Question

Client's Financial Questions: Provide a brief discussion of approximately 300 words detailing the risks inherent in stock returns in a portfolio of shares using the concepts of standard deviation and diversification as a basis for your discussion. .Under what conditions can a firm's weighted average cost of capital be used for assessing new projects? In the context of the net present value (NPV) model discuss: o The conditions that must be observed such that a project that has a positive NPV should be chosen. Why, in these circumstances, would a project that has a positive NPV be chosen? o Why depreciation does not involve a flow of cash and therefore can be ignored. excluded from the cash-flow estimation o The effect of sunk costs within the analysis of a project's viability.

Answer 1

Question 1:

The stock returns are not linear in fashion. That is they do not go up in a straight manner like the bond returns. In some years the stock returns are positive and in others they are negative. The return on stocks average over the years and hence a return over and above inflation can been seen over long periods of time (say 10 years). The risk in stocks can also be reduced by diversification. This involves choosing companies that are present in different industries. For example, instead of choosing three stocks in the financial sector, one can choose one stock each in the financial, retail and information technology space. Diversification helps because there are different business cycles in the different industries. If the financial sector is going through a down cycle, this can be cancelled out by the retail sector which may be going through an up cycle. Therefore through diversification, one can reduce the volatility and get above average return. However, the point to be noted here is the too much diversification will not help and may also result in reduced returns in the stock market. The volatility in returns can also be reduced by making your portfolio beta equal to one which is that of the entire market. You can select one stock which a beta greater than that of the market (like 1.5) and another stock with a beta lower than that of the market (like 0.5). The stock with the beta higher than the market will have a higher risk and and a higher standard deviation and the stock with the beta lower than the market will have a lower risk and a lower standard deviation. So in this manager you can manage risk and return based on the individual risk appetite of the investor.

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