Risk is directly related to potential returns from an investment. Investors provide capital today expecting a higher return in the future. Risk can be analyzed on a standalone basis for individual assets or on a portfolio basis considering multiple assets. Higher risk investments have a wider range of possible returns and the expected return depends on assigning probabilities to all potential outcomes and calculating a weighted average.

1. CAPITAL BUDGETING AND RISK
RISK ANALYSIS
SAN LIO 1

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. What is the return on your 25,000
investment
The computation of your return on this
investment is as follows:
AMOUNT RECEIVED KSH 29,500
LESS AMOUNT PAID KSH 25,000
RETURN 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.  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.  Rate of return= Amount received- Amount Invested
Amount Invested
 In our example above the rate of KSH return would be
RR= 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. 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. An assets stand alone risk is the risk an investor
would be exposed to if he/she held only this
particular one asset
EXAMPLE
Imagine 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. 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. 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. 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. 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. 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.  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. THUS
 EXPECTED RETURN= Summation of probability of
return* possible return
 ER= (P1)(R1) +(P2)(R2)+ ....(Pn)(Rn)
EXAMPLE
Demand prob rate of return
Strong 0.15 0.20
Normal 0.15 -0.20
Weak 0.70 0.10
Required
Calculate the Expected Return (ER)
SAN LIO 14

15. SOLUTION
r= (0.15*0.2 )+( 0.15*-0.20) +( 0.7*0.10)
= 0.03 -0.03 +0.07
= 0.07 = 7%
SAN LIO 15