Explain what beta means and how it related to the required return of the stock
Real-world capital markets are clearly not perfect, for example.
High betas may mean price volatility over the near term, but they don't always rule out long-term opportunities. Sure, there are variations on beta depending on things such as the market index used and the time period measured.
The project offers a return greater than that needed to compensate for its level of systematic risk, and accepting it will increase the wealth of shareholders. The RRR is a subjective minimum rate of return, and a retiree will have a lower risk tolerance and therefore accept a smaller return than an investor who recently graduated college.
Until something better presents itself, though, the CAPM remains a very useful item in the financial management toolkit.
Expected return-beta relationship
Consider a utility company: let's call it Company X. It's a difficult metric to pinpoint due to the different investment goals and risk tolerance of individual investors and companies. Think of an early-stage technology stock with a price that bounces up and down more than the market. Therefore, an asset may have different betas depending on which benchmark is used. At the same time, many technology stocks are relatively new to the market and thus have insufficient price history to establish a reliable beta. If you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk. These prices are determined by two market forces -- demand and supply, and the gap between these two forces defines the spread between buy-sell prices. Compare Investment Accounts. Conclusion Research has shown the CAPM stands up well to criticism, although attacks against it have been increasing in recent years. The RRR is what's needed to go ahead with the project although some projects might not meet the RRR but are in the long-term best interests of the company. A value investor would argue that a company represents a lower-risk investment after it falls in value—investors can get the same stock at a lower price despite the rise in the stock's beta following its decline. Overall, it seems reasonable to conclude that while the assumptions of the CAPM represent an idealised world rather than the real-world, there is a strong possibility, in the real world, of a linear relationship between required return and systematic risk. A beta can be zero simply because the correlation between that item's returns and the market's returns is zero. As a result, the RRR is a subjective rate of return.
The assumption of a single-period transaction horizon appears reasonable from a real-world perspective, because even though many investors hold securities for much longer than one year, returns on securities are usually quoted on an annual basis.
The reason for this is that the risk associated with individual investors is much higher than that associated with the government. Compare Investment Accounts.
The higher RRR relative to other investments with low betas is necessary to compensate investors for the added level of risk associated with investing in the higher beta stock. The relative volatility ratio described above is actually known as Total Beta at least by appraisers who practice business valuation.
These assumptions are essentially saying that WACC can be used as the discount rate provided that the investment project does not change either the business risk or the financial risk of the investing organisation.
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