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List the methods that a firm can use to evaluate a potential investment.
The methods used to evaluate a potential investment of the firm are as follows
- Net present value(NPV)
- Internal rate of return(IRR)
- Profitability index(PI)
- Cash discounted flow
- Pay back period
- Accounting rate of return(ARR)
Why is the NPV a preferred method when evaluating a potential investment opportunity?
Npv can be explained as the difference between the initial cost outlay and the present value of the future cash flows. The total present value of the yearly net cash flow is the Net present value.
Net present value may be used to find the value or reliability of any investment and also to decide if it is far better than the other investments in the market. It is considered to be a potential investment if the NPV is positive & a bad investment decision if the NPV turns out to be negative. Whereas, if the NPV is equal to “0” the decision is indifferent, it can be either accepted or rejected based on other alternates/factors.
What is the IRR? How is it related to the NPV? Is the IRR always an effective method when evaluating a potential investment opportunity, and why?
IRR is the internal rate of return. It is very closely related to NPV, except for a fact that IRR uses only single discount rate, which serves as an advantage & also a major limitation. It equally proportionates the discount rate of the present value of the future cash flows with the initial investment. However, IRR is not very effective when it comes to multiple cash flows (particularly with both positives & negatives)
IRR equates in between initial investment and the present value of future cash flows whereas NPV gives the difference between the initial cost outlay and the present value of the future cash flows. IRR illustrates the advantages of the project, and NPV decides the best investment opportunity than the other investments.
Despite all cons, IRR is still a very popular approach to investment decision amongst managers for its simplicity & also the fund managers prefer to see a percentage rather than a dollar value.
Using the article from the Sydney Morning Herald, discuss why John Whiteman, the senior portfolio manager at AMP Henderson, can be considered ‘skilled’ in respect of his stock pickings. Why would it benefit fund managers to use discounted cash flows when picking stocks?
As per the article on Sydney Morning Herald, John Whiteman & his team were considered to be “skilled” for the following reasons-
The DCF approach to picking stocks has always proved to be a successful option to John Whiteman. He claims that the DCF approach to working out today’s share price, given the future cash flows of the business is the most efficient & effective way to estimate the time value of money. Since the discount rate addresses the two main criteria involved in any investment (time value of money & risk), the fund managers consider it to be very useful & effective, despite all its complexities. Also the long term forecast(10 yrs ahead) coupled with the DCF approach has enabled the AMP Henderson team to make wise investment decision over the last few years.
Discounting the future cash flows to today’s dollar helps in knowing the stock worth/business value of the firm as on date. As we all know, a dollar today is worth more than a dollar tomorrow. The DCF approach once again proves the current value of the business is the most important aspect when it comes to investment decisions.
A firm that pays out 65% of its earnings as dividends has an accounting rate of return of 20%. Its P/E ratio is 10 and its earnings per share is 108 cents.
- What is the price per share?
- What is the dividend yield?
- If shares were bought, what would be the payback period? Assume the only return is the dividend.
- What is the net book value per share of the asset investment of the company?
- If the risk-adjusted required rate of return is 6%, what would be the NPV per share for buying shares?
- Would you buy shares using AROR or NPV?
Chapter 11-Return, Risk and the Security Market Line
Discuss how risk is associated with the variances on an asset’s expected return. What are some of the factors that come into play with respect to changes in the price of a particular security in the market?
Investment, risk & return are closely related to each other. The higher the investment & the risk the greater will be the return. All investment decision involves risk. The deviation is the difference between the actual & the expected return and is directly proportional to the risk taken. Variance is the average squared deviation between the actual return and the average return In short; standard deviation is the square root of the variance.
What is risk with respect to investment? Identify the two types of risk and discuss each one. Which is the most important type of risk? Why can only one type of risk be mitigated or eliminated?
Risk and investments are proportional, that it depends on the market strategic values, like the high risk you take the high returns you expect.
Risks associated with individual assets, are of two types:
- Systematic risks
- Non-systematic risks
Systematic risks are the risks which influence large number of assets may be to a greater or smaller extent. These risks influence market wide effects, so these are called market risks.
Non-systematic risks are that affects a single asset or a small group of assets, as these risks are unique to individual companies or assets these are called as unique or asset-specific risks.
Only one type of risk can be mitigated or eliminated, which is non-systematic risk, because these type of risks can be reduced or primarily avoided as it causes to a single asset or small group of them, but when you consider with systematic risk, it causes affect to the wide-range of assets or to an larger extent which couldn’t be reduced or completely avoided.
What is beta? How does beta relate to systematic risk?
Beta is a key component for the capital asset pricing model and is used to calculate the cost of equity or the risk involved. It is the covariance of the return of an individual stock with the market proxy portfolio return divided by the variance of the markets proxy return. A beta of 1 implies the asset has the same systematic risk as the overall market & less/more than1 implies lesser/greater risk respectively.
What is the SML? What is the CAPM, and how does the SML relate to the beta coefficient?
SML(Security Market Line) is the pictorial representation of the market equilibrium. The slope of the SML is based on the reward to risk ratio & at SML the beta is always considered to be 1. A more risky stock will have a higher beta and will be discounted at a higher rate as opposed to the less sensitive stocks which will have lower betas and be discounted at a lower rate.
CAPM is “Capital aaset pricing model” which is an equilibrium model of relationship between risk and return, the equation of the SML showing the relationship between the expected return and beta.
Beta coefficient is the amount of systematic risk present in a particular risky asset relative to an average risky asset.we need the measuring level of systematic risk for different investments.The specific measurements that we use is called bets coefficient.
Given below is the graphical representation of how SML relates to the beta coefficient.
Using the article from The Sydney Morning Herald, discuss how diversification is used to bring about a positive outcome for retail investors. Why do investment portfolios with different asset classes need to be continually monitored? What are some alternative asset classes that investors can diversify into?
Diversification is that which reduces the risk,when into investing some assets will do very well,some will do very badly and most will perform upto expectations.Those which do very well will equivalate the very bad done assests minimising the risk with little variation to get the positive outcomes.
Diversification reduces unsystematic risk,according to the Sydney Morning Herald diversification gives mostly with possible positive outcomes for the investment made which enhances the minimisal of the risks taken by the retail investors.However ,the risk of holding common stock cannot be completely eliminated by diversification.
Asset classes is a group of investments that display similar characteristics viz., shares, bonds, property or cash rather than the same basket,which mitigates the risk involved in the investments.
Assume that you have the betas of all the companies listed on the ASX. Now you select 20 shares based on their betas and, by investing an equal amount in each share, you create a portfolio with a beta of 1.1. You make sure you select shares with betas ranging in value from 0.4 to 2.4.
- Is this likely to be an efficient portfolio?
- Is the portfolio likely to be well diversified?
- Is the portfolio likely to have much non-systematic risk?
Now your selection is based upon putting the company names into a hat and withdrawing 20. Revisit Question 6 with relation to this portfolio.
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