Fundamentals of Finance - Assignment Example

Fundamentals of Finance Part i) Investment - Portfolio: Total Investment = ' 2,000,000 Minimum Return = 25% The projects are indivisible and the investors are high risk takers. Investment on Project B is ' 800,000 and that of the other projects is ' 1,200,000. As the projects are indivisible, it is evident that Top Choice has to take up Project B and any one of the other three projects, so that the total investment comes up to ' 2,000,000. Project B: Initial Investment = ' 800,000 Expected Return EB = 28% Risk 'B = 10% Proportion Invested in Project B (AB) = (800,000 / 2,000,000) = 40% Portfolio 1: Projects A and B Expected Return = (AA * EA) + (AB * EB) = (0.6 * 0.22) + (0.4 * 0.28) = 0.244 = 24.4% RAB = 0.7 Std. Deviation = '(EA2*'A2) + (EB2*'B2) + (2*EA*EB*RAB* 'A*'B) = '0.00178 = 0.0422 = 4.22% Portfolio 2: Projects C and B Expected Return = (AC * EC) + (AB * EB) = (0.6 * 0.30) + (0.4 * 0.28) = 0.292 = 29.2% RCB = 0.65 Std. Deviation = '(EC2*'C2) + (EB2*'B2) + (2*EC*EB*RCB* 'C*'B) = '0.004447 = 0.0667 = 6.67% Portfolio 3: Projects D and B Expected Return = (AD * ED) + (AB * EB) = (0.6 * 0.34) + (0.4 * 0.28) = 0.316 = 31.6% RDB = 0.3 Std. Deviation = '(ED2*'D2) + (EB2*'B2) + (2*ED*EB*RDB* 'D*'B) = '0.00509 = 0.0714 = 7.14% It is clear from the above calculations that the portfolio 1 (Projects A and B) has a lower expected return (24.4%) than the minimum required return. Hence Top Choice should not invest in Portfolio 1. Portfolio 2 (Projects B and C) have an expected return of 29.2% and a risk of 6.67%. This is acceptable as the expected return is higher than the minimum required rate. However the Portfolio 3 (Projects B and D) have the highest expected returns (31.6%) with a risk of 7.14%. This portfolio is best suited for Top Choice as they are high risk takers. Hence the ' 2,000,000 should be invested in the following projects: Project B: ' 800,000 Project D: ' 1,200,000 The investment will yield an average return of (31.6% of ' 2,000,000) ' 632,000 with a standard deviation of (7.14% of ' 2,000,000) ' 142,800. This indicates that the return will be in the range of (' 632,000 - ' 142,800) and (' 632,000 + ' 142,800), i.e., ' 489,200 and ' 774,800 respectively. ii) Views and Approaches to Capital Structure: A company can be financed by a number of different modes. The type of capital financing that has been chosen for the company is referred to as the capital structure of the company. A company can be financed using debentures, equity shares, long term loans, etc. These options however are based on the nature of risk the investors are willing to take. The following sections will discuss the various financing options that are available for investors to finance their companies and the factors that affect the choice have also been discussed. a) Equity Financing: This is the most common mode of financing used by companies. Here companies raise monies for the business by selling stocks of the company. These can either be preferred or common stock and can be sold both to individuals as well as investors. This is also referred to as the share capital of the company. These stocks provide the buyers with an ownership in the company. This is perceived to be 'easy money' as it does not involve any debt. Here the company does not require repaying the amount to the investors, as long as the business makes profits. Equity financing is best suited for people who are risk takers (J Ogilvie & B Koch 2002). b) Debt Financing: This type of financing is when a company borrows money from other sources like banks, etc, under an agreement to pay back within a fixed amount of time. Here the lenders do not get any ownership of the business and the relationship remains active until all the monies are paid back. This can be of two main types a) short term financing, where loans taken are for a period less than one year. These are mostly taken by people who are willing to take risks. b) Long term financing is when loans are taken for period higher than one year. This type of loan is best suited for investors who are risk adverse (J Ogilvie & B Koch 2002). c) Equity - Debt Financing: This is a combined form of financing. This is best suited for investors who prefer to be safe however are willing to take up a certain amount of risk. Here the combination of equity and debt is based on the amount of risk a company is willing to undertake (J Ogilvie & B Koch 2002). Part 2: i) Required Rate of Return Beta for Top Choice ' = 1.5 Expected Return on securities = 5% Expected Return on Market Portfolio = 15% The required rate of return is dependent on the beta value for Top Choice. This beta value represents the sensitivity (correlation) of movements of the cash flows of Top Choice to movement in the stock market return on equity. The expected return on securities represents the risk free rate of return (securities), whereas the expected return rate from the market portfolio has a risk premium. Hence the return from market portfolio to include the risks involved. The beta value of Top Choice is used to determine the risk premium as ' (Rm - Rf). This rate is added to the risk free rate (Rf) to arrive at the Risk Adjusted Rate of Return. Hence the required return from the stock market is determined as: Rate of Return R = Rf + ' (Rm - Rf) where Risk free return Rf = 5% Return on Market Rm = 15% Top Choice Beta ' = 1.5 Rate of Return R = 0.05 + 1.5 (0.15 - 0.05) = 0.05 + 1.5 (0.10) = 0.05 + 0.15 = 0.20 = 20% Hence the required rate of return on the stock of the firm is 20%. ii) a) Investors' required rate of return: Investor's required rate of return is the minimum rate of return that an investor would expect from his investments. It can also represent the interest rate paid by the investor, if he had borrowed the amount that has been invested. In some cases, the required rate represents the opportunity costs, i.e., the rate of return that the investor could have earned, if he had opted some other project or investment (Samuels and Brayshaw, 2000). b) Systematic'risk: Systematic risk is also known as market risk or non - diversifiable risk. This is the risk that is caused by factors that affect the price of all securities. The effect on each of the securities can be in different proportions however every security is affected by these factors, for example the changes in interest rates. These risks cannot be completely eliminated however can be reduced to a great extent by acquiring securities (William, 1964, Weston and Copeland, 1988). c) Unsystematic risk:' This is also referred to as specific risks. These risks unlike the systematic risks affect a very small number of assets. These are normally company or industry specific in nature and can be reduced through appropriate diversification. These involve the risks that are faced due to price changes under different circumstances for particular securities when compared to the rest of the market. The only way of eliminating these risks completely from a portfolio is through diversification (Weston and Copeland, 1988, William, 1964). d) Standard deviation' Investors utilise standard deviation as a measure of risk of the stock portfolio. Standard deviation helps analyse the volatility of the investments. Higher stock returns are mostly accompanied by higher risks. Higher standard deviation indicates that the average or expected return will also vary by the same amount. Similarly the lesser the standard deviation, lesser is the volatility of the stock. In short investors use this method to gauge the volatility of an investment (Weston and Copeland, 1988). Part 3: Assumptions of Capital Asset Pricing Model: The Capital Asset Pricing Model is an economic model used to value stock, securities etc., by relating the risk and the expected return. The assumptions made in the Capital Asset Pricing Model are explained below. The model assumes that investors are risk averse and maximise the expected utility of the period wealth. Also the model assumes that investors have homogenous expectations of the returns and these can be defined as the prediction of the future returns for the specified time period based on all the information at that point in time. The model also assumes that there are no taxes or transactions costs for buying of securities and the market operations are perfect in nature. However in the real world, all securities are subject to taxes as well as transaction costs. In most cases the large institutions pay low transaction costs and can be exempt from taxes however the individuals are required to pay the taxes as well as transaction costs (William, 1964). The model also assumes that capital markets are balanced and the investments are priced in accordance with the risk levels. The model also assumes that the returns on assets are based on normal distribution. Also it is assumed that the asset markets do not face any friction and the information is costless and also available to all the investors. Finally the model also assumes that the assets are all perfectly divisible and are priced competitively i.e., the human capital does not exist (William, 1964). Even though the assumptions are not all accurate, this model is still considered to be one of the most accurate investment models to determine the risk and return of any investment. Part 4: i) Trade credit: Trade credit is one of the simplest forms of short - term credit. It is when a firm provides goods and services to customers with an agreement to bill and pay later. This is very commonly used, and is one of the best forms of capitalisation, as long as the business is managed well. Trade credit acts as an alternative and a valuable source of financing. Trade credit acts as an essential tool for financing growth for a number of businesses. These can be beneficial to companies that have a well - planned financial plan. In simple terms, when delivery of goods are taken, the purchaser get up to almost three months of time to pay for the goods. This allows the purchaser to enjoy up to three months of interest free credit (Entrepreneur, 2008). ii) Overdraft facility: This is another very common form of financing for companies. Here the companies can make payments for the business current accounts in excess of the available cash balances. This is a facility that is normally provided by the banks to the businesses and is repayable when demanded by the bank. There are a few factors however those are related to this facility. a) The facility amount is decided after negotiation with the bank, and this amount should not be exceeded, b) this is a short - term form of financing and is not a permanent form, and c) the amount is charged with an interest, which is generally fixed by the bank as an overdraft facility fee (BBA, 2004). ii) Commercial paper: A commercial paper is a promissory note that is an unsecured money market instrument. These have a fixed maturity of 270 days, and are normally issued by banks and large corporations. This is mainly to help the large corporations meet their short - term debt obligations. Here the banks and corporations agree to pay the face value of the note on the maturity date. These notes do not require any collateral to back it (Reuters, 2007). iv) Transaction loan:' These are loans that are extended by banks for specific purposes only. These are different from the normal lines of credit and the credit agreement that can be used for various purposes. Transaction loans are normally provided for a particular transaction only and the agreement generally includes all the details of the transaction in detail. The agreement normally include the representations and the warranties, conditions of closing, warrants if any, covenants and event of default details. Bibliography BBA, 2004, 'Overdraft Facility', 19 May 2005, Accessed on 14 December 2008, Retrieved from http://www.bba.org.uk/bba/jsp/polopoly.jsp'd=210&a=472 Entrepreneur, 2008, 'Trade Credit', Accessed on 14 December 2008, Retrieved from http://www.entrepreneur.com/encyclopedia/term/82538.html Ogilvie, J. and Koch, B., 2002, The Chartered Institute of Management Accountants Study System, Finance, 1st edn., Viva Groups, New Delhi Reuters, 2007, 'FACTBOX - What is commercial paper'', 18 December 2008, Accessed on 14 December 2008, Retrieved from http://uk.reuters.com/article/Internal_ReutersCoUkService_4/idUKNOA83370720071218 Samuels, J. M., Wilkes, F. M. and Brayshaw, R. E., 2000, Management of Company Finance, 6th edn, Thomson Learning, London Weston, J. F. and Copeland, T. E., 1988, Managerial Finance, 2nd edn., Cassell Educational Ltd, London William, S., 1964, 'Capital Asset Pricing model', Accessed on 13 December 2008, Retrieved from http://www.riskglossary.com/link/capital_asset_pricing_model.htm Read More