Critique of Unique's "Is a Bachelor's Degree Losing its Merit"

Hello, again and for the last time. I’ve really enjoyed enlightening all my loyal followers over the past three months, but all good things must come to an end. So, on with the show. I read Unique’s blog once again and I happen to disagree with her stance on the topic of advanced education. I disagree with her opinion on how a Bachelors Degree is the same as a high school diploma. Now more than ever, every credential is a strong asset to have considering the poor economic times. Although as Unique stated that entry level jobs are available for graduates equally to non-graduates, the benefit of a degree results in future promotions and upper management positions. Also, in a competitive job market, with a degree employers view your work ethic and problem solving skills to be a greater advantage to their company’s success.

According to 2006 statistics, in a lifetime a person with a bachelor’s degree earns on average $67,766 than someone that does not complete college. Bachelor degree recipients earn over 60% of non-graduates. Even an associate’s degree increases overall salary by 20% in ones lifetime. Job security and advancement are two of the most important reasons, in my opinion, that a college investment is critical to ones future growth.

College enforces the ideas of discipline and rewarding effort. Also, learning different ideas and concepts and repeatedly applying them to specific projects and tests are important skills to have in the real world. This gives a graduate a competitive edge to offer an employer. Employers hire people who have accomplished the task of earning a degree because they know that if that employee is focused and works hard enough through college then they will allocate the same efforts to the organizations success. It is critical to be able to provide confidence in the hiring and promoting manager’s decision by the simple fact that you worked hard achieve excellence.


Sources:
1. http://bachelordegree.lifetips.com/cat/65327/benefits-of-earning-a-bachelor-degree/index.html

2. http://www.anthemcollege.com/about/importance-of-a-degree.php
3. http://www.collegeview.com/importance_of_college_education.html

Fraud

Hey everybody! I’ve got good news and bad news. First, I’ll give you the good: another exciting edition of Mike Talkin’! Now the bad news: this is the second to last blog ever. I do feel bad since your lives won’t be as complete as before, but life goes on. Today’s topic concerns corporate fraud and the dangers associated with it. Fraud is a growing epidemic among American businesses. It is an internal depletion of a corporation’s assets by theft, embezzlement and other dishonest practices which robs their livelihood. For example, in 2003 U.S. businesses lost 600 billion in assets, a significant increase of $200 billion from a time frame shy of a decade. Enron violated internal ethic practices by buying and selling stocks based on information that was not available to the public. They practiced creative accounting by inflating the value of their assets to gain greater profits and advantages in the market. Arthur Anderson, Eron’s accounting firm also committed fraud in their weak efforts to sufficiently audit their client based off of the higher margins of profit gained from having them as a client.

Fraud also exists in non-profit organizations by workers taking donations, allocating funds to places not agreed upon and paying personal debts with funds that are intended to go to the charities. This practice of dishonesty by creating fake vendors and invoice sheets to allocate monies can exist with any charitable organization. For example, the American Cancer Society’s New York branch created a system in which allowed them to receive a massive volume of 4 million dollars in tax deductions by falsely writing off their tax income returns.

The prevention of fraud lies in a company’s effort to continue to do extensive background checks on their employees along with allocating a strong internal auditing of their assets. Also, by not letting one manager or accountant control most of the cash flow and delegating this responsibility, this would enforce a greater checks and balances system to lower the risk of fraud. Assessing a corporation’s current fraud risk can help with the prevention of dishonest practices by allowing a company to examine which aspects of business need the most security. I think that the most effective and low cost prevention is for the mission of the company to be honesty and for the leaders of the company to set an example of how an organization can be successful without cheating.


Sources:
1. http://www.super-solutions.com/EmployeeFraudandWorkplaceEthics.asp
2. http://encarta.msn.com/encyclopedia_701610398_2/Enron_Scandal.html

3. http://www.protiviti.com/portal/site/pro-us/menuitem.38fa3ddccd35956bbdd22d10f5ffbfa0?showGray=yes&file_name=%2FKnowledge%2FFeature_Articles%2FFeatureArticle_20090327.html

4. http://www.nysscpa.org/cpajournal/2006/106/essentials/p56.htm

Critique of George's Critique of Jessica's M's "Obama Says No More"

Good day everyone. Today I thought to myself, "I should critique a critique", and that's exactly what I did. First, I came across George's critique of Jessica Morse's blog and it was such an interesting topic, I felt compelled to give my two cents. I agree with Jessica and George on Barack Obama’s decision to make strict loan guidelines to the auto industry giants Chrysler, GM and Ford. One reason is because there is a future with these companies to consolidate and restructure their business if forced to because money is not simply handed to them by the government. Not every company gets a bailout and yes, the nation is dependent on the success of the auto industry because it allows us to compete in the global market. However, the production of new lines of vehicles is not worth the nation falling into a deeper deficit. The government’s decision is based on the lack of the auto giants’ abilities to sharpen their focus on marketing, which is what is crucial to making a profit, therefore satisfying bondholders.

Another interesting factor in why the bailout should not just be “handed” to these giants is the prevention of innovation. This struggle will force the corporations to think outside of the box, breaking the monopolistic hold on the technology that would come from companies such as Fiberforge, Aptera and Tesla Motors. These companies have the ability to create more earth friendly, fuel efficient vehicles which would lower the cost of manufacturing. This brings more of a benefit to consumers because with reduced costs of production, it would allow a lower sticker price. Also, outsourcing technological production needs to these smaller companies would enable more consumers to purchase cars that are safer for the environment, electronic in nature (lower gas expense), thereby improving the economic welfare of the nation.

The restricted bailout term appointed by President Obama would force GM, Chrysler and Ford to restructure on their company’s budgets, instead of wasting the government’s money. I believe that if these companies are given large sums of money at the consumer’s expense that the same result of non-profitable investing and wasteful allocation of funds will continue to occur. Unless and until they are forced to recognize that the inner-structuring of their operations in the financial and management strategies are in dire need, they will inevitably fail. Appreciation for the assets obtained by efficient production and possibly outsourcing to more cost-effective smaller companies will most likely drive future success.

Sources:
1 http://usnews.rankingsandreviews.com/cars-trucks/Auto-Bailout/

2 http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2008/12/03/EDSN14G1SR.DTL&type=autos

3 http://abcnews.go.com/Politics/story?id=6431621&page=1

Subprime Mortgage Crisis

Hello all! Today I decided to touch on an issue that has probably affected someone you know, the subprime mortgage crisis. Subprime mortgages have created an unstable economy as a result of lenders loaning funds under unrestrained guidelines. These loans were based off of lenient credit requirements and limited documentation. One type of subprime loan, a no documentation loan, was provided to the borrower for 100% of the residential property’s value. This created a large risk for the lenders because the income of the person was not verified and a credit score of less than 660 was accepted. The majority of these people had low credit scores for lack of responsibility in past debts owed; however, the lender’s raise in overall profit made for their acceleration of practices in loaning money to unqualified candidates.

An interest only loan was also a popular loan program made to entice borrowers of low loan payments. The risk was that they were able to qualify for a loan, never being able to pay down the principal value in the home. One missed paycheck or a family member falling ill and incurring substantial medical bills could cause an unavoidable foreclosure. The economic welfare of the nation suffered considerably because of declining values in comparable sales used for an appraisal to assess the value of a property. This was harmful because it discouraged the purchase of homes and the repayment of monies owed to banks. Also, refinancing for subprime mortgages allowed consumers to borrow against the equity in their home. One missed payment would also force these borrowers into foreclosure, obligating the lender to take ownership of the house and not the money owed.

Another subprime mortgage which was most responsible for creating the economic downfall, in my opinion, was ARMs, adjustable rate mortgages. This had the terrible effect of increasing foreclosures because of a lack of planning from the borrowers which had this loan program. The lenders would lock in an interest rate at a fixed value for two to ten years and then when the fixed rate term was over, the mortgage would adjust upwards. This increased the risk of foreclosure because the borrowers were qualified only on the basis of their debt-to-income ratio for the fixed portion of the loan. After the term had expired, their monthly payments would increase by hundreds of dollars. This was yet another reason why foreclosures did occur. In the future, the economy will not incur the great risk of failure if there are stricter lending standards enforced. Loaning money to people with low credit scores, high debt, lack of income and negligible down payments are factors which caused them to default on the loans given to them. The banks should have better standards, which in turn would better ensure the repayment of these loans.

Sources:
1. http://useconomy.about.com/od/economicindicators/tp/Subprime-Mortgage-Primer.htm

2. http://community.investopedia.com/news/IA/2007/Subprime_Reality_Check.aspx

3. http://news.bbc.co.uk/2/hi/business/7073131.stm

Critque of Unique L.'s "Specialization vs. diversification"

Hope everyone’s having a good day today, and if not, it’s about to be. Luckily for you, I’ve been checking out all the different blogs out there and came across one that’s, let’s just say, unique. Actually, that’s just a corny play on words since the blog I am critiquing is Unique L.’s. The link for her site is http://uniquebl0gs.blogspot.com/ and I will certainly recommend it to everyone I know, it is really that good. The specific blog that interested me was titled “Specialization vs. diversification” and wouldn’t you know it, that’s what it was about. Unique made the argument that specialization allows for greater efficiency. While that may be true, if a company is thinking big, diversification is a must. Here’s my take on the topic.

Diversification in a market is more beneficial to a company’s success than specialization because it allows for a greater possibility of satisfying broader markets with a more diverse base. Diversification allows you to earn more profits from channeling different avenues sparking the buyer interest in product they rarely find through specialization. Specialization is risky because if the niche is not successful the entire business fails to produce a “backup”. Competition is greater with specialization carrying the risk of failure in the market opposed to diversification.
http://www.greensheet.com/gs_online.php?issue_number=071002

Many strategies are associated with successful diversification. I believe that capitalizing on core competencies is the most important because it relieves the threat of competitors by forming a competitive advantage. For instance, Coke offered a diverse product Coke Zero which created a different market for no calorie drinks, diversifying their product (Coke, Diet Coke), extending a value of taste similar to regular Coke feeding the market’s desire for healthier soft drinks. If Coke focused on specialization of their one product, Pepsi and other competitors would have depleted that specific “health” market.
http://www.1000ventures.com/business_guide/im_diversification_strategies.html

Diversification allows for a smaller need of reinvention of the product because of the lesser threat of duplication which specialized markets carry. Concentric diversification is the relation of a new product to an existing one. Another example of this is the creation of the hybrid car. When gas prices and the well-being of the environment become a growing concern, diversification of the auto industry to provide fuel efficient, “green” cars pays off. Conglomerate diversification carries the most risk because it creates a need for a company to diversify outside of its means of production. As discussed in the “reference for business” article, Phillip Morris’ act of joining with Miller Brewing company to gain a broad spectrum of consumers was challenging because neither had experience in the production of their products. In the long run, if this type of business venture is successful, the payoff exceeds the risk.
http://www.gulfnews.com/business/Commerce/10185500.html

http://www.referenceforbusiness.com/management/De-Ele/Diversification-Strategy.html

Bankruptcy

Hello, once again! Today's topic is a very interesting one: How does a company handle going bankrupt. Bankruptcy is becoming more of a reality in this volatile economy for many families and businesses. It is a means of clearing debt to establish financial stability. The purpose of bankruptcy is to build and restructure a business by liquidating assets to clear monies owed, also offering relief of harassment from creditors. Reduction of debt occurs by the organization or individual making an effort through the courts to satisfy and writing off accounts in arrears.

Organizations manage the risk of bankruptcy to maintain current operations and to build the existing business without closing because of the allocation of income to debt. In my humble opinion, Chapter 11 is the most efficient for corporations partly because it relieves financial commitments to outstanding contracts and leases. It allows businesses to allocate a plan for reorganization of debts owed. This lowers the risk of failure because it forces the organization to create a restructuring plan to analyze current financial scheduling downfalls (i.e. income, expenses and liabilities) which forced them into the initial filing of bankruptcy.

One method for the avoidance of financial corruption is through asset management. Flaster/Greenber focuses on the prevention of bankruptcy through careful risk management solutions. They evaluate the existing financial conditions and counsel on ways to reduce the risk of losing assets. The “privatize your life using asset protection strategy” article offers similar insights of protecting assets by methods separating assets and identity, creating a structured plan, timely protection of assets and knowing the opposition. I believe that with these methods of analyzing and evaluating risks, organizations can better control and prevent disrupting business practices.

(1) http://bankruptcy.lawyers.com/commercial-bankruptcy/Business-Bankruptcy-FAQ.html

(2)http://www.uscourts.gov/bankruptcycourts/bankruptcybasics/chapter11.html

(3)http://www.flastergreenberg.com/

(4)http://asset-management.bestmanagementarticles.com/a-29495-privatize-your-life-using-asset-protection-strategy.aspx

Critique of "Risk Maps" by Anna R.

Hello, again. Today must be your lucky day, a double dose of Mike Talkin is what's in store for y'all. Once again, I surfed the net for a blog other than mine, and came across Anna's. Overall I loved all her blogs and will recommend it to everyone I know. The link for the specific blog I chose to critique is http://act-alr.blogspot.com/2009/03/risk-maps.html . The title of this blog is "Risk Maps" and concerns how to go about making a risk map and their use by companies. First, I'd like to explain as best as I can my understanding of the risk map. This will be followed by a short critique of Anna's original blog.

Risk maps help define the certainty of occurrence, using the measures of severity and frequency of risks. Financial, operational and business risks are just a few controlling factors in a business’s success to which mapping would define the most efficient way to prevent these risks. Various forms exist to assess different types of uncertain risks. The risk map is important for assessing “high-stakes” risk. Unexpected risks are the most incorrectly mapped because of their low frequency.

Flood mapping is a very common risk management procedure because it provides the basis of the amount of coverage needed on commercial and residential buildings. FEMA is a government agency which manages risk in daily assessment of property values in a flood zone or flood prone areas. This allows proper coverage on a building and its contents in case of a flood which can cause substantial property damage and unpaid claims. They hire cartographers and engineers to determine special flood hazard area and risk zones. The NFIP, National Flood Insurance Program, uses FEMA’s risk assessment in the flood plan management program consisting of FIRM’s, SFHAs (Special Flood Hazard Areas).

Risk Maps exist to help improve the ecosystem and the environment by assessing factors such as insects, disease and mapping forests to measure the life and death rate of trees. The Geographic Information System database derives evaluated information for the improvement of healing the problems forests tend to have. This process is a “long-term” Forest Health Monitoring program analysis which compiles data into risk maps and models. Forest risk mapping allows more accurate predictions to which forests are prone to drought and fire. Defining these occurrences caused by insects or disease lowers the risk of forest and possibly home consumption by disasters such as massive wild fires and disease outbreaks caused by insects.

As far as Anna's take on the topic, I can't say I disagree with much. I do however disagree with her stance on the correlation between seasonality and car accidents. The weather is tied to certain seasons, which would therefore make the higher rate of accidents in winter correlated to winter itself. The snowy weather is a defining characteristic of winter in a lot of places. I don't think anyone is trying to say that the months of December to February are inherently more likely to have more car fatalities for the simple fact that they are those months. Those months have the bad weather, therefore I don't think it's incorrect to say that the season and car accidents are correlated.

Additional Sources:
http://www.shelterislandrisk.com/resources/documents/RiskMapsMadePractical.pdf
http://www.msc.fema.gov/webapp/wcs/stores/servlet/info?storeId=10001&catalogId=10001&langId=-1&content=productFIRM&title=NFIP%20Flood%20Maps&parent=productInfo&parentTitle=Product%20Information
http://www.srs.fs.usda.gov/sustain/conf/abs/lewis.htm

Internal Control

Good day, everyone! Today's topic, a very important one for anybody running a business, is about the benefits of internal control in limiting exposure to unnecessary risk. The role of internal control is to establish a strong and well executed check and balance system throughout a corporation by utilizing audits for an oversight of operations. Internal audits ensure compliance of regulations by defining efficient ways to reduce the risks of asset loss. Risk assessment, monitoring, information and communication, and control operation environment are essential components to the success of an organization.

Insurance Companies use internal audits to verify that procedures are followed and Errors and Omissions risk is minimized. This is done to prevent and correct operations which raise risk and decrease their overall productivity. IIA is a UK based company which prides itself in creating compliance guidelines for the public by publishing a large knowledge base of risk management. IIA is a tool for companies to assure corporate social responsibility and control of internal operations.

Weak control systems can produce undesirable business operations. These systems can be influenced by communication failures between departments and insufficient financial statements which increase the need of risk management. With increased emphasis on the importance of training and using efficient accounting systems along with financial journals, cooperation, and avoiding the consolidation of financial statements, risk can be lowered, therefore creating a strong foundation for a company’s operating system.

Sources:
http://www.ucop.edu/ctlacct/under-ic.pdf
http://www.iia.org.uk/en/Knowledge_Centre/Academic_research/index.cfm
http://www.gm.com/corporate/investor_information/docs/fin_data/gm06ar/content/financials/mar/mar_01.html

Google Risk Map

Above is a risk map based on the risks that Google faces. All information about Google's risks was obtained from Google's Form 10-K at this site http://www.sec.gov/Archives/edgar/data/1288776/000119312507044494/d10k.htm#toc70021_4 . A risk map is a scatter plot with "Frequency" on the x-axis and "Severity" on the y-axis. Risks can be loosely classified into four main categories: High Severity/High Frequency, High Severity/Low Frequency, Low Severity/High Frequency, and Low Severity/Low Frequency. Risks that fall into the High Severity/High Frequency are the events where risk management is necessary to maximize the value of the firm. For Google, these risks are the acquisition of competitors, revenue growth rate decline, and index spammers (manipulation of web search results).

Risks that are in the High Severity/Low Frequency category are the reduction of advertising revenue, international operations/competitors, the interruption of information technology, and new technologies that block ads. A significant amount of Google's revenue comes from advertising and although these events are not that frequent, they still require attention because of their high severity.

In the Low Severity/High Frequency quadrant, we have the risks of losing Google members, intellectual property rights claims, and the violation of US or foreign laws. These events do occur relatively frequently but since their severity is generally low, any risk management would more than likely be wasteful. All other risks on the map are in the Low Severity/Low Frequency category and shouldn't require a lot of attention unless either the severity or the frequency increases.

Obama and the Economy

For today's blog, I decided to read someone else's blog for a change. I know what you're thinking, "but Mike, isn't your blog the only blog worth reading?" Although that might be true, every once in awhile a good post can be found elsewhere. That good post was from Professor Grace himself and was concerning our new president and his affect on the stock market. President Obama’s disinterest with the nation’s weak economy decreases the value of stock prices, hindering the growth of global alliances. These important long-term relationships strengthen the world economy, building confidence among domestic and international consumers. Hugo Chávez's poor opinion of Obama's ignorance for Latin America is a key example of how he is responsible for influencing the decrease in stock prices.(1.) His misdirected concentration of resources used for research (i.e. lifting restrictions on federal funding of human embryonic stem cell research), instead of focusing on steps towards economic growth, abolishes future gain potential in the market.

Another downfall lies in the Social Security and income tax increase which he allocated to the high bracket income earners, in turn making them less apt to put forth maximum effort in the workforce. This will decrease the stock market investment rate, disintegrating prices
further.(2.)

Diminishing long-term investments significantly decreases the value of the stock market by the capital gains tax put forth by the President.(.3) Obama’s taxation on individual investors and large corporations will slow the growth of the market causing the fall of long-term investments making them illiquid if owned over a year. Also, the increase from 15% to 28% on the capital gains tax coupled with the allowance of the 2010 Bush tax cuts to expire, creates an undesirable formula of disaster weakening stock prices.(4.)

Sources:
1. http://kdka.com/politics/hugo.chavez.barack.2.965323.html
2. http://www.consumeraffairs.com/news04/2008/07/mccain_obama.html
3. http://theeprovocateur.blogspot.com/2008/06/barack-obama-vs-stock-market.html
4. http://boards.msn.com/thread.aspx?ThreadID=691804

Normal Distribution

Hi, everybody! Today I'm going to talk about the misuse of the normal distribution in the financial world. The normal distribution is a continuous distribution where the mean, the mode, and the median are all equal. Another defining characteristic of the normal distribution is that it has a skewness of 0, in other words it is symmetrical. The standard deviation helps tell us the cumulative probability of getting a certain x within the distribution. The distribution holds that 68.27% of all values fall within plus/minus one standard deviation, 95.45% are within plus/minus two standard deviations, and 99.73% are within plus/minus three standard deviations.
While the normal distribution is appropriate for many phenomena such as people's height, thermal noise, and IQ tests which are actually based on the normal distribution, among others, people tend to overuse it and ignore the long-tails that occur in some financial distributions. Although many financial measures can be approximated using the normal distribution, events such as worst case scenarios regarding cash flow can have some long-tails which don't fit under the normal curve. A distribution such as the pareto or the log-normal would account better for large losses since these distributions are skewed to the right allowing the possibility of large losses to be realized.

Stem Cell Policy

It's been awhile since I've been able to bestow some knowledge on y'all and luckily I've come across a very interesting article. The article is from the Wall Street Journal Online and is called "Obama to Reverse Policy on Stem Cells". The link for the article is http://online.wsj.com/article/SB123637565340956847.html . The piece tells us that President Obama will issue an executive order lifting restrictions on federal funding as it relates to stem cell research. Former President Bush had basically grandfathered the stem cell research at the time but stopped any future funding for stem cell lines not being researched. Of course, the hope is that stem cells may help us find cures for diseases such as Parkinson's and diabetes among others. The issue is controversial since opponents view it as taking a life to save a life, since days-old embryos are destroyed in the process.
I know what you're thinking, "Interesting article but I thought this was a blog about risk management?" Well it is, and this is how it relates. Looking at the very big picture, I would suggest that this is a way of the government looking at the risk management of their citizens. If we were to have a cure for diabetes, for example, people would spend less on their continuing diabetes treatment. This would allow people to spend their money elsewhere, in a way helping the economy. The main benefit would be that there would be more people who live longer. This increase in people would lead to more tax revenue for the government. Therefore, the government is managing the risk of their citizens dying.

Cash Flow at Risk

Good day to all the loyal followers of my blog. Although you currently number less than one, it's comforting to know that you all come to me for your risk management knowledge. Today we're going to look more at the variables in the net present value equation and the increased risk to a firm when adding new projects. In an example in class we had a pharmaceutical company that is considering the introduction of a new drug. There is, of course, litigation risk. The cost of the drug is $100M and expected revenue for year one is $140M. The standard deviation of current drug earnings is $25M and $20M for the new drug. The cost of capital is 6%, the marginal cost of holding risk capital is 11%, and the correlation between the new and existing drugs is 25%. Here we look at the 95% level and find that CaR is $41M currently and $59M when the new drug is added. Thus, the NPV is (140/1.06)-100-.11(59-41)=$30.13M.
Now let's assume that three things have changed from above but the rest has remained the same. Expected revenue in year one is now $106, the cost of capital has dropped to 5%, and we're going to look at the 99% level. The 99% level means in this case that we are looking at the worst loss in cash flow we could expect one percent of the time. The net present value in this case would be (106/1.05)-100-.11*((59*2.326)-(25*2.326))=-1.8M. If we ignored the increased risk to the company, then the NPV would be a positive $1M and the new drug would be added. But since we need to consider the added risk, this new drug would not be added. Also, I looked at the same numbers but at the 95% level and that alone reduced the NPV by $800K. So, it depends on what level we want to be protected at.

The Demise of Fannie Mae

I came across an interesting article from the New York Times Online regarding the failure of Fannie Mae and the subsequent takeover by the government. The link for this website is http://www.nytimes.com/2008/10/05/business/05fannie.html?pagewanted=1&_r=1. For those of you who don't know, Fannie Mae is a government sponsored enterprise created to increase the availability and reduce the cost of credit in the mortgage market. Fannie Mae makes their money by purchasing mortgages from lenders, holding some and reselling most to Wall Street investors. Loans are classified according to their level of risk. Fannie Mae will guarantee to pay a loan it sells in case of default for a fee according to its risk. If the risks are accurately classified the fees should cancel out the cost of the loan.
Where Fannie Mae went wrong was in taking on too many risks. There was pressure from shareholders, Congress, and even the mortgage companies they were buying the loans from. Countrywide Financial, a longstanding and important trading partner, demanded that Fannie take on riskier loans or else they would sell to competitors. Fannie Mae felt that too much business would be lost and bought loans they weren't necessarily comfortable with. I think the main problem was that the risks weren't being properly identified. A former employee speaking on the condition of anonymity said that they were buying loans that would have previously been rejected and that they weren't charging nearly enough for payment in case of default. They felt they had to keep up with competitors and this was justification for taking on so much risk. For a two year period, they didn't have a Chief Risk Officer. When they did hire one he urged the CEO to charge more for the risky loans, but that urging went unheeded.

Taking on a New Project

Hello, y'all. The topic today is what happens to a firm's risk when a new project is undertaken. In class we had an example looking at the profitability of adding a new project with an expected cash flow in year one of $58M and a volatility of $50M. It was determined that the new project looked profitable until we looked at the added risk to the firm. Now, I am going to look at changing our expected cash flow from $58M to $75M and the volatility from $50M to $55M. I will assume all other variables remain unchanged, i.e. initial cost is $50M and the cost of capital is 6%.
The net present value of the project is $20,754,717. It looks very profitable. Let's look now at the added risk. The volatility of the existing projects and the new one is $90,967,027. The CaR of the existing projects is 1.65 times the volatility of $50M and that is $82,500,000. The CaR of the new and the existing projects is 1.65 times $90,967,027, which is $150,095,595. It costs the firm some money to hold the extra risk. Let’s suppose that cost is 10%.If we assume that the cost of the firm holding the extra risk is 10%, then our new NPV is 20.8M - .1*(150.1M-82.5M) which is $13,995,198. This project would be accepted since we have a positive net present value.
The risk of the firm always goes up when a new project is added that has a positive correlation with the existing projects. A new project carries a certain volatility which puts a certain amount of money at risk. When adding new projects that are positively correlated to the old ones, the risk of the firm will go up. Projects that are negatively correlated will lower the risk of the firm since it does the opposite of the other projects, thus canceling out some of the fluctuations between new and old projects.

Why is RMI valuable?

How's everyone doing? This is the third installment of the ever more popular "Mike Talkin" and probably the best one yet. The topic today is a good one: why is risk management and insurance valuable? I know what you're thinking...didn't risk management cause the AIG meltdown? No, that was bad risk management or risk mismanagement as I like to say.

Risk management is the process of settling on a level of risk aversion/tolerance, then identifying and measuring the risks, and then by protecting oneself with insurance or other means. The simple answer is that risk management is valuable because it protects a company from large losses. A couple of ways that effective risk management can benefit a firm are by reducing the number of on-the-job accidents and most importantly, minimizing legal liability. By understanding your risks, a company can implement procedures such as safer working conditions as one example. Lawsuits can be devastating to small companies and having a good protocol in place can minimize the number of accidents. Furthermore, your employees will be more efficient if they feel they are in a safe workplace.

Hello, again. Back for another exciting edition of Mike Talkin, I will try not to disappoint. No promises though. The topic du jour is the basic valuation model and what happens when the variables are manipulated. The formula is as follows:
∞
∑ (E[NetCashFlow@t]/(1+r)^t) – Bankruptcy Costs
t=1

Bankruptcy costs include paying collection costs for lenders, numerous court costs, and having to pay everyone you can among other things. These costs are affected by the probability of going bankrupt. With proper risk management and insurance, these costs will decrease. This alone will increase the value of the firm, but lower bankruptcy costs also allow the firm to receive a better interest rate. The lower the interest, the more valuable a firm will be. This inverse relationship also implies that with a higher interest rate, the value of the firm will decrease.

Hello, people on the Internet. Welcome to my musings: "Mike Talkin'". Yes, you read right: I spell "talkin'" with no G. That is because I have attitude. My topic today is the CAPM and the assumptions that are necessary for it to operate. The Capital Asset Pricing Model is designed to find the required rate of return on a particular asset. Components of the CAPM are β, the risk-free rate and the expected market return. β measures the firm's sensitivity to the market.

The assumptions under the CAPM are: it's a publicly traded firm, many shareholders with well diversified portfolios, management is risk neutral, no agency problems, uninsured risk is uncorrelated with the risk of other securities in the portfolio, and there are no taxes. These assumptions limit the reliability of the model because we don't live in a perfect world. Most shareholders aren't going to be terribly diversified so that right there puts the model into question. Management isn't going to be risk neutral, there will be some level of risk aversion. Lastly, the no taxes assumption doesn't make sense since those are one of the two certain things in life.