INVESTMENT RISK

AND
FINANCIAL PERFORMANCE
OF CAR INDUSTRY
(TOYOTA, HONDA, FORD)

MUHAMMAD YASIR YAQOOB

GULSHAN MEHBOOB
TANZEELA ASHRAF
A COMPARASION OF INVESTMENT RISK IN CAR INDUSTRY

Abstract:
The purpose of this research is to analyze the empirical risks involved in investment of
car industry due the uncertainty during the last 5years and its impact on their financial
performance. For this analysis, data is collected from websites of three car manufacturers
(Toyota, Honda, and Ford) and their 5years performances are statistically analyzed. For
calculations of risk (i.e. systematic risk) we use Beta from Capital Assets Pricing Model
(CAPM). After applying the statistical tools it is observed that investment patterns have
declined due to some factors of risks effecting. When these factors are known to industry,
they can take precautionary measures to avoid them to increase their performance and
investors must consider these factors before investing.
Key Words: investment risk, CAPM, analysis, investment patterns.

Introduction: The investment patterns have decreased in automobile market due to

increase in oil prices (Moon, 2005) and risk involved in political and financial/economic
instability also changes the investment patterns (Feils, Dorothee & Şabac., 2000). These
higher financial risks made the investors reluctant in investing their funds (Muradagola,
Bakkeb & Kvernes, 2005) as especially in technology-based firms (like car Industry)
higher uncertainty is involved so they have higher risks (Masion & Harrisson, 2004), so
we can say that every investment involves risk but some factors make it higher or lower.
For this reason three world’s very well known car manufacturers (Toyota, Honda and
Ford) are taken and analyzed from their last 5 years data to investigate the effect of these
factors on investment risk and its effect on this huge industry and how it will effect
investment decisions.
Risk-less investments are always backed by some sort of guarantee and it is the
confidence of stable government (Wang, 2009). In contrast, the Risky investment have no
back of guarantee, although it has a huge level of risk in it, but it has a high return
(Gallagher, 2003). Wise investors invest their money/capital in some business/company
after proper risk analysis based on some statistical tools. Investing capital is a kind of
trade off between the firm’s gains and losses (Okuyama & Francis, 2007), so with every
risk a firm/investor gains or looses.

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A COMPARASION OF INVESTMENT RISK IN CAR INDUSTRY

Investor’s intention to invest is based on their future cash flow and its expected rate of
return with respect to the risk involved (Sankey, 2009) and future performance is only
analyzed by a company’s past performances (Sankey, 2009). Investors first analyze all
their alternatives and then decide whether to invest or not in some particular firm
(Tziralisa, Kirytopoulosb, Rentizelasa & Tatsiopoulosa, 2009). Investors who have the
forecasting abilities receive high return (Schuck, 1995) because they calculate their risk
and then they invest. Some investors invests in companies who are committed to their
social responsibilities even if they perform poorly (Michelson, Waikes, & Laan, 2004),
but major emphasis is given to high return. If every risk gives surplus return then every
financial system will be regular (Eisenberg & Noe, 2001).
Knowing future perfectly could make investment decision very simple resulting in high
returns but the element of uncertainty about future returns increases the risk in investment
(Forbes, 2009). So, investment decisions are made on the basis of future outcomes and it
also increases risk. For the calculation of risk we use some formulas and graphs through
which the companies and investors calculate risk factor, (Burchett & Tummala, 1997),
(Korna & Zeytun, 2008) and these statistical analyses gives the original face of the
company and also calculates the risk encountering.
The reason for selecting this topic is the emerging issues of economic and political
instability prevailing nowadays and its major effects on industrial sector all over the
world and especially in Pakistan. The car industry is affected so much by the external
factors and so we being a student of finance have selected this industry to analyze it by
applying and testing the financial models.
This analysis will help the car industry to evaluate their performances and also will point
out the indicators which are effecting on their annual outcomes. It will also help the
investors to evaluate their investment outcome in car industry and to make investment
decisions easy and decomposes the systematic risk in investment and so tracks the firm’s
performance (Kee, Zhenyuxu & Yap, 2004). As being a developing country, the foremost
industry firms and government can better handle the complications in investment (Jan &
Hsiao, 2004) and take effective measures.

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A COMPARASION OF INVESTMENT RISK IN CAR INDUSTRY

Literature Review:
Investment Risk: The inherent part of business is risk (Tchankova, 2002) and “Risk”
technically has a core conception in the financial decision making (Weber, 2005). In
other sense the Risk is a force to decrease financial mismatches in costs and profit
inconsistency (Mieghem, (2007) and investment is the active redirection of
resources/assets to create benefits in the future. The use of resources/assets to earn
income or profit in the future and uncertainty about future restricts investment (Leroy,
2004) and this uncertainty about future can increase or decrease the expected rate of
investment in a firm (Stefanou, 1987). All future investment decisions were evaluated on
an economic decision analysis basis utilizing this range of risk tolerance (Walls, 2005).
Investment comes with the risk of the loss and risk is the probability that an investment's
actual return will be different than expected i.e. degree of uncertainty (Keeney, 1979) and
therefore investors fear more about unpredictable risks than predictable risks (Autumn,
1990). An investor while investing chooses between two types of investment i.e. risk-less
with fixed rate of return (e.g. Bond) and other is risky with mean rate of return
(Fitzpatrick & Fleming, 1991). Public sector investment is also effected by private
investor’s investment (Grant & Quiggin, 2001), so to attract international and domestic
investors to finance in car industry specific to Pakistan’s volatile business environment is
quite difficult (Karibskii, Shishorin, & Yurchenko, 2002).
Investment is also effected by the risks which can be identified from
entrepreneurs/borrower’s perspective (hope of earning) and lender’s perspective (chances
of loosing) (Nakamurm, 2002) thus every investor while investing his or their
money/capital calculates the results (i.e. return) from it. Investment risk is reduced when
there is low ratio between debt and equity (Muradagola, Bakkeb and Kvernes, 2005).
It is also acknowledged that investors who are more risk averse take high risky decisions
than less risky investors (Dacharaoui, Dionne, Eeckhoudt & Godfroid, 2004) and new
firms are dependant upon investors decisions while offering their shares to public (Higins
& Gulati, 2006) so firms manage their risk for these cash-flows and to get investment
(Hankins,2009)

Systematic Risk: Systematic Risk which is also known as market risk have the factors
that can affect the overall economy or securities market. Systematic Risk can be related
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A COMPARASION OF INVESTMENT RISK IN CAR INDUSTRY

by the capital budgeting system (Boquist & Moore, 1983). The systematic risk can be
minimized or overcome by the investment portfolio or is transferable to insurance and
reinsurance companies (Hartwig & Wilkinson, 2005) and in results the investors/firms
can maximize their profitability (Maslov, 2006), (Dempsey, 2002).

Systematic risk is unavoidable or cannot be diversified. (Dahl, Mikkel, Melchior, Martin

& Thomas, 2008) but infact it is controllable or transferable (Hartwig & Wilkinson,
2005). Systematic risk shows high degree of uncertainty in manufacturing concerns than
in non-manufacturing concerns (Kee, Zhenyuxu & Yap, 2004), so that’s why car industry
is highly affected by this. Financial Managers must take some effective measures to apply
the right methodologies to understand the systematic risk (Boquist & Moore, 1983) and
to avoid this risk as much as he can. Investment in developing countries like Pakistan is
more risky due to political instability (i.e.systematic risk) (Philipp Harms, 2001).

Un-systematic Risk: Un-systematic Risk as compare to systematic risk affects only on a

single company or industry and is diversifiable by expanding your portfolio. (Dahl,
Mikkel, Melchior, Martin & Thomas (2008) so, if the level of unsystematic risk increases
it will limit the investment (Tomotsu, 2002). Higher unsystematic risk dispirits economic
growth, because in that scenario the investors have less trust of maximum return (Ángel,
Martín, Sotos & Picazo, 2007) and so he will invest less. Both of these risk constraints
shows intensity of risk while making investment decision (Bosman & Winden, 2008) and
also shows that in this risky business environment what type of investment may or may
not increase companies’ investment portfolio. When investments are needed then it is
necessary to control these risks (Nooteboom, Jong, Vossen, Helper & Sako, 2000). Every
firm can earn in future if both parties (i.e. investor and firm) will share every kind of the
possible risk involved. (Allen & Gale, 1999)

H-1: There is a positive relationship between Investment Risk and Rate of Return i.e. if
investment risk will increase then the rate of return will also increase.

H-2: There is negative relationship between Investment Risk and Financial Performance
i.e. if investment risk will increase then the financial performance will decrease.

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A COMPARASION OF INVESTMENT RISK IN CAR INDUSTRY

Dependant Variable:
Financial Performance is measuring the results of a firm's policies and operations in
monetary terms. These results are reflected in the firm's return on investment, return on
assets, value added, etc” and so the financial performance and growth of a firm is
dependant on its operating environment (Roper, 1999). Profitability is the net return
available for use, and this variable is very much important for funds flow (Evan, 1967)
and there exists a deep relationship between investment and returns with respect to the
firm’s profitability (Xu, 2009). Firm financial performance and profitability can also be
measured by the managerial ownership, (Lopes-Iturriaga & Rodriguez-Sanz,
2001). Organizations first forecasts the profits of the business and then maximum
acceptable risk on investment is set to announce the rate of return (Farragher, Edward.,
Kleiman, Robert & Anandi , 1999) up to twentieth century firms usually don’t disclose
their real profitability but now this trend has been changed and firms disclose these
information to attract investors (Hawkins, 1963). The investment in firms has a sensitive
effect of their cash flows and ambiguity effects investment (Boyle & Guthrie, 2003). It is
observed that if a company’s performance is low in market then investment may be risky
(Lin, 2008) (Chua & Koh, 2007) and the uncertainty about profitability switches due to
technology advancement as keeping the drift constant (Alvarez & Stenbacka 2001). The
uncertainty about income of a firm has a negative impact on the future investments of this
firm (Lee, 2008). Business and investors can do best while they are performing good, to
improve financial performance and to increase profitability (Spiller, 2000). It is seen that
the increased rate of competitors in auto market has improved their performance (Chung,
Mitchell & Yeung, 2003).
By understanding the vagueness effects of advance forecast about investment behaviors
resultant from financial or economic models, it is believed that an investor can reduce the
investment uncertainty and can improve its financial performance. (Budescu, 2005).
Firms usually use financial systems to convey their investors about their financial
performances (Ozbilgin, 2005). According to the previous researchers finding there exists
a negative relationship between the investment risk and the financial
performance/profitability of the car industry. As the financial performance is good then

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A COMPARASION OF INVESTMENT RISK IN CAR INDUSTRY

the investment will be less risky and vise versa. Banks usually give the past performance
data of the organizations to the investors before investment (Weber, Siebenmorgen &
Weber, 2005).

Return on Investment: Return on investment is that “Do you get what you pay for?”
(Balachandran, 2006) and it is the ratio of money gained or lost (whether realized or
unrealized) on an investment relative to the amount of money invested or it is the
probability of the profit earned on the amount invested. Investment decision is made on
the relative outcome of the investment’s net present value (NPV) (Boyle & Guthrie,
2003). Therefore, the decision making becomes easy for an investor if he is aware of the
rate of return of his investment (Li & Wu, 2009) and if a firm wants to increase the return
on investment it must increases its turnover of capital (Komonen, Kortelainen &
Räikkonen, 2006). In calculating the required rate of return the deliberate aim was to
keep the calculations quiet easy and also the same method for all investment substitutes,
so that the results can be justifiable (Lounnsedt & Svesson, 2000) but there a tradeoff
does not exist between and investor values and his desired rate of return (Michelson,
Waikes & Laan, 2004). Investors usually prefer their investment with high return but
lower risk (Brockett & Kahane, 1992). While assessing the risk profile of an investment
portfolio, the rational investor is unconcerned to the investment time prospects (Dempsey
2002). Risk premium is linked by the risky ness of the investments raise gross measures
of the returns (Shi & Gurbaxani, (2007). In the periods of high-market instability, risk-
sharing profits of a restricted liability agreement possibly are above the incentive effects
of a linear contract with infinite risk (Raghu, Sen, & Rao, 2003). Individuals are more
risk tolerant when the investment tenure is long, (Jaggia & Thosar, 2000).

Capital Asset Pricing Model (CAPM) is used to determine a theoretically appropriate

required rate of return of an asset or investment. Beta used in the Capital Asset Pricing
Model (CAPM) is the coefficient of Systematic Risk and it is known as the best risk
measuring tool available and it is not stable overtime (Levy, 1997). Rate of return is
calculated on the basis of investment horizon and Beta depends on that horizon (Tang &
Lee, 1997). According to this model investors cannot diversify market risk but they can
diversify the firms risk (Fairchild, 2002). Investors before investing interpret the
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A COMPARASION OF INVESTMENT RISK IN CAR INDUSTRY

performance of a company with the help of this beta for considerations (Hodges, Taylor
& Yoder, 2003) and if the beta is positive, the risk of the company will increase thus
resulting in high return and vice versa (Lin, 2008). Capital Asset Pricing Model is the
model used here to calculate the company’s performance and to study the relationship
between risks and return (Levy, 1997) as in the investment literature, the maximum rate
of investment is uncertain (Nakamura, 2002). Theories and systematic tools are helpful to
clarify the complexity of different investment patterns (Moon, 2005).

Calculation of risk from CAPM is done through the formula CAPM= Rf + (Rm- Rf) β

As systematic risk varies between companies, investor will require a higher return from
shares in those companies where the systematic risk is greater. Investment decisions are
negatively sway by the interest rate uncertainty (Calcagnini & Iacobucci, 1996).

Theoretical Framework:

Figure 1.
Growth
(Financial
Performance)

Investment Risk

Return on
+ Investment

Research Methodology:
The 5 years data of these three companies for this research is taken from websites
www.finance.aol.com, www.sogotrade.com , www.Thestreet.com , www.Ockham.com ,
www.Reuters.com and the risk rates are taken from the website of state bank of Pakistan.

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A COMPARASION OF INVESTMENT RISK IN CAR INDUSTRY

From this data the Net Income for the year is taken (Table 1) and then analyzed (Graph 1)

Table 1.

PROFITABILITY DURING LAST 5 YEARS

Years 2005 2006 2007 2008 2009

Toyota 10.94 B 12.08 B 14.11 B 15.19 B -4.36 B
Honda 4.54 B 5.25 B 5.08 B 5.30 B 1.37 B
Ford 3.63 B 1.86 B 12.61 B -2.76 B -14.68 B

* The amounts are shown in billions

Below is the graph which shows the profitability in a linear form.

Graph 1.

Profitability

20000000000
15000000000
10000000000
5000000000 Toyota
Profits

0 Honda
-5000000000 2005 2006 2007 2008 2009 Ford
-10000000000
-15000000000
-20000000000
Years

Rf (Risk free rate) and Rm (Market risk rate) is taken on estimations from the last 5 years
situation in the manufacturing industries (i.e. auto industries) in Pakistan from the
website www.finance.gov.pk/admin/images/survey.
Beta is taken on an assumption that if the profitability increases its beta increases and
vice versa. This assumption is based on the logic that when the profitability increases,

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 A COMPARASION OF INVESTMENT RISK IN CAR INDUSTRY

investors invest more and so the price value of the company in the stock also increases
which results in the increase in beta and vice versa. The profitability is taken from the
Table 1 with the base year 2009 and then ratios are taken to calculate beta.
Table 2.

Years 2005 2006 2007 2008 2009

Factors T H F T H F T H F T H F T H F

Risk Free Rate ( Rf ) 7% 7% 7% 7% 7% 7% 8.5% 8.5% 8.5% 9.5% 9.5% 9.5% 10% 10% 10%

Market Risk ( Rm ) 8.5% 8.5% 8.5% 9% 9% 9% 9% 9% 9% 11% 11% 11% 13% 13% 13%
-
Beta (β) -1.63 2.15 -0.16 1.80 2.49 -0.08 -2.10 2.41 -0.56 -2.26 2.51 0.12 0.65 0.71 2.77

CAPM 0.04 0.10 0.06 0.03 0.12 0.06 0.07 0.09 0.08 0.04 0.14 0.09 0.11 0.121 0.183

The graph below shows the effect of beta on the investment risk of these companies
Graph 2.

0.200
0.180
0.160
0.140
0.120 Toyota
CAPM

0.100 Honda
0.080 Ford
0.060
0.040
0.020
0.000
2005 2006 2007 2008 2009
Years

Discussion:
In this research paper we have studied the impact of investment risk on the financial
performance and the return on investment of the auto industry (Toyota, Honda & Ford).
After typical analysis, the result shows that the financial performance of a company is
highly affected by the investment risk. Table No. 2 and Graph No. 2 shows that if the
company have more risky stock its beta is high and being a rational investor the investor

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A COMPARASION OF INVESTMENT RISK IN CAR INDUSTRY

do not want to invest money in that company with the fear of risk to loose his/her money
capital, so in this case the company’s financial performance goes down, due to lack of
financials recourses.
The above Table No: 2 and Graph No. 2 shows that from 2005 to 2009 the Company
Ford has more variances in its stock and its financial performance is continuously
reducing. As the profitability of Ford Company is very much lower than other two
companies (i.e. Toyota and Honda) but when we see at its rate of return (i.e. CAPM) the
same company Ford is offering very high return on investment, so we can say that if
profitability is low the company has to offer high return to attract the investors. Ford
Company as predicted by the data and its graph in last 5 years has offered high return so
to increase its investment because investors find it very difficult to invest in such
company whose profitability is going low only else if it is providing high return on their
investment. Finally in last two years the company goes to loss because there is less
investment in it. So these variances in its stocks are more risky for investment because in
year 2009 its beta comes to positive i.e. at 2.77 and shows the high risk in investment
which is greater than the Honda and Toyota’s beta, which in result increase the rate of
return (Graph No. 2 shows its continuously upward slop of curve). This high rate of
return will attract the investor to invest their money/capital in this company to earn more.
But the rational investor will not go to invest in this company although it’s giving more
return the reason is that the ford has more risk and instability in its stock and its financial
performance is also going down.
The Toyota Company’s data shows (Table No.1 & Graph No.1) the increasing trend in its
profitability from 2005 to 2008, but in the year 2009 it suffer loss due economic
conditions in Pakistan. In year 2009 (Graph No.1) its curve of profitability has negative
slope and also affects the beta of the company which also increase to 0.65 in year 2009 as
compare to last four years which deficits the increase in investment risk and increase in
the rate of return offered by the company.
The 3rd company i.e. Honda shows (Table No.1 & Graph No.1) positive increasing trend
in financial performance from year 2005 to 2008. Although its stock was more risky as
compare to Ford and Toyota, but it has more investment and also gives more return to
their investors (Table No.2 & Graph No.2) because both the graphs shows a consistency

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A COMPARASION OF INVESTMENT RISK IN CAR INDUSTRY

in its profitability and rate of return. Its profitability is stable i.e. they are earning in a
regular rate so they will offer a rate of return which they can pay to their investors
So as per above discussion and the scenario the risk in investment is highly affected by
the financial performance of a company and the risk is based on the return offered by the
company. From this research we can predict that Honda Motors is the right option for
investors to invest in the current situation. Hence it is proved that higher the risks will
results in higher rate of return (Graph No 2).
Also Pakistani investors are risk averse so they tend to invest in such kind of investments
which are more stable and more paying. As per our hypothesis there is a negative
relationship between the financial performance and investment risk of a company but at
the same time a positive relationship is developed between investment risk and return on
investment. It also shows that the independent variable Investment risk have strong
negative relationship with its dependent variable financial performance and strong
positive relationship with rate of return.
Implications:
The research can be used as a measure to improve the performance in an industry and
also it is very much useful to analyze a company’s performance and suggests investors
when and in which company to invest.
This study also identifies that the Honda Company is more stable in its financial
performance and return on investment patterns and the other auto companies can bench
mark their strategies to grow up in the industry. This study will guide the investors that
do not go for only the higher returns also completely analyze the company’s pervious
financial position, to save their money/capital.

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