Business SENIOR

HIGH
Finance SCHOOL

Self-Learning
Module
Risk and Return Trade-off
18
Quarter 3
Business Finance - 12
Quarter 3 – Module 18: Risk and Return Trade-off
First Edition, 2020

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 Business SENIOR
HIGH

Finance SCHOOL

Self-Learning
Module

18
Quarter 3

Risk and Return Trade-Off

Introductory Message

For the Facilitator:

Welcome to the Business Finance Self-Learning Module on Risk and Return

Trade-off!

This Self-Learning Module was collaboratively designed, developed and

reviewed by educators from the Schools Division Office of Pasig City headed by its
Officer-in-Charge Schools Division Superintendent, Ma. Evalou Concepcion A.
Agustin, in partnership with the City Government of Pasig through its mayor,
Honorable Victor Ma. Regis N. Sotto. The writers utilized the standards set by the K
to 12 Curriculum using the Most Essential Learning Competencies (MELC) in
developing this instructional resource.

This learning material hopes to engage the learners in guided and independent
learning activities at their own pace and time. Further, this also aims to help learners
acquire the needed 21st century skills especially the 5 Cs, namely: Communication,
Collaboration, Creativity, Critical Thinking, and Character while taking into
consideration their needs and circumstances.

In addition to the material in the main text, you will also see this box in the
body of the module:

Notes to the Teacher

This contains helpful tips or strategies that
will help you in guiding the learners.

As a facilitator you are expected to orient the learners on how to use this
module. You also need to keep track of the learners' progress while allowing them to
manage their own learning. Moreover, you are expected to encourage and assist the
learners as they do the tasks included in the module.
 For the Learner:

Welcome to the Business Finance Self-Learning Module on Risk and Return

Trade-off!

This module was designed to provide you with fun and meaningful
opportunities for guided and independent learning at your own pace and time. You
will be enabled to process the contents of the learning material while being an active
learner.

This module has the following parts and corresponding icons:

Expectation - This points to the set of knowledge and skills that

you will learn after completing the module.

Pretest - This measures your prior knowledge about the lesson

at hand.

Recap - This part of the module provides a review of concepts

and skills that you already know about a previous lesson.

Lesson - This section discusses the topic in the module.

Activities - This is a set of activities that you need to perform.

Wrap-Up - This section summarizes the concepts and

application of the lesson.

Valuing - This part integrates a desirable moral value in the

lesson.

Posttest - This measures how much you have learned from the
entire module.
 EXPECTATIONS

At the end of the lesson, you are expected to:

1. identify the risk and;
2. understand the trade-off between risk and profitability.

PRETEST

DIRECTIONS: On the space provided, write TRUE if the idea being expressed is
correct and FALSE if otherwise.

_________ 1. The high risk will always result in higher returns for a company.

_________ 2. Business owner, should be able to balance the risk and the potential
return of your investments

_________ 3. The lesser the risk in a given investment, the higher the opportunity for
gain.

_________ 4. To reduce the risk to an acceptable level is through diversification.

_________ 5. Financial managers ensure that the proposed business will earn more
than the risk-free rate.

RECAP

We have learned, to define the net present value method and IRR
method. The purpose of using those methods for capital budgeting, cost-benefit
analysis.
 LESSON

RISK and RETURN (Reward) TRADE-OFF

Risk refers to the degree of uncertainty and/or potential financial loss

inherent in an investment decision. Risk is the chance that your actual return will
differ from your expected return, and by how much. Return is the money you expect
to earn on your investment.

Let’s say that two customers come to you offering to buy 100,000 units of
product X under terms n/60. Customer A is a wealthy millionaire with lots of liquid
assets while Customer B suffered severe financial losses over the past five years and
has limited liquid assets. If you were to charge interest to their account, which
customer should be charged a higher interest rate?

In general, the riskier the investment, the higher the potential return should
be. This is because the return that we are going to expect from the investment already
incorporates a risk premium. In our example, we should charge Customer B the
higher interest rate because of the possibility that Customer B would be unable to
pay the principal after 60 days. The relationship between risk and the potential
return is depicted by the image below:

Risk & Reward

As you can see, risk and rewards point to the same direction indicating a direct
relationship between risk and potential return. To get higher potential returns, you
need to take risks. As a business owner, you should be able to balance the risk and
the potential return of your investments. You cannot simply invest in low-risk
investments because of the low returns but you cannot also invest everything in high-
risk investments because of the impact it would have if the investment fails. One way
to reduce the risk to an acceptable level is through diversification wherein you invest
in different types of investments with different risks and returns. This is an
application of the saying “Don’t put all your eggs in one basket."
Trade-off Between Risk and Profitability
It refers to the level at which the firm maintains its current assets and current
liabilities implies a choice between profitability and risk. To avoid liquidity problems
a firm would want to have higher level of current assets that will result to low risk of
insolvency. However, a higher level of current assets will reduce profitability. The
same with current liabilities the firm would want to have higher levels of current
liabilities to contributes profitability since current liabilities are a less costly in terms
of interest incurred. To incur higher level of current liabilities it faces a higher risk
of insolvency since it has more obligations that are maturing shortly, which it might
not be able to pay when due.

The risk and return trade-off.

In making investment decisions, financial managers take note of the risk and
returns of the projects they are entering. This trade off which an investor faces
between risk and return while considering investment decisions is called the risk-
return trade off.
• Recall the story of Jack and the Beanstalk. In the story, Jack trades his cow for
three magic beans. This is a very risky move for Jack since these beans may be fake
and therefore, worthless. Luckily those magic beans grew into a beanstalk that
allowed Jack to gather riches beyond his wildest dreams while fighting with a giant
along the way. Jack gambled in this transaction. Should Jack decide not to sell the
cow for magic beans and instead sold it at the current market value, the story would
be different. As we can see, the higher the risk, the higher the returns, but of course,
if turned sour, the higher the losses as well.

• This situation is also true for making financial decisions. Taking a higher risk allows
you to earn higher returns. Low-risk investments like treasury notes, also called risk-
free instruments, earn a low and steady income flow. In making investment
decisions, financial managers ensure that the proposed business will earn more than
the risk-free rate since they need to compensate for the risk the investment will
entail. This introduces us to the Required Rate of Return. It is the minimum expected
yield investors require to select a particular investment.
 ACTIVITIES

Problem Solving. Analyze and show your computation in a sheet of paper.

Rahul had been pleading with his father for over a month to revise his pocket money.
Finally, his father decided to use this as an opportunity to teach him an important
investing lesson. He called Rahul and told him that he was ready to reconsider his
pocket money. He gave him 2 options to choose from:
Option A: I will increase your pocket money by 20% if you score above 90% in your
upcoming exams. However, if you score below 90%, your pocket money will be
reduced by 15%.
Option B: Your pocket money will be increased by 5% effective immediately and will
not depend on how you score in your exams.

While it took some time for Rahul to figure out which option was suitable for him?

WRAP-UP

• Discuss the concept of risk-return.

• Explain trade-off between risk and profitability.
• Elaborate risk and return trade-off.

VALUING

• How the risk and return trade-off can be applied in real life.
• Why is it a bad idea in investing in just one investment?
• What is your understanding about the saying “Don’t put all your eggs
in one basket.”
 POSTTEST

DIRECTIONS. Read the questions and encircle your answer.

1. It is the degree of uncertainty and potential financial loss inherent in an

investment.
A. Return B. Trade-off
C. Risk D. Profitability

2. The money you expect to earn on your investment.

A. Return B. Trade-off
C. Risk D. Profitability

3. Low-risk investments like treasury notes

A. Risk-return free instruments B. Risk-free instruments
C. Risk- instruments D. None

4. “Don’t put all your eggs in one basket.”

A. Agree with B. Maybe
C. Disagree D. None

5. Which is NOT true about profitability?

A. The primary goal of all business ventures.
B. Total income is less than its total expenses
C. Activity yields profit or financial gain
D. All of the above
 KEY TO CORRECTION

B 5.
5. TRUE A 4.
4. TRUE B 3.
3. FALSE higher return
A 2.
2. TRUE Rahul, the higher risk the
C 1.
1. TRUE Option A is the best option for
Pretest Activity PostTest

REFERENCES

Alminar-Mutya, Ruby F. (2018). Business Finance: A Management Approach.

Mandaluyong City, Philippines: Anvil Publishing, Inc.
Tugaz, Florenz C.; Dela Cruz, Aeson Luiz C.; Paril, Joshua S.; and Tang, Alger C.
(2017). Business Finance. Areneta Ave., Cubao, Quezon City, Philippines:
Vibal Group Inc.
Business Finance Teachers Guide
https://finpeg.com/blog/risk-return-tradeoff/