Question

Let's start this week with a review of "risk" and "returns" in business. First, what is "risk" in business? How can we measure risk? Next, what is the relationship between risk and return?

Now, let's breakdown WACC and CAPM. What is the formula for WACC? What does each variable stand for? What is the formula for CAPM? What does each variable stand for?

Finally, how does WACC and CAPM relate to "risk" and "return?"

Answer 1

Risk is deviation of outcome from what we expect or predict . for example if we expect/predict a Stock X to give 10 % return in a year . But at the end of the year actual return is different from 10%. This deviation could be Upward or downward. It is incorrect to say only Loss is the risk.

In business risk could be any deviation in predicted and actual Sales, cost ,profit,change in competition, Change in policies,exchange rate etc

There are various ways to measure risk, i.e alpha, Beta, Standard deviation etc

Alpha is return compared with Benchmark return, if the return is higher, it will be Positive alpha and if the retun is lower than benchmark it will be called negative alpha.

Beta measures systematic risk, suppose the variables are risk and return, where risk is independent variable and return is dependend variable. Beta will measure the change in return with every one unit change in risk.

Standard deviation measures the dispersion as per the mean value of the data set..

It is always said that higher risk will give higher return, When it comes to risk and return one need to trade off between these two according to their expectation, risk aversity.

WACC= Equity/(Debt+ Equity)*Cost of Equity+ Debt/(Debt+ Equity)* Cost of debt *(1- Tax rate)

Weighted average cost of captial measure cost perecentage based on the ratio of Equity and debt of the company.

since Debt gives us Tax benefit it should also be considered.

CAPM is Capital Asset prossing model,helps in determning the required rate of return

Required return= Risk free rate of return+ Beta* (expected market retun- Risk free rate of return)

Expected return - Risk free rate of return is also called Risk premium

Beta says the how much return is required with one unit change in risk premium.

Risk free rate of return generally considers Treasury bill returnss