Question

Question 1 Risk and Return (TOTAL: 25 MARKS)

1.1 Investors often use a method called the capital asset pricing method (CAPM) to measure the required rate of return.

a) Define the capital asset pricing method

b) Explain how CAPM is useful for measuring the required rate of return

1.2 Using an example, discuss how diversification of investments affects the riskiness and expected rate of return of a portfolio.

1.3 Explain how COVID-19 impacts the profitability, liquidity, and cash flow projections of businesses.

Answer 1

11)

a) The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. It relates to the risk return trade-off of individual asset to market return. The CAPM model has linear relationship between returns on individual shares and the stock market returns. It is an attractive to the dividend valuation model and dividend growth model as a method of establishing the cost of equity.

b) The Capital Asset Pricing Model provides the required rate of return based on the perceived level of systematic risk of an investment.

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk free security plus a risk premium. If the expected return does not meet the required return, then the investment should not be undertaken. The security market line (SML) plots the results of the CAPM for all different risks ( betas).

The CAPM also makes use of the principle that returns on shares in the market as a whole are expected to be higher than the return of risk free investment.

12) Diversification is a strategy that can help to reduce risk. Diversification in investment can be achieved in different ways such as individuals can diversify one type of asset classification such as stocks. Diversification of portfolio across different types of assets such as stocks, bonds and real estate. Many options of diversification are available before an investor. The ultimate goal is to improve performance by reducing risk.

For example, Mutual fund is an best example for diversification of investment. Mutual fund is an investment instrument that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other similar assets. Mutual funds pools together money from many investors and invest it on behalf off the group in accordance with a stated set of objectives. By investing in mutual funds we can diversify the risk into different portfolios or securities and maximise the return. If there is a loss in one security we can reduce the risk by the return from other investments through diversification. So diversification of investments helps to reduce the riskiness and to maximise the expected rate of return of a portfolio.

13) As an impact of Covid -19, there is a significant deterioration in profitability, liquidity and cash flow projections of businesses. As part of this pandemic, many people loss their jobs, income and they had to spend their savings for buying necessities and they didn't have any surplus for investment. So it affects not only the investment but also many sectors such as construction, tourism, manufacturing, insurance, education and the like. Estimating future cashflows could be particularly challenging for many companies due to the increase in economic uncertainty. Due to the high degree of uncertainty and resulting challenges in forecasting cashflows, it could be helpful to base those forecasts on external sources such as economic projections by respected central bank and other iinternational organisation. To cushion the economic and financial market impacts, government has committed to fiscal stimulus, liquidity provisions and financial support. Companies will be to understand the terms and status of these provisions and consider what impact they might have on their cash flow projections. Covid -19 have a significant impact on the risk free rate and on equity specific risk premium used in determining appropriate discount rate to discount future cash flows.