Discussion 5 - CAPM

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Feb 20, 2024

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1. Diversifiable risk, also known as unsystematic risk, is defined as firm-specific risk and hence impacts the price of that individual stock rather than affecting the whole industry or sector in which the firm operates. Therefore, would it be worthwhile to diversify an investment with unsystematic risk? Unsystematic risk can be reduced through diversification of a portfolio. Because unsystematic risk is often specific to a particular company or industry, it can be avoided (Chen, 2021). But, whether or not it is “worthwhile” to diversify an investment with unsystematic risk is ultimately a decision affected by an investor’s risk tolerance. Risk tolerance refers to the amount an investor is willing to risk due to uncertainty, in the face of possible gains. Often, those with an aggressive investing style are most likely to take big risks of suffering a major loss in hopes of instead gaining a big return (Thune, 2021). Diversification decreases risk in any portfolio, but choosing to diversify an investment with unsystematic risk is likely only worthwhile to those that have moderate to aggressive investing styles which is more often the case for those that are wealthy and can afford to lose more money or those that are still quite young and therefore have time to make up for losses (Thune, 2021). 2. What are the benefits and limitations of a company paying dividends? A dividend is the distribution of part of the earnings of a company to its equity shareholders, most commonly paid via cash dividend. For a company, the major advantages to paying dividends include an increased interest from potential investors and greater shareholder loyalty. From an investors point of view, an advantage to being paid dividends includes confirmation of a return on his/her investment and the ability to use the dividends make new investments. Conversely, for a company, the major disadvantage of paying dividends is that the payout of the dividends are funds that are unable to be used to grow the business which can make it more difficult to increase stock value. From an investors point of view, a disadvantage to dividends is that the distributions are taxable income so the investor is unable to defer the gain (Plaehn, 2018). 3. Under what conditions are the dividend growth rate at least equal to the growth rate of the cash flow? A credible dividend policy is consistent with the earnings that the company achieves (i.e., the dividend profile is consistent and compatible with the earnings profile). Companies that make a profit at the end of fiscal period can choose to pay dividends to shareholders or retain the profit to reinvest in the growth of its business. A mature company that has moved past its initial growth stage, may choose a 100% payout ratio, meaning that the company has chosen to pay out their entire income as dividends (Hayes, 2022).

Chen, J. (2021, April). Unsystematic Risk . Investopedia. https://www.investopedia.com/terms/u/unsystematicrisk.asp Hayes, A. (2022, January). Dividend Payout Ratio. Investopedia. https://www.investopedia.com/terms/d/dividendpayoutratio.asp Plaehn, T. (2018, November). Advantages & Disadvantages of Paying Cash Dividends . Pocket Sense. https://pocketsense.com/advantages-disadvantages-paying-cash-dividends-5959.html Thune, K. (2021, October). What is Risk Tolerance? The Balance. https://www.thebalance.com/what-is- risk-tolerance-2466649 Vernimmen, P., Quiry, P., Dallochino, Y., Fur. L., & Salvi, A. (2017). Corporate Finance, 5th Edition. Wiley. http://doi.org/10.1002/9781119424444.part6

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