Explain Amazons financial risk, cost of capital, and risk reward from historical data. Interpret Amazons financial information using Capital Asset Pricing Model (CAPM).
Competency
Evaluate financial risk, cost of capital, and risk-reward tradeoffs
Student Success Criteria
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Scenario
You graduated from college three months ago and have landed a job with TBMV & Associates Financial. Part of your training is to attend a business seminar. It just so happens that you attend one where Brian Olsavsky, CFO of Amazon, is the guest speaker. One of Brians main messages revolves around all his success and how Amazon will continue to grow.
You are a firm believer that history repeats itself. It is your belief that the next big risk taker will come along soon, and Amazon will be a thing of the past. In friendly conversation at your table, you state your thoughts and conclude Brian must not share your same belief.
Unbeknownst to you, his secretary is seated at your table. Giggling, she asks what you mean. You tell her that William Pollard stated that learning and innovation go hand in hand. The arrogance of success is to think that what you did yesterday will be sufficient for tomorrow.? Then you proceed to tell her that Brian does not take enough risks. His secretary goes back to Brian with what you have said. Brian would like to know what you meant and your thoughts, so he hires your firm to do a risk evaluation. When you arrive back to your office, you are given Amazons data file and instructed to evaluate the financial risk of Amazon.
Instructions
Using Microsoft Word, create a financial proposal that addresses the following:
Explain Amazons financial risk, cost of capital, and risk reward from historical data.
Interpret Amazons financial information using Capital Asset Pricing Model (CAPM).
Devise strategies for Amazon to achieve investment high returns and low risk using Modern Portfolio Theory (MPT).
NOTE – Be sure the financial proposal displays proper grammar, spelling, punctuation, and sentence structure.
Deliverable 6 Notes Risk Evaluation
Capital Asset Pricing Model
Interpreting financial information using the Capital Asset Pricing Model, or CAPM has not always been an easy task. Capital asset pricing model is a theory of the relationship between expected return and risk. It is often used in finance to determine an appropriate rate of return for an asset being added to a portfolio to make it well-diversified.
Beta
Capital asset pricing model states that expected return is a linear function of systematic risk, beta. Beta can be defined as a measure of an assets systematic risk. It measures the volatility of an assets returns relative to the markets returns. So, when looking at risk of a stock we look to see if beta is greater or less than 1. If the stocks beta is greater than 1, that is an indication that the security’s price tends to be more volatile than the market. If the beta is less than 1, it is an indication that the securitys price tends to be less volatile than the market.
What CAPM Tells Us
So, what information does the capital asset pricing model actually provide? It depends on how beta is plugged into the equation. When plugged into the cost of equity equation, the capital asset pricing model shows the equilibrium relationship among the anticipated return on any risky asset and its systematic risk. To put it in the perspective of an investor, it provides a minimum satisfactory rate of return the investor should request on the risky asset.
How to Calculate CAPM
The following formula is often used to calculate capital asset pricing model:
RA = Rrf + [Ba X (Rm Rrf)]
Where:
Ra = Expected return on a security (a long-term assumption about how an investment will play out over its entire life.)
Rrf = Risk-free rate (typically equal to the yield on a 10-year US government bond.)
Ba = Beta of the security (a measure of a stocks risk (volatility of returns) reflected by measuring the fluctuation of its price changes relative to the overall market.)
Rm = Expected return of the market
Therefore, Rm Rrf will provide the risk premium, which represents the additional return over and above the risk-free rate, which is required to compensate investors for investing in a riskier asset class.
CAPM and WACC
The capital asset pricing model is also important when trying to calculate the weighted average cost of capital. The weighted average cost of capital shows the percentage or WACC = (E/V x Re) + (D/V x Rd) x (1 T))
Where:
E = market value of the firms equity (market cap)
D = market value of the firms debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate
This information is especially important when knowing the risk associated with each item in the portfolio to have diversification and risk reduction.
Summary
In essence, the capital asset pricing model signifies a new and diverse approach to an important task. Financial decision makers can use the model in combination with outdated techniques and sound judgment to develop accurate, valuable estimations of the costs of equity capital. The capital asset pricing model is used in finance to determine return on stock based on market behavior. Financial decision makers can use capital asset pricing model in conjunction with traditional techniques and sound judgment to develop realistic, useful estimates of the costs of equity capital.
What is CAPM?
Capital asset pricing model is a theory of the relationship between expected return and risk.
Define Beta
Beta can be defined as a measure of an asset’s systematic risk.
What does Beta measure?
It measures the volatility of an asset’s returns relative to the market’s returns.
What information does CAPM provide?
It depends on how beta is plugged into the equation. When plugged into the cost of equity equation, the capital asset pricing model shows the equilibrium relationship among the anticipated return on any risky asset and its systematic risk. To put it in the perspective of an investor, it provides a minimum satisfactory rate of return the investor should request on the risky asset.
Modern Portfolio Theory
There are strategies available for use in investing for achieving high returns and low risk using Modern Portfolio Theory, or MPT. When the capital asset pricing model is used to determine the risk and weight of stock in a portfolio, analysts also have to consider the type of portfolio.
Market Portfolio
In looking at the type of portfolio, pertaining to high returns, analysts find the term market portfolio, which is a portfolio that contains all risky assets. In the corporate world, the purpose of investing and having a portfolio is to have high returns and take low risk. Financial managers know that this does not always happen, but the way analyst try to balance this is through MPT. What exactly is modern portfolio theory?
What Is Modern Portfolio Theory?
Modern Portfolio Theory is the idea that an investment’s potential returns are directly tied to the level of risk involved. Modern Portfolio Theory is a mean-variance analysis, or essentially a mathematical framework that assembles a portfolio of assets in such a way that the expected return is maximized for a given level of risk. There are four strategies to mitigate risk.
Risk Mitigation
Avoidance
Avoidance which means if a risk presents an unwanted negative consequence then the investor should try to completely avoid the risk by stepping away from the option or situation.
Transference
Transference is the last option in which the investor can try and transfer the risk to another area.
Reduction or Control
Reduction or control is an option in which the investor can try and control the level of risk or at least reduce the level of risk.
Acceptance
Acceptance is another option in which there is always some level of risk. If the risk level is low enough and worth the risk, the investor can always accept the risk.
Diversification
All of these options can be executed through a simple process called diversification. Diversification occurs when a stockholder or organization invests in several different assets instead of having just a single investment. Diversification is a key component in finance as it lays the groundwork for practical investment plans. A well-positioned diversified portfolio, with risk levels determined by the investors risk preferences, should be the goal of every investor.
There is a limit to diversification effects as additional assets are added to a portfolio. This occurs because assets have exposures to common influences, such as the ups and downs of the overall market.
Diversification does lower the level of portfolio risk, but as all assets are exposed to a common economic and market environment, after a while, additional increases in the number of assets do not continue to lower portfolio risk.
Decreasing Risk Using Foreign Stock
One way to increase the number of stocks in the portfolio and to keep decreasing the level of risk is to invest in foreign stock. Organizations have what is called corporate umbrellas or parent companies in which many small companies or business entities are owned by one big organization. An example of these types of parent companies are Johnson and Johnson and Proctor and Gamble. Both of these giant parent companies own many smaller companies in which some are foreign to balance the portfolio and lower risk.
Summary
In this section we have discussed modern portfolio theory as well as the type of portfolio that carries all the risk. The goal is always to have high returns and a low risk, but we have learned that is not an easy task.
Revsine, L. (2020). Financial Reporting and Analysis (8th ed.). McGraw-Hill Higher Education (US).
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