Overall Industry Context

The objective of the given report is to highlight the underlying risk and return with regards to Fly Safely Limited along with highlighting the innate relationship between the two in the light of the Modern Portfolio Theory. Additionally, the role of the beta as a measure of risk also needs to be explored. Further, the risk profile of the company needs to be highlighted considering the relevant risk and return of a more established airline namely Always Reliable Limited. Lastly, the underlying relationship between risk and cost of debt also needs to be highlighted.

It is apparent that the company belongs to the airline industry which is typically a risky industry considering the fact that it is highly competitive owing to the pressure from both domestic as well as foreign airlines. Also, the performance of the airlines is highly dependent on the underlying price of crude as fuel forms a significant portion of the operating expenses (Arnold, 2015). The overall risk associated from the industry can also be gauged from the fact the cost of debt for Always Reliable Limited which has a consistent track record of providing investors returns is 7.5% while the risk free rate is only 2.1%. A significant portion of this 540 bps risk premium is associated with the underlying industry which the lenders tend to consider as risky. Further, the standard deviation of returns for Fly Safely Limited also demonstrate the same since it amounts to 4.52% p.a. which is quite high considering that average returns for the company stands at 5% p.a. (Damodaran, 2015).

Risk & Return Theoretical Framework

In accordance with MPT, there is an innate relationship between risk & returns. The central tenet which forms the basis of this relationship is the fact that investors are risk averse and hence tend to prefer investments or financial assets with lower risk.  As a result, to get the investors to invest in risky assets, incentive needs to be offered to them in the form of higher returns (Brealey, Myers and Allen, 2014). If these high risk assets are offered at lower returns, the investors would prefer other financial assets which would offer similar returns but at a lower risk. Therefore, higher risk  and higher returns tend to go hand in hand considering that higher return essentially is the result of willingness on the part of the investor to take higher risk (Petty et. al., 2015).

With regards to investing in financial markets, there are essentially two types of risks namely systematic risk and unsystematic risk. The unsystematic risk is the risk which is associated with investment in particular company industry and can be mitigated by forming a diversified portfolio. However, systematic risk is the risk which is associated with the market as a whole and thereby cannot be mitigated. The measure of this risk is known as beta which tends to highlight the underlying risk associated with a particular stock or investment (Parrino and Kidwell, 2014). Further, considering that beta of the market or benchmark index is taken as 1, hence the beta of the stock or underlying portfolio tends to highlight the respective risk of the investment in comparison with the underlying market and hence provide an estimate of the overall risk. It is imperative to highlight that beta tends to ignore the presence of any unsystematic risk and solely focuses on measuring systematic risk and is based on the Capital Asset Pricing Model (Northington, 2015).

Risk & Return – Fly Safely

On the basis of the given data, it is apparent that beta for Fly Safely Limited is 1.43. This is higher than the beta for the relevant market index (beta =1) and also a more established player in the airline industry i.e. Always Reliable Limited with a beta of 0.88. It is apparent that the systematic risk for Fly Safely Limited is 43% higher than the benchmark index while that of Always Reliable Limited is 12% lower than the index. The higher risk of Fly Safely is also demonstrated from the standard deviation of returns of Fly Safely Limited which stands at 4.3% p.a. in comparison to 1.7% p.a. for Always Reliable Limited. This discussion clearly highlights the higher risk associated with Fly Safely Limited (Lasher, 2017).

In wake of the higher risk associated with Fly Safely Limited, it would be expected that the returns for the investors should compensate for this higher risk. However, this is not the case as the average returns for investors is 5% p.a. which is significantly lower than 8% p.a. being offered by Always Reliable Limited on a consistent basis. Thus, it is apparent that Always Reliable Limited tends to provide higher returns and at a lower risk in comparison to Fly Safely Limited and hence Always Reliable Limited would be a preferred investment (Christensen et. al., 2013).

Relationship between risk and cost of debt

It is imperative to note that the starting point of cost of debt is the risk free rate which is given as 2.1% in the given case. After this, the appropriate risk premium is computed and applied on the basis of the industry to which the company belongs and also the company specific risks coupled with risk associated (Damodaran, 2015). In this regards, the cost of debt of Always Reliable Limited must be taken into consideration. For this airline, the cost of debt is 7.5% p.a. For Fly Safely Limited, it is apparent that the underlying risk is comparatively higher as apparent from the standard deviation and beta owing to which the lender would expect a higher return on debt so as to compensate the underlying higher credit default risk (Petty et. al., 2015).  Therefore, the cost of debt for Fly Safely Limited would be significantly higher than 7.5% p.a.

Conclusion

Based on the above discussion, it is apparent that MPT states that risk and returns are connected. Beta is the measure of systematic risk. For Fly Safely Limited, the risk is significantly higher than index and also Always Reliable Limited but the returns do not compensate for the risk. Also, the cost of debt for Fly Safely Limited would be higher in comparison to Always Reliable Limited owing to higher risk associated with the former.

References

Arnold, G 2015, Corporate Financial Management, Financial Times Management, Sydney

Brealey, RA, Myers, SC & Allen, F 2014, Principles of corporate finance, McGraw-Hill Inc., New York

Christensen, M, Drew, M, Blanchi, R  & Ross, S 2013, Fundamentals of Corporate Finance, McGraw Hill Inc., New York

Damodaran, A 2015, Applied corporate finance: A user’s manual, Wiley, John & Sons, . New York

Lasher, WR 2017, Practical Financial Management, South- Western College Publisher, London

Northington, S 2015, Finance, Ferguson, New York

Parrino, R & Kidwell, D 2014, Fundamentals of Corporate Finance, Wiley Publications, London

Petty, JW, Titman, S, Keown, A, Martin, JD, Martin, P, Burrow, M & Nguyen, H 2015, Financial Management, Principles and Applications, Pearson Education &French Forest Australia, Sydney