# Risk And Return Essay

1026 words - 5 pages

Determining the cost of equity and rate of return is an important financial principle. Company shareholders are able to make intelligent decisions when the information is readily available. This paper will describe three specific theories and models that yield the cost of equity. After providing a clear description of all three, I will focus on one particular model, the Capital Asset Pricing Model (CAPM), which is a simplistic approach to cost of equity. Then lastly, the CAPM will be applied to a few companies and discussed.
Three Models
There are several tools available to estimate the rate of return. Three of these tools are capital asset pricing model, the dividend growth model, ...view middle of the document...

Each of these requires a separate beta. The beta of each factor is the sensitivity of the price of the security to that factor.” (Money Terms, 2011) The main focus with this theory is the factors. Unfortunately, because the factors are many and some ambiguous, it may be quite difficult to capture all of the required information. Therefore, this leaves room for inaccuracies which is risky in of itself. The formula used for this particular method is as follows: E(RIBM) = Rf + BIBM,1[R1 - Rf] + BIBM,2[R2- Rf] + BIBM,3[R3 – Rf]. As seen, with each factor, there is an associated beta.
The final method that can be used is the Dividend Discount Model (DDM). The DDM states that “today's price of a share of stock equals the present value of all expected future dividends. Assuming that earnings are expected to grow at a constant rate forever and dividends are a fixed fraction of earnings…” (Investopedia, N.D.) This model is unique in the sense that it can only be used for companies that have dividends which often times ends up being the larger more stable companies.
CAPM, the Method of Choice
After thorough research and evaluation, the method of choice is the CAPM. This method is one that can be used by investors regardless of the size of the company or type of investment. Conversely, both the DDM and arbitrage pricing theory methods rely on certain factors and situations of when they could be used. As mentioned previously, the DDM is restricted to companies that have dividends and tend to be stable. Additionally, it does not truly take into consideration the associated risks. The arbitrage pricing theory, on the other hand, is based on the inclusion of multiple factors such as non-company factors. This theory accounts for consumer spending if applicable to a specific company. This factor can be ambiguous. For this reason, yielding an accurate value is quite difficult. If one portion is missing, the end result will be skewed. Lastly, the...

## Other Essays Like Risk and Return

### The Sharpe Ratio and the Information Ratio

687 words - 3 pages The Sharpe Ratio and the Information Ratio Sharpe Ratio and Information Ratio used to determine the risk-adjusted return of an investment portfolio. Sharpe Ratio The Sharpe Ratio introduced a method of assessing manager performance relative to risk taken. Sharpe Ratio centres on the use of a RFR, this places all mangers on a level playing field regardless of style. (Expected Portfolio Return – RFR) / Portfolio Standard Deviation

### Case 2: Financial Management Essay

1238 words - 5 pages loss. Since T-bonds are issued by federal government, considering the risk of the bond is much lower over a short period of time compared to a long period. “the longer the term, the more sensitive to fluctuation of interest rates.” Therefore, the return on a 1-year T-bond is more likely to be risk free and are guaranteed by the US government. 2) | Calculation | Expected Return | 1-Year T-bond | (0.1*8%)+(0.2*8%)+(0.4*8%)+(0.2*8%)+(0.1*8

### Diversification in Stock Portfolios

559 words - 3 pages Diversification in Stock Portfolios Assignment # 3 Presented To Dr. James Glenn May 15, 2011 Financial Management- FIN 534-5016 Strayer University Introduction The expected return on stocks is established as the computation for the return of a security based on the average pay off expected where as the volatility of stocks is the standard deviation of a return. The relationship between risk and return is examined by historical

### Explain What Risk Manegement Means and How Risk Should Be Determined by Calculating Likelihood of Risk and Potential Impact

826 words - 4 pages or undesirable risks events from occuring, and its secondary function is to minimise the impact of any risk events that do occur. The purpose of contingency planning is to produce a documented and well rehearsed procedure that will enable an organisation to quickly return to its normal operational status after an incident has occured. A risk management strategy provides a way to manage the risks that you are facing, It will either prevent

### Financial Analysis

656 words - 3 pages municipal bond, one could conclude that the business is under-performing for the risk taken by having all assets tied up in an non-liquid privately held business – its own. If few would accept such a low rate of return in general, particularly considering the risk of investing in a privately held business, why would someone do it in their own business? It all comes down to leverage and how it’s used. Leverage is the use of debt to, hopefully, increase

588 words - 3 pages they can loan it out to other people of companies, but if they take on to many risk and lose money they will have to close. 11. Which of the investments in the following table would be most attractive to a risk-averse investor? How would you answer differ if the investor was described as risk-neutral? A risk-averse would always prefer an investment with a certain return to an investment with the same expected return but any amount of

### Strategic Capital Management,

1257 words - 6 pages return of stocks. Compare to new and old strategy, Ms Wolfe clearly moved her risk position from neutral risk investor to risk taker investor. This change mainly depended on she though the market of these stocks would be a good performance. In this case, Ms. Wolfe chooses a different way that investing funds into small and unstable stocks in company’s portfolio to avoid risk of market. So she is a contrarian investor. III. Background of

### A Snapshot on Marginal Risk Contributions

2477 words - 10 pages provides directly the marginal risk contributions, considering that we can add or remove any facility from the portfolio. Marginal Risk Contributions & Pricing The goal of risk-based pricing is to ensure a minimum target return on capital, in line with shareholders’ requirements. A hurdle rate serves as a benchmark for risk-based pricing and for calculating creation or destruction of value with ‘Shareholders Value Added’ (SVA). It is the

### Enterprise Risk Management in the 21st Century

630 words - 3 pages strike an optimal balance between growth and return goals and related risks, and efficiently and effectively deploys resources in pursuit of the entity’s objectives. The purpose of risk management is to identify potential pitfalls or problems before they happen so that risk-handling actions may be put into place and enforced accordingly on the course of the product or project to prevent adverse outcome and minimize its effects on the enterprise. Risk

### Understanding Concepts Return Stock, Risks, Portfolio, Beta, Wacc

559 words - 3 pages return as well too and can not be accurately calculated only to a point that the risk could be mayor then the systematically. UNDERSTANDING CONCEPTS STOCKS RISK 4 Question 3 Explain why the total risk of a portfolio is not simply equal to the weighted average of the risks of securities in the portfolio. On this I will explain with an example you

### Financial risk management 2

561 words - 3 pages be particularly risky in terms of finance. Financial risk management is therefore particularly pertinent for megaprojects and special methods have been developed for such risk management.[4] [5]  See also * Market risk * Corporate governance * Liquidity risk * Megaprojects and risk * Risk adjusted return on capital * Risk modeling * Risk pool  References * Crockford, Neil (1986). An Introduction to

## Related Papers

### Bond Math Essay

696 words - 3 pages return on the Copiers, Inc. Bond when it was issued. Rating | AAA |   | AA |   | A |   | BBB | Beta | 0.19 | | 0.20 | | 0.21 | | 0.22 | Source: Fama, Gene and Ken French, 1993, "Common Risk Factors in the Returns on Bonds and Stocks", on Bonds and Stocks, “Journal of Financial Economics, 33, 3-56, Table 4 | Expected Return Rate = (Risk Free Return) + (Beta) * (Expected Market Return – Risk Free Return) Risk Free Return: Treasury

### Cost Of Capital Essay

1828 words - 8 pages -specific discount rate, and will review the theory, and the advantages and disadvantages of the CAPM. Whenever an investment is made, for example in the shares of a company listed on a stock market, there is a risk that the actual return on the investment will be different from the expected return. Investors take the risk of an investment into account when deciding on the return they wish to receive for making the investment. The CAPM is a method

### Portfolio Construction Essay

1409 words - 6 pages Constructing an efficient portfolio with a desired combination of the selected securities: Efficient portfolio gives the highest return in a minimum level of risk. The objective of constructing a efficient portfolio is to theta maximization and minimize the risk. The efficient set is determined by finding that portfolio with the greatest ratio of excess return (expected return minus risk free rate) to standard deviation that satisfies the

### Sharp Ratio Essay

541 words - 3 pages Soundsleep Assignment 2 Subject: Sound sheep funds ranking Per your request, I have compared the five funds based on the sharpe ratio, and Jensen alpha calculations. I also compared the result to the earlier analysis done based on average return, standard deviation and beta. Sharpe ratio, measures investment performance of the portfolio compared to risk taken. It’s most appropriate to use when evaluating diversified portfolios