INVESTMENT RISKS AND RATES OF RETURNS i.
PROJECT RISK
TYPES OF RISK
1. BUSINESS RISK
 is the exposure a company or
organization has to various factors like
competition and consumer preferences
that might lower its profits or lead it to
fail.
TYPES OF BUSINESS RISK
a. COMPETITIVE RISK
 The risk that your competition
will gain advances over you that
prevent you from reaching your
goals. For example, competitors
that have fundamentally cheaper
cost base or better product.
b. ECONOMIC RISK
 The possibility that conditions in
the economy will increase or
reduce your sale.
c. OPERATIONAL RISK
 It is the result of insufficient or
failed processes; the potential
failures related to the day to day
operations of an organization.
d. LEGAL RISK
 The chance that new regulations
will disrupt your business or that
you will incur expenses and
losses due to legal dispute.
e. COMPLIANCE RISK
 The chance that you will break
laws and regulations.
f. STRATEGY RISK
 The risk associated with a
particular strategy.
g. REPUTATIONAL RISK
 The chance of losses due to
declining reputation as a result of
practices that are perceived as
dishonest, disrespectful or
incompetent.
h. PROGRAM RISK
 The risk associated with a
particular business program or
portfolio of projects.
 The risk associated with projects.
j. INNOVATION RISK
 Risk that applies to innovative
areas of your business such as
product research.
k. COUNTRY RISK
 Exposure to the conditions in the
countries in which you operate
such as political events and the
economy.
l. QUALITY RISK
 The potential that you will fail to
meet your quality goals for your
products. Services and business
practices.
m. CREDIT RISK
 The risk that those who owe you
money to fail to pay. This is
mostly related to accounts
receivable risk.
n. EXCHANGE RATE RISK
 The risk that volatility in foreign
exchange rates will impact the
value of business transactions
and assets.
o. INTEREST RATE RISK
 The risk that changes to interest
rates will disrupt your business.
p. TAXATION RISK
 The potential for new tax laws or
interpretations to result in higher
than expected taxation.
q. PROCESS RISK
 The business risk associated with
a particular process.
r. RESOURCE RISK
 The chance that you will fail to
meet business goals due to lack
of resources such as financing or
the labor of skilled workers.
s. POLITICAL RISK
 The potential for political events
and outcomes to impede your
business.
t. SEASONAL RISK
 A business with revenue that’s
concentrated in a single season
such as ski resort.
2. VOLATILITY RISK
 refers to the risk that a portfolio may
experience changes in value due to
volatility (price swings) based on the
changes in value of its underlying assets
- particularly a stock or group of stocks
experiencing volatility or price
fluctuations.
3. INFLATION RISK
 sometimes called purchasing power
risk
 is the risk that the cash from an
investment won't be worth as much in
the future due to inflation changing its
purchasing power.
 Inflation risk is more of a concern for
investors who have debt investments
like bonds or other cash-heavy
investments.
4. LIQUIDITY RISK
 is involved when assets or securities
cannot be liquidated fast enough to ride
out an especially volatile market.
 This kind of risk affects businesses,
corporations or individuals in their ability
to pay off debts without suffering losses.
5. REINVESTMENT RISK
 The risk of loss from reinvesting
principal or income at a lower interest
rate. Suppose you buy a bond paying 5%.
 Reinvestment risk will affect you if
interest rates drop and you have to
reinvest the regular interest payments at
4%. Reinvestment risk will also apply if
the bond matures and you have to
reinvest the principal at less than 5%.
 Reinvestment risk will not apply if you
intend to spend the regular interest
payments or the principal at maturity.
6. HORIZON RISK
 The risk that your investment horizon
may be shortened because of an
unforeseen event, for example, the loss of
your job.
 This may force you to sell investments
that you were expecting to hold for the
long term. If you must sell at a time when
the markets are down, you may lose
money.
7. LONGEVITY RISK
 The risk of outliving your savings. This
risk is particularly relevant for people
who are retired, or are nearing retirement.
8. MARKET RISK
 is a broad term that encompasses the risk
that investments or equities will decline
in value due to larger economic or
market changes or events.
TYPES OF MARKET RISK
a. EQUITY RISK
 experienced in every investment
situation in that it is the risk an
equity's share price will drop,
causing a loss
b. INTEREST RATE RISK
 is the risk that the interest rate of
bonds will increase, lowering the
value of the bond itself
c. CURRENCY RISK
 applies to foreign investments
and the risk of losing money
because of a exchange rate.
MEASUREMENT OF RISK
1. BETA
 is a measure of a stock's volatility in
relation to the market.
 It measures the exposure of risk a
particular stock or sector has in relation
to the market.
 If you want to know the systematic risk
of your portfolio, you can calculate its
beta.
1. A beta of 0 indicates that the portfolio is
uncorrelated with the market.
2. A beta less than 0 indicates that it moves in the
opposite direction of the market.
3. A beta between 0 and 1 signifies that it moves in
the same direction as the market, with less
volatility.
4. A beta of 1 indicates that the portfolio will move
in the same direction, have the same volatility
and is sensitive to systematic risk.
5. A beta greater than 1 indicates that the portfolio
will move in the same direction as the market,
 with a higher magnitude, and is very sensitive
to systematic risk.
STEPS IN COMPUTING BETA
1. Find the risk-free rate. This is the rate of return
an investor could expect on an investment in
which his or her money is not at risk. The risk
free-rate is 2%.
2. Determine the respective rates of return for
the stock and for the market or appropriate
index. These figures are also expressed as
percentages. Usually the rates of return are
figured over several months. The stock’s rate of
return is 7% while the market rate of return is 8%.
3. Subtract the risk-free rate from the stock's
rate of return. If the stock's rate of return is 7%
and the risk-free rate is 2%, the difference would
be 5%.
4. Subtract the risk-free rate from the market (or
index) rate of return. If the market or index rate
of return is 8% and the risk-free rate is again 2%,
the difference would be 6%.
5. Divide the first difference above by the second
difference above. This fraction is the beta figure,
typically expressed as a decimal value. In the
example above, the beta would be 5 divided by 6,
or 0.833.
HOW TO CALCULATE BETA
To calculate the beta of a security, the covariance between
the return of the security and the return of the market must
be known, as well as the variance of the market returns.
𝐂𝐨𝐯𝐚𝐫𝐢𝐚𝐧𝐜𝐞
𝐁𝐞𝐭𝐚 =
𝐕𝐚𝐫𝐢𝐚𝐧𝐜𝐞
where:
Covariance – Measure of a stock’s return relative to that
of the market
Variance – Measure of how the market moves relative to
its mean
Covariance
 measures how two stocks move together.
 A positive covariance means the stocks tend to
move together when their prices go up or down.
 A negative covariance means the stocks move
opposite of each other.
Variance
 refers to how far a stock moves relative to its
mean.
 Variance is used in measuring the volatility of an
individual stock's price over time.
 Covariance is used to measure the correlation in
price moves of two different stocks.
Calculating the Beta for Tesla Inc. (TSLA):
Let's assume the investor also wants to calculate
the beta of Tesla Motors Inc. (TSLA) in comparison to the
SPDR S&P 500 ETF Trust (SPY). Based on data over the
past five years, TSLA and SPY have a covariance of
0.032, and the variance of SPY is 0.015.
𝟎.𝟎𝟑𝟐
𝐁𝐞𝐭𝐚 𝐨𝐟 𝐓𝐒𝐋𝐀 = 𝟎.𝟎𝟏𝟓 = 2.13
Therefore, TSLA is theoretically 113% more
volatile than the SPDR S&P 500 ETF Trust.
2. COEFFICIENT OF VARIATION
 Is a statistical measure of the points in a
data series around the mean.
𝝈
𝑪𝑽 = 𝒙 𝟏𝟎𝟎
̅
𝒙
Where:
𝝈 − standard deviation
𝐱̅ − mean
3. STANDARD DEVIATION
 measures the dispersion of a data set
relative to its mean
 Denoted by lower case Greek sigma 𝜎, or
sd or s.
 A low 𝜎 indicates the data are tightly clustered
around the mean.
 A high 𝜎 indicates the data are widely dispersed.
 Standard deviations of price data are frequently
used as a measure of volatility. It is often used by
investors to measure the risk of a stock or a stock
portfolio.
where:  A company with high operating leverage has a
∑ - Greek Sigma, means summation large proportion of fixed cost, which means that a
𝐱̅ – x-bar or x-not, means average of x values big increase in sales can lead to outsized changes
N – count of values (or number of numbers) in profits.

EXAMPLE: % ∆𝐄𝐁𝐈𝐓
𝐃𝐎𝐋 =
% ∆𝐒𝐀𝐋𝐄𝐒

EXAMPLE:

COMPANY XYZ (in millions)

2019 2018 % Change

EBIT 14, 358 13, 224 8.58%

Sales 55, 632 52, 465 6.04%

Degree of 1.4205
Operating
Leverage

CURRENT YEAR−PREVIOUS YEAR

%∆=
PREVIOUS YEAR

14,358−13,224
% ∆EBIT = 13,224
= 8.58%
55,632−52,465
% ∆SALES = 52,465
= 6.04%

𝟖.𝟓𝟖%
𝐃𝐎𝐋 = 𝟔.𝟎𝟒% = 1.4205
σ
CV = x 100
x̅

9.3 DEGREE OF FINANCIAL LEVERAGE (DFL)

CV = x 100  is a leverage ratio that measures the sensitivity of
̅̅̅̅
80
a company’s earnings per share (EPS) to
CV = 0.11625 x 100 fluctuations in its operating income, as a result of
CV = 11.625 changes in its capital structure.

DEGREE OF OPERATING, FINANCIAL AND  DFL is best used to help a company determine an
TOTAL LEVERAGE appropriate amount of debt.
 The higher the DFL, the more volatile EPS will
DEGREE OF OPERATING LEVERAGE (DOL) be.
 Quantifies a company’s operating risk that is a
result of the structure of fixed and variable cost. 𝐄𝐁𝐈𝐓
𝐃𝐅𝐋 =
 Is an indication of how a company’s cost are 𝐄𝐁𝐈𝐓 − 𝐈𝐍𝐓𝐄𝐑𝐄𝐒𝐓
structured and is used to determine the break-
even point for a company. where:
EBIT – Earnings before interest and taxes/
 The DOL ratio assists analysts in determining the operating income
impact of any change in sales on company Interest – interest expense
earnings
EXAMPLE:
Assume hypothetical company BigBox Inc. has 17.65%
DOL = 28%
= 0. 6304
operating income or earnings before interest and taxes
(EBIT) of 100 million in Year 1, with interest expense of 10,000,000
10 million, and has 105 million shares outstanding. DFL = = 1.0526
10,000,000 −500,000
EPS for BigBox in Year 1 would thus be:
DTL = 0.6304 x 1.0526 = 0.6636
EBIT – INTEREST EXPENSE
EPS =
NO. OF SHARES
100 million – 10 million
EPS = = 0.86
105 million

100 million
DFL = = 1.11
100 million −10 million

This means that for every 1% change in EBIT or operating

income, EPS would change by 1.11%.

DEGREE OF TOTAL LEVERAGE (DTL)

 can also be referred to as the “degree of
combined leverage” because it considers the
effects of both operating leverage and financial
leverage.
 is a ratio that compares the rate of change a
company experiences in earnings per share (EPS)
to the rate of change it experiences in revenue
from sales.

 This ratio can be used to help determine the most

optimal level of financial and operating leverage
to use in any firm.
 A firm with a relatively high level of combined
leverage is seen as riskier than a firm with less
combined leverage because high leverage means
more fixed costs to the firm.

DTL = DOL x DFL

EXAMPLE:

2019 2018

EBIT 10, 000, 000 8, 500, 000

Sales 8, 000, 000 6, 250, 000

Interest Expense 500, 000

10,000,000 −8,500,000
% ∆EBIT = 8,500,000
= 17.65%
8,000,000 −6,250,000
% ∆SALES = 6,250,000
= 28%