Unit 4: Risk and Return
We are all familiar with the concept of risk and return. Even in our personal lives, we take risks knowing they can influence the return or outcome.
- Risk: not studying for the final exam in finance.
- Return: not getting a passing grade.
- Risk: not buying auto insurance.
- Return: the cost if you have an accident.
- Risk: investing in a health club membership.
- Return: weight loss and improved physical condition.
The study of corporate finance is the study of business risks and returns. Whether you consider the sole proprietors who invest their money in the start-up of a business that they have long dreamed about, the individuals investing in the stock market to improve their financial position for retirement, or the institutional investors representing millions of shareholders, all face the same basic uncertainties. They will invest money today for a future return, facing the risk that it will not meet their expectations.
Completing this unit should take you approximately 8 hours.
Upon successful completion of this unit, you will be able to:
- explain why accepting greater risk requires an expectation of greater returns;
- recognize the impact of interest rates on investment financing;
- explain how stocks are valued;
- calculate the risk of an investment; and
- explain how firms evaluate risk in investment decisions.
4.1: Investment Returns
In finance, we are frequently calculating the risk of our investments. A basic rule is that the greater the return on an investment, the greater the risk you must assume. Investment analysis requires a constant analysis of risk. In financial terms, the risk of an investment is that it will not provide the expected return. If you invest a sum of money with an expectation of a 10% return, and the actual return is 15%, you have exceeded the investment goals.
- Any discussion on investments requires an understanding of the risks and returns involved. After you read, you will be able to explain the concept of risks and returns.
Every investment made by a firm or an individual carries some degree of risk. The investor must evaluate risk as a determination is made on whether to invest their funds. Read this section to learn more about the different types of risks you may face.
Recall that financial risk is the possibility that an investment will return less than expected. Different investors, projects, and investment requirements will carry different levels of risk. Each investor, or investment group, will determine what level of risk is acceptable. Read this section to learn more about measuring risk.
4.2: Interest Rates and Bonds
Without trying to make our discussion more complicated, we need to consider what interest rate we should use in our investment decisions, especially as we go farther into the future for our return.
Most people understand that interest is money you earn when you save your money. They also know that different investment vehicles like savings accounts, stocks, or bonds, can have different interest rates, or rates of return. In finance, interest is used in a number of our analysis tools and may be known by different names such as discount rate, cost of capital, the opportunity cost of capital, or required return. Amazingly, these are all the same thing. It just depends on which side of the desk you are sitting on or what you are looking to do.
- A company can purchase bonds as an investment or can issue bonds as a mechanism to raise capital. It is important to understand the different types of bond issues that a company can use, and the impact of interest rates on those bonds. After this reading, you will be able to explain how a company can use long-term bonds as part of their capital budget.
One consideration that an investor in corporate bonds must make is the degree of risk they will assume with the investment. There are different classifications of bonds, and this section will offer some descriptions of the types of bonds and their risks.
4.3: Stocks
The primary responsibility of management is to make decisions, invest funds, and allocate resources in a way that increases the value of the firm, and thus the return to shareholders. The price of a firm's stock, and whether or not it is increasing or decreasing, is a fundamental of firm value.
A share of stock represents an ownership stake in the business. As such it is a form of equity. The company receives the investment from the owner, and the owner is entitled to a share in the money earned. From the standpoint of the firm, this is a form of equity financing. For the investor/shareholder, this is an investment in future value, and there is some expectation of return.- Stock is a fundamental element in publicly traded firms and is important for both the firm and the shareholder. After reading these sections, you will be able to discuss how stocks are issued, and how to evaluate dividends.
Corporations can issue two types of stocks, common and preferred. Each type of stock has unique characteristics and will be reviewed for the advantages and disadvantages for the shareholder. For example, common shareholders have the right to vote on company policies and for the board of directors. This article discusses these differences.
Not all stocks pay dividends, and those that do will vary in the amount and frequency of payments to shareholders. The potential for receiving dividends represents a value-added for these stocks. The dividend discount model is often used in valuing stocks that offer dividends.
4.4: Portfolio Risks
No discussion about investments is complete without some consideration of risk. From a financial perspective, we define risk as the probability that the actual return on an investment is less than the expected return.
Now, it is not that the risk is that you could lose all of your money. We will assume that you have spent enough time doing due diligence by analyzing an investment's positive and negative implications and have decided that it is appropriate to invest.
In every investment, you should have some expected rate of return that you are looking for. In the case of a T-bill paying a 5% interest per year, your expected rate of return is 5% for each year you hold the T-bill. Good news! This is a risk-free investment, as the return is guaranteed by the full faith of the U.S. government. Therefore, the probability of earning a 5% return on your investment is 100%. (We hope).
However, suppose someone comes to you with an investment opportunity. They explain to you that they own 100 acres of land somewhere in the Midwest, and they are going to mine for gold. If there's "gold in them hills", you should be able to get a return of 20% on your investment. Well, are you writing out a check?
At this point, you recognize that this investment is anything but a sure thing. So, you begin identifying and evaluating the potential risks involved. You might consider: the probability of finding gold, what if you need to invest more because you need to dig deeper, what will the price of gold be in the future, etc. The more risk that you identify, the greater the return you will need to get for your investment. This is where you would apply a risk factor, or the amount you will increase the risk-free rate to discount those projected future cash flows.
We use the term portfolio to represent a package of investment products, such as a stock portfolio. A company can also have a portfolio of products or market segments that they serve. In this section, you will learn how to evaluate a portfolio of various stocks/products, and how you can diversify the holdings in a portfolio to mitigate the implied risks that come with these investments.
We have discussed the implications of risk on investments. When certain factors are known, such as the risk-free rate, the beta of a stock, and the current market risk premium, we can calculate its potential return using the Capital Asset Pricing Model (CAPM). Read this section to learn more about this model.
A widely used method for reducing the risk of an investment portfolio is to ensure a diversification of stocks or not by not putting "all your eggs in one basket". An additional consideration is the weight or amount of the different stocks included. This process allows for a diversified portfolio. Read this chapter for a discussion of portfolio diversification and weighting.
Part of creating and maintaining a diversified stock portfolio is reviewing and evaluating what is happening with each stock in the portfolio. Stocks are dynamic and will rise and fall over a given period. Deciding when to buy and sell stocks requires a thorough analysis of their performance in the market. Read this section on the implications for expected returns to learn more.
4.5: Rates of Return
The rate of return, or the realized rate of return, is the actual return that you make on an investment. For example, if you were to invest $1,000.00, and earned $1,200.00 as a result of this investment, your rate of return would be 20%.Rate of Return = (Current Value) – (Investment) / Investment × 100
= ($1,200.00) – ($1,000.00) / $1,000.00 × 100
= 20.0%You need to be able to determine the rate of return on an investment. After reading this section, you will be able to calculate the real rate of return, not the expected rate, on an investment.
We have discussed the implications of risk on investments. When certain factors are known, such as the risk-free rate, the beta of a stock, and the current market risk premium, we can calculate its potential return using the Capital Asset Pricing Model (CAPM). Read this section to learn more about this model.
4.6: Return on Invested Capital (ROIC)
We have already discussed the management responsibility for creating and increasing the value of the firm and maximizing shareholder wealth. In the previous unit, you learned how to calculate the real rate of return on an investment. Now, we'll consider the calculation of returns from a business standpoint, which will include the addition of the cost of the money invested by the firm.
A company has access to capital from two general sources, debt and equity. Debt is the amount of funds that the firm borrows, including short-term and long-term debt. Debt financing must be repaid according to the terms of the borrowing agreement and includes the interest charges incurred. Equity is the funds that come from the shareholders, in the form of stock purchases or other infusions of cash. Equity financing does not have a legal responsibility to be repaid but comes with the shareholders expectation of a return on their investment.
When evaluating firms for investment opportunities, shareholders are keenly interested in knowing how well the company is doing in generating returns on the capital that they invest. Watch this video that discusses the return on capital.
As we have already discussed, a company raises capital from debt and equity financing. This capital is invested in projects that will generate a return for the investors. But every project has a degree of risk, risk that the returns will not be as expected. This chapter reviews the concept of estimating these risks, and how that is used in the evaluation of potential investment opportunities.
4.7: Dividend Policy
As we discussed in the previous unit, shareholders invested in the company because they believed that there was a potential for that business to grow and grow profitably. They expect returns. As a shareholder, they can receive their return in two ways. One is to sell their stock, and the second is to receive regular cash payments in the form of dividends while hanging on to their stock.
After a company has paid all of its operating expenses, allocated funds for continuing business operations, and invested in capital projects needed for growth, the remaining funds, or free cash flow, are available for distribution. The company can use this money to pay down debt, pay interest charges, or to pay dividends. The amount to be paid to shareholders will be part of the financial planning function of the firm and will be detailed in the dividend policy. This policy will address the level of dividends to be distributed, how the distribution will be made (dividend or stock buyback), and the forecast for maintaining a stable and consistent dividend.
When companies achieve a degree of financial success, which we will define as consistently generating a profit from their operations, some decisions need to be made that recognize the requirements for ongoing operations and a return for investors. The company will keep part of the profit (earnings) to continue operating the business, which are retained earnings. The amount of earnings left belongs to the shareholders and can be distributed to them as dividends. Read these sections, which discuss dividends for common stock and for preferred stock.
4.8: Stock Buyback
The previous section discussed the idea of a dividend policy. This policy is part of the firm's strategic plan. It will address two critical issues: 1) how often the firm will distribute dividends, and 2) what the amount of the dividends will be. However, one issue these companies will face is the diversity of their shareholder group, or that all shareholders are not the same. For example, some members of this group are more interested in the growth of share value over receiving cash dividends. These individuals may be in higher tax brackets and would like to receive their taxable dividends at some time in the future, perhaps when their tax rates are lower. Other members of this group are interested in having more cash now.
One approach that has addressed this difference among shareholders is for the firm to offer a stock buyback program. This allows individual shareholders to exercise their preference. Those who want money now can sell part or all of their shares back to the company. Those interested in increasing the value of their shares will hold on to them, knowing that the buyback program usually results in a higher stock price.
Companies have used stock buyback programs more frequently as they provide a reasonable approach to meet the financial expectations of their diverse shareholder groups. These programs are important to the firm and the shareholders; after reading this section, you will be able to explain why stock buyback programs are used.
Study Session
This study session is an excellent way to review what you've learned so far and is presented by the professor who created the course. Watch this as you work through the unit and prepare for the final exam.
We also recommend reviewing this Study Guide before taking the Unit 4 Assessment.
Unit 4 Assessment
- Receive a grade
Take this assessment to see how well you understood this unit.
- This assessment does not count towards your grade. It is just for practice!
- You will see the correct answers when you submit your answers. Use this to help you study for the final exam!
- You can take this assessment as many times as you want, whenever you want.