This shows therelationship between the market returns and the investment returns.
A ? of 1means a security’s price moves with the market. When ? is less than 1, it meansthat the security is less volatile than the market and if it is more than 1, itindicates that the security is more volatile. This then helps determine theexpected return an investment on security can generate, and whether or not undertakingthe risk it involves is worth it. Moreover, standard deviation is anotherstatistical measurement that can also be used to analyse and determine thereturn on an investment. As ?, it also measures volatility, the difference isthat it takes into account historical values to compare against.
If aninvestment’s standard deviation is higher than previous and relatable values,then this new investment might be more volatile. If the standard deviation issmaller, then the new investment might be less volatile.Another method to calculate risk is the weightedaverage cost of capital (WACC), which many firms use as their discount ratewhen measuring investments. This is mainly used when a company’s project isfinanced by equity and debt, and where the cost of capital is measured as aweighted average of both debt and equity, using the formula below: The given resultfor WACC indicates the return the firm should get overall, from the investmentthey might want to undertake. It can be used mainly as an internal measurer tohelp firms make decisions like expanding their business or engaging in mergersrequiring large amounts of finance. Hence by using WACC to arrive at thediscount rate a firm needs to analyse and determine the investment’s net presentvalue, by deriving the future cash flows based on the discount rate, a similarapproach to the expected return in CAPM. Based on these factors, a firm candetermine whether undertaking certain activities are worth pursuing. If thediscount rate is high, it means that a smaller investment can be made to obtaina fair and positive return in revenue for the project and vice versa.
When calculatingan appropriate discount rate, firms might face some difficulties. Firstly,investments can be greatly influenced by time, as there might be certainchanges in time affecting the outcomes of an investment, of which the companymight not expect. Hence, this makes it relatively harder to calculate the rightdiscount rate, especially if the investment is projected to the long-run.
Thisis because it is more likely for risk to vary as opposed to short-runinvestments. Secondly, if a firm embarks in a new project within a certainindustry, its ? “may be greater than the betaof existing firms” (Ross, 2011), which means that this firm’s project will bemore volatile and risky to undertake. For example, during recession atechnology start-up company may fail while well established companies like IBMmay not be as affected. Due to this, firms must make the right adjustment to reflecta greater risk, as discussed before where the risk-adjusted discount rate isused. Therefore, arriving at a more appropriate discount rate and a morereliable and effective representation of what to expect from their investmentin terms of return and risk. Thirdly, it might be likely for fraud to happenwhen analysing an investment or project. It can occur as there might not be sufficientor effective internal controls to tackle such issues.
Hence, the person incharge, a company’s analyst or accountant can manipulate their work and useincorrect information. Therefore, they can mislead investors, company’s ownersand other stakeholders to undertake a viable project when this might not be thecase. A company must work and rely on an experienced individual that has a goodunderstanding of what she or he is doing and should always monitor their work. Lastly,an evident factor that can change the value of a discount rate is simply theunexpected situations and changes that can happen.
Particularly in the economyand markets, as these are unpredictable and can vary greatly from year to year.For example, a new government in the UK comes into power, whom might decide tochange economic policies such as increasing or lowering the interest rates.Thus, directly affecting the stock market and stock prices too.