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AND RATES OF
RETURNS
INVESTMENTS, RISKS
AND RATES OF RETURNS
▰ Types of Risks
Business Operations and Financing
▰ Measures of Risks
a. Beta
b. Coefficient of Variation
c. Standard Deviation
▰ Degree of Operating, Financial and Total
Leverage
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What is a risk?
A probability or threat of damage,
injury, liability, loss, or any other
negative occurrence that is caused by
external or internal vulnerabilities, and
that may be avoided through pre-
emptive action.
Any action or activity that leads to loss.
Risk is inherent in any business enterprise, and
good risk management is an essential aspect of running
a successful business. 3
TYPES OF RISK
2. Financial Risk
Risks that involves financial loss to firms.
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BUSINESS RISKS
Business Risk is a future possibility that may prevent you from achieving a business
goal.
1.Competitive Risk 11.Country Risk
2.Economic Risk 12.Quality Risk
3.Operational Risk 13.Credit Risk
4.Legal Risk 14.Exchange Rate Risk
5.Compliance Risk 15.Internet Rate Risk
6.Strategy Risk 16.Taxation Risk
7.Reputational Risk 17.Process Risk
8.Program Risk 18.Resource Risk
9.Project Risk 19.Political Risk
10.Innovation Risk 20.Seasonal Risk
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BUSINESS RISKS
1.Competitive Risk
The risk that your competition will gain advantages over
you that prevents you from reaching your goals.
Example: Competitors that have a fundamentally cheaper cost
base or a better product.
2.Economic Risk
The possibility that conditions in the economy will
increase your costs or reduce your sales.
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BUSINESS RISKS
3. Operational Risk
The potential of failures related to day-to-day operations of
an organization such as customer service process.
4. Legal Risk
The chance that new regulations will disrupt your business
that you will incur expenses and expenses due to a legal
dispute.
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BUSINESS RISKS
5. Compliance Risk
The chance that you will break rules and regulations. In
many cases, a business may fully intend to follow the law
but ends up violating regulations due to oversights or
errors.
6.Strategy Risk
The risks associated with a particular strategy.
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BUSINESS RISKS
7. Reputational Risk
Reputational risk is the chance of losses due to a
declining reputation as a result of practices or incidents
that are perceived as dishonest, disrespectful or
incompetent. The term tends to be used to describe the
risk of a serious loss of confidence in an organization
rather than a minor decline in reputation.
8. Program Risk
The risks associated with a particular business program or
portfolio of projects.
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BUSINESS RISKS
9. Project Risk
The risks associated with a project. Risk management of
projects is a relatively mature discipline that is enshrined
in major project management methodologies.
10. Innovation Risk
Risk that applies to innovative areas of your business
such as product research.
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BUSINESS RISKS
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BUSINESS RISKS
13.Credit Risk
The risk that those who owe you money to fail to pay. For
the majority of businesses this is mostly related to
accounts receivable risk.
14.Exchange Rate Risk
The risk that volatility in foreign exchange rates will
impact the value of business transactions and assets.
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BUSINESS RISKS
15.Internet Rate Risk
The risk that changes to interest rates will disrupt your
business.
Example: Interest rates may increase your cost of capital thus
impacting your business model and profitability.
16.Taxation Risk
The potential for new tax laws or interpretations to result
in higher than expected taxation. In some cases, new tax
laws can completely disrupt the business model of an
industry.
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BUSINESS RISKS
17.Process Risk
The business risks associated with a particular process.
Processes tend to be a focus of risk management as
reducing risks in core business processes can often yield
cost reductions and improved revenue.
18.Resource Risk
The chance that you will fail to meet business goals due
to a lack of resources such as financing or the labour of
skilled workers.
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BUSINESS RISKS
19.Political Risk
The potential for political events and outcomes to impede
your business.
20.Seasonal Risk
A business with revenue that’s concentrated in a single
season such as a ski resort.
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TYPES OF FINANCIAL
RISKS
1. Market Risk
2. Credit Risk
3. Liquidity Risk
4. Operational Risk
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Market Risk
Market risk involves the risk of changing
conditions in the specific marketplace in which a
company competes for business.
This type of risk arises due to the movement in prices of
financial instrument.
Directional Risk - caused due to movement in stock price, interest rates
and more.
Non-Directional Risk - volatility risks.
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Credit Risk
Arises when one fails to fulfill their obligations
towards their counterparties.
Credit Rik is the risk businesses incur by extending credit to
customers. It can also refer to the company's own credit risk
with suppliers.
Sovereign Risk - arises due to difficult foreign exchange policies.
Settlement Risk - arises when one party makes the payment while the
other party fails to fulfill the obligations.
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Liquidity Risk
▰ Liquidity risks includes asset liquidity and operational funding
liquidity risk.
Asset liquidity refers to the relative ease with which a company can
convert its assets into cash should there be a sudden, substantial need
for additional cash flow.
Operational funding liquidity is a reference to daily cash flow.
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Operational Risk
Arises out of operational failures such as mismanagement
or technical failures.
The operational risk category includes lawsuits, fraud risk, personnel
problems, and business model risk which is the risk that a company's
models of marketing and growth plans may prove to be inaccurate or
inadequate.
Fraud Risk - arises due to lack of control
Model Risk - arises due to incorrect model application
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MEASURES OF
RISKS
A. BETA
B. COEFFICIENT OF VARIATION
C. STANDARD DEVIATION
RISK MANAGEMENT
Risk management is a crucial process used
to make investment decisions. Risk
measurement is a key component of risk
management and ongoing performance
assessment.
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HOW IS RISK
MEASURED?
Risk is a rather fluid concept, yet experts have
developed ways to measure it. To them, risk equals
volatility, fluctuations in the price of a security or
index of securities. The more fluctuation, the
higher the volatility. Generally, the higher the
volatility, the higher the risk--but also the potential
for a higher rate of return.
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MEASURES OF RISK
Three of the most used common measures of risk
are beta, coefficient of variation, and standard
deviation.
Beta
a risk ratio that measures the systematic risk
(e.g. volatility) of an investment in comparison
to the market as a whole.
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BETA
Beta is represented as a positive integer, with 1 as a baseline measure
representing perfect matching of the security and market price movements.
ß > 1 : indicates the security will have more movement than the market/ high
volatility
ß < 1 : indicates the security will move less than the market/ low volatility
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Coefficient of Variation
In finance, the coefficient variation is important in investment
selection. From a financial perspective, the financial metric
represents the risk-to-reward ratio where the volatility shows the
risk of an investment and the mean indicates the reward of an
investment.
By determining the coefficient of variation of different securities, an
investor identifies the risk-to-reward ratio of each security and
develops an investment decision.
Generally, an investor seeks a security with a lower coefficient (of variation) because it
provides the most optimal risk-to-reward ratio with low volatility but high returns.
However, the low coefficient is not favorable when the average (expected return) is
below zero. 27
Formula
Mathematically, the standard formula for the coefficient of
variation is expressed in the following way:
Where:
σ – the standard deviation
μ – the mean
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Formula
In the context of finance, we can re-write the above formula
in the following way:
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EXAMPLE
Stocks: Fred was offered stocks of ABC Corp. It is a mature
company with the strong operational and financial
performance. The volatility of the stock is 10% and the
expected return is 14%.
ETFs: Another option is the Exchange-Traded Fund (ETF),
which tracks the performance of the S&P 500 index. The ETF
offers an expected return of 13% with a volatility of 7%.
Bonds: Bonds with excellent credit ratings offer an expected
return of 3% with a 2% volatility.
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EXAMPLE
In order to select the most suitable investment opportunity, Fred decided to
calculate the coefficient of variation of each option. Using the formula above, he
obtained the following results:
Based on the calculations above, Fred wants to invest in ETF because it offers the
lowest coefficient (of variation) and the most optimal risk-to-reward ratio.
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Standard Deviation
Standard deviation measures the dispersion of data from
its expected value.
The standard deviation is used in making an investment
decision to measure the amount of historical
volatility associated with an investment relative to its
annual rate of return.
It indicates how much the current return is deviating from its
expected historical normal returns.
For example, a stock that has a high standard deviation experiences
higher volatility, and therefore, a higher level of risk is associated with
the stock. 32
Standard Deviation
Standard deviation helps determine market
volatility or the spread of asset prices from
their average price.
When prices move wildly, standard deviation is
high, meaning an investment will be risky.
Low standard deviation means prices are calm,
so investments come with low risk.
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Formula:
Where,
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DEGREE OF
LEVERAGE
OPERATING LEVERAGE, FINANCIAL LEVERAGE AND TOTAL
LEVERAGE
LEVERAGE
The use of various financial instruments or borrowed
capital, such as margin, to increase the potential return
of an investment.
The amount of debt used to financed a firm's assets. A
firm with significantly more debt than equity is
considered to be highly leveraged.
DEGREE OF LEVERAGE: Measure of how much
leverage the firm uses.
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CLASSIFICATION OF
LEVERAGE
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OPERATING LEVERAGE
Operating Leverage is the ratio of a company's
fixed costs to its variable costs.
It is used to evaluate a business’ breakeven point—
which is where sales are high enough to pay for all
costs and the profit is zero.
A firm with relatively high fixed operating cost will
experience more variable operating income if sales
change.
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EFFECT OF OPERATING
LEVERAGE
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Degree of Operating Leverage
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What does this tell us?
If DOL = 2, then a 1% increase in sales will result in a 2%
increase in operating income (EBIT).
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FINANCIAL
LEVERAGE
The use of fixed-cost sources of financing (debt, prefered
stock) rather than variable-cost sources (common stock).
Additional volatility of net income caused by the presence of
fixed costs funds.
The potential benefits are that if operating income is rising,
net income will rise more quickly. The negative side is that if
operating income is falling, net income will fall more quickly.
It is a two-edged sword (positive and negative).
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DEGREE OF FINANCIAL
LEVERAGE
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FORMULA
DFL = %change in EPS / %change in EBIT
= (change in EPS/EPS) / (change in EBIT/EBIT)
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What does this tell us?
If DFL = 3, then a 1% increase in operating income will result
in a 3% increase in earnings per share.
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TOTAL LEVERAGE
Total Leverage: by using operating leverage and financial
leverage, a small change in sales is magnified into a larger
change in earnings per share.
This multiplier effect is called the degree of total leverage.
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FORMULA
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What does this tell us?
If DTL = 4, then a 1% increase in sales will result in a 4%
increase in earnings per share.
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LEVERED COMPANY (EXAMPLE)
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DOL
DOL = (Sale - Variable Cost) / EBIT
= (1,400,000 - 800,000) / 350,000
= 1.714
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DFL
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DTL
DTL = (Sales - Variable Costs) / (EBIT
- I)
= (1,400,000 - 800,000) / 225,000
= 2.667
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OPERATING VS. FINANCIAL
LEVERAGE
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Key Takeaways
The degree of operating leverage (DOL) is a multiple that
measures how much the operating income of a company will
change in response to a change in sales.
The DOL ratio assists analysts in determining the impact of
any change in sales on company earnings.
A company with high operating leverage has a large
proportion of fixed costs, which means that a big increase in
sales can lead to outsized changes in profits.
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Key Takeaways
The degree of financial leverage (DFL) is a leverage ratio that
measures the sensitivity of a company’s earnings per share to
fluctuations in its operating income, as a result of changes in
its capital structure.
This ratio indicates that the higher the degree of financial
leverage, the more volatile earnings will be.
The use of financial leverage varies greatly by industry and by
the business sector.
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