Interpreting Risk and Return Measures through CAPM and Company Context

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ACC00716 Finance Session 1, 2018
Assessment 2: Business Case Studies 1

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Introduction
The report is developed for providing an in-depth explanation of the risk and return
measures of part 2(a) and part 2(b). This is carried out through the use of extracts of Capital
Asset Pricing Model (CAPM) and the company context that will help in interpreting the results
of the above parts.
Interpreting the Results of Parts 2(a) & 2(b) through the use of CAPM and Company
Context
Capital Asset Pricing Model (CAPM) is used for depicting the impact of the market
conditions on the securities prices and thus determining the potential returns to be realized from
an investment. The model provides an assessment of the market risk in quantitative terms nod
thus facilitates the investors in achieving a reliable value for the expected returns from a security.
The market risk is assessed through the use of CAPM model through calculation of beta that
indicates systematic risk. Systematic risk is the market risk that cannot be reduced by an investor
as it impacts the potential returns of a security due to presence of uncertainty within the market.
As such, the model proves to be quite useful for the investors in determining the market risks that
is not calculated through the use of other investment analysis model such as dividend growth
model. As per the CAPM model the expected return on a security is equal to the risk-free return
in addition to a market premium that is based on beta of security (Ross, Jaffe and Kakani, 2008).
The major advantage of the use of this model is that it helps in gaining an estimation of the cost
of equity. It proves to be highly useful in determining the expected return of an asset and thus
taking accurate decisions whether an asset is to be added in a well-diversified portfolio.
Diversification of portfolio helps in reducing the unsystematic risk that is associated with a
particular stock and thus can be minimized (Peterson and Fabozzi, 2002). The expected return on
an asset is calculated through the use of following formula:
Required return = risk free rate + beta coefficient × equity risk premium
In the above formula risk-free rate can be stated as a rate of return on an investment that
is risk-free and equals to the return realized on a 10-year government bond. Beta coefficient in
the above formula indicates systematic risk that is the risk inherent within a security due to
fluctuations in the market condition. Beta coefficient more that 1 indicates that the investment