Question

A) What is Beta and how can we use Beta to measure risk.

(B) Analyze the concept of the Security Market Line and how it interacts with the Beta concept to determine an expected rate of return.

(C) Provide an example of how you could use Beta to measure risk as a financial manager.

Answer 1

a.

Beta is a measure of level of systematic risk or market risk in investment. systematic risk is type of risk that affect whole market and cannot be controlled. when beta of the company is changed that is level of risk change then the cost of capital of company is also change.

Capital assets pricing model formula for calculation of cost of capital is mention below:

Required rate of return = Risk free rate + (Market Return - Risk free rate) × Beta

So, when beta increases then required rate of return on assets also increases.

b.

security market line (SML) shows the relationship between required rate of return and level of risk (beta). security market line helps to determine the risk aversion level among investors. the flatter the slope of the security market line the higher the level of risk aversion. security market line (SML) uses beta as a risk measure and required rate of return at each level of risk (beta).

c.

Goal of financial management or finance manager in either private company or public company is to maximize shareholder wealth. Increase shareholder wealth mean increase the stock price of equity, earning per share of company, so that the stockholder who is real owner of company, wealth will increase. Consider this as vision of the financial management.

if beta of company is higher the required rate of return is higher and so value of firm would be lower. So, finance manager should always concentrate and minimize the beta of company.