Chapter 2

RISK & RETURN

INTRODUCTION
• A basic premise lies in financial management is that investors like
returns and dislike risk.
• Therefore people will invest in risky assets only if they except to
receive higher returns.
• In any decisions-making situation, a Financial Manager can never
predict with certainty the outcome of the decision.
• Because of this, the FM would need to consider the risk and the
expected return, and their impact on achieving the company’s goal.

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RETURN
Definition
¤ Reward for investing
¤ Consists of :
- Periodic cash payment or current income interest, dividend, rent
- Capital gains (losses) or increase (decrease) in market value asset

SP > PP = CAPITAL GAIN (PRICE APPRECIATION)

SP < PP = CAPITAL LOSS (PRICE DEPPRECIATION)

¤ Example :
Mr. Ehsan purchase 100 shares of Marc stock at RM100 per share. He held the shares for one
year during which time he received dividends of RM0.80 per share. At the end of one year, he
sold the shares when they were RM45 per share.
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CLASSIFICATION OF RETURNS
1. Realized return
- Actual return that has been earned or obtained.

2. Required rate of return (ROR)

- Minimum ROR required by investors to compensated for taking a comparable level a risk.
- 2 basic components :
* Risk-free rate of return for riskless investment (in government securities)
* Risk premium additional return to receive for assuming risk.
As the level of risk increase demand for additional expected return.
Required Rate Of Return ( R) = RISK-FREE RATE + BETA (RISK PREMIUM)

* Risk Premium = expected market return – risk-free rate

* Example
Abba Berhad has a beta 0.55. If the expected return is 12% and the risk-free rate is 4.5%,
calculate the required rate of return of Abba Berhad 4
ANSWER :

REQUIRED RATE OF RETURN

= RISK-FREE RATE + BETA (RISK PREMIUM)

= 4.5% + 0.55 ( 12% - 4.5%)
= 8.63%

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3. Expected rate of return
- Definition the expected benefits or returns an investment generates come in the form of
cash flows.
- Weighted average of all possible returns – weighted by he probability of the occurrence of
that return.
- Cash flow (not accounting profits) is the relevant variable the Financial Manager uses to
measure returns.
- Regardless of the type of security, whether it is a debt instrument, preferred stock, common
stock, or any mixture of these (such as convertible bonds)

EXPECTED ROR (R) = [P₁R₁] + [P₂R₂] + …….. + [PᵢRᵢ]

= ∑ [ Pᵢ x Rᵢ ]

Pᵢ = probability of occurrence of Iᵗ ͪ return

Rᵢ = return associated with the Iᵗ ͪ return

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Example :
1. Calculate the expected rate of return R

Investment Return
Probability
(RM)

0.4 3,000

0.5 2,700

0.1 2,200

= ∑ [ Pᵢ x Rᵢ ]
= 0.4 (3,000) + 0.5 (2,700) + 0.1 (2,200)
= 1200 + 1350 + +220
= RM2770

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Example :
2. Calculate the expected rate of return R

Probability Rates of Return

20% 12%

30% 15%

50% 5%

= ∑ [ Pᵢ x Rᵢ ]
= 0.2 (12) + 0.3 (15) + 0.5 (5)
= 2.4 + 4.5 + 2.5
= 9.4%

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RISK AND RETURN
RELATIONSHIP BETWEEN RISK AND RETURN

RISK
 A chance that some unfavorable event will occur -
hazard or exposure to loss or injury
 Definition the possibility that actual future
return will deviate from expected returns
 Represents the variability of returns (net income,
cash flows, earnings per share, return on investment,
holding period returns, etc)

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Measuring Risk

 VARIANCE [ σ²]
 Refers to the weighted average of squared deviations of possible
occurrences from the mean value (expected return) of the
distribution, with the weights being the probability of
occurrence.
 Measure of return’s volatility average squared differences
between the actual returns & the average return (mean value)

σ² = ∑ Pᵢ ( Rᵢ - R)²

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 STANDARD DEVIATION [σ]

 Statistical measure of dispersion of the probability distribution of possible

returns.
 Measure the risk of returns, in term of the spread of dispersion of the
distribution in the returns.
 Tells how much a particular return can deviate from the average return or
mean return
 If the distribution is very spread out, the returns that will occur are said to
be very uncertain RISKY, and vice versa

σ = ∑ Pᵢ (Rᵢ - R)²

= σ²

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Example :

Return of Langkasuka Bhd

Economic Condition Probability
(RM)
Strong growth 0.4 2,800
Moderate 0.5 2,300
recession 0.1 2,000

a) Calculate the expected rate of return

b) Determine the variance and standard deviation of Langkasuka Bhd

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Calculation :
a) R = ∑ [ Pᵢ x Rᵢ ]
= 0.4 (2,800) + 0.5 (2,300) + 0.1 (2,000)
= 1,120 + 1,150 + 200
= RM2,470

b) σ² = ∑ Pᵢ (Rᵢ - R)²
= 0.4 (2,800 – 2,470)² + 0.5 (2,300 – 2,470)² + 0.1 (2,000 - 2470) ²
= 43,560 + 14,450 + 22090
= 80,100
= 283.02

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 COEFFICIENT OF VARIATION (CV)

 A standardized measure of risk per unit of expected return.

 Ratio of the SD to the expected return measure of relative risk.
 Provides a more meaningful basis for comparison when the
expected return & the SD of alternative investments are not the
same.

CV = Std Deviation / Expected Return

= σ / R

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Example :

Return of Langkasuka
Economic Condition Probability
Bhd (RM)
Strong growth 0.4 3,200

Moderate 0.5 2,500

recession 0.1 1,900

a) Calculate the following :

i.Expected return
ii. Standard of deviation
iii. Coefficient of variation

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Calculation :
a) R = ∑ [ Pᵢ x Rᵢ ]
= 0.4 (3,200) + 0.5 (2,500) + 0.1 (1,900)
= 1,280 + 1,250 + 190
= RM2,720

b) σ = ∑ Pᵢ (Rᵢ - R)²
= 0.4 (3,200 – 2,720)² + 0.5 (2,500 – 2,720)² + 0.1 (1,900 – 2,720) ²
= 92,160 + 24,200 + 67,240
= 183,600
= 428.49

c) CV = σ / R
= 428.49
2720

= 0.1575 @ 15.75%
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Example :

Return of Langkasuka
Economic Condition Probability
Bhd
Optimistic 0.2 0.2

Normal 0.7 0.3

Pessimistic 0.1 0.4

a) Calculate the following :

i.Expected return
ii. Standard of deviation
iii. Coefficient of variation

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Calculation :
a) R = ∑ [ Pᵢ x Rᵢ ]
= 0.2 (0.2) + 0.7 (0.3) + 0.1 (0.4)
= 0.04 + 0.21 + 0.04
= 0.29

b) σ = ∑ Pᵢ (Rᵢ - R)²
= 0.2 (0.2 – 0.29)² + 0.7 (0.3 – 0.29)² + 0.1 (0.4 – 0.29) ²
= 0.00162 + 0.00007 + 0.00121
= 0.0029
= 0.05385 @ 5.385%

c) CV = σ / R
= 0.05385
0.29

= 0.1857 @ 18.57%
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Example :

Project Expected return Standard

Deviation
AA 12% 8%
BB 27% 14%

Which project should financial manager choose ?

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How to choose an investment
alternative
• Situation 1
??
Project X Project Y
R = 33% R = 33%
σ = 6% σ = 12.4%

Conclusion:

Since the standard deviation project Y is higher than

project X, it is shows that project Y is more risky
compared to project X. Therefore, it is better to choose
project X since it gives the same level of return at
lower risk.

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• Situation 2

Project X Project Y
R = 25% R = 36%
σ = 12.4% σ = 12.4%

Conclusion:

In this situation, it is prefer to choose project Y

because it gives a higher return (36%) at the same of
standard deviation (12.4%). In the other word, the
company can earn a higher return at the same risk

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• Situation 3

Project X Project Y
R = 25% R = 38%
σ = 3.25% σ = 9.2%

Conclusion:

In this situation, you need to calculate CV because it

measure of risk per unit. CV for Project X = 13% while
for Project Y = 24.2%. It can conclude that project Y is
more risky compared to Project X since the CV is
higher. So choose project X.

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TYPES OF RISK
• Also known as non-diversifiable risk & marketable risk.
• Attributable to market factors that affect all firms.
• Results from forces outside the firm’s control not unique to the given
security.
• Variability of return on stocks or portfolios associated with changes in return
on the market as a whole.
SYSTEMATIC RISK

• Category :

¤ Purchasing Power Risk possibility that the investor will receive a lesser
amount of purchasing power than was originally invested.
¤ Interested Rate Risk fluctuation in the value of an asset as a result of
the change in interest rates & conditions of the money & capital markets.

• Risk associated with changes in stock prices as a result of a broad swing in the
stock market as whole.
• Unavoidable

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 • Diversifiable risk / unique risk
• Variability of returns on stocks that is not the result of general market movements.
• Specific to a particular firm or industry & they do not affect other firms or
industries in the economy.
• Sources :

¤ Business risk risk that a firm will have general business problems.
UNSYSTEMATIC RISK
¤ Liquidity risk risk that an asset may not be sold on short notice for its
market value [unable to convert asset into cash]
¤ Default risk possibility that the issuing company will be unable to make
interest payments or principal repayments on debt.

• Example labor strikes, shortage of raw materials, shortage of specified skilled

labour, lawsuits, competitor, technological breakthrough
• Can be minimized @ eliminated through diversification.
• Diversification spread an investment over a range of investment instruments in
order to minimize the risk of losing all the investments should one investment go
bad.
• Hold a diversified portfolio consisting of stocks, bonds, real estate & savings
accounts.

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INVESTOR, RISK AND RETURN
3 types of investor (relates with risk & return) :

Risk Averse Risk Taker Risk Indifferent

Dislike risk expose to

the minimum risk level Prefers to take risk
possible.
Same satisfaction from a
risk-free situation & a risky
situation.
Require an increase in Willing to accept a decrease
return to compensate for in return for an increase in
the increase in risk. risk

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RELATIONSHIP BETWEEN RISK AND
RETURN
Risk and return have a positive relationship

The higher risk, the higher the potential return

You CANNOT minimize risk and maximize returns

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