Financial Management:: Risk, Return, and Valuation

Financial Management:
Principles & Applications

Thirteenth Edition
Chapter 4
Risk, Return, and
Valuation
Copyright © 2018, 2014, 2011 Pearson

CopyrightEducation, Inc. All
© 2018, 2014, 2011 Pearson Rights
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Learning Objectives
1. Return defined and measured
2. Risk defined and measured
3. Portfolio Risk and Return
4. Capital Asset Pricing Model (CAPM)
5. Explain the efficient market hypothesis and why
it is important to stock prices.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
4.1 RETURN DEFINED AND
MEASURED
RETURN
Return is the primary motivating force that drives
investment. It represents the reward for undertaking
investment.
Methods of Return Measurement
The two most popular summary statistics are as follows:
1. Arithmetic Mean Return
2. Geometric Mean Return
Other Methods of Return Measurement
3. Return on Equity (ROE)
4. Internal Rate of Return (IRR)
5. Weighted Average Required Rate of Return
RETURN
Arithmetic Mean Return : A measure of mean annual
rates of return equal to the sum of annual holding period
rates of return divided by the number of years.
r i
R 
n
Geometric Mean Return :The geometric (compound)
average rate of return answers the question, “What was
the growth rate of your investment?”
1
GM  [(1  r1 )(1  r2 )(1  r3 )....(1  rn )]  1
n
RETURN
Example 1: A stock earns the following returns over a
four year period: r1 = 0.30, r2 = -0.20, r3 = 0.42 and r4=
0.36. Calculate the following:
(a) Arithmetic Mean Return
(b) Geometric Mean Return.
Solution
0.30 - 0.20 + 0.42 + 0.36
R  0.22 100%  22%
4 1
GM  [(1  .30)(1  .20)(1  .42)(1  .36)] 4  1
1
GM  [(1.3)(0.8)(1.42)(1.36)]  1
4
GM  1.19  1  0.19  100%  19%

RETURN
Problem 1: Ali invested $12014.88 in SOM Meat
Distributors five years ago. The investment had yearly
arithmetic returns of -9.7%, -8.1%, 15%, 7.2%, and
15.4%. Compute the following:
a) Arithmetic Mean Return (3.96%)
b) Geometric Mean Return (3.38%).
4.2 RISK DEFINED AND MEASURED
RISK
Risk is the chance that the actual return from an
investment may be less than the forecast return. Risk
refers to the chance that some unfavorable event will
occur. Risk refers to potential variability in future cash
flows.
Types of Risk
The various risks that must be considered when making
financial and investment decisions are as follows:
1. Business risk
2. Liquidity risk
3. Default risk
Types of Risk
4. Market risk
5. Interest rate risk
6. Purchasing power risk
Business risk is caused by fluctuations of earnings
before interest and taxes (operating income).Business
risk depends on variability in demand, sales price, input
prices, and amount of operating leverage.
Liquidity risk is the risk that a company or bank may be
unable to meet short term financial demands. This
usually occurs due to the inability to convert a security or
hard asset to cash without a loss of capital and/or
income in the process.
Types of Risk
Default risk is the risk that a borrower will be unable to
make interest payments or principal repayments on debt.
For example, there is a great amount of default risk
inherent in the bonds of a company experiencing
financial difficulty.
Market risk, also called "systematic risk," cannot be
eliminated through diversification, though it can be
hedged against. Sources of market risk include
recessions, changes in interest rates & natural disasters.
Interest rate risk is the risk resulting from fluctuations in
the value of an asset as interest rates change. For
example, if interest rates rise (fall), bond prices fall (rise).
RISK
Purchasing power risk is the risk that a rise in price will
reduce the quantity of goods that can be purchased with
a fixed sum of money.
Methods of Risk Measurement
The level of risk may be measured by various methods.
Some of them are as follows:
1. Standard deviation
2. Coefficient of variation
3. Sharpe Ratio
4. Beta coefficient
Expected Rate of Return
Expected rate of return is the rate of return expected
to be realized from an investment. Expected return
E(𝒓) is what the investor expects to earn from an
investment in the future. The expected rate of return
is the weighted average of the possible returns for an
investment. It is the weighted average of the possible
returns, where the weights are determined by the
probability that it occurs.
Mathematically,
r   pi ri
Standard Deviation
•Standard
deviation (is a measure of how far the actual
return is likely to deviate from the expected return. The
smaller the standard deviation, the tighter the probability
distribution and, thus, the lower the risk of the
investment. Variance is the average squared difference
between the individual realized returns and the expected
return. Standard deviation is the square root of the
variance and is more commonly used to quantify risk.
   (r i  r ) Pi
2
Coefficient of variation
•Coefficient
of variation (CV) is the standardized
measure of the risk per unit of return. Therefore, when
comparing securities that have different expected
returns, use the coefficient of variation. The coefficient
of variation is computed simply by dividing the standard
deviation for a security by expected value: /. The higher
the coefficient, the more risky the security.

CV 
r
RISK
Example 2: Assuming the following probability distribution of the
possible returns, calculate the expected return 𝒓I , the standard
deviation (𝝈) of the returns & Compute the coefficient of variation
(CV). Yrs.
1
1 0.1
0.1 -20%
-20%
2
2 0.2
0.2 5%
5%
3
3 0.3
0.3 10%
10%
4
4 0.4
0.4 25%
25%
Solution
r   pi ri &    i
( r  r ) 2
Pi
RISK
( (
0.1 -20 -2 -32 1024 102.4
0.2 5% 1 -7 49 9.8
0.3 10% 3 -2 4 1.2
0.4 25% 10 13 169 67.6
r =12% 2
=181
r   pi ri  12%
  181  13.45%
 13.45
CV    1.12
r 12
RISK
Problem 2 : The probability distribution of the rate of return
on Sintech Limited is as follows:
Rate of Return Probability
10% 0.2
20% 0.3
30% 0.5
a. What is the expected rate of return?
b. What is the standard deviation of the rate of return?
c. Compute the coefficient of variation (CV)
RISK
Example 3: Ken Parker must decide which of two securities
is best for him. By using probability estimates, he computed
the following statistics:
a. Compute the coefficient of variation for each security, and

b. Which method is superior and why?
Solution
 20  10
CV    1.67 CV    1.25
rx 12 ry 8
RISK
The coefficient of variation is therefore the more useful
measure of relative risk. The lower the coefficient of
variation, the less risky the security relative to the
expected return. Thus, in this problem, security Y is
relatively less risky than security X.
Example 4: Stocks A and B have the following probability
distributions of possible future returns:
RISK
a. Calculate the expected rate of return for each stock
and the standard deviation of returns for each stock
b. Calculate the coefficient of variation
c. Which stock is less risky? Explain.
Solution
( (
0.1 -15 -1.5 -20 400 40
0.2 0 0 -5 25 5
0.4 5 2 0 0 0
0.2 10 2 5 25 5
0.1 25 2.5 20 400
r pr i i  5%   90  9.5%
RISK
• Solution
( (
0.1 -20 -2 -39 1521 152.1
0.2 10 2 -9 81 16.2
0.4 20 8 1 1 0.4
0.2 30 6 11 121 24.2
0.1 50 5 31 961
r pr i i  19%   289  17%

b) The coefficient of variation is /. Thus, for stock A:
 9.5  17
CV    1.9 CV    0.89
ra 5 rb 19
RISK
c) Stock B is less risky than stock A since the coefficient
of variation is smaller for stock B.
Problem 3 : Using the following information for Hilac,
Inc.'s stock, calculate their expected return, standard
deviation and coefficient of variation.
State Probability Return
Boom 20% 40%
Normal 60% 15%
Recession 20% (20%)
Answer: 13%, 19.13% & 1.4715
Sharpe Ratio
Stand-Alone Risk is the risk an investor would face if he
or she held only one asset.
Sharpe Ratio is a measure of standalone risk that
compares the assets realized excess return to its
standard deviation over a specified period. An investment
with a higher ratio has performed better than one with a
lower ratio.
Sharpe ratio  (Return - Risk free rate)/
Sharpe Ratio
Example 5: Historical returns for Stocks A and B over the
past 5 years are listed below. The risk-free rate is 3%.
a. What are the coefficients of variation for Stocks A and B?

b. What are the Sharpe ratios for Stocks A and B? Which
stock has performed better on a risk-adjusted basis?
Explain.
RISK
Solution
(
1 20 5.6 31.36
2 30 15.6 243.36
3 -2 -16.4 268.96
4 6 -8.4 70.56
5 18 3.6 12.96
14.4% 627.2
r 
 r i

72
 14.4 S
 i
( r  r ) 2

627.2
 12.52%
n 5 n 1 5 1
S 12.52
CV    0.87
r 14.4
RISK
Solution
(
1 25 0.1 0.01
2 18 -6.9 47.61
3 50 25.1 630
4 10 -14.9 222
5 21.5 -3.4 11.56
24.9% 911.18
r 
 r i

124.5
 24.9 S 
 i
( r  r ) 2

911 .18
 15.09%
n 5 n 1 5 1
S 15.09
CV    0.61
r 24.9
Sharpe Ratio
Solution
b. The Sharpe ratio for Stock A
Sharpe ratio  (r  rf )/
 (14.4  3)/12.52  0.91
The Sharpe ratio for Stock B

Sharpe ratio  (r  rf )/
 (24.9  3)/15.09  1.45
Stock B has the lower coefficient of variation and the
higher Sharpe ratio—indicating that Stock B has
performed better on a risk-adjusted basis.
ASSIGNMENT
1. Ali invested $12014.88 in SOM Meat Distributors five
years ago. The investment had yearly arithmetic
returns of -9.7%, -8.1%, 15%, 7.2%, and 15.4%.
Compute the following:
a. Arithmetic Mean Return (3.96%)
b. Geometric Mean Return (3.38%).
2. Susan Bright will get returns of 18%, -20.3%, -14%,
17.6%, and 8.3% in the next five years on her
investment in Coffee Town, Inc. stock, which she
purchases for $73,419.66 today. Find the following:
a. Arithmetic Mean Return (1.92%)
b. Geometric Mean Return (.59%).
ASSIGNMENT
3. If there is a 20% chance we will get a 16% return, a
30% chance of getting a 14% return, a 40% chance
of getting a 12% return, and a 10% chance of getting
an 8% return, what is the expected rate of return?
Answer: 13%
4. You are considering investing in a firm that has the
following possible outcomes:
Economic boom: probability of 25%; return of 25%
Economic growth: probability of 60%; return of 15%
Economic decline: probability of 15%; return of -5%
What is the standard deviation of returns on the
investment? Answer: 9.21
ASSIGNMENT
5. You are considering investing in a project with the
following possible outcomes:
Probability of Investment
States Occurrence Returns
State 1: Economic boom 15% 16%
State 2: Economic growth 45% 12%
State 3: Economic decline 25% 5%
State 4: Depression 15% -5%
Calculate the expected rate of return for this investment.
Answer: 8.3%
ASSIGNMENT
6. What is the standard deviation of an investment that
has the following expected scenario? 18% probability of
a recession, 2.0% return; 65% probability of a moderate
economy, 9.5% return; 17% probability of a strong
economy, 14.2% return. Answer: 3.68%
7. The probability distribution of the rate of return on Intech
Limited is as follows :
10% 0.3
20% 0.5
30% 0.2
ASSIGNMENT
6. What is the standard deviation of an investment that
has the following expected scenario? 18% probability of
a recession, 2.0% return; 65% probability of a moderate
economy, 9.5% return; 17% probability of a strong
economy, 14.2% return. Answer: 3.68%
7. The probability distribution of the rate of return on Intech
Limited is as follows :
10% 0.3
20% 0.5
30% 0.2
Chapter 4: Part A
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Financial Management:

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Copyright © 2018, 2014, 2011 Pearson

GM  1.19  1  0.19  100%  19%

a. Compute the coefficient of variation for each security, and

r pr i i  19%   289  17%

a. What are the coefficients of variation for Stocks A and B?

The Sharpe ratio for Stock B

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