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# Capital budgeting and risk

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### Capital budgeting and risk

1. 1. CAPITAL BUDGETING AND RISK RISK ANALYSIS SAN LIO 1
2. 2. 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
3. 3. What is the return on your 25,000 investmentThe computation of your return on this investment is as follows:AMOUNT RECEIVED KSH 29,500LESS AMOUNT PAID KSH 25,000RETURN 4,500However if you sold the shares for Ksh 23,000, your Kenya money return would be –ve KSH 2000But fair analysis of risk and return calls for: SAN LIO 3
4. 4.  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 eitherRates of returnPercentage return SAN LIO 4
5. 5.  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
6. 6. 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 investmentAn 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
7. 7. 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 FREEBut supposing this KSH 50,000 was in the stocks of newly listed company- SAN LIO 7
8. 8. The implication here is that this investment is absolutely not predictable.Thus the investment’s returns can not be determined with certaintyIf 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
9. 9. 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 returnsThus 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
10. 10. Note that risky assets rarely generate sufficient returns to meet their expected rates of returnsRisky assets either earn LESS or MORE than was originally envisagedRemember if assets earned their expected returns, then they would not be risky at allInvestment RISK is thus closely linked to the PROBABILITY that the investor could actually earn less or more than the expected return SAN LIO 10
11. 11. RISK , PROBABILITY & EXPECTED RETURNThe specification of a larger range of possible returns from an investment reflects the investor’s uncertainty in as far the actual return is concernedThus a larger range of expected returns makes the investment riskierAn investor basically determines how certain these expected returns are by analysing estimates of expected returnsThis is done by the investor by assigning probability values to ALL POSSIBLE RETURNS SAN LIO 11
12. 12. 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 returnThese probabilities are subjective estimates based on historical performance of the investment or similar investmentsThe investor will simply make modifications to suit his future expectations accordingly SAN LIO 12
13. 13.  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
14. 14. 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
15. 15. SOLUTIONr= (0.15*0.2 )+( 0.15*-0.20) +( 0.7*0.10) = 0.03 -0.03 +0.07 = 0.07 = 7% SAN LIO 15