advanced financial management unit 1 notes
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This document discusses risk analysis and techniques for measuring risk. It defines risk and uncertainty, and outlines different types of risk including systematic and unsystematic risk. Several techniques for measuring risk are described, such as the risk-adjusted cut off rate method, certainty equivalent method, sensitivity technique, probability technique, standard deviation method, and coefficient of variation method. Decision tree analysis is also covered as a technique for risk measurement.
![CHETHAN.S
DEPARTMENT OF MANAGEMENT
5
SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073.
Techniques of Measuring Risk:-
1. Risk-adjusted cut off rate Method.
2. Certainty Equivalent Method.
3. Sensitivity Technique.
4. Probability Technique.
5. Standard deviation Method.
6. Co-efficient of variation Method.
7. Decision Tree analysis.
1. Risk-adjusted cut off rate Method:-
Under this method, the cut off rate or minimum required
rate of return [mostly the firm’s cost of capital] is raised by
adding what is called ‘risk premium’ to it. When the risk is
greater, the premium to be added would be greater.](https://image.slidesharecdn.com/vthsemafmunit-1notes-180729143542/85/advanced-financial-management-unit-1-notes-5-320.jpg)
advanced financial management unit 1 notes
- 1. CHETHAN.S DEPARTMENT OF MANAGEMENT 1 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073. UNIT-1 INVESTMENT DECISIONS AND RISK ANALYSIS Risk:- Risk involves the chance an investment's actual return will differ from the expected return. Risk includes the possibility of losing some or all of the original investment. Definition of Risk:- Emmett J Vaughan, “Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped so far.” Uncertainty:- The lack of certainty, a state of limited knowledge where it is impossible to exactly describe the existing state, a future outcome, or more than one possible outcome. Risk Analysis:- Risk analysis is the systematic study of uncertainties and risks we encounter in business, engineering, public policy, and many other areas. ADVANCED FINANCIAL MANAGEMENT
- 2. CHETHAN.S DEPARTMENT OF MANAGEMENT 2 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073. Difference between Risk and Uncertainty. BASIS FOR COMPARISON RISK UNCERTAINTY Meaning The probability of winning or losing something worthy is known as risk. Uncertainty implies a situation where the future events are not known. Ascertainment It can be measured It cannot be measured. Outcome Chances of outcomes are known. The outcome is unknown. Control Controllable Uncontrollable Minimization Yes No Probabilities Assigned Not assigned Types of Risk:- A. Systematic Risk Systematic risk is due to the influence of external factors on an organization. Such factors are normally uncontrollable from an organization's point of view. It is a macro in nature as it affects a large number of organizations operating under a similar stream or same domain. It cannot be planned by the organization. The types of systematic risk are depicted and listed below.
- 3. CHETHAN.S DEPARTMENT OF MANAGEMENT 3 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073. 1. Interest rate risk, 2. Market risk and 3. Purchasing power or inflationary risk. Now let's discuss each risk classified under this group. 1. Interest rate risk Interest-rate risk arises due to variability in the interest rates from time to time. It particularly affects debt securities as they carry the fixed rate of interest. 2. Market risk Market risk is associated with consistent fluctuations seen in the trading price of any particular shares or securities. That is, it arises due to rise or fall in the trading price of listed shares or securities in the stock market. 3. Purchasing power or inflationary risk Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates) from the fact that it affects a purchasing power adversely. It is not desirable to invest in securities during an inflationary period. B. Unsystematic Risk Unsystematic risk is due to the influence of internal factors prevailing within an organization. Such factors are normally controllable from an organization's point of view.
- 4. CHETHAN.S DEPARTMENT OF MANAGEMENT 4 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073. It is a micro in nature as it affects only a particular organization. It can be planned, so that necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk. The types of unsystematic risk are depicted and listed below. 1. Business or liquidity risk, 2. Financial or credit risk and 3. Operational risk. Now let's discuss each risk classified under this group. 1. Business or liquidity risk Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the sale and purchase of securities affected by business cycles, technological changes, etc. 2. Financial or credit risk Financial risk is also known as credit risk. It arises due to change in the capital structure of the organization. The capital structure mainly comprises of three ways by which funds are sourced for the projects. These are as follows: 1. Owned funds. For e.g. share capital. 2. Borrowed funds. For e.g. loan funds. 3. Retained earnings. For e.g. reserve and surplus. 3. Operational risk Operational risks are the business process risks failing due to human errors. This risk will change from industry to industry. It occurs due to breakdowns in the internal procedures, people, policies and systems.
- 5. CHETHAN.S DEPARTMENT OF MANAGEMENT 5 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073. Techniques of Measuring Risk:- 1. Risk-adjusted cut off rate Method. 2. Certainty Equivalent Method. 3. Sensitivity Technique. 4. Probability Technique. 5. Standard deviation Method. 6. Co-efficient of variation Method. 7. Decision Tree analysis. 1. Risk-adjusted cut off rate Method:- Under this method, the cut off rate or minimum required rate of return [mostly the firm’s cost of capital] is raised by adding what is called ‘risk premium’ to it. When the risk is greater, the premium to be added would be greater.
- 6. CHETHAN.S DEPARTMENT OF MANAGEMENT 6 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073. 2. Certainty Equivalent Method:- The certainty equivalent is a guaranteed return that someone would accept rather than taking a chance on a higher, but uncertain, return. To put it another way, the certainty equivalent is the guaranteed amount of cash that would yield the same exact expected utility as a given risky asset with absolute certainty, and represents the opportunity cost of risk.
- 7. CHETHAN.S DEPARTMENT OF MANAGEMENT 7 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073. 3. Sensitivity Technique:- Sensitivity analysis is a good technique for forecasting the attention of management on critical variable and showing where additional analysis may be beneficial before finally accepting a project. Conditions: Optimistic. Most likely. Pessimistic. Sensitivity analysis involves the following three steps: Step 1: Identification of all those variables having influence on the project’s NPV or IRR. Step 2: Definition of the underlying quantitative relationship among the variables. Step 3: Analysis of the impact of the changes in each of the variables on the NPV of the project. Advantages and Limitations of Sensitivity Analysis: Advantages: a. It gives greater visibility to the weak spots in an investment. b. It will help management to more critically investigate such factors to validate the assumptions. c. It aids management in proper decision-making.
- 8. CHETHAN.S DEPARTMENT OF MANAGEMENT 8 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073. Limitations: i. Variables are often interdependent, which makes examining them each individually unrealistic. For example, change in selling price will effect change in sales volume. ii. The analysis is based on using past data/experience which may not hold in future. iii. Assigning a maximum and minimum or optimistic and pessimistic value is open to subjective interpretation and risk preference of the decision-maker. iv. It is neither risk-measuring nor a risk-reducing technique. It does not produce any clearer decision rule.
- 9. CHETHAN.S DEPARTMENT OF MANAGEMENT 9 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073. 4. Probability Technique:- A probability is the relative frequency with which an event may occur in the future. When future estimates of cash inflows have different probabilities the expected monetary values may be computed by multiplying cash inflows with the probabilities assigned.
- 10. CHETHAN.S DEPARTMENT OF MANAGEMENT 10 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073. 5. Standard deviation Method:- Standard deviation is the most common quantitative measure of risk of an Asset. Unlike the range, it considers every possible events and weight equal to its probability is assigned to each event.
- 11. CHETHAN.S DEPARTMENT OF MANAGEMENT 11 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073. 6. Co-efficient of variation Method:- A coefficient of variation (CV) is a statistical measure of the dispersion of data points in a data series around the mean. It is calculated as follows: (standard deviation) / (expected value). The coefficient of variation represents the ratio of the standard deviation to the mean, and it is a useful statistic for comparing the degree of variation from one data series to another, even if the means are drastically different from one another.
- 12. CHETHAN.S DEPARTMENT OF MANAGEMENT 12 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073.
- 13. CHETHAN.S DEPARTMENT OF MANAGEMENT 13 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073. 7. Decision Tree analysis:- A decision tree is a schematic, tree-shaped diagram used to determine a course of action or show a statistical probability. Each branch of the decision tree represents a possible decision, occurrence or reaction. The tree is structured to show how and why one choice may lead to the next, with the use of the branches indicating each option is mutually exclusive.
- 14. CHETHAN.S DEPARTMENT OF MANAGEMENT 14 SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073.