Major Questions in Financial Analysis - Coursework Example

Q1. The Modigliani and Miller paper mentions that a firm’s value is never affected by how it is financed, may it be through bankruptcy, absence of taxes or agency costs. This Modigliani-Miller theorem is also known as the principle of capital structure irrelevance. Dividend policy is the making of a decision to either paying cash dividends at a later period or at the present time. Dividends are also paid in stock dividends because they do not provide liquidity to stockholders or investors but create capital gains. According to Modigliani and Miller, they believe that capital gains and current dividends are not investor’s preferences. They also state that the market value is not determined by the dividend policy. In relation to the irrelevance of dividends, two theorems are applied; these are Modigliani-Miller approach and residual theory (Thompson & Mathew 82). Q2. The major assumption behind the residual income valuation model is the clean surplus relationship, that stresses the relationship among book value per share, dividends and earnings: BV1 = BV0 + EPS1 - D1. It means that all the accounting profits and distribution to shareholders can be explained by changes in the book value. Another assumption is that the ohslon model comes from the information dynamics that brings together current information to future residual income. Consistent with Ohlson’s information dynamics it is found out that residual empirical research income follows a mean reverting process. In conclusion Ohlson’s formulation of the residual income valuation model provides an economical structure for incorporating information in earnings, book value and income forecasts. The fact that there are no taxes or difference in tax rates is another major assumption made. The book value of equity uses the clean surplus approach that states earnings and net dividends modify book equity. The future residual income is overcome by the use of the equation below V0 = B0 + ?(RIt / (1 + r)t) = B0 + ? ((Et - r x Bt-1) / (1 + r)t) where V0 - value of a company's stock. B0 - present book value per share. Bt - book value per share at the end of period t. r - cost of equity. Et - future EPS for period t. RIt - residual income per share for period t. Q3. Francis and Schipper realized that in recent times, the value relevance of accounting information has been under constant scrutiny by the stock market researchers and set out to test it. Another test that they made use of is that of investigating the relationship between a set of independent accounting variables and security price dependent variable. In order, to extend their tests to account for change in relevance over time, they made use of linear regression, which was an estimation technique that determined the value relevance of accounting data. Q4. The property of timeliness is an important role in accrual accounting since it aligns the expense recognition and timing of revenue. Accountants produce an earnings variable by adding accruals to operating cash. Conservatism is defined as the asymmetry between loss and gain recognition. Loss accruals are important in that they allow management compensation; determine earnings quality and improving the usefulness of financial statements generally. Journal of Accounting and Economics clearly outlines the effects of international institutional features on the accounting income properties as follows. The international differences in demand for accounting directly affect change in market value over time. Asymmetry by public disclosure is characterized by the stakeholders and shareholders governance models of common and code law countries. Litigation, regulation and taxation cause variations within the common Law countries. The value strategies include low price to book ratio, buying low stocks and low price to cash flow ratio stocks. The major finding of these strategies is that it is a successful investment strategy in that the value stocks outperform the whole market and growth stocks. Q5. Lakonishok, Shleifer and Vishny, found out that stocks with higher (lower) future returns have lower (higher) trading turnover over four years, and the low turnover premium is less likely associated with compensation for risk or liquidity supposition. If the turnover effect presents mispricing due to prearranged expectation bias, then professionals should exploit this chance and do away with the mispricing quickly. The glamour stocks, which have high individual instability and stocks with a low number of institutional owners have the greatest low turnover premium. The turnover effects for unstable stocks exceed low stability stocks. Value share stocks feature low price-to-earnings, price-to-cash or price-to-book flow ratios. Glamour stocks on the other hand are characterized by valuation metrics. This knowledge therefore, explains the persistence in performance of value stocks over glamour stocks. Q6. Francis and Schipper realized that in recent times, the value relevance of accounting information has been under constant scrutiny by the stock market researchers and set out to test it. Another test that they made use of is that of investigating the relationship between a set of independent accounting variables and security price dependent variable. In order, to extend their tests to account for change in relevance over time, they made use of linear regression, which was an estimation technique that determined the value relevance of accounting data. Q7. X0 represents the distribution of possible earnings before interest on debt, r*is the interest rate paid on debt and I represents the amount of investment. All the above three figures are available in the annual report of the organization. Q8. The starting point for the Shiller’s test is if an agent is risk neutral, an asset’s price should be equal to the expected future dividends at a discount. For this reason, some assumptions have to be done. The main assumption is the asset should pay a single liquidating dividend with the present value being V and the current price being P. With this in mind, then P=E (V). Other statistical assumptions used are a large number of such whose assets were liquefied are compared to the sample variance of the set of prices and set of realized values. Q9. An institutional investor is an organization or non-bank employee that buys and sells shares in large quantities that then qualifies them for lower commissions and preferential treatment. Asset allocation is a key concept in money management and financial planning. It is a process where investments are divided equally among assets, real estate and stocks. Corporate governance is a term that may refer to internal or external factors affecting an organization either defined by government regulations, clients, stockholders, officers or constitution of a corporation. Capital market anomalies are relations between a firm’s characteristics and its average stock returns. Value investing is a strategy used to select stocks that trade for lower values than their actual values. Such investors look for company stocks that are undervalued by the market. Q10. The advantages of bottom up approach are as follows. The benefits of this approach are experienced in the early phases since the business and customers are aware of the products being offered. It also does not need custom adapters in the early stages. The password management can be used for a large number of users. An organization broadens its identity management skills during its earlier phases of implementation. With all its advantages it also has its disadvantages such as; the organizational structure used must be replaced later in a roll-out phase. This structure is majorly driven by the currently existing infrastructure instead of business processes. The advantages of top down approach are as follows. The main benefit of this is that the organization realizes a certain use of its resources from the application that is individually managed. Another advantage is that maintenance and operation resources are fully impacted as those of the bottom up approach. Its disadvantages include high cost of implementation, custom adapters should be developed at an early stage, and its coverage in the first phases is limited. Q11. Information cascade mechanism is a study that concentrates on the effects that information has on an economy and the decisions made in the company. Information has diverse characteristics that affect an economy such as it influences many decisions; it is hard to control yet easy to spread. DeBondt and Thaler found out Information cascades are important in economic psychology as they explain the behavior of financial markets. That is so because they feed the process of frantic buying or selling. All this starts as a harmless hunch but rapidly moves into irrational herd-like behavior. Therefore, such behavior maybe the main reason we talk about ‘confident or bull’ markets. Information cascades affect all manner of decision-making and the movement of the herd’ in this scenario being the group, team, board can be very difficult to resist. People rarely ask any questions but just follow the majority. Q12. The rationale for a contrarian investment strategy is that it follows the general market trends and not the crowd; they totally do the opposite of the general trend. This strategy looks for poor performing stocks, buys them and keeps them until their values appreciate. According to Lakonishok, Schleifer and Vishny the contrarian investment strategy is among the best in the world since it is more of an instinctual than factual strategy. It entails careful research into the thoughts and insights of the majority investors and then concentrating on what has been neglected by the market. Once this is achieved, it is possible to tell whether a profit will be realized by going the opposite direction of the market indicators. Q13. According to Barth, Cram and Nelson, the components of earnings have a substantially more predictable ability for cash flows in the future than several accumulations of aggregate earnings. There is no evidence to indicate investors fully understand accruals due to the fact that accrual types that are assessed to be unreliable are associated with lower stock returns and less persistent earnings during the coming years. Q14. a. Active manager’s performance is evaluated by first knowing what to expect from active management. Afterwards, review the conventional approaches to risk and performance evaluation then presentation of newer alternatives to performance appraisal. The use of timing assessing ability is also another way to evaluate an active manager’s performance. b. B. Active management is profitable in that an organization’s financial operations are kept in check by the active managers and thus profits are realized per given financial year. Q15 a. There are three major theorems in the area of bon investment and trading: Expectations theory; Liquidity Preference Theory; and Risk Theory. Expectation theory states that the bon forward rate is equal to the expected future spot rate. Liquidity Preference theory states that investors require a liquidity premium to hold long term securities. Interest rate risk impacts the valuation of bonds in the way that interest rates are inversely proportional to bond prices. Duration and convexity play a very important role in the area of bond trading and investment. While the duration theory assumes a linear relationship between price and yield, convexity assumes a curvilinear relationship between price and yield. While duration theory is suitable for small changes in accurate, the convexity theorem is more accurate for large changes in yield. b. The main approaches to active bond portfolio management include interest rate anticipation, valuation analysis, credit analysis, yield spread analysis and bond swaps. These strategies require major adjustments in order to take advantage of interest rate fluctuations. Managers try to outperform the buy and hold strategy by using skill and their wit. Q16 a. The major anomalies experienced by economists in the operation of capital markets are the calendar time effect, the small firm effect, weather effect, mean reversion effect, book value, market value effect and winner loose effect. b. The small firm effect states that slow firms have more potential to grow. They might be more vulnerable to volatile business environments, and hence can witness fluctuating stock valuation. The calendar time effect and the weather effect are attributed to seasonal tendencies. The winner loose effect is attributed towards behavioral characteristics. Q17 a. The variations in GAAP are driven by the subjective decisions, and this brings about a rationale for the international accounting standards to create common standards, which are acceptable to all financial markets. The other issue is how the extent of variations in GAAP is measured. b. Ball, Kothari and Robin found out that the effect of international institutional factors on properties of accounting earnings are directly proportional. Lev and Zarowin show that there is a clear relationship between earnings and share returns in that earnings received are after a period of time just like shares are given room and time to grow and gain value (Littleton 1989). Q18. a. According to Fischer value relevance can be measured as the profits gained from accounting based trading rules. This interpretation uses the assumption that financial statements lead to stock prices drifting. Another interpretation of value relevance is that financial statements can summarize information regardless of the source that affects share value. Interpretation number three is that value relevance can change the whole mix of information in the market place. Value interpretation can be measured as the ability to predict future cash flows, future dividends, future earnings, and future book value by earnings. b. Lev and Zarowin (Journal of Accounting Research, 1999) studied the relationship between accounting data and capital market information such as stock market to analyze the usefulness of financial information. The researchers used cross-sectional regression to evaluate the relationship between annual stock returns and change of earnings. The equation used by them includes: Where, Rit is the firm I’s stock return for fiscal year t Eit is the reported earnings before extraordinary items for firm I in fiscal year t ?Eit is the annual change in earnings The researchers found that the relationship between the earnings reported and the stock price has been declining over a period of time. Q19. a. Information cascades arise when individuals study the actions and behaviors of others and make the same decisions as those they are observing prior to their own information signals. This has been researched by Bikhchandani, Hirshleifer and Welch. b. Information cascades should be fragile since they are always rational with parties with high quality information. SEC A Q1. a. The mean variance approach ensures that all investors know about a particular portfolio of securities. By use of the mean variance approach, investors are happier accepting a greater risks if it is associated with a sufficiently large increase in expected return. b. Institutional investors do not use this approach but the asset allocation approach while individual investors use it (Michie 2003). Q2 a. International investment by institutional investors has the following benefits: Potential growth of underdeveloped markets and once institutional investors successfully identify these markets they could have substantial returns on their investments. Another major benefit of international investment is that institutional investors can diversify their portfolio since not all of their money is in one country thus reducing their risk, by so doing they can withstand hard economic troubles in their home country. b. Both institutional investors as well as individual investors have specific reasons to exhibit home asset preference rather than holding a global portfolio. While hedging possibilities against domestic risks, trading costs and border controls, information asymmetries and country level regulations and governance explain why institutional investors typically do not hold global portfolios. Individual investors have more of behavioral characteristics such as familiarity and patriotism as possible explanations of home asset preference. Q3 a. Institutional investors have the herd behavior’ since they would first like to know what other investors are doing so that they would do the same. The consequence of financial stability with such behavior is that they stagnate funds and stock that does not appreciate in value. The two types of security markets are the primary and secondary market. The primary is used for new issued securities, and the secondary is used for securities already in use. They are both used for equity securities. Investment companies include mutual funds, closed end funds and unit investment trusts (UITs). Shares for both UIT and mutual funds are redeemable while closed ended funds are not. Portfolio risk is measured by modeling the market that changes the portfolio’s value. The risk measurement is extracted from the probability distribution of changes in portfolio value (list 2007). b. Herding amongst institutional investors can be categorized into two categories: intentional herding and unintentional herding. Research has shown (Scharfstein and Stein, 1990) that intentional herding often leads to destabilization of stock prices, increased volatility in stock prices and reduced stability of financial market. Herding in general might lead to inefficient financial market. Q4. Francis and Shiffer (1999) used portfolio tests to determine the proportion of stock returns that is explained by key accounting numbers. They created two portfolios. While ?Earnt measured the excess returns that could have been made if the actual value of earnings were available for year t, ?Casht measured the excess returns that could have been made if the actual value of cash flow were available for year t. They perform the tests for years 1952 to 1994. The execessive returns calculated implied that the cash portfolio was the weakest of all indicators. Q5. The theory of Information cascade suggest that any information regarding actions or endorsements of one set of economic decision makers often influence the decisions and purchased done by others. Any individual who neglecting his own information signal and taking a decision based on somebody else’s action is said to be showing information cascade. One of the primary intuitions pointed out by the authors include the predisposition of mankind to imitate. Another reason that is stated is that most individuals face similar decision problems. The theory of information cascade can also be seen in the equity market. Institutional as well as individual investors often show herding behavior. SEC B Q5. There are only two securities traded in the bond market; the government issued securities and corporate issued securities. Sustaining high returns by mutual funds is not easy but, by investing in growth mutual funds, the chances of huge capital gains and value funds are practical. Q6. Growth mutual funds are mutual bond funds that invest in stocks of various well situated companies (Kelleher 2001). Trade margin is the purchase of stocks without having the whole amount of money to do so. Q7. Portfolio risk can be categorized into two types of risks: safety risks and dispersion measures. Three important and popular risk measures include: MiniMax, mean-abolute deviation, and standard deviation. Standard Deviation is the most common and simple measure to evaluate risk of a portfolio. The mean absolute deviation is more respect to outliers when compared to standard deviation. While standard deviation reduces if a riskless asset is added to a portfolio, the same does not hold true for MiniMax. MiniMax is complicated to calculate and may require substantial effort in large portfolios. Section C Q8. The basic principle of Shiller’s test on market volatility is based on the premise that the current discount-rate models leave a residual since returns can be forecasted. Shiller proposed that the share prices can be seen as predictions of company dividends. In order to make use of the excessive volatility of the markets, Lakonishok, Shleifer and Vishny suggested the use of Contrarian strategies to invest. They recommend investing disproportionately in stocks that are underpriced and underinvest in stocks that are overpriced. Since they are contrarian to the popular strategies followed by others, they are able to generate higher returns. Q9. The Ohlson’s residual income model and Miller Modigliani investment opportunities model are two key models in evaluation of companies. Both these models have had a great impact on the capital markets. The Ohlson’s model has also incorporated the themes of Modigliani and Miller model. Both the models state that the market value is affected by dividends on a dollar-to-dollar basis. Also, the expected future profits are negatively related to the dividends paid in the current period. The Ohlson’s model proposes a relationship between stock prices and accounting figures such as earnings and book value of the organization. The model has been found to be more efficient in predicting stock prices as compared to the MM model in various researches. However, in their research, Dechow, Hutton and Sloan witnessed ambiguous support for the model. They also suggested that the previous dividend-discount models had a large number of unrealistic assumptions. Their findings can be explained by the fact that information dynamics is empirically descriptive. Besides, investors often give more weightage to news items in earnings forecast rather than the organization’s current earnings and book value. Q10. Breton and Taffler (2001) in their paper “Accounting information and analyst stock recommendation decisions: a content analysis approach” evaluate the relative importance of accounting measures as compared to non-accounting measures. The authors conclude that while the accounting information is of importance in valuation, firm’s management, strategy and its trading environment are the most important factors used by financial analyst while coming up with stock recommendations. Barth, Cram and Nelson in their paper “Accruals and the prediction of future cash flows” studied whether earnings disaggregation, imposing valuation model linear information (LIM) structure, and separate industry estimation of valuation model parameters aid in predicting contemporaneous equity values. The authors concluded that earnings should be disaggregated into cash flow and other major accrual components. Also, the utility of abnormal earnings, accruals and accrual components vary from industry to industry. Section D Q5. Bond market is the financial market involved in dealing with debt instruments. In this market, new debt can be issued as well as old debt securities can be purchased and sold. Bonds can be issued by many institutions such as companies, governments, municipalities. Participants might also involve in mortgage backed debt. The bond market is generally considered to be less risky as compared to other markets such as equity or derivatives. However, the return on a bond is less as compared to that of equity. People holding bonds will get principal as well as interest as per the pre-defined schedule. Derivatives can be categorized in the following types: Forwards: Payment takes place at a specific time in the future at a predetermined price today. Futures: Contracts to buy or sell asset on or before a future date at a pre-specified price. Options: These contracts give the owner only the right and not the obligation to buy or sell an asset. Q6. The key asset classes and the implications of historical prices are given below: Debt: Historical distribution is often not an important indication of the prices and returns in the future. It is often based on the pre-agreed rate of interest and time period. Real Estate: Generally, real estate shows increasing price trend over a period of time. Stocks: The technical analysis of stock markets suggest that stocks generally show significant trends over a period of time. Q7. The expenses incurred in mutual fund are paid by investors. The prices cover: distribution charges, management fee, other fund expenses, shareholder transaction fees and securities transaction fees. These expenses are often very high and reduce the actual return of the mutual fund. Trading on margin is trading in the market with borrowed money from the broker. Work cited Kelleher, Jim. Equity valuation for analysts & investors: New York: McGraw-Hill, 2010. Print. Lease, Ronald. Dividend policy: its impact on firm value. Boston, Mass.: Harvard Business School Press, 2000. Print. List, John. Does market experience eliminate market anomalies? the case of exogenous market experience. Cambridge, Mass.: National Bureau of Economic Research, 2011. Print. Littleton,Charles., and Basil S. Yamey. Studies in the history of accounting. Homewood, Ill: Richard D. Irwin, 1956. Print. Michie, Richard. The global securities market: a history. Oxford: Oxford University Press, 2006. Print. Scharfstein, D. and Stein, J. (1990). Herd Behavior and Investment, American Economic Review 80: 465 - 479. Thompson, Paul, and Matthew Yeung. The impact of transparency on broker recommendations and share price volatility: an analysis of Singaporean companies. Kuala Lumpur, Malaysia: University of Nottingham in Malaysia, Division of Business and Management, 2001. Print. Thybo, Poul. Two types of contrarian investment strategies: A test. New York, NY: Sinpsis, 2006. Print. Top of Form Bottom of Form Read More