Unformatted text preview: ect risk and linking it to the required return
(RADR). Portfolio Effects
As noted in Chapter 5, because investors are not rewarded for taking diversifiable
risk, they should hold a diversified portfolio of securities. Because a business firm
can be viewed as a portfolio of assets, is it similarly important that the firm maintain a diversified portfolio of assets?
It seems logical that by holding a diversified portfolio the firm could reduce
the variability of its cash flows. By combining two projects with negatively correlated cash inflows, the firm could reduce the combined cash inflow variability—
and therefore the risk.
Are firms rewarded for diversifying risk in this fashion? If they are, the value
of the firm could be enhanced through diversification into other lines of business.
Surprisingly, the value of the stock of firms whose shares are traded publicly in an
efficient marketplace is generally not affected by diversification. In other words,
diversification is not normally rewarded and therefore is generally not necessary.
Why are firms not rewarded for diversification? Because investors themselves
can diversify by holding securities in a variety of firms; they do not need the firm CHAPTER 10 FOCUS ON PRACTICE Risk and Refinements in Capital Budgeting Brand Ad-vantages Advertising has always been an
easy target for cost cutting when
times are tough, because few
companies can reliably track or
predict the return on investment
(ROI) for such spending. This is
changing, however, as consultants
and financial and marketing managers develop quantitative
methodologies to measure returns
from advertising and brand communications. Here are two different approaches to this capital budgeting dilemma.
Isolating advertising’s contribution to revenues is much harder
than analyzing increased volume
or revenue from other types of
capital expenditures, especially for
manufacturers. Because it considers strong brands critical to differentiating itself from the competition, General Mills’ Big G cereal
division has developed a...
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