finance business.docx

finance business.docx

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financebusiness

Name:

StudentNo:

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WordCount:

2000words

TablesofContentPages

1.Overviewofreport3

2.Riskmeasurementofassetsandportfolios

2.1RiskMeasurementofassets3-4

2.2Riskmeasurementofportfolio4-5

3.CommonStockValuation

3.1Dividenddiscountmodel5-6

3.2Constantgrowthmodel6

3.3Price-to-earningsratio7

3.4Earningspershare7

4.Computationofcostofcapital

4.1Costofdebt7-8

4.2Requiredreturn9

4.3Weightedaveragecostofcapital9

4.4Earningyieldmethod10

5.Conclusion10

6.Bibliography11-12

1.Overviewofreport

Thisreportisdividedintothreeconsecutiveparts.Theyare:

1.Waysofmeasuringtheriskofsingleassetsandportfolios

2.Fourwaysofcommonstockvaluation

3.Fourwaysofcalculatingcostofcapitalinanorganization.

2.Riskmeasurementofassetsandportfolios

2.1RiskMeasurementofassets

Thefollowingaretwomethodswhicharecommonlyusedtomeasuretheriskoftheassets:

1.Probabilitydistribution

2.Sensitivityanalysis

2.1.1Probabilitydistribution

Probabilitydistributiondetermineswhichoutcomewillmostprobablyoccurredandwhichoutcomewillnotprobabletooccurred.Forexample,inthemainexamination,thelecturermighttakesintoaccountofthedifferentscenarios:

a.Thefirstprobabilityisthatallthestudentspasstheexamination

b.Thesecondprobabilityaportionofstudentpassandanotherportionofstudentfailtheexamination.

c.Thethirdprobabilityisthattheentirestudentsfailthemainexamination.

Theriskmeasurementbyusingprobabilitydistributioncanbedonewhentheexpectedreturnisobtained.Theexpectedreturncanbecalculatedbythefollowingformula:

Ri=Returnfortheithpossibleoutcome

Pi=Probabilityassociateswiththeitsreturn

N=Numberofoutcomesconsidered

（Sources:

Dr.AkinSeber,2011）

Forexample,CompanyXhadinvestedintrucksandtheprobabilityofearning10%fromtheinvestmentis0.50.Inaddition,thecompanyhadalsoinvestedinbuildingthatcarriedthe0.25probabilitychanceofearning15%fromthatparticularinvestment.Thus,theexpectedreturninthiscaseis:

Expectedreturn=（0.5x0.1）+（0.25x0.15）=8.75%

Theexpectedreturnforbothinvestmentswillbe8.75%.

2.1.2Sensitivityanalysis

Sensitivityanalysisisamethodthatwillconsidertheseveralprobableoutcomesoreventwhenassessingtheriskofthesingleassets.Theestimationoftheeventsoroutcomeswillthenclassifiedintoeitherworst（pessimistic）,expected（mostlikely）,orthebest（optimistic）inrelationtothesingleasset（HowardM.Adelman,RaphaelT.Haftka,1986）.

Thepurposeofapplyingsensitivityanalysisistodeterminingtherange.Rangecanbeobtainedbythecomparingtheoptimisticwithpessimisticoutcomes.Largerangeindicatesthatmoreriskwillbeexposed.Forexample,WesleyLimitedinvestedin$30,000ofmachineryAand$40,000ofmachineryB.Theannualreturnfortheinvestmentwasestimatedbelow:

Annualrateofreturn

MachineryA

MachineryB

Pessimistic

10%

15%

Mostlikely

20%

10%

Optimistic

30%

20%

TherangeforthemachineryAis10%whiletherangeofmachineryBis5%.Thus,machineryAismoreriskytoinvest.

2.2Riskmeasurementofportfolio

Theriskimposedtotheportfoliocanbemeasuredinaccordancewiththemethodsthataresimilarwiththesingleassets.Themaindifferencebetweentheriskmeasurementsoftheportfoliowiththesingleassetsisthattheportfolioismorefocusingonthebenefitsofinvestorwhilethesingleassetswillbemoreconcentrateonthebenefitofthecompany.Themethodthatisfrequentlyusedbythecompanytoassesstheriskoftheportfolioistwo-assetportfolio.Theriskwillbemeasuredintermofvarianceaswellasstandarddeviationunderthismeasurement.Theformulaoftwo-assetportfolioisshownbelow.

（Sources:

KhanandJain,2007）

Forexample,LompacProductdecidedtoinvestineitherstockAorstockB.Thefollowingtableshowsthedetailsoftheinvestmentforbothofthestocks.

StockA

StockB

Standarddeviation

10%

20%

Expectedreturn

5%

10%

Shareinportfolio

0.6

0.4

Thecoefficientofcorrelationfortheinvestmentsofbothstocksisassumedtobe0.361.

Thetwo-assetportfolioinsuchcaseis11.60%andcalculatedbelow:

=[（0.1x0.6）^2+（0.2x0.4）^2+2（0.6）（0.4）（0.361x0.1x0.2）]^（1/2）

=11.60%

3.CommonStockValuation

Therearefourmethodsthatcanbeusedforthepurposeofcommonstockvaluation.Theyare:

1.Dividenddiscountmodel

2.Growthrate

3.Price-to-earningsratio

4.Earningspershares

3.1Dividenddiscountmodel

Thedividenddiscountmodelisthemodelsinwhichthestockispricedatthefuturedividendreceivedafterdiscountingfortherequiredreturnanditisflexibleagainstthepotentialriskandthetimevalueofthemoney（JamesL.Farrell,Jr.,1985）.Themodelwillhelpacompanytodeterminethefactorssuchasincreaseininterestrateandinflationratewhichcausethechangesinthestockprice.

Zerogrowthratemodelsareoneoftheexamplesofthedividenddiscountmodel.Theannualdividendpaymentwillremainconstantunderthismodel.Thestockpricecanbeobtainedbydividingtheannualdividendwiththerequiredreturn.Forexample,acommonstockpaysadividendof$1.20perannumandtherequiredreturnforthestockis10%.Thusthestockpricewillbeequivalentto$1.20/10%whichisequalto$12.

3.2Constantgrowthratemodel

Anothermodelthatisusedincommonstockevaluationisgrowthratemodel.Underthismodel,thedividendspaymentwillgrowsteadilyannually.Thus,aformulahadbeenderivedfromthedefinitionofthemodelwhichcanbeshownbelow:

Stockprice=D/（k-g）

D=Dividendpaidnextyear

k=rateofcapital

g=Dividendgrowthrate

（Sources:

ThomasH.Payne,J.HowardFinch,1999）

Forexample,astockpays$2dividendperyearwiththeannualgrowthrateof2%.Therequiredreturnis10%.Thestockpriceforthenextyearwillbecalculatedasfollowed:

Stockpricefornextyear=$2x1.02/（10%-2%）=$25.50

Thestockpriceforthenextyearis$25.50.Inordertoobtainedthegrowthrate,thecurrentyearstockpriceneedtobedetermined.

Stockpriceforthecurrentyear=$2/0.02=$100

Thegrowthrateforstockpriceis$100-$25.50=$74.50

3.3Price-to-earningsratio

Price-to-earningsratioistheratiothattakesintoconsiderationoftheprice,earningsandalsoearningsgrowth.Thisratioiscalculatedtodeterminewhetherinvestorscangetbackthemoneyfromthepurchaseofthesharesandtoachieve“apples-to-apples”costcomparison（Leibowitz,M.L.andKogelman,S.,1994）.Itcanbeobtainedbyusingtheformulabelow:

Price-to-earningsratio=Marketvalueofshares/Earningspershare

（Sources:

Danielson,M.G.andDowdell,T.D.,2001）

Forexample,SpectraCompanycurrentlybuysa$50shareandtheearningobtainedfromshareoverayearis$2.Theprice-to-earningsratioinsuchcaseis$25（$50/$2）.

3.4Earningspershare

Earningspershareratioarecalculatedtodeterminethestrengthandthestabilityofthecompany.Higherratioindicatesthatmoremoneyisearnedfromtheshareinvestment.Theformulaofearningpershareisshownbelow:

Earningspershare=（Netincome–dividendofpreferredstock）

Numberofordinarysharesoutstanding

（Sources:

HaroldBierman,Jr.,JeromeEHass,2009）

Forinstance,theProphetCompanypaysdividendof$10in2009andthenetincomeof$100withandthe10outstandingshares.ViolinCompanyontheotherhandpaysdividendof$15andencompassesnetincomeof$90with15outstandingshares.TheearningspershareofProphetCompanyare$9（$90/10）whilefortheViolinCompanyis$5（$$75/15）.ThisimpliesthatProphetCompanyearnsmoremoneyascomparetoViolinCompany.

4.Computationofthecostofcapital

Fourwayscanbeappliedinthecomputationofthecostofcapital.Theyare:

1.Costofdebt

2.Requiredreturn

3.Weightedaveragecostofcapital

4.Earningyieldmethod

4.1Costofdebt

Costofdebtistherateinwhichthecompanypaysforthedebt.Itisusefulintheriskassessmentprocess.Highercostofdebtindicatesthatthecompanyismoreveryrisky.Theformulaofcostofdebtcanberesolvedintobeforetaxandaftertaxwhichareshownbelow:

Costofdebtbeforetax=（interest/principal）x100%

Costofdebtaftertax=[interestx（1-taxrate）]/netprincipalx100%

（Sources:

Mello,A.,andJ.Parsons,1992）

Forinstance,theCanCorporationborrowedanamountof$40,000loanwiththeinterestof5%.However,only$36,000ofloanhadbeenusedandthetaxrateis20%.Thus,the4.44%ofcostofdebtofthecompanyiscalculatedas:

（$40,000x5%）/$36,000x（1-0.2）=4.44%.

4.2Requiredreturn

Therequiredreturnisthereturnratethatisimposedforinvestor’sinvestmentinstockofthecompany.Therequiredreturnvarieswithdifferentcompanies.Higherrateofreturnreflectsthecompanyisstable.Therequiredreturniscalculatedbyusingthefollowingformula:

Requiredreturn,r=rf+B（rm–rf）

rf=riskfreeinterestrate

B=systematicrisk

rm=expectedrateofreturnonmarketportfolio

（Sources:

Easley,D.,S.Hvidkjaer,andM.O’Hara,2002）

Forexample,ParcelLimitedhasasystematicriskof1.2.Theriskfreeinterestrateis10%andtheexpectedreturnwillbe20%.Therequiredreturnis22%andiscalculatedasfollowed:

r=10%+1.2（20%-10%）=22%

4.3Weightedaveragecostofcapital

Weightedaveragecostofcapitalistheaverageofthesourcesoffinancinganditmeasurestheinterestpayablebycompanyforeachfinancingsources.Thiswillcomprisethecommonstock,