Page 75 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 5: Risk and Return Analysis

Notes

Did u know? Most managers are risk averse for a given increase in risk, they expect increase
in return. They generally tend to be conservative rather than aggressive when accepting
risk for their firm.

Self Assessment

Fill in the blanks:
1. The chance that the firm is available to cover its financial obligations is known as ………….
risk.
2. ………….is measured as cash distributions during the period plus the change in value
expressed as a percentage of value of the investment at the beginning of the period.
3. For the ……………….manager, the expected return does not change as risk increases from
one level to another.

5.2 Risk Measurement
The concept of risk can be developed by considering a single asset in isolation. We can see the
expected return behaviour to assess risk and statistics can be used to measure it.
Sensitivity analysis and probability distribution can be used to assess the general level of risk
associated with a single asset.

5.2.1 Risk Assessment
Sensitivity Analysis or Scenario Analysis uses several possible return estimates to ascertain the
extent of variability among outcomes. One common method is to have pessimistic (worst), most
likely (expected) and optimistic (best) estimates of the return associated with a given asset. In
this case, the assets’ risk can be measured by the range of returns. The range is found by subtracting
the pessimistic outcome from the optimistic outcome. The greater the range, the more variability
or risk, the asset is said to have.

Example: N Co. wants to choose the better of two investments A and B. Each require an
initial outlay of 100,000 and each has a most likely annual rate of return of 15%. Management
has made pessimistic and optimistic estimates of returns associated with each as follows:
Asset A Asset B
Initial investment 100,000 100,000
Annual rate of return
Pessimistic 13% 7%
Most likely 15% 15%
Optimistic 17% 23%

Asset A appears to be less risky than asset B, its range of (17% –13%) 4% is less than the range of
16% (23% –7%) for asset B. The risk averse decision maker would prefer Asset A over Asset B.
Since A offers the same most likely return as B (15%) with lower risk (smaller range).
Although the use of sensitivity analysis and range is rather simple, it doesn’t give the decision-
maker a feel for variability of returns that can be used to estimate the risk involved.

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