Financial Problems Slide

Introduction to Financial Management
Chapter 5

Risk and Rates of Return

FIN 254 (Instructor- Saif Rahman)

Introduction to Risk and Return
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Risk and return are the two most important attributes of an investment. Research has shown that the two are linked in the capital markets and that generally, higher returns can only be achieved by taking on greater risk. Risk isn’t just the potential loss of return, it is the potential loss of the entire investment itself (loss of both principal and interest). Consequently, taking on additional risk in search of higher returns is a decision that should not be taking lightly.
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FIN 254 (Instructor- Saif Rahman)

There is a risk-return trade-off. Increasing return requires bearing more risk. Reducing risk means sacrificing return.
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FIN 254 (Instructor- Saif Rahman)

Expected Rate of return
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The rate of return expected to be realized from an investment.

Company

Expected Rate of Return

Probability

IBM

-22% -2 20 35 50

10% 20 40 20 10

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FIN 254 (Instructor- Saif Rahman)

Return: Calculating the expected return for each alternative k  expected rate of return k   k i Pi i 1 ^ ^ n ^

k IBM  (-22%) (0.1)  (-2%) (0.2)  (20%) (0.4)  (35%) (0.2)  (50%) (0.1)  17.4%
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FIN 254 (Instructor- Saif Rahman)

Summary of expected returns for all alternatives
IBM Market USR T-bill Shell
Exp return 17.4% 15.0% 13.8% 8.0% 1.7%

IBM has the highest expected return, and appears to be the best investment alternative, but is it really? Have we failed to account for risk?

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FIN 254 (Instructor- Saif Rahman)

Risk
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Probability of incurring harm

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For investors, risk is the probability of earning an inadequate return.
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If investors require a 10% rate of return on a given investment, then any return less than 10% is considered harmful.

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FIN 254 (Instructor- Saif Rahman)

Risk
Illustrated
Probability
The range of total