Learning Objectives

To explore the Risk and Return associated

in Corporate Finance.
To identify the types of Risk in decision
making process.
To identify the appropriate situation of
Risk in Corporate Finance.
 Chapter Contents
Concepts of Risk
Difference between Risk and
Uncertainty
Factors Creating Risk
Classification of Risk
Return
Type of Return
Problems
 Concepts of Risk
Risk is the possibility of an unfavorable
deviation from expectation. Risk is the
causes of uncertainty which portion is
predict. Or risk is the uncertainty as to
the occurrence of an economic loss.
So risk may be defined as either-i) the
possibility of loss, ii) the possibility of
an unfavorable deviation from
expectations , because any unfavorable
deviation from expectation is a loss.
Risk is a combination of hazards measured
by probability.
According to R.N. Mishra, “Risk
should not be confused with –
the causes of loss
the peril which is the causes of loss
Hazard which is consideration that
may increase the change of loss.
Loss itself which is the
unintentional decline or
disappearance of value arising from
Risk is a term which refers to the
probable disadvantageous,
undesirable or unprofitable
outcome of a fortuitous event.
Wherever there is uncertainty
with respect to a probable loss
there is risk.
 Difference between Risk and
Uncertainty
Given below the following difference
between risk and uncertainty.
1. Definition :
-The possibility of any occurrence in
future is called risk.
-Any occurrence may be happen or not
in the future is called uncertainty.
2. Expression:
-It show in mathematically.
-It does not show in mathematically.
4. Database:
-Risk needs a historical fact. So it
must have a database.
-Uncertainty is one kinds of fatality
fact .so it has not any database.

5. Avoid ability:
-Sometimes risk is avoidable to apply
some technique.
-Uncertainty is always unavoidable.
5. To know:
-If apply some technique then must
know what is the result.
-The decision maker does not know the
result.

6. Frequency distribution:
-In risk, the possible fact is reputation
and that can be converting to a
frequency.
-It does not convert to the frequency.
7. Relationship with income:
- Every investor has taken an extra
benefit to cover risk.
-Uncertainty is not measurable, so there
have no relation to uncertainty.
8. Unite of measurement:
-To measure a risk different type of tools
be use – standard deviation , variation ,
range , quarterly deviation etc.
-It is not measurable and it does not
apply any kinds of tools.
Those are the major difference between risk
and uncertainty.
 Factors Creating Risk
Risk is too much important to done a
business carefully. The factors which is
influenced the risk are given as
The condition of general economy
Technological factor
Competition
Political factor
Inflation
Consumer’s preference
Internal factors of business enterprise
Financial risk
Natural uncertainty
Human factor
 Classification of risk
On the basis of investment, risk can
be classified into two. Given
below the classifications of risk-

A. Systematic Risk and

B. Unsystematic Risk.
 Classification of Risk
Mainly two types of risk, systematic risk and
unsystematic risk. Given below the classification of
risk.
Risk

Systematic Risk Unsystematic

Risk

Market Interest rate Purchase power Default Business

Financial
Risk Risk Risk Risk Risk
Risk
 A. Systematic Risk
The risk which is not controllable is
called systematic risk.
It is influenced by external factor.
So management cannot control over
this situation.
e.g. control by central bank of
taxation policy, increase of rate of
taxation, strike and hortal etc.
Four types of systematic risk.
Those are-

[Link] Risk
[Link] Rate Risk
[Link] Power Risk
[Link] Risk
1. Market Risk:
The risk which is creating by overall
economy is called market risk. It is directly
affected by the national economy. E.g.
government policy, changes of government.
On that causes the investor faces that’s risk is
called market risk.

Changes of stock price is depends on the

changes of investor and the sale and
purchase of stock by speculator’s. On the
other hand for the decrease of stock price in
the market and the investor faces a sort of
2. Interest Rate Risk:
For the changes of rate of interest in the
market and then the changes of interest
rate is called interest rate risk. If the
interest rate is decrease then the profit is
decreased for the investor. Fluctuation of
return on the investment by the fact of
interest rate is called interest rate risk.

If overall interest rate in the market is low

then the borrower collect more fund and if
interest rate is low then collect small
3. Purchasing Power Risk:
An investor faces some risk for
uncertainty .those uncertainty are -
i) Inflation – inflation risk is called
purchasing power risk. If inflation is higher
then purchasing power is low. Suppose an
investor serve to invest a specific purpose,
but on this time inflation rate is increased.
Then he cannot serve this specific purpose.
ii) Reducing for income – if the return is low
then the investor faces some risk that is his
purchasing capacity must be decreased.
So we say that for reducing the purchasing power
the investor faces the risk is called purchasing
power risk.
4. Default Risk:
If purchase any companies share then it
go to bankrupts or price of stock is down
and down is called default risk. So default
risk for –
 Bankrupts,
 Stock price is down for every time,
 Destroyed of company.
This type of risk is not controllable by the
management
 B. Unsystematic Risk
The portion of risk which is avoidable is
called avoidable or unsystematic risk.
In this risk the investor may apply some
technique for avoid the risk.
We can say that the risk which is create by
its internal causes and lacking of
management efficiency.
e.g., unsystematic production, labor strike,
misuse of assets ect.
Unsystematic risk are divide into
two-

[Link] Risk and

[Link] Risk
[Link] Risk:
The risk which directly effect to the
business is called Business risk. e.g.
Overall economy of the country ,
Technology changes ,
Open market ,
Political situation ,
Inflation ,
Changes of consumers attitude
Internal factors etc.
Those factors are make those risk is called
business risk.
According to Weston and Brigham,
“Business risk is defined as the uncertainty
in protection of future return on assets or
on equity if the firm uses no debt”.
According to J. Hampton, “Business risk is
defined as the change that the firm will not
have the ability to complete successfully
with the assets that it purchase”.
2. Financial Risk:
Financial Risk is the portion of total risk. So
we say that financial risk is that part of total
risk that management introduces through
debt financing. If the management thinks
that their earning is not sufficient to repay
the interest, then the company falls in
financial risk.
According to J. Hampton , “ Financial risk is
the change that investment will not generate
sufficient cash flows to cover interest
payment of money borrowed to finance it or
principle repayments on the debt to provide
profits to the firm”.
Measurement of Risk
3 ways to measure a risk.

i) Beta co- efficient

ii) Standard deviation
iii) Subjective estimate
 Return
Return is the motivating force in the
investment process. It is the
reward for undertaking the
investment. Or, outcome the
investment process is called return.

Return can be positive or negative.

Positive return provide profit and
negative return provide loss.
 Components of return
When investor buys a stock are a
bond, their return comes in two
forms –

A Dividend or Interest payment

and
Capital Gain or a Capital Loss.
 Type of Return
Return is two types

Nominal Rate of return- It means how

much more money you will have at the
end of the year.

Real Rate of return- Its means how

much more you will be able to buy with
your money at the end of the year.
 Example-1
Suppose you buy the stock of General
Electronic at the beginning of 2025 when
its price was about $ 102 per share. By
the end of the year the value of the
investment had appreciated to $ 155.

The capital gain is = $(155-

102)
= $53
In addition in 2025 General Electronics paid a
dividend of $ 1.46 per share.
The percentage of return on your investment –

% of return = Capital gain + Dividend

Initial Share price

= $53 +
$1.46
$102
=0.534
 Problem-1
State of Probability Return
Economy (P) IBBL
NCCB

Recession 0 .20 4% -10%

Normal 0.50 10% 14%
Boom 0.30 14%
30%

Requirement-
i) Expected return
ii) Standard deviation
iii) Co-efficient of variance.
Difference between Business Risk and
Financial Risk
01. Definition
The risk which directly effect to the
business is called Business risk.
Financial risk is that part of total risk that
management introduces through debt
financing
02. Example
overall economy of the country , technology
changes , open market , political situation ,
inflation , changes of consumers attitude
It create only loan financing.
[Link]
Economic sources, political sources,
technological sources etc.
Only the debt financing.

04. Affected Parties

Mainly stock holders and staffs.
At first owners of the company, then
financer.
05Avoid ability
It is not avoidable.
But it is avoidable from insurance company.
Mainly it is avoidable.

06. Measurement
It is measurable. it follows some technique –
variance , standard deviation etc.
It also measurable. It can use leverage to
measure.
07. Risk control
It is not controllable.
It is controllable.

08. Scope
Its scope is large.
Its scope is small.
09. Influence
Its influence by the external factors.
Its influence only by its capital structure.

10. Relation
Business risk is related to companies
operating leverage.
Financial risk is related to its financial
leverage.
 Opportunity Cost
Loosing the best one is the
opportunity cost of investment.
Suppose a company has 3
opportunities to take a project.
Company look which opportunity
gives more return, then he can avoid
others. The other project return is
the opportunity cost of the taking
project.
 Relationship between Return and
Opportunity Cost
Project -1 Project -2
Outlay Return Outlay
Return
1, 00,000 12% 1, 00,000
11%

The company chooses this project which project

gives more return.

Return ≥Opportunity cost of capital

 Relationship between Risk and
Return
All investment can bear risk. And return
came from investment. So risk and
return is so much related.

The relation between the risk and return

given in the following graph:
 Risk and Return
Rate of Return
(%)
CML

12.0 H

10.5 A
10.0
9.5 B
8.0 L

Risk
0 RiskL RiskA RiskH
This is the relationship between risk
and return. If any investor wants high
return, he must bear more risk.

So we can easily say that the risk,

return and opportunity cost is related to
each others.
Thank You