Corporate Finance

Overview of Risk & Return

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Risk and Return

The value of a firm is affected by two key

factors:
1. Risk , and
2. Return
Risk
It is defined as the variability of returns from
those that are expected.

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Return
It is the realisable cash flows earned by its owner on
investment during a given period of time.
In general terms, the rate of return is defined as:

Dt + (Pt - Pt - 1)
k=
Pt - 1
Where,
k = Required rate of return
Pt = Price of the security at time t
Pt-1 = Price of the security at time t-1
Dt = Income to be received from the security at time t

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Use of Probabilities
To compute the returns of a share under various
scenarios, we use probability.
We assign probability to various scenarios and compute
the value thereafter.
Note:
1. The possible outcomes must be mutually exclusive
and collectively exhaustive.
2. The sum of the probabilities assigned to various
possible outcomes is 1.

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Expected Rate Of Return
When various possible outcomes are given, it is
computed as follows:

k = ∑ PiKi

Where,
k = Expected rate of return
Pi = Probability associated with the ith possible outcome
ki = ith possible outcome
n = No. of possible outcomes
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e.g.: For XYZ Ltd., the data is as follows:
Economic condition
Boom Normal Recession
Probability 0.30 0.50 0.20

Return on XYZ stock (in %) 25 20 15

Compute the expected rate of return.

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e.g.: For XYZ Ltd., the data is as follows:
Economic condition
Boom Normal Recession
Probability 0.30 0.50 0.20

Return on XYZ stock (in %) 25 20 15

Compute the expected rate of return.

Solution:
We have,
k = ∑ PiKi = 0.30 × 25 + 0.50 × 20 + 0.20 × 15 = 20.5%

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Risk
It refers to the variability of a probability
distribution.
It is measured by Standard Deviation.
For, we have
σ = [∑ pi (ki - 2
k) ]½

Where,

σ = Standard deviation
pi = probability associated with the occurrence of the ith rate of return
ki = ith possible rate of return
k = Expected rate of return
n = No. of possible outcomes
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e.g.: For XYZ Ltd., Compute the risk associated with the same.
Economic Condition
Boom Normal Recession
Probability 0.30 0.50 0.20
Return on XYZ stock (in %) 25 20 15

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e.g.: For XYZ Ltd., Compute the risk associated with the same.
Economic Condition
Boom Normal Recession
Probability 0.30 0.50 0.20
Return on XYZ stock (in %) 25 20 15

Solution:
Economy ki Ki-k (ki-k)2 pi Pi(ki-k)2
Boom 25 4.5 20.25 0.30 6.075
Normal 20 - 0.5 0.25 0.50 0.125
Recession 15 - 5.5 30.25 0.20 6.050
∑pi (ki - k)2 = 12.25

∴ σ = [∑ pi (ki - k)2]½ = (12.25)½ = 3.5%

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Note:1. If we have historical return data rather than probability distribution of
return, the return and risk are calculated as follows:
Mean Return = k = ∑ki /n, Standard Deviation = [∑(ki – k)2/(n-1)]½
2. If the rate of return of individual securities are perfectly positively
correlated , diversification results in risk reduction.

Year Stock A Stock B

1 11 15
2 13 9
3 -8 27
4 27 -3
5 17 12

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Year Stock A Stock B

1 11 15
2 13 9
3 -8 27
4 27 -3
5 17 12
K= 12% 12%
σ= 12.76% 10.81%

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Diversifiable Risk & Non- diversifiable Risk
Diversifiable Risk
It is mainly because of firm factor. Hence it does not
affect the entire economy. Thus, It can be diversified
away by including several securities in a portfolio.
It is also known as Unsystematic Risk or, Non-market
Risk.
e.g : New Competitor
Plant Breakdown
Non-availability of Raw Materials etc.

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Non-diversifiable Risk
This type of risk is due to the influence of certain
economy-wide factors such as govt., inflation
,industrial policy etc.
This risk cannot be diversified away. It affects all the
securities.

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Beta (β)
It is an index of systematic risk. It measures
the sensitivity of a stock’s return to changes in
the returns on the market portfolio. By
definition, the β for the market portfolio is 1.

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Note:
1. As diversifiable risk is more or less eliminated by
holding a diversified portfolio, systematic risk
becomes the relevant measure of risk of an
investment.

2. The magnitude of influence of economy-wide

factors tend to vary from one firm to another.

3. The return on risky security is more volatile than the

return on the market portfolio whereas the return
on the conservative security is less volatile than the
return on the market portfolio.
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Beta reflects the slope of the regression relationship.

Cov ( kj , km )
Bj = 2
σ m
Where,
Cov (kj,km) = Covariance between the security j and the return on the market
portfolio = [(kj-kj)(km- km)]/(n-1)

σm2 = Variance of return on the market portfolio

ρim = Correlation coefficient between the return on jth security and
the return on the market portfolio [∴Cov (kj,km) = ρim σj σm ]

σj = Standard deviation of return on the jth security

σm = Standard deviation of return on the market portfolio
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Capital Asset Pricing Model (CAPM)
It describes the relationship between risk and expected
(required) return. As per this model, we have

Kj = rf + βj (km - rf)
Where,
Kj = Expected rate of return on security j
rf = Risk free rate of return
βj = Beta Coefficient of security J
km = Expected rate of return on market portfolio

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Security Market Line
* Graphical version of CAPM
* Shows relationship between the beta factor &
the expected rate of return of security

Risk-premium
17 for aggressive
14 security
11
Risk-premium
Rate of
for neutral
return
security
8
Risk-premium
Risk-free rate = rf for defensive
risk-free real rate
security
+ inflation rate
0.5 1 1.5 ß
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* higher the beta , higher the expected rate of
returns & vice-versa.

* If B < 1 ⇒ Defensive security

If B = 1 ⇒ Moderate security
If B > 1 ⇒ Aggressive security

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