Financial Decision Making: Principles of Managerial Finance Essay

Abstract

Risk is common for every business decision. Investors generally want higher returns with lower risks. Therefore investors will make the investment in risk projects only if they can expect amount return. In this discussion, we will give the precise definition of risk, procedure of measuring risk, two alternative method of measuring risk, the appropriate time of using method and finally relationship between risk and return.

Risk

Risk is nothing but a chance that the actual outcome may differ from the expected outcome. Alternatively, it can be said that risk defines a situation where more than one favorable or unfavorable outcome of investment are exists.

It is also may be said that risk refers a situation in which range of consequences of outcomes is known, but specific consequence of outcome is unknown.

There are different types of risks in an business organization. These are – production, marketing, exchange rate, legal, and financial risks.

Reasons of Financial Risk

There several reasons behind financial risks exist for a company. The most significant reasons are-

1. The future interest rate can not be measurable accurately.
2. For the present funds, the lenders are willing to provide, but future funding level is uncertain.
3. The market value of collateral can be changed
4. “The ability to generate the cash flow needed to repay the loans is always uncertain” (Kay, Edwards, and Duiffy, 2004).

How to quantify the risks

Risk is a difficult concept to grasp, and a great deal of controversy has surrounded attempts to define and measure it. Considering the range of risks, the risk of an asset can be measured quantitatively by using statistics. There are two wide-used methods to quantify the financial risks. They are –

1. Standard Deviation
2. Coefficient of Variation

The both methods can be used to measure risks or the variability of asset returns.

Standard Deviation to measure risk

The most used statistical tool of measuring the risk is standard deviation which measures the dispersion around the expected value.

Standard Deviation Calculation

To calculate standard deviation, we proceed in taking following steps:

• Calculate the expected rate of return.

i = 1

Expected Rate Return = k^ = ∑ⁿ Pi Ki

• Subtract the expected rate of return (k^) from each possible outcome (ki) to obtain a set of deviations about K^.

Deviationi = ki – k^.

• Square each deviation, then multiply the result by the probability of occurrence for its related outcome, and then sum these products to obtain the Variance of the probability distribution.

i = 1

Variance = σ ² = ∑ⁿ (ki – k^) Pi

• Finally, find the square root of the variance to obtain the standard deviation.

i = 1

Standard Deviation = σ = √∑ⁿ (ki – k^) Pi

Where,

Ki = return for the I th outcome.

Pi = probability of occurrence of the I th outcome.

n = number of the outcomes considered.

Time When Standard Deviation is Appropriate

When we need to decide one asset investment from two or more asset investments based on their dispersion of expected value of return. To be most useful, we need a measure of the tightness of the probability distribution. One such measure is the standard deviation, the symbol for which “ σ “, pronounced “sigma”. The smaller the deviation, the tighter the probability distribution, and, accordingly, the lower the risk.

Coefficient of Variation

Coefficient of variation is a measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns.

Calculation of Coefficient of Variation

n CV = standard deviation / mean or expected rate of return

It can be shown as – CV = σ / K^

To calculate coefficient of variation, we proceed in taking following steps:

• Calculate the standard deviation.

i = 1

Standard Deviation = σ = √∑ⁿ (ki – k^) Pi

Where,

Ki = return for the I th outcome.

Pi = probability of occurrence of the I th outcome.

n = number of the outcomes considered.

• Calculate the expected rate of return.

i = 1

Expected Rate Return = k^ = ∑ⁿ Pi Ki

• Finally, Find out the coefficient of variation.

CV = σ / K^

Or, CV = standard deviation / mean or expected rate of return

Time when Coefficient of Variation is appropriate

The (CV) shows the risk per unit of return, and it provides a more meaningful basis for comparison when the expected returns on two alternatives are not the same.

Recommendation: Situation-Based Financial Decision Making

We can clear the financial decision-making by using the above-stated risk measuring tools with the help of demonstrations of three different situations. These are –

1. When two investments have the same expected returns but different standard deviations, the firm should choose the one with the lower standard deviation for lower risk.
2. When two investments with the same risks (standard deviation) but different expected returns, the firm should select the investment with the higher expected return.
3. And most important is, when between two investments, one investment is higher expected return, but the other is lower standard deviation, then the firm should calculate the coefficient of variation of the both investments, and select the lower coefficient of variation for the lower risk.

Bibliography

BRIGHAM, F. EUGEnE and Enrhardt, C. Michel. (2002). Financial Management Theory and Practice, 10th Ed., The Dryden Press: International Student Edition. (pp. 203 –210).

Gittman, J. Lawrence. (2002). Principles of Managerial Finance. 11. st. Ed. Pearson Education (Asia) PTE LTD, (pp. 221-226).

Gupta, S. P. and Gupta, M. P. Business Statistics, 12th Thoroughly Revised & Enlarged Edition. Pp. 162 -174).

Kay, D. Ronald., Edwards, M. William., and Duiffy, A. Patricia. (2004). Farm Management. 5th Ed. McGraw-Hill.