When affecting a company’s portfolio, which includes every investing

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:

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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.