Understanding the Concepts of Realized Return of the Stock - Assignment Example

Understanding the concepts of realized return of the stock, systematic and unsystematic risk, risk of the portfolio, beta, WACC Q.1. Identify the components of a stock’s realized return. A.1. The realized return on stock is computed as the total amount of gains made on the same over a specific time period. Computation of the same takes into consideration the different gains emanating from the different assets held by the stock. It also takes into consideration the losses attributed owing to the alteration made in the value of respective assets taken previously. Thus the total realized value of the stock is the summation of the realized value of the different assets. Segregating the different factors or components of a stock’s realized return it can be seen that such return is constituted essentially by three main blocks. The first factor reflects the total return that is expected of the stock. Second factor hints on the different economic changes that are taking place in the external world and the effect of such changes on the position of the stock. The third factor endeavors to figure out alterations in the external climate, which tend to render some unique effects on the firm’s stock position. Understanding of the components of realized return of a stock is essential for different stocks tend to reflect different types of sensitivity depending on the various factors. Further through the understanding of the firm’s stock position it becomes easy to infer on the stability position of the firm. (Brigham & Daves, 2009, p.97; What is a Realized Return?, n.d.). Q.2. Contrast systematic and unsystematic risk A.2. The concept of systematic risks hints at the evolution of risks, which happen not by the occurrence of chance events. These risks rather happen due to the simultaneous occurrence of events, which do not rely on chances. Thus systematic risks are generally undiversified in nature. They can be easily correlated to the occurrence of certain external events. Examples of systematic risks entail changes in the state of economic conditions, which brings in abrupt losses for the economy as a whole. Hence a tight regulation brought about by the monetary organizations causes the rise in the rates of interest for financial concerns. However because of the correlated happenings of these risks due to changes in the economic conditions these risks become simultaneous in nature. Thus it becomes difficult to render insurance schemes covering such risks for these risks go on occurring spontaneously with economic changes. On the other hand the happening of unsystematic risks is related to the occurrence of events, which generally take place owing to chance factors. Risks emanating out of chance events cannot be correlated to the occurrences of the events, which are probable, by nature. For example the outbreak of fire in a complex is simply a probabilistic event and depends highly on chance factors. Thus any amount of expected economic loss amounting from such counters an unsystematic risk and can be insured beforehand (Condamin, Louisot, & Naim, p.4). Further the due to certainty measures the amount of systematic risks can be rendered for explanations and also can be easily modeled. On the contrary, the unsystematic risks for the uncertainty factor adhered to it fails to be modeled. (Los, 2001, p.114) Q.3. Explain why the total risk of a portfolio is not simply equal to the weighted average of the risks of the securities in the portfolio. A.3. The total risk of a portfolio is computed based on the variance or standard deviation of the different returns emanating out of the different assets of the portfolio. However the variance computed does not depend on the weighted average of the different range of returns amounting from the employment of different assets. Rather the computation of the total risk of the portfolio is done based on the factor of correlation of each asset to other assets employed such. Thus if two assets constitute a certain portfolio then the total risk of such portfolio is computed based on the individual investments made on the assets, the variance and standard deviations of those and the correlation factor of those assets (Khan, 2004, p.3.4). The total risks of the portfolio computed based on variances or the standard deviations of individual assets and of their correlations helps in the effective management of such risks. This diversified outlook is thus held best rather than dependence on the weighted average computation of the risks involved (Investment Analysis and Portfolio Management, n.d., p.219). Q.4. State what beta measures are and its uses. A.4. The beta measures are employed to compute the effect of change in market and economic conditions on the amount of security deposits. Thus the beta measure helps to understand the level of risk adhered to a certain project depending on a change of the economic conditions. Estimates made show that if the beta computed becomes more than unity the same clearly reflects the amount of volatility of the security in the financial market. Volatility of the security measured by the Beta measure confronts on the flexibility of the same with changes in the market. A rise or fall in the market causes a proportionate rise or fall in the level of security. Thus beta measures which are less than unity reflect less involvement of risk as in the previous case. The employment of beta factor reflects the amount of risk involved in the investments made on the portfolio thereby signifying the rate of return (Puxty, Dodds & Wilson, 1988, p.117). The Beta measures used in the computation of risks in the stock portfolio tracks the changes in the stock depending on the alterations of the market conditions. It also tracks the flexibility of such depending on the changes in the total stock market of the economy (Grossman & Livingstone, 2009, p.578). Q.5. State what WACC measures and explain the WACC assumptions used to value a project. A.5. The WACC measure is the acronym for the Weighted Average Cost of Capital. The Weighted Average Cost of Capital is computed based on the summation of the weighted costs of debt and equity finance of a company. The weighted costs of the two finance types are measured based on the contribution of each in framing the capital structure of the concern. The formula employed for computation of the WACC is Cost of Debt Capital Employed + Cost of Equity Capital Employed. The Cost of Debt is taken after deduction of tax. Both the costs are associated with their relative contribution to the capital structure. Thus the exact formula will amount to WACC = Cost of Debt (1-Cost of Tax on Debt) * Cost of Debt/Total Capital Structure + Cost of Equity Capital * Cost of Equity Employed / Total Capital Structure of the firm. (Bierman, 2009, p.194). The measure of Weighted Average Cost of Capital clearly indicates that a firm’s capital structure is a blend of both ownership and debt capital. The significance of the weights is measured depending on the relative contribution of the two capital types to the total capital structure of a concern. (Hansen, Mowen & Guan, 2007, p.719). The Weighted Average Cost of Capital measure is employed to create a discount in the factor of cash flows while computing the Net Present Value for project evaluation. However the use of the WACC measure is governed by certain assumptions which can be stated as follows. Firstly, the capital structure of the firm is held as being constant. Thus the weighted costs of debt and equity capital is taken as unaltered. Second assumption holds that a comparison can be drawn between the risks of the project undertaken to the position of the company. Third assumption holds that the magnitude of the project undertaken must be less than that of the company. This is held for computing realistic figures of interest and dividend. The fourth and final assumption holds significant perpetuity in the flows of the amount of dividend and interests together with cash inflows. The level of perpetuity ensured helps in the computation of the WACC measure for valuation of a project (Pizam, 2005, p.651). References 1. Brigham, E. & P. Daves (2009), Intermediate Financial Management, Cengage Learning. 2. Bierman, H. (2009), An Introduction to Accounting and Managerial Finance: A Merger of Equals, World Scientific. 3. Condamin, L., Loisot, J. & P. Naim (2006), Risk quantification: management, diagnosis and hedging, John Wiley and Sons  4. Investment Analysis and Portfolio Management (n.d.), Tata McGraw-Hill. 5. Khan, M. (2004), Financial Management: Text, Problems And Cases, Tata McGraw-Hill. 6. Los, C. (2001), Computational finance: a scientific perspective, World Scientific. 7. Puxty, A., Dodds, J., & R. Wilson (1988), Financial management: method and meaning, Taylor & Francis. 8. Pizam, A. (2005), International encyclopedia of hospitality management, Butterworth-Heinemann. 9. “What is a Realized Return?”, (n.d.) wisegeek.com, Retrieved on February 16, 2011 from: http://www.wisegeek.com/what-is-a-realized-return.htm Read More