Risk and the Required Rate of Return


Accompanying Files
Study exercises problems
Study exercises answers

SUMMARY

Cost of capital requires informed judgment because:

  • the rate is determined by returns offered on alternative securities with the same risk;
  • risk is defined in terms of variance in actual returns around an expected return;
  • if is too high, investment will be constrained;
  • choices have to be made on issues, including risk premium and gearing;
  • the issues of cost of capital and the value placed on a share are two sides of the same coin.

Companies finance their investments and operations by issuing common stock  sold to the owners, who then add these shares to their personal portfolios and require a rate of return that is appropriate for the risk they accept. Managers must know how their decisions affect the risk of using owners' money for investments. Then, the managers can use the opportunity cost to evaluate their alternatives and to make the choice that maximizes owners' wealth. The analysis and valuation of any investment proposal requires a prediction about its future performance. No one can predict the future with perfect certainty, so investment decisions are subject to a great deal of risk Two familiar statistics, the mean and standard deviation of rate of return, are used to measure these predictions. The mean represents an investment's expected return and the standard deviation represents its risk. That risk and valuation are two sides of the same coin is discussed extensively in the Mariott Corporation case in which cost of capital and the mechanics are emphasized (HBS number 9-289-047).

LEARNING OUTCOMES

When participants have completed this workshop, they should understand:

  • why considering risk is important;
  • how to calculate the standard deviation of risk;
  • the role of diversification in the investment process;
  • fundamentals of the CAPM and how its risk measure, called beta, can be used by investors and managers;
  • some of the limitations related to beta.

 



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