Unit 3:

Fundamental Concepts in Financial Management

(6 hours)

Introduction

Business firm play a vital role in facilitating the transfer of goods, services and
claims on assets in the economy. Its operating managers are almost continually
entering its input markets to procure raw materials and labor services and the
output markets to sell its products or provide services. In doing so, the
principles of time value of money must be considered to maintain the firm’s
profitability and stability. Similarly, the firm’s financial manager must enter
the financial markets to acquire the funds needed to finance its operations. In
carrying out its operations, business firms are also concerned with risks as
they relate to the management and valuation of a business. Within the firm,
management personnel are continually analyzing risk-return trade-offs in
making decisions. Therefore, a sound understanding of the basic concepts of
financial environment, risk and returns and time value of money is essential in
realizing successful business operations.

Learning Outcomes

At the end of this unit, student can:

 Elaborate the nature, sources and classification of risk;

 Discuss the principle of time value of money;
 Compute for the future and present value of money.

Financial Management Module 1

Topic 4: Risk and Rates of Returns

Activating Prior Knowledge

You did great in your activity in our Module No. 3!

Complete the mind map below by arranging the following picture, words or
phrases.

Tells us a story of what you had learned or discovered in our last week’s
module, most especially in your end of the topic activity.

Congratulations! You have unlocked new module!

Welcome to Module No. 4!

Financial Management Module 2

 Learning Objectives

After successful completion of this module, you should be able to:

 Explain the nature, sources and effects of risk;
 Differentiate stand-alone risk from risk in a portfolio context;
 Discuss the difference between diversifiable risk and market risk, and
explain how each type of risk affects well-diversified investors.
 Explain what the CAPM is and how it can be used to estimate a stock’s
required rate of return

Presentation of Contents

RISK
 Definitions of Risk
 It is the threat that an event or action will adversely affect an
entity’s ability to achieve its objectives and/or execute its strategies
successfully.
 In business, it means a chance of a financial loss or variability of
returns associated with a given asset.

 Types of Risk
 ASSET RISK – risk related to market changes or poor investment
performance of a financial asset (e.g. shares, options, futures,
currency)
 FINANCIAL RISK – is the risk that a company will not have
adequate cash flow to meet financial obligations.
 Sources of Financial Risks
- Financial risks arising from an organization’s exposure to
changes in market prices such as commodity prices, interest
rates and exchange rates.
- Financial risks arising from the actions of, and transactions
with other organizations such as vendors, customers and
counterparties in derivatives transactions.
- Financial risks resulting from internal actions or failures of
the organization particularly people, processes and systems.
 BUSINESS RISK - relates to the particular operations of the firm
such as the nature of its products, the rate of technological change in
the industry, the specific markets in which its products are sold and
its raw materials are purchased and the relationship between its
fixed and variable costs.

Financial Management Module 3

 Risk have both Quantitative and Qualitative Factors

 QUANTITATIVE risk factors  QUALITATIVE risk factors

- Cash (monetary) loss - Increased legislation
- Cost of property, equipment or - Loss of public trust
inventory - Injuiry to the unit’s and/or
- Cost of defending a lawsuit entity’s reputation

 RISK-RETURN TRADE-OFF
 An investor will demand greater return for assuming a greater risk
and expect a lower risk level for a lower return.
 The risk-return trade-off depends on a person’s degree of risk
aversion.
 The more risk averse an investor is, the greater the risk premium
that investor will demand before taking the risk.
 Risk of an individual security held in a diversified portfolio is
measured by its incremental effect on the risk of the total portfolio.
 If the portfolio is sufficiently large and well diversified, its owners
or managers may simplify their analysis of risk of an individual
security by relating its fluctuations in rate of return to those of the
market as a whole.

 Risk analysis can be confusing but it will help if you keep the ff.
points in mind:
 All business assets are expected to produce cash flows and the
riskiness of an asset is based on the riskiness of its cash flows. The
riskier the cash flows, the riskier the asset.
 Assets can be categorized as financial assets and as real assets. In
theory, risk analysis for all types of assets is similar and the same
fundamental concepts apply to all assets. However, in practice,
differences in the types of available data lead to different procedures
for stocks, bonds and real assets.
 A stock’s risk can be considered in two ways: (a) on a stand-alone or
single-stock basis or (b) in a portfolio context where a number of
stocks are combined and their consolidated cash flows are analyzed.
 In a portfolio context, a stock’s risk can be divided into two
components: (a) diversifiable risk which can be diversified away
and is thus of little concern to diversified investors and (b) market
risk, which reflects the risk of a general stock market decline and
cannot be eliminated by diversification.
 A stock with high market risk must offer a relatively high expected
rate of return to attract investors. Investors in general are averse to
risk so they will not buy risky assets unless they are compensated
with high expected returns.

Financial Management Module 4

  If investors, on average, think a stock’s expected return is too low to
compensate for its risk, they will start selling it, driving down its
price. Conversely, if the expected return on a stock is more than
enough to compensate for the risk, people will start buying it,
raising its price. The stock will be in equilibrium, with neither
buying nor selling pressure, when its expected return is exactly
sufficient to compensate for its risk.

STAND-ALONE RISK
 Stand-alone risk is the risk an investor would face if he or she had only
one asset.
 MEASURING RISK OF AN INDIVIDUAL ASSET
 The riskiness of an asset may then be depicted as the probability
distribution of the various cash flows (or rates of return) that might
result from owning it.
PROBABILITY – is the percentage chance that a given outcome
will occur.
PROBABILITY DISTRIBUTION – depicts a set of possible
outcomes and the % of chance of occurrence of each
 MEASURES OF DISPERSION
Range – the difference between the highest and lowest estimates of
outcomes.
 Range = highest – lowest
Expected Value – average rate of return after considering
probability distribution.
 EV = ∑ (Expected Rate of Return x Probability)
Variance – the square of the difference between the expected rate
of return and the expected value.
 r2 = ∑ (Expected Rate of Return – Expected Value)2 x
Probability
Standard Deviation – the square root of the variance.
 The tighter the probability distribution of expected future
returns, the smaller the risk of a given investment.
 r = √r2
Coefficient of Variation – a measure of relative dispersion used in
comparing the risk of assets with differing expected returns.
 It shows the risk per unit of return and it provides a more
meaningful risk measure when the expected returns on two
alternatives are not the same.
 CV = SD/EV
 The greater the dispersion of the probability distribution of
outcomes, the greater the risk.

Financial Management Module 5

 RISK IN A PORTFOLIO CONTEXT
 CAPITAL ASSET PRICING MODEL (CAPM)
 It is a model based on the proposition that any stock’s required rate
of return is equal to the risk-free rate of return plus a risk premium
that reflects only the risk remaining after diversification.
 Logically, the risk and return of an individual stock should be
analyzed in terms of how the security affects the risk and return of
the portfolio in which it is held.
EXAMPLE:
Pay Up Inc. is a collection agency that operates through 37 offices in the United States. It is not well known,
its stock is not very liquid and its earnings have experienced sharp fluctuations in the past. This suggests that
Pay Up is risky and that is required rate of return should be relatively high. However, Pay Up’s required
return in 2008 (and all other years) was quite low in comparison to most other companies.

This indicates that investors think Pay Up is a low-risk company in spite of its uncertain profits. This
counterintuitive finding has to do with diversification and its effect on risk. Pay Up’s earnings rise during
recessions whereas most other companies’ earnings decline when the company slumps. Thus, Pay Up’s stock
is like insurance – it pays off when other things go bad – so adding Pay Up to a portfolio of “regular” stocks
stabilizes the portfolio’s returns and makes it less risky.

 CAPM is based on portfolio theory and the assumption of an

efficient market. This model segregates market (systematic) risk
and uses the measure of it, beta (ß), to relate the risk of an
individual asset that of the market as a whole.
 The formula is: Rj = RF + (Rm – RF) ßj
where:
Rj – expected rate of return on investment
RF – risk-free rate of return
Rm – expected rate of return on the market
ßj –the measure of the market risk

EXAMPLE: Assume that the risk-free rate of return is 7 percent,

the expected rate of return on the market is 12 percent and the beta
of the particular asset is 1.6 what is the expected rate of return on
the asset?

Rj = RF + (Rm – RF) ßj
= 7% + (12% - 7%) 1.6
= 15%

Financial Management Module 6

 EXPECTED RETURN ON A PORTFOLIO
 It is the weighted average of the expected returns on the assets held
in the portfolio.
Stock Expected Peso Percent Product
Return Invested of Total (2 x 4)

(1) (2) (3) (4) (5)

China Life 18.00% ₱ 25,000 25% 4.500%

CCB 16.85% ₱ 25,000 25% 4.213%

HSBC 13.45% ₱ 25,000 25% 3.363%

Holdings

ICBC 9.20% ₱ 25,000 25% 2.300%

Average 14.38% ₱ 100,000 100% 14.376%

 ADDITIONAL POINTS
1. The expected returns would be based on a study of some type but
they would still be essentially subjective and judgmental because
different analysts could look at the same data and reach different
conclusions.
2. If we added companies considered to be relatively risky, their
expected returns as estimated by the marginal investor would be
relatively high; otherwise, investors would sell them, drive down
their prices and force the expected returns above the returns on
safer stocks.
3. Realized rate of return is the return that was actually earned
during some past period. The actual return usually turns out to be
different from the expected return except for riskless assets.

 PORTFOLIO RISK
 The portfolio’s risk is generally smaller than the average of the
stocks because diversification lowers the portfolio’s risk.
 Correlation is the tendency of two variables to move together.
 Correlation Coefficient is a measure of the degree of relationship
between two variables.

Financial Management Module 7

Diversification is completely useless for reducing risk if the stocks in the
portfolio are perfectly positively correlated.
 Combining stocks into portfolios reduces risk but does not completely
eliminate it.
 As a rule, portfolio risk declines as the number of stocks in a portfolio
increases.

Financial Management Module 8

 The portfolio’s total risk can be divided into two parts:
 DIVERSIFIABLE RISK
 It is the part of a security’s risk associated with random events.
 It can be eliminated by proper diversification.
 It is also known as company-specific or unsystematic risk.
 It is caused by such random, unsystematic events as lawsuits,
strikes, successful and unsuccessful marketing and R & D programs,
the winning or losing of a major contract and other events that are
unique to the particular firm.

 MARKET RISK
 It is the risk that remains in a portfolio after diversification has
eliminated all company-specific risk.
 It is also known as nondiversifiable or systematic or beta risk.
 It stems from factors that systematically affect most firms: war,
inflation, recessions, high interest rates and other macro factors.
 Because most stocks are affected by macro factors, market risk
cannot be eliminated by diversification.

 RISK IN A PORTFOLIO CONTEXT: THE BETA COEFFICIENT

 RELEVANT RISK – is the risk that remains once a stock is in a
diversified portfolio is its contribution to the portfolio’s market risk. It
is measured by the extent to which the stock moves up or down with
the market.
 BETA COEFFICIENT – is a metric that shows the extent to which a
given stock’s returns move up and down with the stock market. It
measures market risk.

 BENCHMARK BETAS
 It is apparent that the steeper a stock’s line, the greater its volatility
and thus, the larger its loss in a down market.

Financial Management Module 9

 b = 0.50 - Stock is only half as volatile or risky as an average
stock.
b = 1.00 - Stock is of average risk.
b = 2.00 - Stock is twice as risky as an average stock.

 THE SECURITY MARKET LINE

 The CAPM is depicted graphically by the SML.

SUMMARY
 Interest rate is the amount a lender charges for the use of assets
expressed as a percentage of the principal. It could be nominal or
effective interest rate.
 Risk is the threat that an event or action will adversely affect an
entity’s ability to achieve its objectives and/or execute its strategies
successfully. It could either be classified as asset risk, financial risk or
business risk.
 A stock’s risk can be considered in two ways: (a) on a stand-alone or
single-stock basis or (b) in a portfolio context where a number of
stocks are combined and their consolidated cash flows are analyzed.
 In a portfolio context, a stock’s risk can be divided into two
components: (a) diversifiable risk which can be diversified away and is
thus of little concern to diversified investors and (b) market risk,
which reflects the risk of a general stock market decline and cannot be
eliminated by diversification.
 CAPM is based on portfolio theory and the assumption of an efficient
market. This model segregates market (systematic) risk and uses the
measure of it, beta (ß), to relate the risk of an individual asset that of
the market as a whole.

Financial Management Module 10

 Application

CRITICAL-THINKING EXERCISES
1. Does an average investor’s willingness to take on risk vary over time?
Explain.
2. Should companies completely avoid high-risk projects? Explain.
3. Briefly explain the fundamental trade-off between risk and return.

PROBLEM SOLVING:
XXX Company is considering the following project opportunities with their
relative data:
PROJECT A PROJECT B

Net Cost of Investment P 4,000,000 P 4,000,000

Rate of Return

Economy Probability

Excellent 40% 16% 24%

Good 50% 12% 12%

Fair 10% 10% 6%

Required: Compute for the range, variance, expected value, standard
deviation and coefficient variation.

Financial Management Module 11