Introduction to Finance: the Basics - Assignment Example

Introductory Finance Student’s Name Institutional Affiliation Date Question 1 An ordinary share also referred to as a common share refers to a financial security that entitles shareholders to dividends and residual economic value in the event that the company unwinds after paying preference shareholders and bondholders. The other name for an ordinary share besides a common share is a voting share. On the other hand, a preference share is a financial instrument that grants shareholders a preferential right by entitling them to capital repayment and receipt of dividends in the event of winding up the company. The other names for a preference share is a preferred share or a preferred stock. On the amount of dividends that preference and ordinary shareholders receive, it is evident that preference shareholders receive fixed dividends on an annual basis. Conversely, ordinary shareholders do not receive fixed dividends (Zacks, 2017). On the contrary, their dividends fluctuate and could be higher than the dividends received by preference shareholders. Having the right to vote is the other distinguishing aspect between preference and ordinary shares (Steptoe, 2009). Preference shareholders do not have any voting rights. Preference shares present a cumulative dividend feature that necessitates the payment of preference shareholders prior to making dividend payments to ordinary shareholders on the occurrence of non-payment of dividends. On the contrary, ordinary shares grant ordinary or common shareholders the right to vote in AGMs (Annual General Meetings). Moreover, holders of ordinary or common shares have the ability to elect a company’s board of directors. When the company files for bankruptcy protection, preference shares grant their shareholders entitlement to receipt of dividend payments before common shareholders (Zacks, 2017). Question 2 In general, the term risk refers to the probability or chance of a deviation from the expected outcome (Hansson, 2005). In finance, understanding the term risk necessitates an understanding of the nature of cash flows, accounting numbers, contingent exposures, and economic exposures. Under the nature of cash flows, it is evident that the timing of the cash flows and specific amounts involved constitute the risk aspect of cash flows. This also includes understanding the effect of the risk factors on the accounting numbers of the organisation since changes in the earnings reported by the organisation would be the indicators of the different outcomes of the organisation. It is also apparent that financial risks extend to contingent exposures that refers to the transactions that organisation expects in the future (Moles, 2013). Economic exposure also presents a general type of financial risk that emanates from the interaction between changing macroeconomic variables and the overall competitive position of the organisation. On the nature of cash flows, an analysis of the financial risk covers the interaction between the timing of cash flows and the amount of the cash flows. This results in the consideration of four types of cash flows. Type 1 cash flows involve cash flows that comprise of contracted payments that the organisation has to meet in the future such as principal and coupon payments. Type 2 cash flows comprise of contracted payments in which the organisation knows the specific amount of payment but is unaware of the expected time of payment such as customer payments when the seller offers trade credit. Type 3 cash flows comprise of contracted payments characterised by unknown amounts and fixed timings. Finally, Type 4 cash flows entail contracted payments characterised by uncertain timing and amount of future cash flows. On accounting definition, transaction exposure presents substantial financial risk to the organisation. A good example is foreign exchange rate risk. Contingent exposures are future costs or expenses that the organisation anticipates to happen in the future with a high probability even though they are not binding to the organisation currently. Finally, risks associated with competitive or economic exposure include changes in commodity prices, interest rates, and foreign exchange rates (Moles, 2013). Question 3 The goal of fund management and the approach used to manage the funds forms the basis of differentiating active from passive fund management. For instance, investment professionals oversea the management of funds in active management. This is not the case under passive management where investment professionals do not oversea the fund management process. In active fund management, investment professionals strive to exhibit performance that exceeds specific benchmarks (Kremnitzer, 2012). On the other hand, passive fund management focuses on replicating the results of a particular benchmark as opposed to exceeding the results, as it is the case under active fund management. The process of hiring professionals in active fund management focuses on identifying professionals that can add value to the specific benchmark under consideration. On the contrary, passive fund management focuses on the market efficiency concept, low costs, and tax efficiency (Baird, 2016). In general, the distinguishing factors between active and passive fund management include investment management fees, tax efficiency, potential for achieving above-market returns, potential for yielding below-market returns, potential for down-market protection, and the overall decision-making process. On the fund management fees, the fees in passive management are generally lower than the fees under active management. While passive fund management is generally tax efficient, the investment manager determines the tax efficiency under active management. Based on the objectives of the investment professionals in relation to the specific benchmarks, it is evident that active fund management guarantees potential returns that exceed the market performance while passive management does not guarantee such returns. Active management also exhibits potential for below-market returns while passive management guarantees the potential in the event of incorporation of fees. Active fund management also guarantees potential for down-market protection whereas passive fund management does not guarantee such potential (Baird, 2016). Finally, the decision-making process under active fund management leverages on the market conditions as opposed to the case under passive management where the process seeks to replicate the benchmark performance. Question 4 The main significance of the loan-to-value (LTV) ratio to the borrower is the fact that it enables the borrower to understand the loan repayment terms. In the event that the LTV is in excess of 80%, the borrower should regard the transaction as high-risk. The implication is that the borrower would end up paying more over the course of the mortgage. In essence, the ratio would be instrumental in enabling the borrower to make effective decisions in making new purchases or applying for a mortgage. Consequently, LTV ratios are instrumental in enabling the borrower to get lower rates for a mortgage. Borrowers that have low LTV ratios present a high likelihood of getting a low mortgage rate as compared to borrowers that have a high LTV ratio. For a conventional mortgage loan, a substantial percentage of lenders requires borrowers to deposit 20% of the total cost of the asset in form of down payment in the quest to avoid paying for private mortgage insurance (PMI). In most cases, lenders include PMI to the monthly mortgage payments in order to protect themselves in the event that the borrower is unable to pay all monthly mortgages. For a borrower, it would be proper to opt for mortgage plans with LTV ratios below 80%. Such plans are less risky to the lender and increase the likelihood of the borrower getting the asset as compared to mortgage plans where the LTV is more than the 80% threshold. In essence, lenders consider borrows with an LTV ratio of below 80% as less risky thereby making it feasible to grant lower mortgage rates. In conclusion, the significance of the LTV ratio to the borrower emanates from the fact that the ratio enables the borrower to make proper purchasing and refinancing decisions by enabling them to get low rates of interest. Question 5 a. The reason behind the introduction of the new Superannuation Guarantee in Australia was to meet the immediate need for increased self-provision for retirement income with the use of compulsory superannuation contributions. The other rationale for SG’s introduction was to strengthen the performance of the national saving scheme in Australia. In essence, the new scheme would guarantee greater domestic saving thereby relaxing the account constraint that had an adverse effect on the performance of the Australian economy. The implication was that Australia could record a faster rate of economic development without having to rely on foreign savings that resulted in an unsustainable foreign debt. To be precise, the objective of the SG was to attain an increase in national saving of seven-tenths of 1% of GDP by 2005 and a similar increase in national saving of 1.25% of GDP within a span of the following 40 years following its implementation (Drew & Stanford, 2003). b. I think that the SG has contributed immensely towards increasing national savings for retirees. However, I still think that the amount of savings is inadequate to deal with the financial needs of the continuously increasing number of Australian retirees. Consequently, it is proper to state that the SG scheme is still incapable of providing Australians with adequate funds that would enable them to retire comfortably. It is also evident that the problem is getting bigger and bigger on an annual basis because of the dramatic increase in the population of aged Australians that are in need of retirement funds. The fact that the system devolved substantive risks onto individuals presents the other challenge. Retiring members that have considerably small superannuation balances are susceptible to the effects of short-term downturns in investment markets. Therefore, I think the system has been unable to achieve its objectives. Question 6 The six positive characteristics associated with an investment in the property market are as follows: a. Immobile: It is evident that majority of property is immobile. The immobility of property has made it possible for lenders to offer mortgage terms that span over long periods without the fear that the borrower can run away with the property. b. Durable: Property investments such as land and buildings are indestructible in almost all the cases. Consequently, they continue to gain value over the period for as long as the investor would still want to keep the property. c. Investment and consumption good: Property investments is good for both investment and consumption. One can purchase property such as a house on a piece of land and use the house to cover his head. The individual could as well decide to sell the house at some point in the future at a higher price thereby having acquired the property as an investment. d. Heterogeneity: It is possible for an investor to leverage on the existing local knowledge about the property in the acquisition and management of a very profitable portfolio comprising of real estate investments. e. Illiquidity: Even though it is not easy to sell property without substantial loss of value, it is evident that the lack of liquidity is advantageous when investing in real estate since it makes the investment stable by acknowledging the value of the asset for long-term investors. f. Tangible: Apparently, all property investments are tangible. It is possible for an investor to visit a purchased piece of land or tenants on an already constructed apartment (Wargent, 2014). Question 7 The key benefits of investing in a property fund are as follows a. Broad diversification: The acquisition of a commercial property fund grants access to other significant assets such as industrial properties, offices, and shopping centres. This provides a guarantee of diversification and scale on the part of the investor. b. Delegation of property management: For an individual that invests in property fund, it is possible to delegate the management of property to a team of professionals in investment. c. Economies of scale: Investing in a large property fund guarantees economies of scale to the investor by implying greater cost efficiency. d. Improved liquidity: Property funds have exhibited improved liquidity in the recent years by allowing the selling and purchasing of single units rather than the entire property asset. This is a benefit to investors as either they can sell or purchase units based on their preference and available capital (Property EU, 2015). Question 8 The price-earnings ratio (P/E) provides a measure of the current share price of a company in relation to its earnings per share. In the question, the following details of the company are available: Operating profit before tax = $13.8 million Taxable income = $10 million Company tax rate = 30% Authorised share capital = $10 million Issued share capital = $7.5 million Current share price = $21.60 To compute P/E ratio, we apply the formula From the information available, the market value per share is $21.60. To determine earnings per share, we apply the formula Where  And  Using the values to compute Earnings Per Share, we find Using the formula for Price Earnings Ratio Comparing the P/E ratio with the industry average of 12 times, it is evident that the company’s P/E ratio is higher than the industry average. This implies that the earnings growth expected by the company and its investors in the future is higher than the average growth of earnings in the industry. Question 9 In determining the unit price of the balanced fund, we apply the formula Therefore, we need to compute the net asset value (NAV) of the fund. In determining the value, we compute the sum of all the assets in the portfolio less the liabilities and divide the difference by the total number of units in the fund. Applying the formula, the unit price of the balanced fund would be Type equation here. Since , we can state the formula for the unit price as  Therefore, the unit price of the balanced fund is $4.70. Question 10 a. The net tangible asset price per unit of the fund In calculating the net tangible asset price per unit of the fund, we apply the formula Applying the formula to the fund, the total assets of the fund is $80,000,000. The total liabilities are worth $50,000,000 with the number of units being 20,000,000. The case does not indicate the existence of intangible assets. Therefore, the net tangible asset price per unit of the fund will be Therefore, the net tangible asset price per unit of the fund is $1.5 b. Given that the market price of the fund is currently trading at a discount of 10% to the net tangible asset price per unit above, the value of the market price will be Therefore, the current market price of the fund is $1.35. A price different to the NTA may occur for an A-REIT since the NTA represents the book value in the company whereas the A-REIT denotes reasonable prices that a willing buyer could reasonably purchase the property from a seller. References Baird, R.W. (2016). Active vs. Passive Money Management. Baird’s Asset Manager Research. Advisor Perspectives. Drew, M. E., & Stanford, J. D. (2003). A review Of Australia's compulsory superannuation scheme after a decade (No. Discussion Paper No 322). Hansson, S. O. (2005). Seven myths of risk. Risk Management, 7(2), 7-17. Kremnitzer, K. (2012). Comparing active and passive fund management in emerging markets. University of California, Berkeley, Economics Department. Senior Honors Thesis. Moles, P. (2013). Financial risk management. Edinburgh Business School, Heriotwatt University, UK. Property EU. (2015). Why invest in property? Legal and General Investment Management. Steptoe. (2009). Preference Shares. Steptoe & Johnson LLP. Wargent, P. (2013). The Basic Characteristics of Property as an Investment. StreetNews. Retrieved from: http://www.streetnews.com.au/the-basic-characteristics-of-property-as-an-investment/ Zacks. (2017). Common vs. Preferred Shares. Finance. Retrieved from: http://finance.zacks.com/common-vs-preferred-shares-4388.html Read More