FINANCIAL MANAGEMENT ACTIVITY - RISK AND RETURN

Answer the following questions:

1. Explain the difference between stand-alone risk and risk in a portfolio

context.
○ Stand-alone risk, as opposed to the risk associated with a well-diversified
portfolio, is the risk connected to a single operational unit, corporate division, or
asset. Stand-alone risks must be carefully examined since, as a limited asset, an
investor stands to either receive a huge return if its value improves or a
devastating loss if things don't work out as expected. A total beta calculation or
the coefficient of variation are used to determine its value (CV). Additionally,
Stand-alone risk plays a significant role in the capital budgeting chapters and the
evaluation of small company owners' physical assets. When we are talking about
risks in a portfolio context, from the word “portfolio” it has a compilation of every
asset, investment, bond, security, market funds, and cash. Every investment
carries its own risk and it has variation depending on which type of investment
the company bought. The main difference between the two is that stand-alone
risk focuses on a specific asset or investment whereas the risk in a portfolio
context takes all of the investments and assessment into consideration which can
impact any available assets.

2. Explain the relationship of risk and return.

○ For every investment, it is important to understand that it will always come with
a risk whether it’d be high or low return. Risk refers to the future uncertainty of
potential financial loss from the investment. While return is the money gained
from the investment over a period of time. It can easily be understood using an
example. For instance, NCT company invested in shares for a corporation and it
is a high risk, high return investment. During the year, the corporation earned
more sales than the past year and they would issue dividends 10% higher for this
year. Thus, he will gain profit from his investment but if the corporation did not
perform better than last year and the dividends are lower than this year, then the
 return would be a loss considering that he had high investments. The relationship
of risk and return would always be linear except for some scenarios where the
market is down or the corporation did not perform well.

3. Discuss ways of avoiding investment risk.

○ According to Ameriprise, there are 3 ways to reduce investment risk. Firstly, asset
allocation refers to the way you weigh the investments in your portfolio to achieve
a specific objective. In simple terms, it is the act of investing in different types of
assets such as stocks, bonds, alternative investments, and cash. If your goal is to
have financial growth, then you must decide to place a greater percentage on
assets in stocks and a lower percentage for bonds. Again, it is crucial for the
investor to be aware of the potential risks and returns for each assets class.
Secondly, portfolio diversification refers to the process of selecting a variety of
investments within each asset class, which can help investors who are trying to
minimize their investment risks. To illustrate, if Kier is an investor for ABC
corporation he would buy more stocks to increase his potential returns to the
company however, this is not a wise decision as the risk for the investment can
fluctuate widely in value with the price of one holding. However, if Kier invested
stocks in more than 10 companies across all of the industry then he can reduce
the risk of his investment by minimizing the potential substantial loss. If the
return of one investment is low, the return on another may be high which can
help offset loss of the prior investment. Finally, dollar-cost averaging is an
investment strategy that can help smooth out the effects of market fluctuations in
your portfolio investments. With this approach, typically you apply a specific
dollar amount of how many shares, bonds, or mutual funds you will buy on a
regular basis. For example you have $1,000 per month to invest in a specific
stock and you will invest the same every month which may help lower the average
cost than trying to reduce the risks by trying to time when the market will have
lower prices of the shares. It is a good strategy as it is systematic and the average
cost of your shares will be better than waiting for the down time and not investing
at all.
4. Define diversification. Explain how diversification helps in mitigating risk.
○ Diversification is the strategy in which you mix a wide variety of investments
among various financial instruments across a wide range of industries in a single
 portfolio; in an attempt to lower the risks. Examples of various asset classes or
financial instruments include stock market (shares of a company), real estate and
properties, commodities, bonds, exchange-traded funds, mutual funds, and cash.
Diversification is an investment strategy to mitigate the risks of market volatility
since not every asset will impact one another because they are different from
each. Diversification is synonymous with the phrase, “Do not put all of your eggs
in one basket.” In the financial industry, everything can fluctuate at any time
therefore, if you invested in different asset classes then you will have a chance to
offset the possible losses from a rising industry since, the financial industry has a
trend and pattern.

5. Determine the difference between diversifiable risk and market risk.

○ Diversifiable risk is also known as unsystematic risk and it refers to the firm-
specific risk that impacts the price of the individual security rather than the
whole portfolio. For instance, a corporation is expected to have lower sales for
this year because there has been a problem with the manufacturing; therefore,
the risk will ONLY affect the company and its investors and not the entire
industry. While market risk or also known as the systematic risk which refers to
the risk of losses on financial investments due to adverse price movements.
Systematic risk covers a broader range of markets and can even affect a whole
financial industry. Most of the common examples are natural disasters, inflation,
changes in interest rates or equity or commodities, war, recession, and even
terrorism. The main difference between the two is the scope of the risk: for
diversifiable risk it is specific to a company or a single asset while for market risk,
it affects the whole system which are most likely caused due to possible economic
problems.

6. Describe what the CAPM is and illustrate how it can be used to estimate a
stock’s required rate of return.
○ The capital asset pricing model (CAPM) is a mathematical model designed to
portray how financial markets price securities and calculate the expected return
on the investments. In the financial and investing industry, CAPM is regarded as
a crucial tool in understanding the market environment as it helps in measuring
the systematic and its impact on the asset. Additionally, it is also a tool in
 estimating the fair value of an asset and understanding the relationship between
risk and return. The CAPM has these assumptions: (1) All investors want to avoid
risk. (2) Investors have the same time period to evaluate information. (3) There is
unlimited capital to borrow at the risk-free rate of return (4) Investments can be
divided into unlimited pieces and sizes. (5) There are no taxes, inflation, or
transaction costs. (6) Risks and returns are linear to each other. However, all of
these assumptions are unrealistic and many criticize this model as it is not
realistic for a market environment. Nonetheless there are still financial analysts
and investors who believe that it could still predict the expected return and
conclude from that prediction. To illustrate how it is used, Stevenson wants to
calculate the expected rate of return for security for his work as a freelance
investment banker. The following are the data needed to calculate CAPM: the
risk-free rate is 4%, the expected return of the market is 12%, and the systematic
risk b of the security is 1.3. So what does this answer give us? If the expected
return they are looking for is equal to or less than 14.4%, then this is a good
option for them to invest in.

7. Expound on these statements:“The riskier the cash flow, the riskier the
asset.”
○ Cash flow is the change in the quantity of money that a company, organization, or
person has. The term is used in finance to refer to the quantity of cash (currency)
produced or spent during a specific period of time. Cash flows in and out of the
company thus, it is important to understand that if a person has a good cash flow
where there is more inflow than outflow then, they can manage their cash
properly. It is crucial to understand that whenever the company earns money
from the business it would then be used to capitalize for their expenses and the
excess could be used for investing. When a person is investing, they must
consider how much money should be allocated for the amount of the investment
and/or periodical payments for it, because if it comes a time where there is no
more inflow of the cash on the person then, it is more likely to be stopped or
defaulted because the person cannot provide financial support for the
asset/investment. Therefore, if the cash flow is risky, then the asset is also risky
because it is possible for a person or company to default for the investment and
 cash flow and the asset is directly proportional to each other.

8. Discuss how changes in the general stock and bonds markets could lead to
changes in the required rate of return on a firm’s stock.
○ Changes in the general stock and bond markets are only one of many factors that
might have an impact on the expected rate of return on a company's shares. The
minimum return that investors anticipate receiving from their investment in the
company's shares is represented by the expected rate of return, sometimes
referred to as the cost of equity. Firms employ it to figure out the proper discount
rate to apply when assessing possible investments and projects. The expected rate
of return on a company's shares may vary as the overall stock market undergoes
fluctuations, such as a bull or bear market. In a bull market, stock prices may rise
as a result of greater demand and high levels of investor confidence. Once
investors are willing to settle for a lesser return on their investment, the expected
rate of return on a company's shares may decrease as a result. In contrast, low
investor confidence and less demand during a bear market can result in falling
stock prices. In this scenario, the expected rate of return on a company's shares
may rise as investors demand a larger return to offset the elevated risk involved
with equity investing. The expected rate of return on a company's shares might
also change as a result of changes in the bond market. Bond yields rise as interest
rates rise, which may cause investors to switch their investments from stocks to
bonds, which are a comparatively safer alternative. When investors want a bigger
return to compensate for the greater risk involved with investing in stocks, this
might reduce demand for stocks and increase the expected rate of return on a
company's shares. Conversely, if bond yields decrease in response to falling
interest rates, investors may decide to switch their investments from bonds to
stocks, which may provide better returns. Due to investors' potential willingness
to accept a lower rate of return on their investment, this might raise the demand
for stocks and lower the needed rate of return on a company's shares.

9. Discuss how changes in a firm’s operations might lead to changes in

required rate of return on the firm’s stock.
○ The required rate of return, which is the minimal return on investment that an
investor anticipates to achieve in order to offset the degree of risk associated in
an investment, can be impacted by changes to a company's operations. The
market environment, the company's financial performance, and the degree of
investment risk are a few of the variables that affect the necessary rate of return.
A company's operations adjustments might have a number of effects on the
needed rate of return. The amount of risk associated with the investment may be
reduced, for instance, if the firm launches new goods or services, enters new
markets, or adopts a more effective sales strategy. The investor could be willing to
settle for a lesser return in exchange for a reduced degree of risk, which could
lead to a lower necessary rate of return. The required rate of return, however,
could go up if the business's activities become riskier as a result of modifications
like joining a fiercely competitive industry or spending money on an unproven
new technology. Investors will ask for a greater rate of return to make up for the
increased risk they are incurring. The effect of modifying a firm's operations on
the needed rate of return will ultimately rely on the details of the investment and
the company. To establish the proper required rate of return, investors must
carefully assess the possible risks and benefits of every investment. Investors can
make better investment selections if they are aware of how adjustments to a
company's operations may impact the needed rate of return.

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