Question one:
This week we focus our attention to Risk, Return, and the Capital Asset Pricing Model (CAPM). One of the primary concepts in the field of finance is the risk-reward trade off. An assumption of risk-reward is the tenet of risk aversion for investors. This tenet asserts that if investors have a choice between two stocks of equal return and different risk, they would choose the stock with the lower risk. Or, for a given level of risk tolerance, investors will seek to maximize their returns. The average investor, the incremental investor, is assumed to be risk averse, and thus risk aversion is built into market rates and prices.
As you continue your discussions on WACC, explain and explore CAPM as well. (150 words)
Question two:
For the second discussion for this week, let's begin with Beta. Beta is the relevant risk of a stock which is a measure of price volatility compared to the market. In other words, the relevant risk can be measured by the extent to which the particular stock moves down or up compared to the stock market. It is measured by a metric called beta coefficient or simply beta. Beta measures the tendency of a particular stock to move with the stock market. Investors may decide to invest in a stock based on its beta. Market beta is always 1. Consider the following two stocks.
Stocks Beta
General Electric (GE) 1.47
Google, Inc (GOOG) 1.18
This indicates that Google is less volatile compared to General Electric. Accordingly due to GE's higher relevant risk, market participants and investors expect a higher rate of return, or Rs (minimum required rate of return cost of stock) for the stock. Using CAPM, we could calculate Rs for each of the above stocks.
Rs = Rf + beta (Rm - Rf)
Rf = 2% (risk free rate of return which is the average rate for 10 year Treasury Notes)
Rm = 10%, (let's assume this was the average market return for 2012)
Therefore we have:
GE > Rs = 2% + 1.47(10% - 2%) = 13.76%
GOOG > Rs = 2% + 1.18(10% - 2%) = 11.44%
As you could see investors expect a higher rate of return for GE. Conversely, the cost of capital for GE is higher than Google due to its high relevant risk, Beta. ( 150 words )