Unit Two Risk and Return Accounting Finance.ppt

Risk and Return

1. Chapter 2
Risk and Return of Investment
Meaning of Return
the primary motivating force that drives investment.
It is a gain or loss from an investment made. And it does have two
components an income component and a capital gain or loss
component.
The income component is cash you receive while owning the asset
while the capital gain or loss component is when the value of asset
owned is appreciating in price or depreciating.

2. o The return may be defined in terms of
(i)Realized return, i.e., the return which has been earned, and
(ii) Expected return, i.e., the return which the investor anticipates to
earn over some future investment period.
The expected return is a predicted or estimated return and may or
may not occur. The realized returns in the past allow an investor to
estimate cash inflows in terms of dividends, interest, bonus, capital
gains, etc, available to the holder of the investment.

3. Meaning of Risk
•It is the possibility that actual future returns will deviate from expected
returns
•From the perspective of financial analysis then, it is the possibility that
the actual cash flow will be different from forecasted cash flows
(returns). Therefore if an investment’s returns are known for certainty
the security is called a risk free security. An example on this regard is
Government treasury securities.

4. Types of Risks
(I)Systematic Risk/ Non-diversifiable risk
•It refers to that portion of variability in return which is caused by the
factors affecting all the firms. It refers to fluctuation in return due to
general factors in the market such as money supply, inflation,
economic recessions, interest rate, policy of the government, political
factors, credit policy, tax reforms, etc. these are the factors which
affect almost all firms. The systematic risk is also called the general
risk.

5. Types of Systematic Risk:
a)Market risk: The market risk refers to variability in return due to
change in market price of investment. There are different social,
economic, political and firm specific events which affect the market
price of equity shares.
b)Interest Rate Risk: The interest rate risk refers to the variability in
return caused by the change in level of interest rates. Such interest rate
risk usually appears through the change in market price of fixed income
securities.
c)Purchasing-Power Risk/ Inflation Risk: The inflation risk refers to
the uncertainty of purchasing power of cash flows to be received out of
investment. It shows the impact of inflation or deflation on the
investment. The inflation risk is related to interest rate risk because as
inflation increases, the interest rates also tend to increase.

6. (I)Unsystematic Risk/ diversifiable risk
•The unsystematic risk represents the fluctuation in return
from an investment due to factors which are specific to
the particular firm and not the market as a whole. These
factors are largely independent of the factors affecting
market in general.
•Since these factors are unique to a particular firm, these
must be examined separately for each firm and for each
industry. These factors may also be called firm-specific
as these affect one firm without affecting the other firms.

7. •Types of Unsystematic Risk:
(a)Business Risk: Business risk refers to the variability in incomes of the firms and
expected dividend there from, resulting from the operating condition in which the
firms have to operate.
(b)Financial Risk: Refers to how a firm finances its activities. It refers to the
degree of leverage or degree of debt financing used by a firm in the capital
structure. Higher the degree of debt financing, the greater is the degree of financial
risk. The presence of interest payment brings more variability in the earning
available for equity shares. This is also known as financial leverage.
(c) Operational risk: Operational risks are the business process risks failing due to
human errors. This risk will change from industry to industry. It occurs due to
breakdowns in the internal procedures, people, policies and systems.

8. •The operational risk is further classified into following types.
Model risk: Model risk is the risk involved in using various models to value
financial securities. It is due to probability of loss resulting from the
weaknesses in the financial model used in assessing and managing a risk.
People risk: arises when people do not follow the organization’s procedures,
practices and/or rules.
Legal risk: arises when parties are not lawfully competent to enter an
agreement among them. Furthermore, this relates to regulatory risk, where a
transaction could conflict with a government policy or particular legislation
(law) might be amended in the future with retrospective effect.

9. Measures of Historical Rates of Return

11. Example :1
•The following information is given for a corporate bond. Price of the bond
at the beginning of the year: Br. 90, Price of the bond at the end of the
year: Br. 95.40, Interest received for the year: Br. 13.50. Compute the rate
of return.

12. Measuring of historical risk
Example:2
•The rate of return of equity shares of Wipro Ltd., for past six years are given below:
Year 01 02 03 04 05 06
Rate of return (%) 12 18 -6 20 22 24
Solution:
Calculation of Average Rate of Return ( R )
Calculate variance and standard deviation

13. I.
Example3:Suppose have collected returns for New Honda Dealership Inc. and for
Harry’s Automotive Repair Inc. for past 4 years. Based on the return on Dealership
and Repair :
1. Calculate average return
2. calculate variance and standard deviation
Return
Year Dealership Repair
2001 19 14
2002 39 8
2003 15 11
2004 0 19

14. Measuring Expected Return And Risk
•EXPECTED RATE OF RETURN
n
E (R) = p
i
R
i

i=1
STANDARD DEVIATION OF RETURN ( Expected Risk of the return)
 = [ p
i (R
i - E(R) )
2
]
1/2
Example 3:
Mr. Red invested in equity shares of White Ltd., its anticipated returns and associated
probabilities are given below:
Return (%) -15 -10 5 10 15 20 30
Probability 0.05 0.10 0.15 0.25 0.30 0.10 0.05
You are required to calculate the expected rate of return and risk in terms of standard
deviation.

15. Calculation of expected return and risk in terms of standard deviation
Return(R) Probability (P) (P × R) (??????−??????ഥ) (??????−??????ഥ)
??????
(??????−??????ഥ)
??????
x P
-15 0.05 - 0.75 -24.5 600.25 30.0125
-10 0.10 -1.0 -19.5 380.25 38.0250
5 0.15 0.75 -4.5 20.25 3.0375
10 0.25 2.50 0.5 0.25 0.625
15 0.30 4.50 5.5 30.25 9.0750
20 0.10 2.00 10.5 110.25 11.0250
30 0.05 1.50 20.5 420.25 21.0125
1.00 ??????ഥ = 9.5% ∑(??????−??????ഥ)
??????
x P = 112.8125
Expected Return ??????ഥ = 9.5%
Standard Deviation ∑(??????−??????ഥ)
??????
x P = ξ??????????????????.????????????????????????= ????????????.??????????????????

16. Example:
Suppose have estimated possible returns for New Honda Dealership Inc. and Harry’s
Automotive Repair for the coming year based on how the economy does
Return on:
Economy Prob. Dealership Repair
Boom 0.25 40% 6%
Average 0.55 15% 15%
Bust 0.20 -1% 17%
You are required to calculate the expected rate of return and risk in terms of standard
deviation.

Solution:
E(r) Dealership = 0.25(40) + 0.55(15) + 0.2(-1) = 18.05%
E (r) Repair = 13.15%

     198.1475
2
18.0510.2
2
18.05150.55
2
18.05400.25
2
Dealership
σ 
Dealership = 14.08%
Repair = 4.20%
Return is more uncertain for the dealership

17. Coefficient of Variation
•Standard Deviation is an absolute measure. It is not
suitable for comparison, particularly when investment
proposals involve different capital outlay or different
monetary values of probable cash inflows. In such cases, a
relative measure of dispersion should be employed for
comparison. For comparison in such cases, coefficient of
variation approach is the best measure. This realization is
responsible for the emergence of coefficient of variation
approach in capital risk analysis.

18. The formula for the calculation of coefficient of variation is:
?????????????????????????????????????????????????????????????????? ???????????? ??????????????????????????????????????????????????????=
???????????????????????????????????????????????? ??????????????????????????????????????????????????????
????????????????????????

The coefficient of variation suggests that, the more is the coefficient of variation of a project, the
greater is the risk associated with that project.
Example:
Assume you reached at the result of mean of company A and B, were Br 30,000 and Br 35,000
respectively, and Standard deviation of 17,078 and 25,000 respectively, determine Coefficient of
variation:
Answer:
?????????????????????????????????????????????????????????????????? ???????????? ?????????????????????????????????????????????????????? (?????????????????????????????????????????? ??????)=
???????????? ????????????,??????????????????
????????????,??????????????????
?????? ??????????????????=????????????.???????????? %
?????????????????????????????????????????????????????????????????? ???????????? ?????????????????????????????????????????????????????? ሺ?????????????????????????????????????????? ??????ሻ=
???????????? ????????????,??????????????????
????????????,??????????????????
?????? ??????????????????=????????????.???????????? %