Risk and Return After completing the study of this chapter, you should be able to: ” w State why an understanding of risk and return is necessary. Define risk and explain how it can be measured. © State the meaning of return and explain its various measures. © Explain risk-return relationship. 4.1 INTRODUCTION One of the most important factors in evaluating investment proposals is the level of risk inherent in a project. If high risk is involved, the required return on the project will also be high. First the level of risk is measured, and then the level of return. Finally, the two are brought together so that higher risk investments offer a higher return and vice versa. Thus, determining the acceptability of investment proposals of a firm involves a trade-off between risk and returns. We, therefore, give in this chapter an introduction to the basic concept of risk and return. The risk-return analysis is used for capital budgeting decisions, purchase of shares, bonds, etc. and any readily identifiable capital or financial investments. 4.2 WHAT IS RISK? Risk is the likelihood that the actual return from an investment may be less than the forecast return. Put in a different form, risk may be defined as the variability of returns from an investment. Methods of Risk Measurement The level of risk may be measured by various methods. Some of them are as follows: 1. Subjective estimates: As a rule of thumb, qualitative estimates may be made as measures of risk, Expressions such as ‘low’, ‘moderate’ or ‘high’ risk are used in different situations. Depending on the levels of variation of returns, risk may be expressed as high (returns varying widely), moderate (returns varying moderately), 87] and Return [58] Chapter 4° Risk an ee [58 level of variation), However, this method of i ay and low (for low leve from some limitations ation: This represents the variability of forecast returns Whey . Standard deviatio stributi d deviation i i imate a normal probability distribution. Stansstd eee they returns approxi of the best measures of variability or dispersior meets 18S cen, rien echo ‘The greater the value of standard deviation, the higher is th, ti desirable p * w= ais = |B -0, (44) ‘a Expected retum = E(R) = ith rate of return from an investment proposal Probability of occurrence of ith rate of return No. of outcomes v and vice versa. where, es The expected returns from two shares are given in the following tabular format. Which ofthe two shares is more risky? Return from Probability of Return from Probability of share A (%) ___ occurrence share B (%) occurrence 20 0.10 12 0.30 10 0.40 u 0.30 15 0.50, 13 0.40 1.00 00 When commentin; i ! ; olved in each share, standard deviation ¢ the ems weighted by the probability factor in each case is calculated. i Tepresent returns from share A and >i Tepresent returns from share B. Then t® expected retums are computed as followse Pe, Return from Probability du A wan eco Probability Expect (%) % o ® Ox@=@ a 15 050 4 u ee 3 1 . Zs 3 0.40 5 The variance of retums from share A is as follow: s:What is Risk? ims from share B is: Fe variance of ett Retum (y) o- yy 12 0.01 ul 1.21 13 121 A B 7 10.26 0.850 Standard deviation V10.26 0.850 = 3.20% = 0.92% The variability of returns of share A is more than that of share B. Hence, investment in share A involves a greater degree of risk. Standard deviation is, however, an absolute measure of dispersion and does not consider variability of returns in relation to expected return. 3. Coefficient of variation (CV): It is a relative measure of dispersion which measures the risk per unit of return. It is calculated as the standard deviation (0;) divided by the expected return (R). cv-& (42) The greater the CV, the higher will be the risk and vice versa. The CV is considered to be the best measure of variability when the expected returns on two alternatives are not the same. 4. Beta coefficient: The relationship between risk and return is developed in the Capital Asset Pricing Model. We have discussed this in Chapter 7 when dealing with the cost of (equity) capital and in Chapter 16, dealing with portfolio management. According to the Capital Asset Pricing Model, the required rate of return is equivalent to risk-free return plus risk premium. Symbolically, Where, E(R) = Ry + BKm — Rp) (4.3) m= Market retum B = Risk factores GO| Chapter 4: Risk and Retum Beta (B) represents the risk of asset in terms of its effects on the risk of a group of asset, known as porifolio.' It gives a measure of the extent of market-related risks which are non. diversifiable, When B = 1, the investment is considered to be of average (normal) risk, The Greater the value of beta, the higher will be the risk and vice versa. Thus, beta is Measured — CoV eam ee (44) B 9, where, Cov(am) = Covariance of returns on an individual company’s share (a) with returns for market as a whole (m) ©,, = Variance of market returns We know that: CoV{a, m = Na, m) FaFn (4.5) where, T(a, m) = Coefficient of correlation between a and m ©, = Standard deviation of returns from share a O» = Standard deviation of market rate of returns Therefore, (46) CS Lae What is the required rate of retum under the capital asset pricing model in situations I, It and IIL, respectively? Situation Risk-free return Return on market Portfolio —_ Beta (B) (%) (%) ! . 2 0.95 I 7 14 880 1 6 10 od We know that: E(R) = Ry + B(Ky ~ Rp In situation 1, E(R), per cent = 8 + 0.95 (12 - 8) = 11.8 0, F(R), per cent = 7 + 1.5 (14 ~ 7) = 175 I, —_E(R), per cent = 6 + 1.0 (10 - 6) = 10 The greater the beta, the higher will be the risk and the higher the risk premium. This pushes the required rate of return upwards. A portfolio is the combination of different investments that constitute an investor's total holding, For details see Chapter 16.Meaning of Rew [64] You are given returns on share A and market returns over the last 10 years. Calculate 6 and comment on the result, Year 12 3 4 5 6 7 8 9 10 naa. il 47 jo 5 5 60 75 5 Is 17.5 Prey ul 5 3 75 6 65 10 15 Year) Return on [Market return,|(Ry- R)|(Ruy ~ Ry) | (Ra ~ Ra) |(Ru - Ryo? \share A,Rq(%} Ru (%) Ru - Rw) 1 ul 10 3 3 9 9 3 4 5 4 2 8 4 3 10 il 2 4 8 16 4 a s 3 2 6 4 5 5 3 -13 -10 130 100 6 10 15 2 0.5 1 0.25 7 15 6 05 -l 0.5 I 8 5 35 3 -3.5 10.5 12.25 9 15 10 z= 3 21 9 10 115 15 95 8 16 64 Total 80 70, 270 219.5 R, =80+10=8 R E(Ry - RyRy — Rw) _ 270 — ER = Ra Ru ~ Bu? — = Cove a) = 92172 = 1 o, ahd -R,? = 7g 2952195 ‘ov(RavRw) __30_ 4.37 B= oO, 21.95 Th alls, the degree of risk is moderately high. 4 3 MEANING OF RETURN Retums ‘xamp| tum gon the investors’ perceptions. As, for financial ratios—say. return on investment, values to cash inflows rather than to Tay have different meanings dependin . Some investors measure returns by using n equity, etc. Other investors may assign MoreChapter 4: Risk and Return distant retums. Yet some others may be primarily concerned with growth—investors in Such & situation would accept projects that will promise long-term growth of sales, returns, cash flows, etc. In the next sections, we consider the following three measures of returns: 1, Retum on equity (ROE) 2. Internal rate of return (IRR) 3. Weighted average cost of capital (ko) as the required rate of return 4.3.1 Return on Equity I is the actual dividend plus accrued capital gain (loss) from the investment expressed in relation to cost of investment. Symbolically, _D+(R =P.) tl ROE (47) where, ROE = Annual retum on equity D, = Dividend received on share at the end of the year, t P, = Market price of share at the end of the year, ¢ P.4 = Cost of share at time period, t- 1 Mlustration 4. An investor purchased the shares of a company at Rs. 200 per share on 1 January 2007. For the year ended 31 December 2007, the company paid a dividend of Rs. 20 per share. Ifthe market price of the share was Rs. 250 on 31st December, calculate the rate of return from the investment. ROE= Rs. 20 + (250-200) Rs.70 Rs. 200 Rs. 200 = 0.35 or 35% A variation of the above measure may be the use of av In other words, instead of taking return for a single year, calculated based on equation (4.7) and the average of the ret the event of a wide variation in the returns over a given pe smooth out the fluctuation to a considerable extent. ‘erage rate of return on equity. ROE for a number of years is ‘turns is taken for the purpose. In tiod, the average method helps t0 4.3.2 Internal Rate of Return In Chapter 3, we discussed the time value of money. When the expected cash inflows are converted into their present values, they give a better measure of the future return in terms of today's value. In capital budgeting decision, we have discussed the concept of internal rate of return (IRR)—a measure of the project return based on discounted cash flow concept. The IRR for an investment proposal is the discount rate (r) that equates the present value of the expected net cash flows (say, C), C2, ..., C,) such that,Meaning of Return {63 J G_ G — +o dan! (ery (l+n)" ay where. = Initial outlay | ¢, = Stream of future cash flows n = Number of years (project life) IRR is then compared with the required rate of return (kp) for sereening and, finally, the profitability is determined on the basis of its relative rates. It is based on the philosophy that the best investment is the one that secures the highest rate of return while equating the capital outlay with the present value of the net cash flows. 43.3 Weighted Average Required Return We have briefly discussed the capital asset approach for determining the firm's required return vy new investment proposals. Many firms still use a weighted average of costs of debt and cquty to develop an overall required return. According to this approach, the required rate of ‘cum is equivalent to the firm's weighted average cost of capital, In other words, E(R) = ko (4.9) where, E(R) = Required rate of return ky = Firm's weighted average cost of capital The weighted average cost of capital (ko) is the average of the costs of various (long term) sources of capital, weighted by the proportions of capital employed (book values or market values). Thus, 4. (4.10) ey = kaw + Kwa + kyirs + Kava where, k, = Cost of equity capital k, = Cost of retained earnings J, = Cost of preference share capital k, = Cost of debt capital (long term) ; ; Wi, Wo, wy and Ws = Respective weights that may be the book values of the capital employed or market values thereof. ¢ followin} id specific costs of capital are the A company’s capital structure an‘ Afrer-tax cost of capital (%) al (Rs., lakh) Source Amount of capi Equity 1000 16 Preference 200 9 800 7 Long-term debt 200064] Chapter 4: Risk and Retwm The company wants to take up a new project involving Rs. 50 lakh. What Will be 4, minimum acceptable rate of return for the project? . The minimum acceptable rate of return should be equivalent to the compan Y'S Weighieg average cost of capital which is calculated in the following table. Weighted Average Cost of Capital Source Amount of capital Weights After-tax cost Weighted average (Rs. lakh) (proportion) —_of capital (%) cost of capital (%) @ Q) QB) (4) 3) x (4) = (6) Equity 1000 0.5 16 8.0 Preference 200 0.1 9 09 Long-term debt 800 04 iL 228 2000 1.0 ky = 117 Thus, the minimum acceptable rate of return from the proposed project is 11.7%. Alternatively, using equation (4.10), we can ascertain the average cost of capital as follows: ky = kw, + Kyw2 + kawy = (0.16 x 0.5) + (0.09 x 0.1) + (0.07 x 0.4) = 0.117 or 11.7% Nore: In computing the average cost of capital, we have taken book values as weights. If the market values are given, we could take market values as weights. If they are greater than the book values, then the market value wei : ights would normally push up the average cost of capital and, hence, the minimum acceptable rate of returm, The rationale for using the wei rate of retum is that the firm has alr : mbination of sources, and, accordingly, the average cost of capital provides a more uniform basis for comparison among projects. 4.4 RISK-RETURN RELATIONSHIP There is a fundamental relationship between the degree of risk associated with a project and the expected return from the project, that is, if the risk is high, the return should also be hig! ‘When the risk is low, the return will also be low. This relationship is shown in Figure 4.!- In Chapter 16, we discussed two types of risks: market related (non-diversifiable) am firm/industry related (diversifiable). An investor is Compensated by the risk premium, i? addition to the risk-free rate of return, fo undertaking market-related risk. Equation (4.3) i# Capital Asset Pricing Model may be repeated as: FIR) = Ry + Ky ~ R)Risk-Retum Relationship [ 65 where, E(R) = Expected rate of return R, = Risk-free return (e.g. RBI bond rate, NSC rate) B = Degree of non-diversifiable risk (known as systematic risk) K,, = Market rate of return. It is the expected return on market portfolio which represents a group of assets weighted at the same rupee value as all assets in the market. Other things being constant, the greater the degree of systematic risk, the higher will be the expected return and vice versa. Expected return Expected risk Figure 4.1 General relationship of risk and return. TS Cee An investor wants to invest Rs. 1,000,000 in the share of a company. There are two opportunities: to invest in the share of company A (B = 1.6) Rs. 600,000 and to. invest the balance in the share of company B (8 = 1.3), Alternatively, the entire money can. be invested in RBI 6.5% bonds. If the market rate of return is 12%, what will be the expected returns from investment in company A and company B, and also the average expected retum from the portfolio? B(Ra) = Ry + B Km ~ RB) = 8% + 1.6 (14% - 8%) 8% + 9.6% = 17.6% E(Ry) = Ry + B Kn — R) 8% + 1.3 (14% - 8%) 8% + 7.8% = 15.8% ‘The average expected rate of return of the portfolio is, E(R) = E(R,)w; + E(Rp)w2 (4.11) where, W; = Proportion of investment in company A share to total investment = 6 + 10 = 0. Ww = Proportion of investment in company B share to total investment = 4 = 10 = 0.4 E(R) = 17.6% x 0.6 + 15.8% x 0.4 = 10.56% + 6.32% = 16.88% As against the risk-free return of 8%, the investor will compare the expected return of 16.88% from tne proposed portfolio in selecting his or her investment.a i Chapter 4: Risk and Return In Figure 4.1, we have shown the general pattern of risk and return. Tt was ay oversimplification ofthe relationship between the two. But if we introduce the concept ofr free return (Rand risk premium (B) into the diagram to make it more logical in consonane. with the Capital Asset Pricing Model, the relationship between risk and return will appear ¢ in Figure 4.2 : | Premium. for risk 2 Rate of retum Degree of risk Figure 4.2 Relation between risk and return-security market line. The non-diversifiable systematic risk consists of two components: business or operating misk and financial risk”. The former is the chance that the firm will not have the ability to compete successfully with its asset structure. Financial risk arises out of financing by debt capital. Risk-free investment Tepresents an investment in the government securities. If such securities are held to maturity, they do not offer any risk of default on either interest or Principal. Accordingly, one can get this return at a zero risk level. For a rational investor, this is the minimum acceptable retum for any investment. ‘The market line indicates the relation: variable and return, a dependent variable. Market return is the expected return on the marke Bombay Stock Exchange securities in total showed an 18 holding a portfolio of, say, 3% of every stock on the return. * portfolio. For example, suppose the % annual return last year. An investor Exchange would also receive an 18% KEY CONCEPTS AND TERMS * Beta coefficient * Return on equity * Capital asset pricing model © Risk * Coefficient of variation * Risk-return relation * Internal rate of return * Standard deviation * Return * Weighted average return * Operating risks and financial risks are discussed in Chapter 8,Assignments [ 67 SUGGESTED FURTHER READING + Bhabatosh Banerjee, Chapter 2, Financial Policy and Management Accounting rth ed.. Prentice-Hall of India, New Delhi, 2005, , «John J. Hampton, Financial Decision Making: Conce 4th ed.. Prentice-Hall of India, New Delhi, 1989. ASSIGNMENTS OBJECTIVE-TYPE QUESTIONS pts, Problems and Cases, 1. The most acceptable measure of risk is: {a) Subjective estimates (b) Standard deviation (c) Coefficient of variation (d) None of the above. n . Which of the following statements is not a correct explanation of the capital asset pricing model? (a) Beta gives a measure of the extent of market-related risks which are non- diversiable (b) When beta value is 1.0, the investment is considered to be of normal risk (©) The expected return on an investment with a beta value of 2.0 is twice as high as the market rate of return (d) The expected return from an investment with negative beta would be less than the risk-free rate of return 3. If the risk-free return (R)) is 8%, beta value () is 1.8 and market rate of return (K;,) is 14%, the expected rate of return, E(R), would be: (a) 18.8% (b) 17.5% (©) 19.8% (d) 18.4% 4. The weighted average cost of capital is taken as the required rate of return of the firm because: (a) It takes into account costs of all long-term components of capital () Due weights are given to the proportions of capital employed in long-term sources (©) The firm must earn a rate of return at least equivalent to its average cost of capital (d) It is the combination of costs and weights of the sources of capital under consideration Ra68] Chapter 4: Risk and Retum 5. If the capital employed by a firm represents Rs. 10 ra in equity ~ Rs. debt with an after-tax cost of 15% and 6%, respectively, the gl ave of capital of the firm (a) 10.625% Slay age (b) 11.625% (©) 12.625% (a) 9.625% EXERCISES 1, Define risk and explain the methods of risk measurement. 2. The expected returns from two shares are given below. Measure the degree of 1, in each case and comment on the Tesults. Return from Probability of Return from Probability ot share A (%) occurrence share B (%) Occurrence 16 0.20 10 0.50 20 0.30 18 0.30 18 0.50 5 0.20 1.00 1.00 3. 8. You are given returns on share A and market returns over the last 10 years. Wha is the beta value and what does it indicate? Yer 1 2 3 4 5 6 7 8 a R(%)30 1533 5b 9 25 48 105 30 4 Ru(%)33° 1239, 1s sh 30 pS ae 45 525 What is retur on equity? Explain its rationality, aires erties rate of return and explain how it can be determined. im andl tpstable example the weighted aver © Cost concept of required rate o retum and examine its rationality. : ae Calculate required rate of return wader capital and C, respectively. Situation Risk-f asset pricing model in situations A.3 Beta (§) Portfolio . $F 10% 0.90 B iz ee 11% 1.40