SC-FFM

UNIT 8
Risk and Return
Foundations of Financial Management Study Guide

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Table of Contents
Course Outline ..........................................................................................................................................................................4

Unit 8: Risk and Return ........................................................................................................................................................ 6

8.1 Risk and return fundamentals ................................................................................................................................. 7
8.1.1 Investment risk ................................................................................................................................................................ 7
8.1.2 Return on investment ................................................................................................................................................8
8.2 Measuring risk and return ....................................................................................................................................... 10
8.2.1 Calculate the expected rate of return ........................................................................................................... 10
8.2.2 Calculate the annual rate of return on an investment ...................................................................... 12

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Course Outline
The aim and purpose of this course are to introduce students to the world of finance which
is a critical area of competence for managers and owners of businesses. This course is
presented specifically for individuals who are studying finance for the first time. It provides
a solid foundation in the fundamental concepts of finance and introduces the financial
aspects using a practical application approach.

In this course, we will cover the following units:

Unit 1: Introduction to Financial Management

Unit 2: Introduction to Accounting Principles and the Accounting Equation

Unit 3: Financial Statements

Unit 4: Analysis of Financial Statements

Unit 5: Introduction to Working Capital Management

Unit 6: Budgeting and Financial Planning

Unit 7: Time Value of Money

Unit 8: Risk and Return

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Icons

What the icons mean

Readings
Read the sections of the prescribed text listed.

Video/Audio
Access and watch/listen to the video/audio clip listed.

Additional Resources or Readings

Find the recommended information listed.

Reflection
Reflect on the questions or problems posed.

Example
Examples of how to perform an activity or calculation with
the solution/appropriate response.

Knowledge Check
Test the knowledge you have learnt or practice a new skill.

Case Study
Learn from scenarios or real-life examples and apply
critical thinking.

Think Point
Reflect and think about the activities or questions in a
topic or unit.

Vocabulary
Learn and apply these terms.

End of Unit Formative Assessment

Complete the compulsory graded questions at the end of
each unit in the online quiz.

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Unit 8: Risk and Return

Purpose

In Unit 1 three key decision areas of the financial management functions were discussed:
decision-making, financing, and dividends. To make effective long-term investment
decisions management needs to identify the level of risk they are prepared to accept and
the percentage of return they expect to receive for the level of risk taken.
Risk can be viewed in relation to a single asset or a portfolio of assets. In this unit, we only
look at the risk of a single asset, specifically the investment of company shares. To maximise
the share price the management team must learn to assess two key determinants: risk and
return. Each financial decision presents certain risk and returns elements, and the unique
combination of these elements has an impact on the business
Learning outcomes
By the end of this unit, you should be able to explain the concept of risk and return and
its impact on financial decision-making as well as calculate the expected and actual
rate of return of an investment.

Unit outcomes

1. Explain the relationship between risk and return;

2. Calculate the actual return on an investment; and
3. Calculate the expected rate of return on an investment.

Unit duration

12 Hours

Vocabulary
Important terms and definitions

The possibility that the actual outcome will differ from the expected
Risk
outcome.
The risk that a business will not be profitable. Business risk includes the
Business risk
uncertainty surrounding the industry in which a business operates.
The risk is that a business will not be able to pay the interest on debt
Financial risk
and/or repay its debt when it falls due.
Refers to the combination of business and financial risk.
Combined risk

The expected return is the sum of the values of each possible outcome
Expected return
multiplied by the probability (or likelihood) of each outcome.

Introduction

This unit aims to give you a fundamental knowledge of the relationship between the return
that investors seek from an investment and the methods of assessing the risk of the
investments.

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Start of unit reflection

How familiar are you with the content covered in this unit? Rate your current competency
against the Learning Outcomes for this unit on the following scale:

1 = Novice This subject matter is completely new to me.

I have a basic understanding of the subject
2 = Partial understanding or competence
matter but still, require support.
3 = Average understanding or I have a fair grasp of the subject matter and
competence its application.
I have a strong grasp of the subject matter
4 = Above average understanding or
and could easily apply it in a variety of
competence
contexts.
I have mastered this subject area, and I
5 = Expert
could teach it to others.

Unit Learning Outcomes Your rating

LO1: Explain the relationship between risk and return.

LO2: Calculate the actual return on an investment.

LO3: Calculate the expected rate of return on an investment.

8.1 Risk and return fundamentals

This topic will define and explain risk and return, and the relationship between risk and
return. Different investors have different risk preferences.

The video explains what risk and return is. Watch this video.

Video What are Risks and returns? (1.34 minutes)

At: https://www.youtube.com/watch?v=Zv8j1noeu-A

8.1.1 Investment risk

Risk is the chance of financial loss. Assets that have a greater chance of loss are viewed as
riskier than those with a lesser chance of loss.
The amount of risk can be determined by the extent of the variance between the actual
outcome and the expected outcome. In other words, how big the difference is between
what happened and what is expected to happen. In financial management, we refer to
investments as either risk-free investments or risky investments. The return on a risk-free

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investment is much lower, but the risk of losing your principal investment and returns are
a lot less. In some cases, you are even guaranteed to receive the specified return on your
investment.

The reason for shares being a risky investment relates to the fact that you may lose your
original investment amount. However, the potential returns on shares are greater than on
government bonds, as higher risks are rewarded with higher returns.

All investors require a return commensurate with the level of risk taken. The extent of the

investors respond to risk in different ways. Certain investors are more risk-averse than
others.

Investors may be categorised into three risk categories:

• Conservative - A conservative investor is risk-averse and will select the investment
with the lowest possible risk. The conservative investor will generally select
investments that offer a lower risk and a lower return.
• Moderate - The moderate investor is neutral towards risk.
• Aggressive - The aggressive investor is a risk-taker and prefers investments with
higher risk. The aggressive investor will generally select investments that offer
higher risk and a higher return.

There are two types of risks:

• business risk; and

• financial risk.

Business risk is the risk that a business will not be profitable. Business risk includes the
uncertainty surrounding the industry in which a business operates. Numerous factors
affect business risks, such as demand for a product, sales price variances and cost variances.

• Demand variance - A decrease in demand for a product (i.e. a decrease in sales

volume) due to competition or recession would increase the business risk.

• Sales price variance - An increase in the selling price of a product due to an increase
in the cost of materials and/or overheads could result in a decrease in sales volume
and therefore an increase in business risk.

• Cost variance - An increase in the cost of materials and/or overheads would

decrease operating profit and therefore increase the business risk.

Financial risk is the risk that a business will not be able to pay the interest on debt and/or
repay its debt when it falls due. Financial risk, therefore, relates to the amount of debt a
business incurs to finance the business operations. Higher levels of debt increase the
financial risk of the business. Combined risk refers to the combination of business and
financial risk.

8.1.2 Return on investment

The return on an investment is the reward or compensation for selecting a certain risk
profile.

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Return on an investment in the shares of a company comprises two elements:

• dividend income; and
• increases in the value of the shares.

Return is normally expressed as a percentage of the initial price of an investment. The

nature of the relationship between risk and return is such that as the expected level of risk
increases, the level of expected return also increases.

The comparison of possible investments should take both the expected return and
expected risks into consideration. Investment decisions cannot be made solely on the
expected returns.

The relationship between risk and return is said to be linear or direct because the higher
the risk, the higher the expected return. You may depict the relationship between risk and
return as follows:
higher higher
lower lower

Knowledge Knowledge Check: Return on Investment

Check
1. When the expected risk increases, the level of expected return will
decrease. Indicate if the following statement is true or false.

2. The risk that a business will not be profitable is called __________risk

and the risk that a business will not be able to repay its debt is called
financial risk.
3. The ______________ investor is a risk taker that prefers high risk
investments.

4. An increase in the selling price of a product due to an increase in the

cost of materials and/or overheads is considered to be an element of:
a) Business risk
b) Financial risk
c) Combined risk
d) Demand risk

5. The riskier the investment, the _______________the expected return.

a) higher
b) lower
c) more constant
d) none of the above

6. Different investors respond to risks in different ways. Certain

investors can accept more risk than others. Regarding this, name
and describe the three categories of investors, in line with the level
of risk that they will tolerate.

Solutions:

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1. False. When risk increases the investor expects to receive higher

returns on the investment.
2. The risk that a business will not be profitable is called business risk
and the risk that a business will not be able to repay its debt is
called financial risk.
3. The aggressive investor is a risk taker that prefers high-risk
investments.
4. The correct answer is (A).
5. The correct answer is (A).
6. Conservative risk-averse, will select the investment with the
lowest possible risk
Moderate neutral towards risk
Aggressive risk-taker and prefers investments with higher risks.
Will require higher returns on risky investments.

8.2 Measuring risk and return

This topic aims to develop an understanding of the balance between the return that an
investor seeks from an investment and the methods of assessing the risks of the
investment. You will learn how to calculate the annual rate of return and the expected rate
of return which should assist an investor in making a financial decision.

This section reviews an issue that has already been established, namely that the
performance of any investment is measured by the percentage of return, expressed on an
annual basis. This formula is consistent with a fundamental objective of financial
management, which is to maximise shareholder/investor wealth.
In the second section, you will learn how to calculate the annual rate of return and the
expected rate of return. You need to note that for this course you will only learn how to
calculate the annual rate of return and expected rate of return for investment for one year.

8.2.1 Calculate the expected rate of return

While information about current and past returns is useful, managers are more concerned
with the expected return on the investment. Estimating the expected return is
complicated because many factors may affect that estimate such as the current economic
conditions, industry conditions and market conditions. The emphasis is on the word
expected.
It is easier to estimate the expected return on investments that have a track record (history)
of past performance. Certain investments will not have a record of past performance. When
calculating the expected return probabilities are assigned to different expected returns.
The expected return is the sum of the values of each possible outcome multiplied by the
probability (or likelihood) of each outcome.
The expected return on an investment may be calculated using the following formula:

n
Re = ∑j=1 Pj x Rj

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Where
Re = expected return
Pj = the probability that the outcome j will occur
Rj = the return for the outcome j

Where the expected return = Probability x Return for the outcome

Example Calculation of Expected Return on Investment

For example, you are considering investing in a company, and you are
provided with the expected returns and the likelihood of each
expected return. What is the expected rate of return on this
investment?

Start by first changing the probability to a decimal by saying

23 ÷ 100 = 0.23

and then multiply the probability with the possible return.

Possible Return Probability Weighted Value

12% 23% 2.76%
16% 52% 8.32%
20% 25% 5.00%
100% 16.08%

Calculations:
(12 x 0.23) + (16 x 0.52) + (20 x 0.25) = 16.08%
The video explains how to calculate expected returns by comparing two investments.
Watch this video.

Video How to find the Expected Return on Risk (6.52 minutes)

At: https://www.youtube.com/watch?v=h7Fqk529BP0

Investment risk is the idea that an investment will not perform as expected and that the
actual return will deviate from the expected return. Risk is measured by the difference
between actual returns and expected returns. This difference is referred to as the variance.
The variance is measured by calculating the standard deviation.

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The calculation of standard deviation does not form part of this module. You only need to
understand that returns with a large standard deviation indicate a greater risk.

8.2.2 Calculate the annual rate of return on an investment

Return on investment may be measured after events have taken place. To measure this,
you need to know that returns are created in two ways:
• the investment creates income; and
• the investment gains (or loses) value.

To calculate the annual rate of return on an investment, the following information is

required:
• the income created;
• the gain (loss) in value; and
• the original value at the beginning of the year.

The formula used to calculate the annual return on investment is:

D0 +( P1 - P0 )
The percentage return = X 100
P0

The formula above can also be written as

Income from Investment (Income from the investment - Gain from Sale)
The percentage return = x 100
Original Value of Investment

This video explains the percentage return on investment. Watch this video.
Video Calculating the Total Return on a Stock (4.30 minutes)

At: https://www.youtube.com/watch?v=3Y1J_6xWDKc

Example Calculate Annual Rate of Return on Investment

If you buy a share for R100 today and it pays an R2 dividend, and a year
later the market price is R105 then your actual return on this
investment will be:

2 + (105 - 100) 7
The percentage return = x 100 = x 100 = 7%
100 100

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The 7% return represents the capital gain of R5 in the price of the

share and the R2 dividend.

Knowledge Knowledge Check: Measuring Risk and Return

Check

1. Risk can be measured by using the statistical indicator called the

______________.

2. Michelle purchased shares in Gold Limited a year ago for R145 per
share. A dividend of R12.40 per share was paid at the end of the year.
The shares are currently trading for R185. What rate of return did
Michelle earn on the investment in Gold Limited shares?

3. You purchased shares in Texas Taxi a year ago for R48 per share. A
dividend of R2.80 per share was paid at the end of the year. The
shares are currently trading for R88 each. What rate of return did you
earn on your Texas Taxi shares?
a) 94.21%
b) 48.64%
c) 89.17%
d) 22.73%

4. You are considering investing in one of two companies TryMe

Limited and WishMore Limited. The possible returns have been
estimated as follows:
TryMe Limited WishMore Limited

Possible Probability Possible Probability

Return Return

14% 50% 13% 25%

17% 25% 19.50% 50%

22% 25% 23% 25%

Solutions:

1. Risk can be measured by using the statistical indicator called the

standard deviation.
2. Michelle purchased shares in Gold Limited a year ago for R145 per
share. A dividend of R12.40 per share was paid at the end of the year.

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The shares are currently trading for R185. What rate of return did
Michelle earn on the investment in Gold Limited shares?
12.40+(165-145)
Rate of return = x 100 = 52.40 ÷ 145 = 0.3614 x 100 = 36.14%
145

3. The correct answer is (C).

4. You are considering investing in one of two companies TryMe
Limited and WishMore Limited. The possible returns have been
estimated as follows:

TryMe Limited

Possible Return Probability Weighted Value

14% 50% 7%

17% 25% 4.25%

22% 25% 5.5%

Expected Rate 16.75%

Calculation:
14 x 0.50 = 7%
17 x 0.25 = 4.25%
22 x 0.25 = 5.5%

WishMore Limited

Possible Return Probability Weighted Value

13% 25% 3.25%

19.50% 50% 9.75%

23% 25% 5.75%

Expected Rate 18.75%

Unit conclusion

This unit defined risk and return, the relationship between risk and return, risk preferences
and the types of risk. In addition, calculations of the actual rate of return and expected rate
of return were performed.

End of unit reflection

Now that you have worked through Unit 8, rate your own competency against the Learning
Outcomes for this unit using the following scale:

1 = Novice This subject matter is completely new to me.

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2 = Partial understanding or I have a basic understanding of the subject

competence matter but still, require support.
3 = Average understanding or I have a fair grasp of the subject matter and
competence its application.
I have a strong grasp of the subject matter
4 = Above average understanding or
and could easily apply it in a variety of
competence
contexts.
I have mastered this subject area, and I could
5 = Expert
teach it to others.

Unit Learning Outcomes Your rating

LO1: Explain the relationship between risk and return.

LO2: Calculate the actual return on an investment.

LO3: Calculate the expected rate of return on an investment.

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