ZeePedia Add to Favourites   |   Contact us


Financial Management

<<< Previous INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification Next >>>
 
img
Financial Management ­ MGT201
VU
Lesson 19
INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following
topics
·  Introduction to Risk
·  Risk and Return for Single Stock Investment
Before discussing this important topic we should go through the area of finance which we have
studied up till now.
Part I (Introduction and Capital budgeting)
FM Markets, Concepts, Definitions
Review of Accounting
Interest Rate Theory & Calculations
Investment Decisions: NPV (Valuation), IRR, Payback
Capital Budgeting: NPV & DCF
Capital Rationing (Budgeting for Real Assets)
Part II (Securities Valuation)
Valuation of Stocks & Bonds (Direct Claim Securities)
The Chapter 4 and 5 of text book cover the topics of risk and return. It is the fundamental concept to
understand the topics of portfolio theory and Capital Asset pricing model (CAPM).In the previous
lectures, we are ignoring the origin of required rate of return.
Risk:
Chinese Definition of Risk:
It is defined as the combination of danger and opportunity. Risk is the combination of both.
When we talk about risk with the reference to the investment we are talking about risk in term of the
uncertainty in outcome of our investment. We are talking about the variability, spread, or volatility that
can take place in the expected future Value (Cash Flows) or Returns. For example, we are asking
ourselves if we invest Rs 1,000 for buying a share today then what will be the price of the share one
year from now. There is no guarantee about the price of the share after one year therefore there is an
uncertainty or risk we are taking because we do not know the final outcome. So, the difference or
variation in the possible outcomes of a particular investment also represents the risky ness of a particular
investment.
As we have studied earlier that there are two major categories of assets
1 Real Physical Assets 2 .Financial Assets (Stock & bonds)
Risk can be understood with reference to the uncertainty of Future Cash Flows produced by
Assets (Physical & Financial Securities). Businesses make forecasts based on certain assumptions which
we have discussed in lecture 5 of your course. These forecasts are not 100% accurate and there is
uncertainty in the possible outcome. The actual cash flows one or five years from now may be very
different from the forecasted and this to represent risk. When we talk about risk in investing in direct
claim securities then we need to keep in mind the distinction between Stand Alone Risk (or Single
Investment Risk) as oppose to market or Portfolio Risk (or Collection of Investments Risk).which is a
risk of particular investment compare to other investments you have made. In Portfolio risk we are
interested in overall risk of entire collection of investments that made by the company. We will study
this topic in the next lectures.
In case of portfolio risk we can further made distinction between Diversifiable Risk and Market
risk
Diversifiable Risk: random risk specific to one company, can be virtually eliminated.
Market Risk: It is defined as uncertainty caused by broad movement in market or economy. More
significant.
Causes of Risk:
These can be Company-Specific or General. It may be because of Cash Losses from operations
or poor financial management of the company. This is one possibility but the real question is that why
these losses occurred. One of the reasons for the losses might be the company's Debt, Inflation,
Economy, Politics, War or Fate. Final analysis of risk is that it is a game of fate or chance.
84
img
Financial Management ­ MGT201
VU
Measurement of Risk:
It is important to attach different numbers to the risk so that we can rank different investments.
Risk is measured in terms of the standard deviation or variance. You have studied these terms in the
statistics. Risk is still quite subjective even after the numbers you have calculated after standard
deviation. The reason is that you have to keep in mind what kind of risk you are talking about. Are you
Stand Alone Risk or Portfolio Risk?
Market Risk or Diversifiable Risk?
Stock Price Risk or Earnings Risk?
Another important thing is Time Horizon for which you are measuring the risk. Are you
investing in Stocks over 1 Year or over 30 Years?
The level of risk might change as time period of the investment change.
Fundamental Rule of Risk & Return:
This rule can be summed up in saying that No Pain - No Gain. Investors will not take on
additional Market Risk unless they expect to receive additional Return which is common sense and
quite logical. Most investors are Risk Averse. Another important principle that one should to keep in
mind is Diversification.
Diversification:
It states that don't put all your eggs in one basket. Diversification can reduce risk. By
spreading your money across many different Investments, Markets, Industries, Countries you can avoid
the weakness of each. Make sure that they are Uncorrelated so that they don't suffer from the same bad
news. Due to certain change in the interest rates some of the investments in your portfolio may go up
and the others go downward.
Every Day Examples of Risk-Return Pairs:
Risk Level
Return
·  Climbing Mount K2
High
??
·  Gambling on Cricket Matches
High
High
·  Oil drilling in Badin Block
High
High
·  Satta / Speculation in Shares
High
Med-High
·  Construction Commercial Plaza
Medium
High
·  Investing "Blue Chip" Stocks
Medium
Medium
·  Crossing Road at Peak Traffic
Medium
??
·  Investing TFC's
Med-Low
Low
·  Depositing Money in Bank A/c
Low
Low
·  Investing in T-Bills
Low
Low
Before taking about the risk we first see the different possible outcomes of a particular investment
by analyzing the expected return. It is mentioned earlier that once we have an idea of the variation then
we can measure the risk of that investment.
Range of Possible Outcomes, Expected Return:
Overall Return on Stock = Dividend Yield + Capital Gains Yield (Gordon's Formula)
Simply, Return is proportional to Capital Gain which is proportional to Selling Price. We can use
Forecasted Selling Price as measure of Return. The wider the range of Possible Outcomes that can occur,
the greater the Risk
The chance that a future event will actually occur is measured using Probability
Expected ROR = < r > =
pi ri
Where pi represents the Probability of Outcome "i" taking place and ri represents the Rate of Return
(ROR) if Outcome "i" takes place.  The Probability gives weight age to the return. The Expected or
Most Likely ROR is the SUM of the weighted returns for ALL possible Outcomes.
Now let us take a look of case of investing in the share of the particular company.
Suppose you are deciding whether to invest in the Stock of Company ABC. You're not sure
because the Future or Forecasted Price of the Stock after 1 year could reach any one of 3 Possible
Values (or Outcomes). Before you can estimate the most likely or Mean or Expected Future Price, you
need to guess the Probability of Each Possible Outcome
85
img
Financial Management ­ MGT201
VU
Outcomes (After 1 Yr)
Probability (%)
"Bull Market" (Stock Price P1*=140)
30%  or 0.3
"Normal Market" (Stock Price P1*=110)
40%  or 0.4
"Bear Market" (Stock Price P1*=80)
30%  or 0.3
100%
1.0
Po= Present Market Price Rs100. P1*=Forecasted Price.
The Sum of Probabilities of all Possible Outcomes MUST Add Up to 100% (or 1.0).
Payoff Table & Expected ROR
Payoff Table for Investment in Stock
Outcomes (1 Yr)
Prob (p)
ROR <r> = (P1*-Po)/Po)
Price Rises (P1*=140)  0.3
+ 40 % = (140-100)/100
Price Same (P1*=110)  0.4
+ 10 % = (110-100)/100
Price Falls (P1*=80)
0.3
- 20 % = (80-100)/100
1.0
Expected ROR of Investment in Stock
Most Likely or Weighted Average or Mean ROR Rate of Return < r >
Expected ROR = < r > =
pi ri.
= p1 (r1) + p2 (r2) + p3 (r3)
= 0.3(40%) + 0.4(10%) + 0.3(-20%)
= 12% + 4% - 6% = 10%
Probability Distribution
Forecasted Returns for Single Stock Investment
"BELL"
0.45
Curve
0.4
Proba
0.35
bility
0.3
(p)
Possible
0.25
Outcomes
0.2
0.15
"Expected ROR" or Most
0.1
Likely or Mean ROR = 10%
0.05
0
-20
10
40
Rate of Return after 1 Year < r >
In the diagram, the probability graphed on y axis and the rate of return is graphed on x axis. All
three outcomes are shown in the form of the bars. In this diagram the largest probability takes place at
the value of the expected rate of return which is 10%. If the top of each vertical bar is connected then
the bell curve is formed. It is easy to calculate the risk after calculating the expected rate of return. We
simply use the formula of standard deviation to calculate the risk
Stand Alone Risk of Single Stock Investment:
The wider the range of Possible Outcomes (i.e. the greater the variability in potential returns)
that can occur, the greater the Risk
Risk Measured using Standard Deviation (Note: Variance = Standard Deviation 2)
Risk = Std Dev =
( r i - < r i > )2 p i .  =
Summed over each possible outcome " i " with return "r i " and probability of occurrence "p i ." < r i
> is the Expected (or weighted average) Return
This topic will be discussed in detail in the next lecture
86
Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios