Financial Management Cases Analysis - Essay Example

Financial Management - Part B XXX - in the Organization - of Organization XXX (Manager's - in the Organization - Name of Organization Subject: Report defining Diversification, Literature Review and Recommendations to Client on how diversification can help decrease risk to his current portfolio. Table of Contents Table of Contents 3 Diversification 4 Literature Review 6 The Problem 6 Proposed Solution 6 Asset Classes 7 Geographic Diversification 8 Sector Diversification 9 Summary 10 Addendum 12 Addendum - 1 - Conservative Portfolio 12 Addendum 2 - Moderately Conservative Portfolio 13 Addendum 3 - Moderately Aggressive Portfolio 14 Addendum 4 - Aggressive Portfolio 15 Addendum 5 - Very Aggressive Portfolio 16 Addendum - 6 - Leverage under Modigliani and Miller's Theorem using it for purchase of property 17 References 20 Diversification Markowitz the father of diversification introduced a model known as the Modern Portfolio Theory, which indicates the relationship between how rational investors will use diversification to optimize their portfolios for reward and decrease risk (Markowitz, 1952). By combining a variety of investments options such as stocks, bonds and real estate assets an investor can achieve diversification and thus avoid "putting all his eggs in one basket". However, it should be remembered that it is not possible to have zero risk and 100% rewards, yet with the correct combinations of diversification it is possible to achieve an optimal balance or risk and reward depending on the investment goals, growth strategies and available time horizons (Witt and Dobbins 1979). The aim of diversification is to reduce the extreme ups and downs in returns and rather to create a consistent return under different economic and market conditions (McGowan, Collier and Young 1992). There are many different asset classes that are available to an investor when making an investment decision. Depending on the return the investor is looking at, the time horizons that the investor is expecting to reap the benefits in and also the level of risk the investor is willing to accept, he or she can invest in a varying combinations and thus achieve diversification of his or her portfolio. Some of the asset classes that are available to us today are money market funds, bonds funds and equity funds. Money market funds are short-term debt instruments that are very liquid and can be converted to cash easily. Treasury bills and commercial paper fall into this category. The risk of loss is lower and pay higher yields than deposit accounts. Bond funds on the other hand pay a regular income, have a longer maturity period and the actual income can fluctuate during economic upturns and downturns since it is for a longer period of time than the money market funds, however they are relatively safer than equity funds. Equity funds yield much higher returns than both money market and bonds funds however they can be very volatile in the short term and cause havoc in a portfolio. Therefore it is advisable to invest in them for long-term gain rather than short term gain. Diversification can be further classified into geographic, industry and style diversification as well. By this it is meant that we can diversify our portfolios by equity, bonds and money market funds from different regions and countries - which is known as geographic diversification. Sector or industry diversification is investing in equity and bonds from different industries instead of sticking to one particular industry. Style diversification is investing in a portfolio that has instruments that have short term and long term yields or under valued and over valued stocks or all (Adair, Berry and McGreal 1994). The Addendum gives a detailed description of the different diversification strategies that can be used by an individual when combining two classes of assets and gives an indicative calculation of how risk and rewards are leveraged under each strategy by just changing the weight given to the different classes under different strategies (Dye and Groth 2000). The assumptions made there are that bonds and money market investments yield goes up when equity yields go down and vice versa. And also that, return from fixed income (bond funds) are 35% and equity is 50%. Further money for investing in bond funds has been borrowed at 10%. Literature Review The Problem It is my that the current portfolio that is under review which is 100% vested in stocks of different shopping malls in Sydney, Australia while at the moment is reaping a good yield will not remain so - especially taking into account the looming credit crisis that the United States is currently faced with and the cascading effects of recessionary forces that are expected to flow to the economies of the other first world countries. Therefore it is my recommendation that the portfolio under review should be diversified to bring in moderate to high yields if possible under these trying circumstances and at the same time to minimize or reduce the risk that will inevitably be faced if there is no diversification of the current portfolio. Proposed Solution Diversifying a portfolio can be done in many different ways; it is my recommendation that the investor should look at many different modes of diversification such as asset diversification, geographic diversification, sector diversification and even style diversification. Further the appendix will also look at a theorem put forward by Modigliani and Miller, where it is stated that in the absence of taxes the value of a firm is unaffected by how that firm is financed (Modigliani and Miller, 1963). In this literature review I will be taking into account the different forms of investments that are available and what would work best for the investor under the present circumstances. The asset classes that I will be looking at here will be namely bonds, money market and equity funds. In terms of geographic diversification we will be looking at regional, national and international diversification options and last but not least I will also look at how sector diversification can help leverage and minimize risk while increasing the yield and giving stability to existing portfolio. To this effect the report will be taking a close look at the real estate markets and investment opportunities in Sydney, Australia, throughout Australia and outside such as the United Kingdom and other locations. Asset Classes When looking at diversifying a portfolio the most common asset classes that are available to an individual are money market funds, bond funds and equity stocks. Since the investor is fully invested in equity funds we will look at this area and see what can be done to increase diversification and minimize any risk if possible while at the same time attempting to retain the long term return at a consistent level with what it is under the present circumstances. Under the present circumstances the investor is fully invested in shopping mall stocks. These shopping malls are located in the Greater Sydney area and the investor is a major stockholder in these shopping malls. Owing to Australia's robust economy and currently strong dollar and also good economic times the investor has not suffered any losses nor is likely to suffer any in the short term. However having such an undiversified stock holding alone is cause for concern along with the looming fears of recession in the United States that can have cascading effects on the rest of developed world as well. Therefore it is advisable that the investor liquidates some of his stock and invests those funds in a variety of bond funds and money market funds. Bonds are stable and in times of economic downturn when equity funds take a hit the bond market goes up and with the correct balance, which can help offset some of the adverse effects that will be faced by the investor. Further bonds are safe and will be an excellent investment vehicle to ensure some fixed stable income for the investor in these uncertain times. Money market funds have a high level of liquidity and very short maturity periods and can be used to further reduce the risk of being 100% vested in equity funds alone. However money market fund returns are much lower than bond funds too and the biggest benefit that can be expected from it - is that the money market funds consist of such instruments like treasury bills and commercial paper that have little or no risk at all as they are generally government paper and the government of Australia has not been known to default ever. Further though there is a lower yield, it does have as short as a 90 day maturity periods that enables quick returns even though they are low and again can help bring in a secure and guaranteed income to the investor in the event there is an economic downturn. Geographic Diversification Geographic diversification can be diversifying the stocks that the investor is currently invested in to other regions of Australia like Melbourne, Perth, Brisbane or Canberra, further it can also mean that the investor should be open to looking at diversifying his stock in asset classes that are outside of Australia (Witt 1978). He can look at New Zealand the Asia Pacific region, the South East Asian region; China, India, the European Union and North America have some very lucrative investment opportunities for the eager and ambitious investor (Atherton and Yap 1979). The investor is currently invested solely in one sector with, one asset class in one very specific geographic location and that is shopping mall stocks in shopping malls located in Sydney Australia. Therefore there are many different options opened to the investor currently to diversify regionally, nationally and internationally not only in equity funds but also money market funds and bond funds (Siegel, Omer, Rigsby and Theerathom 1995). For starters the investor can diversify his stockholding by investing in equity in shopping malls that are outside of Sydney Australia if he feels that that is a wise choice. However the report does not recommend that but rather would recommend the investor to look at the most lucrative and safe options regionally, nationally and internationally and invest in those instruments and locations as a means of diversifying his holding and creating a safety net for himself for the impending recession that most developed countries are gearing for at present. To this effect it would be a good idea to invest in bonds sold by the United States government that can bring in a stable income in times of economic downturn. Further treasure bills that are issued not only by the Australian government but other developed nations would be a wise form of investment as well (Black, Buckland and Fraser 2002). As stated earlier commercial paper too will be a low risk investment if the investor is afraid of the volatility of international markets and fluctuating exchange rates. Sector Diversification Similar to the current investment portfolio not having any diversity in terms of asset classes or geography, similarly the entire portfolio has been vested in one sector and that is shopping malls located in Sydney, Australia. As stated earlier this is not a very wise choice and can open up the investor to much hardship and loss of income in the event there is a downturn in the economy. Being invested in one sector alone is similar to "putting all your eggs in one basket", which is an absolute no-no when it comes to investment. Therefore as much as the investor should look at diversifying his portfolio in terms of asset classes and geographically too, he should immediately look at diversifying sector as well. While there is a looming credit crisis in the United States and a real fear of the housing boom that has been experienced in the past few years coming to an end and the "bottom falling out of the market". This would be a very good time to look at the real estate market both in Australia and outside (McAllister 2000). Investments as we know can be for short term and long term earnings potential and if the real estate market is going down - stocks and investment costs in this sector is currently on the decline, which means it is a good time to analyze the market and buy into the market with the objective of making long term gains. Further though the housing market is on the decline in the United States and feared to have the same trends in other developed economies as well it can be said that commercial real estate market is not experiencing the same decline and can still be depended upon to bring in a good yield in the coming years (Newell and Wen Peng 2007). Summary In summary it can be said that there are many different forms of diversification that the investor can look at to reduce his level of risk in the event of an economic downturn. Since he is currently heavily vested in equity funds, the investor for starters can diversify some of his holdings and invest in bond and money market funds that usually work in the opposite direction as equity funds and will help bring in a stable income even in times of economic downturn. Next the investor can diversify his portfolio geographically to further reduce the risk and increase the chances of receiving a stable income. Last but not least sector diversification and investing in real estate driven stocks and bonds can bring in immense yields in the long term (Domian, Louton and Racine 2003). Addendum Addendum - 1 - Conservative Portfolio Here the individual is invested in very low yield but safe investments for a majority of his portfolio and only one tenth of his portfolio yields a high return and can be considered risky. But yet when the borrowing cost for the fixed income is taken into account he risks 1% even with a good market for Fixed Income and 14% when the bonds market is down. Investment % Yield per 1% Equity Upturn Moderate Economy Equity Downturn Fixed Income Securities 90% 10 585 900 1,035 Equities 10% 30 450 300 150 Total 100% 40 1,035 1,200 1,185 Profit/Loss from Moderate year -14% -1% Addendum 2 - Moderately Conservative Portfolio Here a fourth of the investment is vested in high risk options however still three fourth of the investment is in low risk options and will open the investor to much risk if the equity market is doing badly. But will give him an 8% return if the equity market does well. Investment % Yield per 1% Equity Upturn Moderate Economy Equity Downturn Fixed Income Securities 75% 10 488 750 863 Equities 25% 30 1,125 750 375 Total 100% 40 1,613 1,500 1,238 Profit/Loss from Moderate year 8% -18% Addendum 3 - Moderately Aggressive Portfolio Here over half the investment in secure or low risk options and a significant amount in high-risk areas that will still reap high benefits. Therefore in times of equity upturn there will be at least three fourths of the income earned. While in times of equity downturn there will be a 28% decrease in income too. Investment % Yield per 1% Equity Upturn Moderate Economy Equity Downturn Fixed Income Securities 60% 10 390 600 690 Equities 40% 30 1,800 1,200 600 Total 100% 40 2,190 1,800 1,290 Profit/Loss from Moderate year 22% -28% Addendum 4 - Aggressive Portfolio Here the majority of the investment is in equities, while the rest of the investment is vested in fixed income securities. There is some instability in such an investment portfolio. But for investors who are risk averse for various reasons this would be an ideal situation. Investment % Yield per 1% Equity Upturn Moderate Economy Equity Downturn Fixed Income Securities 30% 10 195 300 345 Equities 70% 30 3,150 2,100 1,050 Total 100% 40 3,345 2,400 1,395 Profit/Loss from Moderate year 39% -42% Addendum 5 - Very Aggressive Portfolio This is the current investment strategy that is being undertaken. A 100% of the investment is in shopping mall stocks or rather invested in equities and the risk is high, due to the fact that with an economic downturn you can suffer considerable losses that can be even more far reaching than that indicated by the calculations given below. This is because there is no fixed income or cash and equivalent funds but only equity in shopping mall equity, which in effect is "putting all your eggs in one basket". Investment % Yield per 1% Equity Upturn Moderate Economy Equity Downturn Equities 100% 30 4,500 3,000 1,500 Total 100% 30 4,500 3,000 1,500 Profit/Loss from Moderate year 50% -50% Addendum - 6 - Leverage under Modigliani and Miller's Theorem using it for purchase of property Here we look at what would happen if the client had hundred thousand pounds and used an entire part of it to purchase equity and a remaining part as down payment to purchase a rental property for another hundred thousand pounds. The rental property would bring in an income of 10% on the whole value and the client would have to pay 5% mortgage interest on the borrowed funds. And these revenues and interest rates will remain stable in the long term during an equity upturn or downturn. It is also assumed for the following example that the client has no additional maintenance or administrative costs for the rental property. In the table below it is clear that with 75% of the funds vested in equities and the rest in real estate the client would receive a 39% return on his investment. Investment Value Yield per 100 Equity Upturn Moderate Economy Equity Downturn Property 25,000 10 6,250 6,250 6,250 Equities 75,000 30 33,750 22,500 11,250 Total 100,000 40 40,000 28,750 17,500 Profit/Loss from Moderate year 39% -39% Borrowing 75,000 5 Here with only 50% vested in equity he will make only a 33% return when there is equity up turn. Investment Value Yield per 100 Equity Upturn Moderate Economy Equity Downturn Property 50,000 10 7,500 7,500 7,500 Equities 50,000 30 22,500 15,000 7,500 Total 100,000 40 30,000 22,500 15,000 Profit/Loss from Moderate year 33% -33% Borrowing 50,000 5 With only 25% vested in equities he will make a 23% return on his income as shown below. Investment Value Yield per 100 Equity Upturn Moderate Economy Equity Downturn Property 75,000 10 8,750 8,750 8,750 Equities 25,000 30 11,250 7,500 3,750 Total 100,000 40 20,000 16,250 12,500 Profit/Loss from Moderate year 23% -23% Borrowing 25,000 5 Looking at the above scenarios the client will no doubt think it best to be vested in equity as much as possible. However a couple of things should be kept in mind. Real Estate markets do very well in the long term and while the return on income may not be great he's leveraging quite a bit by borrowing funds and earning a return on the borrowed funds as fell as the invested funds. Further if he pays down the mortgage he will have equity in the property, for the amount paid down as well as the increase in property value over the years. This increase in value stands true in the long term even if the client financed the mortgage as an interest only mortgage and nothing more - and decides to sell the property after a few years at an increased value and cash in on the equity accumulated. References Adair, A. S, Berry, J. N and McGreal, W. S (1994), "Investment Decision Making: A Behavioural Perspective", Journal of Property Finance, 5:4, 32 Atherton, J and Yap, D. C. L (1979) "Risk Reduction by International Diversification", Managerial Finance, 5:1, 18-28 Black, A, Buckland, R and Fraser, P (2002) "Changing UK stock market sector and sub-sector volatilities, 1968-2000", Managerial Finance, 28:8, 26-43 Domian, D. L, Louton, D. A and Racine, M. D (2003) "Portfolio Diversification for Long Holding Periods: How many stocks to investors need" Studies in Economics and Finance, 21:2, 40-64 Dye, R. T and Groth, J. C (2000) "Value weighting and simple optimization of portfolios: an empirical examination", Managerial Finance, 26:6, 23-35 Markowitz, H. (1952) "Portfolio Selection", Journal of Finance, 7: 1, 77-91 McAllister, P (2000) "Is direct investment in international property markets justifiable" Property Management, 18:1, 25-33 McGowan, C. B, Collier, H. W and Young, C. M (1992) "Optimal Portfolio Selection: A Pedagogical Note", Managerial Finance, 18:2, 49-62 MacGregor, B. D (1990) "Risk and Return: Constructing a property portfolio", Journal of Property Valuation and Investment, 8:3, 233- 242 Miller, M. and Modigliani, F., (1963), "Corporate income taxes and the cost of capital: a correction." American Economic Review, 53:3, pp. 433-443. Newell, G and Wen Peng, H (2007), "The significance and performance of retail property in Australia", Journal of Property Investment & Finance, 25:2, 147-165 Siegel, P. H, Omer, K, Rigsby, J. T and Theerathom, P (1995) "International Diversification: A Review and Analysis of the Evidence", Managerial Finance, 21:9, 50-77 Witt, S. F (1978) "International Portfolio Diversification", Managerial Finance, 4:2, 198-203 Witt, S and Dobbins, R (1979) "The Markowitz Contribution to Portfolio Theory", Managerial Finance, 5:1, 3-17 Read More