Diversification of a portfolio means managing various equity options under one roof. Investing in different shares amounts to diversification of an investment. Diversification reduces the risks attached to the portfolio and provides an opportunity to the investor to earn better. Diversification cannot eliminate all risks in the business. This is due to the fact that even after diversification there are various factors which affect the upward and downward movement of shares. Market forces, economic policies and political stability have a significant impact on the movement of equity shares. Diversification can reduce the risks to a great extent but there is no assurance that it can eliminate the risks inherent in the business. A portfolio may consist of various equity options but each equity has to face market and industry risks, no amount of diversification can eliminate the risk to zero. A manager may wish to eliminate the risk but it is not possible to do so because of the various factors that affect an investment and the share market. Every industry faces risks which can be overcome by diversification but there will always be a certain amount of risk associated with the business. Reducing the risk should be the motive but elimination cannot be completely achieved. Whatever the risk remains after diversification can be dealt with in an appropriate manner.
Weighted average cost of capital is the rate of return on the various assets of the business. The minimum value which the investors earn on their investment is determined by wacc. Investors use the Wacc to decide whether to invest or not. If a company’s rate of return is higher than wacc, it is creating value for the investors. In the other case, the company is losing value and might lose investors. In terms of wacc, the financial manager aims to increase the value for the shareholders. Only then will they invest in the company. The financial manager always tries to make sure that the rate of return of the company is higher than wacc. Wacc will represent the minimum rate at which the company creates value for the company. To maintain a proper rate of wacc is the aim of a financial manager. This will lead to higher investments and prove to be beneficial for the company. Most investors only look at the wacc before making an investment. The higher the value added by the organization, the higher will be the prospective investment made.
Payback period is the time period within which the investment will be fruitful. It only considers the amount of time that will be taken for an investment to earn returns. Payback period is useful when the investor wishes to determine the number of years it could take for the investment to show some returns. The amount of time taken for the investment is clearly determined using payback method. When an investor has a choice of investing in various projects, payback method maybe used. It will help decide which investment will show positive returns within the different time periods. The shortest duration within with the returns will be positive may be chosen to invest. Another determinant is the life of the asset, if an investment is to be made in an asset the payback period needs to be considered. Only if the return on investment earned takes less time than the total life of an asset, then the investment should be considered. It is not worth investing in an asset which does not generate returns until the total duration of its life. Payback period also helps choose between two projects which carry the same amount of risk.
Bibliography
Importance and use of weighted average cost of capital. (n.d.). Retrieved from Efinance Management: http://efinancemanagement.com/investment-decisions/286-importance-and-use-of-weighted-average-cost-of-capital-wacc
Taillard, M. (n.d.). Diversification cant completely eliminate risk exposure. Retrieved from Corporate Finance for Dummies: http://www.dummies.com/how-to/content/diversification-cant-completely-eliminate-risk-exp.html
Woodruff, J. (n.d.). Advantages and Disadvantages of Payback capital budgeting method. Retrieved from Houston Chronicle.
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