ACC00716 Finance Assignment: Risk, Return and Investment Decisions

This finance assignment delves into the critical trade-off between risk and return in investment decisions. It applies the Capital Asset Pricing Model (CAPM) to analyze the expected returns of individual stocks, including CSL Ltd and a hypothetical company, considering both systematic and unsystematic risks. The assignment explores portfolio construction with equal weights, comparing the risk-adjusted returns of individual stocks and a diversified portfolio. The analysis highlights the benefits of diversification in enhancing risk-adjusted returns, emphasizing the importance of balancing returns per unit of risk. The assignment also covers systematic and unsystematic risks and their effects on investment decisions. Furthermore, the assignment includes the computations of expected returns using the CAPM model and provides recommendations based on the risk and return trade-off.

FINANCE
ACC00716
STUDENT ID:
[Pick the date]

Question 1
a) $3,716,657.93
b) $12,632.20 million
c) 6.01%
d) $6,365.29
e) 4.00%
f) $35
Question 2
a) (i) The computation of the expected return on CSL Ltd (selected company) is shown
below using the requisite inputs from S&P Capital IQ database and the Capital Asset
Pricing Method (CAPM).
(ii) The computation of the expected return on hypothetical company is shown below using
the requisite inputs from S&P Capital IQ database and the Capital Asset Pricing Method
(CAPM).

b) Based on the respective return and risk associated with the individual stocks, the requisite
computations for the portfolio with equal weights have been conducted as follows.
Question 3
Trade-off Between Risk & Return
In relation to making investment decisions, two attributes related to the stock which are of
highest significance are essentially the associated risk and return. While investors want
highest return, it is noteworthy typically it is not possible without the increase in risk. There
is an inherent trade off involved as the investors wanted high returns but with low risks. As a
result the investor needs to aim for that balance where returns per unit risk assumed is the
highest. This is also seem inbuilt in the CAPM approach where investors tend to expect
returns depending on the associated risk (captured by beta). Here the stocks which are
expected to deliver a high returns would have a high risk associated with them. If this is not
done, then it is likely that investors would show a tepid response to such an investment as
there are alternative investments that offer similar returns but with lower assumption of risk
(Damodaran, 2015).
With regards to the overall investing related risk, it is noteworthy that primarily there are two
main components highlighted as follows.
1) Unsystematic Risk – This risk may be attributed to the fluctuation in the stock price
on account of the specific factors related to the stock. These factors would not have
impact on the market as a whole and thereby are known as firm specific factors whose
impact is contained within the company or the industry. However, these factors of
bringing significant variation in the price of the underlying stock leading to risk. This
risk is also known as diversifiable risk as this risk can be controlled through investing
in a well diversified portfolio instead of individual stocks. The firm specific factors
which are the source of unsystematic risk lose importance in case of a diversified

portfolio as weight of the company is reduced and also because hedging is performed
in the portfolio through movement of other stocks (Berk et. al, 2016).
2) Systematic Risk – This type of risk is unrelated to factors impacting specific
companies or industries and is related to the factors that tend to impact all the
businesses. These factors typically include macroeconomic indicators such as
inflation, unemployment, GDP growth along with interest rate movements. This type
of risk cannot be eliminated through diversification. The measurement of this risk is
done through beta which is essentially a relative measure indicating the stock risk
when compared with the underlying market index (Lasher, 2017).
Trade-off between Risk & Return (Individual Stocks)
The trade off between risk and return is evident at the level of individual stocks which is
reflected through the application of CAPM. For CSL Ltd, the beta is only 0.33 which implies
that the systematic risk associated with the stock is considerably lower when compared to the
benchmark index. This observation does not cause any unexpected surprise as CSL is a
global speciality biotechnology player which is based in Australia. The company over the last
many years has carried out pioneering work to resolve various deadly outbreaks that have
surfaced from time to time. Thee earnings of such a company are expected to be quite stable
with limited effect of economic factors as well. The CAPM model has been used to estimate
the expected returns of 2.3 percent on the CSL stock owing to low risk (Brealey, Myers and
Allen, 2014).
For the stock pertaining to fictitious company, the systematic risk is even lower than CSL
which is impacting the returns from this stock. On an individual level, it does not make sense
for a rational investor to put money in this money if this is not part of the portfolio. This is
because the risk free proxy rate is 1.91 percent hence it would be better for the investor to
buy in government bonds which would have a superior return. However, these contrarian
stocks (that have negative beta) are ideal for portfolio formation and reduction of risk through
the diversification (Bodie, Merton and Cleeton, 2016).
Trade-off between Risk & Return (Portfolio)
The trade off in return and return is also applicable for the portfolio formed with the two
stocks in the given case. When the portfolio beta is compared with that of CSL Ltd, it shows
a significant decline but the same has been achieved with the reduction in estimated returns

also which on the portfolio are lower than individually on the CSL stock. Thus, in order to
critically analyse any potential diversification based benefits that have been realised in the
given case, it makes sense to compute the returns delivered for unit risk assumed. The
required computation in this regards are performed in the following table (Lasher, 2017).
The computations performed above clearly highlight the diversification linked benefits which
tend to enhance the risk adjusted returns significantly. Clearly, amongst the choice of the two
individuals stocks and the portfolio, it is quite obvious that the rational choice would be to
select the portfolio over individual stocks (Berk et. al., 2016).
References
Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V. and Finch, N. (2014) Fundamentals
of corporate finance. 3rd ed. London: Pearson Higher Education AU.

Bodie, Z., Merton, R. C., and Cleeton, D. L. (2016) Financial economics, 2nd ed. New York:
Pearson,
Brealey, R. A., Myers, S. C., and Allen, F. (2014) Principles of corporate finance, 2nd ed.
New York: McGraw-Hill,
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons,
Lasher, W. R., (2017) Practical Financial Management. 5th ed. London: South- Western
College Publisher,