(^62) Financial Management
But what if you are going to hold the share to maturity and not sell. Then your only
return is the dividend amount. This means that this perpetual dividend is what you
would use to value the share. So you simply use the perpetuity formulas mentioned
above for constant or growing dividends.
Finding out the present value of the share seems easy-Doesn't it! Now comes the
tedious question, what return do you expect from the security? Now every security has
a different risk profile and you being a rational human being would expect a return that
is commensurate with the risk that you are going to bear. So let us devote some time to
understand the nature of risk and then how do we use this knowledge to reach the
desired rate of return on the share.
Risk
Risk and return go hand in hand in investments and finance. One cannot talk about
returns without talking about risk, because, investment decisions always involve a trade
- off between risk and return. Risk can be defined as the chance that the actual outcome
from an investment will differ from the expected return. This means that, the more
variable the possible outcomes that can occur (i.e. the broader the range of possible
outcomes), the greater the risk.
Risk and Expected Rate of Return
The width of a probability distribution of rates of return is a measure of risk. The wider
the probability distribution, the greater the risk or the greater the variability of return or
greater the variance. An investor cannot expect greater returns without being willing to
assume greater risks.
Sources of Risk
l Interest Rate Risk. It is the variability in a security's return from changes in the
level of interest rates.
l Market Risk. Market risk refers to the variability of returns due to fluctuations
in the securities market.
l Inflation Risk. With rise in inflation there is reduction of purchasing power, hence
this is also referred to as purchasing power risk and affects all securities.
l Business Risk. This refers to the risk of doing business in a particular industry
or environment and it gets transferred to the investors who invest in the business
or company. It may be caused by a variety of factors like heightened competition,
emergence of new technologies, development of substitute products, shifts in
consumer preferences, etc.
l Financial Risk. Financial risk arises when companies resort to financial leverage
or the use of debt financing. The more the company resorts to debt financing, the