Page 73 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 5: Risk and Return Analysis

Introduction Notes

In the most basic sense, risk is the chance of financial loss. Assets having greater chances of loss
are considered as more risky than those with lesser chances of loss. More formally, the term,
risk, is used synonymous with uncertainty in terms of variability of returns associated with a
given asset. As for example, interest of 600 on Govt. Bond of 10,000 for 1 year since there is no
variability associated with interest, it is considered as risk-free. Whereas 10,000 investment in
equity shares over 1 year period may give return anywhere between 0 to 2000. It is considered
risky because of high variability in its return.

5.1 Risk and Return characterization

Some risks directly affect both finance managers and the shareholders whereas some risks are
from specific and some are shareholders specific. These are given below:

Box 5.1: Specific Risks

Firm Specific Risk
Business Risk The chance that the firm will be able to cover its operating costs. Level is
drawn by the firms revenue stability and the structure of its operating cost
(fixed vs. variable).
Financial Risk The chance that the firm is available to cover its financial obligations. Level is
drawn by the predictability of the firm’s operating cash flows and its fixed
cost financial obligations like interest on debt/bond.
Shareholder Specific Risk
Interest Rate The chance that changes in interest rate will adversely affect the value of an
Risk investment. Most investments lose value when the interest rate rise and
increase in value when it falls.
Liquidity Risk The chance that an investment can be converted into money at a reasonable
price Liquidity is significantly affected by the size and departments of the
markets in which an investment is normally traded.
Market Risk The chance that the value of an investment will decline because of market
factors that are independent of investment (such as economic, political and
social events). The more the value of the given investment responds to market
uncertainties, the greater its risk and the less it refunds, the smaller the risk.

Box 5.2: Firm and Shareholders Risk

Event Risk The chance that a totally unexpected event will have a significant effect on the
value of the firm or a specific instrument. These events, such as government’s
withdrawal of a popular prescription along with affect only a small group of
firms or investments.
Exchange Rate This is future cash flow getting affected by fluctuation in the currency exchange
Risk rate. The greater the chance of an unexpected exchange rate fluctuation the
greater the risk of cash flows and therefore the lower the value of the firm or
investment.
Purchasing The chance that changing price levels due to inflation or deflation in the
Power Risk economy, will adversely affect the firms or investments’ cash flows and values.
Typically, firms or investments with cash flows that moves with general price
levels have a low purchasing power risk and those with cash flows that do not
make with general price levels have high purchasing power risk.
Tax Risk The chances that with adverse change in tax laws firm and investment values
change adversely are considered more risky.

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