Principle Of Finance

Risk & Return

Section

Prepared by T/A : Norhan Elnashar

 Introduction
• Risk : The chance of financial loss or, more formally, the variability of
returns associated with a given asset.
- Example : A $1,000 government bond that guarantees its holder $100
interest after 30 days has no risk, because there is no variability
associated with the return. A $1,000 investment in a firm’s common
stock, which over the same period may earn anywhere from $0 to
$200, is very risky because of the high variability of its return. The more
nearly certain the return from an asset, the less variability and
therefore the less risk.
• Return represent the total gain or loss on an investment .
 Introduction (2)
Risk

Uncertainty Certainty
0% 100%
 Return calculation
• The most basic way to calculate return is as follows :

X 100

Expected rate
of return
Cash flow in Ending Price
form of
dividends Beginning
Price
 Problem (1)
• Robin’s Gameroom wishes to determine the returns on two of its video machines,
Conqueror and Demolition. Conqueror was purchased 1 year ago for $20,000
and currently has a market value of $21,500. During the year, it generated $800
worth of after-tax receipts. Demolition was purchased 4 years ago; its value in
the year just completed declined from $12,000 to $11,800. During the year, it
generated $1,700 of after-tax receipts.
 Problem (2)
• Rate of return . Douglas Keel, a financial analyst for Orange Industries, wishes
to estimate the rate of return for two similar-risk investments, X and Y. Keel’s
research indicates that the immediate past returns will serve as reasonable
estimates of future returns. A year earlier, investment X had a market value of
$20,000, investment Y of $55,000. During the year, investment X generated cash
flow of $1,500 and investment Y generated cash flow of $6,800. The current
market values of investments X and Y are $21,000 and $55,000, respectively.
a. Calculate the expected rate of return on investments X and Y using the most
recent year’s data.
b. Assuming that the two investments are equally risky, which one should Keel
recommend? Why?
Answer
 Problem (3)
• Return calculations For each of the investments shown in the
following table, calculate the rate of return earned over the
unspecified time period.
Answer
 Return Measurement for a Single Asset:
Expected Return
• The most common statistical indicator of an asset’s risk is the standard deviation,
k, which measures the dispersion around the expected value.
• The expected value of a return, r-bar, is the most likely return of an asset.

Probability

Expected rate of
return Return of
the
outcome
 Return Measurement for a Single Asset: Expected
Return (cont.)
Example
• Table 5.4 Expected Values of Returns for Assets A and B
 Problem (4)
• Risk and probability Micro-Pub, Inc., is considering the purchase of one of two
microfilm cameras, R and S. Both should provide benefits over a 10-year period,
and each requires an initial investment of $4,000. Management has constructed
the following table of estimates of rates of return and probabilities for pessimistic,
most likely, and optimistic results:

• Calculate the expected rate of return.

Answer
 Problem (5)
• Swan’s Sportswear is considering bringing out a line of designer jeans. Currently,
it is negotiating with two different well-known designers. Because of the highly
competitive nature of the industry, the two lines of jeans have been given code
names. After market research, the firm has established the expectations shown in
the following table about the annual rates of return

• Calculate the expected value of return for each line.

Answer
Risk Measurement for a Single Asset: Standard
Deviation
• The expression for the standard deviation of returns, k

Standard
deviation
Expected rate Probability
of return

Return of the
outcome
Risk Measurement for a Single Asset: Standard
Deviation (cont.)
Example
 Risk Measurement for a Single Asset:
Coefficient of Variation
• The coefficient of variation, CV, is a measure of relative dispersion
that is useful in comparing risks of assets with differing expected
returns.
• Equation 5.4 gives the expression of the coefficient of variation.

Standard
deviation

Average
return
Risk Measurement for a Single Asset:
Coefficient of Variation (cont.)
So which assets here have higher risk ?

- Based on these SD , the firm would prefer asset

C which has a lower SD than asset D ( 9%
versus 10%)
- However , management would be making a
serious error in choosing assets C over asset D
because the relative dispersion ( risk of the
assets ) as reflected in the CV is lower for D
than for C ( 0.50 versus 0.75 ) .
- Clearly , the use of the coefficient of variation
to compare asset which is effective because it
also considers the relative size or expected
return of the asset .
 Problem (6)
• Metal Manufacturing has isolated four alternatives for meeting its need for
increased production capacity. The data gathered relative to each of these
alternatives is summarized in the following table.

• Calculate the coefficient of variation for each alternative.

Answer
 Problem (7)
• Assessing return and risk Swift Manufacturing must choose between two asset
purchases. The annual rate of return and the related probabilities given in the
following table summarize the firm’s analysis to this point.

Calculate:
- Expected return
- The standard deviation of each
project.
- CV
Answer
Project 257
Answer
Answer
Project 432
Answer
 Problem (8)
Three assets – F,G and H are currently being considered by Perth industries . The probability
distributions of expected returns for these assets are shown in the following table :

Asset F Asset G Asset H

i Pr Return Pr Return Pr Return
1 0.10 40% 0.40 35% 0.10 40%
2 0.20 10 0.30 10% 0.20 20
3 0.40 0 0.30 -20 0.40 10
4 0.20 -5 0.20 0
5 0.10 -10 0.10 -20

a) Calculate the expected value of return for each of the three assets . Which provides the largest expected return ?
b) Calculate the standard deviation for each of the three assets returns . Which appears to have the greatest risk ?
C) Calculate the Coefficient of variation for each of the three assets returns , which appear to have the greatest relative risk ?
Based on standard deviation, Asset G
appears to have the greatest risk, but
it must be measured against its
expected return with the statistical
measure coefficient of variation, since
the three assets have differing
expected values. An incorrect
conclusion about the risk of the assets
could be drawn using only the
standard deviation.