Financial Management - Assignment Example

Question 1: Bond Valuation i The fair price of Greenwich Research Plc bond is 887.70. The fair price of the bond is the present value of the bond. This is determined by discounting all the cash flows emanating from the bond issue using the yield to maturity as the appropriate discount rate. The cash receipts anticipated from the bond issue is the regular coupon payments plus the redemption value of the bond. ii Macaulay duration is 8.24 months whereas the Modified Duration is 8.03 months. Macaulay duration is the mean time to maturity of the cash flows emanating from a bond issue. This is determined by multiplying the present value in a given period by the number of period which are then summed up and then divided by the sum of present values. iii The table below shows the duration approximation for different YTM’s. Yield to Maturity (Annualized) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Duration Approximation 29.56% 22.17% 14.78% 7.39% 0.00% -7.39% -14.78% -22.17% -29.16% -36.95% iv Convexity = 76.93. Convexity measures the market risk that a bond portfolio is exposed to. A bond with a higher convexity shows that the bond price will always be higher than a bond with a lower convexity irrespective of the movement of interest rate. v The table below shows duration and convexity approximation for different yields to maturity. Yield to Maturity (Annualized) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Duration and Convexity Approx. 0.351 0.253 0.162 0.077 0.000 -0.070 -0.134 -0.222 -0.237 -0.284 vi The graph below is a plot for different yields to maturity against the Annual Percentage change in price, the Duration approximation and the Duration with convexity approximation. Question 2: Equity Valuation The companies chosen for equity valuation in this paper are Sigma-Aldrich Corp and WW Grainger Inc. Sigma-Aldrich Corp is in the materials sector and in chemicals industry whereas WW Grainger Inc. is in industrial sector. This paper has used the dividend discount model to determine the intrinsic value of the stocks of these companies. Intrinsic value is the real value of the security which is sometimes different from the market value of the security. The market value of a security is the price of the security as determined by the forces of demand and supply of the stock in the market. This may not be a reliable measure of the real value of a stock since market value is mostly influenced by the information about the company which is available in the public. However, not all information about the company is freely available to the general public hence the difference between the intrinsic value and the market value of a stock. Therefore, this paper will rely on dividends to compute the intrinsic value of the selected stocks. Dividend is the share of profit that is distributed to the shareholders of the company. These dividends are declared to be paid by the board of directors of the company whenever the company has made profit during the year. An investor will invest in the company in anticipation of regular payment of dividends. The assumption made in this case is the company will be profitable and its board of directors will always declare dividends at the end of the financial year of the company. It is also assumed that the dividend declared next year will be as estimated and that the growth rate of dividend is constant. Another assumption is that the companies are going concern hence they are not expected to close any time soon which makes the dividend payment to perpetuity. The dividends are usually paid yearly which coincides with the fiscal year of the company. Therefore, the dividends form a stream of cash flows to the shareholder. This means that the dividends occur periodically but at different years during the life of the company. Due to time value of money these dividends can only be compared through discounting the streams of cash flows to their present value. Based on the intrinsic value of stocks, the stock is considered undervalued if its intrinsic value is higher than its market value. Such a stock should be bought since it is good for investment. On the other hand, the stock is considered overvalued if its intrinsic value is lower than its market value. Such a stock should be sold since it is not good for investment and the investor will make good return by selling it. Therefore, it is advisable for investors to sell stocks of Sigma-Aldrich Corp. This is because the intrinsic value of Sigma-Aldrich Corp stock is lower than its market value which shows that this stock is overvalued. The intrinsic value is $96.98 which is lower than the market value of $135.92 as at 3rd December 2014. This means that if an investor sells this stock on 3rd December 2014 he stands to gain since the real value of the stock is lower than the market price. However, it is advisable for investors to buy stocks of WW Grainger Inc. This is because the intrinsic value of WW Grainger Inc. stock is higher than its market value which shows that this stock is undervalued. The intrinsic value is $449.11 which is higher than the market value of $250.57 as at 3rd December 2014. This means that if an investor buys this stock on 3rd December 2014 he stands to gain since the real value of the stock is higher than the market price. Question 3: Efficient Frontiers The table below shows the 20 stocks selected for investment in a portfolio which will be efficient and produce minimum variance. No. CO. NAME CODE 1 GENERAL ELECTRIC U:GE(P) 2 BOEING U:BA(P) 3 UNITED TECHNOLOGIES U:UTX(P) 4 3M U:MMM(P) 5 UNION PACIFIC U:UNP(P) 6 CATERPILLAR U:CAT(P) 7 DANAHER U:DHR(P) 8 EMERSON ELECTRIC U:EMR(P) 9 PREC.CASTPARTS U:PCP(P) 10 EATON U:ETN(P) 11 ILLINOIS TOOL WORKS U:ITW(P) 12 WELLS FARGO & CO U:WFC(P) 13 PNC FINL.SVS.GP. U:PNC(P) 14 BB&T U:BBT(P) 15 M&T BANK U:MTB(P) 16 REGIONS FINL.NEW U:RF(P) 17 KEYCORP U:KEY(P) 18 COMERICA U:CMA(P) 19 E I DU PONT DE NEMOURS U:DD(P) 20 DOW CHEMICAL U:DOW(P) The historical stock price data has been collected for 61 months starting from 1st August 2008 to 1st August 2013 which is equivalent to 5 years. The historical price obtained is monthly stock price which is adjusted for dividends and split. This section describes the method used to obtain the data which was used to carry out the task. It also explains the computations that were done to put the data into useable form to address the issues of interest in this report. The report is interested in getting the price data for the 20 stocks selected for the period between 1st August, 2008 and 1st August 2013. Since there are enough years use the monthly stock price data which is selected by clicking on the monthly option. It is crucial to change this into monthly since the default data is daily prices. In addition, the dates have to be changed to the specific time series in this paper. On the start date insert 1st August, 2009 and on the end date section insert 1st August 2013. Click on the get prices button in order to populate the historical monthly prices for the respective stock for the period identified in the paper. This data is downloaded since it is required for further analysis using the excel program. The data price used in this paper is the adjusted closing price since it is already adjusted for dividends and stock splits. This data is sort according to date from newest date to old dates, that is at the top there will be price data for August 2013 and at the bottom it will be the price data for the month of August year 2009. When the data is organized in this manner it will be easier to calculate returns by using the excel spreadsheet. The return for the stock is arrived at by subtracting the earlier monthly data price from the current monthly price and then dividing by the previous monthly price. The graph below shows a plot of annualized average return against the standard deviation when short sales are allowed and when short selling is not allowed. It can be seen from the graph above that the best approach is to disallow short selling. This is because the option has only positive returns as opposed to allowing short selling whereby there are chances of getting negative returns. When short selling is allowed the return is high; however, the associated risk as measured by the annualized standard deviation is correspondingly high which negates the higher return obtained. This is a major problem to short selling since the stocks which are considered to have higher returns are bought whereas the stocks with lower returns are disposed of. The problem is that the investor will be exchanging low risk stocks with higher risk stocks thus exposing the portfolio to unnecessary risk. Nevertheless, short selling is attractive to risk taker investor in anticipation of higher returns. However, for a risk averse investor they should disallow short selling in exchange for a low return whose probability of receipt are higher due to lower risk of investment. Moreover, there is transaction costs associated with short selling which reduces the target profit from the sale of the stock. Short selling does not give time for the stock to realize its full potential and start earning good return. Most companies take time to put structures in place and improve its profitability. Therefore, a newly bought stock should be allowed to grow and only sell it when its price has risen significantly. Furthermore, short selling ignores the cash flows arising from dividend payment since the stock can be disposed of before dividends are declared.. an investor can maximize his wealth by buying a stock at a low price and then selling it at a later date when its price is high which is basically speculative business. the investor can also leave his stocks in the company and only wait to be rewarded with dividends when the company distributes the profit gained to its shareholders. Either of these ways the investor stands to gain from his investment. Therefore, before short selling a stock the investor should also consider the expected dividend receipt from his investment in the stocks of the company. The dividend receipt may in fact be higher than the net receipt from the sale of the shares. Another problem may arise whereby the investor disposes of a stock for a low price compared to the stock he purchases from the stock market. Therefore, in order to maintain the same number of stocks he will be required to add more funds from other sources. Therefore, this report concludes that short selling of stocks is not a good investment strategy. Question 4: Essay An exchange traded fund is a security which tracks a stock index but trades like the real stock on a stock exchange market. Therefore, an ETF is not a company’s stock but rather replicates the performance of the underlying stock. This means that ETFs too experience changes in price throughout the day as they are sold and bought. Trading in ETFs helps an investor to invest in a variety of stocks which would otherwise be impossible to invest in. ETF will help an investor to diversify the index fund and allow short selling, buying on margin and purchasing very few shares as little as a single share. Therefore, an investor can use ETFs to overcome the limitation of short selling the underlying index which requires that shares can only be short sold in round lots of shares (100 shares and its multiples). This form of trading definitely helps an investor to structure his investment portfolio in various dimension since he does not experience constraints with regard to the number of shares of a particular company to add in his portfolio. According to Brigham and Herhardt (2009) a portfolio means a collection of stocks as a single investment. A well constructed investment in exchange traded funds will ensure a high return from the investment. The exchange traded fund is used to grow the share price of the underlying stock for a long term investor. This is not used in daily trading purposes. This should be shares that do not pay dividends regularly but retains the earnings in the company for investment. The cash flow in an exchange traded fund as explained in Needles, Powers and Crosson, S.V., (2010) occurs when the investment is made. Thereafter, cash flows arise continuously depending on the activity level of the investor. An investor may leave his portfolio to grow and only accrue dividends when the underlying index has dividend payment to the holders as declared by their board of directors. A cash flow can also occur in between if a speculating investor sells shares of a security with falling price or buys more of a security that is anticipated to have an increase in price. The investor in exchange traded funds benefits from risk reduction. The investment in Exchange Traded Fund entails investment in a collection of assets. This brings about diversification which significantly reduces returns variation without necessarily causing a corresponding reduction in expected returns. Risk reduction is experienced since better than anticipated returns from one asset in exchange traded fund offsets worse than anticipated returns from another asset in the portfolio. Exchange traded fund are traded continuously. This increases the flexibility of ETFs since the investor can take advantage of share price fluctuations. They can sell the shares in the underlying stock when they expect a decline in the stock price. Likewise, the investor will buy the underlying index when they expect an increase in the price of the stock. This form of trading enables an investor to minimize the risk and expense when getting into and out of investment positions. However, there are costs associated with this trade which increases the expenses of the fund which are actually charged to the investor. Exchange Traded Funds (ETFs) are transacted in high volumes than the individual underlying index thus higher liquidity. Block and Hirt (2008) observe that an investor can take advantage of a slight increase in security price of the underlying security to sell large volumes of the security and invest in a low priced stock. As much as this is true it is possible that the stock which is being bought is selling higher than the disposed stock which means that in average the investor will be left worse off since he will have fewer number of stocks in his portfolio. Therefore, his liquidity does not improve. However, increase of different stocks in a portfolio investment has the limit to which risk can be lowered. Therefore, the risk of investment in Exchange Traded Fund can only be lowered upto the level of risk in the underlying index. On the other hand, if the fund manager invested wisely and in many different stocks, the risk of the fund will be similar to market risk hence the investor is not exposed. Therefore, the risk of an ETF can only be measured in terms of all the stock invested by the fund. In this case, some of the stocks will be more risky than the underlying stock while others will be less risky than the base index because of the principle of diversification. In addition, investor in Exchange Traded Funds cannot get a return that is higher than the underlying index because exchange traded fund does not work to outdo their corresponding assets in the portfolio. This shows that they are not a complete replicate of the primary index. Moreover, the fund manager is paid by the investors in the fund. These expenses works to reduce the return obtained from investing in the fund. Therefore, the return from an ETF will always be less than the return from the respective underlying stock. Nevertheless, if the fund manager invests prudently, the members are likely to get profit which distributed among the members which when added to the stock return may be higher than the return from the base index. References Brigham, E. and Herhardt, M. 2009. Financial Management: Theory and Practice, 13th Edition. Ohio: Thompson South-Western. Needles, B.E., Powers, M. and Crosson, S.V., 2010. Financial and Managerial Accounting. New York: Cengage Learning. Block, S. B., and Hirt, G. A. 2008. Foundations of financial management (12th ed.). Boston, MA: McGraw-Hill/Irwin. Read More