Risk and Returns - Assignment Example

Running Head: RISK AND RETURN Topic: Risk and return Risk and return analysis for an investment vehicle portfolio for Wal-Mart stores The rate of return that an investor require for investing in particular securities depends so much with the risk associated with such investment. The greater the amount of risk, the larger the amount of return an investor expects as a compensation for bearing such a bigger risk. Based on utility theory, it suggests that any average investor is risk averse, i.e.

fear the risk. Given same expected rate of return for two assets having different risks, then its obvious that he would prefer investing in a less risky one. This is contrary to risk taker investors who would instead invest in a riskier security. In order to diversify the risk, the assets are held together forming a portfolio. The sum of variance for the portfolio is almost lower than a single average weight of individual portfolio, therefore, minimizing the overall risk of investment (Rachev, 2005).

 To clearly illustrate the model, the following capital structure for Wal-Mart stores for the year 2010 is used. Type of financing Market ValueWeightsLong-term debt $35M 35%Preferred stock $15 M 15%Common stock Equity $50 M 50% $100M 100% Each component cost could be determined using various formulas. For instance, to determine the cost of debt using the Wall mart sore which has $1,000 PV (par value) zero coupon bond outstanding. Assuming that the bonds are currently trading at $ 385.54 with a 10 year maturity period and a tax rate of 40%, then the cost could be determined as follow.

Po= ∑ (Ii+Pi)/1+kd) j and Ki = kd (1-T). Then, 385.54= ($0+$1,000)/ (1+kd) 10 = (1+kd) 10=2.5938 kd =0.1=10% thus since T=40, then ki= 6%Another component whose cost should be determined is preferential stock. This is the required rate of return of the preferential shareholders who have invested in the company.Kp= Dp/Po. Assuming that the Wal-Mart has finical stock outstanding which $100 par value, $ 6.3 par value for dividend and current market value of $ 70 per share, then Kp= Dp/Po: kp=$6.

30/$70= 9% Finally the cost of equity would be determined using capital asset pricing model would be used to determine the cost of the components. Assuming that the risk free rate in the market is 4% and having been given the beta factor of 3 for bond and 0 for money market instruments. Ke=Rj= Rf+ (Rm-Rf) βj, Ke=4% + (11.2%-4%) 3= 25% Now the weighted average cost of capital can be computed since we have all the weights for each security. According to the formula that WACC= (Bernstein, 2001). WACC =0.35(6%) +0.15(9%) +0.50(24.6%) =2.1+1.35+12.3= 16%If the capital structure changes, i.e. relying so much on debts than equity the individual capital component weights will change as shown bellow;Type of financing Market ValueWeightsLong-term debt $70M 70%Preferred stock $15 M 15%Common stock Equity $15 M 15% $100M 100%That being the case withal the variables being constant, then WACC= would be calculated as, WACC =0.7(6%) +0.15(9%) +0.15(24.6%) 4.2+1.35+3.69 = 9 %.For a risk take investor, he will consider using debt which is much cheaper than common equity and preference stock.

This is a risky investment, though the overall return will be much higher. The average weighted cost of capital will be much lesser i.e. 9% as par the computation above. On the hand if the investor considers using less debt which is cheaper and opt to use more equality and common stock as shown in the capital structure bellow;Type of financing Market ValueWeightsLong-term debt $10M 10%Preferred stock $20M 20%Common stock Equity $70M 70% $100M 100% =0.1(6%) +0.20(9%) +0.70(24.6%)= WACC=0.6+1.8+17.22 = 20%. In conclusion, it is clear that risk is a universal factor in investment decision since no one can really stay away fro it.

Though that is the case, risk can be reduced based on individually capability as well as their knowledge. For one to have successful portfolio management, then it will depend on the right mix of all assets and individual investor’s overall risk expectation. Type of financing WeightsWeightsWeightsLong-term debt 35%70%10%Preferred stock 15%15%20%Common stock Equity 50%15%70%100%100%100%WACC16%9%20%One of the key important choices which an investor has to consider is his where his risk tolerance lies.

This will depend on macroeconomic variables such as inflation rate, unemployment and economic outputs. As shown in the analysis above, each shared holder will opt to have his choice of capital structure base on his risk tolerance.Reference:Bernstein, W. (2001). The best intelligent asset allocator: How to build your portfolio to maximize returns & minimize risk. New York: McGraw Hill.Rachev, S. (2005). Fat-tailed & skewed asset return distributions: implications for risk management, portfolio selection, & option pricing.

Hoboken, N.J: John Wiley & Sons.