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COURSE:FINANCIAL MANAGEMENT 2
Course Code: ACC 121A
Course Description: Conceptual Frameworks and Accounting Standards
Course: BS Accountancy

MODULE 2

Estimating Risk and Return on Assets

Risk is the variability of an asset’s future returns. It refers also to the chance that some
unfavorable events will occur.

PROBABILITY AND PROBABILITY DISTRIBUTION

Probability is the percentage chance that an event will occur and range between 0 to 1.
If all possible events or outcomes are listed, and the probability is assigned to each event, the
listing is called probability distribution.

Example : For the election forecast, the following probability distribution could be set up.

Outcome Probability

Win 0.6 60%

Lose 0.4 40%
1.0 100%

Expected Value or Expected rate of return on investment is the weighted average of all possible
returns from an investment, with the weights being the probability of each return.

 Objective Probability Distribution based on past outcomes of similar events.

  Subjective Probability Distribution based on opinions or educated guesses about the
likelihood that an event will have a particular future outcome.
 Discrete Probability Distribution is an arrangement of the probabilities associated with
the values of a variable that can assume a limited/finite number of values.
 Continuous Probability Distribution is an arrangement of probabilities associated with
the values of a variable that can assume an infinite number of possible values.

Exercise 1: Assume that 2 investment prospects are available to Mr. Martin who has a P100,000
funds. He is considering the following:

a. Investment in XYZ Products Inc., a manufacturer and distributor of computer terminals and
equipment for a rapidly growing data transmission industry, or
b. Investment in JUNELCO which supplies an essential service.

The rates of return probability distributions for the two companies are as follows:

XYZ PRODUCTS, INC

State of Probability of Rate of Return Expected Rate
Economy this State (%) of Return (%)
Occurring
Boom .30 100 30
Normal .40 15 6
Recession .30 (70) (21)
Expected Value of Outcome 15%

JUNELCO
State of Probability of Rate of Return Expected Rate
Economy this State (%) of Return (%)
Occurring
Boom .30 20 6
Normal .40 15 6
Recession .30 10 3
Expected Value of Outcome 15%
EXPECTED PORTFOLIO RETURNS (Fp)

- Weighted average of the expected returns from the individual assets in the portfolio.

Where:
wi = proportion of portfolio invested in asset
fi = expected return of asset
n = number of assets in the portfolio

Exercise 2: DEF Properties is evaluating two opportunities, each having the same initial
investment. The project’s risk and return characteristics are shown below:

Project A Project B
Expected Return 0.10 0.20
Proportion invested in each 0.50 0.50
project

What is the expected return portfolio combining Project A and project B?

Fp= (0.5) (0.10) + (.50) (0.20) = 0.15 or 15%

STANDARD DEVIATION

- A statistical measure of the variability of a probability distribution around its expected

value.
- It is calculated as follows:

1. Compute the expected value (f)

2. Subtract (f) from each possible return to obtain the deviations (ri – f)

3. Square each deviation (ri – f)

4. Multiply each squared deviation by its probability of occurrence, pi (ri – f) , and then add.
The result is called the variance (σ2), which is the standard deviation squared.

5. Take the square root of the variance to get the standard deviation.

Exercise 3: Using the data of XYZ Products, Inc. and JUNELCO above. Compute the standard
deviation.

The expected rate of return as previously computed is 15% (k).

ki – k ( − ) ( − ) - pi
100% - 15% = 85% 7,225% (7,225%) (0.3) = 2,167.5%
15% - 15% = 0 0 (0) (0.40) = 0.0
-70% - 15% = -85% 7,225% (7,225%) (0.3) = 2,167.5%
Variance 4,335.0%

Standard Deviation (σ) = . = 65.84%