BUS601: Financial Management

4a. Explain why accepting greater risk requires an expectation of greater returns 

• What is the definition of financial risk?
• What are some approaches to measuring risk?
• How are interest rates used in evaluating risk?

We are all familiar with the general concept of risk. It is usually applied when addressing issues that deal with an unknown outcome. For example, there is a risk that we will find the final exam in this course very difficult. Of course, there are also ways to mitigate, or lessen, this risk. We can make sure to study all of the material, complete all of the assignments, and use this study guide. These steps can reduce the risk. In the business world, we define financial risk as the potential that an investment will have a rate of return that is less than our expected rate.

Obviously, the firm will spend considerable time evaluating potential investment opportunities, and part of this research includes an analysis of the risks associated with any investment. There are several areas that the firm will review, including their degree of experience with the new initiative. For example, it is less risky for an automobile manufacturer to introduce a new car model than to launch a line of home appliances. There are issues with brand awareness, technology, sales channels, distribution networks, manufacturing capabilities, etc. We can add economic risks, business risks, and market risks, to name a few more. There are methodologies used to offer some ways to measure risk, including probability analysis, portfolio models, discounted cash flows, and forecasted interest rates.

When a company borrows funds from a financial institution, interest is involved. Interest represents income for the lender and an expense for the borrower. The interest rate that the lender will charge is based, in part, on the risk that the borrower will be able to repay the loan. The greater the risk of default by the borrower, the higher the interest rate. A firm knows its cost of capital, including the interest rate that it will pay for any borrowed capital. Recall that the calculations of the net present value and internal rate of return for evaluating investments require the use of interest rates.

To review, see:

• Understanding Return
• Types of Risk
• Measuring Risk

 

4b. Recognize the impact of interest rates on investment financing

• What is the difference between the rate of return and the expected rate of return for an investment?
• How is the Capital Asset Pricing Model (CAPM) used in the evaluation of a potential investment?

If you invest money in treasury bills or bonds, there is a stated interest rate which is the rate of return that will be applied over a given period. Suppose that you buy a $1,000 bond with an interest rate of 10% per year. In one year, you will receive your $1,000 plus $100 in interest for a total of $1,100. However, when a firm invests in new equipment to support its projections for growth, the rate of return is not specifically known. They must consider the market risk and the firm-specific risk.

Market risk (systematic risk) is based on considering the market as a whole and recognizing that fluctuations in the market can influence the financial market. The firm-specific risk (unsystematic risk) represents the risk associated with a particular investment made by a firm. A company can reduce this risk by investing in a balanced portfolio of projects. An investor can reasonably expect a return comparable to the overall market risk. A firm that wants to make investments that will be beneficial and of interest to its shareholders will add a premium to the expected rate of return, or the risk premium. The company will also need the risk-free rate, which is typically associated with a treasury bill (guaranteed).

With this information, it is possible to calculate the expected rate of return on a specific investment. Note that this is expected but can certainly be more or less given market changes and unforeseen issues with the initiative. You can use the capital asset pricing model (CAPM) to determine the expected rate.

To review, see Long-Term Financing: Bonds.

 

4c. Explain how stocks are valued

• What are debt financing and equity financing?
• What are the differences between common stock and preferred stock?
• What are some of the ways that can be used to determine the value of a share of stock?

In analyzing the benefits of any investment being considered, the firm evaluates the potential returns that will benefit the firm and the firm's shareholders. As the analysis starts to provide firm numbers on the cost of the investment, attention will be given to how the initiative will be financed. The firm will look at debt financing, which will come from lending sources and incur a liability for the company. This is accounted for as the debt to be repaid and the interest expense. The other source of funds will come from equity financing. Equity is a form of ownership. For example, the firm can raise money by issuing shares of stock. The funds raised from shareholders do not incur interest and do not need to be repaid. (Although shareholders would like to see a return on their investment!)

A company can offer two types of stock, namely common and preferred. Each type of stock has certain specific differences. Preferred stock has the benefit of having a guaranteed dividend payment. If the dividend payment is not made, the company cannot pay any dividends to common shareholders. Additionally, in the case of bankruptcy, preferred shareholders are at the top of the list of claimants for the firm's assets. Preferred shareholders have no voting rights for the corporation's board of directors. On the other hand, common stock does give the shareholder voting rights, but there is no guarantee of dividend payments. In the event of a bankruptcy, common shareholders have a residual claim on assets that remain after all other claims have been paid.

Investors buy stock in firms that they believe represent opportunities for financial growth and that will provide the expected rate of return. The value of each share is represented by its price and the potential earnings from dividend payments. If the firm's value increases, it is expected that the share price will increase. This represents a return for any shareholder who sells their stock at a greater price than they purchased it. Additionally, if the shareholder receives dividends and can forecast a stream of future dividend payments, that also represents a return.

A simple calculation of the value of a share is to take the owner's equity (balance sheet), assets minus liabilities, and divide it by the number of shares outstanding. That is what each shareholder is entitled to if the firm were to liquidate today. When considering the potential for dividend payments, remember your review of discounted future cash flows. Generally, depending on the firm and forecast for dividends, an investor can consider a constant dividend stream (same dividend payment) or a dividend stream with constant growth (growing at a constant rate).

To review, see:

• Shareholder's Equity
• Common and Preferred Stocks
• Dividend Discount Model

 

4d. Calculate the risk of an investment

• What is the meaning of financial risk?
• What is a stock portfolio?
• How does building a portfolio of investments reduce investment risk?

As previously noted, every project that requires cash today for some expected return in the future poses some risks for the investor. Financial risk is the possibility that our investment will produce a return that is less than what we expected (calculated). If there were no risks, and if the returns were guaranteed, there would be more investing taking place. The starting point for calculating risks for new investment is to find what return is available if there is no risk. We look for a treasury bill or bond that will repay the face value (investment cost) and a stated interest rate (risk-free rate). Given that the lower the risk, the lower the expected rate of return, the interest rate is modest. For investors, this is the starting point and represents the base return.

If the investor is willing to assume more risk (risk-taking), they will look for a larger return or an amount greater than the risk-free rate. The greater the risk, the greater the expected return. To get estimates on this larger return, there can be a review of the performance of similar products, services, and industries. Forecasts will be made regarding revenue generation and growth, expenses, and projected profit levels. This rate, plus the risk-free rate, is used to assign a value to the investors' expected rate of return.

One way that investors can reduce the financial risk of their investments is by building a stock portfolio of diversified investments. A portfolio can contain the stocks of various companies, each with a different level of financial risk, which, when combined (weighted), can provide some protection from the risks of an individual stock. Simply stated, don't put all of your eggs in one basket! Companies can also build a diversified portfolio of the projects that they invest in. This can include investments in different products, services, divisions, markets, etc., which can also lower the firm's financial risk.

To review, see:

• Risk and Return Basics
• Expected Return

 

4e. Explain how firms evaluate risk in investment decisions

• What are some of the risk factors to consider when evaluating an investment opportunity?
• How does calculating the standard deviation of potential outcomes help make an investment decision?
• How does the firm/investor calculate the return on invested capital?

A firm must spend resources and time evaluating potential investments. The firm is committed to making investments that will positively affect its value. A firm can accomplish this by identifying initiatives that can increase revenue generation, help with cost controls, increase operating efficiencies, improve the quality of products and services, and any number of additional projects that assist the company in increasing their stock prices, dividend payments, or both.

Identifying potential risks that come with every investment and finding ways to minimize those risks is critical. The market is filled with examples of firms that became great success stories, but even more that failed and lost their investor's money. A firm's risk factors can include the experience needed to succeed, comprehensive data collection, in-depth financial analysis, availability of capital, the time required to reach a return, uncertainty in the economy, and many more. The better the research, the more likely that the firm will identify issues and determine how much risk they represent.

Numerically, the firm can make an effort to calculate the standard deviation of the potential investment outcomes. If you remember from statistics, the standard deviation measures how different the results of this particular investment will be from the average of all outcomes. Often, historical data is used to obtain a set of actual outcomes. These outcomes can be assumed to have the same weight, or our research may identify the need for some adjustments. The average of these outcomes is the expected rate of return.

One method for demonstrating how efficient the firm is at investing its capital and creating value is calculating the return on invested capital (ROIC). The formula for determining the ROIC is: (net income – dividends) / (debt + equity). In other words, the firm has generated a certain amount of profit, after paying dividends to shareholders, based on their use of debt and equity financing. The higher the ROIC, the better the job that the firm is doing for their shareholders.

To review, see:

• Risk and Return Basics
• Expected Return

 

Unit 4 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• capital asset pricing model
• common stock
• constant dividend stream
• debt financing
• dividend stream with constant growth
• equity financing
• financial risk
• firm-specific risk
• interest rate
• market risk
• measuring risk
• preferred stock
• rate of return
• return on invested capital (ROIC)
• risk factors
• risk-free rate
• risk premium
• standard deviation
• stock portfolio