Productivity at your daily life

In a book on financial management for business firms, why do we spend so much time discussing the risk of stocks? Why not begin by looking at the risk of such business assets as plant and equipment? The reason is that, for a management whose primary objective is stock price maximization, the overriding consideration is the risk of the firm’s stock, and the relevant risk of any physical asset must be measured in terms of its effect on the stock’s risk as seen by investors. For example, suppose Goodyear Tire Company is considering a major investment in a new product, recapped tires. Sales of recaps, hence earnings on the new operation, are highly uncertain, so on a stand-alone basis the new venture appears to be quite risky. However, suppose returns in the recap business are negatively correlated with Goodyear’s regular operations—when times are good and people have plenty of money, they buy new tires, but when times are bad, they tend to buy more recaps. Therefore, returns would be high on regular operations and low on the recap division during good times, but the opposite would occur during recessions.

The result might be a pattern like that shown earlier in Figure 3-5 for Stocks W and M. Thus, what appears to be a risky investment when viewed on a stand-alone basis might not be very risky when viewed within the context of the company as a whole. This analysis can be extended to the corporation’s stockholders. Because Goodyear’s stock is owned by diversified stockholders, the real issue each time management makes an asset investment should be this: How will this investment affect the risk of our stockholders? Again, the stand-alone risk of an individual project may be quite high, but viewed in the context of the project’s effect on stockholders’ risk, it may not be very large. We will address this issue again in Chapter 8, where we examine the effects of capital budgeting on companies’ beta coefficients and thus on stockholders’ risks.

Explain the following statement: “The stand-alone risk of an individual project may be quite high, but viewed in the context of a project’s effect on stockholders, the project’s true risk may not be very large.”

How would the correlation between returns on a project and returns on the firm’s other assets affect the project’s risk?

Taken From : Five-Minute MBA – Corporate Finance

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