Question

What are the average returns of some U.S. assets and their historic risks?

What is the Beta coefficient and how can be measured?

What is the CAPM and the least risky security you can think of?

What is the risk of a portfolio and how can be minimized?

Why can’t a firm finance with only the lowest-cost type of capital?

Suppose interest rates in the economy increase. How would such a change affect the costs of both debt and common equity based on the CAPM?

What is the WACC?

Answer 1

What are the average returns of some U.S. assets and their historic risks?

This question requires external research data, hence in the image below average returns of all major products is shown in recent years:

Source: https://www.bullionvault.com/gold-guide/annual-asset-performance-comparison

2. What is the Beta coefficient and how can be measured?

A. Beta co-efficient is the measure of systematic risk and it is the ratio of covariance between of market and security returns to the market return. It can be measured as:

Beta (B) = Cov _(a,b) / (Market return) ²

^3. What is the CAPM and the least risky security you can think of?

A. CAPM is Capital Asset Pricing Model, which gives the risk and return relationship of particular assets in question, it creates a graphical representation for measuring the risk-return. The least risky asset would be risk-free securities.

4. What is the risk of a portfolio and how can be minimized?

A. Every portfolio has risk attached to it, due to risky assets in the portfolio. There are 2 types of risks - systematic and unsystematic risk. Systematic risk (also known as market risk) is due to market fluctuations. It is controlled by other factors in market and economy as a whole. Unsystematic risk refers to that which is related to the individual asset in question, generally referred to default of the issuing party. The portfolio has an overall risk, which is a combination of risks of all assets in respective proportion of their value. Portfolio risk can be minimised by investing in different types of assets - risky plus risk free assets. An analysis should be done regarding the best proportion to be maintained on an ongoing basis.

5. Why can’t a firm finance with only the lowest-cost type of capital?

A. The lowest cost of capital may not be the market prevalent rate. Secondly, the lower cost of capital may be due to a prticular type of asset (debt or equity). A good running firm should have a mix of both debt and equity, and hence it may be possible that this may not create the lowest cost to the firm.

6.  Suppose interest rates in the economy increase. How would such a change affect the costs of both debt and common equity based on the CAPM?

A. Increase in interest rates in economy would adversely affect the price of debt assets and may indirectly affect the equity market. It directly affects the cost of borrowing. This type of risk is known as systematic risk as it is not in anyone's control to adjust the market rates. Hence it affects the CAPM for systematic risk.

7. What is the WACC?

A. WACC is Weighted Average Cost of Capital. In a portfolio, as it is a mix of different types of assets, each asset has its own risk and return attached with it. However, the portfolio cannot determine any particular return or risk from any particular asset. Hence a weighted average method is devised, which considers the proportion of each asset in the portfolio, and hence risk and return of each asset is calculated based on such proportion. The return which is calculated from such proportion is used as the WACC.