QUESTION 1 a) Distinguish between systematic and unsystematic risk. as the only relevant risk and why? b) In the context of the Capital Asset Pricing Model how would you define beta? How are betas determined and where can they be obtained? limitations of betas? c) What information does beta give to a financial manager? What are the Which is often regarded

QUESTION 2 a) What is the time value of money? flows? b) What factors need to be taken into account when choosing an appropriate discount rate? c) What do you understand by the terms (i) “net present value” (NPV) and (ii) “internal rate of return” (IRR)? d) Compare and contrast the NPV and IRR. Why is it important to “discount” future cash

CONTENTS

PART ONE: QUESTION 1 1. INTRODUCTION . 2. RISK 2.1 2.2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 3 4 5 6 6 7 7 8 10

Systematic Risk and Unsystematic Risk Why Systematic Risk is OftenRegarded?. . . . . . . . . . . . . . . . .

3. BETA (β) 3.1 3.2 3.3 3.4

Definition of Beta .

How to Determine Betas . Limitations of Betas .

Information Given to a Financial Manager. .. . . . . . . .

4. CONCLUSION

PART TWO: QUESTION 2 5. 6. 7. 8. 9. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 12 13 15 16 18 18 19 20

UNDERSTANDING THE TIME VALUE OF MONEY? .

THE IMPORTANT OF DISCOUNT FUTURE CASH FLOWS FACTORS OF CHOOSING A DISCOUNT RATE . . .

NET PRESENT VALUE AND INTERNAL RATE RETURN . 9.1 9.2 9.3 Definition of Net Present Value(NPV) . . . .. . . . . . . . . . . . . .

Definition of Internal Rate Return.(IRR). . Contradiction between NPV and IRR . . . . . . . . . . . . . . . .

10. CONCLUSION 11. REFERENCES

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PART ONE: QUESTION 1

1. INTRODUCTION What is the ultimate goal in a diversification strategy? Most investors must say “it is to Certainly, everyone knows

improve the investment performance by reducing the risk”.

risk is an essential element of strategic management and often appears as on an element of empirical studies reported in the strategic management literature. It figures prominently

in both management and many empirical studies of industry, firm and business unit performance (Bettis and Mahajan, 1990). Two measures of risk have predominated in the strategic management literature: one or both of the parameters (alpha α or beta β) derived from the Capital Asset Pricing Model (CAPM), including risk-adjusted returns from the CAPM, and variance or its derivatives, for instance, standard deviation. Thereinafter, this assignment will concentrate on categorizing risk and evaluating its relationship with betas from an asset pricing perspective.

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2. RISK One way to categorize risk is to distinguish between systematic risk and unsystematic risk. Total risk is the sum of systematic (market) risk and unsystematic (non-market or specific) risk. Simply, systematic risk is non-diversifiable component of total risk and

unsystematic risk is the diversifiable component of total risk. Here below is the methods to represent total risk. Total risk = Systematic risk + Unsystematic risk = Undiversifiable risk + Diversifiable risk = Market risk + Issuer risk 2.1 Systematic and Unsystematic Risk William Sharpe (1964) and John Lintner (1965) developed the CAPM to mark the birth of asset pricing theory. The CAPM extend the model of portfolio choice developed by In the portfolio theory, Harry Markowitz (1952) introduced the

Harry Markowitz (1959).

notions of systematic and specific (unsystematic) risk.

Systematic risk is the risk of holding the market portfolio. individual asset is more or less affected.

As the market moves, each

To the extent that an asset participates in such This is a risk that can affect all

general market moves, it entails systematic risk.

companies at the same times, including...