As firms age, managers may expand activities a firm engages in. As a firm’s scope of activities is widened, diversification may affect a firm’s overall level of risk. Risk is measured by the standard deviation of project returns. Chapter 9 (section 9.3) introduces the principle of diversification as a means of reducing or eliminating firm-specific risk. CAPM (see p. 340 of our required textbook) utilizes the principle of diversification to identify an efficient portfolio of assets maximizing investment returns for a given level of market risk. Beta, or a measure of the sensitivity of a stock or portfolio to market risk, is an element of CAPM especially helpful to a firm’s financial managers and investors. This discussion revolves around a firm’s use of these tools in determining how a new investment project may potentially affect the firm. The new project appears to have a different risk profile than other elements of the firm. In this case, financial managers must make decisions as to how the new project will be assessed from a financial standpoint.
Module 6: Case Transcripts
National Opera House Risk Profile Presentation
You are proud to be employed as a financial manager for a historic National Opera House (NOH), a fictional entity based in a major city in the United States. The NOH is home to the nation’s oldest professional opera and ballet companies. Like many opera houses, however, the NOH saw a decline in demand for its performances as the digital age brought increased use of streaming services and lower demand for traditional arts and cultural performances. The nation’s median age has grown younger, steepening the decline in interest in traditional entertainment.
Measures taken to expand the NOH’s portfolio of activities to date have not significantly changed the risk-profile of the NOH. Shareholders receive a comfortable return on invested funds. Shareholders expressed support for the continuation of traditionally popular performances, such as La Traviata and Swan Lake, and only reluctantly agreed to periodic performances of the House’s opera and ballet companies at innovative venues. Shareholders allowed the opera and ballet to perform abroad at high-profile locations, including Paris, Moscow, and London, for instance. Facilities were updated to freshen and modernize seating, staging, and public areas. Museum-like components were incorporated into facilities, showcasing the rich history of NOH. Merchandise sales were introduced to complement other offerings. A café and formal dining areas were added, and performance dates and times were increased. Costuming was revised. All these activities were assumed to be only as risky as past activities in which the NOH had engaged.
Revenues have failed to achieve expected levels of growth after these changes were implemented. Management is troubled by variations in cash flows. Variations in cash flows indicate risk. The NOH’s revenues are sensitive to variations in market activity, indicating a high Beta or firm-specific risk. To address this risk, managers are hoping to launch a new project called “NOH Live.” The theater is currently reviewing this project. NOH Live will engage audiences through digital audio and video content on a live-streaming platform. Interviews, commentary, and news items will be streamed alongside traditional performances in an effort at educating and engaging a younger audience. Well-known arts and fashion publications, news outlets, and numerous non-profit organizations have approached the NOH pledging funding in return for advertising opportunities, and government and municipal authorities each pledged continuing financial support. These funding sources are not expected to vary with market activity. Managers believe that an evolving marketplace presents both a challenge and an opportunity for an organization working to balance a storied history with a need to move forward quickly into new markets and revenue sources. Revenue sources for this project are expected to be less variable than revenues from all other existing projects. Managers feel confident that NOH Live will reduce risk associated with the NOH and improve the firm’s overall financial position by improving revenue flows with minimal investment in infrastructure. Managers also expect that NOH Live will reduce dependence on short and long-term financing used to bridge market downturns when revenue falls to a greater extent than demand in other areas of the economy.
To move forward with this project, your team will determine a rate of return acceptable to shareholders. Shareholders’ required return depends on the risk-level of a new project in relation to the firm’s existing projects. For this reason, your team is assigned to present the risk-profile of NOH Live to the Board. This risk-profile presentation will illustrate the effect of widening or diversifying the firm’s portfolio of projects. Your team will explain how the present value of future cash flows depends upon the riskiness of those cash flows. The team has determined that it will also address the firm’s Beta. While the firm’s Weighted Average Cost of Capital (WACC) measures the risk of all projects the firm has historically engaged in, Beta measures firm-specific risk. An additional project may raise or lower the firm’s Beta depending on the new project’s level of risk in relation to other projects in which the firm is involved. You plan to explain the implications of this fact to investors.
Remember that your Board consists of arts patrons without financial expertise or training. Based upon this module’s required reading and the background information given, form an initial post covering the following three issues:
• Explain one reason why this project (NOH Live) is expected to lower risk through its effect on the standard deviation of project returns. Consult p. 339 of our required text for information.
• Explain the principle of diversification and draw one parallel between NOH Live and a listed small-cap firm of your choosing in a different sector (see Resource to use below) illustrating how the principle of diversification may lower risk in relation to returns. Refer to pp. 311-317 and 340-346 for more information.
For the principle of diversification to apply, you will want to choose a comparison firm that is dissimilar from NOH Live, such as a radio/media firm called E.W. Scripps (Links to an external site.), which is presented as having stable revenues and a lower Beta than the opera/ballet performance house.
• Comment on limitations of using historical returns to measure firm-specific risk. You may consult pp. 302-309 and 345-346 of our required text for information.