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Risk & Return (Business Risk (Nature of business itself &…
Risk & Return
Business Risk
Nature of business itself & uncertainty that surrounds the business' operating environment
Variability of sales
Variability of costs
Nature of firm's cost structure
EG - seasonal business
DOL = Contribution / Contribution - FC
High DOL = high FC compared to VC
Reflected in variability of sales & structure of costs
Financial Risk
Interest must be paid regardless of performance of firm
DFL = EBIT / EBIT - I
Different Re
Z-Score = (x - Re) / standard deviation
Coefficient of Variance = standard deviation / Re(or EV)
Standard Deviation
Measure of dispersion (risk) of possible outcomes
Greater standard deviation = greater uncertainty = greater risk
Risk
Expectation that actual outcome of project may differ from expected outcome
Mean-Variance Rule
Investment A will be preferred to Investment B if either
Re(A) > Re(B) & equal risk
Re(A) = Re(B) &Risk of B > Risk of A
Return to shareholders = ((P1 - P0) + D) / P0
Total risk = Systematic (market) risk + Unsystematic (specific) risk
Unsystematic risk is reduced by diversification