Financia

l
Financial
Management
Manage
ment
Chapter Five Part one

( FMI ) Romario
RomarioKhaled
Khaled
2024 01271535731
01271535731
01149154059
01149154059
 Financial Management [CHAPTER FIVE PART ONE]

Chapter 5 Part one

RISK AND THE REQUIRED RATE OF RETURN

Learning objective
1. The Meaning of Risk, Return, and Risk Preferences.
2. Assessing and Measuring Risk and Return for a Single Asset.
3. Measuring Risk and Return for a Portfolio.
4. The Types of Risk and the Role of Beta in Measuring the Relevant Risk.
5. The Capital Asset Pricing Model (CAPM) and its Relationship to the Security
Market Line (SML).
6. The Major Forces Causing Shifts in the Security Market Line (SML)

1. The Meaning of Risk, Return, and Risk Preferences.

1-1– what do mean by Risk and Return

Certainty : is that if we are certain 100% of outcome or return of any action ( no Risk )
Uncertainty : is that if we are not certain 100% of outcome of any action and there
were more than on expected outcomes some of it best and other is worst ( that is Risk )
Risk :
- is a measure ‫ قياس‬of the uncertainty surrounding the re- turn that an investment will
earn.
- is related to ( volatility ‫ & تقلب‬changeability ‫ & تغير‬variability ) of returns
. ‫هو عدم اليقين و التاكد من النتائج و ذلك لوجود احتماالت كثيرة من االيجابي و السلبى‬
- Is the Possibility of lose
- defined as Risk , Inflation ,Discount rate ,Required rate of return , range
and Standard deviation

Return :
- is the total gain or loss of an investment over a given period.( time value and frame )
- is the price of Risk ‫ثمن تحمل الخطورة‬
Any investment or assets have 2 returns
1 - Income received as ( Dividends ‫ & توزيعات الرباح‬interest payments ‫ ) فوايد‬cash flow
received . ( Profit Maximization )
2 – Change in Value ‫تغير قيمة االصل او استثمار مثال لو سهم ف هيبقى قيمته فى السوق حاال اللى ممكن تزيد او‬
(Wealth Maximization ) ‫تقل‬

Romario Khaled 01149154059 Page 1

Financial Management [CHAPTER FIVE PART ONE]

1-2 – Risk preference and attitude toward risk ‫انواع المستثمرين و ميلهم للمخاطرة‬
(High Risk Expected High Return )
Risk : is the probability that investor cannot cover the money paid in the investment
- Economist use three categories to describe how investor respond to risk
( Trade off ) ‫التنازل عن ميزة ممن أجل الحصول على أخرى‬

- prefers less risky over more risky investments,

- who believes that two different investments have the same expected return
will choose the investment whose returns are more certain & Stated
1 -Risk Averse
- when choosing between two investments, a risk-averse investor will not
‫متجنب المخاطر‬ make the riskier investment un- less it offers a higher expected return to
compensate the investor for bearing the additional risk.
- chooses investments based solely on their expected returns,
2 - Risks neutral Disregarding the risks ‫يتجاهل المخاطر‬.
‫محايد‬ - When choosing between two investments, a risk-neutral investor will
always choose the investment with the higher expected return
Risk indifferent
regardless of its risk.
‫غير مهتم بال مخاطر‬
3 - Risk Taker or prefers investments with higher risk and may even sacrifice ‫ يضحى‬some
seeking ‫مجازف‬ expected return when choosing a riskier investment.

Romario Khaled 01149154059 Page 2

 Financial Management [CHAPTER FIVE PART ONE]

2 - How to measure and assessing return of any Assets ( investment )

2-1 – Actual Rate of Return ( Already Done) (No Probability )
is the sum of any cash distributions (for example, dividends or interest payments) plus
the change in the investment’s value( new – old ) , divided by the beginning-of-period
value. (old )
‫تعالي نفرض مثال ان ده سم فبعد سنة لو عايز احسب هو كسبنى وال خسرنى او العائد منه ايه هبص علي توزيعات االرباح‬
‫اللى اخدتها و علي سعره دلوقتى كام اما لو عايز اعرف نسبة العائد هستخدم القانون ده‬

‫) كاش ( توزيعات االرباح‬ ‫السعر اول المدة‬ ‫السعر اخر المدة‬

‫العائد من االستثمار‬
‫السعر اول المدة‬
Example 5.1 :
Romario Purchase a new House by 20.000 $ at 1/1/2023 and he start to rent it to software
company by annual rent 3000 $ at 30/6/2023 Romario house is worth by 25.000. $
Calculate Romario return at 30/6/2023 and Find the annual return
Solution

B)Annual rate of return

Semiannual multiply by 2 ( 40 % * 2 = 80 % annual rate of return )

If you want the annual rate of return and given is :

Semiannual multiply by 2
Quarterly multiply by 4

5 Years divided by 5

Romario Khaled 01149154059 Page 3

Financial Management [CHAPTER FIVE PART ONE]

Example 5.2 :
Robin wishes to determine the return on two stocks that she owned during 2012, Apple Inc., and
Wal-Mart. At the beginning of the year, Apple stock traded for $411.23 per share, and Wal-Mart
was valued at $60.33. During the year, Apple paid $5.30 in dividends, and Wal-Mart shareholders
received dividends of $1.59 per share. At the end of the year, Apple stock was worth $532.17, and
Wal-Mart sold for $68.23. Substituting into Equation 8.1, we can calculate the annual rate of
return, r, for each stock
Solution

Given
Stock Apple Wal-Mart
(old) 411.23 $ 60.33 $
5.3 $ 1.59 $
(new ) 532.17 $ 68.23 $

Romario Khaled 01149154059 Page 4

Financial Management [CHAPTER FIVE PART ONE]

2-2- The Expected Rate of Return [ E(R) ] ‫ ( المحتمل‬Probability )

Example 5.3 :
Romario Decide to open Café , but before start a business he need to valuate the Expected rate of
return to café business in Egypt .from a survey he find that there are 3 main cases and each case
have rate of return and probability to happen along the year .
State of the economy Probability of state Return of stock A
Optimistic (Booming ) 20 % 25 %
Most likely ( normal ) 60 % 18%
Pessimistic ( Recession ) 20 % -10 %
Solution
To calculate Expected rate of return we must use

The Expected rate of return will be :

Get the sum of multiplication of
(probability of case one *return of case one ) + (probability of case Two *return of case Two )
+ (probability of case three *return of case three )
E(R) = r = (20 % * 25 % + 60 % * 18 % + 20 % * - 10% ) = 13.8 %
Example 5.4 :

the following data is to 2 investment in different stocks . Find the Expected return of 2 Projects

State of the economy Probability of state Return of stock A Return of stock B

Optimistic (Booming ) 20 % 25 % 60 %
Most likely ( normal ) 60 % 18% 20 %
Pessimistic ( Recession ) 20 % 10 % - 15 %

Solution

E(R) A = (20 % * 25 % ) + ( 60 % * 18 % ) + ( 20 % * 18 % ) = 17.8 %

E (R) B = . (20 % * 60 % ) + ( 60 % * 20 % ) + ( 20 % * 15 % ) = 21%

Romario Khaled 01149154059 Page 5

Financial Management [CHAPTER FIVE PART ONE]

Most common MCQ and (T&F) of this part and Exams

1 For the risk-seeking manager, no change in return would be required for an increase FALSE
in risk.
For the risk-averse manager, required return would decrease for an increase in risk. FALSE
2
3 For the risk-indifferent manager, no change in return would be required for an increase in True
risk.
The return on an asset is the change in its value plus any cash distribution over a given FALSE
4
period of time, expressed as a percentage of its ending value.( beg value )
5 For the risk-averse manager, the required return decreases for an increase in risk FALSE
6 Business risk is the chance that the firm will be unable to cover its operating costs and is True
affected by a firm's revenue stability and the structure of its operating costs (fixed vs.
variable).
7 ) Interest rate risk is the chance that changes in interest rates will adversely affect the value True
of an investment; most investments decline in value when the interest rates rise and increase
in value when interest rates fall.
8 Liquidity risk is the chance that changes in interest rates will adversely affect the value of an FALSE
investment; most investments decline in value when the interest rates rise and increase in
value when interest rates fall.
9 If a person's required return does not change when risk increases, that person is said to be
A) risk-seeking. B.) risk-neutral.
C) risk-averse. D) risk-aware. B
1 If a person's required return decreases for an increase in risk, that person is said to be
0 A.) risk-seeking. B) risk-indifferent. A
C) risk-averse. D) risk-aware
1 ________ is the chance of loss or the variability of returns associated with a given asset.
1 A) Return B) Value
C.) Risk D) Probability C
1 The ________ of an asset is the change in value plus any cash distributions expressed as a
2 percentage of the initial price or amount invested.
A.) return B) value A
C) risk D) probability
1 If a person requires greater return when risk increases, that person is said to be
3 A) risk-seeking. B) risk-indifferent.
C.) risk-averse. D) risk-aware. C
1 Last year Mike bought 100 shares of Dallas Corporation common stock for $53 per share.
4 During the year he received dividends of $1.45 per share. The stock is currently selling for D
$60 per share. What rate of return did Mike earn over the year?
A) 11.7 percent B) 13.2 percent
C) 14.1 percent D) 15.9 percent
1.45$+ (60$-53$)/53 = 15.9%

1 Tim purchased a bounce house one year ago for $6,500. During the year it generated $4,000
5 in cash flow. If Time sells the bounce house today, he could receive $6,100 for it. What C
would be his rate of return under these conditions?
$6,100 - $6,500  $4,000
Answer: Realized return = = 55%
$6,500

Romario Khaled 01149154059 Page 6

Financial Management [CHAPTER FIVE PART ONE]

2.3 - How to measure risk of an investment :

1 – scenario analysis : uses several possible alternative outcomes (scenarios)
pessimistic (worst), most likely (normal), and optimistic (best) outcomes and
the returns associated with them for a given asset.

2 – Range : is found by subtracting the return associated with the pessimistic outcome
from the return associated with the optimistic outcome.
( Range = optimistic - pessimistic)
The greater the range, the more risk .

Example 5-5 : calculate the range and identify the Risky assets to invest

Solution

Range ( A) = 17 % – 13 % = 4 %
Range (B) = 23% - 7 % = 16 %
Project B is the Risky
Example 5.6 : calculate the range and identify the Risky assets to invest

Solution

Romario Khaled 01149154059 Page 7

Financial Management [CHAPTER FIVE PART ONE]

3 – variance and standard deviation ‫االنحراف المعيارى او معيار التشتت‬

( the most use )
-The standard deviation, , measures the dispersion ‫ تشتت‬of an investment’s return
around the expected return .
The expected value of a return, r or [E( R )], is the average return that an investment is
expected to produce over time.
- measure the degree of deviation between Return and expected return
‫بيقيس االختالف ما بين العائد و العائد المتوقع مع مرور الوقت‬

Higher standard deviation and variance higher risk

OR = √

Steps :
1 – Find Expected Return if it not an give E( R ) r

2 – Find the( Variance ) : the sum of ( difference between Each Return and the
Expected return Step (1) (r – E(R )) Power 2 multiplied by its Probability (P).

3 – Find the square root of step (3)

√
Or Use

Romario Khaled 01149154059 Page 8

 Financial Management [CHAPTER FIVE PART ONE]

Example 5.7 : calculate the variance and SD identify the Risky assets to invest

-
Solution

- First step find expected rate of return E( R )

E ( R) A = (.25 * 13%) + (.5 * 15% )+ (.25 * 17%) = 15 %
E ( R) B = (.25 * 7% ) + (.5 * 15% )+ ( .25 *23%) = 15 %

- Second step find the Variance

Variance (A)= ∑ =
= ∑
= 1/5000 = to get in percentage multiply by 100 =.02 = 2 %
Variance (B) = ∑

= 2/625 = to get in percentage multiply by 100 =.32 = 32 %

Assets B is risker than A
- Third step fine SD
SD (A) = √
‫√ علي االله‬ ‫اوعي تعمل كدة‬
SD (B) = √
‫√ علي االله‬ ‫اوعي تعمل كدة‬
OR

Use

SD(B) =
√
= .0141 = 1.4 %

SD(B) = √
= .0565 = 5.6 %

Romario Khaled 01149154059 Page 9

 Financial Management [CHAPTER FIVE PART ONE]

Example 5.8 : Find the : Expected return and standard Deviation of this Assets

The expected value and the standard deviation of returns for asset A is (See below.)

Asset A

A) 12 percent and 4 percent

B) 12.7 percent and 2.3 percent
C) 12.7 percent and 4 percent .0004869 = .04869
D) 12 percent and 2.3 percent
Answer:

Return = .25 *10% + .45 * 12 % + .3 * 16 % = .127 = 12.7 %

SD =
√
= .023 = 2.3 %
Answer is B
4 - Coefficient of Variation ‫ معامل االختالف‬for (investor that risk nature )

OR

The coefficient of variation, CV :

- measure the risk per unit of return

- is a measure of relative dispersion (deviation) ‫التشتت‬that is useful in comparing the
risks of assets with differing expected returns.
- we often use the CV is to compare between two assets one of them have higher return
and the other have lower risk . (IMP)
- Higher coefficient of variation means that an investment has more volatility ‫( تقلب‬RISK)
‫ارتفاع معامل التشتت يعني أن االستثمار لديه المزيد من التقلبات نسبة إلى العائد المتوقع‬
Higher CV is higher risk
From the last example
CV of Assets A = %

CV of Assets B = %
Assets B is risker than A / Lower CV is better assets

Romario Khaled 01149154059 Page 10

Financial Management [CHAPTER FIVE PART ONE]

Example 5.9

Champion Breweries must choose between two asset purchases. The annual rate of
return and related probabilities given below summarize the firm's analysis.

For each asset, compute

(a)the expected rate of return.
(b) the standard deviation of the expected return.
(c)the coefficient of variation of the return.
(d) Which asset should Champion select?
Answer: (a)

(a) E (R ) Assets A = 30 % * 10 % + 40 % * 15 % + 30 % * 20 % = 15 %

E (R ) Assets B = 40 % * 5 % + 20 % * 15 % + 40 % * 25 % = 15 %

(b) SD(Assets A) =
√
= .0387 = 3.87 %

SD(Assets B) = √
= .0894 = 8.94 %

(c) CV(Assets A ) = 3.87% /15 % = 0.258 = 25.8 % = 26 %

CV ( Assets B ) = 8.94 % /15 % = 0.596 = 59.6 % = 60 %

(d) Asset A; for 15% rate of return and lesser risk. And less CV

Romario Khaled 01149154059 Page 11

Financial Management [CHAPTER FIVE PART ONE]

Imortant Note

Note that :
1 – if you have 2 investment have the same risk ( we will select the higher expected rate
of return )
2 - if you have 2 investment have the same expected rate of return ( we will select the
lowest risk )
3 - if you have 2 investment have different risk and different expected rate of return we
will use Coefficient of variance (CV) and select the lowest

5 -The Historical return ( more than one year ) (NO probability)

1 – average return =

where n is the number of observations (years or periods )

2 – Historical variance and SD =

3 -

Example 5.10
the return for an investment for Past 5 years is : 10 % ,18% ,12%,10%,5%
calculate CV .
1 – mean return or average return =

2 – standard deviation =

=√

CV = =

Romario Khaled 01149154059 Page 12

Financial Management [CHAPTER FIVE PART ONE]

Example 5.11 ( VIP )

Calculate the :
1 – Average return
2 – Historical SD
3 – CV
Answer
1 – Average return

2 - SD Historical =√

= 5.6 %

3- CV = 5.6% 10.5% = 0.53

Romario Khaled 01149154059 Page 13

Financial Management [CHAPTER FIVE PART ONE]

Investment A guarantees its holder $100 return. Investment B earns $0 or $200 with
1 equal chances (i.e., an average of $100) over the same period. Both investments have FALSE
equal risk. (Range )
The real utility of the coefficient of variation is in comparing assets that have equal expected FALSE
2 returns.
3 One measure of t he risk of an asset may be found by subtracting the worst outcome from the best
outcome. TRUE
The larger the difference between an asset's worst outcome from its best outcome, the higher the risk
4 of the asset. TRUE
5 The risk of an asset can be measured by its variance, which is found by subtracting the worst
outcome from the best outcome. FALSE
6 Coefficient of variation is a measure of relative dispersion used in comparing the expected returns of
assets with differing risks. ( ‫العكس‬ FALSE
7 The more certain the return from an asset, the less variability and therefore the less risk. True
8 The lower the coefficient of variation, the greater the risk and therefore the higher the expected FALSE
return.
9 The ________ is the extent of an asset's risk. It is found by subtracting the pessimistic outcome from
the optimistic outcome.
A) return D
B) standard deviation
C) probability distribution
D.) range
1 The ________ of an event occurring is the percentage chance of a given outcome.
0 A) dispersion
B) standard deviation C
C.) probability
D) reliability
1 Which asset would the risk-averse financial manager prefer? (See below.)
1

D
VIP

A) Asset A.
B) Asset B.
C) Asset C.
D.) Asset D.
1 Given the following expected returns and standard deviations of assets B, M, Q, and D, which asset
2 should the prudent ‫ حكيم‬financial manager select?
C

A.) Asset B
B) Asset M
C) Asset Q
D) Asset D

Romario Khaled 01149154059 Page 14