a) Explain: Diversifiable risk Non-diversifiable risk The difference between the two
b) How can the Capital Asset Pricing Model be relevant in calculating the firm’s weighted average cost of capital?
c) What is the market portfolio?
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Solved: a) Explain: Diversifiable risk Non-diversifiable risk The difference between the two
Expert Answer
solution (a)
Diversifiable risk (also known as unsystematic risk) represents the portion of an asset’s risk that is associated with random causes that can be eliminated through diversification. It’s attributable to firm-specific events, such as strikes, lawsuit, regulatory actions, and loss of a key account. Unsystematic risk is due to factors specific to an industry or a company like labor unions, product category, research and development, pricing, marketing strategy etc.
While the non-diversifiable risk (also known as systematic risk) is the relevant portion of an asset’s risk attributable to market factors that affect all firms such as war, inflation, international incidents, and political events. It cannot be eliminated through diversification and the combination of a security’s non-diversifiable risk and diversifiable risk is called total risk.
In the other word Systematic risk is due to risk factors that affect the entire market such as investment policy changes, foreign investment policy, change in taxation clauses, shift in socio-economic parameters, global security threats and measures etc. Systematic risk is beyond the control of investors and cannot be mitigated to a large extent. In contrast to this, the unsystematic risk can be mitigated through portfolio diversification. It is a risk that can be avoided and the market does not compensate for taking such risks.
Solution (b) The CAPM formula requires only three pieces of information: the rate of return for the general market, the beta value of the stock in question and the risk-free rate.
Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return – Risk-Free Rate)
Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return – Risk-Free Rate)
The rate of return refers to the returns generated by the market in which the company’s stock is traded. If company CBW trades on the Nasdaq and the Nasdaq has a return rate of 12 percent, this is the rate used in the CAPM formula to determine the cost of CBW’s equity financing.
The beta of the stock refers to the risk level of the individual security relative to the wider marker. A beta value of 1 indicates the stock moves in tandem with the market. If the Nasdaq gains 5 percent, so does the individual security. A higher beta indicates a more volatile stock and a lower beta reflects greater stability.
The risk-free rate is generally defined as the (more or less guaranteed) rate of return on short-term U.S. Treasury bills, or T-bills, because the value of this type of security is extremely stable and return is backed by the U.S. government. So, the risk of losing invested capital is virtually zero, and a certain amount of profit is guaranteed.
Solution (c) A portfolio consisting of all assets available to investors, with each asset held in proportion to its market value relative to the total market value of all assets
