What is the role of return and risk in financial decisions?

What is the role of return and risk in financial decisions?

What is the role of return and risk in financial decisions? The purpose of this assignment is to solidify your understanding of the applications of the risk
and return concepts and their role in valuing financial assets. The scores of this assignment will
help in assessing the following learning goal of the course: “students successfully completing
this course will be able to Analyze risk-return characteristics to assess the valuation of financial
assets”.

Why the concept of risk and return is an important aspect of finance?

Instructions:
You are required to use a financial calculator or spreadsheet related to the risk and return stocks, and bonds valuation. You are required
to show the following 3 steps for each problem (sample questions and solutions are provided for
guidance):
(i) Describe and interpret the assumptions related to the problem.
(ii) Apply the appropriate mathematical model to solve the problem.
(iii) Calculate the correct solution to the problem.
Sample Questions and Solutions
Sample Question # 1:
A company has an issue of 12-year bonds that pay 5% interest, annually. Further, assume that
today’s required rate of return on these bonds is 7%. How much would these bonds sell for
today? Round off to the nearest $1.

What is the relationship between risk and return in financial management?

Solution
(i) The problem assumes that the face value of the bond is $1000. The bond will pay an
annual coupon of 5% i.e., coupon or interest amount of $50 is assumed to paid every
year. It also assumes that investors currently required a return of 7% on investments
with similar risk characteristics. The use of bond valuation concept is appropriate to
calculate the true value of these bonds. The accuracy of the solution depends on the
correctness of the assumptions on face value, coupon payments, and required rate of
return assumption.
(ii) The use of the bond valuation concept which suggests that the true value of a bond is the
present value of its future coupon and face value discounted at investors’ required rate
of return is appropriate to calculate the true value of these bonds. We are required to
compute the present value (PV) which represents the true value of the bond.
(iii) FV= $1000; PMT=$50; Rate = 7%; N=12 years; Compute PV = ? = $841.15
Value of the Bond = $841.15

What is the difference between risk and return?

2
Sample Question # 2:
A company just paid a dividend of $1, and the dividends are expected to grow at a constant rate of
4% forever. If the required return of the stockholders is 12%, what is the price of this company’s
stock?
Solution
(i) The problem assumes the stock will have a constant growth of 4% forever. The
constant growth model is appropriate to use for this problem. The accuracy of the
solution depends on the correctness of the constant growth assumption.
(ii) The constant growth model is given as: P0 = D1/ (R-g); where
• P0 is the current price to be calculated,
• D1 is the next period’s dividend,
• R is the required return on this stock
• g is the constant growth
D1 needs to be calculated in order to apply this model.
(iii) D1= $1.00 x (1+0.04) = 1.04
P0 = 1.04/(0.12-0.04) = $13;
the stock price should be $13 based on the constant growth model.