1. Risk and Return-1

8/9/2019 1. Risk and Return-1

1/57

THE FOUR BASICPRINCIPLES OF

FINANCE


2/57

7-2

PRINCIPLE 1: Money Has a TimeVa!e"

A peso received today ismore valuable than a pesoreceived in the future.

We can invest the pesoreceived today to earninterest. Thus, in the future,you will have more than one

peso, as you will receive theinterest on your investmentplus your initial investedpeso.


3/57

7-#

PRINCIPLE 2: T$e%e is a Ris&-Re'!%nT%a(e-o))"

We only take risk when we expect to becompensated for the extra risk withadditional return.

The higher the risk, the higher will be theexpected return.


4/57

7-*

PRINCIPLE #: Cas$ Fo+s A%e T$eSo!%,e o) Va!e"

rofit is an accountingconcept designed tomeasure a business!s

performance over aninterval of time.

"ash flow is the amount of

cash that can actually betaken out of the businessover this same interval.


5/57

7-

P%o)i's .e%s!s Cas$

#t is possible for a firm to report profits buthave no cash.

$or example, if all sales are on credit, thefirm may report profits even though nocash is being generated.


6/57

7-/

In,%emen'a Cas$ Fo+

$inancial decisions in a firm shouldconsider %incremental cash flow& i.e. thedifference between the cash flows the

company will produce with the potentialnew investment it is thinking about makingand what it would make without theinvestment.


7/57

7-7

PRINCIPLE *: Ma%&e' P%i,es Re)e,'In)o%ma'ion"

#nvestors respond to newinformation by buying andselling their investments.

The speed with whichinvestors act and the waythat prices respond to newinformation determines the

efficiency of the market.


8/57

7-0

PRINCIPLE *: Ma%&e' P%i,es Re)e,'In)o%ma'ion" ,on'"

#nvestors in capital markets will tend toreact positively to good decisions made bythe firm resulting in higher stock prices.

'tock prices will tend to decrease whenthere is bad information released on thefirm in the capital market.


9/57

Ris& an( Re'!%n

C$a3'e% 7


10/57

7-14

Ris& an( Re'!%n 5e)ine(

Ris& is a measure of the uncertainty surroundingthe return that an investment will earn or, moreformally, the variability of returns associated with

a given asset. Re'!%n is the total gain or loss experienced on an

investment over a given period of time( calculatedby dividing the asset!s cash distributions during

the period, plus change in value, by its beginning)of)period investment value.


11/57

7-11

Ca,!a'in6 '$e Reaie( Re'!%n )%om anIn.es'men'

Reaie( Re'!%n represents the total gain or losson an investment.

The most basic way to calculate return isas follows*


12/57

7-12

Ca,!a'in6 '$e Reaie( Re'!%n )%oman In.es'men' ,on'"

+xample * -ou invested in share ofstock for / and sold a year later for011. The company did not pay any

dividend during that period. What will bethe cash return on this investment2


13/57

7-1#


Cas$ Re'!%n 8 P244 9 4 - P3 P14


14/57

7-1*


We can also calculate the rate of return asa percentage. #t is simply the cash returndivided by the beginning stock price.


15/57

7-1


Ra'e o) Re'!%n 8 P244 9 4 - P ; 8 114"#ne common method involves consideringpessimistic 8worst;, most likely 8expected;, andoptimistic 8best; outcomes and the returnsassociated with them for a given asset.

Ran6eis a measure of an asset!s risk, which isfound by subtracting the return associated with thepessimistic 8worst; outcome from the returnassociated with the optimistic 8best; outcome.


27/57

7-27

Ris& o) a Sin6e Asse'

#n the example on Table 4)0,the expected return is0.@9( however, the return

could range from )19 to


28/57

7-20


A more scientific approach is to examine thestock!s standard deviationof returns.

The greater the standard deviation, thegreater the uncertainty, and, therefore, thegreater the risk.


29/57

7-2


S'an(a%( (e.ia'ion( )

measures thedispersion around the expected value.

e?ual to the s?uare root of the variance

more commonly used

E=3e,'e( .a!e o) a %e'!%n is the averagereturn that an investment is expected to

produce over time.


30/57

7-#4


et us compare two possible investmentalternatives*

8; Treasury Bill Treasury bill is a short)term

debt obligation of the government. Assume thisparticular Treasury bill matures in one year andpromises to pay an annual return of /9. ATreasury bill is considered %is&-)%eeas there is norisk of default on the promised payments.

80; "ommon stock of the Ace ublishing "ompany an investment in common stock will be a riskyinvestment.


31/57

7-#1


The 3%o>a>ii'y (is'%i>!'ion of aninvestment!s return contains all possiblerates of return from the investment along

with the associated probabilities for eachoutcome.

$igure 4) contains a probabilitydistribution for the Treasury bill and Aceublishing "ompany common stock.


32/57

7-#2


33/57

7-##


The probability distribution for the Treasurybill is a single spike at /9 rate of returnindicating that there is 119 probability

that you will earn /9 rate of return. The probability distribution for Ace

ublishing company stock includes returnsranging from )19 to C19 suggesting the

stock is a risky investment.


34/57

7-#*


Dsing e?uation 4)=, we can calculate theexpected return on the stock to be /9while the expected return on Treasury bill

is always /9.

Eoes the higher return of stock make it abetter investment2 Fot necessarily, wealso need to know the risk in both theinvestments.


35/57

7-#


We can measure the risk of an investmentby computing the variance as follows*


36/57

7-#/


37/57

7-#7


'o we observe that the publishing company stockoffers a $i6$e% e=3e,'e( %e'!%nbut also entailsmo%e %is&as measured by standard deviation. Aninvestor!s choice of a specific investment will be

determined by their attitude toward risk.

Investment ExpectedReturn

StandardDeviation

Treasury Bill 5% 0%

CommonStock

15% 1!"5%


38/57

7-#0


The ,oe))i,ien' o) .a%ia'ion, CV, is a measure ofrelativedispersion that is useful in comparing therisks of assets with differing expected returns.

A higher coefficient of variation means that aninvestment has more volatility relative to itsexpected return.


39/57

7-#



40/57

?eome'%i,

.s" A%i'$me'i,A.e%a6e Ra'eso) Re'!%n


41/57

7-*1

?eome'%i, .s" A%i'$me'i, A.e%a6eRa'es o) Re'!%n

Arithmetic average may not alwayscapture the true rate of return reali5ed onan investment. #n some cases, geometric

or compound average may be a moreappropriate measure of return.


42/57

7-*2

?eome'%i, .s" A%i'$me'i, A.e%a6eRa'es o) Re'!%n ,on'"

$or example, suppose you bought a stock for0/. After one year, the stock rises to =1and in the second year, it falls to /. What

was the average return on this investment2

Arithmetic average

3 8019)/19; G 0

3 )/9


43/57

7-*#


Heometric average

3 I8 < .01; x 8 < J)./1K;L,M0 ) 3 )00./C9


44/57

7-**


6ere, )/9 is the simple arithmeticaverage while )00./C9 is the geometric orcompound average rate.

Which one is the correct indicator ofreturn2 #t depends on the ?uestion beingasked.


45/57

7-*

C$oosin6 '$e Ri6$' @A.e%a6e Both arithmetic average geometric average are important

and correct. The following grid provides some guidance asto which average is appropriate and when*

#uestions $ein addressed& 'ppropriate 'veraeCalculation&

()at *as t)e averae o+ t)eannual rates o+ return,

()at annual rate o+ returncan *e expect +or next year,

T)e arit)metic averaecalculated usin annual rateso+ return!

()at *as t)e averae ro*t)o+ our investment,

()at annual rate o+ returncan *e expect over a multi-

year )ori.on,

T)e eometric averaecalculated over a similar pastperiod!


46/57

7-*/

Com3!'in6 ?eome'%i, A.e%a6e Ra'eo) Re'!%n ,on'"

"ompute the arithmetic and geometricaverage for the following stock.

/ear alue o+ t)estock

0 5

1 25

13!50


47/57

7-*7

Com3!'in6 ?eome'%i, A.e%a6e Ra'eo) Re'!%n ,on'"

Arithmetic Average 3 8C1)/1; G 0 3 -

Documents

1. Risk and Return-1