FINANCIAL TECHNIQUES

FOR
PROCUREMENT AND SUPPLY CHAIN MANAGEMENT

BY LUKAS NAKWEENDA
 CHAPTER 4

RISK AND REQUIRED RATE OF RETURN

“The Higher the Risk, the Higher the Return”

(For more detailed content, please refer to the text book and other sources)!

Source: Correia
 After engaging this chapter, you should be able to:

 Distinguish between business and financial risk;

 Calculate indicators of returns based on earnings before interest and tax

(EBIT);

 Calculate and explain the indicators of risk such as degree of operating

leverage (DOL), degree of financial leverage (DFL), Variance of returns,
standard deviation of returns and co-efficient of variation;

 Discuss the importance of diversification when it comes to risk vs return;

 Calculate the expected returns and standard deviation of a portfolio;

 Explain the behavioural finance view of risk vs return.

3
 4.1. There is a trade-off between risk and return
4

Return

Risk
 4.2. What is Risk?
5
 The word risk is usually used in a context of potential hazard
of possibility of an unfortunate outcome resulting from a given
action.

 In financial management, risk also indicates the expectation

that the actual outcome of the project may differ from the
expected outcome.

 The term risk and uncertainty are used interchangeably.

 4.3. What is Business Risk?
6
 Business risk refers to the nature of the business itself
and the uncertainty that surrounds the business operating
environment.
Obvious examples:
Think about the tourism sector during lockdowns;
Coffee shops during summer;
Property rentals during massive retrenchments;
Car rentals during lockdowns;

 This is reflected in variability of sales and costs and the

nature of the firm’s cost structure.
 4.4. Variability of Costs Relationship btw FC and variable costs
7

45,000,000 45,000,000 45,000,000

40,000,000 40,000,000 40,000,000
35,000,000
Sales Revenue 35,000,000 35,000,000
30,000,000 30,000,000 30,000,000
25,000,000 25,000,000 25,000,000
20,000,000 20,000,000
Fixed costs 20,000,000
Variable costs
15,000,000 15,000,000 15,000,000
10,000,000 10,000,000 10,000,000
5,000,000 5,000,000 5,000,000
- - -
0 5000 10000 15000 20000 25000 30000 35000 40000 45000 0 5000 10000 15000 20000 25000 30000 35000 40000 45000 0 5000 10000 15000 20000 25000 30000 35000 40000 45000

Fixed costs remain constant in total Unlike the FC, Variable costs
regardless of the sales volume (Level of remain constant per unit
Activity). regardless of the Level of Activity.
NB: For a given range. Variable costs are directly
related to the sales volume.
 4.5. Variability of Costs vs Break-Even Point
50,000,000
8
45,000,000
Note how the
40,000,000 Total Cost
line does not
35,000,000
begin at zero.
30,000,000
Profit
25,000,000
Sales revenue
Why?
Total Cost
20,000,000

15,000,000
Break-even
10,000,000
Loss
5,000,000

-
0 5000 10000 15000 20000 25000 30000 35000 40000 45000

The break even point is where Sales Revenue is equal to total

costs (fixed + variable costs). Thus, neither profit nor loss is
made.
 4.6. Business Risk In Context
9  Practical example:

LPS (Pty) Ltd has the following budgeted information for the
year ended 2023:
Total Fixed costs (TFC) R10m p.a.
Variable cost (VC) R400 per unit
Selling price (S) R1000 per unit
Expected demand 30 000 units (minimum)

As a procurement manager, tell us: How many units you

would expect to produce in June before no profit/loss is
made?
 4.7. Business Risk – Example …
10
 Break-even point (BEP) is calculated as follows:

 BEP = TFC ÷ contribution per unit

 BEP = TFC ÷ (Selling price per unit – variable cost per unit)

 BEP = R10m/(R1000-R400) = 16 666.66667 = 16 667 units

 Why are we saying at 16 667 units is the BEP?

 Look: N$
Sales (16 666.66667 @ N$1000) 16,666,666.67
Less: TVC (16 666.66667 @ N$400) - 6,666,666.67
Total Contribution 10,000,000.00
Less: TFC - 10,000,000.00
Profit/(Loss) 0.00
4.8. What is the effect of volume on Earnings Before Interest & Tax (EBIT)

11

No. of units 30,000 40,000 % change

Rm Rm
Sales (R1000 per unit) 30.0 40.0 33%
Variable costs (R400 per unit) 12.0 16.0 33%
Contribution 18.0 24.0 33%
Fixed costs 10.0 10.0 0%
EBIT 8.0 14.0 75%
 4.9. How do we ‘model’ Business Risk & Operating Leverage
12  How do we measure operating leverage?
All figures in Millions

S-VC 30.0 - 12.0

DOL = =
S-VC-F 8.0
= 2.25

 This means an increase in sales of 10% will lead to an

increase of 10% x 2.25 that is 22.5% in EBIT.

 In our example, sales increased by 33.3% and EBIT

increased by 33.3% x 2.25 = 75%.
 4.10. Why knowing your DOL i.r.o. Business risk
13

 Assume now that LPS (Pty) Ltd decides to install machinery which
will increase fixed costs by R5m per year and reduce variable
costs by R150 per unit.

 As procurement manager:

1. Advise how this development will affect your initial BEP? Good or
Bad to LPS (Pty) Ltd? New BEP = R15m/(R1000-R250) =20 000 units, Bad! Why?

2. Accordingly, advise how it will affect your EBIT, assuming that

your sales volume ‘range’, remains between 30k and 40k units.
New DOL = R22.5/R7.5 = 3 times, Thus, 3 x 33.3333% = 100% as your change in EBIT
 4.11. Importance of knowing your DOL i.r.o. Business risk
14
 How will EBIT react now to the Machinery installation?

All figures in Millions

No. of units 30,000 40,000 % change

Rm Rm
Sales (R1000 per unit) 30.0 40.0 33%
Variable costs (R250 per unit) 7.5 10.0 33%
Contribution 22.5 30.0 33%
Fixed costs 15.0 15.0 0%
EBIT 7.5 15.0 100%

 DOL = 22.5/7.5 = 3. A 33.33% increase in sales has resulted in 100% increase in EBIT.
 4.12. Take home on Business risk
15  The riskier option offers greater potential losses if sales
volumes are low and greater profits when sales volumes are
high.

 Thus, total business risk is, therefore, a function of both sales

and costs.

 Proof: Suppose LPS (Pty) Ltd sales dropped from 30 000 units
to 20 000 units. Assume that the rest of the information
provided in the previous slide remain the same.

 Your EBIT at 20 000 units would be: 3 x -33.33% = -100%

 Initially you had a +100% increase in EBIT, now you are having a
-100% drop in EBIT.
 4.13. Financial Risk
16
 Financial Risk is due to financing our assets with debt.

 Remember, A = OE + L or Vf = Ve + Vd

 Why? Because, interest must be paid regardless of the

performance of the firm.

 How do we measure financial risk?

 Through Degree of Financial Leverage (DFL):

EBIT
DFL =
EBIT - I
 4.14. Total company risk
17  Operating leverage and financial leverage work together to create
what is referred to as Degree of Combined Leverage (DCL)

 The Degree of Combined Leverage is:

DCL = DOL x DFL

or
S-VC
DCL =
S-VC-F-I

Or DCL = Contribution ÷ Net income before tax

 4.15. Consolidated Example: Total company risk
18
Example from the Textbook
Leverhi Gearlow
S-VC 66.6 34.2
DOL = =
S-VC-F 33.3 27.9
= 2.0000 1.2258

EBIT 33.3 27.9

DFL = =
EBIT - I 27.0 27.0
= 1.2333 1.0333

DCL = DOL x DFL = 2.4667 1.2667

or
S-VC 66.6 34.2
DCL = =
S-VC-F-I 27.0 27.0
= 2.4667 1.2667
 Back to Statistics Quickly

 What can you remember from your Statistics background?

20 4.16 Measuring Returns

Returns consist of two components:

1 – Dividends received
2 – Capital Appreciation

Returns from an investment (such as shares) can be measured.

21

4.17. Expected Returns

o The inclusion of probabilities allows for the

approximation of an expected return.
 4.18. Example of Measuring Expected Returns using P(i)
22 • Remember, Probabilities add up to 100%.
• All events are mutually exclusive.

State of the economy Probability Return

Super boom 10% 50%
Boom 20% 30%
Normal 45% 10%
Recession 15% -10%
Severe recession 10% -20%

Expected
State of the economy Probability Return
Return
Super boom 10% 50% 5.0%
Boom 20% 30% 6.0%
Normal 45% 10% 4.5%
Recession 15% -10% -1.5%
Severe recession 10% -20% -2.0%
Re = expected return 12.0%
Class Exercise : Let us look at a bigger picture here!

What if we had more than ‘one’ stock or share?

State of economy Probability STOCK A STOCK B STOCK C
Return Return Return
Boom 15% 15% 25% 11%
Normal 30% 7% 13% 10%
Recession 55% -2% -13.5% 3%

REQUIRED:
1) For each of the three stocks, calculate the:
i. Expected return
ii. Standard deviation
iii. CV
2) On the basis of CV, as a potential investor, which of the 3 stocks would you
prefer and why?
 4.19. Mean-Variance Rule
24
•X is preferred to Z.

• W is preferred to Y.

• Why?
Superior returns in
each case for the
same risk.

X is superior to Y,
as it offers the
same return for a
lower level of risk.
 4.20. Measuring Risk
25

 A more scientific approach is to examine the share's

standard deviation of returns.

 Standard deviation is a measure of the dispersion of

possible outcomes.

 The greater the standard deviation, the greater the

uncertainty, and therefore , the greater the risk exposure.
26 4.21. Measuring Risk – Standard Deviations

The standard deviation formula:

The above calculation is explained further in the textbook.

 4.22. The Normal Distribution
27

Mean = 12%
(The expected
rate of return)

What does the

peak of the
graph denote?

One Standard Deviation: Two Standard Deviations:

68.3% chance that the return will 95.5% chance that the actual return
be between –1σ and +1σ will fall between +2σ and –2σ
 2.23. Measuring Risk for a Single Share
28

Expected
State of the economy Probability Return
Return
Super boom 10% 50% 5.0%
Boom 20% 30% 6.0%
Normal 45% 10% 4.5%
Recession 15% -10% -1.5%
Severe recession 10% -20% -2.0%
Re = expected return 12.0%

Probability x Return
= 10 % x 50% = 5.0%
 2.24. Measuring Risk for a Single Share
29

Deviation
State of the economy Probability Deviation Variance
squared
1 2 3 4
Pj R - Re (R-Re)2 1x3
Super boom 10% 38% 14.44% 1.44%
Boom 20% 18% 3.24% 0.65%
Normal 45% -2% 0.04% 0.02%
Recession 15% -22% 4.84% 0.73%
Severe recession 10% -32% 10.24% 1.02%
σ2 = Variance = 3.86%
 2.25. Risk for a Single Share
30

Meaningless till we compare it with our competitor’s share. See next slide
 2.26. Equal Expected Returns : Comparison of single shares

31 o Suppose a potential investor has an option choosing

between two alternative identical expected returns for
the shares of the following companies.

EXAMPLE
LPS (Pty) Ltd Competitor
Expected return 20% 20%
Standard deviation 9.20% 15.40%

Answer:
o Given the scenario above, based on the mean
variance rule, the potential investor is likely to invest
in the share of LPS Ltd than that of the Competitor.

o The demand for LPS Ltd share will force its price
upwards and downwards for Competitor’s share until an
equilibrium is reached.
 2.27. Behavioural Finance
32

 Individual investors underperform the market index – S&P500;

 Overtrading;
 Concentration of shares;
 Investing in the employer’s shares;
 Investing based on recent past performance;
 Over-optimism when markets are rising;
 Media attention;
 Over-confidence.
THANK YOU!