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CAPITAL BUDGETING AND RISK RISK ANALYSIS SAN LIO 1
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RISK ANALYSIS Risk has a direct relationship with returns. An individual or business spend money today with an expectation to earn MORE money tomorrow The concept of return provides investors with a convenient way of expressing the financial performance of an investment For example, you buy 5000 shares of Safaricom today for KSH 25,000. If we assume the company does not pay dividends (they are paying 2 cents!), and you sell the shared at the end of the year for KSH 29,500. SAN LIO 2
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What is the return on your 25,000 investmentThe computation of your return on this investment is as follows:AMOUNT RECEIVED KSH 29,500LESS AMOUNT PAID KSH 25,000RETURN 4,500However if you sold the shares for Ksh 23,000, your Kenya money return would be –ve KSH 2000But fair analysis of risk and return calls for: SAN LIO 3
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The size of the investment and the associated return together with the waiting period ( you can imagine a KSH 1million Investment for one year and a return of Ksh 200!) Thus you need as an investor to know the timing of the in vestment The solution to these issues is to express an investment results as eitherRates of returnPercentage return SAN LIO 4
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Rate of return= Amount received- Amount Invested Amount Invested In our example above the rate of KSH return would beRR= 29,500-25,000* 100= 18% 25,000 The problem of time is resolved by expressing the rates of return on annual basis. Thus rates of return are superior to KSH returns as measure of an investment SAN LIO 5
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Risk is defined as an unfavourable event- which if it occurs will expose an investor to a loss of either part or the whole of his investmentAn assets risk can be categorised in two ways namely: On a stand-alone basis where the asset is considered in isolation on a portfolio basis where the asset is held as one of a number of assets in a portfolio SAN LIO 6
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An assets stand alone risk is the risk an investor would be exposed to if he/she held only this particular one assetEXAMPLEImagine an investor buys Ksh 50,000 of short-term T-Bills with expected return of 5%What this means is that this assets return is known to be 5% with certainty, and therefore this particular asset is RISK FREEBut supposing this KSH 50,000 was in the stocks of newly listed company- SAN LIO 7
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The implication here is that this investment is absolutely not predictable.Thus the investment’s returns can not be determined with certaintyIf the investor’s expected rate of return (which may be worked out considering all the factors that might affect this investment) is say 15%, there is still the danger that the investor might actually earn much less, or even more on this investment.This stock is definitely a risky investment SAN LIO 8
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Remember, an investment is:The current commitment of KSH or capital for a period of time in assets or financial instruments in order to derive future returns which will compensate the investor for: The time the funds have been committed The expected rate of inflation The uncertainty of the future returnsThus no investment should be undertaken unless the expected rate of return is sufficient to compensate the investor for the perceived risk associated with the investment. SAN LIO 9
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Note that risky assets rarely generate sufficient returns to meet their expected rates of returnsRisky assets either earn LESS or MORE than was originally envisagedRemember if assets earned their expected returns, then they would not be risky at allInvestment RISK is thus closely linked to the PROBABILITY that the investor could actually earn less or more than the expected return SAN LIO 10
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RISK , PROBABILITY & EXPECTED RETURNThe specification of a larger range of possible returns from an investment reflects the investor’s uncertainty in as far the actual return is concernedThus a larger range of expected returns makes the investment riskierAn investor basically determines how certain these expected returns are by analysing estimates of expected returnsThis is done by the investor by assigning probability values to ALL POSSIBLE RETURNS SAN LIO 11
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The probability ranges from ZERO i.e. no change of the return to ONE i.e. complete certainty that the investment will provide the specified rate of returnThese probabilities are subjective estimates based on historical performance of the investment or similar investmentsThe investor will simply make modifications to suit his future expectations accordingly SAN LIO 12
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For example if an investor knows that about 20% of the time the rate of return on his investment was say 12%, using this information together with future expectations regarding the economy, one can derive an estimate of what might happen in the future Thus if we multiply possible outcomes with their probability occurrence, and SUM the products, this results in what is known as the WEIGHTED AVEAGE of outcomes. This is because probabilities are basically weights (what is a weight?) SAN LIO 13
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THUS EXPECTED RETURN= Summation of probability of return* possible return ER= (P1)(R1) +(P2)(R2)+ ....(Pn)(Rn)EXAMPLEDemand prob rate of returnStrong 0.15 0.20Normal 0.15 -0.20Weak 0.70 0.10RequiredCalculate the Expected Return (ER) SAN LIO 14
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