Page 74 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 5.1.1 Return Defined

If we are going to assess risk on the basis of variability of return, we need to be certain what
return is and how to measure it. The return is the total gain or loss experienced on an investment
over a given period of time. It is measured as cash distributions (either dividend or interest)
during the period plus the change in value expressed as a percentage of value of the investment
at the beginning of the period. For Example, suppose one buys a security for 100 and receives
10 in cash and is worth 110 one year later. The return would be ( 10 + 10)/ 100 = 20 per cent.
Thus, return accrues from two resources, income plus price appreciation (or loss in price). The
expression for calculating the rate of return earned on any asset over period t, k can be defined
t
as:

C + P - P
-
K = t t t 1
t
P t 1
-
Where, K = actual, expected or required rate of return during period t
t
C = Cash flow received from the investment during time period t–1 to t
t
P = Price (value) of asset at time t
t
P = Pric e (value) of asset at time t – 1
t – 1
Example: X, a high traffic video arcade wants to determine the return on its two video
machines – C and D. C was purchased 1 year back for 200,000 and currently has a market value
of 215,000. During the year, it generated 8000 cash receipts. D was purchased 4 years ago, its
value in the year declined from 120,000 to 118,000. During the year, it generated 17,000 cash
receipts. The annual rate of return of C and D will be as follows:

+
-
8000 215000 200,000 23000
For C = = = 11.5%
200,000 200,000
-
+
17000 118000 120,000 15000
For D = = = 12.5%
120,000 120,000
It may be noted that though market value of D declined during the year, its cash flow enabled it
to earn higher rate of return than C during the same period.

5.1.2 Risk Preferences
Perception of risk varies among managers and firms. The three basic risk preference behaviour
is identified – risk averse, risk indifferent and risk seeking.
1. For the risk indifferent manager, the expected return does not change as risk increases
from one level to another. In essence, no change in return is expected for the increase in
risk.
2. For the risk average manager, the expected return increases for an increase in risk. These
managers shy away from risk and hence expectations of return go up to compensate for
taking greater risk.
3. For the risk-seeking managers, the expected return decreases with increase in risk. Because
they enjoy risk, these managers are willing to give up some return to assume more risk.
However, such behaviour is not likely to benefit the firm.

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