Financial asset pricing and discounted price flow models Knowing the risk of an investment and understanding how that risk will affect future returns are crucial aspects of deciding whether the expected return is worth the risk. The capital asset pricing model (CAPM) provides a basis from which risk and the effects of risk are determined by the investor, while the discounted price flow model (DPCM) can help the investor decide of the amount he is willing to invest in a company in anticipation of projected future cash flows. As stated in the previous paragraph, the financial asset pricing model is a tool used to determine the risk of an investment and, therefore, to decide whether the risk is worth the investment. The CAPM generally favors the idea that not all risks are considered in determining the value of an asset; in fact, through diversification, part of the risk can be eliminated. The CAPM works from the idea that there are two main risks involved in investments: systematic and unsystematic. Systematic risks are risks, such as interest rates, that cannot be eliminated through diversification. Unsystematic risks are risks inherent in specific types of securities. As the individual investor builds their portfolio, the risks decrease. Because systemic risks are the risks that cause the most anxiety among investors and as a way to calculate these systemic risks, William Sharpe created the CAPM. With the recent wave of financial scandals, the discounted price feed model has taken on new importance. DPFM is used to determine the value of a company based on its projected future cash flows. Projected free cash flows are discounted to a present value using the company's weighted average costs of capital. ...... middle of paper ...... combine an investment in a company's debt. It is more or less an IOU of a company with a fixed rate of return and repayment of principal at maturity. For example, if Company A holds a $1,000 bond that pays 5% interest per year, it will receive 5% of $1,000 each year and its $1,000 back on the maturity date. Good deal, right? Fake. Having this fixed rate of 5% will not generate much capital that a business can use for its needs. So, what would be most beneficial for a particular business? I would recommend the stocks if the goal is to meet short-term capital needs. Stocks, while relatively volatile, are easy to liquidate and provide much more capital. I would only recommend bonds if the company's capital needs are not immediately needed. Bonds provide more stability and REFERENCESInvestopediahttp://www.investopedia.com/articles. Retrieved April 28, 2007