When companies engage in investments, they are deemed

to face risk which they must account for through the return the investment

might generate for the company. Total risk consists of two main types affecting

a company’s portfolio, which includes every investing activity or projects the

company handles. Firstly, systematic risk, which “influences a larger number of

assets, each to a greater or lesser extent” (Ross, 2011) and have market wide

effects like inflation. Due to this, systematic risk is unavoidable as a

company cannot control what occurs in the market. Secondly, unsystematic risk,

which “affects a single asset or a small group of assets” (Ross, 2011) and are thus

unique to specific companies like bad management. Hence, this risk is unrelatable

to the market and companies can control it in a great extent. This means that

they can reduce unsystematic risk, and even eliminate it through

diversification, so a portfolio with many assets has almost no unsystematic

risk.

In the case

where companies undertake new projects, they must calculate the total risk the

project can potentially present. Thus, the discount rate needs to be calculated

for a project which should be “discounted at a rate commensurate with its own

risk” (Ross, 2011). Beta (?) is widely used to

quantify risk, as it measures the volatility of a portfolio compared to the

market. One statistical measure that incorporates ? is the capital asset

pricing model (CAPM). It is used when a project’s risk is different from the corresponding

company’s risk, which means it is a systematic risk. CAPM measures the value of

a company’s asset, for example the value of purchasing new stocks, which is

determined by considering the risk involved and the expected return of that

stock. Evidently, the expected return from the stock should be greater than the

investment made to purchase it, and should also be positively related to its

risk, for companies to engage in investing on the stock market. Hence, the

discount rate can be based on the return the investor expects to receive, and

it is also used to determine whether an investment is worth taking, by projecting

any possible positive returns. This is done by using the discount rate to

estimate the net present value of future free cash flows of an investment, ensuring

that enough money will be generated to recover the investment made. Since, the

market is greatly involved in this matter, the expected return on market must

be accounted for too. This can be calculated using the formula shown below:

The expected

return on the market “is the sum of the risk-free rate plus come compensation

for the risk inherent in the market portfolio” (Ross, 2011) for a given period

of time. Whereby ? incorporates the risk premium factor, that is used in the

CAPM calculation for a risk-adjusted discount rate as shown by the formula

below:

The formula implies that the expected return

on a security is linearly related to its beta, from which one can imply that if

there is a higher risk, there should also be a higher return on the portfolio,

security and such. Hence, under this model, the investing company can expect to

have a greater return if greater risk is also taken. For certain investments,

the risk-adjusted discount rate is applied. For example, in long-term

investments, it might be more likely for a higher market uncertainty to exist.

Hence, the risk-adjusted discount rate accounts for this too, and based on the

risk a company faces, there is an adjustment made that changes its discount

rate accordingly. In the case of stocks, these should have a return to compensate investors for the additional

risk of holding stocks over holding risk-free treasuries.