# UCLA ECON 103 - Chap013 (1) (7 pages)

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## Chap013 (1)

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- Pages:
- 7
- School:
- University of California, Los Angeles
- Course:
- Econ 103 - Introduction to Econometrics

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Chapter 13 Risk Analysis Solutions to Questions Chapter 13 Risk Analysis Question 13 1 What is meant by partitioning the internal rate of return Why is this procedure meaningful To illustrate what is meant by partitioning the IRR remember that the IRR is made up of two components of cash flow 1 cash flow from operations and 2 cash flow from the sale of the investment Partitioning is done to obtain some idea of the relative weights of these components of return and to get an idea of the timing of the receipt of the largest portion of that return Partitioning is meaningful because it helps the investor to determine how much of the return is from annual operating cash flow and how much is from the projected resale cash flow Operating cash flow is generally more certain than projected resale cash flow Therefore the greater the proportion of resale cash flow versus operating cash flow the greater the risk facing the investor This could be useful in comparing multiple investments Question 13 2 What is a risk premium Why does such a premium exist between interest rates on mortgages and rates of return earned on equity invested in real estate A risk premium is a higher expected rate of return paid to an investor as compensation for incurring additional risk on a higher risk investment In general investors are considered risk averse and must be compensated more for the higher risk of some investments This premium exists between mortgage interest rates and returns on equity invested in real estate because the equity investor is assuming more risk than the mortgage lender The lender assumes less risk because a lender would have first claim on the property should there be a default If this were not the case the investor would be better off lending on real estate than investing in it Question 13 3 What are some of the types of risk that should be considered when analyzing real estate and other categories of investment Business Risk Financial Risk Liquidity Risk Inflation Risk Management Risk Interest Rate Risk Legislative Risk Environmental Risk Question 13 4 What is the difference between business risk and financial risk Business risk is the risk of loss due to fluctuations in economic activity that affect the variability of income produced by a property Financial risk or debt financing referred to as financial leverage magnifies the business risk Financial risk increases as the amount of debt increases Question 13 5 Why is the variance or standard deviation used as a measure of risk What are the advantages and disadvantages of this risk measure Lower variability in returns is considered by many analysts to be associated with lower risk and vice versa Therefore by using a statistical measure of variance one has an indication of the extent risk is present in an investment The standard deviation gives us a specific range over which we can expect the actual return for each investment to fall in relation to its expected return It has the advantage of being relatively easy to calculate It has the disadvantage of treating the both higher than expected returns and lower than expected returns the same It could be argued however that investors should be more concerned about returns being lower than expected or lower than some threshold return 13 1 Chapter 13 Risk Analysis Question 13 6 What is meant by a real option A real option is an option related to investment in tangible assets like real estate that involves the option to wait to decide whether to invest additional capital based on future economic conditions Land can be viewed as having the option to invest additional capital in the future to construct a building Question 13 7 What is meant by the term overage for retail space Overage refers to the rent that is paid above the minimum rent in the lease where the rent is based on a percentage of the tenant s sales once sales exceeds a specified breakpoint The total rent is the minimum rent plus the overage rent Question 13 8 How does the use of scenarios differ from sensitivity analysis Sensitivity analysis involves changing one variable at ta time such as the market rent or the vacancy rate Scenarious involves changing several variables at once for each scenario e g a pessimistic most likely and optimistic scenario For each scenario there might be a different assumption about market rents vacancy rates and the resale price because they are interrelated Solutions to Problems Chapter 13 Risk Analysis Problem 13 1 Investment A Year 1 2 3 4 BTCF 5 000 10 000 12 000 15 000 PV 4 501 8 103 8 753 9 849 4 sale 120 000 78 792 109 998 Difference from 110 000 due to rounding of IRR The BTIRR for Investment A is 11 09 percent This is used as the discount rate for calculating the present value Present value of BTCFO is 31 206 Present value of BTCFS is 78 792 Investment B Year 1 2 3 4 BTCF 2 000 4 000 1 000 5 000 PV 1 774 3 145 697 3 092 4 sale 180 000 111 301 120 009 Difference from 120 000 due to rounding of IRR The BTIRR for Investment B is 12 77 percent This is used as the discount rate for calculating the present value 13 2 Chapter 13 Risk Analysis Present value of BTCFO is 8 708 Present value of BTCFS is 111 301 a The BTIRR for investment A is 11 09 and the BTIRR for investment B is 12 77 b For investment A PVATCFO is 31 206 110 000 or 28 and PVATCF S is 78 792 110 000 or 72 For investment B PVATCFO is 8 708 120 000 or 7 rounded and PVATCF S is 111 301 120 000 or 93 c Investment B is much more dependent on the reversion It might be considered more risky because there is often more uncertainty about the estimated resale price than the cash flow from operations especially when there are leases on the property Problem 13 2 INVESTMENT I Optimistic Most Likely Pessimistic 1 Estimated BTIRR 15 00 10 00 5 00 2 Expected Return 10 00 10 00 10 00 3 Deviation 1 2 5 00 0 00 5 00 4 Squared Deviation 25 00 0 00 25 00 5 Probability 0 20 0 60 0 20 Variance Std Deviation 6 Product 4 x 5 5 00 0 00 5 00 10 00 3 16 INVESTMENT II Optimistic Most Likely Pessimistic 1 Estimated BTIRR 20 00 15 00 5 00 2 Expected Return 14 00 14 00 14 00 3 Deviation 1 2 6 00 1 00 9 00 4 Squared Deviation 36 00 1 00 81 00 5 Probability 0 20 0 60 0 20 Variance Std Deviation 6 Product 4 x 5 7 20 0 60 16 20 24 00 4 90 The expected BTIRR and standard deviation of the BTIRR are calculated above for Investment I and II The expected BTIRR is higher for Investment II 15 vs 10 but the standard deviation is …

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