Risk & Return[Single Asset Case]

☺ In order to achieve the goal of share price maximisation, the financial manager must learn two assess the two key determinants of share price: risk and return.

☺ Each financial decision presents certain risk and return characteristics, and all major financial decisions must be viewed in terms of expected risk, expected return and their combined impact on their share price.

Risk© With any financing or investment decision, there is

some uncertainty about its outcome.

© Uncertainty does not know exactly what will happen in the future.

© Risk can be defined as “the potential for variability in returns”.

© Uncertainty does not knowing what's going to happen and risk is the degree of uncertainty.

© In financing and investment decisions there are many types of risk we must consider.

Return/Return on a single Asset©During a given period of time return is the

realizable cash flow from an investment.

©The rate of return on a share consists of its dividend yield and the capital gain percentage.

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P

PPDIVR

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Average Rate of ReturnAverage rate of return is the sum of the various one – period rates of return divided by the number of periods.

Variability of Returns OR Measuring Risk

• The variability of rates of return may be defined as the extent of the deviations of individual rates of return from the average rate of return.

• Important measure of risk is the variance or standard deviation of possible returns.

• Standard deviation is the square root of variance.

Variability of Returns OR Measuring Risk

The variability of rates of return may be defined as the extent of the deviations of individual rates of return from the average rate of return.

Important measure of risk is the variance or standard deviation of possible returns. Standard deviation is the square root of variance.

Variance

Variance is usually denoted by 2 and is calculated by the following formula:

Var = 2

1

2 1

n

tt RR

n

Standard DeviationStandard deviation is the square root of the variance and is represented as and is calculated by the following formula.

Deviation Standard = Variance

2

Expected Rate of Return and Risk [incorporating Probabilities in Estimates]

ReturnExpected return of the investment is the sum of the product of each outcome (return) and it associated probability.

nnPRxPRxPRRE ...................2211

Risk The following formula can be used to calculate the variance of returns.

nn PRERPRERPRER2

22

212

12 )(.............)()(

n

inn PRER

1

22 )(

2