Business Case Study on Risk and Return Measures: ACC00716 Finance

This case study provides an in-depth analysis of risk and return measures, utilizing the Capital Asset Pricing Model (CAPM) to interpret results. It explains how CAPM helps assess market risk and determine potential returns, focusing on systematic risk and beta coefficients. The analysis includes a comparison between a hypothetical company and Cochlear, highlighting the relationship between risk and expected return. Portfolio diversification is discussed as a strategy to reduce unsystematic risk and improve investment outcomes. The study concludes that CAPM is a valuable tool for investors in evaluating investment opportunities. Desklib provides a platform for students to access this and other solved assignments for academic support.

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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

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has high systematic risk in comparison to the market and vice-versa. Equity risk premium is the
rate of return to be realized from a broad market through deduction of the risk-free rate. It can be
regarded to as a reward received by an investor for taking the systematic risk associated with a
portfolio that relatively presents an equity market.
The model has been used for calculating the expected return of Cochlear. As per the
model, the expected return on an asset is directly related with its beta coefficient. This is because
the risk-free rate of return and the market return is relatively same for all the business entities
that are listed under a market index. However, the investors cannot reduce the systematic risk
associated with the company as it depends on market volatility. The investors through
undertaking greater risk have also the opportunity of realizing larger returns as both have a direct
relationship. The estimated rate of return on the company under context can be calculated
through the use of risk-free rate of return, the risk premium and the beat factor. The risk-free rate
of return has been taken from the Reserve Bank of Australia website as the return realized by 10
year Australia treasury bonds and is equal to 2.60%. The market risk of the company under
context and the hypothetical company as provided in the question is 6.50%. The hypothetical
company has the beat of -0.25 while that of the company in context is 0.63 (Morning Star, 2018)
that is taken from the morning star. Thus, as beta of the selected company is more than that of
hypothetical company, it can be said that Cochlear Company has more market risk in comparison
to that of hypothetical company (Weston and Brigham, 2015).
However, the investors also have the potential opportunity of realizing higher returns by
investing in the stocks of Cochlear Company as it has higher beta. Thus, as per CAPM model the
higher the risk associated with a security the better is the expected rate of return. The expected
rate of return for the selected company is calculated as 6.69% whereas that of hypothetical
company is 0.97 through the use of formula provided by CAPM model. The values of the
expected rate of return for both the companies have provided a clear depiction that higher the
beta of a security, the more is the expected rate of return (Weston and Brigham, 2015). The
investors in this case can reduce the unsystematic risk associated with the Cochlear Company
through creation of a diversified portfolio. Diversification can be achieved through the creation
of a portfolio that consists of 50% of stock of Cochlear Company and the remaining 50% of the
hypothetical company. This will provide a good combination of stocks in the portfolio with one

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security having higher risk and other lower and therefore diversifying the risk. This will improve
the probability for the investors to realize higher returns in the future better that that gained from
investing alone in the stock of the Cochlear Company. This is because the existence of market
risk can have a negative impact on its rate of return in the future context. The beta of portfolio as
calculated is 0.19 and expected rerun is 3.83% which indicates that diversification has reduced
the risk to a large extent (Reilly and Brown, 2011).
Conclusion
The risk and return measures can be successfully interpreted through the application of
CAPM model as it has established a clear relation between them. Therefore, the model has high
significance for the investors to realize the potential worth of an investment through calculating
its expected rate of return.

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References
Morning Star. 2018. Cochlear Company.
Peterson, P,P and Fabozzi,F,J,. 2002. Capital budgeting: theory and practice. John Wiley & sons.
Reilly.F.K. and Brown.K.C. 2011. Investment analysis & portfolio management. South western
Cengage learning.
Ross, A., Jaffe, J. and Kakani, R.K. 2008. Corporate Finance. Pearson
Weston, J.F. and Brigham, E.F., 2015. Managerial finance. Hinsdale, IL: Dryden Press.
Weston, J.F. and Brigham, E.F., 2015. Managerial finance. Hinsdale, IL: Dryden Press.