Risk and Return - Assignment Example

ANALYSIS OF EQUITY AND FIXED INCOME INVESTMENT (Student Name) (Course No.) (Lecturer) (University) (City/State) (Date) Question 1 Part (a) Risk is defined as the prospect of losing some or all of your assets invested in a business. This may arise when the actual returns on investment are lower than the anticipated returns. All investments involve a level of risk. When making a decision on how to invest, it is important to understand the risk associated with the investment to choose whether you are ready to take the risk. Returns are the profitability measure in an investment that evaluates the performance of a business by dividing net profit by net worth. Returns take many forms, including interests, capital appreciation, and dividends. Returns are significantly affected by income tax, which reduced the amounts of your returns and inflation, which reduces the value of your return. Risk and return are directly related. The relationships is represented by trade-offs. The more risk taken, the greater the possible results. A good example is a lottery ticket: a high risk is taken of one losing their money but there is an extreme possibility of high reward in terms of the giant checks. At the other end are options such as saving your money in a bank account where the risks of losing your money are minimal but the interest rates are so low. The business value is measured by the available stock, superior management, sales and earnings growth. When these factors are high, the business value can be rated very high as compared to a business with less success based on its earnings and its sales. Part (b) In financial terms, an asset is any resource that can be utilized for economic gain. Any resource, either tangible or intangible that can be owned or controlled to produce positive economic value is considered a resource. Financial assets include bonds, stocks and real estate properties. Market value equals what one can get for a particular financial asset from market quotations. It is based on today’s expectation of a company’s future operational and financial outcome. For small companies, it is what investors are willing to pay to buy all or some shares in a company. Stock market values are the total sum of stock price, times the outstanding stock. For publicly held companies, the price is easily determined because the stocks are traded in the stock market (STIMES, 2011, 127). Intrinsic value is, therfore, described as the asset's true value and is independent from market value. It is the fundamental value which cannot be readily proven. Intrinsic value therefore is the internal estimates of your company’s worth or value. All applicable information and data are incorporated to value your company even if the insiders are the only people who have the full information. For example, when all the stockholders are asked to each value their company, each would come up with an intrinsic estimate, but most likely with varying results. The price that investors are willing to pay for stocks in a company depends on what they think if the company itself. Whether they place high, low or an average amount depends on what the investor thinks the stocks are worth. Such calculations determine the buying and selling decisions of stocks. The supply and demand of stocks therefore set the market price. The market value of a company is generally driven by the public; this is, external opinions and expectations, whereas the intrinsic value is driven by private; this is, internal opinion and expectations. Investor’s goal is to maximize their wealth whether he has invested in a public or private company. This wealth refers to the intrinsic value of the company because the market value may or may not fully reflect the real company’s value. Fewer people invest in private companies hence the intrinsic value is higher than the market value. Question 2 The capital asset pricing model(CAPM) is extremely important in modern financial economics. The model is used to express the relationship between the risk of an asset and its expected return. This relationship is very important in that; it provides a platform for evaluating possible investments for example in analyzing securities, one is able to tell whether the expected results forecasted for a stock is greater or less than the standard return given its risk. The model also helps us to make a wise guess as to expected return on assets that are yet to be taken to the stock market for example, how will a new business project affect the return investors require on an already established company’s stock? CAPM is used theoretically to determine required rate of return of an asset, if the asset is to be auxiliary to an previously diversified portfolio, given that assets non-diversifiable risk. Because investors will try to avoid risk at all cost, they will choose to have securities to take lead of the benefits of diversification. This makes them want to know how the stock will contribute to the risk and expected return of their portfolios. The standard deviation of a stock cannot show how that stock will contribute to the risk and return of a diversified portfolio therefore a measure of a security’s systematic risk is needed. Systematic risk is often represented by beta in finance. Security market line (SML) and its relationship to systematic risk(beta) are used in individual securities to show how individual securities in relation to security risk class must be priced in the market. The SML equation is as follows: We get the Capital Asset Pricing Model (CAPM) by rearranging the above equation and solving for E(Ri) An asset is therefore correctly priced when its observed price is the same as the value obtained by calculating using the CAPM rate. If the observed price greater than the value, the asset is overvalued. The assumptions of CAPM are that all investors aim to maximize economic utility, are rational, price takers, can borrow and lend unlimited under the risk-free rate of interest and that all investors receive all information at the same time. The model is of great essence though it has its own shortcomings, which include assumptions that the asset returns are normally distributed random variables, it also assumes that the variance of returns is a measurement of risk and that the probability belief of all investors match the true distribution of returns. CAPM model is therefore considered a pricing tool when there is no price in the formula because it helps in evaluating possible investments and predict the expected returns on assets that are yet to be traded. Question 3 Part (a) Interest coverage ratio is a measure of an enterprise ability to meet its interest payments. It is calculated by dividing the earnings before interest and taxes in a year by interest expenses for the same time period. It is a measure of the number of times a company could make interest payments on its debt with its earnings before interest and taxes. This ratio measure is mostly used by lenders, creditors and investors to determine the whether a company is worth taking a risk of lending it money. The ratio gives an understanding of how much decline in earnings a company can sustain before going bankrupt. This can be articulated mathematically using the formula: Interest coverage ratio = earnings before interest and taxes / interest expenses Interest recovery ratio is indirectly proportional to the company’s debt burden, therefore, the lower the interest coverage ratio, the higher the company’s debt. This means that the company’s possibility of becoming bankrupt is very high because less earnings are available to meet its interest payments. When a company records an interest recovery ratio below 1.0, this indicates that the business is going through hardships generating the money necessary to pay its interests. An interest rate of 1.5 is generally considered the lowest level of any company. A high ratio indicates a good financial status as it shows that the company is more able to meet its interest needs from operating earnings. A very high ratio may imply that a company is using too little debt, which may not give the direct credit advantage to shareholders. This may also suggest that the company is neglecting opportunities to magnify earnings through leverage. Many investors are risk takers and would prefer investing in companies which they will make much profit through leverages. Most investors will therefore shy away from such companies because their interest rates are minimal (STIMES, 2011, 149). Part (b) Supply and demand is one of the major factors that affect an investments return. An increase in demand will lead to an increase in pricing unless the supply is increased to match with the demand. If an increase in demand is not met by an increase in supply, the price rate increases. For example, if more people want to buy cars than sell them, the price will be high. On the contrary, if more people want to sell cars than buy, the price would be low. The supply and demand of a commodity is affected by the earnings. A change in the value earned causes a market reaction which immediately affects the supply and demand for the commodity. Economic variables influence the price of shares. A company is well known due to its value, return and share price. If the share market notes a negative thing about a company that may harm its earnings, the company’s share prices drops. If a positive thing is heard about a company, its share prices rise. Investors constantly view companies’ earnings to know where to place their money. Interest rates affect companies directly because debt repayment costs rise and fall with rate charges. They interest rates will determine the rate of borrowing or your returns if you invest your money in shares. When there is much money circulating, the interest rates falls but rises when there is tight liquidity. The rate of inflation is also a major determinant. Inflation pushes the cost of commodities up faster than companies can pass it to consumers adversely affecting earnings (STIMES, 2011, 193). Company news is very important. Any news that affects your company affects the share price because share market depends on the information given out there. With available information, investors are able to access political and economic news. Legislations governing the manner in which a company operates may lower positively or negatively affect a company. For example, when the government lowers the rates of tax, this may increase share prices because a lower tax burden increases earnings. Reference STIMES, P. C., 2011, Equity Valuation, Risk and Investment a Practitioner's Roadmap. Chichester, John Wiley & Sons. Available from. http://public.eblib.com/choice/publicfullrecord.aspx?p=708507. Last accessed on 12th February 2013 Read More