AE19- FINANCIAL MANAGEMENT

INVESTMENTS, RISKS AND RATES OF RETURN

TYPES OF RISKS
Business risk and financial risk combine to determine the total risk of a firm’s future return on equity.

A. BUSINESS RISK- a risk INHERENT in a firm’s operations, which arises from uncertainty about future
operating profits and capital requirements. Business risks depend on, but not limited, to the following:
a) Variability in product demand (example: cars vs. food in times of financial problems)
b) Exposure to variability in sales price and input costs (example: Samsung may be able to pass
unexpected costs to their customers)
c) Ability to bring new products to the market- the slower this ability, the greater the business risk.
Being faster to the market allows companies to more quickly respond to changes in consumer
desires
d) International operations- in every international transaction, there will be a risk of currency
fluctuation and political risk
e) Operating leverage- the higher the percentage of a firm’s fixed costs (high degree of operating
leverage), the higher the business risk.

B. FINANCIAL RISK- the additional risk placed on the common shareholders as a result of the decision to
finance with debt. If a firm uses debt (financial leverage), then the risk is concentrated on the
common stockholders.

Problem:
ABC Company is deciding whether the amount of P300,000 that it needs should be financed purely
in equity (common shares) or a mixture of debt and equity.

Two proposals are to be considered:

Proposal A is financed with all equity.
Proposal B which will be financed with equity (P225,000) and with debt ( P75,000) at an interest rate
of12%.

The budget for the upcoming year’s operations are as follows:

Sales Price - P3.00 Expected sales in units - 80,000
Variable cost per unit -P1.20 Tax rate - 30%
Fixed cost -P90,000

1) Which proposal would generate the greater return on equity?

2) At what point would the other proposal generate a higher return on equity?

MEASURES OF RISK
No investment should be undertaken unless the expected rate of return is high enough to
compensate for the perceived risk. Try to answer this question: Where would you rather invest, in stocks of
an oil company or in a treasury bill where both investments have an expected rate of return of 10%?
Investment risk then is related to the probability of actually earning a low or negative return.
The greater the chance of a low or negative return and the larger the potential risk, the riskier
the investment.

Illustration: How to determine expected rate of return.

You are trying to decide which of the two companies below you should invest in. The expected rate of return
for both companies are given in the table.
Demand for product Probability Rate of return (ABC Rate of Return (XYZ
Company) Company)
Strong 30% 60% 30%
Normal 40% 10% 10%
Weak 30% (40%) (10)

Determine the expected rate of return for both companies.

STANDARD DEVIATION
The measure of risk that measures the tightness of the probability distribution. The tighter the
probability distribution of expected future returns, the smaller the risk of a given investment.
 The greater the standard deviation of the expected return, he riskier the investment. A large
standard deviation implies that the range of possible returns is wide, i.e. the probability distribution is broadly
dispersed. Conversely, the smaller the standard deviation, the tighter the probability distribution and the
smaller the risk.

Steps in calculating the standard deviation:

1) Calculate the expected rate of return.
2) Subtract the expected rate of return from each possible outcome to obtain a set of deviations.
3) Square each deviation then multiply the squared deviations by the probability of occurrence for each
related outcome. Sum these products to obtain the variance of the probability distribution.
4) Find the square root of the variance to arrive at the standard deviation.

Exercise: Compute for the standard deviation of ABC Company and XYZ Company in the previous illustration.
1) ABC Company
Rate of Expected Rate Deviation Squared Probabilities Squared
Return of Return from Expected Deviation Deviation x
ROR Probability

Variance
Standard deviation

2) XYZ Company
Rate of Expected Rate Deviation Squared Probabilities Squared
Return of Return from Expected Deviation Deviation x
ROR Probability

Variance
Standard deviation

COEFFICIENT OF VARIATION- standard deviation divided by expected rate of return.

This shows the risk per unit of return, and it provides a more meaningful basis for comparison than
the standard deviation when the expected returns on two alternatives are different.

Illustration: ABC Company uses the coefficient of variation to compare the returns and risks of projects. The
expected returns and standard deviations of returns for its Sapphire project and Ruby project are shown
below.

Sapphire project Ruby project

Expected return 10% 12%
Standard deviation 40% 54%

Which project would be evaluated as riskier based on the coefficient of variation?

OTHER TYPES OF RISKS

1) Market risk- the possibility that an individual or other entity will experience losses due to factors that
affect the
overall performance of investments in the financial market. Market risk, or systematic risk,
affects the performance of the entire market simultaneously. This risk is also called
undiversifiable risk.

2) Liquidity risk- the possibility that an asset cannot be sold on short notice for its market value. If an asset
is sold at high discount, it is said to have a substantial amount of liquidity risk. Note that an asset is
liquid if it can be sold or converted to cash on short notice. If an asset is not liquid, investors will
require a higher return for it than for a liquid asset.
3) Political risk- the risk that a foreign government may act in a way that will reduce the value of the
company’s investment. It maybe avoided by making foreign operations dependent on the domestic
parent for
technology, markets and supplies.

4) Exchange rate risk- the risk of loss because of fluctuations in the relative value of foreign currencies. This
occurs
when amounts to be paid or received are denominated in foreign currency.

5) Interest rate risk- the risk that an investment security will fluctuate in value due to unexpected
fluctuations in
interest rates. Interest rate risk is mostly associated with fixed-income assets (e.g.
bonds)rather than with equity investments. The interest rate is one of the primary drivers of a
bond’s price.

6) Credit risk- the possibility that a borrower will not be able to meet his financial obligation, such as paying
back a
loan or making a payment on a credit card. It can also refer to the risk that an investment will
lose value or go into default.

7) Company risk- the risk inherent in a particular investment security. Since individual securities are
affected by the
strength and weaknesses of the issuer, this risk can be offset by portfolio diversification. This
risk is also known as unsystematic risk or diversifiable risk.

BETA COEFFICIENT- also known as beta factor, is a statistical measurement of how much an investment
or security
moves in relation to the overall market. High beta stocks, which generally means any stock
with beta
higher than 1.0, are supposed to be riskier but provide higher returns potential. Lower beta
suggests
lower risks but also potentially lower returns.

PRACTICE EXERCISES:
1) An investment security with high risk will have a (an):
a) Lower expected return c) high standard deviations of risk
b) Increasing expected rate of return d) lower price than an asset with low risk

2) The marketable securities with the least amount of default risk are:
a) Government securities c) commercial papers
b) Repurchase agreements d) none of the given

3) From the viewpoint of an investor, which of the following securities provide the least risk?
a) Debentures b) mortgage bond c) income bonds d) subordinated
debentures

4) In theory, which of the following coefficient of variation would eliminate risk in an investment
portfolio?
a) -1.0 b) 0.0 c) 1.0 d) 1.2

5) A measure that describes the risk of an investment project relative to other investments in general is
the:
a) Beta coefficient b) standard deviation c0 expected return f) coefficient of variation

6) If the price of an individual stock goes up by 15% and the market goes up by only 10%, then the beta
is:
a) 25 b) 1.5 c) 0.5 d) none of the given

7) Based on the following information about stock price increases and decreases, make an estimate of
the stock’s beta: Stock Market
July +1.5% +1.1%
August +2.0% +1.4%
September +2.5% +2.0%
 a) Beta equals 1.0 c) Beta is greater than 1.0
b) Beta is less than 1.0 d) there is no consistent pattern of returns

8) One type of risk to which investment securities are subject can be offset through portfolio
diversification. This type of risk is referred to as:
a) Market risk b) company risk c) liquidity risk d) undiversifiable risk