value) 2008 2007AssetsCurrent assets:

Cash and cash equivalents 3,350$ 7,307$ Short-term investments 5,331 5,490 Trading assets 3,162 2,566 Accounts receivable, net of allow ance for doubtful accounts of $17 ($27 in 2007) 1,712 2,576 Inventories 3,744 3,370 Deferred tax assets 1,390 1,186 Other current assets 1,182 1,390

Total current assets 19,871 23,885 Property, plant and equipment, net 17,544 16,918 Marketable equity securities 352 987 Other long-term investments 2,924 4,398 Goodwill 3,932 3,916 Other long-term assets 6,092 5,547

Total assets 50,715$ 55,651$

Intel's 2008 Form 10-K, page 57. www.sec.gov

See accompanying notes in the 10-K.

Question

Asset Risk

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Asset Risk

Asset risk varies considerably across assets. This creates demand for disclosure of asset line items on balance sheets.

Insiders’ and outsiders’ risk assessments are more informed to the extent they understand the business context:

Can identify things that can go wrong

Can secure and analyze information to estimate the likelihoods these things will occur and their related consequences

Take Aways

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Asset Risk

Uncertainty is necessary for measurement to be challenging.

Insiders and outsiders need to understand related uncertainties and risks to prepare and evaluate the usefulness of reported measures.

Take Aways

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Risks and Rewards

Risk and reward are the downside and upside of uncertainty, respectively.

What You Should Know

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Risks and Rewards

The larger the risk, the bigger the expected reward:

Assuming the risk can’t be diversified, the asset holders are not risk seekers, and everyone is behaving rationally.

Generally, if enough buyers perceive risk has increased, prices will decrease to compensate buyers for assuming the increased risk.


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Risks and Returns

To allow investors to compare investment opportunities for assets of different sizes, possible future realizations are usually expressed as possible future returns: Possible future returns = (possible future realization – current value) / (current value)


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Risks and Returns

The larger the risk, the bigger the expected return:

Assuming the risk can not be diversified away and the asset holders are not risk seekers.

Generally, if enough buyers perceive risk has increased, prices will decrease to compensate buyers for assuming risk, which increases expected returns.

When you hear someone say “risk and reward” go together, you should interpret this more precisely as “risk and expected return” go together.


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Risks and Returns

The larger the risk, the bigger the expected return:


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2828

Risks and Returns

Answer the following questions from the perspective of a representative student in your group:

What investments have you and others made in your human capital, and thus, what is at risk?

How will the returns on these investments be realized in the future?

What can you do to manage the risks and rewards, and thus, the expected returns associated with these investments?

Questions

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Compare the risks and expected returns of Intel’s cash and inventories and what Intel can do to manage them.

INTEL CORPORATIONCONSOLIDATED BALANCE SHEETS

December 27, 2008 and December 29, 2007(In Millions--Except Par Value) 2008 2007AssetsCurrent assets:

Cash and cash equivalents 3,350$ 7,307$ Short-term investments 5,331 5,490 Trading assets 3,162 2,566 Accounts receivable, net of allow ance for doubtful accounts of $17 ($27 in 2007) 1,712 2,576 Inventories 3,744 3,370 Deferred tax assets 1,390 1,186 Other current assets 1,182 1,390

Total current assets 19,871 23,885 Property, plant and equipment, net 17,544 16,918 Marketable equity securities 352 987 Other long-term investments 2,924 4,398 Goodwill 3,932 3,916 Other long-term assets 6,092 5,547

Total assets 50,715$ 55,651$

Intel's 2008 Form 10-K, page 57. www.sec.gov

See accompanying notes in the 10-K.

Question

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Risks and Returns

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Risks and Returns

The expected return on an entity’s assets is the combined amount debt holders and owners expect to receive beyond the amount invested in the assets.

Risks and expected returns go together:

The higher the risk that investors perceive when they are considering an investment,

The higher the expected return they will require to compensate for this risk.

The realized return on an entity’s assets is the combined amount debt holders and owners actually receive above and beyond the amount invested.

Take Aways

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Financial Leverage and its Consequences

Financial leverage is the extent to which assets are financed by liabilities rather than equity.

Leverage is measured as liabilities/assets or by comparable ratios involving assets, liabilities, and owners’ equity.

The consequences of financial leverage depend on:

The magnitude of the financial leverage and

The risks and rewards associated with the assets


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From the owners’ perspective, assets’ risks and rewards are amplified by financial leverage.

The reason for this amplification is owners must pay the same amount to creditors to meet obligations regardless of the value realized from the assets.


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Answer the following questions from the perspective of a representative student in your group:

Is the financial leverage associated with your assets, liabilities, and owners’ equity low, medium, or high?

Are the consequences of this financial leverage, low, medium, or high?

If your answers differ for the above questions, why do they differ?

Questions

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3434


Excessive financial leverage is frequently cited as a primary cause of the recent economic crisis.

What was the problem: increased financial leverage, increased asset risk, both?

What can we conclude about the information and mechanisms that were in place to manage the consequences of leverage prior to the crisis:

Incentives?

Monitoring and communication?

Plans, policies, training, contracts, and controls?

Questions

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Financial leverage amplifies the owners’ share of the risks and rewards associated with a company’s assets.

Financial leverage ratios often differ greatly across industries because of differences in asset risks.

Analyzing the consequences of financial leverage can be particularly problematic when assets and liabilities are not recognized on balance sheets:

Off-balance sheet financing often occurs when assets and liabilities can not be measured reliably, which also tends to be when there is considerable risk.

Prior to recent changes in GAAP, off-balance sheet financing also occurred frequently when companies entered into complex contractual arrangements (securitizations) that allowed them to recognize smaller related assets and liabilities.

Take Away

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Closing Thoughts

A basic tenant of modern finance is risks and rewards go together. There are some important implicit assumptions behind this concept:

Investors know how to assess risk and rewards, pursue their economic self interests rationally within the confines of social norms and laws, and are risk averse or risk neutral.

The risks are limited to those associated with measurable uncertainty, meaning limited to possible outcomes and probabilities that can be specified in advance.

Insiders’ and outsiders’ perceptions about risks and rewards can vary greatly depending on their access to related information and the ways they process this information, as can perceptions among outsiders.

Analyzing the consequences of financial leverage ratios without analyzing asset risk is a recipe for disaster. Return to menu

11 making informed judgments part 4 risks and rewards navigating accounting, ® g. peter &...

Documents

asset riskquantifying

computers future benefits

failure of risk management

john wiley sons

possible realized values

possible realization

value of intangibles

general definitions