RISK AND RETURN OF AN INVESTMENT

One of the ideal measures to reduce risk as an entrepreneur while simultaneously maximizing
revenue is by diversifying your investment. Investors can choose multiple investments that offer
different returns accordingly. There are different investment options available to every
investor/entrepreneur such as stocks, bonds, commodities, mutual funds, etc. Stocks usually carry
high chance of failure but can give good returns. On the other hand, government bonds can carry
low to zero risk but offer low return/profits. Investors can also choose to invest in stocks with high
risk and compensate for the risk by investing in bonds. Bonds usually give assured returns,
although it is low. They can also invest in mutual funds for a longer period with moderate risk.
However, some experts suggest that investing in different industries or markets is the best way to
reduce risk. Because different sectors prosper and fall at different times. For example, during the
onset of the COVID-19 pandemic, many internet and e-commerce companies flourished, whereas
automobile companies didn’t do well.

Types of Risk

Types Of Risk

• Market risk – It is also called systematic risk and arise due to various market related
factors like economic and political problems, interest rate and currency fluctuations, etc.
They have a huge impact on the investors.
• Specific risks – They are related mostly to company itself. They may be controlled through
diversification an monitoring.
• Credit risk – This is related to credit worthiness of the company or business. If the
financial condition of the business is good, it will be able to meet its current and future
obligations and repay its debts on time. This will lead to good credit rating. Credit risk is
the result of deteriorating financial health of the company.
• Liquidity risk – This is the result of the business not being able to earn good revenue to
meet its financial obligations and maintain high working capital.
• Interest rate risk – The fluctuations in the interest rates in an economy can affect the
business’s borrowing capacity.
 • Inflation – The inflation leads to erosion of value of investments and the value of cash
flows in future
• Systematic risk is the risk that is inherent to the broader market. On the other hand,
unsystematic risk is specific to a company or industry. In addition, Systematic risk is
uncontrollable, whereas unsystematic risk can be mitigated through diversification

Types Of Return
• Capital gains – Any good investment will rise in value as time passes by. Thus, the assets
will be valued higher if they are sold later on as compared to its purchase price, giving
capital gain.
• Dividends – they are a steady source of income for investors who invest in shares of
companies giving regular dividends which are a part of the profits set aside for investors.
• Interest – Borrowers like individuals or corporates borrow money for meeting expenses
or capital requirements. The lenders give the funds to get interest on the principal amount
which is a return on investment for the lenders.
• Rental income – Any property rented out can earn rent on a regular basis, which is also a
return in the real estate property.
• Return from currency trading – Profits earned from trading in exchange rates by using
the differences is exchange rate of different currency is also a form of return for those who
do currency trading.

Calculating the expected Return, Standard deviation and Variance

The expected return is calculated by multiplying the probability of the state by the return of the
firm. For example: calculate the expected return of the firms given the different state of the
economy.
State Probability of state Return on stock of firm A Return on stock of firm B
Boom 20% 30% -5%
Normal 50% 12% 7%
Recession 30% -10% 15%
Solution: ExReturn Firm A: (0.2)(0.3) + (0.5)(0.12) + (0.3)(-0.1) = 0.09 or 9%

Standard deviation Firm A: 0.2x(0.3-0.09)2 + 0.5x(0.12-0.09)2 + 0.3x(-0.1-0.09)2 = 0.0201

Variance Firm A: √(0.0201) = 0.1418 or 14.18%

Please solve for firm B (I have given you only the answers)
ExReturn Firm B: …………………………………………= 0.07 or 7%
Variance Firm B: …………………………………………………………. = 0.0048
Standard deviation Firm B: …………………………………………= 0.0693 or 6.93%

NEW TOPIC

THE TIME VALUE OF MONEY

The Time Value of Money (TVM) is a simple concept that money available in the present is worth
more than the same amount of money in the future. Inflation is an important factor when it comes
to the TVM because it tends to erode the purchasing power of money over time. For instance, the
price of a loaf of bread today has more than doubled from ten (10) years ago, which means you
could have purchased a lot more bread for the same amount of money back then than you could
today. SASCO bread was sold at R9 ten years ago and the same SASCO bread is selling at R18
today.

Calculating the Future value of an investment

A formula that can be used for calculating the future value of money to compare it to the current
value of money is as follows:

𝑖
𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 (𝐹𝑉) = 𝑃𝑉[1 + 𝑛](𝑛 𝑥 𝑡) OR [PV (1 + r)n]

• FV: is the future value of money

• PV: is the current value of money

• i: is the interest rate that could be earned

• t: are the number of years it will take

 • n: is the number of compounding periods of interest per year

Example: Calculate the future value of R50,000 invested for one year at 8% interest rate.

8%
Solution: FV = 50,000 [1 + ](1 𝑥 1) OR 50,000(1+0.08)1 = R54, 000
1

Calculating the Present value of future amount

You can also find the present value of a future amount by making PV the subject of the formulea.
For example, how much did Alex invest one year ago if he gained an 8% interest rate and
currently has $10,000?

𝑖 𝐹𝑉
Solution: PV = 𝐹𝑉 ÷ [1 + 𝑛](𝑛 𝑥 𝑡) OR [ ]
(1 + 𝑟)𝑛

PV = 10,000 ÷ (1+0.08)1 = 9,259.26

Calculating Ending Balance with Simple Interest

The ending balance, or future value, of an account with simple interest can be calculated using the
formula: S = P(1 + rt)

Where S= simple interest; P= principal; r= interest rate; t= time/period of the investment.

Calculate the simple interest for a 3-year saving account at a 10% rate with an original balance of
$1000. Solution: S=1000 [1+(10%) (3)] = 1300

Mandla has been given R250,000 by his grand father to invest in any business of his choice.
Mandla has decided to invest in a supermarket that will give him an annual interest rate of 15%.
Calculate the simple interest of the investment after 10 years.

Calculating Compound Interest of an investment amount

Sihle invest R10,000 into a savings account at an annual interest rate of 6%, compounded
monthly. Calculate the investment amount after 20 years.

𝒓 𝒏𝒕
Solution: Investment amount (𝑨) = 𝑷 (𝟏 + )
𝒏

Where: A = future value of the investment/loan

P = principal investment or loan amount
r = annual interest rate (decimal)
n = number of times interest is compounded per year
t = time in years
𝟎.𝟎𝟔 𝟏𝟐𝒙𝟐𝟎
A = 𝟏𝟎𝟎𝟎𝟎 (𝟏 + ) = R33, 102.04
𝟏𝟐

Another example: Assuming that Mabaso has been give R500, 000 by his wife to invest in a
business that has a 12% interest rate compounded semi-annually (meaning two times a year).

i. How much will Mabaso recoup from the investment after 10-years.
ii. How much will Mabaso recoup from the investment after the same period of 10 years
provided the interest rate was compounded quarterly?

NEW TOPIC

WORKING CAPITAL MANAGEMENT

Working Capital (WC) is the current or short-term net assets of a firm resulting from short term
assets (such as cash, bank balance, receivables, closing, marketable securities, etc.) minus short
term liabilities (such as creditors, payables, bank overdraft, etc.). WC can also be referred as
circulating capital for day-to-day operations of a firm. In other term, WC is the short-term capital
reservation for immediate use. WC is therefore known as Revolving (or Circulating) Capital or
Short-term Capital that is required for managing the financing requirements on both expenses (like
payables and payments to creditors) and short-term (current) assets such as cash, marketable
securities, debtors and inventories. Indicatively, the investment in current assets revolve fast and
sooner liquefiable into cash and can again possibly be used or invested in other purpose/current
assets. In application, firms attempt to manage two requirements: liquidity (WC) and profitability
of the business.

Liquidity refers to the efficiency or ease with which an asset or security can be converted into
ready cash without affecting its market price. The more liquid an investment is, the more quickly
it can be sold (and vice versa), and the easier it is to sell it for fair value or current market value.
The most liquid asset of all is cash itself. Current ratio, quick ratio, and cash ratio are most
commonly used to measure liquidity.

Profitability is defined as a firm’s ability to use its resources to generate revenues in excess of its
expenses. In other words, it is a company’s capability of generating profits from its operations.
Profitability ratios include profit margin ratios (such as gross profit margin, operating profit
margin, net profit margin) and return on investment ratios (return on asset (ROA), return on equity
(ROE)). A company's profitability ratios are most useful when compared to those of similar
companies, the company's own performance history, or average ratios for the company's industry.

WORKING CAPITAL POLICY AND RELATIVE MEASURES

WC management implies implementation of WC policies with the control of day-to-day cash

requirements, inventories, receivables, accrued expenses, and account receivables. To have
efficient WC policies, it is important to know about determination of the level of WC and how the
WC can be financed. For calculation of WC, amounts of current assets and current liabilities are
in consideration. Therefore,

Gross WC = Total Current Assets (TCA)

Net WC = TCA – Total Current Liability (TCL)

Net Operating WC = Operating CA – Operating CL

= (Cash + Inventory + Account Receivables) – (Short Term Liabilities).

Current Ratio = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 ÷ 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒍𝒊𝒕𝒊𝒆𝒔

Quick Ratio = (𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 – Inventory) ÷ 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒍𝒊𝒕𝒊𝒆𝒔

Inventory Turnover (ITO) = 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅 ÷ Inventory

ROA = Net income ÷ Total asset

ROE = Net Income ÷ Shareholders’ Equity

I. Policy A – Aggressive Approach: In this policy, a firm will maintain its WC at a minimum
level even below the WC requirement. This can be a result of possible non-collection form
debtors and delayed payment to creditors. On the other hand, available funds might have
been invested in long-term assets. This sometimes make the firm to suffer from deficit of
WC and the WC requirement can be met by selling out long-term/fixed assets. This is on
hand a high risk to the firm to lose its profitable assets for the urgent requirement of WC.
Though this policy can lead to an advantage of less current assets and WC requirement,
this policy make the firm to earn more return on investment (ROI) as the result of facing
high risk. As this policy endorses high risk to high return, it is called as aggressive WC
policy.
II. Policy B – Moderate/Matching Approach: Most firms apply this approach, since WC is
managed as per the requirements. As per the revenue of the firm, the excess current assets
will be converted into profitable assets and those assets can be liquidated, if there is a WC
requirement. This approach has moderate risk to the business. In this approach, credit limits
to the customers and creditors are pre-set in order to manage the WC requirement. The
firms will act in meeting the deadlines to receive payments from debtors and to pay to
creditors. In this policy, a firm must maintain its current assets to match with the current
liabilities with low amount of cash in hand. This approach enables the firm to act
defensively to face the WC requirement as necessary.
III. Policy C – Conservative Approach: This approach refers to lowest risk of managing the
WC. This policy cannot ensure optimum use of funds in assets. This policy facilitates a
firm to perform targeted revenue after analysing possible uncertain events, especially the
fluctuations in sales. This policy helps a firm to have a smooth functioning of the operating
 cycle. As this policy facilitate the firm to operate at a reasonable earning with higher
investment in current assets (this can cause higher interest cost and reducing the
profitability), the firm may enjoy lower return on investment; and therefore, this can be a
major disadvantage of this policy.

It is notable that there are three types of finances in a firm, namely: Short-term fluctuating finance
(say X, represented by fluctuating current assets), Short-term continuously evolving finance (say
Y, represented by permanent current assets), and Long term finance (equity and debt – say Z,
represented by fixed assets). Also, based on the approaches, the financial managers can also be
categorised: Moderate Practitioner (for Policy B), Aggressive Practitioner (for Policy A) and
Conservative Practitioner for Policy (C). In this context, the moderate practitioner manages the
WC by mostly using the fluctuating finance (X); the aggressive practitioner manages the WC by
mostly utilising both the fluctuating finance and short-term continuously evolving finance (X +
Y); and the conservative practitioner manages WC with all three types of finances (X + Y + Z).

NEW TOPIC

BUSINESS PLAN
A business plan is a formal document that outlines a company's objectives and the strategies the
company uses to achieve the objectives. A business plan also outlines a company’s financial
forecasts and serves as a comprehensive roadmap for business growth and development. It is
crucial for both startups and existing businesses. The business plan also serves as a powerful
marketing tool for entrepreneurs to use to access critical resources such as financial capital. The
main components of a business plan are:

i. Executive summary: it should appear first in your business plan and should summarise
what you expect your business to accomplish.
ii. Company description: it should spell out key information about your business, goals and
the target customers you want to serve. It should also explain how your business is different
from your competitors.
iii. Market analysis: Here, entrepreneurs show that they have a key understanding of the ins
and outs of the industry and the specific market they plan to enter. They also substantiate
their strengths that they highlighted in their company description with data and statistics
that break down industry trends and themes. Show what other businesses are doing and
how they are succeeding or failing. Your market analysis should also help visualize your
target customers. This includes how much money they make, what their buying habits are,
which services they want and need, among other target customer preferences.
iv. Competitive analysis: A good business plan will present a clear comparison of your
business vs your direct and indirect competitors. This is where you prove your knowledge
of the industry by breaking down their strengths and weaknesses. Your end goal is show
how your business will stack up. And if there are any issues that could prevent you from
jumping into the market, like high upfront costs, this is where you will need to be
forthcoming. Your competitive analysis will go in your market analysis section.
v. Description of Management and Organisation: our business must also outline how your
organization is set up. Introduce your company managers here and summarize their skills
and primary job responsibilities. An effective way could be to create a diagram that maps
out your chain of command. Don’t forget to indicate whether your business will operate as
a partnership, a sole proprietorship or a business with a different ownership structure. If
you have a board of directors, you’ll need to identify the members.
vi. Product and service breakdown: A detailed breakdown of your products and services is
intended to give a complementary but fuller description about the products that you are
creating and selling, how long they could last and how they will meet existing demand.
This is where you should mention your suppliers, as well as other key information about
how much it will cost to make your products and how much money you are hoping to bring
in.
vii. Marketing plan: This is where you describe how you intend to get your products and
services in front of your target customers. Break down here the steps that you will take to
promote your products and the budget that you will need to implement your strategies.
viii. Sales strategy: This section should answer how you will sell the products that you
are building or carry out the services that you intend to offer. Your sales strategy must be
specific. Break down how many sales reps you will need to hire and how you will recruit
them and bring them on board. Make sure to include your sales targets as well.
ix. Request for funding: If you need funding, this section focuses on the amount of money
that you need to set up your business and how you plan to use the capital that you are
raising. You might want to include a timeline here for additional funding that you may
require to complete other important projects.
x. Financial plan/projections: This final section breaks down the financial goals and
expectations that you’ve set based on market research. You’ll report your anticipated
revenue for the first 12 months and your annual projected earnings for the second, third,
fourth and fifth years of business. If you’re trying to apply for a personal loan or a small
business loan, you can always add an appendix or another section that provides additional
financial or background information.