Principles of Managerial Finance

CHAPTER 5 Risk and Return 219

TABLE 5.3 Assets A and B

Asset A Asset B

Initial investment $10,000 $10,000

Annual rate of return

Pessimistic 13% 7%

Most likely 15% 15%

Optimistic 17% 23%

Range 4% 16%

LG2

sensitivity analysis
An approach for assessing risk
that uses several possible-return
estimates to obtain a sense of the
variability among outcomes.

range
A measure of an asset’s risk,
which is found by subtracting the
pessimistic (worst) outcome from
the optimistic (best) outcome.

5. The term sensitivity analysisis intentionally used in a general rather than a technically correct fashion here to sim-
   plify this discussion. A more technical and precise definition and discussion of this technique and of “scenario analy-
   sis” are presented in Chapter 10.

5–3 Compare the following risk preferences:(a)risk-averse,(b)risk-indifferent,

and(c)risk-seeking. Which is most common among financial managers?

5.2 Risk of a Single Asset

The concept of risk can be developed by first considering a single asset held in

isolation. We can look at expected-return behaviors to assess risk, and statistics

can be used to measure it.

Risk Assessment

Sensitivity analysis and probability distributions can be used to assess the general

level of risk embodied in a given asset.

Sensitivity Analysis

Sensitivity analysisuses several possible-return estimates to obtain a sense of the

variability among outcomes.^5 One common method involves making pessimistic

(worst), most likely (expected), and optimistic (best) estimates of the returns

associated with a given asset. In this case, the asset’s risk can be measured by the

range of returns. The rangeis found by subtracting the pessimistic outcome from

the optimistic outcome. The greater the range, the more variability, or risk, the

asset is said to have.

EXAMPLE Norman Company, a custom golf equipment manufacturer, wants to choose the

better of two investments, A and B. Each requires an initial outlay of $10,000,

and each has a most likelyannual rate of return of 15%. Management has made

pessimisticand optimisticestimates of the returns associated with each. The three

estimates for each asset, along with its range, are given in Table 5.3. Asset A

appears to be less risky than asset B; its range of 4% (17% 13%) is less than

the range of 16% (23% 7%) for asset B. The risk-averse decision maker would

prefer asset A over asset B, because A offers the same most likely return as B

(15%) with lower risk (smaller range).