Risk

and
Leverage
CPALE Syllabus Covered
2.2.4 Risks and leverage
2.2.4.1 Types of risks (business/operating,
financing)
2.2.4.2 Measures of risks (coefficient of
variation and standard deviation)
2.2.4.3 Degree of operating, financial and total
leverage
Risks
• Risk is defined in financial terms as the chance that an outcome
or investment’s actual gains will differ from an expected outcome
or return.
• Risk includes the possibility of losing some or all of an original
investment.
• A fundamental idea in finance is the relationship between risk
and return.
o The greater the amount of risk an investor is willing to take,
the greater the potential return.
o Risks can be reduced using diversification and hedging
strategies.
TYPES OF RISKS
1. Financial Risk – Systematic risks and Unsystematic risk
o Systematic risks – also known as market risk, are risks that
can affect an entire economic market overall or a large
percentage of the total market.
o Unsystematic risks – also known as specific risk or
idiosyncratic risk, is a category of risk that only affects an
industry or a particular company.
2. Business Risk – refers to the basic viability of a business – the
question of whether a company will be able to make sufficient
sales and generate sufficient revenues to cover its operational
expenses and turn a profit.
TYPES OF RISKS
3. Credit or Default Risk – the risk that a borrower will be unable
to pay the contractual interest or principal on its debt
obligations.
4. Country Risk – the risk that a country won’t be able to honor
its financial commitments.
5. Foreign-Exchange Risk – when investing in foreign countries,
it’s important to consider the fact that currency exchange rates
can change the price of the asset as well.
6. Interest Rate Risk – the risk that an investment’s value will
change due to a change in the absolute level of interest rates.
TYPES OF RISKS
7. Political Risk – the risk an investment’s returns could suffer
because of political instability or changes in a country.
8. Counterparty Risk – the likelihood or probability that one of
those involved in a transaction might default on its contractual
obligation.
9. Liquidity Risk – this is associated with an investor’s ability to
transact their investment for cash.
10. Operational Risk – the risk of a change in value caused by the
fact that actual losses, incurred for inadequate or failed internal
processes, people and systems, or from external events
(including legal risks), differ from the expected losses.
Relationship
between RISK
and RETURN • Risk is an important factor to consider
when making financial decisions.
• Under rational market conditions,
higher-risk investments should
provide a higher expected rate of
return than low-risk investments.
RETURN
(rate of return or
• Return is the amount received on an
holding period investment after holding it for a period of
return) time in relation to the initial investment.

(year-end market value – beginning-of-year market value) + passive income

R=
beginning-of-year market value
Illustration
Mr. Smith holds Apple shares which had a carrying value of P200 at the
beginning of the year. By year end, the shares are selling P220 per share.
Mr. Smith received P5 cash dividends during the year. Compute for the
Rate of Return.

R = 12.50%
Illustration
Mr. Jones bought 1,000 shares of Wallmart Co. at P10 per share. One year
later, Mr. Jones sold the shares for P14. The investor earned dividends of
P200 over the one-year holding period. The investor also spent a total of
P40 on trading commissions in order to buy and sell the shares. Compute
the Rate of Return.

R = 41.60%
EXPECTED
VALUE OF • The expected return is the amount of
RETURNS profit or loss that an investor can expect
from an investment.
• The percentage or rate of return that is
expected to be realized on an investment
after taking into account the probability of
possible outcomes.
Illustration
If an investment has a 70% chance of gaining 20% and a
30% chance of losing 10%, calculate the expected rate or
return.

R = 11%
CAPM • CAPM describes the relationship between
systematic risk and expected return on
Capital Asset assets, specifically stocks.
Pricing Model • CAPM is widely used in finance to price
risk securities and generate expected returns
for assets given their risk and cost of capital.
• The model is based on the concept that a
stock’s required rate of return is equal to the
risk-free rate of return plus a risk premium
that reflects the riskiness of the stock after
diversification.
FORMULA: CAPM
r = rf + β (rm – rf)
r = rf + β (MRP)
r = Risk free rate + Risk Premium

Beta
 Measures a stock’s market risk, and shows a stock’s volatility relative
to the market.
 Indicated how risky a stock is if the stock is held in a well-diversified
portfolio.
FORMULA: CAPM
Types of BETA • A potential investment’s beta is a measure of
a. beta = 1.0 how much risk the investment will add to a
portfolio that resembles the market.
b. beta < 1.0
• A beta greater than one indicates that a stock
c. beta > 1.0 is riskier than the market.
d. negative beta • If a stock has a beta less than one, the
formula assumes it will reduce portfolio risk.
SECURITY
• The SML is a graphical presentation of the
MARKET LINE capital asset pricing model (CAPM) that
shows different levels of systematic, or
market risk, of various marketable
securities plotted against the expected
return of the entire market at any given
time.
PORTFOLIO
RETURN • This is the gain or loss realized by an
investment portfolio comprised of various
types of investments.
• Portfolios seek to deliver returns based on
the investment strategy’s stated objectives
as well as the risk tolerance of the
portfolio’s target investors.
Illustration
Miss Anderson plans to invest in 3 stocks:
Stock A - Investing P40,000, expected return of 18%
Stock B - Investing P25,000, expected return of 12%
Stock C - Investing P35,000, expected return of 10%
Miss Anderson wants to calculate the overall expected
return on her total portfolio of investments in these 3
stocks.
R = 13.7%
Risk and Expected • The maturity period of an investment
Return for Various affects the associated risk. The longer the
Security Classes maturity period, the higher the risk.
• The issuing entity also affects the degree
of risk. Government issued instruments
have lower risk compared to instruments
issued by private institutions.
• The nature of the instrument also affects
the risk, debt instruments have lower risk
compared to equity instruments.
MEASURES OF
• Financial risk can be measured using
RISKS different approaches depending on the
decision situation.
• The financial manager should be skillfull
in identifying the appropriate measurement
tool that will result to the correct decision.
INDIVIDUAL
RISK
MEASUREMENT • Risk measurement for Stand-
Alone or Single Asset.
1. Standard Deviation
2. Coefficient of Variation
STANDARD DEVIATION
• This is a method of measuring data dispersion in regards to the
mean value of the dataset and provides a measurement regarding
an investment’s volatility.
• Low standard deviation – the data points tend to be very close to
the mean.
• High standard deviation – the data points are spread out over a
large range of values.
STANDARD DEVIATION
• As it relates to investments, the standard deviation measures how
much return on investment is deviating from the expected normal
or average returns.
• When prices swing up or down significantly, the standard
deviation is high, meaning there is high volatility.
• When there is a narrow spread between trading ranges, the
standard deviation is low, meaning volatility is low.
STANDARD DEVIATION
Relating Standard Deviation to Risk
• The more unpredictable the price action and the wider the range,
the greater the risk.
• Range-bound securities, or those that do not stray far from their
means, are not considered a great risk. That's because it can be
assumed—with relative certainty—that they continue to behave in
the same way.
• A security with a very large trading range and a tendency to spike,
reverse suddenly, or gap, is much riskier, which can mean a larger
loss.
STANDARD DEVIATION
FORMULA:

𝜎= √ ∑ ( 𝑥 − 𝑥 ) 𝑃
2

= standard deviation
x = data within the population
x = mean or average of the population or expected return
P = the corresponding probability of each data
COEFFICIENT OF VARIATION
• It is easy to compare investments with similar returns but different
standard deviation or investments with similar standard deviations
but different returns.
• However, it is quite difficult to compare investments which have
different returns and different standard deviations.
• To allow the comparison, the coefficient of variation may be
utilized.
COEFFICIENT OF VARIATION
• The CV is a formula to represent the relative level of risk (standard
deviation) per unit of return:

• Ideally, the CV formula should result in a lower ratio of the

standard deviation to mean (return), meaning the better risk-return
trade-off.
Illustration
The following probability distributions for two stocks have been
estimated: Returns
Probability Stock A Stock B
0.3 12% 5%
0.4 8% 4%
0.3 6% 3%

1. Compute for the Expected Returns of Stock A and B.

2. Compute for the Variance of Stock A and B.
3. Compute for the Standard Deviation of Stock A and B.
4. Compute for the Coefficient of Variation of Stock A and B.
5. Which stock is riskier?
Answers

A B
Expected Returns 8.60% 4.00%
Variance 0.056% 0.006%
Standard Deviation 2.37% 0.77%
Coefficient of Variation 0.2756 0.1925
Degree of Operating, • Leverage in general refers to an
Financing and Total investment strategy of using borrowed
Leverage funds to improve overall company
profitability.
• Effective leveraging is attained if the
return is greater than the financing cost.
This is known as Financial Leverage.
• Financial Leverage should not be confused
with Operating Leverage.
• Operating Leverage is a strategy of
increasing overall profitability by
increasing unit sales.
OPERATING LEVERAGE
• Concerned with the relationship between sales revenue and
earnings before interest and taxes.
• This is the potential use of fixed operating cost to magnify the
effects of changes in sales on the firm’s earnings before interest
and taxes.
• The numerical measure of DOL follows:
= Contribution Margin ÷ Earnings Before Interest and Taxes
= % change in EBIT ÷ % change in Sales
FINANCING LEVERAGE
• Concerned with the relationship between EBIT and EPS.
• This is the potential use of fixed financing cost to magnify the
effects of changes in EBIT on EPS.
• The numerical measure of DFL follows:
= Earnings before interest and taxes ÷ Earnings before tax
= % change in EPS ÷ % change in EBIT
• Financial leverage with preferred shares
= EBIT÷ {EBIT – Interest – [Preferred Dividends ÷ (1-T)]}
TOTAL LEVERAGE
• Concerned with the relationship between Sales Revenue and
EPS.
• This is the potential use fixed cost, both operating and financial,
to magnify the effects of changes in sales on the firm’s EPS.
• The numerical measures of Degree of Total Leverage or Degree of
Combined Leverage follows:
= Contribution Margin ÷ Earnings before Tax
= % change in EPS ÷ % change in Sales
ILLUSTRATION
Two companies have the same EBIT of P3,000,000 but different
capital structure. Company Y is mostly focused on equity financing
using both common and preferred equity. Its preferred dividend
payment is P150,000, and the interest payment is P250,000. By
contrast, Company Z tends to use debt financing and has only
common equity. Its interest payment is P1,250,000. The tax rate for
both companies is 30%.
Requirement: Compute the degree of financial leverage for both
companies.
Y = 1.18
Z = 1.71
ILLUSTRATION
Y = 1.18
Z = 1.71
• Company Z is more sensitive to fluctuations in EBIT than
Company Y.
• If EBIT of both companies rises by 5%, the EPS of Company Y
will increase by 5.9%, and the EPS of Company Z will increase by
8.55%.
• In contrast, the drop of EBIT by 10% will lead to decrease in the
EPS of Company Y by 11.8% and by 17.1% for Company Z.
END