Wk 4 Discussion – Financial Management Tools [due Day 3]
Investors need to know how much risk they have to take to confidently expect a certain percentage return. Likewise, managers want to know what return shareholders require so that they can decide how to meet those expectations.
Respond to the following in a minimum of 175 words:
- Select 2–3 of the topics below and discuss how they each influence financial decisions regarding risk and return:
- The capital asset pricing model (CAPM)
- The constant–growth model
- Compute forward-looking expected return and risk
- Risk premiums
THE CAPITAL ASSET PRICING MODEL (CAPM)
The capital asset pricing model (CAPM) is a methodology used to choose which assets to include in a well-diversified portfolio by calculating the asset’s necessary rate of return, which is theoretically suitable.
The asset’s expected return is predicted by the model to be equal to the risk-free rate plus a risk premium after accounting for the asset’s non-diversifiable risk, or beta.
Financial analysts assess investment possibilities and offer client recommendations using the CAPM model. Individual investors may also use the model to evaluate the risk and return of possible investments.
Investors want risk premiums, or higher returns, in exchange for owning riskier assets as opposed to risk-free ones. Depending on the degree of risk attached to the asset, the magnitude of the risk premium fluctuates. If everything else is equal, investors who are willing to accept a larger risk premium will expect a bigger return on their investment.
Risk premiums have a significant impact on how risk and profit are traded off in financial decision-making. Investors must balance the danger of primary loss with the possible return of an investment when deciding which investments to make. Larger predicted returns are typically associated with riskier investments, which also carry a higher chance of loss. Investors need a premium called a risk premium to make up for the higher risk.
Investments may become less appealing when risk premiums are higher because the prospective return must be high enough to compensate for the elevated risk. Investors will prefer the investment that is less hazardous, for instance, if two investments have the same expected return but one is riskier than the other. Risk premiums can so significantly influence how financial decisions are made.