Warren Buffets only two rules for Investing:

Rule # 1: Never lose money.

Rule # 2: Never Forget Rule #1
 Investments
Introduction (Risk & Return overview)
Overview
Finance, as an area of study, can be divided into two major
categories:
a) Public Finance which deals with the finances of a government;
b) Business Finance. Business finance has three sub areas, namely,
financial institutions and markets, investments, and business
financial management.
All Finance managers have to make three vital decisions for a
business: Investing, Financing & liquidity decisions with a goal of
value creation for the firm.
All Investing decisions take into account two factors: Risk & Return
It is important for the firm to be valuable for investors so that they
invest in the business, which is necessary for a business to
continue & grow
Risk & Return

In different situations risk is measured and quantified in different

ways but generally the idea of risk is related to the uncertainty of
outcomes. If actual outcome may differ from the expected
outcome then there is risk in the given decision situation.
In the context of portfolio theory total risk is bifurcated into 2
types: diversifiable risk and non diversifiable risk.
 Risk & Return
In different situations risk is measured and quantified in different ways
but generally the idea of risk is related to the uncertainty of outcomes.
If actual outcome may differ from the expected outcome then there is
risk in the given decision situation.
In the context of portfolio theory total risk is bifurcated into 2 types:
Total risk = Systematic Risk + Unsystematic Risk
= Diversifiable Risk + Non diversifiable Risk
= Var (i)
Non Diversifiable Risk = (Beta i)2 * VARm OR Beta*(SDM)
Diversifiable Risk = Total Risk minus Diversifiable Risk
Risk of stock market = VARm
Risk & Return Risk Analysis
Total risk of a firm has two components:
1. Business risk
The uncertainty of income caused by the firms
industry
Generally measured by the variability of the firms
operating income over time
2. Financial risk
Additional uncertainty of returns to equity holders
due to a firms use of fixed obligation debt
securities
The acceptable level of financial risk for a firm
depends on its business risk
Business risk
Business risk is the risk associated with the volatility in operating
earnings.
Business risk is composed of both operating and sales risk.
Sales risk is the uncertainty associated with the number of units
produced and sold, as well as the sales price.

Operating
Sales Risk
Risk

Business
Risk

7
Risk & Return Risk Analysis
Business Risk
A company whose break-even point is higher has higher fixed
operating costs and therefore just to attain breakeven level of
sales (no profit no loss) it has to make high level of sales to cover
high level of fixed operating costs per year such as depreciation.
Business risk of such a co is higher.
Two factors contribute to the variability of operating earnings or business
risk:
1. Sales variability
Earnings must be as volatile as sales
Some industries are cyclical
2. Operating leverage
Production has fixed and variable costs. Fixed production
costs cause profit volatility with changes in sales. Fixed
production costs are operating leverage
Understanding Leverage

Leverage is the use of fixed costs in a companys cost structure.

Operating leverage relates to the companys operating cost
structure.
Financial leverage relates to the companys capital structure.

Fixed Fixed
Costs Costs

9
Why worry about leverage?

1. A companys use of leverage affects its risk and return.

2. Operating leverage and financial leverage provide
insight into a companys business and its future.
3. Leverage helps us understand a companys future cash
flows and the risk associated with those cash flows and,
hence, its valuation.

10
Understanding Leverage - Example
Leverage increases the volatility of earnings and cash flows
hence, it increases risk to suppliers of capital (creditors and
owners).
Consider two companies, Company One and Company Two, with
the following information:
Company Company
One Two
Number of units produced and sold 1,000 1,000
Sales price per unit 250 250
Variable cost per unit 125 25
Fixed operating cost 50,000 100,000
Fixed financing expense 5,000 55,000

Debt 50,000 550,000

Equity 700,000 200,000
Total assets 750,000 750,000
11
What does leverage do exactly?
Company Two uses more operating and financial leverage than Company One.

Company One Company Two

200,000
150,000
100,000

Net 50,000
Income 0
- 50,000
- 100,000
- 150,000

Number of Units Produced and Sold 12

Risk & Return Risk Analysis
Business Risk
There are two measures of business risk widely used:
1. Beta (Unlevered)
2. Degree of operating leverage (DOL)

Standard Deviation (SD) of sales, SD of EBIT, SD of NI,

SD of EPS and SD of ROE, are also used as measure of
business risk.
Risk & Return Risk Analysis
Business Risk
There are two measures of business risk widely used:
1. Beta (Unlevered)
Beta ( Un Levered) = Beta (Levered) / [ 1 + (1 T) * Debt / OE ratio]
(Discussed later)

2. Degree of operating leverage (DOL)

DOL = % Change in EBIT / % Change in Sales
Risk & Return Risk Analysis
Business Risk (DOL)
Year 1 Scenario A Scenario B Scenario C
Sales 100 200 200 200
Fixed Costs 30 60 80 90
Variable 40 80 80 80
Costs
EBIT
Risk & Return Risk Analysis
Business Risk (DOL)
Year 1 Scenario A Scenario B Scenario C
Sales 100 200 200 200
Fixed Costs 30 60 80 90
Variable 40 80 80 80
Costs
EBIT 30 60 40 30
Risk & Return Risk Analysis
Business Risk (DOL)
Scenario A Scenario B Scenario C
Change in EBIT 30 10 0
% Change 100% 33% 0%
Change in Sales 100 100 100
% Change 100% 100% 100%
DOL 1 0.33 0
Risk & Return Risk Analysis
Financial Risk
Financial risk of a business is due to the manner its
assets are financed; if assets are financed by equity
capital alone then such a business is called all equity
financed , and has no financial risk.
Its stocks beta levered and beta unlevered are same as
its debt to equity ratio is zero.
But if assets are financed by both equity capital and
debt capital then such a business has financial risk
because if the debt providers are not serviced as per
the contract, they can go to court and have the
business declared bankrupt.
 Risk & Return Risk Analysis
Financial Risk
This financial risk can be quantified in different ways
such as:
1. Financial Ratios:
financial leverage or equity multiplier; (Debt/OE
ratio, TA / OE ratio)
Debt ratio; (Total Debt / TA ratio)
2. Degree of financial leverage (DFL) which is measured as
% change in NI / % change in EBIT.
The presence of fixed financial costs imply financial risk
is higher, and such a co has to earn sufficiently high
EBIT to be able to pay fixed annual interest expenses
related to its debt capital financing.
Risk & Return Risk Analysis
Financial Risk Financial ratios
Financial risk of a co is result of its capital structure, and is usually
quantified by debt to equity ratio ( LT L / OE). This ratio is used
both as a quantification of capital structure as well as
quantification of financial risk of a co. Debt to equity ratio can also
be calculated as Wd /Wc
Debt to equity ratio of 1.5 times means that for every rupee
invested by owners in the corporation, 1.5 rupees were borrowed,
meaning there is a relatively heavy reliance on debt capital in this
business; and most of the capital to finance FA and NWC was
provided by the creditors (lenders) and not by the owners
(shareholders).
This manner of financing a business by using more debt than equity
gives rise to financial risk which is also called insolvency risk or
bankruptcy risk.
Generally a business is insolvent when its TL exceed its TA.
 Risk & Return Risk Analysis
Financial Risk Insolvency
Why such a situation arises that a corporations TA are less than TL and thus its
OE is negative?
Usually it would happen due to persistent losses in a business, because
losses eat up OE: first the RE (retained earnings are also called reserves) and
then the share capital within OE is eaten up by the negative NI, thus if a
business shows losses year after year, slowly first its RE is wiped out by the
losses, then its Paid-up share capital is wiped out, and then further
incurrence of losses would turn its OE into a negative number.
Equation for the statement of changes in RE:
End RE = Beg RE + NI cash dividends stock dividends
If year after year a business corporation experiences losses (that is negative
NI), then its RE keeps shrinking and ultimately turns negative; in that case it
is termed accumulated losses. In such cases, it is possible that the
amount of negative RE is so big that it exceeds the amount of paid-up share
capital, the result is negative OE.
Risk & Return Risk Analysis - Financial Risk Insolvency
Statement of changes in OE:
End OE = Beg OE + NI + shares issued cash dividends shares repurchased
The above equation shows that OE increases when NI is positive, and
decreases if NI is negative. If the state of insolvency persists in a
corporation, sooner or later such a business goes bankrupt.
On the plea of its creditors, judge declares such a business bankrupt and
usually orders liquidation of its assets through a court appointed person,
and cash thus generated by liquidating (selling) the assets is distributed by
the court among the liability holders (creditors) of such a business
according to the seniority of their legal claim on the assets of this
business.
Owners have the last claim on the assets of business, and it is not unusual
that incase of liquidation of an insolvent business through the court
orders, the owners end up receiving nothing.
Some of the creditors may also not receive their full claims if the
liquidation of assets does not generate sufficient cash.
Risk & Return Risk Analysis
Financial Risk (DFL)
Scenario A Scenario B Scenario C
Year 1 Year 2 Year 3 Year 4
EBIT 100 200 200 200
Interest 0 0 50 100
EBT 100 200 150 100
Taxes (0%) 0 0 0 0
NI 100 200 150 100
Risk & Return Risk Analysis
Financial Risk (DFL)
Scenario A Scenario B Scenario C
Change in EBIT 100 100 100
% Change 100% 100% 100%
Change in NI 100 50 0
% Change 100% 50% 0%
DFL 1 0.5 0
How risk effects Investors (creditors and
owners)
Business risk is affected by demand uncertainty, output price
uncertainty, and cost uncertainty.
Financial risk adds to the companys business risk, increasing the risk
to creditors and owners.
The creditor claims are fixed, whereas the equity claims are
residual.
In the event that creditor claims cannot be satisfied, there may be
legal statuses that help sort out the claims:
Reorganization is the restructuring of claims, with the
expectation that the company will be able to continue, in some
form, as a going concern.
Liquidation is the situation in which assets are sold and then the
proceeds distributed to claimants.
25
Risk & Return Risk Analysis
Total Risk
Total Risk of a business = Business Risk + Financial Risk
Total Risk is measured by Degree of Total Leverage
Degree of Total Leverage = DOL * DFL
Or,
DTL = % Change in NI / % Change in Sales
If DOL is 2 and DFL is 3 then DTL = ?
Risk & Return Risk Analysis
Total Risk
Total Risk of a business = Business Risk + Financial Risk
Total Risk is measured by Degree of Total Leverage
Degree of Total Leverage = DOL * DFL
Or,
DTL = % Change in NI / % Change in Sales
If DOL is 2 and DFL is 3 then DTL = 2 * 3 = 6;
Meaning 1%age point change in sales causes 6 %age
point change in NI.
Quote of the Day:
If you arent thinking about holding a stock for
10 years, dont even think about holding it for
10 minutes. ---- Warren Buffet
Risk & Return Risk Analysis
Relevant Risk of a security
Relevant risk of a security is sensitivity of stocks returns
to changes in market returns and it is quantified as beta of
a stock. As most of the companies have liabilities and
therefore financial leverage, so it is more accurate to call
their stock beta as levered equity beta denoted as beta L
.
Statistically beta of a stock is a ratio as given below:
Beta( Levered) = COV i,m / VAR m
Where, i is ROR of any stock ; and m is ROR of
stock market
Risk & Return Risk Analysis
Relevant Risk of a security
Stock KSE
Prices 100
Index
Year 1 50 10,000
Year 2 60 12,000
Year 3 75 13,000
Year 4 80 12,500
Year 5 95 14,000
Risk & Return Risk Analysis
Relevant Risk of a security
Stock KSE Return Return on
Prices 100 on Stock Market
Index
Year 1 50 10,000
Year 2 60 12,000 20% 20%
Year 3 75 13,000 25% 8.3%
Year 4 80 12,500 6.67% -3.8%
Year 5 95 14,000 18.75% 12%
Risk & Return Risk Analysis
Relevant Risk of a security
Stock KSE Return Return
Prices 100 on Stock on
Index Market
Year 1 50 10,000
Year 2 60 12,000 20% 20%
Year 3 75 13,000 25% 8.3%
Year 4 80 12,500 6.67% -3.8%
Year 5 95 14,000 18.75% 12%
Average
Risk & Return Risk Analysis
Relevant Risk of a security
Return Return Ri Ri Rm (2) * (3) (Rm
on on bar Rm bar Rm bar)
Stock Market (2) (3) ^2
(3) ^2
Year 2 20% 20%
Year 3 25% 8.3%
Year 4 6.67% -3.8%
Year 5 18.75% 12%
Average 17.6% 9.125%
Sum
Cov
(i,m)
Var (m)
Risk & Return Risk Analysis
Relevant Risk of a security
Return Return Ri Ri Rm Rm (2) * (3) (Rm Rm
on Stock on bar bar bar) ^2
Market (2) (3) (3) ^2
Year 2 20% 20% 2.4 10.875
Year 3 25% 8.3% 7.4 -0.825
Year 4 6.67% -3.8% -10.93 -12.925
Year 5 18.75% 12% 1.15 2.875
Average 17.6% 9.125%
Sum
Cov (i,m)
Var (m)
Risk & Return Risk Analysis
Relevant Risk of a security
Return Return Ri Ri Rm Rm (2) * (3) (Rm Rm
on Stock on bar bar bar) ^2
Market (2) (3) (3) ^2
Year 2 20% 20% 2.4 10.875 26.1 118.26
Year 3 25% 8.3% 7.4 -0.825 -6.105 -0.68
Year 4 6.67% -3.8% -10.93 -12.925 141.27 167.05
Year 5 18.75% 12% 1.15 2.875 3.306 8.26
Average 17.6% 9.125%
Sum 164.57 292.89
Cov (i,m) 82.28
Var (m) 97.60
Risk & Return Risk Analysis
Relevant Risk of a security
Return Return Ri Ri Rm Rm (2) * (3) (Rm Rm
on Stock on bar bar bar) ^2
Market (2) (3) (3) ^2

Year 2 20% 20% 2.4 10.875 26.1 118.26

Year 3 25% 8.3% 7.4 -0.825 -6.105 -0.68
Year 4 6.67% -3.8% -10.93 -12.925 141.27 167.05
Year 5 18.75% 12% 1.15 2.875 3.306 8.26
Average 17.6% 9.125%
Sum 164.57 292.89
Cov (i,m) = Sum of Column 2 & 3 / (N-2) = 164.57/2 = 82.28
Var (m) = Sum of (Rm Rm bar)^2 / (N 1) = 292.89 / 3 = 97.60
Beta Levered = Cov (i,m) / Var (m) = 82.28 / 97.60 = 0.84
Risk & Return Risk Analysis
Relevant Risk of a security
Please note that according to professor Hamadas Equation:
Beta ( Levered) = Beta (UL) [ 1 + (1 T) * Debt / OE ratio]
This equation allows you to bifurcate relevant risk of shares of a
levered co into 2 parts ; namely,
Business risk as quantified by Beta (UL) (beta unlevered) and
Financial risk as quantified by Debt / OE ratio.
Please note that in real life you can calculate beta levered of a
corporations share from past data of percentage rate of returns of
that stock and overall stock market as COV i,m / VAR m ; and its
debt to equity ratio can be calculated from balance sheet.
Only then, beta unlevered is calculated indirectly by inserting the
values of beta levered and debt to equity ratio in Professor
Hamdas equation.
Risk & Return Risk Analysis
Relevant Risk of a security
Please note that according to professor Hamadas Equation:
Beta ( Levered) = Beta (UL) [ 1 + (1 T) * Debt / OE ratio]
This equation allows you to bifurcate relevant risk of shares of a
levered co into 2 parts ; namely,
Business risk as quantified by Beta (UL) (beta unlevered) and
Financial risk as quantified by Debt / OE ratio.
If 2 companies have same beta levered , same debt to equity ratio and
same corporate income tax rate then their business risk as measured
by beta unlevered would also be same; but if one of these co has
higher debt to equity ratio (financial risk) then its business risk
measured by beta unlevered would be lower because both have same
relevant risk measured by beta levered.
Risk & Return Risk Analysis
Relevant Risk of a security
MCB had Debt ratio of 0.25, Tax rate of 35% with Cost of
Equity of 14%, Covariance with market of 45 & Market
has a variance of 30.Calculate its Beta levered &
Unlevered.
Risk & Return Risk Analysis
Relevant Risk of a security
MCB had Debt ratio of 0.25, Tax rate of 35% with Cost of
Equity of 14%, Covariance with market of 45 & Market
has a variance of 30.Calculate its Beta levered &
Unlevered.

Beta( Levered) = COV i,m / VAR m

= 45 / 30 = 1.5
Beta ( Un Levered) = ??
Risk & Return Risk Analysis
Relevant Risk of a security
MCB had Debt ratio of 0.25, Tax rate of 35% with Cost of Equity of
14%, Covariance with market of 45 & Market has a variance of
30.Calculate its Beta levered & Unlevered.
Beta( Levered) = COV i,m / VAR m
= 45 / 30 = 1.5
Beta ( Un Levered) = Beta (Levered) / [ {1 + (1 T)} * Debt / OE ratio]
Risk & Return Risk Analysis
Relevant Risk of a security
MCB had Debt ratio of 0.25, Tax rate of 35% with Cost of Equity
of 14%, Covariance with market of 45 & Market has a variance
of 30.Calculate its Beta levered & Unlevered.
Beta( Levered) = COV i,m / VAR m
= 45 / 30 = 1.5
Beta ( Un Levered) = Beta (Levered) / [ {1 + (1 T)} * Debt / OE ratio]
= 1.5 / [{1 + (1-0.35)} * 0.25/0.75]
= 0.30
Returns
Rate of return on any asset (Stocks, bonds, real estate plots, paintings,
jewelry, etc) , as a generic concept , has 2 components namely a
periodic income yield plus a capital gains yield.
For the shareholders of a corporation periodic income is in the form of
cash dividends so it is called dividend yield, for bondholders periodic
income is in the form of interest so it is called interest yield.
But for investors in paintings or jewelry or plot of land there is no
periodic income.
The second portion of the rate of return is simply a percentage increase
(or decrease) in the price of the asset over the period, which is usually
one year. It is termed capital gains yield.
 Returns Realized Vs Expected
Expected (ex ante) rate of return (ROR)
ROR (shares) = expected dividend yield + expected capital gains yield
= (DPS 1 / Po) + (P1 - Po) / Po
Note: Po refers to current price, P1 refers to expected price after one year,
and DPS 1 refers to expected cash dividends per share during the next year.
Realized , ex-post, actual ROR: Its the rate of return about which there is
no ambiguity as it is actual historic rate of return. For a share it is equal to
realized dividend yield plus realized capital gains yield.
For example If share of MCB was bought at Rs 250 a year ago and it gave Rs
5 DPS during the year , and now after one year it is trading in the stock
market at Rs 300 then Its realized ROR = ?
Returns Realized Vs Expected
Expected (ex ante) rate of return (ROR)
ROR (shares) = expected dividend yield + expected capital gains yield
= (DPS 1 / Po) + (P1 - Po) / Po
Note: Po refers to current price, P1 refers to expected price after one year, and DPS
1 refers to expected cash dividends per share during the next year.
Realized , ex-post, actual ROR: Its the rate of return about which there is no
ambiguity as it is actual historic rate of return. For a share it is equal to realized
dividend yield plus realized capital gains yield.
For example If share of MCB was bought at Rs 250 a year ago and it gave Rs 5 DPS
during the year , and now after one year it is trading in the stock market at Rs 300
Realized Div Yield = DPS / Po = 5 /250 = 2%; and its realized capital gains yield is (P1
Po) / Po = (300 - 250) / 250 = 20%; and realized annual rate of return (ROR) for the
investor is: dividend yield + capital gains yield = 2% + 20% = 22%.
Risk & Return Bringing it all together!
The more relevant and contentious issue is to calculate expected or ex-ante ROR.
There is an equilibrium theory of risk and return called CAPM (Capital assets Pricing
Model) and it is represented by an equation :
Kc = Rf + {(Rm Rf) * B(Levered)}
Here, Kc refers to risk adjusted ROR required by shareholders of a corporation and
beta levered is the relevant risk of that asset; so this model brings together risk and
return in one equation and it says that higher risk leads to higher returns and vice
e versa.
Technically CAPM gives risk adjusted required ROR. The rate of return for shares
estimated by using CAPM is termed required rate of return as the compensation for
the risk involved.
On the other hand the expected dividend yield plus expected capital gains yield
give expected rate return.
Risk & Return Bringing it all together!
Interestingly, the required ROR and expected ROR from
a share are same only when its price is at equilibrium
(which is also called fair value) otherwise if the 2
returns are not same then the stock is either
underpriced or over priced at its current Po.
It is a fundamental principle of finance that ex-ante (
i.e. before the fact) relationship between expected
ROR and risk of any asset is positive.
Positive relation between risk and return means higher
risk taking is expected to lead to higher return,
conversely, you can say there is no way to earn higher
return without taking higher risk.
Risk & Return Bringing it all together!

MCB had Debt ratio of 0.5, Tax rate of 35% with Cost of
Equity of 14%, Risk free rate of 5% & Market return of
10%. Calculate its Beta levered & Unlevered.
Risk & Return Bringing it all together!

MCB had Debt ratio of 0.5, Tax rate of 35% with Cost of
Equity of 14%, Risk free rate of 5% & Market return of
10%. Calculate its Beta levered & Unlevered.
Kc = Rf + {(Rm Rf) * B(Levered)}
14% = 5% + {(10% - 5%)}* BL
BL = 1.8
 Risk & Return Bringing it all together!

MCB had Debt ratio of 0.5, Tax rate of 35% with Cost of Equity of 14%,
Risk free rate of 5% & Market return of 10%. Calculate its Beta levered &
Unlevered.
BL = 1.8
Beta ( Un Levered) = Beta (Levered) / [ 1 + (1 T) * Debt / OE ratio]
= 1.8 / [ 1 + (1-0.35)*1]
= 1.09
Assuming a risk free rate of 7%, calculate
Required rate of return & Expected rate of return
for both stocks, should we invest in these stock?

Year Stock A Stock B Market

1 20 200 10,000
2 35 220 12,000
3 40 230 13,000
4 50 250 13,500
5 45 270 14,000
WD 40% 60%
Tax 30% 30%