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Financial Management

Titman Keown Martin


Financial Management
Principles and Applications
Titman Keown Martin
Twelfth Edition

12e
ISBN 978-1-29202-306-9

9 781292 023069
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An Introduction to Risk and Return

Regardless of Your Major


Using Statistics Statistics permeate almost all areas of busi-
ness. Because financial markets provide rich
sources of data, it is no surprise that the tools
used by statisticians are so widely used in finance. In this chapter, we use the basic tools of
descriptive statistics, such as the mean and measures of dispersion, to analyze the riskiness of
potential investments. These tools, which are essential for the study of finance, are widely used
in all business disciplines as well as in the social sciences. A good understanding of statistics is
extremely useful, regardless of your major.

Your Turn: See Study Question 1.

1 Realized and Expected Rates


ofReturn and Risk
We begin our discussion of risk and return by defining some key terms that are critical to de-
veloping an understanding of the risk and return inherent in risky investments. We will focus
our examples on the risk and return encountered when investing in various types of securi-
ties in the financial marketsbut the methods we use to measure risk and return are equally
applicable to any type of risky investment, such as the introduction of a new product line.
Specifically, we provide a detailed definition of both realized and expected rates of return.
In addition, we begin our analysis of risk by showing how to calculate the variance and the
standard deviation of historical, or realized, rates of return.

Calculating the Realized Return from an Investment


If you bought a share of stock and sold it one year later, the return you would earn on your
stock investment would equal the ending price of the share (plus any cash distributions such as
dividends) minus the beginning price of the share. This gain or loss on an investment is called
a cash return, which is summarized in Equation (1) as follows:
Cash Ending Cash Distribution Beginning
= + - (1)
Return Price (Dividend) Price
Consider what you would have earned by investing in one share of Dicks Sporting Goods
(DKS) stock at the end of May 2008 and then selling that share one year later at the beginning
of June 2009. Substituting into Equation (1), you would calculate the cash return as follows:
Cash Ending Cash Distribution Beginning
= + - = +17.80 + 0.00 - 23.15 = - +5.35
Return Price 1Dividend2 Price
In this instance, you would have realized a loss of $5.35 on your investment, because the
firms stock price dropped over the year from $23.15 down to $17.80 and the firm did not
make any cash distributions to its stockholders.
The method we have just used to compute the return on Dicks Sporting Goods stock
provides the gain or loss we experienced during a period. We call this the cash return for
the period.
In addition to calculating a cash return, we can calculate the rate of return as a percent-
age. As a general rule, we summarize the return on an investment in terms of a percentage
return, because we can compare these percentage rates of return across different investments.
The rate of return (sometimes referred to as a holding period return) is simply the cash
return divided by the beginning stock price, as defined in Equation (2):


An Introduction to Risk and Return

Ending Cash Distribution Beginning


+ -
Rate of Cash Return Price 1Dividend2 Price
= = (2)
Return Beginning Price Beginning
Price
Table 1 contains beginning prices, dividends (cash distributions), and ending prices span-
ning a one-year holding period for five public firms. We use this data to compute the realized
rates of return for a one-year period of time beginning on October 8, 2008, and ending with
October 9, 2009. To illustrate, we calculate the rate of return earned from the investment in
Dicks Sporting Goods stock as the ratio of the cash return (found in Column D of Table 1)
to your investment in the stock at the beginning of the period (found in Column A). For this
investment, your rate of return is a whopping 45%  $7.37/15.32. Even though Dicks paid
no cash dividends, its stock price rose from $15.32 at the beginning of the period to $22.69,
or by $7.37 over the yearyou would have earned a 45 percent rate of return on the stock if
you had bought and sold on these dates.
Notice that all the realized rates of return found in Table 1 are positive except for Walmart
(WMT), which experienced a negative rate of return. Does this mean that if we purchase shares of
Walmart stock today we should expect to realize a negative rate of return over the next year? The
answer is an emphatic no. The fact that Walmarts stock earned a negative rate of return in the past
is evidence that investing in stock is risky. So, the fact that we realized a negative rate of return
does not mean we should expect negative rates of return in the future. Future returns are risky and
they may be negative or they may be positive; however, P Principle 2: There Is a RiskReturn
Tradeoff tells us that we will expect to receive higher returns for assuming more risk (even though
there is no guarantee we will get what we expect).

Calculating the Expected Return from an Investment


We call the gain or loss we actually experienced on a stock during a period the realized rate of
return for that period. However, the riskreturn tradeoff that investors face is not based on re-
alized rates of return; it is instead based on what the investor expects to earn on an investment

Table 1 Measuring an Investors Realized Rate of Return from Investing in Common Stock
Stock Prices Return
Cash
Beginning Ending Distribution
(Oct. 8, 2008) (Oct. 9, 2009) (Dividend) Cash Rate
Company A B C DCBA E D/A
Dicks Sporting Goods (DKS) $15.32 $22.69 $0.00 $ 7.37 45.0%
Duke Energy (DUK) 16.38 15.82 1.16 $ 0.60 1.8%
Emerson Electric (EMR) 32.73 37.75 1.32 $ 6.34 19.4%
Sears Holdings (SHLD) 57.74 67.86 0.00 $10.12 17.5%
Walmart (WMT) 55.81 49.68 1.06 (5.07) 9.1%
Legend:
We formalize the return calculations found in Columns D and E using Equations (1) and (2):
Column D (Cash or Dollar Return)
Cash Ending Cash Distribution Beginning
= + - = PEnd + Div - PBeginning
1Dividend2
(1)
Return Price Price

Column E (Rate of Return)

Rate of Cash Return PEnd + Div - PBeginning


= = (2)
Return, r Beginning Price PBeginning


An Introduction to Risk and Return

in the future. We can think of the rate of return that will ultimately be realized from making
a risky investment in terms of a range of possible return outcomes, much like the distribution
of grades for a class at the end of the term. The expected rate of return is the weighted aver-
age of the possible returns, where the weights are determined by the probability that it occurs.
To illustrate the calculation of an expected rate of return, consider an investment of
$10,000 in shares of common stock that you plan to sell at the end of one year. To simplify
the computations we will assume that the stock will not pay any dividends during the year, so
that your total cash return comes from the difference between the beginning-of-year and end-
of-year prices of the shares of stock, which will depend on the state of the overall economy. In
Table 2 we see that there is a 20 percent probability that the economy will be in recession at
years end and that the value of your $10,000 investment will be worth only $9,000, providing
you with a loss on your investment of $1,000 (a 10 percent rate of return). Similarly, there
is a 30 percent probability the economy will experience moderate growth, in which case you
will realize a $1,200 gain and a 12 percent rate of return on your investment by years end.
Finally, there is a 50 percent chance that the economy will experience strong growth, in which
case your investment will realize a 22 percent gain.
Column G of Table 2 contains the products of the probability of each state of the econ-
omy (recession, moderate growth, or strong growth) found in Column B and the rate of return
earned if that state occurs (Column F). By adding up these probability-weighted rates of return
for the three states of the economy, we calculate an expected rate of return for the investment
of 12.6 percent.
Equation (3) summarizes the calculation in Column G of Table 2, where there are
n possible outcomes.

Expected Rate Rate of Probability Rate of Probability Rate of Probability


of Return = Return 1 * of Return 1 + Return 2 * of Return 2 + g + Return n * of Return n (3)
3 E1r24 (r1) (Pb1) 1r22 1Pb22 1rn2 1Pbn2

We can use Equation (3) to calculate the expected rate of return for the investment in
Table 2, where there are three possible outcomes, as follows:
E1r2 = 1-10, * .22 + 112, * .32 + 122, * .52 = 12.6,

Measuring Risk
In the example we just examined, we expect to realize a 12.6 percent return on our investment;
however, the return could be as little as 10 percent or as high as 22 percent. There are two
methods financial analysts can use to quantify the variability of an investments returns. The

Table 2 Calculating the Expected Rate of Return for an Investment in Common Stock
Probability Cash Percentage Rate of Product  Rate
State of of the End-of-Year Beginning Return Return  Cash of Return 
the State of the Selling Price Price of from Your Return/Beginning Price of Probability of State
Economy Economya (Pbi) for the Stock the Stock Investment the Stock of the Economy
Column Column Column
Column A Column B Column C Column D ECD FED GBF
Recession 20% $ 9,000 $10,000 $(1,000) 10%   $1,000  $10,000 2.0%
Moderate growth 30% 11,200 10,000 1,200 12%  $1,200  $10,000 3.6%

Strong growth 50% 12,200 10,000 2,200 22%  $2,200  $10,000 11%

Sum 100% 12.6%


a
The probabilities assigned to the three possible economic conditions have to be determined subjectively, which requires management to have a thorough
understanding of both the investment cash flows and the general economy.


An Introduction to Risk and Return

first is the variance of the investment returns and the second is the standard deviation, which
is the square root of the variance. Recall that the variance is the average squared difference
between the individual realized returns and the expected return. To better understand this we
will examine both the variance and the standard deviation of an investments rate of return.

Calculating the Variance and Standard Deviation of the Rate of Return


on an Investment
Lets compare two possible investment alternatives:
1. U.S. Treasury Bill. A short-term (maturity of one year or less) debt obligation of the U.S.
government. The particular Treasury bill that we consider matures in one year and prom-
ises to pay an annual return of 5 percent. This security has a risk-free rate of return,
which means that if we purchase and hold this security for one year, we can be confident
of receiving no more and no less than a 5 percent return. The term risk-free security
specifically refers to a security for which there is no risk of default on the promised
payments.
2. Common Stock of the Ace Publishing Company. A risky investment in the common
stock of a company we will call Ace Publishing Company.
The probability distribution of an investments returns contains all the possible rates of
return from the investment that might occur, along with the associated probabilities for each
outcome. Figure 1 contains a probability distribution of the possible rates of return that we
might realize on these two investments. The probability distribution for a risk-free investment
in Treasury bills is illustrated as a single spike at a 5 percent rate of return. This spike indicates
that if you purchase a Treasury bill, there is a 100 percent chance that you will earn a 5 percent
annual rate of return. The probability distribution for the common stock investment, however,
includes returns as low as 10 percent and as high as 40 percent. Thus, the common stock
investment is risky, whereas the Treasury bill is not.

Figure 1
Probability Distribution of Returns for a Treasury Bill and the Common Stock of the Ace Publishing Company
A probability distribution provides a tool for describing the possible outcomes or rates of return from an investment and the associated
probabilities for each possible outcome. Technically, the following probability distribution is a discrete distribution because there are only five
possible returns that the Ace Publishing Company stock can earn. The Treasury bill investment offers only one possible rate of return (5%)
because this investment is risk-free.

1.0 Chance or Probability Rate of Return


Treasury
bill of Occurrence on Investment
0.4
Publishing
1 chance in 10 (10%) 10%
0.35 Co.
Probability of occurrence

2 chances in 10 (20%) 5%
0.3
4 chances in 10 (40%) 15%
0.25
2 chances in 10 (20%) 25%
0.2
1 chance in 10 (10%) 40%
0.15

0.1

0.05

0
10% 5% 15% 25% 40%
Possible returns

>> END FIGURE 1


An Introduction to Risk and Return

Using Equation (3), we calculate the expected rate of return for the stock investment as
follows:
E1r2 = 1.1021-10,2 + 1.20215,2 + 1.402115,2 + 1.202125,2 + 1.102140,2 = 15,

Thus, the common stock investment in Ace Publishing Company gives us an expected rate
of return of 15 percent. As we saw earlier, the Treasury bill investment offers an expected
rate of return of only 5 percent. Does this mean that the common stock is a better investment
than the Treasury bill because it offers a higher expected rate of return? The answer is no, be-
cause the two investments have very different risks. The common stock might earn a negative
10 percent rate of return or a positive 40 percent, whereas the Treasury bill offers only one
positive rate of 5 percent.
One way to measure the risk of an investment is to calculate the variance of the possible
rates of return, which is the average of the squared deviations from the expected rate of re-
turn. Specifically, the formula for the return variance of an investment with n possible future
returns can be calculated using Equation (4) as follows:

2
Variance in Rate of Expected Rate Probability
Rates of Return = Return 1 - of Return * of Return 1
1s22 1r12 E1r2 1Pb12
2
Rate of Expected Rate Probability
+ Return 2 - of Return * of Return 2
1r22 E1r2 1Pb22

2
Rate of Expected Rate Probability
+ g + Return 3 - of Return * of Return n (4)
1rn2 E1r2 1Pbn2

Note that the variance is measured using squared deviations of each possible return from the mean
or expected return. Thus, the variance is a measure of the average squared deviation around the
mean. For this reason it is customary to measure risk as the square root of the variancewhich,
as we learned in our statistics class, is called the standard deviation.
For Ace Publishing Companys common stock, we calculate the variance and standard
deviation using the following five-step procedure:
Step 1. Calculate the expected rate of return using Equation (3). This was calculated previ-
ously to be 15 percent.
Step 2. Subtract the expected rate of return of 15 percent from each of the possible rates of
return and square the difference.
Step 3. Multiply the squared differences calculated in Step 2 by the probability that those
outcomes will occur.
Step 4. Sum all the values calculated in Step 3 together. The sum is the variance of the
distribution of possible rates of return. Note that the variance is actually the aver-
age squared difference between the possible rates of return and the expected rate of
return.
Step 5. Take the square root of the variance calculated in Step 4 to calculate the standard de-
viation of the distribution of possible rates of return. Note that the standard deviation
(unlike the variance) is measured in rates of return.
Table 3 illustrates the application of this procedure, which results in an estimated
standard deviation for the common stock investment of 12.85 percent. This standard de-
viation compares to the 0 percent standard deviation of a risk-free Treasury bill invest-
ment. The investment in Ace Publishing Company carries higher risk than investing in the
Treasury bill because it can potentially result in a return of 40 percent or possibly a loss
of 10percent. The standard deviation measure captures this difference in the risks of the
two investments.