Realized return refers to the yields that an investor actually earns from his or her investments over a given period of time. An investor periodically calculates the actual yield generated on his or her investments in order to determine the stability of the portfolio. A stock’s realized return has several components. Dividends are components the realized returns, which refer to payments made by a firm to shareholders (Brigham & Ehrhardt, 2009). Capital gains also form part of realized returns. Capital gains are profits realized by a company from the sale of its investments at a higher price than the price of initial acquisition. Share price appreciation is another component of the realized returns of stocks. It refers to the increase in the price of shares meaning that the shares have greater value.
Systematic risk refers to that risk that cannot be eliminated through diversification because it affects the firms in the industry in the same manner i.e. systematically (Brigham & Ehrhardt, 2009). It is also referred to as the market risk because it affects the entire market or a broad range of assets in a given portfolio. Examples include changes in the rate of interest or political instability. On the contrary, unsystematic risk is that risk that can be eliminated through diversification because it is specific to a given industry in the market. Unsystematic risk influences a specific class of securities or an individual security. Examples of unsystematic risk include industrial strikes specific to a given industry, the outcome of an unfavorable suit or a natural disaster.
The total risk of a portfolio is not simply equal to the weighted of the risks of the securities in the portfolio. The total risk of a portfolio is calculated by determining the individual risk components of the investment. It comprises the free risk from government securities and the excess risk (Brigham & Houston, 2007). The excess risk represents the actual risk of securities because it contains both the systematic and unsystematic risk. The beta factor helps in determining the systematic risk whereas the standard deviation measures unsystematic risk. Thus, the total risk is not just a weighted average but a combination of systematic and unsystematic risks in a portfolio.
Beta is a coefficient of the capital asset pricing model (CAPM), which measures systematic risk in a portfolio of assets in relation to the entire market. The beta factor can be used to measure the volatility of stocks in the stock market to determine how the systematic risk affects stock prices (Brigham & Houston, 2007). Beta can assist in determining the sensitivity of the returns of a security in comparison to market returns. The calculated value of the beta coefficient helps investors in making the right decisions regarding the right combination of investments. For instance, a beta value of 1 indicates that the stock’s price will move with the market. A value of less than 1 shows that the stock will be less volatile than the market, while greater than 1 indicates a more volatile security compared to the market. This information enables investors in making the right decisions.
The Weighted Average Cost of Capital (WACC) measures the expected returns from the company’s assets that assist in financing the firm. It involves all sources of capital such as ordinary shares, preference shares and bonds that are weighted average. In valuing a project using WACC, investors make several assumptions. They assume that WACC is measured in nominal terms thus including inflation. Another assumption is that WACC is based on market value as opposed to book value. In addition, there is the assumption that WACC is market driven hence being the required rate of return for making an investment.
References
Brigham, E.F. & Ehrhardt, M.C. (2009). Financial management theory and practice.
Mason, OH: Cengage Learning.
Brigham, E.F. & Houston, J.F. (2007). Fundamentals of financial management. Mason, OH:
Cengage Learning.
