Section I |

Part I

TOPIC 2:TIME VALUE OF

MONEY
Section I |
Part I
Content
Risk-Return trade-off
Future Value computations
Present Value computations

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Part I
Return
• Return is the basic motivating force and the
principal reward in the investment process.
• Returns include:
Interest
Dividends
Capital gains
• An investment's return can be actual or
expected.
• Rate of return can be computed as:

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Section I |

Return
Part I

Example 1
If you bought a share for shs.15 which one year later was valued
at shs.16 and it paid you a dividend of shs.0.50 during the year,
your return would be:
=10%

Example 2
You invested in a share for shs.11. If you expect its most likely
value to be shs.12 one year from now and expect it to pay
you a dividend of shs.0.75 during the year, your expected
return E(r) would be?

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Return
As an investor, you may also consider a number of
possible future [Link]. incorporate probabilities while
computing the expected return.

Example 3
Assume there is a 30% chance for share return in
Example 1 to remain at 10%, a 50 % chance of it
increasing to 11% and a 20 % chance that it might reduce
to 9%.What is the expected return?

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Return
• The expected return in this case is the sum of the
returns*probability.
• I.e. E(r) = P(r1) + P(r2) + ... + P(rn)
• The expected return is denoted as E(r) or
Probability Return P*R

0.30 10% 3.00%

0.50 11% 5.50%

0.20 9% 1.80%

E(r) 10.30%

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Return
You are the financial manager of Simba company. You are
considering proposed investment opportunities. Among the
projects is the one below. The expected returns from the project
are related to future performance of the economy over the
period as follows:
Economic scenario Probability of occurrence (p) Rate of return (r)

Strong growth 0.25 15%

Moderate growth 0.5 12%

Low growth 0.25 8%

What is the expected rate of return?

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Compute the expected return of each asset

Which asset should be accepted based on returns?

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Risk
• In finance terms,risk can be described as the chance that an
investment’s actual return will be different from what was
expected as a result of uncertainty.
• The concept of risk may be defined as the possibility that the
actual return may not be same as expected.
• In other words, risk refers to the chance that the actual
outcome (return) from an investment will differ from an
expected outcome.
• Risk can be divided into two:
• Unsystematic risk (specific risk)
• Systematic risk (market risk)
• Total risk= Unsystematic risk + Systematic risk

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Unsystematic Risk
• This is the risk caused by factors that are unique to a
specific company.
• These factors exist within the company. The risk could
arise from type of product the company is selling, the
use of new technology, an industrial dispute, poor
management etc.
• Also known as diversifiable risk.
• Any rational investors invests in an efficient portfolio so
as to eliminate unsystematic risk.

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Systematic Risk
• Caused by factors that affect the market as a whole e.g.
political climate, economic conditions, inflation, interest
rates, war etc.
• It is also referred to as undiversifiable risk as it is not
eliminated by investing in an efficient portfolio.
• A rational investor is interested on measurement of
systematic risk while identifying securities with the
preferred risk-return characteristics.

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Risk attitudes
Part I

• Risk Averse
• Risk Neutral
• Risk Seeker

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Risk attitudes
Part I

Risk Averse (risk avoiding)

Decision makers that avoid risk as much as possible and
therefore would invest in projects with the lowest risk or risk
free assets.
Risk Neutral
These are not influenced by risk in making their decisions.
They therefore use other criteria such as expected returns in
making their decisions.
Risk Seeker (risk loving)
These are decision makers who are prepared to take high
risks in anticipation of high return
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Risk measurement
Risk is usually measured by calculating :
• Standard deviation (measure of total risk)
• Coefficient of variation (risk per unit of return)
• Beta coefficient (measure of market risk)

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Variance/Standard deviation
• This is a measure of total risk.
• Standard deviation is a statistical measure of the
deviation of outcomes around a mean value.
• The higher the variance and standard deviation the
higher the total business risk.
• Variance (σ2) = √∑ [Ri - E (Ri)]2 * (Pi)

• Standard deviation (σi) = √∑ [Ri - E (Ri)]2 * (Pi)

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Variance/Standard deviation
Example 1
• Having determined the expected return of Simba
company, determine the risk as measured by
standard deviation for the company.
Economic scenario Probability of occurrence (p) Rate of return (r)

Strong growth 0.25 15%

Moderate growth 0.5 12%

Low growth 0.25 8%

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Variance/Standard deviation
Example 2
• Elizabeth is considering investing in Company Z stock. She has conducted some
research and gathered data on the possible rate of return for the stock, which is
subject to the state of the economy as shown below:
State of the economy Probability for State of the economy Possible rate of return for Company Z stock

Expansion 0.3 17%

Normal 0.3 13%

Recession 0.4 10 %

Required:

 Calculate the expected return of the stock.

 Calculate the variance and standard deviation of the stock.

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Example 3

A company is faced with two assets A and B each. The assets will
generate the returns indicated below:

Which asset should be accepted based on risk and returns?

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Example 4
Compute the expected return, risk(as measured by standard deviation) and coefficient of
variation for each of the following projects. Which project would you invest in and why?

Project M Project Q Project S

Return Probability Return Probability Return Probability

10% 0.3 6% 0.4 9% 0.1

15% 0.2 8% 0.1 14% 0.5

8% 0.2 5% 0.2 5% 0.2

3% 0.3 4% 0.3 7% 0.2

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Coefficient of Variation
• This is the ratio of the standard deviation to the
expected return.
• It is considered useful especially while making a
comparison between assets that have different risk-
return characteristics.
• The higher the CV, the higher the risk

• Coefficient of Variation (CV) =

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Coefficient of Variation
• You are considering purchasing Asset A or B with
the following characteristics.
ASSET A ASSET B

Expected return 15% 25%

Standard deviation 5% 10%

Which asset would you invest in based on the CV?

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Coefficient of Variation
• Asset B has the higher risk than asset A as measured
by the CV.
• This means that it has higher risk per unit of return.
• The returns from Asset B are relatively more volatile
(risky) compared to those from Asset A.
• A risk-averse investor would therefore prefer Asset
A.
• However, the final decision depends on investor's
attitude to risk.

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RISK-RETURN TRADE OFF

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Risk-Return trade off

Individual investors perspective
• The general assumption is that investors like high returns and
they dislike risk.
• Therefore, to entice investors to take on more risk, you have to
provide them with higher expected returns thus creating a
fundamental trade-off between risk and return.
Company perspective
• If a company invests in riskier projects, it must offer its investors
(both bondholders and stockholders) higher expected returns.
• The returns that companies have to pay their investors
represent the companies’ costs of obtaining capital.

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Time Value of Money

Part I

• Individuals prefer possession of a given amount now as

compared to having the same amount at some future date.
• Money is worth more the sooner it is received.
• Four reasons may be attributed to an individual’s time
preference for money:
• Risk
• Inflation
• Preference for consumption
• Investment opportunities

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Time preference for
Part I

money
Individuals prefer present consumption due to:
• Risk- Possibility of non-payment or reduced payment if the
promise to pay is broken in the future.
• Inflation - Inflation reduces purchasing power of the
money in the future.
• Preference of current consumption – Urgency of present
wants and possibility of not enjoying future consumption
as a result of occurrences such as illness and death.
• Investment opportunities -The money can be invested in
current investment opportunities which will earn return.

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Required rate of return (RRR)
Time preference for money is expressed by a rate
known as the RRR.
RRR is also known as the discount rate/cost of
capital/ interest rate
It is the minimum rate of return an investor
requires an investment to earn, given its risk
characteristics, for the investment to be considered
worthwhile.
It is is mainly influenced by the investors own
individual risk preference.

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Required rate of return (RRR)
If a proposed investment is expected to yield less than
the RRR of an investor, the investor will not invest in the
project but will seek another alternative.
• RRR = Risk Free Rate + Risk Premium
RRR = Rf + Rp
Where:
Risk free rate = Real Rate of Return + Inflation

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Risk Free Rate (RF)
• It is the rate that investors require for compensation
for the passage of time.
• The rate is usually estimated by the return on
government treasury bills.
• Risk Free Rate = Real Rate of Return + Inflation Premium
• Real Rate of Return - Compensates investors for giving up
use of their funds in an inflation free and risk free market.
• Inflation Premium – Compensates the investor for the
decrease in purchasing power of money caused by inflation.

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Risk premium
• Compensates the investor for uncertainties involved
in future cash flows.
• Comprised of various components including:
• Default Risk Premium – Compensates the investor
for the possibility that the user of funds will be
unable to repay
• Liquidity Risk Premium – Compensates for the
possibility that the security given by the users of
funds will not be easily convertible to cash.
• Maturity Risk Premium – Compensates the
investors for the term to maturity.

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Risk premium
• Sovereign Risk Premium –This compensates the
investor for political uncertainty or instability in the
country or company in which he has invested.
• Exchange Risk Premium – This compensates for the
fluctuations in the value of the country’s currency.
This is important especially if the funds are
denominated in a foreign currency.
• Other Risk Premium –This compensates for
anything that might cause uncertainty.

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Required rate of return (RRR)

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The Capital Asset Pricing Model (CAPM)

• This is a model that was developed to link the

undiversifiable risk and return of an asset.
• The model determines what return an investor
should require for assuming a given level of risk.
• CAPM was initially developed to facilitate pricing of
ordinary shares in the stock market.
• However, the model has been subsequently applied
to evaluate the decisions by investors of corporate
assets.

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Required rate of return (RRR)
• The RRR equation is broken down further
using the CAPM to:
R = R + (E(R ) – R ) β
i. f m f i

• Where:
•R = Required rate of return
i

• E(R ) m= Expected return from the

market
•R f = Risk free rate (returns on
treasury bills)
• E(R )-R = Market Risk Premium
m f

•β i = Beta of security i
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Beta coefficient (βi)
• This is the measure of systematic/market risk.
• It is a measure of the extent to which returns of an
individual stock or portfolio are sensitive to the
stock market returns.
• If for example the average rate of return on the
stock market rises by 5% and the return on an
individual share similarly rises by 5% then the share
has a beta coefficient of 1.0.
• This implies that it is just as risky as the market
average.

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Beta coefficient (βi)
• By definition the market has a β of 1 therefore;
• if an individual stock has a β=1 it can be expected to
have returns as volatile as the market.
• if the stock has β=2 then it is twice as volatile as the
market.
• if a stock has a β=0.5 then it is ½ as volatile as the
market.

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Advice to investors
• Required return may differ from actual or expected
returns.
• If ;
• E(Ri) > RRR then the investment is worthwhile. Ie
underpriced or undervalued = Buy
• E(Ri) < RRR then this would not be a good
investment ie over-priced or overvalued= Sell
• E(Ri)= RRR ;Fairly valued

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Example
Assume that an investor is considering investing in a
security with a Beta of 1.1 and an expected rate of
return of 18.9%.The return on treasury bills is 12%
and the average return in the market is 17.5%.
Required:
Advice the investor.

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Solution
RRR=Rf + (E(Rm)-Rf) βi
=12+(17.5-12)1.1
=12+(5.5)1.1
Ri = 18.05% E(Ri) = 18.9%

E(Ri)>RRR - Security is under priced

- Investor should buy the
security.

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Example 2
As the finance manager of Kazi Enterprises you are considering
investing in the shares of the following companies. The return on
treasury bills is 8% and E(Rm)=15%.
Company Expected return Beta
Maanzi ltd 12% 1.5
Bora ltd 7% 0.7
Wandati ltd 9.50% 0.4
Tukuje ltd 14.30% 1
Fanaka ltd 10% -0.6

Required:
Compute the RRR for each security and state whether they are
undervalued or overvalued.

BF
THANK YOU

BF