Risk may be defined as the likelihood that the actual return from an investment will be less than the forecast return. Stated differently, it is the variability of return form an investment.
Financial decisions incur different degree of risk. Your decision to invest your money in government bonds has less risk as interest rate is known and the risk of default is very less. On the other hand, you would incur more risk if you decide to invest your money in shares, as return is not certain. However, you can expect a lower return from government bond and higher from shares. Risk and expected return move in one behind another.
The greater the risk, the greater the expected return. Financial decisions of a firm are guided by the risk-return trade off. These decisions are interrelated and jointly affect the market value of its shares by influencing return and risk of the firm. The relationship between return and risk can be simply expressed as:
Return = Risk free rate + Risk Premium
Risk free rate is a rate obtainable from a default risk free government security. An investor assuming risk from his investment requires a risk premium above the risk free rate. Risk free rate is a compensation for time and risk premium for risk. Higher the risk of an action, higher will be the risk premium leading to higher required return on that action. A proper balance between return and risk should be maintained to maximize the market value of a firms share. Such balance is called risk-return trade off and every financial decision involves this trade off.
The financial manager in order to maximize shareholders wealth should strive to maximize returns in relation to the given risk. He should seek courses of actions that avoid unnecessary risks. To ensure maximum return, funds flowing in and out of the firm should be constantly monitored to assure that they are safeguarded and properly utilized. The financial reporting system must be designed to provide timely and accurate picture of the firm’s activities.