RISK AND RETURN

Refer to Chapter 6 of your prescribed text book.

1. INTRODUCTION
The objective of the financial manager is to maximise the wealth
of shareholders. To do this the financial manager has to assess
the risk-return relationship of each business decision. In other
words, the financial manager has to determine if the return is
adequate compensation for the risk involved.

2. DEFINITION OF RETURN
The total gain or loss on an asset over a period of time. The gain
or loss consists of the change in value of the asset (an increase
or decrease) plus any net cash inflow generated by the asset.
Return can be calculated over a single period (eg. 1 year) or
multiple periods (using averaging).

a. Annual Return (return over a single period)

Refer to ex. 6.1 pg. 106

b. Averaging multiple rates of return

1. The arithmetic mean
2. The geometric mean
3. The internal rate of return

Refer to ex. 6.2 pg. 107

 3. DEFINITION OF RISK
The potential for an unfavourable outcome is risk.
What is the difference between risk and uncertainty?
Risk can be measured using available data as a result of previous
experience and can be evaluated by means of statistical
measures. While, uncertainty cannot be measured.

GENERAL DEFINITION OF RISK

Risk is exposure to loss or injury, or the chance that something
unwanted will happen.

BROADER DEFINITION
Risk is the probability (chance) of a deviation from the expected
value, that is, the likelihood that the outcome will not be what we
expect.

We can also say that risk is the amount by which income from an
investment can vary or differ from what you expect.

Probability theory makes it possible to predict what the chances

are of each possible event happening.
 4. TYPES OF RISK
Self-study the theory below:
Entrepreneurs face risk in 4 areas namely:
1. Business risk
2. Financial risk
3. Investment risk
4. Liquidity risk

DEFINITION OF BUSINESS RISK

Risk associated with the day-to-day activities of the firm: there is
always a possibility that the income of a firm will not be enough to
cover its costs.
The amount of risk to which a firm is exposed is influenced by the
technological stage of development of the industry, competition,
trade unions, the labour situation, the degree of fixed versus
variable costs of production as well as the ability of the marketing
division to positively influence cash inflows.
Business Risk can also be viewed as the inherent uncertainty
regarding the ability of the earnings before interest and taxes
(EBIT) to cover the operating costs of the firm.
DEFINITION OF FINANCIAL RISK
There is always a possibility that the firm will not have enough
income to pay off its debt and interest payments. Financial risk
arises from the decision to use more debt or less debt in the
capital structure. Financial risk depends on the amount of
financing provided by creditors. The use of debt, leases or
preference shares exposes the firm to more risk. The risk arises
from a fixed cost attached to debt financing which produces a
prior claim on the firm’s cash flows ahead of ordinary
shareholders.

A high proportion of debt in the capital structure raises the risk

profile of the business and therefore increases the firm’s financial
risk.

DEFINITION OF INVESTMENT RISK

Is the probability of earning a return that is less than the expected
return. The greater the chance of a low or negative return the
riskier the investment.
DEFINITION OF LIQUIDITY RISK
Liquidity risk refers to situations where a firm experiences a
probability of loss due to its inability to satisfy its short term
obligations as they become due. This risk can arise due to the
firm not having enough cash to satisfy creditors, unable to convert
illiquid assets to cash at its fair value or unable to sell current
assets in time due to lack of buyers.

5. INVESTORS RISK PREFERENCES

Self-study the theory below:

3 Basic categories of investors

• Risk-indifferent – doesn’t matter if there is a change in
risk as long as they get their required rate of return.
They are not interested in exploring the effects of
changing risk.
• Risk-averse - these investors will only accept an
increase in risk if the return increases enough to make
the risk worth wile. They would rather go for investments
with a fixed return and avoid investments like shares, as
the share price keeps changing.
• Risk-seeking - will look for an increase in risk and will
accept a lower return when the risk is higher.
Self-study the theory below:
6. CATERGORIES OF RISK
• UNIQUE OR DIVERSIFIABLE RISK
Portion of the assets risk that you can avoid by
diversifying your investments. The cause of diversifiable
risk are specific to the particular firm, ex. legal actions,
strikes or loss of key employees.
• NON-DIVERSIFIABLE RISK
Risk that you cannot eliminate by diversifying your
investments. Involves risk of a failure of a whole system
or industry and is caused by market factors like drought,
floods, war, etc.
7. MEASURING NON-DIVERSIFIABLE RISK
The Capital Asset Pricing Model
(this is the same model used in Valuations in the
discounting dividends and expected share price model).
You must be able to use the CAPM in the valuation
chapter.
If investors feel that a firm has become less riskier, they
become more relaxed and may be satisfied with a lower
return on their investment. The beta coefficient , β, measures
non-diversifiable risk. If, β, more than one means that
investors require a higher return. If, β, is less than one it
shows that investors are satisfied with return below the
general market level.
 CAPM describes the relationship between the ROR and
non-diversifiable risk of the firm:

Kj = Rf + [βj x (km – Rf) ]

Where:
Kj = required return on the asset on asset j.
Rf = the risk free rate, normally the rate of return on
government bonds, as we consider these investments to
be risk free.
βj = beta for asset j.
km = the market return,

8. MEASURING RISK OF INDIVIDUAL SECURITIES

NB: refer QU 1 AND 2 to introduce these concepts

We can use Statistics to measure the risk of an asset
quantitatively, that is, to measure the risk and express it as a
number. We do this by looking at the probability of occurrence, for
example if there is a 60% probability of occurrence, we can
expect the given outcome to occur 6 out of 10 times.

A probability distribution is a series of possible outcomes with a

probability attached to each outcome.

We will calculate the following:

1. Expected return or mean: is the weighted average of
possible outcomes.
2. Variance: the sum of the difference between each probable
outcome and the expected return, squared and then
multiplied by the probability of each return.
3. Standard deviation: is a measure of total risk. It measures
how “tightly/closely” the probability distribution is centred on
the expected value. The greater the standard deviation, the
greater the risk.
4. Coefficient of variation (COV): measure of relative
dispersion that is useful in comparing the risk of assets with
differing returns. The greater the COV, the greater the risk.