Business Finance

Governor Pack Road, Baguio City, Philippines 2600

Tel. Nos.: (+6374) 442-3316, 442-8220; 444-2786;
442-2564; 442-8219; 442-8256; Fax No.: 442-6268 Grade Level/Section: Grade 12- ABM
Email: email@uc-bcf.edu.ph; Website: www.uc-bcf.edu.ph

MODULE 7 – FINANCE Subject Teacher:

RISK and RETURN

Learning objectives:
At the end of this module, students must be able to:
1. discuss the relationship of risk and return in finance;
2. identify types of risks;
3. measure risk using various financial tools; and
4. determine the degree of operating and financial leverages.

CONTENTS:

RISK MANAGEMENT:
It is the technique for the measuring, monitoring, and controlling the financial or operational risk on a
firm’s balance sheet.

Risk-Return Trade-off
The principle that potential return rises with an increase in risk. Low levels of uncertainty or risk are
associated with low potential returns, whereas high levels of uncertainty or risk are associated with
high potential returns.

Return – The total gain or loss experienced on an investment over a given period of time; calculated
by dividing the asset’s cash distributions during the period, plus change in value, by its beginning-of-
period investment value.
Risk – A measure of the uncertainty surrounding the return that an investment will earn or, more formally,
the variability of returns associated with a given asset.

Inherent risks of various types of investment

Kinds of Risks:
1. Business Risk - possible causes of business loss due to:
a. Competition
b. Change in demand
c. Uncontrollable cost
d. Managerial error
e. Resource shortage

2. Market Risk – arises from market prices and collateral values of some securities and real property

3. Purchasing Power Risk – The ROI is assured but the buying power is very uncertain.

4. Financial/Leverage Risk – Risk that payment due on borrowed money cannot be met. A risk
added to the owners of the business resulting from financial leverage. This is the extent of to
which fixed income securities (debt and preference shares) are used in a firm’s capital structure.

5. Social/Regulatory Risk – Arises when an otherwise profitable investment is impaired as a result of

adverse legislations or harsh regulatory climate.

6. Political Risk – Arises from the possibility that a host government might take actions harmful to
foreign investors.

7. Speculative Risk – are situations that offer the chance of a gain but might result in a loss.

8. Capital Value Risk – Affects the value of fixed income securities of long and indefinite maturity.

Business Finance Page 1 of 4

 Business Finance
Governor Pack Road, Baguio City, Philippines 2600
Tel. Nos.: (+6374) 442-3316, 442-8220; 444-2786;
442-2564; 442-8219; 442-8256; Fax No.: 442-6268 Grade Level/Section: Grade 12- ABM
Email: email@uc-bcf.edu.ph; Website: www.uc-bcf.edu.ph

MODULE 7 – FINANCE Subject Teacher:

9. Income Risk – The chance that by the time a short-term investment have fallen so that less
income can now be purchased with the same amount of principal.

Degree of Operating Leverage (DOL)

Operating leverage is a measure of how sensitive net operating income is for a given percentage
change in peso sales. If operating leverage is high, a small percentage increase in sales can
produce a large percentage increase in net operating income.
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛
𝑫𝑶𝑳 =
𝐸𝐵𝐼𝑇
**this is to be discussed in detail in higher accounting**

Degree of Financial Leverage (DFL)

Financial leverage measures the amount of debt used in the capital structure of the firm. Debt carries
a fixed obligation of interest payments, and a business entity can greatly magnify the results at
various levels of operation. If the financial leverage is high, the company can enjoy an high return on
investment.
𝐸𝐵𝐼𝑇
𝑫𝑭𝑳 =
𝐸𝐵𝐼𝑇 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
**this is to be discussed in detail in higher accounting**

RATE OF RETURN (ROR) on Investment – represents the interest charged by the investor to the other
party for using the money without considering the eroding effect of the inflationary changes.

MEASUREMENT OF RETURN:
Formula1: calculating return for single asset/investment.
𝐶𝑡 + 𝑃𝑡 − 𝑃𝑡−1
𝑟𝑡 =
𝑃𝑡−1
Where:
rt = actual, expected, or required rate of return during period t
Ct = cash (flow) received from the asset investment in the time period t - 1 to t
Pt = price (value) of asset at time t (present)
Pt-1 = price (value) of asset at time t – 1 (base year)

The expected rate of return on a stock represents the mean of a probability distribution of possible
future returns on the stock.

Formula2: calculating expected return given a probability distribution of returns:

𝑁

𝐄[𝐑] = ∑(𝜌𝑖 𝑅𝑖 )
𝑖=1
Where:
E[R] = the expected return on the stock
N = the number of states
ρi = the probability of state i
Ri = the return on the stock in state i.

MEASUREMENT OF RISK:
Risk is a difficult concept in finance to grasp and to measure. There are several accepted tools to
measure risk in terms of probability distribution.

Given an asset's expected return, its variance can be calculated using the following equation:
N

𝐕𝐚𝐫(𝐑) = 𝛔 = ∑ ρi (R i − E[R])2
𝟐

i=1
Where:
N = the number of states
Business Finance Page 2 of 4
 Business Finance
Governor Pack Road, Baguio City, Philippines 2600
Tel. Nos.: (+6374) 442-3316, 442-8220; 444-2786;
442-2564; 442-8219; 442-8256; Fax No.: 442-6268 Grade Level/Section: Grade 12- ABM
Email: email@uc-bcf.edu.ph; Website: www.uc-bcf.edu.ph

MODULE 7 – FINANCE Subject Teacher:

ρi = the probability of state i

Ri = the return on the stock in state i
E[R] = the expected return on the stock

Standard Deviation:
A statistical measurement of variability of a set of observation.
Rule: The smaller the standard deviation, the lighter the probability distribution, and accordingly, the
lower the level of riskiness of a given investment alternative.
𝐒𝐃(𝐑) =  = √2

Coefficient of Variation (Covariance):

A very useful risk measurement tool that shows the risk per unit of return and provides a more
meaningful basis for comparison when expected returns on two investment alternatives are not the
same.
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
𝐶𝑉 =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒𝑠

Portfolio Risk and Return

Expected Return on a portfolio:
𝑁

𝐄[𝐑 𝐏 ] = ∑ 𝑤𝑖 𝐸[𝑅𝑖 ]
𝑖=1
Where:
E[RP] = the expected return on the portfolio
N = the number of stocks in the portfolio
wi = the proportion of the portfolio invested in stock i
E[Ri] = the expected return on stock i

Covariance between the returns of investments (i.e. A & B) in a portfolio:

𝑁

𝐶𝑜𝑣 (𝑅𝐴 , 𝑅𝐵 ) = ∑ 𝜌𝑖 (𝑅𝐴𝑖 − 𝐸[𝑅𝐴 ])(𝑅𝐵𝑖 − 𝐸[𝑅𝐵 ])

𝑖=1
Where:
 A,B = the covariance between the returns on stocks A and B
N = the number of states
ρi = the probability of state i
RAi = the return on stock A in state i
E[RA] = the expected return on stock A
RBi = the return on stock B in state i
E[RB] = the expected return on stock B

Correlation Coefficient between the returns of investments (i.e. A & B) in a portfolio:

A,B Cov (𝑅𝐴 , 𝑅𝐵 )
𝑪𝒐𝒓𝒓(𝑹𝑨 , 𝑹𝑩 ) = 𝑨,𝑩 = =
A B 𝑆𝐷 (𝑅𝐴 )𝑆𝐷(𝑅𝐵 )
Where:
𝑨,𝑩=the correlation coefficient between the returns on stocks A and B
 A,B=the covariance between the returns on stocks A and B,
 A=the standard deviation on stock A, and
 B=the standard deviation on stock B

Business Finance Page 3 of 4

 Business Finance
Governor Pack Road, Baguio City, Philippines 2600
Tel. Nos.: (+6374) 442-3316, 442-8220; 444-2786;
442-2564; 442-8219; 442-8256; Fax No.: 442-6268 Grade Level/Section: Grade 12- ABM
Email: email@uc-bcf.edu.ph; Website: www.uc-bcf.edu.ph

MODULE 7 – FINANCE Subject Teacher:

References:
✓ BAL 658.15 C1128, 2017. Cabrera, Ma. Elenita Balatbat and Cabrera, Gilbert Anthony B.,
Business Finance for Senior High School, GIC Enterprises
✓ BAL 658.15 G4476, 2017. Gitman, Lawrence J., et. al. Business Finance. JO-ES Publishing House,
Inc.
✓ BAL 332.4 L161, 2015. Laman, Rose Marie B. et. al. Financial System, Market & Management.
GIC Enterprises
✓ BAL 658.15 An15, 2010. Anastacio, Ma. Flordeliza, Dacanay, Roberto C. Fundamentals of
Financial Management, Rex Book Store

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