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Unit 2 of 4 · B.Com Sem 5

Unit 2: Risk, return & governance

Advanced Financial Management notes · PTU syllabus (BCOP 512-18)

3 min read5 topics10 exam questions
On this page
  1. Unit summary
  2. Business and financial risks
  3. Risk–return trade-off
  4. Ethical and governance issues
  5. Agency relationships
  6. Transaction cost theory and integrated reporting
  7. Key terms
  8. Quick revision
  9. Important questions

Unit summary

Every financial decision involves risk, and the way managers handle risk depends on governance and ethics. This unit covers identifying business and financial risks — operational, reputational, political, economic, regulatory and fiscal — the risk–return trade-off, ethical and governance issues, agency relationships, transaction cost theory and integrated reporting.

After this unit you can

  • Identify and classify business and financial risks
  • Explain the risk–return trade-off
  • Explain ethical and governance issues and agency relationships
  • Explain transaction cost theory and integrated reporting

PTU syllabus topics

  • Identifying business and financial risk (operational, reputational, political, economic, regulatory, fiscal)
  • risk-return trade-off
  • ethical and governance issues
  • agency relationships
  • transaction cost theory
  • integrated reporting
ClassificationBusiness risks
Risks

  • Operational

    Failures in processes or systems

  • Reputational

    Damage to brand trust

  • Political

    Government actions

  • Economic

    Recession, inflation, currency

  • Regulatory and fiscal

    Laws and tax changes

1

Topic 1

Business and financial risks

ClassificationTypes of risk
Risks

  • Business risk

    Variability of operating profit from the nature of business

  • Financial risk

    Additional risk from using debt

  • Operational risk

    Failures of processes, people, systems — fraud, IT outages

  • Reputational risk

    Loss of trust from scandals, poor service, ESG failures

  • Political risk

    Government instability, expropriation, policy changes

  • Economic risk

    Recession, inflation, interest and currency movements

  • Regulatory risk

    Changes in laws and compliance demands

  • Fiscal risk

    Changes in taxation (rates, new levies, retrospective tax)

  • Systematic risk: affects the whole market (interest rates, inflation) — cannot be diversified; measured by beta.
  • Unsystematic risk: specific to a firm or industry (strike, product failure) — can be diversified away.
ProcessRisk management process
  1. 1Identify risks
  2. 2Assess likelihood and impact

    Risk map / heat map

  3. 3Respond

    Avoid, reduce, transfer (insurance, hedging), accept

  4. 4Monitor and report
  5. 5Review

Example

The 2012 retrospective tax amendment (Vodafone case) is a classic example of fiscal and regulatory risk for foreign investors in India; it was withdrawn in 2021.

2

Topic 2

Risk–return trade-off

  • Higher expected return requires accepting higher risk.
Key formulasRisk and return measures

  • Expected return

    Σ (Probability × Return)

  • Standard deviation

    √ Σ Probability × (Return − Expected return)²

  • Coefficient of variation

    Standard deviation ÷ Expected return

  • CAPM required return

    Rf + β (Rm − Rf)

Example

Project A: expected return 12%, SD 4% (CV 0.33); Project B: 15%, SD 9% (CV 0.60). A offers less risk per unit of return.

  • Risk attitudes: risk-averse, risk-neutral, risk-seeking — most investors are risk-averse.
  • Diversification: combining assets with low correlation reduces total risk (portfolio theory).
3

Topic 3

Ethical and governance issues

  • Corporate governance: the system by which companies are directed and controlled (Cadbury Report, 1992).
  • Indian framework: Companies Act 2013 (independent directors, audit committee, CSR, related-party rules), SEBI (LODR) Regulations, 2015, Kotak Committee (2017) recommendations.
ClassificationEthical issues in financial management
Ethical issues

  • Earnings management

    Window-dressing results

  • Insider trading

    Trading on unpublished price-sensitive information

  • Related-party transactions

    Diverting value to promoters

  • Excessive executive pay

    Not linked to performance

  • Misleading disclosures

    Hiding risks or debts

  • Treatment of stakeholders

    Employees, creditors, environment

Example

The Satyam scandal (2009) — inflated cash and profits — led to stronger audit, board and disclosure rules in India.

4

Topic 4

Agency relationships

An agency relationship exists when principals (shareholders) appoint agents (managers) to act for them.

ClassificationAgency relationships and conflicts
Agency problems

  • Shareholders vs managers

    Empire-building, perks, short-termism, risk avoidance

  • Shareholders vs debt holders

    Risky projects, excessive dividends, asset substitution

  • Majority vs minority shareholders

    Promoter-controlled firms in India

  • Company vs society

    Externalities, pollution

  • Agency costs: monitoring costs (audits, boards), bonding costs (manager's commitments), residual loss.
  • Solutions: performance-linked pay, ESOPs, independent directors, audit committees, debt covenants, market for corporate control (takeover threat), shareholder activism, stewardship codes.
5

Topic 5

Transaction cost theory and integrated reporting

Transaction cost theory (Coase, Williamson)

  • Firms exist because organising activities internally can be cheaper than using the market when transaction costs (search, negotiation, contracting, monitoring, enforcement) are high.
  • Factors raising transaction costs: asset specificity, uncertainty, frequency, bounded rationality and opportunism.
  • Implications: make-or-buy, vertical integration, outsourcing decisions, and governance structures.

Integrated reporting (IR)

Integrated reporting (International Integrated Reporting Council, framework 2013) is a concise communication about how an organisation's strategy, governance, performance and prospects lead to value creation over the short, medium and long term.

ClassificationSix capitals in integrated reporting
Capitals

  • Financial

  • Manufactured

  • Intellectual

  • Human

  • Social and relationship

  • Natural

  • In India, SEBI encouraged voluntary IR for top 500 listed companies (2017); the Business Responsibility and Sustainability Report (BRSR) is mandatory for the top 1,000 listed companies.

Exam tip

Link IR to agency theory — better disclosure reduces information asymmetry between managers and shareholders.

Key terms

Business risk
Variability in operating profit due to the nature of the business
Systematic risk
Market-wide risk that cannot be diversified
Agency cost
Cost arising from conflicts between principals and agents
Transaction cost
Cost of using the market — search, contracting, monitoring
Integrated reporting
Reporting on value creation using six capitals

Quick revision

  • Risks: operational, reputational, political, economic, regulatory, fiscal; business vs financial.
  • Systematic (beta) vs unsystematic (diversifiable).
  • Governance: Companies Act, SEBI LODR; ethics issues — insider trading, RPTs.
  • Agency conflicts and solutions — incentives, monitoring, covenants.
  • Transaction cost theory explains firm boundaries; IR uses six capitals; BRSR mandatory.

Important exam questions

Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).

Short-answer questions

  1. Q1.Distinguish business risk and financial risk.
  2. Q2.What is reputational risk?
  3. Q3.What is the coefficient of variation?
  4. Q4.What is an agency cost?
  5. Q5.State the main idea of transaction cost theory.
  6. Q6.Name the six capitals of integrated reporting.

Long-answer questions

  1. Q1.Identify and explain the various business and financial risks faced by a company.
  2. Q2.Explain the risk–return trade-off with an illustration.
  3. Q3.Discuss agency relationships, agency costs and governance mechanisms.
  4. Q4.Explain transaction cost theory and integrated reporting.

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