Diversifiable and un-diversifiable risks
Investopedia (2009) defines diversification as a method that eliminates risks through allocation of investments amid different financial tools, industries and others of the same kind. The risks investors encounter are of two types namely diversifiable along with un-diversifiable risks. Diversifiable risk can be dubbed as the ambiguity that results from specific factors of a company that are independent (uncorrelated) to market portfolio. Indeed, the risk is specific to a firm or industry. This risk can be reduced or eliminated via diversification which means that the ambiguity in the components of the diversified portfolio will cancel out. Un-diversifiable risk or market risk is the ambiguity that is dependent on market portfolio and result from wider market factors like inflation, interest rates or gross domestic production. Such risk will never be reduced or eliminated through diversification. Thus, market risk is associated with all companies.
Substantial and unanticipated inflation increase
A substantial and unanticipated increase in inflation is un-diversifiable risk as it will affect the whole economy as well as all firms. Investors in all industries must face the same consequences due to the inflation as no measures or efforts can seclude any of the firms.
A major downturn in the United States
A major recession in the United States will affect the entire economy of the country and is thus un-diversifiable risk. While this might not affect investors in other countries, all savvy investors within the country will feel the impact of the recession.
A key lawsuit filed against an outsized in public traded company
A key lawsuit that is filed against an outsized but in public traded company is a diversifiable risk because the whole economy of the country will not be affected. In essence, some firms in the same industry will benefit in case the lawsuit affects the business of the competing company since the market rivals will have the sole chance to meet the increasing demand.
Application of Capital Asset Pricing Model
It is noted that between the two parts of the savvy investors’ risks, only the un-diversifiable risk is an imperative part of the total risk. This follows the fact that risk proves to be liable to the significant changes on rates of return and it is usually measured by beta. The determination of the expected rates of return depends heavily on beta as different assets carry different amount of market risk. When the beta of a particular asset is high then the rate of return will certainly be high.
- Given that the expected rate of return on asset “i’ is 12%, the risk free rate is 4% and beta “b” for asset is 1.2, the required rate of return can be calculated using the equation for CAPM which is given by rA =rf + bA (rm-rf). However, the risk free rate (rf) = 4%, beta of asset (bA) =1.2 and the required return on asset (rA) =12%. The return on market portfolio (rm) =bArm=rA-rf +bArf = rf + (rA-rf)/bA. Therefore, rm= 4% + (12%-4%)/1.2 = 10.67%
- Given the following:
Required rate of return on asset “j” is 9%, required return on market portfolio is 10% and beta for asset “j” is 0.8. The risk free rate can be calculated using the equation for CAPM which is given by rA = rf + bA (rm – rf). But beta of asset (bA) = 0.8; Expected return on asset (rA) =9%; and return on market portfolio (rm) =10. Thus, the risk free rate (rf) from rA =rf (1-bA) +bA*rm which give us rf= (rA-bA*rm)/ (1-bA). Thus, rf= (9%-0.8*10%)/ (1-0.8) = 5%
- Bhole (2004) claims that when beta=1investments have normal market risk but when beta<1 the investment has below normal market risk. Finally, when beta>1 the investment has greater than normal market risk. Therefore, owning half the total stocks traded in a major exchange means that the beta will be close to normal market risk. The reason is that when the stocks are selected at random, the representation of the stock market will probably fair and the beta would be 1.
A message of CAPM to savvy investors
The entire context of Capital Asset Pricing Model revolves around the determination of investors risk in securities and the return gained from risking (Miller, 2009). Every investor should know that there exist two portion of the total risk of an asset of portfolio. These include the systematic (or market) risk and the diversifiable (or firm specific) risk which have unique relevance to the rates of return. The firm-specific risk can be reduced or eliminated through diversification but the market risk cannot.
Given that the sole purpose of investing through securities is to make more profits, investors need to seek for a critical evaluation of the risk dynamics and their correlation to the expected profits. As a result, the CPAM is an appropriate framework of understanding how to take risk in security investment. The model suggests that investors can expect to get more profit for taking on systematic risk rather than taking on firm-specific risk that can be eliminated through diversification. The essence here is that when the risk is eliminated the value of the investment does not change literally.
A message of CAPM to corporations
It is important for a company to understand the relationship between the return on a risky asset and the risks encountered. Capital Asset Pricing Model concludes that the required return on market portfolio relate to market risk but neither to standard deviation nor the total risk. However, the market risk results from the beta coefficient of the asset. This coefficient is the measure of the asset co-movement within the market index. In most cases companies employ CAPM to assist in estimating the cost of equity financing whether short-range or long-standing. This eventually becomes an essential constituent of the WACC denoting the weighted average of capital cost (Johann, 2008). In addition, CAPM can be used in working capital management to determine the extent to which external financing should be tolerated.
American Superconductor decision
If a firm has assets in place and a valuable real investment opportunity, the most important decision of the management is on how to raise the cash necessary to take on the investment project. By foregoing the debt financing to undertake equity financing in the face of an opportunity the American Superconductor could raise the investment cash from investors without necessarily getting loans from financial institutions or other organizations. Unlike loans or other debts that must be paid back, equity funding allows investors to fund the organization without expecting to get the money back in case the business fails. This could be achieved by preparing a prospectus for the investors and explaining to them the risks associated with their investments. With equity financing, the financing capability of AMSC is not limited and the company is not at a higher risk of going bankruptcy (Harvey, 2002).
Large corporations such as AMSC require vast amounts of money for expansion which cannot be acquired from loans or debt financing when the company has not cleared other long-term loans. In such a case, equity financing will assist the company to get as much capital as the stocks released allows. When investors perceive future growth in case of such an expansion, they readily invest their money through securities. In addition, large corporations have been performing well at the stock market for most of the time and investors would rather invest in them than in smaller business.
However, the instruments through which equity financing is enabled discourage many investors from risking. One of the instruments company uses to raise finances is common stock offering in which extra units of ownership are issued which dilutes the ownership of the corporation or existing shareholders. Though this form of investment represents the highest potential return, the common shareholders receive the last remains of the assets if any during liquidation. For a company to maintain a certain growth level and ensure future expansion it has to retain some part of its earnings in form of retained earnings that is seen as a disadvantage to the shareholders.
Another source of financing is preferred stock in which the rate of dividend is fixed and the holders do not habitually have voting rights. Since the dividend is only paid from profits and the business is not bound to pay dividends incase of losses, the rates of dividends are also fixed. Thus, preferred stock is not a security favored by investors to subscribe. As a result, maintaining capital required to run and expand a business via equity financing usually become challenged by the fear of investors who shun risking through the available securities.
The decision made by AMSC is okay considering the loss experienced in the past and vague profit outlook. AMSC capital structure can be changed when the company is sure of profitability and can do an LBO (leverage buyout). That is, they borrow money to buy stock back and create a new debt/equity structure that is optimal for the anticipated situation of free cash flow.
In determining the cost of equity for the company, we consider the risk of investments through the perspective of trivial investors in that company. Assuming that the investors are well diversified we define risk with respect to risk added on to a market risk. The capital-pricing model and betas that measure market risk are generally predicted from historical stock prices. If that company is floated, the cost of equity is then estimated by deriving the beta first to get statistical value of the company’s systematic risk. If the firm is not floated then there is need to look at the cost of equity of other firms from the same industry bearing similar capital structure. Hence, the cost of equity is determined by peer comparison.
In debt financing there are tax deductions associated with the interest accruing on a loan. Indeed, this is the major attracting factor in debt financing. Generally, both the principle and interests paid on the loan might be categorized as expenses and therefore can be deducted from the income taxes. The interest on loan is tax deductible thus reducing the portion that a government gets from the firm (Graham, 2001). The government is sort of a business partner with its share defined by duty paid on business by the firm. For instance, if the bank is charging 10% for a loan while the government taxes 30%, there is an advantage of taking loan that is deductible. The equivalent interest paid will be = 10%* (1-30%) = 7%.
References
Bhole, L. M. (2004). Financial Institutions and Markets: Structure, Growth and Innovations. Noida, India: Tata McGraw-Hill Education.
Graham, J. R. (2001). Estimating the tax benefits of debt. Journal of Applied Corporate Finance, 14 (1), 42-54.
Harvey, C. (2002). How do CFOs make capital structure and budgeting decisions. Journal of Applied Corporate Finance, 15 (1): 8-23.
Investopedia (2009). The importance of diversification. Web.
Johann, R. (2008). The Free Cash Flow Approach: Firm Valuation Using a DCF-Method and WACC. Munchen, Germany: GRIN Verlag.
Miller, F. (2009). Capital Asset Pricing Model. New York, NY: VDM Publishing House Ltd.