Risky Investment of $500 The Sure Thing NPV = $300 Good Times Payoff = $1,000 75% 25% Bad Times Payoff = $100 Risky Investment is worse, it has NPV = $208 Risky Investment is better, it has NPV = $363 Risky Investment is better, it has NPV = $545 Risky Investment is worse, it has NPV = $150 Expand Project (Cost = $200) Status Quo Payoff = $0 Payoff = $500 Sell Off Assets Payoff = $200 50% 50% Adjust Business Strategy Payoff = $100 Payoff = $0
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
The decision tree below describes a “sure thing” investment and a “risky” investment. Use backward induction to evaluate which is the better investment. Assume all values are already given in present value terms.
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