Compare the following risk preferences: (a) risk-averse, (b) risk-indifferent, and (c) risk-seeking. - 12840

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5-3 Compare the following risk preferences: (a) risk-averse, (b) risk-indifferent, and (c) risk-seeking. Which is most common among financial managers?

 

 

5-4Explain how the range is used in scenario analysis.

 

 

5-13Explain the meaning of each variable in the capital asset pricing model (CAPM) equation. What is the security market line (SML)?

 

 

 

Assessing the Goal of Sports Products, Inc.

Loren Seguara and Dale Johnson both work for Sports Products, Inc., a major producer of boating equipment and accessories. Loren works as a clerical assistant in the Accounting Department, and Dale works as a packager in the Shipping Department.

During their lunch break one day, they began talking about the company. Dale complained that he had always worked hard trying not to waste packing materials and efficiently and cost-effectively performing his job. In spite of his efforts and those of his co-workers in the department, the firm’s stock price had declined nearly $2 per share over the past 9 months. Loren indicated that she shared Dale’s frustration, particularly because the firm’s profits had been rising. Neither could understand why the firm’s stock price was falling as profits rose.

Loren indicated that she had seen documents describing the firm’s profit-sharing plan under which all managers were partially compensated on the basis of the firm’s profits. She suggested that maybe it was profit that was important to management, because it directly affected their pay. Dale said, “That doesn’t make sense, because the stockholders own the firm. Shouldn’t management do what’s best for stockholders? Something’s wrong!” Loren responded, “Well, maybe that explains why the company hasn’t concerned itself with the stock price. Look, the only profits that stockholders receive are in the form of cash dividends, and this firm has never paid dividends during its 20-year history. We as stockholders therefore don’t directly benefit from profits. The only way we benefit is for the stock price to rise.” Dale chimed in, “That probably explains why the firm is being sued by state and federal environmental officials for dumping pollutants in the adjacent stream. Why spend money for pollution control? It increases costs, lowers profits, and therefore lowers management’s

earnings!”

Loren and Dale realized that the lunch break had ended and they must quickly return to work. Before leaving, they decided to meet the next day to continue their discussion.

 

To Do

a. What should the management of Sports Products, Inc., pursue as its overriding goal? Why?

 

b. Does the firm appear to have an agency problem? Explain.

 

 

c. Evaluate the firm’s approach to pollution control. Does it seem to be ethical? Why might incurring the expense to control pollution be in the best interests of the firm’s owners despite its negative effect on profits?

 

d. Does the firm appear to have an effective corporate governance structure? Explain any shortcomings.

 

e. On the basis of the information provided, what specific recommendations would you offer the firm?

 

 

Solution Description

5-3 Compare the following risk preferences: (a) risk-averse, (b) risk-indifferent, and (c) risk-seeking. Which is most common among financial managers?

 

Risk averse is a preference where an investor wants compensation for the higher risk taken. A risk neutral investor on the other hand demands higher return irrespective of the risk taken. A risk seeking investor would seek higher risk investments. This means if two investment opportunities with the same return were presented to him, he will go for the one with the higher risk. Financial managers can be risk averse, risk indifferent or risk seeking, but most of the times they are risk averse. They usually go for options that bring higher returns in return for taking additional risk.

 

5-4Explain how the range is used in scenario analysis.

 

Scenario analysis is a tool that identifies the different outcomes that are possible in the future for a given situation. It is a tool that merely presents the different possibilities instead of predicting the future. Scenario analysis also illuminates the paths that lead to different outcomes.

 

 

5-13Explain the meaning of each variable in the capital asset pricing model (CAPM) equation. What is the security market line (SML)?