a) Risk can be separated into systematic and unsystematic risk. Define systematic and unsystematic risk and explain how diversification can reduce risk. b) The Capital Asset Pricing Model (CAPM) defines a linear relationship between risk and return. Explain the model and what beta tells us about the risk associated with the company. c) If the expected rate of return on the market is 8% and the risk free rate is 3%, a portfolio is expected to have the rate of return of 10%. Calculate beta and explain what assumptions concerning this portfolio and/or market conditions to calculate the portfolio's beta and discuss the limitation of CAPM.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
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