Investment Planning and Systemic Risk - Assignment Example

Part 1: Question 1 The primary markets for securities are the sections of the capital market that involves issuance of new securities. It is a market where new lending and borrowing as well as issuance of new shares (equity) occur. An initial public offering (IPO), for instance, is one of the primary market activities. In this case, new shares are issued to the share market. In addition, issue of bonds by the government represent a primary market activity. In primary markets securities are directly issued to the investors. Only the initial holder of a security can redeem a financial asset. On the contrary, the secondary market involves the subsequent trading of the securities that had been issued earlier. Investors do not buy securities directly from the issuer as in primary market but rather buy from other investors. Furthermore, in this market it is not necessary that the original holder of a security redeems it. Question 2 Systemic risk is a type of investment risk that is “common to all securities” (Dash 90). It is the risk of failure of an entire market or financial system. According to Gallati, systemic risk is the risk that interference in a market or financial system would result in extensive problems in the market (26). This risk is also known as non-diversifiable risk or market risk. One of the characteristics of systemic risk is that it cannot be reduced even with diversification in a market since it is associated with an entire market not performing as expected. For instance, if a major financial institutions collapses it could result in grave problems in a market. Specifically, if a bank collapses not only would it result in depositors loosing money but it could also result in financial pressure to other market participants, and eventual collapse of businesses and other financial institutions and banks. This characteristic ripple effect could result in the fall of an entire market or economy. This affects an investor in the sense that he or she might looses the investment Therefore, an investor is affected by systemic risk as long he or she engages in asset class investment such as investment involving Australian equity (or shares). Furthermore, this risk decreases the benefits obtained from diversification as well as punishes an investor for cling to a levered position (Das and Uppal 2809). Question 3 Fixed interest investments can give profits as well as losses. Using, as an example, a 10-year government bond parcel with two full years remaining in its terms, where the yield rate is 8.95% p.a., paid as a half-yearly coupon, and the market interest rate is 7.50% p.a., the present value of a $100 government bond parcel would be as shown below: The formula for present value calculation is given as follows: PV= FV / [1 + I/C]n Where PV is the present value of investment, FV is future value, I is interest rate, C is the compounding periods per year, and n is the total number of compounding periods. Note that the rate of return of the bond parcel is 8.95% p.a. -7.50% p.a. = 1.45 %p.a. Therefore, PV = $100 / [1+ 1.45 %/2]8*2 PV = $100 / [1 + 0.725%]16 PV = $100 / 1.0072516 PV = $100 / 1.1225 PV = $89.0869 So, given the above condition a government bond investor would receive a profit of $10.9131 in the investment. Therefore, the interest rate determines greatly if an investor would make a loss or profit in a government bond parcel. If the market interest rate rose to a value above the original placed yield rate, the investment would result in a loss. Thau illustrates clearly that an increase in interest rate causes the price of a government bond to decrease (31). Question 4 Different discounted cash flow (DCF) use different discounting rates because the risks under which various investments fall are often unique. That is, it is likely that a particular investment would be affected by different investment risks to another investment and returns might vary because of these risks. Therefore, different discounting rates that reflect corresponding risks to specific investment have to be used to give correct values of the discounted value. Consider this, Yanni and Joanna’s current investment property was purchased six months ago (assuming this to be in the current financial year) for $418,000 in an area that they believe has high growth prospects, and that they have an interest-only loan of $280,000 attached to this property. The expected sale price in three years is $575,000. In addition, cash flows from the property are: In year 1: Rent income $33,000; Cash expenses $12,500 In year 2, rent income is expected to increase by 2% compared to year 1 and cash expenses are expected to increase by 1.5% compared to year 1. In year 3, rent income is expected to increase by 2.5% compared to year 2 and cash expenses by 2.0% compared to year 2. The appropriate discount rate is 8.75%, being the risk-free rate plus a premium. The discount rate also recognises the interest rate for the property loan of 7.75%. The calculations below illustrate the need for different discounted cash flow to use different discounting rates. a) Why DCF is used to evaluate investments and what impact increasing the discount rate will have on the results of a DCF valuation. DCF are used in evaluation of investments because they take into account investment risk that affects the returns of an investment. It is worth to note that increasing the discount rate results in a reduced discounted present value of an investment. b) The present value (PV) and net present value (NPV) to the nearest dollar the of the couple’s investment property is given as follows: The present value is given by the formula below: PV = [PMT / (1+I)] + [PMT / (1+I)2] + [PMT / (1+I)3] Where, I represent the discount rate, and PMT is the cash flow payment for each period. The cash flow of the payments for each investment is given as follows: Year 1 Year 2 Year 3 Sale price 0 0 $575,000 Rent income $33,000 (2%* 33000)+ 33000 = $33,660 (2.5%*33,660) + 33,660 = $34,501.5 Cash expense $12,500 (1.5%*12,500) + 12,500 = $12,687.5 (2%*12,687.5)+ 12,687.5 = $12,941.25 Total $20,500 $20,972.50 $596,560.25 Therefore, PV ={20,500 / [1+0.0875]}+ {20,972.5 / [1+0.0875]2} + {21560.25 / [1+0.0875]3} PV = {20,500 / 1.0875} + {20,972.5 / [1.0875]2}+ {21560.25 / [1.0875]3} PV = {20,500 / 1.0875} + {20,972.5 / 1.1827} + {21560.25 / 1.2861} PV = 18,850.5747 + 17,732.7302 + 463,852.1499 PV = $499,317.61 The net present value (NPV) = $499,317.61 - $418,000 NPV = $ 81,317.6103 c) The internal rate of return (IRR) of this investment to one decimal place is given as follow. Given, PV = [PMT / (1+IRR)] + [PMT / (1+IRR)2] + [PMT / (1+IRR)3] 418,000 = {20,500/(1 + IRR) } + {20,972.50/(1+IRR)}2 + {596,560.25/(1+IRR)3} IRR = 15.753% d) The workings below show whether this investment is good value if comparative properties are returning 15.25% per annum. Using the cash flow below; Year 1 Year 2 Year 3 Income 15%*418,000 = $63,745 15%*481,745 = 72,261.75 15%* 554,006.75 = 83,101.0125 Sale price $575,000 Total $63,745 72,261.75 $658,101.0125 The PV for this investment is given as follows: PV = [PMT / (1+I)] + [PMT / (1+I)2] + [PMT / (1+I)3] PV= {63,745 /1.0875} + {72,261.75 / 1.1827} + {658,101.0125 / 1.2861} 58616.0920 + 61098.9685 + 511702.8322 PV= $631,417.90 - $418,000 213417.9 PV= $631,417.90 NPV = $631,417.90 - $418,000 NPV = $213,417.9 This show that Yanni and Joanna’s property investment is not good value for money when other properties are considered because other properties have a higher net present value (NPV) of approximately $213,417.9 compared to the other NPV of approximately $81,317.6. Question 5 Given that Yanni works for Woolworths Limited (WOW) and owns 5,000 Woolworths shares that he received in lieu of a bonus five years ago, and that Woolworths has reported an NPAT of $1.294 billion and currently has 1.207 billion shares on issue where its current market price is $26.50, a) The price/earnings ratio for Woolworths based on its reported NPAT and current market price (to one decimal place) would be as given below: P/E Ratio = Market price per share / Earnings per share Earnings per share = $1.294 billion /1.207 billion shares = $1.0720 P/E Ratio = $26.50 / $1.0720 = 24.7 b) WOW’s fair price based on the earnings forecast if Yanni has received investment research from an equities broker that forecasts WOW’s EPS for the coming financial year to be $1.485 per share, and the current industry average P/E ratio is 14.05x. WOW’s fair price = P/E Ratio * Earnings per share WOW’s fair price = 14.05 * $1.485 = $20.86 c) Based on the calculations above, the share price is above the calculated fair market price and therefore does not warrant a ‘buy’ but rather warrants a ‘sell’ recommendation. Other general and company-specific factors that may be relevant to making an investment decision about this stock include the current and previous share prices. These are compared to show if the shares have remained stable, increased or reduced in prices and the reasons for that. The company’s assets are also considered. Investment analysts would loot at whether these assets are valued at purchase costs as well as evaluate whether the worth of the assets would be more or less in future, and whether they are being used efficiently. Another factor is the worth of the company if it was split and sold. That is, would some of its section have more value than the entire company? The decisions would also be based on financial information of the company in relation to other similar companies. One goal would be to evaluate if it is better operated and more profitable. In addition, the amount an investor would be willing to pay for an expected future income stream from the earnings of Woolworth considering the risk of not receiving the income at all or in full is also a key factor in making such an investment decision. Part 2: case study This investment plan proposal aims at providing investment advice to Yanni and Joanna based on the given information to enable the couple meet their financial goals. To start with, it is worth to note that Yanni and Joanna have taken some good steps in regards to financial security. One, the couple have been making adequate superannuation contributions besides the compulsory contribution. In addition, the couple are making attempt to pay off their debts as well as investment attempts, including purchase of shares, term deposit and cash management accounts. However, there is need to review this strategy and come up with one which is adequate in regards to goals and risks. Overview on returns, risk and diversification The main aim of any investment is to provide returns after purchase of assets. Investment returns can be gains, profit or financial benefits derived from owning an investment asset. These returns can either be capital returns or income returns. Capital returns are obtained as a result of an increase in the value of an asset over time, while income returns are earned as rent, dividends, interest or distributions made from property investments, shares, fixed interest or managed investments. On the other hand risk is the uncertainty about the expected rate of returns from an investment. The risk is higher when the range of probable outcomes is larger. A more empathised risk is the downside risk, which is risk of a specific investment performing below the expectations. To mitigate risks it is advisable to diversify investments, which refers to investing in a number of different investment assets groups and assets. Often, it is unlikely that different investment in a portfolio would perform poorly or well during the same period. However, it is worth to note that there non-diversifiable risk such as market risk. Market risk is the risk of the entire market collapsing due to one or more key institutional failure. It is noteworthy that there is a concern of loosing money. However, it is important to note that not making any investment at all presents an opportunity cost. This means that the couple would miss on possible investment returns. Furthermore, depositing the money in term deposits exposes their money to risk since the returns do not cover inflation. It is important to note that a holiday does not represent an investment decision. Spending $50,000 in a holiday should not be a priority over investing. One of the good practices for an investor is keeping debts to a minimum. It is advisable that the couple pay off their outstanding personal debts, including the personal mortgage balance of $150,000 secured against their home, the $12,000 bank credit card debt and the $4,000 spread across three store credit cards. The cost of interest on these debts is not tax deductable. It is also good that Yanni and Joanna restrain from accumulating more personal debts. The repayment of these debts would prevent the burden of associated interests and result in some savings. The current asset allocation for Yanni and Joanna investment stands as follows: Table 1. Investment class Allocation (%) Allocation ($) Cash 5 $62,000 Fixed interest (Cash management account) 48. $616,000 Property 32 $418,000 Equities (WOW, NAB, BHP) 15 $190,000 Total 1,286, 000 The debt can be deducted from money in the cash management account. That is, $446,000 ($50,000, $12,000, $4,000) so that the new assets allocation remains as follows: Table 2. Investment class Allocation (%) Allocation ($) Cash 5.5 $62,000 Fixed interest (Cash management account) 15 $ 170,000 Property 37 $418,000 Equities (WOW, NAB, BHP) 15 $190,000 Total 1,116, 000 Yanni and Joanna could balance the available investment to reflect as shown in the table below. Table 3. Investment class Allocation (%) Cash 10 Fixed interest (Cash management account) 30 Property 20 Equities (WOW, NAB, BHP) 40 Total 100% The cash management trust would an appropriate option for putting the money meant for their holiday. The cash management trust has the advantage of reducing the minimum investment threshold to acquire fixed interest investments. In addition, there is the benefit of diversification of fixed interest issues in this portfolio, which is difficult to attain as a small investor through direct holdings. Comments Selling all the share investments and depositing the proceeds in a term deposit has its downsides. That is, while share investments present higher risk they have potential for higher returns. On the other hand, term deposits have lower risks and correspondingly generate much lower returns than equity investment. In addition, this exposes the investors to opportunity cost that has been highlighted earlier. Furthermore, there is the danger of depositing the money in a term deposit since the returns do not cover inflation. More importantly, investing in only one market – like the decision to deposit all the money in term deposits - presents a big risk to an investment; that is the market risk. Elsewhere, investing the money via a margin loan in WOW, WES and WPL is an option, but there are factors to consider. This option provides the benefits of leverage and loan. Note that with leverage one is able to buy more marginable shares for less money. However, in the event of share price falling, the percentage loss is higher with margin accounts. In response to Joanna’s worry about a possible downturn in the markets and contemplation to sell out and buy the shares back when times are better, it is advisable to act otherwise. While a downturn in the markets is not a god thing for investment, in regards to shares, it presents an opportunity for investment. Thus, it would be appropriate to buy more shares since it is likely that their prices have gone down. This would be in anticipation that their value would increase at a later time when the market are better. This is why investment on shares should be based on a long term. Works Cited Das, Sanjiv R. and Uppal, Raman. Systemic Risk and International Portfolio Choice. Vol. 59. No. 6. pp. 2809-2834, 2009. Dash, Ambika P. Security analysis and portfolio management. 2nd edn, I. K. International Pvt Ltd, New Delhi, 2009. Gallati, Reto R. Risk management and capital adequacy, McGraw-Hill Professional, New York, 2003. Thau, Annette. The bond book: everything investors need to know about treasuries, municipals, GNMAs, corporates, zeros, bond funds, money market funds, and more. McGraw-Hill Professional, New York. 2000. Read More