Principles of Managerial Finance

214 PART 2 Important Financial Concepts

portfolio
A collection, or group, of assets.

risk
The chance of financial loss or,
more formally, the variability of
returns associated with a given
asset.

LG1

return
The total gain or loss experi-
enced 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.

1. Two important points should be recognized here: (1) Although for convenience the publicly traded corporation is
   being discussed, the risk and return concepts presented apply to all firms; and (2) concern centers only on the wealth
   of common stockholders, because they are the “residual owners” whose returns are in no way specified in advance.

5.1 Risk and Return Fundamentals

To maximize share price, the financial manager must learn to assess two key

determinants: risk and return.^1 Each financial decision presents certain risk and

return characteristics, and the unique combination of these characteristics has an

impact on share price. Risk can be viewed as it is related either to a single asset or

to a portfolio—a collection, or group, of assets. We will look at both, beginning

with the risk of a single asset. First, though, it is important to introduce some fun-

damental ideas about risk, return, and risk preferences.

Risk Defined

In the most basic sense, riskis the chance of financial loss. Assets having greater

chances of loss are viewed as more risky than those with lesser chances of loss.

More formally, the term riskis used interchangeably with uncertaintyto refer to

the variability of returns associated with a given asset.A $1,000 government

bond that guarantees its holder $100 interest after 30 days has no risk, because

there is no variability associated with the return. A $1,000 investment in a firm’s

common stock, which over the same period may earn anywhere from $0 to $200,

is very risky because of the high variability of its return. The more nearly certain

the return from an asset, the less variability and therefore the less risk.

Some risks directly affect both financial managers and shareholders. Table 5.1

briefly describes the common sources of risk that affect both firms and their share-

holders. As you can see, business risk and financial risk are more firm-specific and

therefore are of greatest interest to financial managers. Interest rate, liquidity, and

market risks are more shareholder-specific and therefore are of greatest interest to

stockholders. Event, exchange rate, purchasing-power, and tax risk directly affect

both firms and shareholders. The nearby box focuses on another risk that affects

both firms and shareholders—moral risk. A number of these risks are discussed in

more detail later in this text. Clearly, both financial managers and shareholders

must assess these and other risks as they make investment decisions.

Return Defined

Obviously, if we are going to assess risk on the basis of variability of return, we

need to be certain we know what returnis and how to measure it. The returnis

the total gain or loss experienced on an investment over a given period of time. It

is commonly measured as cash distributions during the period plus the change in

value, expressed as a percentage of the beginning-of-period investment value. The

expression for calculating the rate of return earned on any asset over period t, kt,

is commonly defined as

kt (5.1)

CtPtPt 1



Pt 1