This report aims at discussing the best model that can be used by the company. The paper will discuss the three models, i.e. CAPM, Dividend Growth and APT. The basic thought process behind the investment decisions revolves…
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It depends on the risk involved in that investment. Hence the investment decision is dependent on the returns, the risk involved (amount of uncertainty in generating the expected returns) and also the investor’s utility indifference (attitude towards risk and expected returns).
A risk averse individual will always aim to reduce the risk involved in his investments and ensure a high return. The investor, in light of the level of risk tolerance, must establish specific return objectives. On the basis of these objectives, he/she can opt for a varied portfolio of investments. Diversification is a way to limit or reduce the risk. Diversification is the balancing act in which the risk-return tradeoffs are adjusted. This implies the concept of relativism and indicates that it is superior to that of absolutism (Ware). Owning a number of investments can reduce the risk involved in an investment. This is called portfolio diversification. This could be by owning shares in a number of different countries or by investing in different asset classes such as fixed interest or property (Bekiaris). Investing in a wider range of domestic stocks and cash, short, mid and long-term bonds, foreign currency-denominated bonds, equity sectors, foreign stocks and emerging market stocks can reduce the risks involved in the investment (Donald).
As mentioned earlier, there are three methods that can be used to estimate the rate of return for Federal Express. These include, Dividend Growth, CAPM, and APT. The Dividend growth model is one which requires the current dividend rate, the constant growth rate of the dividend and the required rate of return. Here in this model a summing of the infinite series is done to get the value of the current price. This model also requires a few more details that need to be provided in order to compute the arithmetical calculation. These include the value of ‘g’, the current rate of return‘d’. One of the biggest drawbacks of this
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Risk free rate + ? (Average Market Return –Risk free rate) Where ? is the beta value of the financial asset The basic assumptions of this model pose as disadvantageous for this model to be considered as a perfect representative of required return calculation.
This concept holds that an investor’s time value of money and level of risks must be considered while rewarding him. These factors are generally computed using a risk measure called beta. Although the CAPM is widely used for anticipating the feasibility of an investment decision, this model has a number of corporate applications also.
Capital Asset Pricing Model.
CAPM (Capital Asset Pricing Model) The CAPM model has emerged to be one of the most important tools in making a fundamental decision related to the investment management. It measures the relationship between the expected rate of return and the risk involved in a particular investment The CAPM tool signifies the linear relationship between the non diversified systematic risks which is measured by beta ?
The model assumes that the lending rate and the borrowing rate are equal. In practice, these two rates differ and therefore, the model will not hold in a real life scenario. also Also it assumes that there is no transaction cost, taxes or holding period of the securities.
James Bradfield (2007, p167) defines portfolio as an assortment of securities. Portfolio theory actually is nothing but a traditional analysis of the association between risk and returns on risky securities. The theory is useful for investors. It assists them to determine and apportion their funds in securities which are risky thus generating a portfolio.
Treasury bills have the least mean return value when they are compared with other types of investments in the shares and stocks of large companies. Since investors are indisposed towards risk they like to play safe by paying more for safety and earning less.
Despite these efforts, it is evident that risks remain a vital and its mitigation needs to be properly consummated. Aside from these concepts, the financial world is also familiar with the term uncertain. Essentially, this refers to the incapability of providing comprehensive list of outcomes and indefinite probabilities.
Capital asset pricing model is one of the leading models for calculating cost of equity by taking into consideration the concept of risk and return. It takes into account the risk free rate of return as well as market risk premium along with beta to
The paper "Capital asset pricing model (CAPM)" gives the detailed information about Developments in the Capital Asset Pricing Model. The foundation of Capital asset pricing model was established in an article of a finance journal in the year 1963 named, Capital Asset Prices: A theory of market equilibrium under conditions of risk.
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