Principles of Finance – FIN 100
Professor Kalonji Ntambwe
November 28, 2010
This Report will contain answers to five (5) questions asked concerning:
• Identify the components of a stock’s realized return.
• Knowing the contrast of systematic and unsystematic risk
• Explaining why Total Risk of a Portfolio is not equal to Weighted Average Risk of securities in a portfolio.
• Understanding what Beta measures
• Understanding what WACC measures and understand WACC assumptions used to value a project.
1. Identify the components of a stock’s realized return.
The component of a stock’s realized return is ...view middle of the document...
Systematic risk is beyond the control of investors and cannot be mitigated largely. The systematic risks are unavoidable and the market does compensate for taking exposure to such risks. In contrast, An unsystematic risk is one that affects a single asset or a small group of assets. Because these risks are unique to individual companies or assets, they are sometimes called unique or asset-specific risks. Unsystematic risk is due to factors specific to an industry or a company like labor unions, product category, research, and development, pricing, marketing strategy etc. the unsystematic risk can be
mitigated through portfolio diversification. It is a risk that can be avoided and the market does
not compensate for taking such risks. (Berk, DeMarzo, and Harford, 2010)
3. Explain why the total risk of a portfolio is not simply equal to the weighted average of the
risks of the securities in the portfolio.
the total risk of a portfolio is not simply equal to the weighted average of the
risks of the securities in the portfolio, because,
4. State what beta measures and its uses
Beta is one of the most used and misused of the financial ratios. It represents an investment’s non-diversifiable risk (and not its total risk) relative to the market risk. Beta is used to measure a stock’s price volatility in relation to the rest of the market. It provides data sources of estimates on historical data. Most data sources use five years of monthly returns to estimate.
5. State what WACC measures and explain the WACC assumptions used to value a project. The cost of capital is mainly used for capital budgeting purposes i.e. to decide which projects to take up, and which to reject. The idea of judging a project with the cost of capital is that if the project cannot return more than the cost of money financing it, it should be rejected.
Using the WACC to evaluate a project makes a couple of assumptions:
• The project will be financed at the same capital structure as the entire firm.
• The risk of the project is the same as the risk of the whole company.
• Violation of these assumptions makes WACC a wrong tool to use. For example, if company is introducing a new product, such as televisions, then evaluating this proposed project with the company’s cost of capital is fine. But, if the company wanted to enter into the retail clothing business, then the WACC of the company is not appropriate for evaluation of this project. One has to calculate a separate project cost of capital.
Title of Paper (Does not Count as Heading)
The introduction to the paper should not have a name, especially not "Introduction" (American Psychological Association, 2009). The first part of the document is assumed to be the introduction. This information is given on page 63 in the new APA guidelines.
Spacing, Indentation, and Headings (Level One Heading)
Paragraphs are indented one half inch and the space key should never be used to set the...