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The Capital Cost Of Risk

The Capital Cost Of Risk

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Published by ClassOf1.com
As risk is increased, the cost of capital can be expected to increase. An extensively used method of adjusting the cost of capital for risk is to use the capital asset pricing model (CAPM). The CAPM makes use of the prices that the market is setting for return-risk trade-offs rather than using subjective measures of attitudes toward risk.
As risk is increased, the cost of capital can be expected to increase. An extensively used method of adjusting the cost of capital for risk is to use the capital asset pricing model (CAPM). The CAPM makes use of the prices that the market is setting for return-risk trade-offs rather than using subjective measures of attitudes toward risk.

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Published by: ClassOf1.com on Jun 19, 2013
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06/19/2013

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Finance
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Sub: Finance Topic: Risk Analysis
*
The Capital Cost of Risk
As risk is increased, the cost of capital can be expected to increase. An extensively used method of adjusting the cost of capital for risk is to use the
capital asset pricing model
(CAPM). The CAPM makesuse of the prices that the market is setting for return-risk trade-offs rather than using subjectivemeasures of attitudes toward risk. To understand the CAPM and its limitations, it is necessary tounderstand the assumptions on which the model is based. It is a single-period model with noassumptions being made about the interaction of return and risk through time. It is assumed that theinvestor is only interested in the expected return and standard deviation (or variance) of the
investment portfolio’s
outcomes. This is a theoretical deficiency. For some probability distributions,this ignores other information that an investor might consider to be relevant. It is assumed that allinvestors must be persuaded to take more risk by the prospect of a higher expected return (they arerisk-averse).The actions of an investor
do not affect price. The investors are “price takers”.
Theinvestors can invest at the default-free rate, and generally we assume that they can borrow at thesame rate but this assumption is easily dropped. Investors can sell securities they do not own; that is,they can borrow securities to sell them. All investors think the same about the expected return andvariance of all securities (they have homogeneous expectations), and they are all perfectly diversified.The quantity of securities to be purchased is fixed and divisible (securities of any dollar amount can bepurchased). There are no transaction costs and taxes. Many of these assumptions could be dropped,and a model very much like the conventional CAPM would be derived. One important function servedby this set of assumptions is a simplification of the model so that we are not distracted byunnecessary complexity.The capital asset pricing model offers hope for accomplishing a systematic calculation of risk-adjusted
present value. The measure reflects the investor’s alterna
tive investment return-risk trade-off opportunities in the same way as the rate of interest on a government bond reflects investment
 
 
Sub: Finance Topic: Risk Analysis
*
opportunities when there is no default risk. One important limitation of the capital asset pricingmodel for corporate decision making should be kept in mind. The model assumes that the investorsare widely diversified, and, equally important, it assumes that the managers of the firm are willing tomake investment decisions with the objective of maximizing the well-being of this type of investor.This means that unsystematic risk (for which the investor is well diversified) may be ignored in theevaluation of investments. It is well known that objectives of firms and managers aremultidimensional and that there will be a reluctance to ignore risk because it does not affect the welldiversified investor. The so-
called “
unsystematic
” risk
is not something that is likely to be ignored by amanagement that includes among its objectives the continuity of existence of the firm.

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