International Business Finance - Case Study Example

International Business Finance Integrative Term Project Author Name Name of Affiliation Table of Contents Introduction 3 Investment in stocks 3 Correcting for inflation and taxes 4 Stock Investors demographics 4 Investment in bonds 5 Investment in current economic situations 5 Conclusion 9 References 10 Introduction In the current investing climate, risk and rate of return are positively correlated. In that regard you would expect that the rate of return for investing in the stock market has to be higher than in bonds because there is so much variation in what happens to stock prices. Investors would prefer to hold on to investment with positive returns during increasing market interest rates. On the other hand, investors would prefer investments with stable returns times of interest rate volatility as they are less volatile and susceptible to the interest rate risk The current economies are experiencing inflation and the investment to counter inflation would be stocks that are high growth and with a decent dividend by nature. There are also some government inflation protected securities for Inflation Protected Securities. The high growth stock is still the best option but the only drawback is that you might not always be able to determine correctly which one would perform well and there is no way to predict perfectly that a chosen stock will remain a high growth option in the future. The Inflation Protected Securities’ on the other are guaranteed for their real return which makes it attractive for those that don’t want the headache of unpredictable inflation rates. Investment in stocks A share of stock is a legal claim to a share of the corporation’s future profits, for example if one has 100,000 shares of stock in a company which authorised shares of 1million, he owns the right to 10 percent of that company’s future profits. It should be noted that if the stock is common stock, one will have the right to vote on major policy decisions affecting the company, such as the selection of the corporation’s board of directors. During market boom stocks returns goes up and at that time anybody who invests in a broad range of stocks-through a mutual fund, for example would have seen his or her wealth increase rather dramatically. However this should not be taken on its face value was seen in the case in 1933 when in a single year go the percentage rate of return that investors in the stock market obtained increased in value by 54 percent but later collapsed or the 1987 market crush where returns were wiped out in a single day. Although the 54 percent rise in the value of investment in 1933 sounds great, it brings us to two serious long-run problems. The first has to do with inflation; the other has to do with taxes. Correcting for inflation and taxes Inflation is important because it reduces the purchasing power of your savings. One needs to know how much you can purchase in real terms when making historical comparisons. Inflation can be adjusted to long-run “real” rate of return turns out which is an annualized corrected rate of 6.6 percent – not bad. But when one takes taxes into account, assuming that you are in the highest marginal tax bracket starting in 2014, you after-tax real inflation-adjusted annualized rate of return drops. So one can beat inflation by investing in the stock market in the long run, but taxes tend to beat investors down. Stock Investors demographics Before investors put their money in stocks of a company, they need to understand who owns stocks of that company. As it turns out, a considerable number of people own stocks, either directly or indirectly through pension plans. In most developed economies more than one household in four owns stocks and mutual funds shares directly; an even greater number own stocks indirectly through their pension plans. This influences the price and returns in terms of capital gain or dividend. Investment in bonds A bond is a legal claim against a firm, entitling the holder to receive a fixed annual coupon payment, plus a lump-sum payment at the maturity date of the bond. Bonds are issued in return for funds lent to the firm; the coupon payments represent interest on the amount borrowed by the firm, and the lump-sum payment at maturity of the bond generally equals the amount originally borrowed by the firm. Bonds are not claims to the future profits of the firm; legally, bondholders are to be paid whether the firm prospers or not. To help ensure this, bondholders generally must receive dividend payments. Investment in current economic situations There are several styles or principles that determine the portfolio allocation when choosing types of different assets. The most popular method of determining allocation is to choose the assets depending on the age or goal of the client. If the client is young, then stocks that are poised for growth are chosen because the client still has plenty of working years ahead of him and very little bonds for the portfolio because he doesn’t need the slow but guaranteed income from bonds. The situation is different however if the client is old. The portfolio this time is designed to hold more bonds than stocks because the client will need most of them within a few years of their lives and has no more time to wait for the stocks to mature and provide them with the income they need (Breedon 1996). Only the short term bonds can provide them some sort of passive income this time. The stocks they hold should be no more than protection against inflation and also a small form of growth for the little time they have left in this world. Another principle used in determining portfolio allocation is to predict those that are poised to increase from their current levels and provide a decent income to the portfolio owner. The method is no different from day trading. This is usually done by those that are skilled in the stock market. Indirectly, since this method relies on the day to day action on the scene, the rate of return when done properly is high enough to compensate for the inflation. In short, all of these methods and principles are designed to earn higher than the inflation rate since it is very hard to escape from. Only the Inflation Protected Securities’ are the only direct form of securities that are intended to prevent the harmful effects of inflation. Quantitative easing alters the prospective rate of return on these assets by increasing the money supply circulating within the economy. The increased money supply will stimulate economic activity which in turns creates more income for employees and businesses alike. The final result of all of these is naturally an increase in the rate of return of a business because they have more capital to spend to acquire market share and there are more employees that have higher purchasing power. The only problem with this method is that it does not always work. The described effects above happen only if all of the conditions are right and when they are done properly. There are instances where the money that was used to flood the market has reached a point where the sale or consumption of goods are still slow or not moving at all will eventually result in an inflation. This is the reason why quantitative easing has to be done carefully. The goal is to increase liquidity by flooding financial institutions with more cash but unfortunately, it will work only if the economy is indeed able to make use of this added capital in the economy. The extra risks when purchasing assets like stocks would be the possibility of having a well performing stock but it does not pay dividends because the company needs to use it for successive investments in order to reach its goals for growth (Bailey 1998). The client would be forced to sell a portion of the stocks if they ever need some cash for personal use and that is not necessarily a good thing because there would be capital taxes involved. It is still better to depend on the dividends these stocks produce because they are passive in nature. Of course, if the client is old and near the end of their life, there is no issue with liquidating some or most of their holdings whenever they need it seeing as they are not going to be able to stay alive and make use of it in the long run anyway. The risks for bonds on the other hand would be the lower returns they have for the investor. They are indeed safer than stocks but any investor would be plagued by inflation if they happen to be unable to invest in a bond with a higher rate than inflation. Bonds should only be chosen for the sake of having an emergency cash fund that yields a decent rate of return. Only stocks offer the possibility of a very healthy profit potential. For both bonds and stocks however, there are common risks that should be dealt with by the investor. There shouldn’t be any excessive trading for stocks and excessive movements for bonds as well because they all incur a broker’s fee or management fee from the brokerage house that you are buying securities from. You earn your profit from choosing securities well and let time do its work on the growth aspect but financial firms derive their revenue from the constant activity of the financial market regardless of whether or not it is good for you. This is the reason why financial brokerage firms encourage day trading in the first place. For the investor however, the rules are different and you would be well advised not to follow what is being done by the majority of the market. Another risks for both these asset classes, would be governmental regulations that can affect the profitability of the companies you are investing in. There are also potential civil wars that can hamper the operational capabilities of the companies you are investing into. Even if you have already been able to determine the fundamental business strength of a company there are always these factors that can’t be explained nor predicted in the financial statements. It is the same reason why any investor should monitor their investments for potential changes in the market that can alter their assets profitability for short term and long term scenarios. There are also rare but nonetheless significant events that can totally impact your investments like civil war in the country you have chosen to invest in or a major civil disturbance at least. Any weather disturbances that can hinder the operations of your chosen business will naturally impact your returns as well (Campbell 2009). Typhoons, floods as well as landslides can all happen anytime. Even the totally unexpected disaster that happened to Japan has far reaching consequences for related business that are not even located in Japan itself. Of course, the detail would also depend on what is the nature of the business you have invested upon. The possibility of default is also present for both stocks and bonds asset class because the companies behind them are facing financial concerns always in the real world. It is for this reason that investors should be very wary and thorough when investigating potential assets to buy. Obvious financial weaknesses as well as operational risks should be fully evaluated before buying anything. It should be noted however that not all risks involving a security for investment can be gleaned just from reading their financial statements. The most significant risks are sometimes based in the future hence; there is no current data that will indicate this for you. The best way to deal with this risk aspect is simply to try to ascertain the future risks in addition to the thorough financial analysis. It should be considered as well into the decision when buying these types of securities. For bonds, obviously the investor should never choose those with weak financial foundations. For stocks, the future profitability is considered equally important as the current financial status because stocks are chosen for their growth not just current financial health. Conclusion All in all, the risks associated with both stocks and bonds can best be determined by due diligence before committing any funds to any of them. If a person is not financially savvy, he or she should best leave the financial decision to a capable financial manager of their retirement funds. References Bailey, R 2005, The economics of the Financial Markets. London: Cambridge University Press Breedon, F & Chadha, JS 1997, The Information Content of the Inflation Term Structure, Bank of England Working paper 75.Available online at [accessed on 13th May 2014] Campbell, JY, Shiller, R & Viceira, L 2009, Understanding Inflation-Indexed Bond Markets, Brookings Papers, 2009. Chadha, J S & Holly, S 2011, Interest Rates, Price and Liquidity - Lessons from the Financial Crisis. London: Cambridge University Press. Cottle, S, Murray R & Block F 2006, Security Analysis. London: McGraw-Hill Fisher DE. & Jordan R J 2006, Security analysis and portfolio management. New Delhi: Prentice hall of India private limited Graham B 2005, The Intelligent Investor: The Classic Text on Value Investing. London : HarperBusiness Greenblat, J 1999, You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits, New York: Touchstone; 1st Fireside Norton, R 2006, Investments. New York: Thomson Higher Education. Young, D. & Berry, M 2009, Macroeconomic Forces, Systematic Risk, and Financial Variables. Journal of Financial and Quantitative Analysis. Read More