Overview with Objectives:
Unit 3 provides an explanation of the relationship between risk and return. Every investment decision carries a certain amount of risk. Therefore, the role of the financial manager is to understand how to calculate the "riskiness" of an investment so that he or she can make sound financial and business decisions. For example, you are the financial manager for a large corporation and your boss has asked you to choose between two investment proposals. Investment A is a textile plant in a remote part of a third world country. This plant has the capacity to generate $50 million dollars in yearly profits. Investment B is a textile plant located in the United States, near a small Virginia Town with a rich textile industry tradition. However, investment B's capacity for profits is only $30 million (due to higher start-up and operating costs). You are the financial manager. Which option do you choose? While investment A has the capacity to yield significantly higher profits, there is a great deal of risk that must be taken into consideration. Investment B has a much lower profit capacity, but the risk is also much lower. This relationship between risk and return is explained in this unit. Specifically, you will learn how to compute the level of risk by calculating expected values and the standard deviation. Also, you will learn about handling risk in a portfolio with different investments and how to measure the expected performance of a stock investment when it is being affected by the overall performance of a stock market. This unit puts what you have learned from the previous units about the cost of capital, net present value, and risk into one widely used model: The CAPM model. The CAPM model is used to compute a company's costs of capital that can be used in net present value calculations. It has been used in court cases for estimating a company's stock value as with the case of the breakup of AT&T in 1984 that resulted in seven companies. Also, the CAPM model is used in computing stock valuation. This unit will show how the financial manager uses this financial tool to value stock and to determine which stocks are the better options for investors, based on their rates of returns and how they compare to the overall stock market return.
learning outcome:
- What is the risk-free rate?
- How does the Capital Asset Pricing Model help to compute return?
- What is the expected return?
- What does CAPM calculate?
- What is the expected rate of return?
- What is the required rate of return?
- What are the criteria to determine if a financial investment should it be made?
- What is the difference between systematic and unsystematic risk?
- What is beta and what does it measure?
- What is the expected return?
- What is the Capital Asset Pricing Model?
- How does CAPM connect the concepts of risk and return?
- What does it mean to be risk-averse?
- What does the financial manager consider when balancing risk with reward?
