ACC M115 Lecture Notes - Lecture 29: Capital Market, Systematic Risk, Standard Deviation

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24 Sep 2020

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You get a cash return plus a holding gain or capital gain" (or loss) If the security you own varies in market price, that variation is a measure of the risk from owning the security, since prices could go up or down. Risk is calculated as the variance or standard deviation of the prices around the average price or trend in average price of that security. A risky security is one whose price varies all over the place. The risk is separated into: systematic risk: the portion of the security"s variation that relates to or correlates with variation in the overall market, unsystematic risk: the security"s own residual variation not related to the market. Risk can be controlled to some extent by holding a variety of securities with different betas. When important events that do affect security prices are also represented in the accounting information, the accounting information will indirectly be predictive too.

Related Questions

Frank, a rational investor, has $2,000 to invest for one yearwhile she completes her professional accounting designation. She iscontemplating investing the full amount in shares of Northern Oil& Gas Ltd. (a1) or in a risk-free government bond yielding anannual return of 3.2% (a2). Frank identifies two states ofnature:

State H: Northern has high future cash flow.

State L: Northern has low future cash flow.

On the basis of her prior information about Northern, Frankassesses the following subjective prior state probabilities:

State H: 0.4

State L: 0.6

The following is the payoff table for these two investments.Payoffs from Northern shares include dividends and estimatedcapital gain for the year. Capital gain is based on the averageanalyst forecast for Northernâs share price. Payoffs are net of(i.e., they exclude) the original investment.

		STATE
		H	L
ACT	A1	484	25
ACT	A2	64	64

The investor is risk adverse, with utility equal to the squareroot of the net dollar payoff.

a. On the basis of her prior probabilities, which act shouldFrank take? Show calculations.

b. Instead of acting now, Frank decides to obtain more aboutNorthern by reading its annual report. He knows that financialstatements are based on a mixed measurement model. Also, he is astudent of financial accounting theory, and estimates the qualityof financial statements prepared according to these standards bythe following information system:


	GOOD	BAD
H	0.7	0.3
L	0.1	0.9

Good evidence means that a company reports profits that arehigher than the average analyst forecast. Bad evidence means thatthe companyâs profits are less than forecast.

Upon reading the current annual report, Frank finds it is good.Which act should Frank take now? Show calculations.

C. After buying Northern shares, Frank is disappointed to notethat the market price of its shares begins to fall, despite thegood news in its earnings report. She now suspects that the goodnews in Northernâs financial statements was not as good as sheoriginally believed. Is this possible? Give reasons why or whynot.

Lewis Securities Inc. has decided to acquire a new market dataand quotation system for its Richmond home office. The systemreceives current market prices and other information from severalonline data services and then either displays the information on ascreen or stores it for later retrieval by the firmâs brokers. Thesystem also permits customers to call up current quotes onterminals in the lobby. The equipment costs $1,000,000 and, if itwere purchased, Lewis could obtain a term loan for the fullpurchase price at a 10% interest rate. Although the equipment has a6-year useful life, it is classified as a special-purpose computerand therefore falls into the MACRS 3-year class. If the system werepurchased, a 4-year maintenance contract could be obtained at acost of $20,000 per year, payable at the beginning of each year.The equipment would be sold after 4 years, and the best estimate ofits residual value is $200,000. However, because real-time displaysystem technol- ogy is changing rapidly, the actual residual valueis uncertain. As an alternative to the borrow-and-buy plan, theequipment manufacturer informed Lewis that Con- solidated Leasingwould be willing to write a 4-year guideline lease on theequipment, including mainte- nance, for payments of $260,000 at thebeginning of each year. Lewisâ marginal federal-plus-state tax rateis 40%. You have been asked to analyze the lease- versus-purchasedecision and, in the process, to answer the following questions: a.(1) Who are the two parties to a lease transaction? (2) What arethe five primary types of leases, and what are theircharacteristics? (3) How are leases classified for tax purposes?(4) What effect does leasing have on a firmâs balance sheet? (5)What effect does leasing have on a firmâs capital structure? b. (1)What is the present value cost of owning the equipment? (Hint: Setup a time line that shows the net cash flows over the period t 5 0to t 5 4, and then find the PV of these net cash flows, or the PVcost of owning.) (2) Explain the rationale for the discount rateyou used to find the PV. c. What is Lewisâ present value cost ofleasing the equipment? (Hint: Again, construct a time line.) d.What is the net advantage to leasing (NAL)? Does your analysisindicate that Lewis should buy or lease the equipment? Explain. e.Now assume that the equipmentâs residual value could be as low as$0 or as high as $400,000 but $200,000 is the expected value.Because the residual value is riskier than the other relevant cashflows, this differential risk should be incor- porated into theanalysis. Describe how this could be accomplished. (No calculationsare necessary, but explain how you would modify the analysis ifcalculations were required.) What effect would the residual valueâsincreased uncertainty have on Lewisâ lease-versus-purchasedecision? f. The lessee compares the cost of owning the equipmentwith the cost of leasing it. Now put yourself in the lessorâsshoes. In a few sentences, how should you analyze the decision towrite or not to write the lease? g. (1) Assume that the leasepayments were actually $280,000 per year, that Consolidated Leasingis also in the 40% tax bracket, and that it also forecasts a$200,000 residual value. Also, to furnish the maintenance support,Consoli- dated would have to purchase a maintenance contract fromthe manufacturer at the same $20,000 annual cost, again paid inadvance. Consolidated Leasing can obtain an expected 10% pre-taxreturn on investments of similar risk. What would be ConsolidatedâsNPV and IRR of leasing under these conditions? (2) What do youthink the lessorâs NPV would be if the lease payment were set at$260,000 per year? (Hint: The lessorâs cash flows would be aâmirror imageâ of the lesseeâs cash flows.) h. Lewisâ managementhas been considering moving to a new downtown location, and theyare con- cerned that these plans may come to fruition prior to theequipment leaseâs expiration. If the move occurs, then Lewis wouldbuy or lease an entirely new set of equipment, so management wouldlike to include a cancellation clause in the lease contract. Whateffect would such a clause have on the riskiness of the lease fromLewisâ standpoint? From the lessorâs standpoint? If you were theles- sor, would you insist on changing any of the other lease termsif a cancellation clause were added? Should the cancellation clausecontain provi- sions similar to call premiums or any restrictivecovenants and/or penalties of the type contained in bondindentures? Explain your answer.

Hurricane Inc. purchased a portfolio of available-for-sale securities in 2016, its first year of operations. The cost and fair value of this portfolio on December 31, 2016, was as follows:

1	Name	Number of Shares	Total Cost	Total Fair Value
2	Tornado Inc.	830.00	$14,857.00	$16,185.00
3	Tsunami Corp.	1,230.00	31,488.00	34,809.00
4	Typhoon Corp.	2,170.00	44,268.00	43,834.00
5	Total		$90,613.00	$94,828.00

On June 12, 2017, Hurricane purchased 1,400 shares of Rogue Wave Inc. at $50 per share plus a $80 brokerage commission.

Required:

Provide the journal entries to record the following (refer to the Chart of Accounts for exact wording of account titles and be sure to enter the year as part of the date):

1.	The adjustment of the available-for-sale security portfolio to fair value on December 31, 2016.
2.	The June 12, 2017, purchase of Rogue Wave Inc. stock.

How are unrealized gains and losses treated differently for available-for-sale securities than for trading securities?

Chart of Accounts

CHART OF ACCOUNTS

Hurricane Inc.

General Ledger

	ASSETS
110	Cash
111	Petty Cash
120	Accounts Receivable
121	Allowance for Doubtful Accounts
131	Notes Receivable
132	Interest Receivable
141	Merchandise Inventory
145	Office Supplies
146	Store Supplies
151	Prepaid Insurance
161	Investments-Rogue Wave Inc. Stock
165	Valuation Allowance for Trading Investments
166	Valuation Allowance for Available-for-Sale Investments
181	Land
191	Store Equipment
192	Accumulated Depreciation-Store Equipment
193	Office Equipment
194	Accumulated Depreciation-Office Equipment

	LIABILITIES
210	Accounts Payable
221	Notes Payable
231	Interest Payable
241	Salaries Payable
251	Sales Tax Payable

	EQUITY
311	Common Stock
312	Paid-In Capital in Excess of Par-Common Stock
321	Preferred Stock
322	Paid-In Capital in Excess of Par-Preferred Stock
331	Treasury Stock
332	Paid-In Capital from Sale of Treasury Stock
340	Retained Earnings
350	Unrealized Gain (Loss) on Available-for-Sale Investments
351	Cash Dividends
352	Stock Dividends
390	Income Summary

	REVENUE
410	Sales
611	Interest Revenue
612	Dividend Revenue
621	Income of Rogue Wave Inc.
631	Gain on Sale of Investments
641	Unrealized Gain on Trading Investments

	EXPENSES
511	Cost of Merchandise Sold
512	Bad Debt Expense
515	Credit Card Expense
516	Cash Short and Over
520	Salaries Expense
531	Advertising Expense
532	Delivery Expense
533	Repairs Expense
534	Selling Expenses
535	Rent Expense
536	Insurance Expense
537	Office Supplies Expense
538	Store Supplies Expense
561	Depreciation Expense-Store Equipment
562	Depreciation Expense-Office Equipment
590	Miscellaneous Expense
710	Interest Expense
721	Loss of Rogue Wave Inc.
731	Loss on Sale of Investments
741	Unrealized Loss on Trading Investments

Journal

Shaded cells have feedback.

A. Provide the journal entries. Refer to the Chart of Accounts for exact wording of account titles. Be sure to enter the year as part of the date.

How does grading work?

PAGE 10

JOURNAL

Score: 33/51

	DATE	DESCRIPTION
1	?	?
2		?
3	?	?
4		?

Points:

6.47 / 10

Feedback

Check My Work

1. The gain or loss is the difference between the portfolio cost and its fair value. The offset account for the gain or loss entry is the valuation allowance account.

2. Increase the investment and decrease Cash for the purchase price (Shares x Per share amount) plus brokerage fee.

Final Question

Shaded cells have feedback.

B. How are unrealized gains and losses treated differently for available-for-sale securities than for trading securities?

Unrealized gains and losses for available-for-sale securities are accumulated over time and reported as a credit (positive) or debit (negative) balance in the Stockholdersâ Equity section. As a result, the changes in fair valueare not reflected on the income statement, as is the case with trading securities. Bypassing the income statement issupported on the grounds that available-for-sale securities will be held for alonger time than trading securities; thus, fluctuations in market prices havea greater opportunity to âcancel outâ over time.

Points:

5 / 5

ACC M115 Lecture Notes - Lecture 29: Capital Market, Systematic Risk, Standard Deviation

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