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Diversified Risk and Capital Investment

Diversified Risk and Capital Investment

Part 1

Investors desire to make their investments in stocks that are safe for their money and efficient. Such stocks should have a low risk. The risk is reduced through a diversified portfolio (Guesmi et al., 2019). A diversified portfolio contains various assets. The table below provides a list of eight stocks that are selected to form a diversified portfolio.

Name Symbol Industry Current price as of 23 May 2021 (USD) 1-year rate of return 5-year rate of return
Johnson and Johnson JNJ Pharmaceutical sector 179.44 -4.2% +30.1%
Walmart WMT Retail 122.60 +18.8% +60.44%
Tesla TSLA Automobile 674.90 -24.23% -4.09%
Coca-Cola KO Beverages 62.86 +17.22% +32.33%
Bank of America BAC Banking 35.87 -8.70% +68.2%
Kraft Heinz Company KHC Consumer 38.99 -45.3% -59.04%
Netflix NFLX Entertainment 187.44 -5.26% +313.4%
Apple AAPL Computer and electronics 143.11 -2.3% +146.22%

Eight companies are considered in the portfolio shown above. They include Johnson and Johnson Company, Walmart, Tesla, Coca-Cola, Bank of America, Kraft Heinz Company, Netflix, and Apple. The performance indicated in the 1-year rate and 5-year rate shows significant changes. Some stocks have gained growth, such as Coca-Cola and Netflix, while Kraft Heinz Company has seen a decline. Therefore, such a portfolio minimizes risks that an investor could have suffered in case an investment was made in Kraft Heinz Company. However, all the other companies could have earned a positive investor return in five years.

Difference between Portfolio Risk and Stand-Alone Risk

Portfolio risk is the possibility that a combination of units or assets within a group of owned assets may fail to achieve the targeted goals. Arguably, when the potential return is high, it means that there would be a higher portfolio risk. Examples of portfolio risks include inflation, sovereign, and principal risk loss (Ghasemi et al., 2018). On the other hand, a stand-alone risk refers to the risk associated with a single operating unit of an organization or asset. It is the risk that an investor assumes when only one asset is analyzed or held. A major difference between the two risks is that an investor loses all the money invested in stand-alone risk. In contrast, in portfolio risk, an investor cannot lose all the money invested when an asset is held in a portfolio.

Effect of Risk Aversion on Stock’s Required Rate of Return

Risk aversion refers to the practice investors adopt to invest in assets with low risk compared to those with high risk, irrespective of the anticipated gains. Arguably, this is normal knowledge for people to avoid uncertainties. However, the degree of risk acceptance varies from one person to another. Therefore, risk aversion differs from one investor to another depending on the investor’s risk tolerance (Riepe et al., 2022). Investors will accept assets with higher uncertainty only when the rate of return is higher. Therefore, there is a direct relationship between risk aversion and the required rate of return, whereby higher risk aversion attracts a lower rate of return while lower levels of risk aversion attract a higher required rate of return.

Difference between Stock Price and Its Intrinsic Value

The stock price of an asset refers to the value upon which it is traded in the market. Unlike the stock price, the intrinsic value of the same stock will be the stock’s book value, which is recorded in the books of the company (Mensah et al., 2022). Arguably, the stock price is the most crucial aspect because it changes from day to day. In addition, the stock’s intrinsic value exists only in theory and is only used when a company is being liquidated, which is not common.

Part 2

Introduction: Project Reflection

A project is proposed to start a social media platform that will offer businesses an opportunity to advertise their products and services. In the wake of e-commerce and digital technology, launching this product will be of great benefit in the future. Notably, the project will offer sellers a platform to engage with their customers, and in the course, the concern of customers will be addressed in no time. Essentially, the project will leverage vast numbers of customers visiting the website to attract most, if not all, potential sellers to the website. Based on the website, the buyers can initiate a purchase option, and the seller can confirm the transaction on the platform. However, the setting of the project will require investment through an initial outlay and subsequent additions until the end of the project. The illustration given below illustrates the project.

Project Product name Initial capital Operational costs License fee Maintenance fee Total
Marketing website Conekta $10,000 $15,000 $5,000 $1,000 $31,000

Since most people have adopted social media in communication and day-to-day activities, the intended project will enhance the benefits they gain from operating online. The business will provide a link to famous social media applications such as Facebook, Instagram, Tik Tok, and Twitter. Notably, the link between these applications and many others will ensure that customers and sellers engage each other from all platform dimensions. It is anticipated that the project will deliver higher levels of customer satisfaction, driving it to higher levels.

Relationship between Risk and Return

It is worth noting that the project will have various risks that may hinder the intended goals’ achievement. However, the anticipated returns are promising, making it essential to assess the relationship between risk and return. The expected return from the proposed project will be 14.4%. The risk involved in the project will be higher if the expected rate of return is not achieved. Such risk will occur when the project fails to attract members of the society as anticipated and receive negative responses in the market. As a result, a critical look into the marketing and adoption of the product will be engaged to ensure that the risk of the project failing remains as low as possible.

As already stated in the prior section of this essay, there is a direct relationship between risk and return. When the risk involved in a project is high, the expected return will also be higher. On the contrary, when the risk involved in a project is low, the returns anticipated will be below. For the subject project, the expected return rate is 14.4% which indicates that the project will incur significant risks. The risk will occur in the form of competition from like businesses that will avoid losing in the project’s materialization. Further, the risk materialization will be the uncertainty surrounding the project’s adoption among the general public. However, high returns will be achieved if the risks do not materialize.

Weighted Average Cost of Capital (WACC) Calculation

The weighted average cost of capital will inform the overall rate of return that the firm will expect from the project once it is implemented. Further, it represents the rate at which a company is expected to pay its security holders on average to finance their activities (Carluccio et al., 2021). The rate considers all elements that make up the firm’s capital structure. Notably, these include the cost of debt capital, cost of equity, and cost of preferential shares. The calculation of WACC for the subject project will be given as follows.

WACC = Cost of equity (ke) + Cost of debt (kd)

= (E/V × Ke) + (D/V) × (1-Tax rate)

= (170,000/250,000 × 18%) + (80,000/250,000) × (1-0.3)

= 0.1224 + 0.0224

= 0.1448

= 14.48%

The project’s WACC will be 14.48%, informed by equity and debt capital. There is no element of preferential shares. The company is expected to have equity of $170,000 and debt of $80,000. The WACC of 14.48% will serve as the project’s expected return, and anything below that rate will not be accepted. Further, a lower rate will indicate higher risk and hinder achieving the intended returns.

Conclusion

While handling investments, investments have to incur a trade-off between risk and returns. Some significant aspects related to such a trade-off have been discussed in this paper. They include a diversified portfolio, risk aversion, stock price, intrinsic value, risk and return, and WACC calculation. In conclusion, it is observed that all these aspects offer insights to investors regarding taking risks, and they should be considered for maximum benefits.

References

Carluccio, J., Mazet-Sonilhac, C., & Mésonnier, J. S. (2021). Private firms, corporate investment and the WACC: evidence from France. The European Journal of Finance, 1-25.

Ghasemi, F., Sari, M. H. M., Yousefi, V., Falsafi, R., & Tamošaitienė, J. (2018). Project portfolio risk identification and analysis, considering project risk interactions and using Bayesian networks. Sustainability10(5), 1609.

Guesmi, K., Saadi, S., Abid, I., & Ftiti, Z. (2019). Portfolio diversification with virtual currency: Evidence from bitcoin. International Review of Financial Analysis63, 431-437.

Mensah, M. O., Peprah, W. K., Owusu-Sekyere, A. B., Ayaa, M. M., & Daniel, B. (2022). Influence of Stocks Intrinsic Valuation on Investment Decision Making: A Literature Review. Journal of Academic Research in Business and Social Sciences12(5), 1268-1275.

Riepe, J., Rudeloff, M., & Veer, T. (2022). Financial literacy and entrepreneurial risk aversion. Journal of Small Business Management60(2), 289-308.

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Question 


Diversified Risk and Capital Investment Essay
Part 1
For the Part 1, you will create a portfolio of 5-8 stocks that demonstrates diversified risk. List the stocks along with their
current price and previous 1-year and 5-year rates of return. Below the list of stocks respond to each question in
paragraph format.

Diversified Risk and Capital Investment

Diversified Risk and Capital Investment

• Explain the difference between portfolio risk and stand-alone risk.
• How does risk aversion affect a stock’s required rate of return?
• Explain the distinction between a stock’s price and its intrinsic value.
Part 2
For the purposes of Part 2, a project is defined as any endeavor that had a capital outlay. Pick a project you have recently
completed or one you would like to complete in the near future. This could be a project in your home, place of work, or
even church or other organization you are familiar with. Respond to the following prompts:
• Introduce your project with a reflection on the importance of selecting the right projects in which to invest capital.
• Describe the relationship between risk and return, and how you would measure for both in your project.
• Explain how you would calculate the weighted average cost of capital (WACC), and its components for your
project.FIN 6301, Corporate Finance 3
Parts 1 and 2 should be submitted in a single document for a combined total of at least two pages in length. Use headings
and subheadings specify parts 1 and 2 and as necessary. You are required to cite and reference at least your textbook.
Use APA style guidelines. Title and reference page do not count towards minimum page length requirement.

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