Most valuations of securities and investments are based on forecast cash flows a

Question

Most valuations of securities and investments are based on forecast cash flows and expected returns. This subjects risk associated with cash flows and returns to increased variability. Risk associated with forecast cash flows a year from now is likely to be less than the risk associated with forecast cash flows five years from now Since there is risk involved in forecast cash flows, financial decision makers require a risk premium to compensate for the risk that they would undertake. There is trade-off between risk and return that represents the balance between the lowest possible risk and the highest possible return for the risk. This relationship between risk and return is represented as follows: Required Rate of Return Risk-Free Rate of Return + Risk Premium The required rate of return can be broken down further into several components such as the inflation premium, default risk premium, liquidity risk premium, and so on. Based on your understanding of the components of required rate of return, identify the determinants with each characteristic described in the following table: Characteristic Component Real rate of return This is the rate for a short-term riskless security when inflation is expected to be zero This is the rate on a Treasury bill or a Treasury bond. This is the premium added as a compensation for the risk that an investor will not get paid in full. As interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Because interest rate changes are uncertain, this premium is added as a compensation for this uncertainty This is the premium added to the real risk-free rate to compensate for a decrease in purchasing power over time Default risk premium | Nominal risk-free rate Maturity risk premium Inflation premium

Explanation / Answer

Solution :

Explanation

It is very true that the projections are mere a budget and analysis of what could be the future it is mere a prediction based on the past and history of the companys performances and hence the longer the period for projection or budget the greater it exposed to risk and it could turn out to be more volatile because of the internal and external factors involved in it

for example there is a possibility that for a particluar sort of industry there could be change in the government regulation because of which there could be decrease in the profit from 2nd year.or a sudden strike in the organization could also stop the production and hence could fall the company's performance which couldnt be predicted .

Victorias investment is more exposed to risk because the closely held companies has less no of share holders and responsibility and regulation whereas the publically traded companies has more rules and regulation and governing bodies associated to that.

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