Analysis And Comparison Of Risk And Return For Fly Safely Limited And Always Reliable Limited Essay.

Data to complete these questions is provided on page 3.  Please complete and submit these questions on the Case Study 1 spreadsheet template provided.

a)Company XYZ has debt maturing in three years (amount shown in Table 1 on page 3 of this document).  How much should the company invest now in an account paying 5% APR, compounded monthly, to ensure it has sufficient funds to repay the debt when it matures?

b)Company XYZ has several alternative long-term cash investment options available to it, Investment A, B or C.  The interest rates (APR) for these options are given in Table 1.  What is the EAR of each investment option?  If EAR was the only factor in the decision highlight which Investment option Company XYZ should choose.

c)Company XYZ is buying new equipment for the amount given in Table 1.  To finance this, Company XYZ’s bank has offered an amortised loan at 4.5% APR, monthly compounding, with 20 years of monthly payments.  What monthly payment will Company XYZ have to make on this loan?  Assume that the entire equipment cost is financed and that payments are made at the end of each period.

d)Company XYZ has an issue of $1,000 par value annual coupon bonds with 10 years remaining until maturity.  The annual coupon rate is given in Table 1, along with the current price of the bonds.  What is the yield to maturity on the bonds?

e)Company XYZ has an issue of $1,000 par value bonds with an 8% coupon rate and quarterly coupons.  The bonds have 7 years remaining until maturity.  The current required return on these bonds is given in Table 1.  What is the current price of the bonds?

f)An investor is considering investing in Fly Safely Limited.  This is a relatively new company and there is limited data on the actual returns.  They have however provided the following return estimates:

Fly Safely Limited is currently investigating options for raising finance to expand its operations.  It is considering two options, either long term bank finance or issuing corporate bonds.  Currently the 10-year Australian Treasury bond rate (proxy for risk free rate) is 2.1%.  Fly Safely Limited has reviewed the Annual Report published by Always Reliable Limited and have noted that their average cost of debt is 7.5%.

Required:

Prepare a report analysing and comparing the risk and return for Fly Safely Limited and Always Reliable Limited.  Your report needs to consider the following

a.The overall industry context in relation to the risk profile of the comany

b.Risk and return theory

c.The meaning and relevance of beta in risk analysis

d.The relationship between risk and return

e.The relationship between company risk and the cost of debt.  

Overall Industry Context

The objective of the given report is to highlight the underlying risk and return with regards to Fly Safely Limited along with highlighting the innate relationship between the two in the light of the Modern Portfolio Theory. Additionally, the role of the beta as a measure of risk also needs to be explored. Further, the risk profile of the company needs to be highlighted considering the relevant risk and return of a more established airline namely Always Reliable Limited. Lastly, the underlying relationship between risk and cost of debt also needs to be highlighted.

It is apparent that the company belongs to the airline industry which is typically a risky industry considering the fact that it is highly competitive owing to the pressure from both domestic as well as foreign airlines. Also, the performance of the airlines is highly dependent on the underlying price of crude as fuel forms a significant portion of the operating expenses (Arnold, 2015). The overall risk associated from the industry can also be gauged from the fact the cost of debt for Always Reliable Limited which has a consistent track record of providing investors returns is 7.5% while the risk free rate is only 2.1%. A significant portion of this 540 bps risk premium is associated with the underlying industry which the lenders tend to consider as risky. Further, the standard deviation of returns for Fly Safely Limited also demonstrate the same since it amounts to 4.52% p.a. which is quite high considering that average returns for the company stands at 5% p.a. (Damodaran, 2015).

Risk & Return Theoretical Framework

In accordance with MPT, there is an innate relationship between risk & returns. The central tenet which forms the basis of this relationship is the fact that investors are risk averse and hence tend to prefer investments or financial assets with lower risk.  As a result, to get the investors to invest in risky assets, incentive needs to be offered to them in the form of higher returns (Brealey, Myers and Allen, 2014). If these high risk assets are offered at lower returns, the investors would prefer other financial assets which would offer similar returns but at a lower risk. Therefore, higher risk  and higher returns tend to go hand in hand considering that higher return essentially is the result of willingness on the part of the investor to take higher risk (Petty et. al., 2015).

With regards to investing in financial markets, there are essentially two types of risks namely systematic risk and unsystematic risk. The unsystematic risk is the risk which is associated with investment in particular company industry and can be mitigated by forming a diversified portfolio. However, systematic risk is the risk which is associated with the market as a whole and thereby cannot be mitigated. The measure of this risk is known as beta which tends to highlight the underlying risk associated with a particular stock or investment (Parrino and Kidwell, 2014). Further, considering that beta of the market or benchmark index is taken as 1, hence the beta of the stock or underlying portfolio tends to highlight the respective risk of the investment in comparison with the underlying market and hence provide an estimate of the overall risk. It is imperative to highlight that beta tends to ignore the presence of any unsystematic risk and solely focuses on measuring systematic risk and is based on the Capital Asset Pricing Model (Northington, 2015).

Risk & Return – Fly Safely

On the basis of the given data, it is apparent that beta for Fly Safely Limited is 1.43. This is higher than the beta for the relevant market index (beta =1) and also a more established player in the airline industry i.e. Always Reliable Limited with a beta of 0.88. It is apparent that the systematic risk for Fly Safely Limited is 43% higher than the benchmark index while that of Always Reliable Limited is 12% lower than the index. The higher risk of Fly Safely is also demonstrated from the standard deviation of returns of Fly Safely Limited which stands at 4.3% p.a. in comparison to 1.7% p.a. for Always Reliable Limited. This discussion clearly highlights the higher risk associated with Fly Safely Limited (Lasher, 2017).

In wake of the higher risk associated with Fly Safely Limited, it would be expected that the returns for the investors should compensate for this higher risk. However, this is not the case as the average returns for investors is 5% p.a. which is significantly lower than 8% p.a. being offered by Always Reliable Limited on a consistent basis. Thus, it is apparent that Always Reliable Limited tends to provide higher returns and at a lower risk in comparison to Fly Safely Limited and hence Always Reliable Limited would be a preferred investment (Christensen et. al., 2013).

Relationship between risk and cost of debt

It is imperative to note that the starting point of cost of debt is the risk free rate which is given as 2.1% in the given case. After this, the appropriate risk premium is computed and applied on the basis of the industry to which the company belongs and also the company specific risks coupled with risk associated (Damodaran, 2015). In this regards, the cost of debt of Always Reliable Limited must be taken into consideration. For this airline, the cost of debt is 7.5% p.a. For Fly Safely Limited, it is apparent that the underlying risk is comparatively higher as apparent from the standard deviation and beta owing to which the lender would expect a higher return on debt so as to compensate the underlying higher credit default risk (Petty et. al., 2015).  Therefore, the cost of debt for Fly Safely Limited would be significantly higher than 7.5% p.a.

Conclusion

Based on the above discussion, it is apparent that MPT states that risk and returns are connected. Beta is the measure of systematic risk. For Fly Safely Limited, the risk is significantly higher than index and also Always Reliable Limited but the returns do not compensate for the risk. Also, the cost of debt for Fly Safely Limited would be higher in comparison to Always Reliable Limited owing to higher risk associated with the former.

References

Arnold, G 2015, Corporate Financial Management, Financial Times Management, Sydney

Brealey, RA, Myers, SC & Allen, F 2014, Principles of corporate finance, McGraw-Hill Inc., New York

Christensen, M, Drew, M, Blanchi, R  & Ross, S 2013, Fundamentals of Corporate Finance, McGraw Hill Inc., New York

Damodaran, A 2015, Applied corporate finance: A user’s manual, Wiley, John & Sons, . New York

Lasher, WR 2017, Practical Financial Management, South- Western College Publisher, London

Northington, S 2015, Finance, Ferguson, New York

Parrino, R & Kidwell, D 2014, Fundamentals of Corporate Finance, Wiley Publications, London

Petty, JW, Titman, S, Keown, A, Martin, JD, Martin, P, Burrow, M & Nguyen, H 2015, Financial Management, Principles and Applications, Pearson Education &French Forest Australia, Sydney