The Concept of Risk in the Field of Finance - Assignment Example

Assignment 7 Name: Instructor: Institution: Date: 1. Outline the primary differences between ordinary and preference shares. (10 Marks) Preference shares sometimes referred to as preferred shares receives a higher advantage in terms of priority for claim over assets in instance of corporate closure. Also preference shareholders are provided with a fixed dividend distribution. Ordinary shares commonly referred to as common shares receives a lower priority over a firm’s assets and unlike preference shares, ordinary shares receives dividend at the decision of the management of a firm (Andres, Betzer, Goergen, & Renneboog, 2009). This is to mean that dividends for preference shares have a specified rate that depends on the management decision. Preference shares are divided into non-cumulative and cumulative. For non-cumulative dividend is lost suppose a firm fails to pay the amount due while for cumulative suppose a firm fails to operate, the dividend owed will accumulate and can be claimed at a future date. In terms of voting rights, ordinary shares in most cases are entitled to one vote for every share hold (Andres, Betzer, Goergen, & Renneboog, 2009). Preference shares on the other hand often lacks voting rights but still can be converted into ordinary shares depending with the management decision and thus can obtain voting rights through such means. For business that are starting up, floating of preference shares is beneficial to them since they are attributed to be a hybrid of a security and a bond and thus deemed favorable to business that are beginning to operate and facing significant number of financial challenges. Floating ordinary shares would increase the financial obligations of the firm and because they are starting up, it might fail to meet a number of those obligations and thus increasing the chances of bankruptcy (Andres, Betzer, Goergen, & Renneboog, 2009). 2. Explain the concept of risk in the field of finance. (10 Marks) In the field of finance risk is use to imply to the projected future improbability about the deviation from the anticipated outcome or anticipated business earnings. The concept of risk in the field of finance and business tries to measure and ascertain the uncertainty that investors are willing to absorb and take for them to realize a given earning or gain from an investment decision made. In the field of finance, risks comes under different terms and recognition and are deemed to originate from a diverse business circumstances. The basic types of risks recognized in the field of finance includes; business risks, credit risks, operational risks, liquidity risk, insurance risks, default risks and sovereign risks (Lounsbury, & Crumley, 2007). The above mentioned risks originates from the uncertainties that exists and arises from a range of factors that tends to influence an investment decision or a situation. The significant of such risks largely depends on the financial instrument used in the cases of an investment decision. The concept of risk management plays a key role in establishing alternative means of control the levels of risks a business is subjected to and thus minimize the potential financial loss it can undergo on occurrence of the risk. The concept of risks provides alternative ways of mitigating risks that originates from a number of factors. Some of the common methodologies used to combat risks are; transferring the risk to another person or business, avoiding the risk totally, accepting the risk partially. It should be noted that in the same field of finance, different level of risk is attributed to different levels of investment assets which calls for appropriate decision while concluding investment decisions (Lounsbury, & Crumley, 2007). 3. Briefly differentiate active and passive fund management styles. (10 Marks) The management of a business have to main approach in which they can manage their funds. These are passive and active fund management. A collective term used is active and passive portfolio management. Management that implements an active fund management uses fund brokers of managers to purchase and sell market funds in an effort to outpace a particular market fund index. Management that implements an active fund management also tries to boast the potential returns that it intends to obtain from subsequent acquisition of market funds (Wermers, 2000). Passive management on the other aims at mimicking the investment funds hold for a specific market index. The main concept that differentiates passive fund management from active management style is that passive fund management entails the development of a portfolio where the management bases their funds allocation that is similar as a specific market index. The management of a business selects market funds and other securities listed in the same category and apply the same weighting criteria. Active fund management on the other hand targets at outdo the specific market target set and management implementing this type of fund management get engaged in an investing activity that that is active and pay close attention to the trends, shifts observed in the market as well as the economic and political landscape witnessed in the industry the operates in (Wermers, 2000). 4. What is the significance to the borrower of the loan-to-valuation ratio (LVR) adopted for margin lending? (10 Marks) The loan-to-value ratio abbreviated as LVT ratio is a financial ratio commonly used by market lenders to evaluate the ratio of loan given to the asset value that an individual or a firm has purchased. To building societies and banks, LVT ratio is a common term of their daily operation as it represents the proportion of the initial mortgage line as a ratio of the aggregate appraised worth of real property. Thus the computation of LVT ratio entails dividing mortgage lien by the appraised worth of the property which is expressed in most cases as a percentage (Fortelny, & Reed, 2005). Building societies and banks uses the loan-to-value ratio to assess the level of risk they are exposed too when they underwrite a mortgage computed as the delta between the value of appraised property and the aggregate amount of money borrowed. Suppose it is the reversed in that the bank or building societies becomes the borrower, they can use the loan-to-value ratio in ascertaining the level or default risks they are subjected to (Fortelny, & Reed, 2005). In other word, when the borrower applies for a loan for a figure that is exact or approximately near the value appraised and thus a loan-to-value ratio becomes high, what will happen is that lenders will have a perception of greater chance of the loan being defaulted and thus they will shun away from giving loans to such borrowers. The basic fact about this perception is that there is no or little if to say so equity value that is built up within the appraised property. Should any chances of foreclosure happens, the lender may be in jeopardy to sell the mortgage for a figure that is deemed sufficient to cover the amount due and make an extra profit from subsequent sales. 5. Part A Purpose of introduction of compulsory superannuation The objective and goal the government’s superannuation scheme was and still remains to invest in a working environment that will ensure individual citizens allocates a proportion of their income to create a retirement investment scheme. By doing so, individuals would have been able to reduce the possibilities of pension payment increment that might lead to cost intensive straining in the economy (Drew, & Stanford, 2003). Part B. I partially consider the government superannuation has significantly met its initial objectives. While the objectives of the compulsory superannuation by the government has been clear and having the best interest of people at its center, the scheme has faced a number of challenges in pursuit of its objectives. People have been so rigid to fully abide by the scheme requirement citing a number of reason such as oppression by reducing their income levels which have to a greater extent affect the working of the scheme and thus meeting its objectives (Drew, & Stanford, 2003). 6. Outline six of the positive characteristics that are associated with an investment in the property market. (10 Marks Property investments are characterized as a long term investments. Specifically, if an investor happens to purchase the property in less populated areas but with a promising population growth. One of the most recognized positive feature of property market i. s multi-generational in that it stands to last. It is this characteristics that makes the property market the most loved and invested by people. The second positive characteristics of property market is that it guarantees people who have invested in it some level of returns. Considering how modern investments have great risks, investors are keen in investing to markets where they are guaranteed some returns despite the risk level and thus the property market has appealed to many people since it guarantees returns (Sweeney, 1989). The third feature of property market is that participants stands to gain maximum benefits since in most cases it is the market forces determine the prices of sales proceeds and thus those who own properties can speculate to sale when prices are favorable or those who intends to buy, they do so when prices are low and sale when prices are high. The fourth feature is that the items trade in the property market are durable. This is an advantage considering the fact that most of the items in the property market appreciate in value with time for instance land. The fifth feature of property market is that items traded in the property market generates returns that is generally consistent. The six characteristics of property market is that participants in the property market are organized especially in developed nations. The advantage of this is that all participants both large and small are accommodated in the market (Sweeney, 1989). 7. Benefits of investing in a property fund Property funds is one of the most invested scheme alongside bonds, shares and cash. In modern days of investments, property funds takes a number of forms from let-to buy to property funds. The above mentioned forms of property funds comes with different risks and opportunity. For individual who have invested in property funds, they stand to make return from two sources that is leasing the property out or selling the investment scheme at a profit. For a firm that has invested in property fund, it can poll resources from a range of investors then reinvest the funds back at a profit (Brown, 1991). Also for a pooled property funds, investors share risks and thus reducing the levels of projected risks that they are exposed to. This is crucial in that investors have some level of certainty in terms of the extent in which they should invest and the level of risk they are covered by other investors. Individuals as well as firm looking forward to expand their business can use property fund scheme as collateral to acquire more funds that will foster expansion. Specifically, for a pooled property funds, where both large and small firms form the scheme, there is increased chance that firms will benefit from large pool of finances capable to meet their individual as well as collective fund demand (Brown, 1991). 8. Price earnings ratio Price earning ration is valuation measure used to assess and compare the levels of a firms stocks prices and the profit levels generated. It is computed as market price per share at the current time divide by the earning per share (EPS). EPS is computed as total earnings for the period divided by the number of shares floated. That is; EPS=Total earnings/ total number of shares floated. Total earnings; Operating profit before tax-company tax =13.8million – (30%10million) =$10.8 million EPS =$ 10.8 million/ 7.5 million shares (issued shares) =$1.44 per share. Current market price per share = $ 21.60 Thus P/E ratio = Market Price per Share/ EPS = $21.60/$1.44 =15 9. Computation of Unit Price Book Value; Asset = Capital+ liabilities Asset = 25 + 100 = $ 125 million C+L =66+135+45+167 = $ 413 Difference between Capital + liabilities and Asset; 413-125= $ 288 million/63 million = 4.57 million per unit. Market Value Assets = 28 + 112 =$140 C + L = 59+296+45+167= $ 567 Difference between Capital + liabilities and Asset; = 567-140= $ 427 milion/ 63 million =6.778 million per unit 10. Calculate the net tangible asset (NTA) price per unit of the “Futuristic Office Property Fund” which is an A-REIT. (5 Marks) Part a Net Tangible Asset (NTA) is the total asset of a firm without including intangible assets less total liabilities. Basic information provided. Assets; Property held by the fund=$80 million Mortgage owed (liability) = $50 million Units issued to the public= 20 million NTA per unit = (property held by the fund – mortgage owed)/ units issued to the public. = ($80million - $50million)/20 million $ 1.5 per unit issued to the public. Part b. Current market price is trading at a 10% meaning that the new price is =90%* $1.5 The new market price = $1.35 per unit issued to the public A 10% discount market price implies that the new market will reduce by the same percentage and thus the initial NTA price would reduce relatively for an A-REIT. References Andres, C., Betzer, A., Goergen, M., & Renneboog, L. (2009). Dividend policy of German firms: A panel data analysis of partial adjustment models. Journal of Empirical Finance, 16(2), 175-187. Brown, G. R. (1991). Property investment and the capital markets. Routledge. Dechow, P. M., Sloan, R. G., & Zha, J. (2014). Stock prices and earnings: A history of research. Annu. Rev. Financ. Econ., 6(1), 343-363. Drew, M. E., & Stanford, J. D. (2003). A review Of Australia's compulsory superannuation scheme after a decade (No. Discussion Paper No 322). Fortelny, A., & Reed, R. (2005). The increasing use of Automated Valuation Models in the Australian mortgage market. Australian property journal, 38(6), 681-685. Gitman, L. J., Joehnk, M. D., Smart, S., & Juchau, R. H. (2015). Fundamentals of investing. Pearson Higher Education AU. Lounsbury, M., & Crumley, E. T. (2007). New practice creation: An institutional perspective on innovation. Organization studies, 28(7), 993-1012. Pivo, G., & McNamara, P. (2005). Responsible property investing. International Real Estate Review, 8(1), 128-43. Sweeney, F. M. (1989). Investment strategy, a property market without frontiers. Estates Gazette, 2. Wermers, R. (2000). Mutual fund performance: An empirical decomposition into stock‐picking talent, style, transactions costs, and expenses. The Journal of Finance, 55(4), 1655-1695. Read More