Financial Management: Cash Flows of the Company - Coursework Example

Question 1 a. Calculating the fair price of the bond This is the value obtained by discounting its expected cash flows that it is expected to generate over a given period to the present time using an appropriate discount rate. Period = 10 years but paid semi annually therefore n=20 Rate =1.65=r Taking base value of 100 the present value o the bond=100/(1+0.0165)20= 72.0862 PVII= Present value of interest income Coupon rate= 3.85. r=3.85/2=1.925% since it is paid semi annually Taking base as 100, PVII is given by; 1.925{1-1/ (1+0.0165)20/0.0165}= 45.1765 Present value of bond= PVP+ PVII=72.0862+45.1765=117.2627. b. Macaulay and Modified duration Modified duration is the approximate change in the price of a bond for a basis change in yield assuming that its expected cash flow remains constant when the yield varies. It is expressed as a percentage change (Blume and Edelen, 2004, p. 82). =1/(1+yield/k){1*pvc1+2*pvc2+....+nxpvcfn/kx} Where k= number of periods n=number of periods to maturity yield= YTM of the bond pvcf=present values of cash-flows YTM={c+(f-p)/n}/(f+p)/2 C=coupon F=face value=100 P=price=80 N=years to maturity=10 YTM={3.85+20/10}/180/2=0.065=6.5% Modified duration={1+0.065/20}{1*219+2*249+3*275+4*296+5*310+6*324+7*355+8*462+9*545}/20= 868.1122 Modified duration =macalauray duration/(1+yield/k) therefore; Macalauray duration=modified duration*(1+yield/k)=868.11(0.065/20)=2.8213575 c. Duration approximation for different YTM’s Duration=v2-v3/2(v1)(change in y) V1=initial price V2= price if yields decline by change in y V3=price if yields increase by change in y Yield =6.5%. assuming a base price of 100,changing rates by 50 bps, the new price for increase in 50bps would be 96 and new price for decreased rates would be 105. Therefore Duration=105-96/2*100*0.005=9. This means that for a 100 basis point change, the approximate change will be 9%. d. Convexity Is the measure of curves in the interaction between prices for bonds and their yields and it shows how the duration of the bond changes as the interest rate changes. It is often used as a risk assessment tool to assess market risks. duration 100 6.5% 9% yield e. Duration and convexity for different YTM’s YTM1= 6.5%, duration= 9%, price=100 YTM2= 10%, duration=13%, price=150 YTM3=4%, duration=5%, price=80 150 Duration 100 80 Bond A Bond B 4% 6.5% 10% Question 2 Intrinsic value of stock 1 The dividend discount model is used to figure out a stock’s intrinsic value. The intrinsic value of stock is the underlying value of a company. It shows the present value of the future cash flows of the company. This method takes care of the dividends that a company will pay out to its shareholders and directly reflects on that company’s ability to generate cash flows. Value of stock= div1/(1+r)1+div2/(1+r)2+........divn/(1+r)n Where: Div= dividends expected in one period r= required rate of return Picked Coca cola Company from the index, EPS=180,P/E=24.3 Div PS=1.22, Payout ratio=1, last trade=43.50 and Div yield=2.80 AT&T Company, EPS=3.26, Div PS=1.84,P/E= 10.4Payout Ratio= 56, Div Yield=5.43 and Last trade=33.91. For AT&T Company: Intrinsic value of stock=1.84/(1+0.0543)1=1.7452+33.91=35.65 For Coca cola Company: Intrinsic value of stock=1.22/(1+0.028)1=1.1867+43.50=44.686 ASSUMPTIONS OF THIS MODEL This model though easy to use, is highly assumptious. It assumes that all the companies pay dividends, which does not hold true in all cases since there are companies that do not pay such but prefer to re-invest the amounts to offer their shareholders a greater value for their money. It assumes that dividends are steady and can be predicted by the company using reasonable means. This is not true since all future values are faced with the problem of forecasting and is prone to errors. According to this model, dividends can be classified into zero growth dividends, constant growth rate dividends and multiple growth rate dividends. This is however hard to put in practice and choose which to take since dividends are unpredictable in their own way. It also assumes that future cash flows can be accurately predicted using existing company policies since future cash flows cannot be forecasted with accuracy. As for the constant growth rate dividends, one can never be sure about the values of stock in the coming year and tell exactly what the change will be. It also assumes that the discount growth rate is always less than the expected rate of return hence one cannot use it to evaluate dividends of high growth rate stocks (Pennathur, Delcoure and Anderson, 2002, p. 503). This model is based on many assumptions and guesses on future profits and unrealistic company policies to put it to use. The rationale behind this model is to determine proper stock price, analyze earnings and dividends of the firm (Minton, 1997, p. 56). When it comes to selling and buying of stock, an investor buys them when they are cheap, holds them for a period until the market value of the share increases, and then sells them at a profit. As for the two companies, AT&T is doing better and an investor would be good to buy such stock now, as they are high growth rate stock. The EPS of Coca cola is at 180 which is good compared to the EPS of AT&T which is at 3.86. an investor in Coca cola earns more per share compared to an investor in AT&T hence a potential investor should buy such shares as it has better returns (Akseli & Gray, 2011, p. 65) Question 3 a. Monthly share prices company 1st month 7th month 13th month 18th month 24th month 31st month 42nd month 50th month 56th month 61st month BAC 5.40 10.12 14.32 17.18 18.91 16.87 16.91 17.00 17.56 17.68 KOG 3.12 3.56 4.23 5.67 4.99 6.12 7.45 6.23 6.51 6.56 SIRI 1.45 2.11 3.45 2.67 1.99 2.81 3.87 3.23 3.28 3.49 AAPL 110 113 109 104 107 120 114 114 113 115 KMI 40.9 50.3 49.3 45.6 42 43.56 40.7 40.3 40.9 41.12 HAL 39 36 40.23 41.2 39.3 39.6 36.3 38.7 39.65 40.37 F 9 10.2 11.4 11.9 11.7 12.3 13.6 13.9 14.7 15.7 CRC 2.03 2.49 2.98 3.50 3.58 3.5 4.20 5.43 5.99 6.46 CSCO 21 23.5 22 24.7 25.2 24.3 26.8 26.9 27 27.50 MSFT 39 41.2 42.3 39.4 42.6 45.1 46.7 47.2 47.9 48.42 QQQ 100.9 101 102.4 102.9 103.4 104.5 106.7 108.5 107.6 105.38 PBR 4 5.4 5.6 5.87 5.27 6.38 6.99 7.20 7.95 8.82 PFE 27.41 28.65 29.95 30.67 32.36 33.46 33.9 32.9 32.43 31.99 SDRL 7.43 7.76 7.94 8.37 8.49 8.98 10.24 11.46 12.89 12.32 FB 69.00 67.29 70.81 72.78 75 78.98 76.34 72.67 72.78 76.36 RF 6.91 7 7.2 7.32 7.77 8.49 8.89 9.21 9.44 10.37 AEO 7.78 6.99 6.78 8.46 9.46 9.83 9.93 10.34 12.93 11.91 GE 21 22.3 22.78 23.41 24.92 25.78 26.49 27.36 26.87 26.01 C 43 45.78 45.78 46.67 48.34 50.19 53.16 55.67 56 56.08 MSFT 39 41.2 42.3 39.4 42.6 45.1 46.7 47.2 47.9 48.42 b. Minimum variance frontier without short selling of risky assets According to Markowitz’s modern portfolio theory, the minimum variance frontier is the minimum amount of volatility of stocks within any given portfolio. It is usually illustrated by a graph showing how the risk of one particular stock will be offset by the rest of the portfolio (Prasad & Kawai, 2013, p. 92). Taking two companies A and B; Taking probabilities of; state probability Company stock A Company stock B 1 20% 5% 50% 2 30% 10% 30% 3 30% 15% 10% 3 20% 20% 10% Company stock A; E {RA} =20(5%) +30(10%) + 30(15%) +25(20%) =12.5% Company stock B; E {RA} =20(50%) +30(30%) + 30(10%) +25(-10%) =20% c. Minimum variance frontier with short selling of risky assets state probability Company stock A Company stock B 1 10% 2% 40% 2 20% 5% 25% 3 20% 10% 5% 3 15% 15% 5% Company stock A; E {RA} = 10(2%) +20(5%)+20(10%)+15(15%)=5.45% Company stock B; E {RA} =10(40%)+20(25%)+ 20(5%)+ 15(5%)=10.75% d. minimum variance frontiers minimum variance portfolio 12.5 5.45 e. Client report The above was obtained by calculating the expected returns of the market portfolios of two companies, A and B. The frontier is then constructed from the two assests each promising the highest returns for a given amount of risk. It is achieved by calculating the returns of all weights possible. Since it is impossible to draw all portfolios, only ones with minimum volatility for a given return will be considered (Herger & Delimatsis, 2011, p. 104). The upper half of the minimum variance frontier is called the efficient frontier. This can be achieved by use of excel using solver which is in the tools and then considering two assets. The return estimates and correlation matrix build up a matrix for covariances which calculates portfolio volatility and finds weights which give the minimum volatility of a given return. The weights of the portfolio determine the proper allocation within the various assets that make up the risky portfolio, which should be opted for by investors (Alexander & Dhumale, 2012, p. 43). The two steps involved are basically, deciding between the risky portfolios and the riskless assets then followed by determination of the allocation between the assets that comprise of the risky portfolio. f. Problems associated with short selling Short selling itself is a very big risk and is a gamble. It is the selling of stock by a seller on behalf of the broker and is promised to be delivered. It is for short-term use of stock that the trade expects to decline in price. Stock prices have been rising over the years and usually appreciate in the end (Green & Davies, 2013, p. 57). Though rising inflation somehow pushes the prices of the stock up hence shorting is going against the market direction. Losses can be infinite when one short sells. This arises when the stock price rises and the short sale loses. Shorting involves the use of borrowed money also known as margin trading. In case of any losses incurred during shorting, one may be required to inject more cash or liquidate their position (Broadie, 1993). Short selling can drive an investor to a short squeeze when he stocks stock with a high short of interest. This happens when stock prices go up and buyers rush to buy the stock to cover their position, which in turn causes a huge demand for the stock hence pushing the price even further (Hamilton & Gray, 2006, p.101). With short selling, one can never be sure of the results and that they will reap as expected. One could be right but at the wrong time hence reaping undesired results. 4. Exchange trade funds An ETF is defined as any type of investment that combines the benefits which a stock has versus its mutual funds with the diversification and principals for investment of a mutual fund. It is a mutual fund that is handled like a stock. Full index replication is considered not always to be possible. Some indices and elements include securities that it hardly bought by all investors. Insufficient or inadequate liquidity of individual adverse taxation and equities of income may ultimately cause full replication inadvisable. In such scenarios, representative sampling of the whole population is the recommended and acknowledged course of action to be taken. Representative sampling designs a portfolio with the use of limited number of securities to enhance the replication characteristics of the index as near as possible. Mathematical optimization process is commonly used by some providers to determine the allocation and distribution of these portfolios while others may use a sampling technique that is stratified. Even with the use of representative sampling, funds continuously hold the securities directly. Synthetic ETFs is tasked with the obligation of reducing tracking error in situations that the fund cannot hold the subsequent securities and instead enter into a swap agreement to achieve the returns on the index benchmark. This approach is considered to be having numerous cons in complex country indices like those of emerging markets. This is because since synthetic replication gives room to less liquid indices for accurate replicated and efficiently without investors foregoing the targeted high level of clearance. In order to clarify that the index replica is accurately as possible, the ETF invests in a substitute basket and in an index swap, causing the return of the substitute basket to be an offset on daily basis against swap index return. The substitute basket is made up with a mounted view to attempt and minimizing costs while maximizing tax as they complying with legal requirements. As a section of the heightened needs and requirements in regards to transparency, the formation of the substitute basket is published on a daily basis. References Hamilton, J., Gray, J. 2006. Implementing Financial Regulation: Theory and Practice. New York: John Wiley & Sons. Green, D., Davies, H. 2013. Global Financial Regulation: The Essential Guide (Now with a Revised Introduction). New York: John Wiley & Sons. Alexander, K., Dhumale, R. 2012. Research Handbook on International Financial Regulation. Cheltenham: Edward Elgar Publishing. Prasad, E., Kawai, M. 2013. New Paradigms for Financial Regulation: Emerging Market Perspectives. Washington: Brookings Institution Press. Akseli, O., Gray, J. 2011. Financial Regulation in Crisis?: The Role of Law and the Failure of Northern Rock. Cheltenham: Edward Elgar Publishing. Herger, N., Delimatsis, P. 2011. Financial Regulation at the Crossroads: Implications for Supervision, Institutional Design and Trade. Kluwar: Kluwer Law International Blume, M., and Edelen, R.2004. S&P 500 Indexers, Tracking Error, and Liquidity. The Journal of Portfolio Management, Vol. 30, No. 3 (2004), pp. 37-46 Broadie M. 1993. Computing Efficient Frontiers using Estimated Parameters. 1993, Vol.45 (1993), No.1, pp 21-58 Chu, P., K. Study on the Tracking Errors and their Determinants: Evidence from Hong Kong Exchange Traded Funds. Applied Financial Economics Vol.21 No.5 (2011), pp.309 – 315 Stillman, R. 2009. Public Administration: Concepts and Cases. 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