Risk - Return and Equity Security Assessment

Question: Discuss about theRisk, Return and Equity Security Assessment. Answer: Introduction In the finance terms diversification implies allocation of the capital in such a way that reduces the overall risk. The investors desire to earn returns as high as possible while keeping the risk at the lowest level (Elton et al., 2009). However, the risk and return run in parallel, which implies that if the return increases the risk will also increase and vise a versa. Thus, it becomes pertinent for the investors to achieve optimization so that the risk and return could be kept balanced. One of the important tools to optimize the risk and return is the formulation of an investment portfolio. The investment portfolio comprises of various types of investment which differs in the risk and return profile from each other. This is where the concept of diversification comes into play (Elton et al., 2009). The diversification would lead to investment in different avenues such as shares, bonds, fixed deposit, derivatives, and others. Polling these different investments together is called formulation of portfolio (Reilly Brown, 2011). Since, the investments in a portfolio bear different risk and return profile, therefore, the loss on one gets set off by profit on another. In this way, the risk of the investor of losing money is reduced to a great extent by diversifying. Thus, the diversification helps the investors in reducing the risk and optimizing the returns on their investments (Reilly Brown, 2011). Although, diversification helps in reducing the risk on the investment but it does not work to completely eliminating the risk. There are two types of risk such as systematic and unsystematic (Reilly Brown, 2011). Through diversification the investor could reduce only the unsystematic risk, which means that systematic risk still persists. Therefore, in the circumstances where the systematic risk is very high, the diversification will not work to reduce the risk. Hence, the investors would not want to diversify in the extreme situations when the systematic risk is too high. Further, it is also to be noted that though diversification reduces the risk, but it also reduces the return. Thus, in the circumstances when the investor is sure that investment in a particular security or alternative will provide expected return, the diversification will be beneficial because it will reduce the return (Reilly Brown, 2011). Problem-2 The capital asset pricing model (CAPM) provides for the computation of the expected return taking in to account the systematic risk. This model is based on the four key variables such as risk free rate, market return, and systematic risk (Levy, 2011). The systematic risk is the risk which can not be reduced by diversifying the investments. It is represented by beta. The beta is computed with reference to the return on a particular security and the returns on the overall market over a definite period. Thus, effectively beta depicts the relationship between the return of the security and the overall market. Further, the risk free rate is taken based on the yield on the government bonds, which bear no risk (Levy, 2011). In computing the return by the CAPM model, the risk premium that is the excess of market return over the risk free rate is multiplied by the beta and then the resultant figure is added to the risk free rate (Baker Martin, 2011). It can be observed that the CAPM does not take in to account the diversifiable risk because it can be reduced by diversifying the investment portfolio. Thus, effectively only systematic risk should be incorporated in computation of expected and exactly is done in the CAPM model. Thus, it could be asserted that the CAPM model provides a fair estimation of the expected return. The expected return arrived by applying the CAPM model is used in analyzing the stocks for investment (Baker Martin, 2011). The return on a particular stock could be compared with the CAPM return to assess the worth that stock from investment view point. Further, the CAPM model is also used in evaluating the financial viability of a project. The use of CAPM model in evaluation of the financial viability of a project is made in computation of the cost of equity. The cost of equity is used to compute the weighted average cost of capital, which is applied for the purpose of discounting the future cash flows and computation of the net present value of the project (Baker Martin, 2011). Problem-3: Capital Asset Pricing Model Rf Risk Free Rate 3.00% Rm Market Return 8.00% B Beta 1.05 CAPM CAPM [(Rf+beta*(Rm-Rf)] 8.25% Problem-4: Matrix Showing CAPM Assumption-1 Assumption-2 Assumption-3 Rf Risk Free Rate 1.00% 3.00% 6.50% Rm Market Return 8.00% 8.00% 8.00% B Beta 0.75 1.05 1.75 CAPM CAPM [(Rf+beta*(Rm-Rf)] 6.25% 8.25% 9.13% Problem-5: Stock Valuation Model Step-1: Cost of Equity (Ke) Rf Risk Free Rate 6.00% Rm Market Return 12.00% B Beta 1.10 Ke [(Rf+beta*(Rm-Rf)] 12.60% Step-2: Valuation Model a Current Dividend $1.75 b Growth Rate 6.00% c Expected Dividend [a*(1+b)] $1.86 d Ke 12.60% e Stock Price [c/d-b] $28.11 Problem-6: Valuation Matrix Growth Rate 2.00% 6.00% 9.00% Beta 0.75 1.1 1.8 Changed Ke 10.50% 12.60% 16.80% Changed Stock Price $21.00 $28.11 $24.46 In the statement presented above, the stock price has been calculated by changing the assumptions in regard to growth rate and beta. In computation of the stock price by applying the dividend model, the growth rate affects the amount of expected dividend and beta affects the CAPM return (Ke). The cost of equity, dividend, and the growth rate are the three main variables based on which the stocks price is computed. Thus, change in any of these variables would affect the price of the stock (CFA Institute, 2016). The above statement presents price of the stock in three scenarios. In the first scenario, the assumptions are made to analyze the impact of decrease in the growth rate and the beta on stocks price. In the second scenario, the growth rate and beta is assumed to be the same as was expected. In the third scenario, the growth rate and the beta is assumed to be increasing from the baseline expectations. From the finance view point, the analysis of the situation by framing different scenarios is considered good because it provides the analysts all the possible outcomes (CFA Institute, 2016). References Baker, H.K. Martin, G.S. (2011). Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. John Wiley Sons. CFA Institute. (2016). CFA Program Curriculum 2017 Level II, Volumes 1-6. John Wiley Sons. Elton, E.J., Gruber, M.J., Brown, S.J., Goetzmann, W.N. (2009). Modern Portfolio Theory and Investment Analysis. John Wiley Sons. Levy, M. (2011). The Capital Asset Pricing Model in the 21st Century: Analytical, Empirical, and Behavioral Perspectives. Cambridge University Press. Reilly, F.K. Brown, K.C. (2011). Investment Analysis and Portfolio Management. Cengage Learning.