Risk There Are Two Kinds of Risk

Risk

There are two kinds of risk that a company faces. Systematic risk is risk that is inherent in the economy. This risk is generated largely by external factors to the company, such that the company has little control over these factors. This type of risk is faced by all companies (or most of them) within the economy and as a result it is very difficult to diversify systematic risk away. Hence, it is undiversifiable risk. The other type of risk is diversifiable risk. This risk type is generally internal to the company, so it is generated by company-specific factors that are not shared by other companies.

In modern portfolio theory, firm-specific risk factors can be diversified away, if a portfolio has enough other securities and securities from different risk categories. A fully-diversified portfolio should have risk equivalent to the broad market (undiversifiable risk) because the risk associated with any one individual firm would be balanced by opposite risk factors associated with other firms.

If there is a substantial increase in inflation, this would be undiversifiable risk. Inflation is an external macroeconomic factor that affects all firms within the economy. Thus, as long as one is limited to building a portfolio within a single country, inflation represents an undiversifiable risk. When modern portfolio theory was originally developed, it was difficult to invest in foreign companies, whereas today many investors can diversify the risk of single-country inflation away simply by investing in other parts of the world. That said, if inflation in one country affects the price of a global commodity (as U.S. inflation would), then the inflation risk would remain undiversifiable.

A major recession in the U.S. used to be considered undiversifiable, because any U.S. investor would have had a difficult time finding companies whose stock did not decline during that recession. Performance of the entire portfolio would be negative affected by the recession. If we take the past recession in 2008-2009 as an example, we can see how this traditional view is challenged. Certainly for somebody who happened to own Apple or Google during that recession, the portfolio would have outperformed the market. More importantly, with many companies from emerging markets available to U.S. investors, it was possible for an investor to diversify the U.S. recession away simply by owning a portfolio that is globally diversified, even with just securities trading on the NYSE and NASDAQ (for example, owning Baidu.com stock). So while a recession in the U.S. affected a lot of economies around the world and would traditionally have been considered undiversifiable, in today's globalized capital markets this is not necessarily the case anymore. Regional recessions can be diversified away with a truly global portfolio.

A major lawsuit filed against a publicly traded corporation is a firm-specific event. This is a clear-cut case of diversifiable risk, because the downside of losing such a lawsuit mainly affects the one firm in question. Owning a diversified portfolio would all but eliminate the risk associated with this event.

2. The capital asset pricing model is a method of determining the cost of equity for a company. This is based on the historic performance of its stock vs. The broad market, which is reflected in the beta. The formula for CAPM is:

Ra = Rf + ?(Rm-Rf)

a. So given the inputs, the 12 = 4 + (1.2)(Rm-4), we can calculate that 12 = 4 + 1.2Rm -- 4.8

12 = 1.2Rm -- 0.8

12.8 = 1.2Rm

Rm = 10.67%

b. 9 = Rf + (0.8)(10-Rf)

9 = Rf + 8 - .8Rf

1 = .2Rf

Rf = 5

c. The beta of the portfolio, if I owned half of the stocks traded on major exchanges, would be 1.0. This is expected because this portfolio would be fully diversified, and there would be no firm-specific or diversifiable risk left in the portfolio.

The main message of the capital asset pricing model for corporations is that the market's expectation of the firm's return is going to reflect the volatility of the stock price. Management should understand that if the firm is volatile in its outputs (profit, etc.) then investors will demand higher returns. For investors, the message of CAPM is that every security has risk, but by diversifying, some or all of that risk can be eliminated.

Part II. Each form of financing (debt and equity) has specific advantages and disadvantages. Debt financing allows the company to maintain control, and it costs less than equity financing. However, it also places a burden on future cash flows, and sometimes there are covenants that can restrict management activities as well, in order to mitigate risk to the lender. Equity financing tends to cost more, and in early stages can dilute ownership. However, equity financing also allows management to have more flexibility, and does not create cash flow obligations.

For each firm, the choice between equity and debt in the capital structure comes down to a combination or practical considerations and management preference. For American Superconductor, management might have felt that the cash flow considerations warranted equity financing. In addition, companies often prefer to match the term of the financing with the term of the project. Thus, projects that reflect general growth in the company are subject to equity financing. This means that AMSC might have felt that the uses for the funds were sufficiently tied to the general growth of the company, or that the company already faced sufficient cash flow obligations and more would restrict its ability to grow or to invest in future capital projects.