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CHAPTER 1
INTRODUCTION TO ACCOUNTING
BALANCING RISK AND RETURN
All decision making concerns the future and financial decision making is no exception. The
only
thing certain about the future, however, is that we cannot be sure what will happen.
Things may not turn out as planned and this risk should be taken into account when making
financial decisions.
As in other aspects of life, risk and return tend to be related. Evidence shows that returns
relate to risk in something like the way shown in Figure 1.6.
Look at Figure 1.6 and state, in broad terms, where an investment in:
(a)
UK government savings account; and
(b)
shares in an oil business
should be placed on the risk–return line.
A UK government savings account is normally a very safe investment. Even if the govern-
ment were in financial difficulties, it may well be able to print more money to repay investors.
Returns from this form of investment, however, are normally very low.
Investing in shares in a commercial business runs a risk of losing part or, possibly, the
entire amount invested. On the other hand, such an investment can produce very high posi-
tive returns. Thus, the government savings account should be placed towards the far left of
the risk–return line and the oil business shares towards the far right.
Activity 1.16
Figure 1.6
Relationship between risk and return
Return
0
Risk
Even at zero risk a certain level of return will be required. This will increase as the level of risk
increases.
This relationship between risk and return has important implications for setting financial
objectives for a business. The owners will require a minimum return to induce them to invest
at all, but will require an additional return to compensate for taking risks; the higher the risk,
the higher the required return. Managers must be aware of this and must strike the appropri-
ate balance between risk and return when setting objectives and pursuing particular courses
of action.
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REASONS TO BE ETHICAL
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The turmoil in the banking sector, earlier this century, has shown, however, that the right
balance is not always struck. Some banks took on excessive
risks in pursuit of higher
returns and, as a consequence, incurred massive losses. They are now being kept afloat
with taxpayers’ money.
Real World 1.6
discusses the
collapse of one leading bank, in
which the UK government took a majority stake, and argues that the risk appetite of banks
must now change.
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