Decision Making Process in the Field of Finances - Essay Example

Strategic and Financial Decision-making Table of Contents Table of Contents 2 Part1- 3 Part2- 5 Part 3- 6 Part4- 8 Reference 12 Bibliography 14 Annexure- 15 Part1- a- Beta is the sensitivity of stock returns to the market returns. As per Mean Variance Portfolio Theory the beta is obtained as- β = Covariance(x,y) / Variance of market “y” is the security return “x” is the market return For the assignment two companies- Tullow Oil Plc and Investec Plc have been selected. Tullow Oil Plc (TLW) is a producer of Oil and natural gas with operations spreading across Africa, UK and South Asia. Investec Plc (INVP) is a financial services company. Both the companies are listed under FTSE 100. The beta of TLW according to Portfolio Theory is 0.64 (Yahoo Finance-a, 2010). The beta of Investec Plc is 2.17 (Yahoo Finance-b, 2010; Yahoo Finance-c, 2010). b- As per Liner Regression analysis beta can be obtained as- E (Ry) –Rf = β (Rm-Rf) According to CAPM the beta of Tullow Plc is 0.67. The beta of Investec Plc is 2.27 as per Liner Regression analysis. Part2- The beta of Investec Plc as per Bloomberg is 1.134 which is less than the value obtained as per Portfolio Theory and CAPM model. Similarly, the beta of Tullow Oil Plc is published by Bloomberg as 1.195 which is higher as compared to the beta obtained under the two approaches (Bloomberg-a, 2010; Bloomberg-b, 2010). The difference in value of the beta obtained as per CAPM and from a published source can be due to various reasons. Like the beta obtained as per calculations is based on the returns over the last twenty four months whereas it is possible that Bloomberg calculates the beta on a daily basis. Therefore, the main reason for varying beta is ‘time period’. Also, the beta calculation has been based on the returns of FTSE 100 whereas it is possible that the publisher may have used a different index. As the publisher uses an extensive time period in estimating beta it is more reliable as it covers a longer stretch of time and is thus more representative. On the other hand, the beta that has been calculated based on the returns over the last two years takes into account the volatility only during this time period. This fails to give a true picture of the stock sensitivity. Suppose, during these two years there is a crisis in the market then this is bound to impact all the stocks. In such situations if the beta is calculated based on the fluctuations over a wide range of period then this will provide a better basis for judgement. Part 3- The beta of Tullow Oil Plc is 0.64 and that of Investec Plc is 2.17. If the beta of the stock is more than 1 it is called an ‘aggressive’ stock whereas if the beta is less than 1 the stock is referred to as ‘defensive’ stock. In the case of aggressive stock the fluctuation in the stock returns is more than the market returns. Like if the beta of the stock is 1.50. This means that if the market moves up by 10 percent the stock will move in the same direction by 15 percent. Similarly, for a defensive stock with a beta of 0.25 like Wal-Mart if the market falls by 10 percent the price of Wal-Mart will fall by only 2.5 percent (Yahoo Finance-d, 2010). This means that Tullow Oil Plc is a defensive stock as its beta is less than 1 whereas Investec Plc is an aggressive stock. This means that the stock price of Investec Plc will move more than in proportion to the market movements. Investing in low beta stocks is recommended when the market conditions are uncertain. An investor can invest his funds in high beta stocks when the market sentiments are positive as one bad news can trigger a huge fall in the value of the portfolio. The pharmaceutical and FMCG stocks are generally low beta stocks. As these industries provide the basic goods and services their price is not much impacted by market conditions. For this reason the investors prefer to invest in these sectors during difficult market times as they are immune to market movements. However, when there is an improvement in the market condition the risk appetite of the investors also changes. With the improvement in the market conditions the risk tolerance level of the investor also increases. At this point one invests in high beta stocks to gain out of market movements. As per CAPM model high beta indicates high risk and the return offered by such stocks is also high. So beta can be considered as a measure of risk. The stocks of the banking and financial services companies generally have a high beta indicating that their returns are vulnerable to adverse market movements. Like Barclays has a beta of 1.756 making it an aggressive investment (Bloomberg-c, 2010). Part4- a- CAPM model takes into account the Systematic Risk or non-diversifiable risk in estimating the return required from a stock. This model considers the sensitivity of the security to non-diversifiable risk represented as ‘beta’, risk-free rate of return and the market rate of return. CAPM uses the Security Market Line (SML) to price an individual stock. SML explains the relationship between the return required on security and the market rate of return. Based on the beta that is borne by the investor SML calculates the return as per the risk. This is expressed as- E(Rj) = Rf + β(E(Rm) – Rf)) E(Rj) is the expected rate of return of the security Rf is the risk-free rate of return β is the stock beta E(Rm) is the market rate of return For risk free rate one can use the return on Government Gilts. For market return one can use the return of an established benchmark index like FTSE 100, S&P 500 etc. Beta is obtained by regressing the stock return on the market return. In SML the x-axis is represented by stock beta and y-axis is represented by the expected return from the security. Market risk premium or “E(Rm) – Rf” represents the market risk premium. The market risk premium of an individual stock is adjusted with the respective beta to find out the “risk premium” on the stock. Risk premium is the return required by the investor for bearing the risk. SML is an important tool for determining whether the security compensates an investor for bearing risk. If the actual return on the security is less than the expected return then it plots below the SML line indicating that the stock is ‘overvalued’. On the other hand, if the return on security is more then the expected return then the stock plots above SML and the stock is said to be ‘undervalued’. A company that wishes to expand its operations outside the core activities must assess the level of risk relating to such investment. Like a company that belongs to the FMCG industry and forays into the financial services exposes itself to higher risk. FMCG is considered to be a low risk industry as it deals in basic goods and services and hence it is not much impacted by market conditions. However, the performance of the financial services is influenced by macroeconomic factors like market situation, credit scenario, market demand etc thereby making it a risky investment proposition. With the rise in risk the required return from this particular industry also increases. Consequently, the cost associated with such investment is also high as the investors are wary of extending capital to them. This raises the required rate of return for this industry. As people will be willing to park their funds in this company only if the returns offered are in proportion to the level of risk. Moreover, the company with FMCG as its core activity will be willing to take the additional risk relating to a new industry only if it is assured of higher returns. With the rise in risk the beta also increases thereby raising the return required from the new investment. This means that the FMCG company will be willing to bear the additional risk associated with the new investment in financial services only if it gets higher returns. b- For expanding its operations a company can opt for internal growth like increasing the scale of operations or it can opt for acquisitions. A business can acquire similar firms in the industry or it can acquire firms belonging to different or unrelated industries. The former helps in increasing its market share. Besides strengthening its position the company can establish itself as a ‘market leader’. Both the forms of expansion have their own sets of benefits. Like in the case, where the company expands internally by raising the level of output it gets the chance of exploiting higher economies of scale. This enables it to lower the cost of output. It can pass on this benefit to the customers by lowering the prices. By offering goods at low prices the company can get an edge over its competitors. This helps the company to increase its market share. The acquisition is also another way of expanding the company operations. Like a company operating at the maturity stage has limited chances of internal growth. Such a company can use the excess cash to acquire a stake in a growing company. Besides this a company can also acquire firms belonging to different industries. This helps it in diversifying its business activities. It has been seen that during downturns certain industries are the most affected whereas there are others that are comparatively less impacted. Investing in such sectors can protect the company from adverse business scenarios. If a company acquires its rival then this helps in raising its market share. The acquisition of a similar business lowers its overall costs. This gives rise to business synergies. The turnover of the company increases with the integration of the sales of its rival firm. It is also possible that the rival enjoys certain trade-marks and patents which can be accessed by the acquirer. The acquirer can cash on the market reputation of the acquiring firm. Moreover the company can establish itself as a market leader and negotiate better terms with the suppliers. With the rise in sales the company can raise the production levels thereby enjoying better economies of scale. On account of bulk purchase of materials the company can ask for higher discounts. The rise in the sales volume and reduced costs can boost the profit margin of the acquirer. Reference Bloomberg-a. 2010. FUNDAMENTALS. INVP:LN Investec PLC. Available at: http://www.bloomberg.com/apps/quote?ticker=INVP%3ALN [Accessed on May 11, 2010]. Bloomberg-b. 2010. FUNDAMENTALS. TLW:LN Tullow Oil PLC. Available at: http://www.bloomberg.com/apps/quote?ticker=TLW%3ALN [Accessed on May 11, 2010]. Bloomberg-c. 2010. FUNDAMENTALS. BARC:LN Barclays PLC. Available at: http://www.bloomberg.com/apps/quote?ticker=BARC%3ALN [Accessed on May 11, 2010]. Yahoo Finance-a. 2010. Historical Price. TULLOW OIL ORD 10P (TLW.L). Available at: http://finance.yahoo.com/q/hp?s=TLW.L&a=04&b=1&c=2008&d=03&e=31&f=2010&g=m [Accessed on May 11, 2010]. Yahoo Finance-b. 2010. Historical Price. (INVP.L). Available at: http://finance.yahoo.com/q/hp?s=INVP.L&a=04&b=1&c=2008&d=03&e=30&f=2010&g=m [Accessed on May 11, 2010]. Yahoo Finance-c. 2010. Historical Price. FTSE 100 (^FTSE). Available at: http://finance.yahoo.com/q/hp?s=^FTSE&a=04&b=1&c=2008&d=03&e=31&f=2010&g=m [Accessed on May 11, 2010]. Yahoo Finance-d. 2010. Stock Price History. Wal-Mart Stores Inc. (WMT). Available at: http://finance.yahoo.com/q/ks?s=WMT+Key+Statistics [Accessed on May 11, 2010]. Bibliography Agar, C. Capital investment & financing: a practical guide to financial evaluation. Butterworth-Heinemann. Bloomberg-d. 2010. U.K. GOVERNMENT BONDS. Government Bonds. Available at: http://www.bloomberg.com/markets/rates/uk.html Moyer, C.R. McGuigan, R.J. Kretlow, J.W. 2009. Contemporary Financial Management. Cengage Learning. Annexure- Read More