Risk and Return Analysis
Risk and Return Analysis
Question 1:
The relationship between the risk and the return can be defined as the positive correlation between them. In risk management procedures, it is highly probable that the investments or the projects which are more risky will generate high profits for the business or investor. Similarly, the investments or the projects which are likely to generate low levels of profits will expose the investors or business to the lower level of risk in the market. (Maranjian, 2013)
There are several methods for the financial accountants to measure the level of returns, according to their acceptable level of risk. The acceptable level of risk is a combination of the inherent risks of business, inflation risk, supply and demand elements and other non financial elements of the business. However, in the case of industry risk, if the risk is high then it is highly probable that the return will be a loss for the business. (Maranjian, 2013)
For example, if the business is investing in the old technology, then there is a risk that the declining industry will generate losses for the business in the future. Therefore, it is very important for the finance managers to create the relationship of risk and return in a perfect positive correlation at the planning stage. (Maranjian, 2013)
The low risk and low return is another relationship between the risk and return. In this scenario, the investments are less risky such as saving deposits in the banks and government bonds. Of these investments, the investors get annual or monthly income. The principal amount remains same and secure. Therefore, low risk and low returns are the best options for the risk adverse investors. The relationship of low risk and high return is very rare in the practical business. (Maranjian, 2013)
Question 2:
The main example of low risk and low return is the saving accounts in the government banks. The government banks are the safest place for any investor to generate a minimum level of interest income without exposing to the risk. The investments in the private banks are another example of low risk and low return. However, in case of the private banks, the interest rate is higher than the government banks. (Maranjian, 2013)
The main example of low risk and high return investment is the lottery tickets. In this case, the investor will purchase a lottery ticket at an affordable price. However, the prize money on the lottery is high as compared to the price of a lottery ticket. Another common example is that the business purchased the machinery for the business at the lower price than the market value from the bidding. However, it is very rare to generate profits from the low risk and high return relationship. (Maranjian, 2013)
If the investor is risk seeker, then the attitude of the investor will be towards the high risk and high return investments. The example of high risk and high return investment is the investments in the property. If the policies of the government are in the favor of real estate business, then it is highly probable that the prices of the properties will increase in the future. Similarly, if the prices of the properties are out of the reach of the buyers, then it is highly probable that the investors will face heavy losses. (Maranjian, 2013)
Another example of high return investments is that the investors invest in the companies which are declared high dividends as compared to the low levels of the dividends. In this case, the risk is that the risky companies will be exposed to the high level of risks and can suffer losses. (Maranjian, 2013)
Question 3:
In these circumstances, the current shareholders will avoid reinvesting in the business because of the higher level of risks. Similarly, if the equity of the business is higher than the debts of the business, then the right issues from the business will be successful and the common stock will be less risky. (Sandilands)
As compared to the shareholders, the preferred shareholders and the lenders are in the much safer position. In case of the liquidity of the business, the lenders are given the funds before shareholder. Therefore, in the risky businesses, the lenders are at much safer position. (Sandilands)
Question 4:
The gearing ratio of the business directs the risk associated to the shareholder and the lenders. However, it is very important to state that if the gearing ratio is higher than the market or the industry, then it is very important for the directors to explain the scenario to the shareholders. The reasons of high gearing ratio must be addressed to the shareholders to maintain the trust of the shareholders for future right issues. (Sandilands)
The concept of risk and return can assist the business in several ways. The main advantage of understanding the relationship is that the investor must understand the level of risk he is accepting to generate a specific level of the returns. Moreover, the concept not only identifies the relation of the risk and the return, but it also identifies the different types of risks which are associated with the industry, market and the business. (Sandilands)
The main benefit of the risk and return concept is that it highlights the non financial elements of the business. The non financial elements are those key factors which direct the working of the business in the future and any uncertainty can identify possible losses in the future. For example, the loss of key directors or the loss of key customer is the most important non financial signals for the investors that the business will face financial problems in the future. (Sandilands)
The concept of risk and return assist the investor to determine the attitude of the investor towards new investments. For example, if the investor is interested in high return, then he will be a risk seeker. Moreover, the risk and return concept suggest that the investors must invest in the pool of investments. The diversification will keep the overall investment safe and the investor will not suffer losses. The loss in one investment will be compensated by the profit of the other investment. (Sandilands)
Similarly, the investment in the different industries will assist the investors to mitigate the risk of investing in one industry. Therefore, the concept of risk and return can help the investors in identifying the different risks and their effects on the investments. (Sandilands)
References
Sandilands, T. Are Corporate Bonds Riskier Than Common or Preferred Stock? Retrieved March
13, 2016, from http://smallbusiness.chron.com/corporate-bonds-riskier-common-preferred-stock-38641.html
Maranjian, S. (2013, April 24). What Is Risk and Return? - DailyFinance. Retrieved March 13,
2016, from http://www.dailyfinance.com/2013/04/24/what-is-risk-and-return/
