Session 2: Risk and Return Measurements

Financial Analysis revised

Page 36 of 54 pages. Chapter: 10: Module 2.1: Intro to Financial Mathematics

Session 2: Risk and Return Measurement

Learning Outcomes
This unit aims at introducing students to the concept of risk and return, the type of risks faced by an organization and how they are measured.

Introduction
The risk/return relationship is a fundamental concept in not only financial analysis, but in every aspect of life. If decisions are to lead to benefit maximization, it is necessary that individuals/institutions consider the combined influence on expected (future) return or benefit as well as on risk/cost. The requirement that expected return/benefit be commensurate with risk/cost is known as the "risk/return trade-off" in finance.

This session discusses the trade-off and, using conventional statistical tools, provides a method for quantifying risk. Two categories of risk borne by the firm's stockholders, business risk and financial risk, are discussed and demonstrated, as is the concept of leverage. The session also examines risk reduction via portfolio diversification and what requirements need to be met for firms to experience the benefits of diversification. The Capital Asset Pricing Model (CAPM) is used to demonstrate the risk/return trade-off by relating the required return on the firm's investments to its beta (or market) risk.

Important Learning Terms

Risk
Systematic risk
Unsystematic risk
Return
Portfolio
Beta
Leverage
Diversification

The Risk/Return Trade-off in Financial Analysis
It is widely accepted that the major determinant of the required return on the asset (or the rate to be applied to a stream of receipts to capitalize its value) is its degree of risk. Risk refers to the probability that the return and therefore the value of an asset or security may have alternative outcomes. Risk is the uncertainty (today) surrounding the eventual outcome of an event which will occur in the future.

Example: when tossing a coin, some one is not sure exactly what will be the outcome. The outcome may be to have a Tail or the Head, so there is a concept of risk. In a football match, three outcomes can be experienced: win, lose or draw. In business, the same can happen regarding the expected return on the investments in various sectors.

In Financial Analysis, the risk/return trade-off states that financial decisions that subject stockholders to more risk must offer a higher expected return.
Risk aversion is the tendency to try to avoid risky situations unless adequate compensation is offered.

Example: The risk averse individual faced with two events each having the same expected outcome will choose the outcome with the lower level of risk.

Measurement of Risk and Return
The expected benefits or returns to be received from an investment come in the form of the cash flows the investment generates.

Categories of Risk and Leverage Faced by the Firm and by Stockholders

This type of risk is magnified by the degree to which the firm relies on fixed operating expenses in producing sales.
In many cases there is not much the firm can do about this type of risk; some industries have more volatile sales and higher fixed operating expense than others.

Operating leverage results when the firm has fixed operating expenses in its cost structure.

These expenses do not disappear when sales drop, nor do they increase when sales increase.
Operating leverage tends to magnify any change in sales on Earnings Before Interest and Taxes (EBIT).
Stockholders are the ultimate bearers of the risk that results from leverage and they are the residual recipients of higher EBIT should sales increase.

B: Financial risk
This type of risk arises primarily because of the fixed interest payments firms must make to their long-term creditors (debt capital).

This type of risk is reflected in volatile Net Income and Earnings Per Share.

Financial leverage results when the firm finances some portion of its assets with borrowed funds

Financial leverage means that changes in EBIT will magnify changes in net income and Earnings Per Share
As a firm increases its degree of financial leverage, its expected return (net income and Earnings Per Share) increases as does its risk
The financial manager has some discretion in determining the extent of financial leverage.

Risk and Diversification
Diversification occurs when different assets make up a portfolio.
The benefit of diversification is risk reduction; the extent of this benefit depends upon how the returns of various assets behave over time.

The market rewards diversification. We can lower risk without sacrificing expected return, and/or we can increase expected return without having to assume more risk.

Diversifying among different kinds of assets is called asset allocation. E.g. A telephone operator with many physical assets such as houses, can diversify by acquiring financial assets which in turn earns return to the company. Compared to diversification within the different asset classes, the benefits received are far greater through effective asset allocation e.g. diversifying among different types of financial assets.

Example of diversification in Telecom industry is when a licensed mobile operator who provides fixed line telephones services also operates the community based telecenters, teleshops, card phones, etc.

Other ways to reduce risk include the use of the following strategies:

Mass advertising to reduce erratic sales and hence to increased profit
Entering into long-term sales or purchase contracts
Recapitalizing toward more equity and less debt so as to reduce the burden of fixed financial expenses
The use of temporary labour instead of permanent employees

Risk in a Portfolio Setting
A portfolio is a collection of risky assets. If we view individual assets as one big asset we have a portfolio.
Because of risk reduction, the nature of risk is fundamentally different when an asset is viewed as part of a portfolio instead of being viewed in isolation.

Measuring the Expected Return and Standard Deviation of a Portfolio
The expected return on a portfolio is the weighted average of the returns of individual assets, where each asset's weight is determined by its weight in the portfolio.

This equation gives the theoretically correct required rate of return on a project based upon its systematic (or beta) risk.

The formula is applicable only in situations where all diversifiable risk has been eliminated.

The risk-free rate (RFR) is a base rate reflecting the fact that the project should at a minimum offer a return equal to what could be earned in the Treasury bill market. Even riskless investments have a positive required rate of return.

The market risk premium, (km - RFR), indicates the premium investors require over the risk-free rate to invest in the general market index.

The required return on a project is positively related to the project's beta.

A very risky project (say a new expansion venture) will have a high beta coefficient, whereas low risk projects (such as a replacement machine) will have a lower beta.

Knowing a project's beta (and thus its minimum required return) is important for good financial management, because it indicates whether or not the expected rate of return is above, equal to, or below the required rate of return and whether or not stockholders are being properly compensated for the non-diversifiable risk they bear due to the project.

Discussion 8
Post your response in the discussions area. (See the procedure for discussions in Course Info.)

1. In competitive telecommunication environment, outline different types of risk faced by the business firms and how these risks can be handled.
Hint: Classify the risks, Suggest methods of handling between the assets held by the firm and based on the market conditions.

2. What is the effect of inflation in the required rate of return in various ICT projects

3. NOW Telecom has developed the following data in the project proposal to provide telecommunication areas in the southern parts in your county.

Calculate the following
a) The expected return of the project
b) The variance of the project
c) The standard deviation of the project

4. Due to the increased competition among the mobile telephone operators in your country, two companies are in discussion to form a merger. This will result in lower operating costs and a wider customer base. Other economies of scale are also expected in this merger. The return of the two firms A and B are the following:

Firm A has total investment in asses of $75, 000,000, three times the size of Firm B. The new firm (Firm C) to be formed will be represented by the portfolio of A and B and on the ratio of their total assets prior to the merger.

Calculate:
a) The expected return and standard deviation of firm A and B before the merger
b) The expected return of firm C
c) The standard deviation of firm C
d) Would you recommend for the merger?