I will discuss risk and return with the constant growth model and risk premiums. The
constant growth model is the model used for companies to pay their shareholders dividends.
The dividends that the shareholders receive are the returns for their investment however, any
investment has risk to it. Based on the constant growth model, the dividends calculated for
the shareholders is based on the company's performance. Projected company performance is
never a guarantee therefore investments for the sole purpose of receiving dividends can be
risky since market performance can be unpredictable due to uncontrollable factors. Risk
premiums are returns in excess for accepting a greater risk for an investment. A standard and
"safe" investment can give someone a return of 5 percent for example where a large "risky"
investment may have the opportunity of giving a return of 20 percent creating a risk
premium of 15 percent or, losing the investment entirely. With risk premiums, the risk is
losing a greater investment to potentially receive a greater return. The CAPM describes the
relationship between risk and expected returns, and taking on more risk is necessary to earn
a higher return. This tool is designed to help investors to analyze their risk and gain, and
choose the limit of investment according to their desired level of leverage. However some
hypothesis behind the CAPM formula have been shown not to hold up in reality. The linear
relationship between beta and individual stock returns also breaks down over shorter periods
of time. These findings seem to suggest that CAPM may be wrong. The CAPM also
assumes that the risk-free rate will remain constant over the discounting period. An increase
in the risk-free rate also increases the cost of the capital used in the investment and could
make the stock look overvalued.The most serious critique of the CAPM is the assumption
that future cash flows can be estimated for the discounting process. If an investor could
estimate the future return of a stock with a high level of accuracy, then the CAPM would not
be necessary.I think its important to mention that William Forsyth Sharpe who developed
the CAPM in the 1960s, won the Nobel Prize in Economic Sciences. He is also known for
creating the Sharpe ratio, a figure used to measure the risk-to-reward ratio of an investment.
Investors have many tools available to help determine the expected return on investment.
Generally, the higher the risk of an investment, the higher potential is for a substantial
return. However, there is an equal potential for loss. Therefore, an investor's goal is to
determine whether the expected return is worth the risk. One tool that assists an investor is
the capital asset pricing model (CAPM), which defines the relationship between the risk of
an investment and its expected return. Using the CAPM, investors can evaluate whether a
stock price is worth the expected return. The CAPM calculates the expected return by adding
the risk-free rate to the market risk premium multiplied by the beta. The beta measures the
relationship of a stock's volatility to the market. Investors use this calculation to discount the
expected gains and determine if the investment is reasonably priced.One factor of the CAPM
is the market risk premium, which is the difference between the expected return and the risk-
free rate. In other words, the extra amount an investor earns when willing to take on
additional risk. The standard for the risk-free rate is usually the rate paid on treasury bonds,
considered low-risk investments. The greater the risk of the investment, the higher the risk
premium. There is always a risk when investing in any type of market. Most agents that sell
you investments usually tell you that it is not protected by the FDIC. A risk premium is an
investment with a higher return but higher risk in falling. For example, Bitcoin has caused a
lot of controversy, many people have invested millions of dollars for currency that in my
opinion electronic money. Many people have lost thousands of dollars in the past years,
although in it gained so much popularity and people started to buy like crazy its value has
gone down significantly.The capital asset pricing model also known as (CAPM) is a model
used to help determine investment returns on stocks, mostly stocks. It helps as a guidance to
see if there is a risk in investing in certain stock, by using math. This helps agents and
people who want to invest help make a more informed decision on which stocks are willing
to yield a better return. This model is very helpful and insightful as this can help prevent loss
of money.The forward-looking expected return and risk computations uses probability
distribution and standard deviation. The actual return depends on how well or weak the
economy is and financial decisions can be dictated by those economic conditions. Using the
sum of each probable return (or the standard deviation) investors and financial managers can
find a rate that they can expect out of the forecasted economic conditions. Essentially, the
probability forecast is like a weighted average of those returns. Since things don't always go
according to plan (or what was predicted), this carries the issue of "risk." Investors want a
concrete number (required return rate) that they can confidently aquire for the level of risk
that they undertook. Since a heavily diversified portfolio won't have firm-specific risk (like a
S&P 500 index) and government bonds/bills are considered risk-free, all that is left is the
"risk premium"--the market risk or the average market return rate (based on historical
figures). So if a firm undertakes new projects to diversify its product line or service, they
will consider the level of risk for their targeted return. They will look at the probability of
the return rate that at least matches up with the market premium (or the firm's premium if
outperforming the market). Depending on the type of investment product you choose, there
is generally a level of risk associated with it. There are some risk-free products available
such as government bonds. A risk premium is the higher rate of return you could receive
from riskier products such as stocks. When you invest, there is a chance the product can
perform badly, and you could lose a great deal. Understanding the risk premium of the
product will help you choose how much you are willing to put into risker things. For
example, in our 20s our financial advisor guided us to more risky products as we were
young and had time to recover from a loss should we incur one. Now that we are reaching
our 50s, our advisor is more conservative with the selections he makes as our time to recover
is less. While meeting with out financial advisor, he references the constant-growth model,
briefly to inform us, of the stocks we are invested in are growing. He also mentions how he
anticipate further growth based on past performance again the current market trends.
Together we determine if a stock price will provide value should we purchase same day, and
what projected dividend potential they have. As stated earlier, we don’t do as much from a
risky standpoint, as we take less risk as we age. However, with the funds we’ve set up for
our children, we are able to make bigger moves. For instance, if debt is used to improve a
family's life with a long-term vision, then I would think it would be considered good debt.
Some examples of good debt could be education, home ownership, investment property, and
/or business ownership. However, most short-term personal debt would be considered bad
debt. Examples of this debt is usually depreciating items, such as car loans, clothing, new
electronics, consumables, and other items bought and paid for via a credit card or similar
finance tool. I would also consider other personal debt as high-risk/bad debt. Some of these
examples may include consolidation loans or second mortgages, that are often used to repay
credit card or auto loans - this is just a way to hide bad debt. Another example of high-risk
debt, in my opinion, is margin accounts; since, the chance of losing money is extremely easy
without proper experience and knowledge of how this works.However, what are some
examples of "bad debt for a business"? Unless the company is borrowing money to pay
weekly payroll or some other immediate need that will not provide value to the company in
the future, what is an example of long-term "bad debt"? I would think, examples of good
debt range from borrowing money to open a new store front, build a new manufacturing
facility, develop/test a new drug, perform R&D, rent a new work location, purchase heavy
equipment (that will be depreciated - maybe for a construction company), buy a
competitor/technology, hire/train new resources to open a new business unit or expansion,
etc. These items bring value to the business. I realize, depending on the industry, the amount
of debt may be higher than the market expects a business to have; however, these types of
debt seems to be "good debt". So, is there a type of (long-term) "bad debt" for a business
that an investor should keep their eye out for?
