Ateneo de Zamboanga University

School of Management and Accountancy

Accountancy Department

LEARNING PACKET
FINMAN2 –FINANCIAL MANAGEMENT
Session 1, First Semester, SY 2020-21

LEARNING PACKET NO. 4 DATE: September 7 – 12, 2020

TOPIC: RISK AND RETURN Week No.: 5
Session: 1

I. CONCEPT NOTES
Return defined
• Benefits derived from an alternative
• For this discussion, the decision making is more on the investment perspective
✔ Return (expressed as a percentage) is total gain/loss from an investment over a period

Basic Computation of Return:

N et benef its f rom investment
r= Cost of investment
• Where:
✔ Net benefits include:
Cash Flows from the investment (interest, dividends, etc.)
Changes in the value of the investment
✔ Cost of investment is the price you spent to acquire the investment

Risk defined
• Uncertainty - not knowing exactly what will happen in the future.
• Risk
✔ degree of uncertainty that the expected return will not materialize
✔ Variability of the return associated with an asset

Why discuss about risk?

• Comparison of returns is not the only thing that will matter in the investment decision.
• Entities invest according to their ​risk preferences​ and this will matter on choosing the best investment.

Risk Preferences
• Describes how investors respond to risk

1. Risk Averse
✔ Prefers less risky over more risky investment
✔ Prefers to avoid risk UNLESS it is compensated by higher return

2. Risk Neutral
✔ Prefers to look at returns and not on risks
✔ Does not consider risk in decision making

3. Risk-Seeking/Taker
✔ Prefers to look at risks more than the returns
✔ Can sacrifice some returns for more risks

Risk Assessment
• Expected Value of Return
• Standard Deviation
• Coefficient of Variation
 • Risk and Return of a Portfolio
• Diversification and Correlation

Expected Value of Return (EVR)

• Consideration of the PROBABILITY of different returns for one investment
✔ Chance that a certain outcome will occur
✔ Formula:
EVR = Σ (Probability x Return)

Standard Deviation (σ)

• Measure of dispersion that considers the values and probabilities for each possible outcome
• Considers the distance (deviation) of each possible outcome from the expected value and the probability
associated with that distance
• Quantifies the risk associated with the return
• Formula:
σ = √Σ [P robability x (Return – EV R)2]

Coefficient of Variation
• A measure of relative dispersion that is useful in comparing the risks of assets with differing expected
returns.
• Assesses the volatility of the return relative to the risk associated with it
• Used when dealing with investment with different returns and risks
• Formula:
CV = EVσ R

Analysis:
• Higher CV means returns are more volatile/sensitive
• Higher CV means more risky investment

Risk and Return of Portfolio

• Portfolio​- collection of investment
• Reason for keeping a portfolio:
✔ Maximize the returns available
✔ Minimizes the risk associated with it

Portfolio Return: = Σ [ Probability x Σ (Proportion x Return)]

Standard Deviation = σ = √Σ [P robability x (Σ (P roportion x Return)– EV R)2]

Correlation and Diversification
• Correlation
✔ Statistical measure of relationship between any two variables, denoted by the coefficient of
correlation
Positively correlated-direct relationship with each other
Negatively correlated-inverse relationship with each other
✔ Lower correlation between two investments means that any changes that may affect one
investment may not as have the same impact to the other, thereby reducing the variability in the
whole portfolio
✔ Possible through diversification
• Diversification
✔ Adding investments to the portfolio that will yield lower possible correlation
✔ Reduces variability in the total returns in the portfolio, thereby reducing the risk of the whole
portfolio

Analysis in the Risk and Return

• Decision making is not only based on return but also on the risks
• In a risk-averse perspective, we want to as much as possible decrease the risk of single investments and
it is possible through portfolio management
• To improve the portfolio, we should study the correlation of investments and diversify to those
investments that will yield lower correlation, and in effect lower the risk
• However​, the limitation of that assumption is that, no matter how many investments you put into your
portfolio, some risks will still be present, and these risks are called ​non-diversifiable risks
 ✔ Also called market risks/systematic risks, they are risk that is present in the market and will not
change regardless of the diversification made
• On the other hand, ​diversifiable risks are the risks specific to each investment and will be mitigated
when put together with other investments in a portfolio

Modern Portfolio Theory

• The idea that we can reduce the risk of a portfolio by introducing assets whose returns are not highly
correlated with one another
• MPT tells us that by combining assets whose returns are not correlated with one another, we can
determine combinations of assets that provide the least risk for each possible expected portfolio return.
• Because of this concept:
✔ Investors hold portfolios of assets and therefore their concern is focused upon the portfolio
return and the portfolio risk, not on the return and risk of individual assets.
✔ The default assumption is to diversify as best as possible in order to reduce the diversifiable risk
✔ Therefore, the focus now is on the non-diversifiable risk, which is addressed by a model
developed by a Nobel Laureate, William Sharpe
Capital Asset Pricing Model
Formula:
Expected Return = Rf + β(Rm – Rf)
Where:
Rf = Return on risk-free investment
✔ This is a return that is not affected by any changes in the market
✔ Example: Return on Treasury bills and notes by the government
Rm = Expected market return
✔ Return from trading a market portfolio of investment
Rm – Rf = ​Market Premium
✔ Compensation you receive from taking risks in the market
β = Beta Coefficient
✔ Measure of return’s sensitivity to the market
✔ measure of market risk, which serves to fine-tune the risk premium for the investment (like
slope)
✔ Assesses the responsiveness of the individual investment to changes in market

Movements in the CAPM

• Inflation
✔ Movement in the market causing prices of commodities to increase
✔ Affects risk-free return and market return
✔ Inflation premium increases both items
✔ Does not affect beta coefficient and market premium
• Changes in Risk Aversion
✔ Movement in the market cause by investors being more risk-averse thereby requiring more
return from the risk they endure
✔ Increases the market return, but not the risk-free return

Limitations on the CAPM

• Historical Data used to estimate beta
• Theoretical Assumption on the relationship of investment and market
• No consideration of:
✔ Variability of investors
✔ Information other than basic knowledge on investment
✔ Taxes and other transaction costs
✔ Only used for risk-averse investors

Sources:
● Fundamentals of Financial Management by Van Horne, 13​th​ edition
● Fundamentals of Financial Management by Brigham and Houston, 11​th​ Edition
● Fundamentals of Corporate Finance by Berk, DeMarzo, and Harford, 4​th​ Edition
II. CHECKING FOR UNDERSTANDING

Exercise 1. JC Wee, a financial analyst for A-Team Industries, wishes to estimate the rate of return for two
investments, X and Y. JC’s research indicates that the immediate past returns will serve as reasonable estimates of
future returns. A year earlier, investment X had a market value of P20,000; investment Y had a market value of
P55,000. During the year, investment X generated cash flow of P1,500 and investment Y generated cash flow of
P6,800. The current market values of investments X and Y are P21,000 and P55,000, respectively.
1. Calculate the expected rate of return on investments X and Y using the most recent year’s data.
2. Using the computations, decide what would be the better investment.
3. What is the main factor to be considered beyond the computation?

Exercise 2​. Expected Value of Return

Probability of Outcome Possible Return
Investment A
Success 25% 24%
Moderate success 50% 10%
Failure 25% –4%
Investment B
Success 10% 45%
Moderate success 30% 30%
Failure 60% –5%

Compute for the expected value of each of the investment.

Exercise 3.​ Based from the previous information:

1. Compute for the standard deviation of the following investment.
2. What inference can you give from the computations done.
3. Compute for the coefficient of variation for the following investment.
4. Using the computations given, what investment will be chosen by a person who is (a) risk averse,
(b) risk neutral, and (c) risk taker?

Exercise 4.​ Single Investment vs Portfolio

Return on Return on
Probability Investment C Investment D
Boom 30% 20% –10%
Normal 50% 0% 0%
Recession 20% –20% 45%

1. Compute for the expected return and standard deviation of the individual investments.
2. Compute for the expected return and standard deviation of if portfolio is to be done with equal
proportion between two investments.

Exercise 5. If the expected return on a risk-free asset is 5% and the market return is 9%, what is the expected
security return if the security’s beta is:
• 0.00?
• 1.00?
• 1.25?
• 2.00?

Exercise 6. If the beta is 1.7 and the expected return of risk-free asset is 10%, what is the expected return if the
market return is:
• 10%?
• 15%?
• 8%?

Exercise 7. Suppose the expected risk-free rate is 5% and the expected return on the market is 12%. Further
suppose that you have a portfolio comprised of the four securities, with equal investments in each:
Security Security Beta
AA 1.00
BB 1.25
CC 1.50
DD 1.00
 • What is the expected return for each security in your portfolio?
• What is the portfolio’s beta?
• What is the expected return on your portfolio?
• If 40% of the investment goes to Security CC and while the remainder is divided to the other investment,
what is the new expected return?

Exercise 8. Assume that a risk-free return of 8% and a market return of 10%, while Investment A has a beta of
1.20. Answer the following independent assumptions.
1. What is the expected return from Investment A?
2. Suppose that as a result of recent economic events, inflation increased by 3%, what is the new expected
return from Investment A?
3. Suppose that as a result of recent economic events, investors have become more risk averse, increasing the
market return to 12%. What is the new expected return from Investment A?

III. ANALYSIS

1. What are the possible sources of return of an investment and how do they differ from one
another?
2. What does the volatility of returns say about the risk associated with the investment?
3. In the perspective of the company seeking investment, how is understanding the risk preference
helpful in gathering enough funds for the business?
4. How are the standard deviation and coefficient of variation used in making decision involving
risks and return?
5. What are some of the non-diversifiable risks affecting the capital market today?
6. According to the modern portfolio theory, what would be the more preferable portfolio
composition, a set of investments with different industries, or a set of investments with different
company size? Why?
7. What is the limitation of using beta and how do we minimize this limitation when using it?
8. What are the instances that could affect the risk aversion of the players in the market?

IV. INTEGRATION
1. Other than the financial instruments being focused in this lesson, what are some other
investments (both tangible and intangible) can you consider if given the funds to do it?
2. How is the concept of diversification relevant to your life as a student?
V. INDEPENDENT LEARNING

The Risk vs Return Game

1. The whole class is divided into 6 groups.

2. Each group will act as a bank, who will lend money to the public, which will be represented by the
instructor. The objective of each bank is to generate the most profits (return on capital) after all
rounds.
3. At the start of the game, each bank will have Php 100,000,000 fund, which will be offered for
lending. The cost of capital is at 3%. Therefore, in offering funds for lending, the interest to be
charged by the bank should be higher than the cost, but not too high that a practical borrower
would not choose you.
4. The banks can offer the funds in three sectors, each with different risk profile:
a. Sector 1 - Personal Unsecured Loan (25% possibility of failing, with loss of 100% of
funding)
b. Sector 2 - Mortgage Loan (25% possibility of failing, with loss of 10% of funding)
c. Sector 3 - Small Business Loans (50% possibility of failing, with loss of 30% of funding)

5. For each round, the public will announce the demand for each sector. Then, the bank has 5 mins to
plan how much of its funds will go to each of the avenue, along with the interest charge for each
avenue.
Example:
● Public needs 100M funding for each sector
● Bank 1 would then offer 25M to Sector 1 at 5%, 40M to Sector 2 at 6%, and 35M to
Sector 3 at 4%.

6. After all offers are given, the public will then choose the bank with the lowest interest charge for
each sector. If there are instances where two or more banks offer the same interest rate, the
investment will be prorated based on the offer on the table.
7. In addition, the instructor will now identify the result of risk of lending for each of the different
sectors (using a random app, like ​https://www.fortunewheel.com)​.
Example​:
● If the random app resulted to 25% failure to Sector 2, The chosen fund shall lose
10% before computing the remaining amount which would earn the interest.
However, the cost of capital is charged to 100% of the fund, regardless of the result
of risk.

8. As a twist, the group shall then compute the remaining fund it has, while the instructor also
computes for it.
● If the group’s balance is lower than the instructor’s balance, the group’s balance will
be the new amount.
● If the group’s balance is higher than the instructor’s, the difference between the two
will be deducted to the instructor’s balance to result to the new group’s balance.
● If the two balances are equal, the bank gains 5% additional fund for its financial
knowledge and competence.

9. Then the next round continues, for a total of 5 rounds. Then the profit will be computed for each
bank/group and ranked from highest to lowest fund. The grades will then be based on the
ranking:
1​st​ – 98%
2​nd​ – 90%
3​rd​ – 85%
4​th​ – 80%
5​th​ – 75%
6​th​ – 70%

Credits to: ​Journal of Financial Education,​ Vol. 29 (SPRING 2003), pp. 66-74

PREPARED BY:
MR. JOHN CARLOS S. WEE, CPA MBA CMITAP
MR. ROMEL W. DELOSA, CPA CMA
MR. ROMMEL REGOR D. ONG, CPA
FINMAN2 Instructors