Understanding Risk & Corporate Diversification
This discussion has 2 parts:
Part A: Stock A has a standard deviation of 10% and an expected return of 8%. Stock B has a standard deviation of 15% and an expected return of 11%. A client wants to know which stock has a better risk-return profile. How would you answer her?
Part B: Stock C has a standard deviation of 20% and a beta of 1.20. Stock D has a standard deviation of 16% and a beta of 1.44. A client wants to know which stock is riskier. How would you answer her?
The material in Chapter 8 of the required text clearly illustrates that there are tangible benefits for individual investors that diversify their portfolios. It makes sense then too for corporations do diversify their product or service portfolios. Or does it? Be sure to read the supplemental readings related to corporate diversification and offer your views on whether corporate diversification is beneficial for the owners (i.e., the shareholders) of the corporation.
Your initial post should be at least 200 words, formatted and cited in current APA style with support from at least 2 academic sources. Your initial post is worth 8 points.
You should respond to at least two of your peers by extending, refuting/correcting, or adding additional nuance to their posts. Your reply posts are worth 2 points (1 point per response.)
Post by classmate 1
Part A: To find the risk return profile, we need to find the return stock per unit risk, that is given by Sharpe ratio, in this case we are able to assume risk free rate is zero.
Stock A standard deviation= 10%
Stock A expected return= 8%
Stock B standard deviation= 15%
Stock B expected return is=11%
Ratio= expected return/ standard deviation
Ratio of stock A= 0.8
Ratio of stock B= 0.7333
As we see from our answer, the ratio of stock A is higher than stock B so that means that stock A has a better risk- return profile.
Part B: If a portfolio is well diversified, the relevant risk can be seen in beta and since stock D has a higher beta, that means that Stock D is riskier. If a portfolio is not well diversified, the relevant risk can be seen as the standard deviation so in that case, Stock C can be seen as riskier.
In my opinion, corporate diversification is beneficial to the shareholders because it helps to spread the risk of the corporation into different product or service portfolios. A corporation cannot rely upon a single product or a service line for its revenue. It must diversify into either related or unrelated areas as long as it has the expertise in those areas. This will help the corporation to generate revenues from different product or service lines and when a particular product or service line fails, the firm can recover as long as there are other product or service lines that can generate revenues. Diversification can also help in gaining shareholders confidence as diversification gives an assurance to the shareholders that the firm has a strong financial foundation due to the varied revenue sources the firm enjoys.
Post by classmate 2
When trying to figure out the risk-return profile, as discussed in Part A, the return of stock per unit risk needs to be found. The Sharpe ratio explains in this scenario to assume the risk-free rate to be zero. When calculated, stock A is 0.8, and stock B is 0.7333. I would tell her that stock A has a higher ratio than stock B, so that means that stock A has a better risk-return profile. In part B, I would tell the investor that when describing the calculation, stock C has a higher standard deviation, which means it is riskier than stock D.
Deciding whether corporate diversification is beneficial for the owners of the corporation, understanding the importance of a strategic approach is paramount (Moyer, McGuigan, & Rao, 2018). When a company decides they want to diversify, a series of questions should be answered. For example, in the current market, what can our company do better than any of its competitors? In other words, finding the strengths of the company is crucial. Another question a corporation can ask themselves is what could be learned by diversifying? And are we sufficiently organized to learn it? When diversifying, managers will receive a large amount of data that will include competitive assessment, market forecasts, and internal rate of return calculations. To be successful, these managers must easily interpret this information and learn from it to help make the best-informed decision for corporate shareholders. Diversity improves business outcomes (Herring, 2017). In conclusion, diversification can be done, and companies like Disney and General Electric are testaments of successful corporate diversification.
Herring, C. (2017). Is Diversity Still a Good Thing? American Sociological Review, 82(4), 868-877.
Moyer, R. C., McGuigan, J. R., & Rao, R. (2018). Contemporary financial management. Mason, OH: Cengage-Southwestern.