Module title: Financial Management

Nasrin Jahan

Assistant Professor of Finance

Department of Business Administration

Shanto Marium University of Creative and Technology

Introduction to financial Management

Concept or definition of Finance:

Finance is a continuous process of collection of fund,

investment of fund and proper utilization of this fund and
distribution of fund for an individual, business as well as
government.
. The word finance comes from the Latin word FINIS which means supply of money,
collection of money, or fulfilling the demand of money.

In narrower sense, Finance means planning of any business financial institutions and
best utilization of money and its management.

In the broader sense Finance is the total management of money in any financial
organization or firms, activities of money market and capital market in home and
abroad.

According to Oxford dictionary of finance, finance is the practice and of money, Money
required to opening the business, extending the business etc.
Finance can be defined as the art and science of managing money. Finance is concerned
with the process, institutions, markets and instruments involved in the transfer of
money among and between individuals, business and governments.

-L.J.Gitman.

Activities of a business concern relevant to financial planning co-coordinating control

and their application are called finance.

-E.W.Walker

From the above discussion we can say that financial planning for individuals, business,
financial institutions, social organization and government organization and taking the
money from different sources by different terms (shorts, medium, or long) and
management of this activities, investment coordination and controlling this process is
called the finance.

Concept of finance management:-

The importance of financial management in social, economic and after all in the whole
life is unlimited. In narrower sense, financial process for the uses of business concern is
called the financial management. In the broader sense, financial management means
such kind of financial process where individual business, organization or govt. take the
fund from the easiest and cheapest sources for the establishing the financial planning
and invest this fund by proper controlling and management.

financial management
From the above discussion we can say that

is that managerial activities which in

concerned with the planning, Organizing ,
Coordinating and controlling of firms
financial resources.

Concept of business finance:-

Business finance is that business activity which is concerned with the acquisition and
conservation of capital funds in meeting financial need and overall objective of business
enterprise “Business finance (management) can be broadly defined as the activity
concerned with the planning raising, controlling and administrating the fund use in
business.

_H.G.Guthmann and HE Dougall.

According to James C Van Hurne Financial management is concerned acquisition,

financial, and management of assets with some overall goal in mind. Thus the decision
function of management can be broken down into three major areas---
 Investment
 Financing
 Assets management decision.
According to Hughes and Kapoor “Financial management consists of all those activities
that are concerned with obtaining money and using it effectively.”

According to Dr.M Habibur Rahman Business finance broadly refers to those activities
involved in seeing that a manufacturing enterprise or business organization has the cash
with which to meet its pay bills to purchase raw materials, to construct buildings, to
equip plant with machinery and to provide many services promptly.

Functions of finance:-

The functions of finance is mainly of two types

 Managerial Function.
 Executive Function.
Managerial function:-The main task that a financial manager has to perform as the
main decision of finance is called managerial function. There are three main of
managerial function are discussed as follows:-

1 .Investment decision:-In order to estimate and arrange for cash requirement of any
enterprise, it is very necessary to decide how much cash will be invested in fixed assets
and how much in short term or current assets. Investment in assets can be categorized
into two ways.

 Working capital management.

  Capital budgeting.

2. Financing Decision:-Second most important function of financial manager is to

identify the requirements and the sources of finance to attain the desire project. Within
this decision a better mix of Debt and equity must be made where Cost of capital is low.

3. Dividend decision:-How to allocate the net profit of is the functional area of

financial manager. After paying all taxes the available net profit of the firm can be
allocated for three purposes a) for paying dividends to the share holders. b) For
distributing bonus. c) And retention of profit for the expansion of business in future. In
Dividend decision the important element is the dividend payout ratio i.e. how much of
the net profit should be paid out to the shareholders. It will depend upon the preference
of shareholders, investment opportunities.

4. Liquidity Decision:

Executive functions:- The function that a financial manager does in support of

Managerial function is called Routine function. The routine functions are as follows:-

1. Financial planning: - The duty of financial manager is to estimate the finance

requirement and determine the sources from where the fund can be raised.

2. Source identification: - Financial manager has to identify the possible sources

from where the planned financing can be procured. They can use owners fund, reserve,
and loan from bank, friends and other sources where they will get it at lower cost.

3. Raising of fund: - Considering the facts of profit and cost of fund, finance manager
will raise financing with cheapest sources.

4. Investment of fund: - Financial manager has to identify the perfact investment

opportunities where funds can be optimally used with low risk and high return.

5. Distribution of fund: - Once when profit is earned it is the major decision what
portion of profit should be retained. To allain both shareholders satisfaction and future
growth they have to make a well combination.

6. Protection of fund: In the way of business operation firms have to face risk and
uncertainties. Firms should not take that projects which can hamper the capital and
operation. More over risky projects generates more profit. So it requires a well balance.

7. Managing of fund: - The fund that is collected and invested distributed should be
managed properly as if that are not misused or mis manages.
8. Forecasting future cash flow: - In day to operation there are frequent cash inflow
and outflow, transaction happened. But there is a problem regarding the timing of cash
inflow and outflow. So management has to make better co-ordination.

9. Forecasting future profits: - On the basis of different information financial

manager have to find out the expected profit for now future.

10. Managing Assets:- Financial manager also takes the responsibility of assts
management. Here they have to take decision considering both profitability and
liquidity.

11. Cost Control:- Cost is a factor that restricts the profitability. Because high cost
reduces the profit and Cost Control can increase the profit.

12. Pricing:- One of the important tasks of financial manager is to determine the price
of product by considering production cost. Amount of production, marketing strategies,
and the quality of product.

Principles of Finance:-

To reach the ultimate goal of the organization, organization needs to have clear idea
about the principles of finance and financial management.

1. Principles of risk return:- Every business is established for earning profit. And
the main objective of financing is to get a positive return. As risk and return are
positively related, so firm may should have to be manageable.

2. Principles of Time value of money:- Time value of money is very important in

the process of financial decision. For example, the value of today Tk100 is not equal to
the value of Tk100 of five years later. So it is an important concept that should be
considered while making the investment decision.

3. Principles of cash flow:- There should be a proper combination of cash inflow and
outflow of an investment. According to this principle every investment project has
inflow and outflow.
4. Principles of profitability and liquidity:- Organization has to generate profit
from investment and it should maintain the liquidity without making the investment but
it will reduce the profit. On the other hand, over investment reduces the liquidity and
thus the firm will fall into cash problem. It will create restriction to perform the day to
day operation. Thus to get success the firm has to make a proper combination between
profitability and liquidity.

5.Hedging principle:- Earning profit for short term by fluctuating profit is called
hedging. Under this head of principle firm will procure short term sources of finance for
investment in short term assets.

6. Principles of Diversity:-Under this principle organization will invest in different

alternatives rather to causing only one project. Because it reduces the risk associated
with the investment.

7. Principles of Business Cycle:- Business cycle has 4 stages initial, growth, and
maturity, stable. Every financial decision should be co-ordination with business cycle.

Classification of finance

There are primarily two types of finance

 Private Finance
 Public Finance.
Private Finance:- When individual or organizations are dealing with finance is known
as private finance, excluding government or public finance. So, financial planning
procurement of funds and uses of funds by any individual or any organization is known
as private finance. Private finance is of three types:-

 Personal finance.
 Business finance.
 Non-business finance.
Personal finance: - When an individual makes planning identification, rising, and
investment and using of the fund to carry out regular personal life efficiently is known as
personal financing.

Business finance: - The financing that is done to perform the function of business
organization very efficiently is called Business finance i.e. the financing which is made
for earning profit is called Business finance. Again business finance is categories into
three types like:-

1. Financing in sole trader-ship, partnership or joint venture company:- The

financing functions performed by single ownership, partnership, and joint venture firms
falls under its category. They may procure funds from short terms, mid terms and long
term sources.

2. State owned finance:- Financing activities done by governed owned enterprises

for earning profit is called state owned Business finance. For example: - BSRS.

3. Autonomous business finance:- Autonomous organizations also need to perform

financial function for example Dhaka University, Chittagong university take loan from
different source and run the business operation smoothly.

Non-business finance: - Finance activities done by non-profit motive firm is known

as non-business finance. The main objectives of those firms are to provide service rather
than making profits. For example Rotary Clum, Hospitals, school etc.

Public finance:- When governments perform the function of finance like

identification of the sources of fund, determine the requirement and rising of that funds
and proper utilization of those funds is known as public finance. The main objective of
government is to make socio-economic development of the people.

Goals of finance:-

There are two major goals of finance. They are—

 Profit Maximization.

 Wealth maximization.

Profit Maximization:- According to this approach, action that increase profit should
be undertaken and those that decrease profits are to be avoided. At first we can define
profit as follows:-

When income is higher/ greater/ excess than expenditure then that is called profit.

For corporation profit are commonly measured in terms of earning per share which
represents total earnings divided by the no. of shares of common stock outstanding. The
term profit can be used in two senses:

 Owners oriented concept: - As an owner oriented concept profit refers to the

amount and share of income which is paid to the owners of the business.
  Operation oriented concept: - As operational concept profitability refers to a
situation where output exceeds input. That means the value created by the use of
resources is more that total of the input resources.

Rational for selecting the profit maximization as a goal:- The maximization of

profit is often considered to be a goal or an alternative goal of a firm. The rationalities
are as follows:-

 Economic efficiency:- Profit is a yardstick to measure the efficiency of every

organization Profitability generally indicates the higher the profit the more
efficient.

 Proper utilization of resources:- The maximization of profit is possible by

proper utilization of resources. The resources are man, machine, materials and
money (4 M). Profitability leads to the efficient and effective allocation of
resources (4 M) s of the organization for different requirements.

 Social welfare:- It a firms earns more profit can spend more for the welfare of
the workers, employees and for the society. Profits also ensure maximum welfare
to the shareholders, employees and prompt payment payment to creditors of an
organization.

From the above discussion we find that the objective profit maximization may be the
goal of a goal of an organization. But it has also some criticism. For what it may not be
the goal of an organization. Now we discuss about the criticism of the profit
maximization:-

 Ambiguity: - The term profit is a vague and ambiguous. It indicates different

meaning to different people. Profit may be short term or long term, may be after
tax or before tax profit, may be return on capital employed or total assets etc.
and so on.

 Timing of Benefit: - An important technical objection of profit maximization

concept is it does not consider the timing profit. That means time value of money
is ignored under this concept.

 It ignores risk.

Wealth maximization:- The alternative to profit maximization is wealth

maximization. It is also known as the value maximization or net present value
maximization.
The operational features of wealth maximization are-
Exactness: - The wealth maximization is based on the concept of cash flows.
Measuring benefits in terms of cash flow avoids the ambiguity.

Quality of benefits: - Wealth maximization criterion considers both the quality and
quantity of benefit. The most certain expected return the better quality of benefits and
the higher the value.

Time value of money:- Wealth maximization consider the time value of profit
considering the time value of money concept, the present value of cash inflows and out
flows helps management to achieve overall objective of an organization.

The other advantages of wealth maximization are as follows:-

 Wealth maximization is a clear term.

 The concept wealth maximization is universally accepted because it takes care of
interest of financial institution, owners, employees and society at large.
 Wealth maximization concept considers the impact of risk factor.

Factor Influencing Financial Decision:-

Every business organization can achieve its ultimate goal. For the achievement,
finance manager has to play a vital role by taking some major financial decisions like,
investment decision, financing decision and dividend decision. These financial decisions
are influenced by some factors. For the convenience of analysis these factors are classify
into two factors-

 Internal Factors.
 External Factors.
Internal Factors:- Internal factors are those which are possible to control by the
business organization itself. The major internal factors are as follows:-

 Size of firm.
 Nature of business.
 The forms of legal organization.
 Situation of business cycle.
 Assets structure.
 Regularity and adequacy of income.
  Economic life of business.
 Terms of credit.
 Management philosophy.
External Factors:- External factors are those which can’t be controlled by the
business organization. Such as economic condition of the country, government
regulation, tax system etc. The most influential external factors are given bellow-

 Government regulation.
 Tax system.
 Economic condition of the country.
 Condition of money market and capital market.

5. Agency Issue:

Management act is an agent for the owners of the firm. An agent is an individual authorized by
another person, called the principle to act in the latter’s behalf. Jensen and meek ling develop a
theory of the firm based on agency theory.

Agency theory is branch of economics relating to the behavior of two interested parties
of the firm like principals and other agent. An agency relation ship exist whenever a principle
hires an agent to act on their behalf. When there is a conflict between these two parties goad
then agency problem exist.

Agency problem is the likelihood that managers may place personal goal ahead of corporation
goals- L.J. Gitman.

Types of agency problem:

Agency problem can be categorized in the following way:

Managers Vs owners:

In case of Joint Stock Company ownership is separated from management. For this reason
owners directly can not take part in management. So they hired management. Most financial
managers would agree with the goal of owner’s wealth maximization. In practice managers are
also concerned with heir personal wealth, job security and other benefits. How ever managers
may have personal goals that compete with shareholder wealth maximization. As a result
conflict of interest between managers and owners is created.

Senior management Vs Junior management:

Sometimes conflict between senior management and junior management arise. Senior
management involve with the policy making. These policies are implemented by lower level
management. Sometimes the policies set up by senior management may not supported by junior
management, act as principal and the junior management act as the agent.

Creditors Vs owners:

Creditors want to have principal and interest payment from owner timely. But owners are not
willing to pay the claim of the creditors from their personal income if sufficient amount of profit
is not earned by the company. As result conflict arises. Sometimes manager on behalf of share
holders hurt the interest of by bond holders by investing in a very high risky project which is
financed by debt capital

Owners Vs other parties:

Owners want to maximize wealth. On the other hand, employees suppliers, buyers and other
parties want to have incremental of salary high quality products with low prices, timely payment
of bill etc. as a result the interest of owner is hampered.

How to solve agency problem

From the conflict of management objective of personal goals and maximizing owners value arise
the agency problem. The agency problem cab be minimized by the acts of ---

 Market force
 Agency cost

1. Market Force: The market force are discussed as follows---

Direct intervention by shareholders:

Major shareholders particularly large institutional in investors such as mutual funds, life
insurance companies and pension funds can exercise considerable influence over most firms
operations. They create pleasure on management to perform. When necessary they exercise
their voting rights as stock holders to replace under performing management.

The threat of take –over:

Another market force is the threat of take over by another firm that believes it can enhance the
target firms value to restructuring its management, operations and financing. The constant
threat of take over tends to motivate management to act in the best interest of the firms owners.

2. Agency cost:
In order to prevent or minimize agency problem shareholders incur agency costs of which there
are four types

Monitoring expenditure: Monitoring expenditure prevent satisfying behavior of

management. These outlays pay for audits and controls procedures that are used to assess and
limit managerial behaviors to do these actions that tend to be in the best interest of owners.

Bonding expenditures

Bonding expenditures protect against the potential dishonest acts by managers. Typically the
owner pays a third- party bonding company to obtain a fidelity bond. This bond is a contract
under which the bonding company agrees to reimburse the firm for up to a stated amount if a
specific manager’s dishonest act results in financial loss to the firm.
 Nasrin Jahan

Assistant Professor of Finance

Department of Business Administration

SMUCT

Chapter: 2
Risk and Return

Chapter Contents:
7.1 Return

7.2 Components of return

7.3 Types of return

7.4 Differences Expected return between and Realized return

7.5 Definition of Risk

7.6 Type of Risk

7.7 Differences between Systematic risk and Unsystematic risk

7.8 Sources of risk

7.9 Mathematical problems

7.10 Exercise

7.1 Return:
Investors postpone current consumption in order to add wealth. So that investor can
consume more in future. So the return is concerned with change in wealth resulting
from the investment. Such change in wealth can either be due to periodic cash inflow in
the form of interest or dividends or caused by a change in the price of the assets.
Narrowly the return is the total gain or loss experienced on an investment over a period
of time. Broadly income received on an investment and any change in market price
which is usually express as a percentage of the beginning market price of the investment
is called return. The return on investment can be expressed in two ways:

 On the basis of taka

 On the basis of rate of rate of return or percentage of return

Scholar’s View

According to I.M pandey,

Return of a security consists of the dividend yield and capital gain.

According to Van Horne,

Return is the income received on an investment plus any change in market price.

According to Khan and Jain,

The return on an asset / investment for a given period is the annual income received
plus any change in market price.

Thus based on the above discussions we can say that the return on an investment for a
given period of time is the total gain or loss experienced on an investment over a given
period of time which is calculated by dividing the assets chance in value plus any cash
distributions during the period by its beginning period investment value.

As an example Mr. Bazlur Rahman wishes to determine the return on two

of its machine. Machine X is purchased one year ago for Tk. 20,000 and
currently has a market value of Tk. 21,500. During the year it generates Tk.
800 of after tax receipt. Machine Y was also purchased one year ago at Tk.
12,000. But currently its market price is declined and the price is Tk. 11800.
During the year it generated Tk. 1700 after tax cash receipt. Calculate the
return of each machine of Mr. Bazlur Rahman.

Solution:
Return of security
( )
=

R=Return on investment

D1 = Expected/ future/ return=800

P1 = Current/Ending market
price=21,500

PO = Purchasing/ Beginning
price=20,000

For Machine X:

( )
( )= Here,

( , , )
= D1 = 800
,

= P1 = 21,500
,

= P0 = 20,000
,

= 0.115 R (x) = ?

= 11.5 %

For Machine Y:
( )
( )= Here,

( )
= D1 = 1700
,

= P1 = 11,800
,
= P0 = 12,000
,

= 0.1250 R(y) =?

= 12.50 %

Although the market value of machine Y declined during the year, its cash flow caused it
to earn a higher rate of return than that earned by machine X during the same period.
Clearly the combined impact of changes in value and cash fiow measured by the rate of
return is important.

7.2 Components of return:

Return from investment are crucial to investor. The total return consist of all price
changes and income received during a specific interval. Investment in any financial
assets offer two potential sources of return. They are:

 Yield
 Capital gain.

So Return = Income Yield + Capital Gain/Loss.

Yield:

Yield refers to the periodic cash inflow received by the investor from an investment.
Some investment pay fixed amount of return each year. Again some other investment’s
income vary quite a bit from year to year. It is in the form of dividend, interest and so
forth. For common stock’s and preferred stock’s income is referred to as dividend and
the income received from bond and other money market instruments is referred to as
interest. So yield is of two types:

 Dividend
 Interest
Income Yield =

Mr. Ziaul Haque buys a share for Tk. 500 and the stock is currently pays
Tk.15 as cash dividend. What would be the return of the investment?

Solution:

Return, =

( )
=

= 3%

Capital gain:

The second component is capital gain. It is the difference between the purchase price
and the price at which the asset can be sold. That means the change price. The price
change may be positive or negative. An increase in the price is referred to as capital gain
where as a decrease in the price of an investment is referred as capital loss. Capital gain
obviously increase investment return and capital losses decrease investment return.
Investments held for more than a year provide long-term gain or losses.

So, Capital Gain/ Loss = (Ending Price –Beginning Price)/ Beginning Price
Or( Selling Price – Purchasing Price)/ Purchasing Price

As an example Mr. Tahsinul Haque buys shares of a bank for Tk. 1000. The stock pays
no dividend. But at the end of one year it sales at Tk.1100. What is the return of
investment.

Solution:
 −
=

( )
=
( )
=

=10%

7.3 Types of return:

Return is the motivating force of investment. It is the reward for undertaking the
investment. The returns vary both over the time and between different types of
investment. Return can be divided on the basis of time in two types:

 Ex-post / Historical / Realized return

 Ex-ante / Expected return

Ex-post / Historical / Realized return:

Historical returns are generated by history of performance of an investment over a

specified time period. It may differ from forecasted return. The realized return has not
always been positive. Thus the actual return on an investment that the investors
received for some previous period of time is known as realized return. Say for example
Tahmidul haque has invested in stock of Beximco pharma Ltd. in the beginning of the
year 2000 and he got 15% dividend per year from the begaining of the year 2000 to the
end of 2012--- these is called historical return.

Ex-ante / Expected return:

Expected return are the best estimates of what returns might be over some future time
period. The expected return are always positive because if there is a possibility of loss,
the investors do not made any investment and the return should be above the risk free
rate of treasury bond. Thus the future return which is expected by the investors over
some future holding period is called expected return. With the reference to previous
example it can be said that an analyst forcasts that stock of Baximco Pharma Ltd. will
provide return on an average of 14% over the next 20 years--- this is called historical
return.

7.4 Differences Expected return between and Realized

return:

Return is the reward for undertaking the investment. The term return is used in
different ways. Such as expected return and realized return. The difference between
expected return and realized return are as follows:

Area of Expected return Realized return

difference
1. Definition the future return which is the actual return on an
expected by the investors investment that the investors
over some future holding received for some previous
period is called expected period of time is known as
return. realized return.
2. Time Expected return is related Realized return is related with
with the future. the past.
3. Nature It is anticipated return. It is historical return.
4. Probability of It is an uncertain return It is certain return which is
occurrence. which may or may not gained.
occur.
5. Forecasting It cannot be used in It is used as the basis of
estimating future unknown forecasting future expected
return. return.
6. Return Expected return is always Realized return may be
positive. positive or negative.
7. Use of data It is assumed return It is consumed return
calculated on the basis of calculated on the basis which
historical return. are actually happened.
8. Probability The probability distribution Frequency distribution is used
distribution are involved in the to describe the realized return.
calculation of expected Probability distribution is not
return used.

7.5 Definition of Risk :

Human life as well as Investment is full of uncertainty. In every stage of investment
process uncertainty is exist. The chance or probability that some unfavorable events will
occur due to those uncertainties is called risk. All investment involves certain amount of
risk.

Generally risk means the possibility of some unfavorable events such as hazard, peril,
and exposure to loss or injury. Risk is the variability of return from an investment. The
return on investment may vary from the expectation of the investors. So, risk may be
defined as the chance of actual outcome will be less than expected outcome from an
investment.

To illustrate the riskiness of financial assets, suppose an investor buys Tk 1, 00,000/- of

short term Treasury bills with an expected return of 5%. In this case the return 5% is
certain. But it the investor invests the money to purchase the stock of National Bank
Limited (NBL) with the expectation of achieving higher return. This return is not
certain. This investor’s expectation may or may not fulfill. Here risk is existing.
Investors assume higher risk to get higher return.

Scholar’s View
According to Webster’s Dictionary,

Risk is defined as a hazard, a peril, and exposure to loss or injury.

According to M.K. Khan and P.K Jain,

Risk to the variability of the actual return from the expected return associated with a
given assets.

According to John J Hampton,

Risk may be defined as the livelihood that the acted return from an investment will be
less than the expected return.

According to J.C Van Horne,

Risk is the defined as the variability of possible return from a project.

According to J.F Weston And E.F.Brigham,

Risk is the chance that some unfavorable events will occur.

From the above it can be said that the deviation between expected and actual outcome
from an investment is called risk.

7.6 Type of Risk

Shortly speaking risk is the variability of return from an investment Return on

investment. Return on investment may vary from the expectation of investors.
Depending upon the elements of risk, it may be broadly divided into two categories.
They are

 Systematic risk
 Unsystematic risk

Systematic risk:

Systematic risk refers to that portion of total variability in return on investment caused
by general economic conditions in which an individual cannot do anything to price
movement and effect all firms simultaneously. Investment manager can do a little about
systematic risk.

Economical, Political, Social, Sociological changes as well as the impact of monetary and
fiscal policies, inflation are the sources of systematic risk. They effect to move the price
of all individual common stocks, bonds, and other securities in the market together at
the same manner .

Therefore it cannot be eliminated by diversification. It affects the economical or

financial system as a whole. The risk associated with macro, pervasive factor is called
systematic risk. It is also called general risk, market risk, unavoidable risk and non
diversifiable risk.

Unsystematic risk:
Unsystematic risk is the unique risks of individual company on investment relates to the
events that affect individual, firms or security independently. So controllable internal
factors related to particular industry of firm is the sources of unsystematic risk.
Management inefficiency, consumer preference, labor strikes, low product quality,
inefficient management, backdated rules and regulations, new patent are the elements
of unsystematic risk. Investment manager can do much about unsystematic risk because
these types of risk can be totally reduced through diversification. Thus the risks
associated with micro factors particularly to a company are called unsystematic risk. It
is also called specific risk, insure risk, and diversifiable risk.

7.7 Differences between Systematic risk and

Unsystematic risk:

Systematic risk and unsystematic risk are the two broad categories of risk. Before
identifying the differences we should have a clear understanding about the
terminologies. However they are defined as below:

Systematic risk:

Systematic risk is the portion of total risk which cannot be eliminated, controlled
through diversification of assets.

Unsystematic risk:

Unsystematic risk is that portion of total risk which can be eliminated, controlled
through diversification of assets.

The major differences between systematic risk and unsystematic risk can be
summarized below:

Area of difference Systematic risk Unsystematic risk

1. Definition: Systematic risk refers to general Unsystematic risk refers to
economic conditions that affect unique risk that affect
all firms and securities particular firm or securities
simultaneously. independently.
2. Elements: Economical, Social, political Management inefficiency,
and sociological changes are the lack of standard rules and
elements of systematic risk. regulations Low product
quality background
technology are the elements
of unsystematic risk.
3. Arise: It arises for economic wide It arises for certain business
uncertainties. phenomenon.
4. Range: It ranges to market wide factors. It ranges to business specific
factors.
5. Relation: It relates to external factors. It relates to internal factors.
6. Investment manager can do Investment manager can do
little about systematic risk. much about unsystematic
risk.
7. Economic level: Systematic risk associated with Unsystematic risk associated
macro pervasive factor. with micro pervasive factor.
8. Diversification: It cannot be diversified away It can be diversified through
through making portfolio of making portfolio of assets.
assets.
9. Called : It is also called general risk non It is also called specific risk,
diversifiable risk and market diversifiable risk and issuer
risk. risk.
10. Affected/relation: It relates to market risk, It relates to Business risk,
interest risk, and inflation risk financial risk and credit risk
affecting all securities in the affecting specific security.
market.
11. Portfolio of assets: Measurement of security’s Unsystematic risk is total
beta is the standardized risk minus systematic risk
measure of systematic risk.

7.8 Sources of risk:

Risk associated with investment can be defined as the variability is occur in future
returns, i,e the degree to which the return on an investment varies unpredictably. There
are some sources of risk which varies industry to industry or firm to firm. But these risks
are arise from mainly two parts. They are systematic risk and unsystematic risk. The
sources of risk under the two heads are given below.

Risk

Systematic risk:

A. Market risk
B. Interest rate risk
C. Liquidity risk
D. Default risk
E. Exchange rate risk
F. Exchange rate risk
 G. Purchasing power risk/inflation risk
H. Property risk
I. Political risk/country risk
J. Tax risk

Unsystematic risk:

A. Business risk
B. Credit risk
C. Financial risk
D. Sector risk/industry risk
E. Portfolio risk

7.8.1 Systematic risk:

Systematic risk is the attributable to a common factor that affects all firms similarly. It
cannot be eliminated by diversification. Systematic risks are discussed below:

A. Market Risk:

The chance that the value of an investment will decline because of fluctuations in the
overall market price is known as market risk. The variability in return includes a wide
range of exogenous factors like recessions, wars structural changes in the economic and
the changes in consumer preference.

B. Interest rate risk:

The variability in an investment’s returns resulting from the fluctuations in the level of
interest rates of fixed income securities is referred to as interest rate risk. Fixed income
securities mean debenture, bond, preferred stock, mortgage loan which pay a definite
amount of interest or dividend annually to the investors. Most investment loses value
when the interest rate rises and increases in value when it falls. So interest rate risk is
one of the vital risk that an investor should consider.

C. Liquidity risk:

Liquidity risk is associate with the particular secondary market. An investment is called
liquid when that can be bought or sold quickly and without significant price concessions
and loss of time. The chance that an investment cannot be easily sale at a reasonable
price is called liquidity risk. The more difficult to make this conversion, the greater the
liquidity risk.

D. Default risk:

Default is in another systematic risk that an investor may faced. This types of risk is
arise when the debtors of the firm would not able to pay the credit amount. For example
Company X sells good to company Y on credit. Company Y promises to pay the debt
with in 3 months. If company Y would not pay the money on due date that was default
risk for company X. Default risk is undiversifiable or uncontrollable and affect almost all
investment but some default risk may be diversified by proper portfolio management.

E. Exchange rate risk:

When an investor invest in the overseas market then exchange rate risk may face.
Exchange rate means the price of one currency in terms of another . It means how many
units of the home country’s currency are needed to buy one unite of the foreign
currency. The exchange rate of currency in continuously fluctuating. The variability of
return on investment due to the fluctuation of currency exchange rate is called exchange
rate risk. It is also called currency risk. It is also called currency risk. The greater the
chance of undesirable exchange rate fluctuations, the greater the risk associated with the
investment.

F. Purchasing power Risk :

Purchasing power means the ability to purchase goods and services. Due to inflation and
deflation this purchasing power of an investor may increase or decrease. Purchasing
power risk refers to the variation in investors return caused by inflation. Inflation means
raising of price of goods and services. Whereas deflation means decreasing the price
level of goods and services. The risk of loss of income both interest or principal because
of decreased purchasing power of money is also known as purchasing power risk.
Purchasing power risk will adversely affect the firms or investments cash flow and value
because generally firms or investments cash flow move with general price level.

G. Tax rate risk :

The level of tax rate is always fixed by the government. Tax rate risk is the chance that
unfavorable changes in tax laws will occur. Firms and investments value are sensitive to
tax law changes. If this change occur adversely is more risky for investment.

H. Property risk:

Property of an individual’s, Business or firm are the subject to property risk. Personal
property, business goods, machine, furniture, automobile, valuable articles etc can be
damaged or destroyed because of fire, lighting, tornadoes, earthquake and various other
causes. The possibilities of loss to of property due to the above causes are called
property risk.

I. Political risk :

Political risk is one of the important risk for the investors today. If political stability is
exist in a country its investment level both nationally and internationally grows high and
vice versa in case of instable political condition. The chance that returns will be affected
by the policies and stabilities of political parties of a nation is termed as political risk.

7.8.2 Unsystematic risk:

Unsystematic risk is unique to a particular industry, firm or Business and can be

eliminated by diversification. The major unsystematic risk are as follows.

A. Business risk:

Business refers to activities conducted for mutual benefit or profit. So business risk
refers to the variability of the earning or profit than expected. The chance that the firm
will be unable to cover its operating cost is called business risk. The level of business risk
is driven by the firms earnings stability and the structure of its operating cost.

B. Financial risk :

Financial risk is involved in the investment activities of a company. It refers to the

possibility that an investment will unable to generate sufficient cash flows to cover both
interest and principal payment of borrowed fund or to provide profit to the firm. The
presence of borrowed money in the capital structure (bond, debt, preferred stock)
creates fixed payment in the form of interest which have a prior claim on the firms cash
flows before the common stock holder receives dividends.

C. Credit risk:

Credit risk is one of the oldest and most vital forms of risk faced by every business or
investment. Credit risk sometimes called company risk which is consist of business risk
and financial risk. Business risk relates to the nature of risk and financial risk relates to
impose the fixed costs in financing. Due to business risk and financial risk the
organization sometimes fail to pay its debt which is called credit risk. This is the
potential loss arising from the failure of a borrower to meet its obligations in accordance
with agreed terms.

D. Sector risk:
Risk that are specific to a certain industry is called industry or Sector risk. An industry
risk is the risk involved with investing in a specific industry. The idea behind such risk is
that different companies in the same industry are often linked in terms of their stock
performance and the risks of their particular industry hold. This types of risk are doing
better or worse than expected as a result of investing in one sector o the economy
instead of other.

7.9 Mathematical problems:

Formula: 01

Return of security
( )
= R=Return of security

D1 = Expected dividend of the year

P1 = Ending price of the stock

PO = Beginning price of the stock

Formula 02:

Expected Return:

= ∑Ri x Pi Where: = Expected Return

Ri = Return for ith income

Pi = Probability for ith income

Formula 03:

Standard Deviation:

σ = ∑( − ) × σ = Standard Deviation

= = Expected Return

Ri = Return for ith income

 Pi = Probability for ith income
Formula 04:

Coefficient of Variation: CV =

Example 01:
Rahim and company has two projects, From the following information, you are required
to calculate the expected returns, standard deviation and coefficient of variation for
evaluation the riskiness of the projects.

Project-A; Cash Inflow Project-B; Cash Inflow Probability

Distribution
Tk. 3000 Tk. 2000 .20
6000 7000 .30
12000 11000 .50
15000 18000 .10

Solution:

For Project-A:

Cash flow Probability Ri x Pi ( − ) ( − )2 x Pi

(Ri) (Pi)
3000 .20 600 (6900) 9522,000
6000 .30 1800 (3900) 4563,000
12000 .50 6000 2100 2205,000
15000 .10 1500 5100 2601,000
∑Ri x Pi =9900 ∑( − ) ×

= 18891,000

Expected Return = ∑Ri x Pi

=9900

Standard Deviation σ = ∑( − ) ×

= √1,88,91,000

= 4346.38
Coefficient of Variation: CV =

.
=
= 0.4390

= 43.90%

For Project-B:

Cash flow Probability Ri x Pi ( − ) ( − )2 x Pi

(Ri) (Pi)
2000 .20 400 (7800) 12168000
7000 .30 2100 (2800) 2352000
11000 .50 5500 1200 720000
18000 .10 1800 8200 6724000
∑Ri x Pi =9800 ∑( − ) ×

= 21964000

Expected Return = ∑Ri x Pi

=9800

Standard Deviation σ = ∑( − ) ×

= √21964000

= 4686.58

Coefficient of Variation: CV =
.
=
= 0.4782
 = 47.82%

Decision:

Particular Project A Project B

8400 9800
σ 3477.93 4686.58
CV 41.40% 47.82%

Although the Expected Returns of project B is higher than project A. But according to
standard deviation and coefficient of variation, project B is greater risky than project A.
So, We accept project A.

Example 02:
Partex Investment company has two projects, From the following information, you are
required to calculate the expected returns, standard deviation and coefficient of
variation for evaluation the riskiness of the projects.

Project-A; Cash Inflow Project-B; Cash Inflow Probability

Distribution
Tk. 13000 Tk.12000 .10
13500 13000 .20
14000 14000 .40
14500 15000 .20
15000 16000 .10

Solution:

For Project-A:

Cash flow Probability Ri x Pi ( − ) ( − )2 x Pi

(Ri) (Pi)
13000 .10 1300 (1000) 100000
13500 .20 2700 (500) 50000
14000 .40 5600 0000 00
14500 .20 2900 500 50000
15000 .10 1500 1000 100000
∑Ri x Pi =14000 ∑( − ) ×
 = 300000

Expected Return = ∑Ri x Pi

=14000

Standard Deviation σ = ∑( − ) ×

= √300000

= 547.72

Coefficient of Variation: CV =

.
=
= 0.0391

= 3.91%

For Project-B:

Cash flow Probability Ri x Pi ( − ) ( − )2 x Pi

(Ri) (Pi)
12000 .10 1200 (2000) 400000
13000 .20 2600 (1000) 200000
14000 .40 5600 0000 00
15000 .20 3000 1000 200000
16000 .10 1600 2000 400000
∑Ri x Pi =14000 ∑( − ) ×

= 1200000

Expected Return = ∑Ri x Pi

=14000

Standard Deviation σ = ∑( − ) ×

= √1200000

= 1095.45
Coefficient of Variation: CV =

.
=
= 0.0782

= 7.82%

Decision:

Particular Project A Project B

14000 14000
σ 547.72 1095.45
CV 3.91% 7.82%
Although the Expected Returns of both project are same. But according to standard
deviation and coefficient of variation, project B is greater risky than project A. So, We
accept project A.

Example 03:
Helal and company has two projects, From the following information, you are required
to calculate the expected returns, standard deviation and coefficient of variation for
evaluation the riskiness of the projects.

Project-A; Cash Inflow Project-B; Cash Inflow Probability

Distribution
Tk. 6000 Tk. 0 .05
8000 5000 .20
10000 10000 .50
12000 15000 .20
14000 20000 .05

Solution:

For Project-A:

Cash flow Probability Ri x Pi ( − ) ( − )2 x Pi

(Ri) (Pi)
6000 .05 300 (4000) 800000
 8000 .20 1600 (2000) 800000
10000 .50 5000 0000 00
12000 .20 2400 2000 800000
14000 .05 700 4000 800000
∑Ri x Pi =10000 ∑( − ) ×

= 3200000

Expected Return = ∑Ri x Pi

=10000

Standard Deviation σ = ∑( − ) ×

= √3200000

= 1788.85

Coefficient of Variation: CV =

.
=

= 0.1789

= 17.89%

For Project-B:

Cash flow Probability Ri x Pi ( − ) ( − )2 x Pi

(Ri) (Pi)
0 .05 000 (000) 000
5000 .20 1000 (5000) 2500000
10000 .50 5000 0000 00
15000 .20 3000 5000 2500000
20000 .05 1000 10000 5000000
∑Ri x Pi =10000 ∑( − ) ×

= 10000000

Expected Return = ∑Ri x Pi

=10000

Standard Deviation σ = ∑( − ) ×
 = √10000000

= 3162.28

Coefficient of Variation: CV =

.
=
= 0.3162

= 31.62%

Decision:

Particular Project A Project B

10000 10000
σ 1788.85 3162.28
CV 17.89% 31.62%

Although the Expected Returns of both project are same. But according to standard
deviation and coefficient of variation, project B is greater risky than project A. So, We
accept project A.

Example-04:
Honey and company has two stocks. The stocks A & B have the following historical
returns:

Year Returns of Stock-A Returns of Stock-B

2006 (%) 18 (%) 14
2007 23 23
2008 26 30
2009 22 20
2010 27 29
Assume that a portfolio consists of 50% of stock A & 50% of stock B. You are required to
calculate

(a) Average return on the portfolio during the period.

(b) Standard deviation of returns for the portfolio.
(c) Coefficient of variation for the portfolio.
Solution:

Year Returns of Returns of Calculation of Portfolio ( − )2

Stock-A Stock-B portfolio return return
2006 (%) 18 (%) 14 (18×.50)+(14×.50) 16 51.84
2007 23 23 (23×.50)+(23×.50) 23 0.04
2008 26 30 (26×.50)+(30×.50) 28 23.04
2009 22 20 (22×.50)+(20×.50) 21 4.84
2010 27 29 (27×.50)+(29×.50) 28 23.04
Σ x=116 Σ( − )2

=102.8

Σ
Expected return =

=
=23.20%

Standard Deviation σ(P) = ∑( − ) ÷ ( − 1)

= 102.8 ÷ (5 − 1)

=5.06

Coefficient of Variation: CV =

.
= .
=0.2181

= 21.81%

Example-05:
Raju and company has two stocks. The stocks A & B have the following historical
returns:

Year Returns of Stock-A Returns of Stock-B

2008 (%) 25 (%) 19
 2009 28 28
2010 33 31
2011 36 34
2012 40 42
Assume that a portfolio consists of 50% of stock A & 50% of stock B. You are required to
calculate

(a) Average return on the portfolio during the period.

(b) Standard deviation of returns for the portfolio.

(c) Coefficient of variation for the portfolio.

Solution:

Year Returns of Returns of Calculation of Portfolio ( − )2

Stock-A Stock-B portfolio return return
2008 (%)25 (%)19 (25×.50)+(19×.50) 22 92.16
2009 28 28 (28×.50)+(28×.50) 28 12.96
2010 33 31 (33×.50)+(31×.50) 32 0.16
2011 36 34 (36×.50)+(34×.50) 35 12.56
2012 40 42 (40×.50)+(42×.50) 41 88.36
Σ x=158 Σ( − )2

=205.2

Σ
Expected return =

=
=31.6%

Standard Deviation σ(P) = ∑( − ) ÷ ( − 1)

= 205.2 ÷ (5 − 1)

=7.16
Coefficient of Variation: CV =

.
= .
=0.2266

= 22.66 %

2.10 Exercise:

Exercise 01:

Salmon company has two projects, From the following information, you are required to
calculate the expected returns, standard deviation and coefficient of variation for
evaluation the riskiness of the projects.

Project-A; Cash Inflow Project-B; Cash Inflow Probability

Distribution
Tk. 20 Tk. 18 .05
19 22 .20
24 25 .50
22 18 .20
26 28 .05

Exercise 02:

Bextex company has two projects, From the following information, you are required to
calculate the expected returns, standard deviation and coefficient of variation for
evaluation the riskiness of the projects.

Project-A; Cash Inflow Project-B; Cash Inflow Probability

Distribution
Tk. 16000 Tk. 10000 .15
8000 9000 .25
13000 12000 .30
18000 19000 .40
22000 26000 .20
Exercise-03:

Shovon and company has two stocks. The stocks A & B have the following historical
returns:

Year Returns of Stock-A Returns of Stock-B

2008 (%) 29 (%) 21
2009 31 31
2010 35 37
2011 32 34
2012 42 40
Assume that a portfolio consists of 60% of stock A & 40% of stock B. You are required to
calculate

(a) Average return on the portfolio during the period.

(b) Standard deviation of returns for the portfolio.

(c) Coefficient of variation for the portfolio.

Exercise-04:

Talha and company has two stocks. The stocks A & B have the following historical
returns:

Year Returns of Stock-A Returns of Stock-B

2008 (%) 35 (%) 39
2009 48 48
2010 53 51
2011 56 54
2012 60 62
Assume that a portfolio consists of 50% of stock A & 50% of stock B. You are required to
calculate

(a) Average return on the portfolio during the period.

(b) Standard deviation of returns for the portfolio.

(c) Coefficient of variation for the portfolio.