Risk In Corporate Finance

Risk In Corporate Finance

One of the abstract concepts in #corporatefinance is the measurement of risk. We always look to maximise returns and minimise risk in finance and life. In finance, most analysts use CAPM to measure the underlying risk in their portfolio despite multiple flaws in how this model measures risk.

Thus, when we say any investment is risk-free, we inherently assume two things:

a)No default risk
b)My expected returns = actual returns

#Sovereignbonds are risk-free because countries can print currency if they face issues to repay their bondholders. However, with sovereign defaults by Greece and Latin American countries, this definition holds only for developed countries.

However, we ignore another factor in assessing risk-free rates – reinvestment risk. For instance, i invest in risk-free sovereign bonds and get coupons yearly. The investment is not risk-free if these coupons cannot get reinvested at a risk-free rate (generally, the yields and interest rate change). Thus, a sovereign zero-coupon bond is only risk-free.

This hypothesis holds in capital budgeting/investments when comparing the #IRR of two projects. However, the IRR assumes that cash flows get reinvested at the IRR rate, which is unrealistic for projects with very high IRR. In such scenarios, we prefer NPV over IRR.