Price of the Market - Essay Example

In simpler terminology, it measures the movement in value of any security with the movement in the price of the market as a whole. This factor can be important in establishing a portfolio. There are many types of companies, some operate very closely with the financial institutions and markets while others have different operations e.g. manufacturing. All types of companies make investments. These investments play a huge role in assessing the cost of capital(Intermediate Financial Management). The cost of capital is basically the interest they pay on debt and dividends on stocks.

This cost basically depends as explained above on the amount of risk associated. If the risk is low, that is beta for a company is low, its cost of capital will automatically below. Investors will be willing to invest in it for lower returns and banks will lend on a lower rate. (Similar example can be found in intermediate financial management)We can better comprehend this with an example. Let us assume that Company X makes investments in Gold mines. Each Gold mine has an equal probability of giving no gold at all and gold worth ten times its extraction cost.

The extraction expenditure for a gold mine; irrespective that it results in gold or not, is $100 for small size mine and $1000 for a large size mine. In the first scenario Company X who is short of money and has just $ 1000 to invest, invests in a large gold mine. Now the risk of a loss of the $1000 investment is 50%, which is very high. This will associate high risk with the company’s future cash flows and investors will require a high return; thus driving its cost of capital up. In the second scenario, however Company X decides to invest in ten small gold mines.

Although the return is the same but the risk has gone down considerably, because most of the risk has been diversified away. (Intermediate Financial Management) This is why CAPM recommends companies to maintain a diverse portfolio of investment (Equilibrium in a Capital Asset Market). These should be investments which are not linked to each other i.e. their betas should cancel out the effect of risk. In the practical world, investors usually invest in sectors, which gain on each other’s bad performance e.g. if you are investing in an Oil marketing Company, you also buy some automobile stock because if the oil prices come down the car sales are bound to go up.