Principles of Corporate Finance Chapter 5 Solutions

Chapter 5

Risk and Return

( Suggested Answer to Chapter Opening Critical

Thinking Question

Venture capital is a form of private equity in which capital is raised in private markets as opposed to the public markets. How can the venture capitalists eventually capitalize on their investments?

Venture capital firms investing in new and promising technologies and start-up companies must find a buyer in order to capitalize on their investment. The “exit” or “selling out” is often achieved via an initial public offering (IPO). Another option is to sell their stake in the company to another venture capital firm or private-equity firm.

( Answers to Review Questions

1. Risk is defined as the chance of financial loss, as measured by the variability of expected returns associated with a given asset. A decision maker should evaluate an investment by measuring the chance of loss, or risk, and comparing the expected risk to the expected return. Some assets are considered risk free; the most common examples are U.S. Treasury issues.

2. The return on an investment (total gain or loss) is the change in value plus any cash distributions over a defined time period. It is expressed as a percent of the beginning-of-the-period investment. The formula is:

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Realized return requires the asset to be purchased and sold during the time periods the return is measured. Unrealized return is the return that could have been realized if the asset had been purchased and sold during the time period the return was measured.

3. a. The risk-averse financial manager requires an increase in return for a given increase in risk.

b. The risk-indifferent manager requires no change in return for an increase in risk.

c. The risk-seeking manager accepts a decrease in return for a given increase in risk.

Most financial managers are risk averse.

4. Scenario analysis evaluates asset risk by using more than one possible set of returns to...