Professional Documents
Culture Documents
CHAPTER 3
RISK AND RETURN
Solutions
3-1
DEFINITION OF RISK
a) In financial management, the term uncertainty tends to be used when it is not possible to
assign probabilities to outcomes. In such instances it is not possible to quantify the uncertainty and thus
it remains an abstract concept. The term risk implies that probabilities can be assigned to a finite number
of possible outcomes. It is therefore possible to establish a range of possible outcomes and to identify
the most likely outcome and the level of certainty that surrounds that probability.
b) Past returns can be measured on the basis of income actually received. They can be
expressed as a percentage of the amount invested in order to determine the return. This is commonly
referred to as the return on the investment. In the case of a financial investment such as a share, the
return may come in the form of dividends received or increases in the share price (capital gains) or both.
The return to the shareholder will thus be the sum of the dividends and the capital gains, divided by the
principal sum invested.
At the time of deciding to invest, the investor is required to predict the future returns, if it is
not a risk free investment. The investor would not wish to invest if adequate returns are not expected.
In that sense, the returns are expected returns, that is a return which is most likely, but not certain. The
amount of uncertainty is dependant upon the range of possible outcomes. For example, if there is little
chance that an investment with an expected return of 15% will fall below 12%, the estimated risk is low.
If however an investment with an expected return of 15% could yield a return of 2% or even a negative
return, its estimated risk is clearly much higher.
c) The government in most countries takes responsibility for economic policy. The
government, like any business, operates on a budget, which reflects income and expenditure. In order
to balance the budget, the government makes use of its fiscal and monetary policy. The fiscal policy
reflects its approach to taxation and monetary policy reflects its approach to regulating the supply of
money and interest rates. The government therefore is able to ensure that its budget balances by
regulating taxation and money supply. For this reason, it is unlikely to suffer the risk of bankruptcy to
which business operations are exposed. In this sense it is the least risky investment. The rate at which
governments offer securities is therefore used as the riskless rate. The risk of default of the face value
of the security is very low. Government will tend to pay the face value of its bonds on redemption, even
if it has to print money to do so, or raise taxes.
Note: Individual countries in the Euro are not able to simply print money (“quantitative easing”) and
therefore do carry the risk of bankruptcy as they are not able to simply let the currency depreciate. This
is unlike the UK and the USA who have let their currencies depreciate in order to deal with budgetary
constraints. A USA citizen lost about 50% of his/her wealth through US Dollar depreciation in the period
of 8 years to 2010 but from then until 2018 we saw the US Dollar appreciating due to the economic
recovery in the USA.
3-2
Finance theory assumes that investors are rational and prefer less risk to more. Investors will
only invest in higher risk investments if such investments offer higher returns. The returns
offered by government securities are considered to be risk-free and corporate bonds should
offer higher returns as they can default whilst equities should offer even higher returns due to
the higher volatility of returns. In portfolio theory, in valuations and capital budgeting, the
discount rates employed will include an adjustment for risk. Finance theory depends on this
relationship; higher risks are matched with higher expected returns.
You may have invested in ordinary shares on the JSE and the return may or may not have
offered a good return. Over the long term, shares typically will offer higher returns but not
necessarily in the short-term. You may have invested in corporate bonds, which may be
subject to interest rate risk.
3-3
Government bonds: No default risk of principal. Long-term government bonds will be subject
to changes in values due to interest rate risk.
Corporate bonds: The risk of default is dependent on the risk of the company and the credit
rating of such a firm. Corporate bond values are subject to interest rate risk.
Debentures: There is a risk of default but debentures may be secured over specific assets.
The values of fixed interest rate debentures are subject to interest rate risk.
Ordinary shares: Ordinary shares are subject to variable earnings and possibly variable
dividends. Share prices can be volatile.
Preference shares: These are subject to default risk and may offer a fixed dividend rate. The
values are normally subject to interest rate risk. Corporate investors can claim STC credits. If
dividends are based on a variable rate such as the prime rate, then preference share values
will not be subject to interest rate risk. However, the dividend flows to shareholders will be
variable.
Convertible notes: Here the investor may have the option to convert debt into ordinary shares
at a predetermined conversion ratio. There will be some interest rate risk (for fixed rate notes)
and a risk of variable earnings if conversion occurs.
Convertible preference shares: Here, the investors have the option to convert preference
shares into ordinary shares. There will be interest rate risk (for fixed rate preference shares)
and a risk of variable earnings if conversion occurs.
3-4
Business risk and financial risk
a) Business risk is the risk associated with the operations and the type of goods or services
being offered by the firm. It is the risk that sales will fluctuate and that goods or services on offer either
will not be able to be supplied, or will not be in demand. Some goods and services are seasonal; others
may have transient demand as a result of changing fashion trends, changes in consumer tastes or
technological developments. Business risk also arises from the nature of the cost structure of the firm.
A firm with a commitment to meet high fixed costs is considered to be more risky than a firm in which
most costs are variable. Business risk is measured by the degree of operating leverage, which is defined
as Contribution/EBIT.
b) Financial risk results from the method used to finance the assets of the business. When
only equity is used, the shareholders do not have a commitment to meet fixed interest charges. In times
of adversity, the return to shareholders will fall, but there will be no creditors demanding interest
payments. The relative quantum of debt in the capital structure is measured by the debt/equity ratio.
The degree of financial leverage is measured by EBIT/Net income.
c) The financial manager can reduce the risk of the company, firstly by seeking investment
opportunities with low risks. This may be difficult, as a business operating in a specific industry is unlikely
to be able to find such investments in that type of industry. The financial manager could diversify by
investing in projects in a different industry, with lower risk. The chances are, however, that the expertise
of the management may be unable to cope with such diversification.
Management may diversify risk by entering into joint ventures with companies in the same
sector to reduce business risk. For example, exploration firms in the oil sector drilling in different areas
will become partners in both fields to reduce the risk of dry wells. Agricultural companies may reduce
business risk by selling future production at a fixed price.
If the business risk is high, the financial manager may attempt to offset this by aiming for a
capital structure with little debt, thus not exposing the company to both business and financial risk. Any
change in the risk profile of the company will have an effect, all other factors remaining constant, on the
share price of the company. A reduction of risk, all other things remaining equal, will increase the share
price, as investors are prepared to risk a higher capital outlay for an expected return which is less risky.
3-5
ASTRID LTD AND DUNCAST LTD
a)
Astrid Ltd Duncast
Selling price/unit R112 500 000 /25 000 R112 500 000/25 000
= R4 500 = R4 500
Variable Cost R25 000 000/25 000 R50 000 000/25 000
= R1 000 = R2 000
Contribution per unit R3 500 R2 500
Break-even(units) R50 000 000/3 500 R25 000 000/2 500
= 14 286 = 10 000 units
c) Though Astrid Ltd has a lower proportion of variable costs, fixed costs are much higher
than Duncast Ltd's and thus Astrid Ltd has a higher breakeven point. Astrid Ltd is also operating closer
to its breakeven point than is Duncast Ltd. In this respect, Astrid Ltd is exposed to more operating risk
than Duncast Ltd. This is verified by the higher DOL. Should sales increase, the impact on Astrid Ltd's
net operating income will be relatively greater than the same increase will have on the net operating
income of Duncast Ltd.
3-6
FLEXET LTD
= R5 400 000 =2
R2 700 000
= 30 000(R250 - R70) .
30 000(R250 - R70) - R2 700 000 - R1 700 000
Note: Taxation is a function of profit – no profit, no tax. At break-even, there will be no profit and therefore
no tax that is due. This assumes that all fixed costs are deductible.
3-7
Q H
a) DOL = (S - VC)/(S - VC – F) = 232/112 145/70
= 2.07 2.07
e) Both companies achieve the same net income with sales of R290m. The companies have
the same degree of operating leverage at sales of R290m, which is confirmed by breakeven sales of
R150m. Quickpro is, however, financed by more debt and is thus more risky than Hendels with regard
to returns to shareholders.
3-8
GLICKS STORES
a) Return to shareholder = (Dividends + Capital gains)/Cost
NOTE: The above figures could be adjusted for the fact that 500 shares were purchased.
The return to the shareholder would however not change. Also note that investors are only interested in
returns after costs and tax where appropriate.
Return on investment is a much more generic term which usually requires further definition.
In the generic sense, it is any defined return, divided by the capital base which was used to generate
that return. So for example, using figures from the financial statements, net income before interest but
after tax, divided by total assets represents the return to providers of capital as a proportion of the
investment in assets. Return to shareholders is generally used as a specifically cash equivalent concept.
It is the return which a shareholder actually earned on the cash paid for shares, which includes capital
gains and dividends received during the year.
c) The return would have been identical to a) above, that is 38.8%. The fact that the investor
has not sold the shares makes the return an unrealized return, but nevertheless, for the period under
review, represents the accretion of wealth which has accrued to the shareholder. Should the shareholder
decide to sell at a later date, and the share price is lower, this would represent a negative return for the
subsequent period. The fact is that the investor had the opportunity to sell earlier, and she would have
realised a return of 38.8% had she sold at the end of the year of holding the share. However, only
realised returns are subject to capital gains tax.
e) Returns are usually expressed in annual terms and must be compared on an annual basis.
If the period had been eighteen months then a rough conversion would be 38.8% x (12/18) = 25.9%,
say 26%.
3-9
Risk / Return
25%
20%
F
15%
Return
C E
10%
A B D
5%
0%
0% 5% 10% 15% 20% 25%
Risk
(ii) An investor willing to take risks would invest in the two shares of F and C, as F offers the
highest return with the highest standard deviation. C offers a lower return and a lower level of
risk. E would not be selected as it offers the same return as C but at a higher level of risk.
(iii) A cautious investor would select A and C, as A offers the lowest return at the lowest level
of risk. C offers a return of 15% with a standard deviation of 15%. Investment B would not be
selected as it offers a lower return than C but at a higher level of risk.
(iv) No. It means that investors will require higher returns for taking on higher risk investments.
(v) Government bonds are considered to be low risk, as the government will always pay the
redemption value of such bonds, either by printing money or increasing tax rates. The risk of
government not being able to meet its commitments is very small. However, the values of long
term bonds will be highly variable, due to the sensitivity of such bond values to changes in
interest rates.
3-10
Lighthouse Ltd
What would the standard deviation be if there was an equal probability of each return
i.e. if there was a 20% chance of each of the above returns?
Variance 6.3%
Std Dev 25.1%
The variance and standard deviation is higher than our example.
This is because equal weighting means that there is greater dispersion from the mean.
3-11
a., b., & c.
Weighted Sq.
Share X Expected return Deviation
Deviation
Probability Return X
0.20 10% 2.00% -5.00% 0.05%
0.60 15% 9.00% 0.00% 0.00%
0.20 20% 4.00% 5.00% 0.05%
Weighted Sq.
Share Y Expected return Deviation
Deviation
Probability Return X
0.20 0% 0.00% -15.00% 0.45%
0.30 10% 3.00% -5.00% 0.08%
0.30 20% 6.00% 5.00% 0.08%
0.20 30% 6.00% 15.00% 0.45%
Expected Return (sum) 15.00%
Variance = sum of sq. deviations 1.05%
0.5
Std Dev = Var 10.25%
Coefficient of Variation (Stdev/ER) 68%
Workings
Expected return 0.3 x 10% = 3%
Deviation 10% - 15% = -5%
2
Squared deviation x Prob. (-.05) x 0.30 = 0.0008
d.
Share X and Share Y offer the same expected return of 15%. However, the risk
associated with investing in Share Y is significantly greater than investing in Share X.
The higher risk in absolute terms is measured in terms of a standard deviation of
10.25% for Share Y as compared to a much lower standard deviation of 3.16% for
Share X. As the expected returns are equal in this case, the additional calculation of
the coefficient of variation is not required but has been calculated in this case. The CV
of Share Y is significantly higher than the CV of Share X.
3-11 (continued)
e.
Weighted Sq.
Share Y Expected return Deviation
Deviation
Probability Return X
0.20 0% 0.00% -17.00% 0.58%
0.30 10% 3.00% -7.00% 0.15%
0.30 20% 6.00% 3.00% 0.03%
0.20 40% 8.00% 23.00% 1.06%
Expected Return (sum) 17.00%
Variance = sum of sq. deviations 1.81%
Std Dev = Var0.5 13.45%
Coefficient of Variation (Stdev/ER) 79%
The expected return increases to 17%, but the risk also increases. The standard
deviation is now 13.45%, and the CV is 79%. The investment decision would probably
not change due to the fact that the additional 2% return will result in a significantly
higher risk. A comparison of the Coefficient of Variation ratios for both companies
indicates that the level of risk relative to the expected return is much higher for Share
Y and an investor would probably remain invested in Share X.
You may ask that if we are increasing the probability of a higher return, why is there
an increase in risk? Obviously we want higher returns. However, the risk is increasing
because there is higher variability around the expected return. The high possible return
of 40% has been included in determining the expected return.
3-12
1 2 1x2 Return - ER Deviation2 x Prob.
Probability Return
0.20 12% 2.40% 6.00% 0.07%
0.20 -6% -1.20% -12.00% 0.29%
0.20 -9% -1.80% -15.00% 0.45%
0.20 15% 3.00% 9.00% 0.16%
0.20 18% 3.60% 12.00% 0.29%
Expected Return (sum) 6.00%
Variance = sum of sq. deviations 1.26%
Std Dev = Var0.5 11.22%
Probability Return
0.20 8% 1.60% 4.00% 0.03%
0.20 -4% -0.80% -8.00% 0.13%
0.20 -6% -1.20% -10.00% 0.20%
0.20 10% 2.00% 6.00% 0.07%
0.20 12% 2.40% 8.00% 0.13%
Expected Return (sum) 4.00%
Variance = sum of sq. deviations 0.56%
Std Dev = Var0.5 7.48%
The average return for the market is 4% and the average return for the company is
6%. The risk of investing as measured by the standard deviation is higher for Home
Wares than for the Market. This means that the volatility of share returns is higher for
Home Wares than the market. We can see that the return of the market never falls as
low as Home Wares, but also does not rise as much.
20%
15%
10%
5%
0%
1 2 3 4 5
-5%
-10%
Home Wares
-15%
Market
3-13
PLUS-TWO
Probability Return
0.05 40% 2.00% 29.50% 0.44%
0.15 20% 3.00% 9.50% 0.14%
0.60 10% 6.00% -0.50% 0.00%
0.15 0% 0.00% -10.50% 0.17%
0.05 -10% -0.50% -20.50% 0.21%
Expected Return (sum) 10.50%
Variance = sum of sq. deviations 0.95%
Std Dev = Var0.5 9.73%
Using Excel.
Difference between the return & mean /stdev 1.490
Using Excel Normsdist function = normsdist(z) 1.0000 Correia:
Cumulative probab. using the Excel Normsdist function 0.9319 =Normsdist(z). In this
case, =Normsdist(1.49)
Probability that return > 25.00% 0.0681
Note: =NORMSDIST (z) indicates the probability that the return will be less than 25%, which is 93.19%.
3-14
ENVIRON LTD
a) and b)
CV of cost = 68/-64
= -1.06
CV of cost = 55/-47
= -1.17
On the basis of the above calculations neither project yields an expected positive NPV at 16% (as the
expected cash flow for each project is negative). In such cases, for normal business decisions, both
projects would be rejected. However if this is an essential project and a CHOICE is required as to which
is the better of the two negative NPV projects, then the following is apparent from the calculated results:
Project A Project B
Higher expected cost Lower expected cost by R17m
Higher standard deviation, so Smaller standard deviation, so
higher possible variation around smaller possible variation
the expected cost. from the expected cost.
Co-efficient of variation is Slighter larger co-efficient
smaller at -1.06 of variation of -1.17
Thus Project B is seen to be only marginally more risky on the basis of CV, but has the
advantage of a lower expected cash outflow, based on data provided, and is thus likely to be selected.
Whether or not the company chooses to go ahead with Project B will ultimately depend on the company's
risk profile.
3-14 (continued)
c) If the probabilities are discrete, that is, in each case there are only four possible outcomes
with the probabilities as assigned, the worst possible cash outflow of R150m exists in Project A, although
with only a 20% probability of occurrence. The worst possible outcome in Project B is a cash outflow of
only R120m, but with a 30% chance of occurrence. As we are dealing with discrete probabilities, that
is, for each of the projects one of the four possible outcomes will eventuate, a less risk averse individual
may reason that Project A has a 20% probability of earning R50m, while Project B has only a 10%
probability of earning R50m. In risk analysis however it is customary to look at the downside risk, that
is the probability of losses rather than to gamble on some low probability, high outcome.
3-15
SIYABONGA LTD
PROJECT G
(R’000)
Cash Expected Deviation2
Prob Variance
Flow value Deviation millions millions
(R000) (R000)
900 20% 180 380 144,400 28,880
800 20% 160 280 78,400 15,680
400 20% 80 (120) 14,400 2,880
300 20% 60 (220) 48,400 9,680
200 20% 40 (320) 102,400 20,480
100% 520 77,600
Standard deviation = (Variance)0.5
= R278 568
Coefficient of variation = Std. Deviation/Expected value
= 0.536
PROJECT H
(R’000)
Cash Expected Deviation2
Prob Deviation Variance
Flow value millions millions
(R000) (R000)
900 20% 180 460 211,600 42,320
500 20% 100 60 3,600 720
400 20% 80 (40) 1,600 320
300 20% 60 (140) 19,600 3,920
100 20% 20 (340) 115,600 23,120
100% 440 70,400
c) The coefficient of variation is the preferred measure of risk (for a single asset in isolation)
because it reflects the standard deviation as a % of the mean. For company cash flows this means that
the company with a lower coefficient of variation is less risky, that is, there is less risk for each expected
Rand of return.
3-16
BAXTER LTD
a) i) If probabilities are discrete, the most likely cost for the flexing machine is R900 000 (40%
probability) and R1300 000 for the binding machine (50% probability). In terms of cash management,
costs reach R150 000 for the Flexing machine, whereas they should never exceed R1400 000 for the
Binding model. On the other hand for the Flexing machine, costs could drop to only R750 000. There
is not a great difference in the NPC for each machine and should the costs fall for the Flexing machine
or rise for the Binding machine, there may be little to choose between the two of them.
ii)
Flexing Machine (‘000)
Expected Deviation2 Variance
Probability Cost Deviation millions
Cost millions
10.0% 750 75 -411 168,921 16,892
40.0% 900 360 -261 68,121 27,248
30.0% 1,420 426 259 67,081 20,124
20.0% 1,500 300 339 114,921 22,984
100.0% 1,161 Variance (m) 87,249
Standard Deviation 295 379
Standard deviation = (R87 248 000 000)0.5
= R295 379
Coefficient of variation = 295 379/1 161 000
= 0,254
b)
Flexing Machine Binding Machine
Z score = (1200 - 1161)/295.38 = (1200 - 1280)/122.88
= 39/295.38 = 80/122.88
= 0.132 = -0.651
Table reading = 0.0517 = -0.2422
3-17
NWABISA LTD
a) Unless there is information which indicates that future factors will impact on Nwabisa
Limited differently to past factors, the most likely return on this investment is 24%.
b) Such factors are probably best discussed by investigating from the most remote factors to
those directly affecting the company as follows:
If conditions seem to be more favourable than the past, investors may be optimistic about exceeding
the historic mean return.
c) i)
More than 33%
Z score = (33-24)/9
= 1
A negative return
Z score = (0-24)/9
= -2.67
Note: The probability that the return will be above 0%, is (0.5+0.4962) = 99.62%
3-17 (continued)
Any slight difference is due to rounding differences due to using Table E. Excel is more accurate.
3-18
a) With interest rates fluctuating in the market, fixed rate government bonds will sell at
fluctuating prices. In retrospect it is possible that the actual returns received over time as a percentage
of capital invested with deviate from the nominal rate. From an ex ante perspective the existing yield to
maturity reflects all future expectations and as there is no risk of default, the future stream of income is
not expected to show any variation. The ex ante standard deviation is therefore always zero.
b)
Coefficient of Variation
Government Bonds 2/8 = 0.25
Paveco Limited 8/14 = 0.57
Energet Limited 12/18 = 0.67
Argyle Limited 11/20 = 0.55
c) The two most fundamental issues to be considered are the expected return and the
estimated risk. The mean returns reflect an average of past returns. An assessment of whether those
returns can be expected to continue in the future is required. The estimated risk has been based on the
standard deviation. The coefficient of variation reflects the units of risk per expected percentage point
of return. Clearly, the government bond is the least risky and the ex ante standard deviation would be
expected to be zero. Energet Ltd seems to have a higher quantum of risk per percentage point of return,
while Argyle offers the lowest.
d) The risk associated with Energet Ltd is higher than that of Argyle, while Argyle is reflecting
higher returns. This situation cannot persist into the future. Risk and return are integrally related and
market forces will cause an adjustment so that expected return is commensurate with risk for all shares
trading in the market.
Probability of less than a zero return is therefore 0.5 - 0.4599 which is around 4%.
Workings
Mean return Standard Coefficient of
(Re) Deviation (s) Variation (CV)
σ = 2 = 0.25
Government bonds 8% 2% Re 8
σ 8 = 0.5714
= 14
Paveco Ltd 14 8 Re
σ 12 = 0.6667
= 18
Energet Ltd 18 12 Re
σ = 11 = 0.55
Argyle Ltd 20 11 Re 20
Note: This is the probability of 0 < z < 1.75. Given the symmetry of the normal curve, this is
equivalent to the probability of –1.75 < z < 0. We are interested in finding the probability of z < -1.75.
We can find this as follows:
P(z < -1.75) = P(z < 0) – P(-1.75 < z < 0) = 0.5 – 0.4599 = 0.0401 = 4.01%
3-19
Mr Fossil should invest in Company A which offers the lowest level of risk and a lower return.
Mr Steady should invest in Company C, which offers medium returns with medium levels of risk.
Mr. Quickbuck should invest in Company E, which offers the highest expected return, albeit at a higher level of risk.
Workings
3-20
(a) What is the expected return and standard deviation?
S Ltd T Ltd
20x1 1 18% 10%
20x2 2 15% 12%
20x3 3 15% 14%
20x4 4 18% 12%
20x5 5 18% 12%
20x6 6 5% 12%
20x7 7 -10% 12%
20x8 8 18% 10%
20x9 9 20% 12%
We used Excel functions to determine the expected return and std. dev.
We could do it the long way by squaring the deviations from the mean and multiplying
this by the probability of occurance (1/9).
3-20 (continued)
(b)
An investor that is indifferent to risk would invest in S Ltd. It offers a higher return, 13% as compared to
11.8% for company, T Ltd.
However, investors would normally take risk into account and the risk of investing in S Ltd is significantly
higher than the risk of investing in T Ltd. Yet the return for S Ltd is only marginally higher. It seems that
for most investors the additional risk is not worth taking on for the additional return that S offers. The
question did indicate that the investor was indifferent to risk and would select S Ltd.
(c)
A risk-averse investor would definitely invest in T Ltd. It offers an expected return of 11.8%, and a
standard deviation of only 1.1%. This means that 67% of returns will be within the range of about 10.7%
to 12.9%.
Workings
3-21