The Investment Analysis and Strategy of the Coca-Cola Company 1.Computation of the Rate of Expected Return for Coca-Cola Company E(RKO): Coca-Cola Company (KO) shares, as shown above, are relatively low-risk, low-return assets. Its beta, at 0.61, accordingly reflects that investing in KO involves systematic risks that are lower than the prevailing market risk. It further means that KO shares, in the course of trading, are bound to be less volatile than the market as a whole. (Reilly & Brown 1997:289) The relatively stable nature of KO shares, however, cannot bring about higher returns.
This observation is in agreement with the accepted rule regarding the risk and returns. Generally, the expected return rates to be generated by securities increase as the risks that the investment is exposed to increase as well. This is known to be applicable up to certain limited levels of risks and returns. The prevailing adverse economic conditions have further contributed to the low expected returns of KO shares. Risk-free rates of treasury bills are at their lowest point these days and market rates of return even of a blue chip like KO cannot be exempted from the general slowdown of business.
The average dividend yield of KO, then, has lowered. All these slumped returns resulted to the computed expected returns of only 1.69% for KO. Particulars Assumptions Risk-Free Rate (RFR) 0.18% RFR is pegged at the 3-month Treasury rate, per Bloomberg. Beta (ßKO) 0.60 The beta figure is taken from the Google Finance website. Please see attached Excel file. Market Rate of Return (RM) 2.70% RM is assumed to be equal to the 5-year average dividend yield of KO, per Yahoo!
Finance. E(RKO) = RFR + ßKO (RM - RFR) = 0.18% + (0.60) (2.70% - 0.18%) = 0.18% + (0.60) (2.52%) = 0.18% + 1.512% = 1.69% 2.
Systematic Risk Factors Concerning Discount Rates Systematic risks can never be totally eliminated. They arise from continuing attempts of portfolio managers to make their respective portfolios as diversified as possible to hopefully spread out the risk and to avoid those big risks associated with putting all of one’s eggs in just one basket. Thus, while their portfolios are never totally free from risks, they become subject to yet another risk – one that stemmed from the so-called “co-movements” of paired assets that were simultaneously borrowed and lent by two parties.
Technically, systematic risk pertains to a part of an asset’s variance that is not caused by the asset on its own but, instead, by the market portfolio as a whole. They cover economic, political, technology and business risks, among others. (Reilly & Brown 1997:22) Just as returns vary according to risks involved and vice versa, discount rates for projects are set in different ranges that match the different systematic risk factors that are taken into account during the finalization of the packaged project. Portfolio managers and analysts employ different mechanisms in their attempts to make sure that all possible factors that may contribute to the overall risk of investing in an asset are well accounted for or are imputed in the return rates to be used in the course of security trading and similar transactions.
One such mechanism is the close monitoring of the security market indices. A good number of those who need to forecast as accurately as possible the movements of stock prices, currencies, bonds and treasury interests and other variables that can significantly affect the total market values of their respective investment portfolios and funds seriously study the security market indices (Reilly & Brown 1997:152).
They closely watch these indices – stock market indices, hedge fund indices, etc. – as if the securities making up their portfolios would increase or decrease in value in unison with their selected indices. Institutional investors on look out for relatively conservative investments, as well, track the movement of indices as a way to measure the levels of risks that currently prevail in the securities markets (Amenc & Goltz 2008:50). However, risks cannot be determined by the movements of indices alone.
Discounts that are set based on analyses of indices, therefore, can turn out to be grossly miscalculated. This practice can be improved if decision-makers in the finance world would do well to remember that the indices can sometimes be influenced by just a few select securities on any given day at the bourse. The indices, therefore, do not necessarily relay the true picture of a particular security or of an entire industry. These indices are products of interrelated securities put together by different selected criteria and methods of computations.
(Brooks & Kat 2002:30) For one, the companies behind the indices were selected based on the sizes of their capitalization. Among companies that are publicly listed, those with the biggest capital figures in their respective industries have been made part of the indices. However, there could have been other equally important criteria for such selection, such as the average profitability rates and the financial leverages of the companies (Amec & Goltz 2008: 56).
The limitations and complexities that indices represent should sufficiently warn investors and analysts about how to interpret them in relation to the market, the industries and the specific securities that make up each of them. It would be wise to remember that markets do not always behave rationally. The daily fluctuations of the different indices of the financial markets across the globe cannot always be justified by valid and fundamental reasons. Authors Amenc and Goltz firmly also point out that the various indices for both equity and hedge fund markets are heterogenerous and that this presents a “problem of representativeness” (2008:54) that analysts should be wary of.
Even stock indices of the same markets (e. g., S&P and FTSE of New York Stock Exchange) have been proven to not agree on the average net returns of stocks for a given period. The systematic risk factors presented by one index would be indicative of a certain risk level; then another index of the same securities market would be naming an altogether different risk level.
Thus, decision-makers setting discount rates for projects of even the same risk levels could actually end up adapting different rates plainly because they did not use the same specific index. This commonly used mechanism for setting rates turns out to yield no definite answers. Meanwhile, some analysts deem it worth their while to make out existing patterns or relationships among the effective rates of returns that apply to securities of various countries such as America, United Kingdom and Japan. The comparability of the economic indicators of different countries, however, has remained to be questionable.
After all, there are major inconsistencies that exist in the range of the accounting practices, the taxation laws and other considerable factors. (Aliber & Click 1993:359) Basing decisions on trends of other countries – collective trends – is not an effective way to quantify the prevailing risks in any given country. The economic, political and cultural peculiarities of individual countries would constitute another case the “problem of representativeness” (Amenc and Goltz 2008:54) exists. The recommended way to examine systematic risk factors that would clearly define the levels of risks that companies are exposed to whenever they set discount rates is to zero in on the securities and the companies that issued them.
On top of these, the sectors they respectively belong to and the economy in general would all have to be examined firsthand – and not through any selected index. Facts that should matter to investors are not always disclosed in the financial statements and annual reports of listed companies and those managing mutual and hedge funds. The lessons taught by Enron should ever be fresh in the minds of those in the position to make investment decisions.
The Enron fiasco was totally expected and practically came out of nowhere. Nothing in the trends of then-current indices held out any warning or any slight sign that a financial catastrophe of such huge magnitude was on its way. Indeed, the market crash that ensued was akin to an unexpected, uninvited guest that forced his way in. Suddenly, the financial world was in chaos. A lot of discount rates previously set turned out to be the culprits responsible for the heavy losses of a number of funds and securities traded.
The crisis happened as it did because nobody was looking. They knitted fiction and sold it off as real. (McLean & Elkind 2004:219) To counter similar dilemmas, there is the need to advocate transparency among involved parties. Companies should disclose all relevant matters that can possibly affect the decisions of the various users of the financial information that they are mandated by law to provide.
It has been pointed out that transparency should be viewed as a means to an end. Transparency per se will not help in determining what discount rates ought to be set for projects. But it can bring to the light the accurate information that discount rates should be based on. (Amenc and Goltz 2008:58) List of References Yahoo! Finance (2009) The Coca-Cola Company (KO) [online] available from [accessed 28 July 2009] Bloomberg (2009) Government Bonds: U. S. Treasuries [online] available from < http: //www. bloomberg. com/markets/rates/index. html> [accessed 28 July 2009] Reilly, F.
& K. Brown (1997) Investment Analysis and Portfolio Management 5th Edition. Orlando, FL: The Dryden Press. Aliber, R. & R. Click (1993) Readings in International Business: A Decision Approach. MIT Press. McLean, B. & P. Elkind (2004) The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron. New York: The Penguin Group. Google Finance (2009) The Coca-Cola Company (KO) [online] available from < http: //www. google. com/finance? q=NYSE: KO> [accessed 28 July 2009] Amenc, N.
& F. Goltz (2008) ‘Revisiting the Limits of Hedge Fund Indices: A Comparative Approach. The Journal of Alternative Investments Spring Issue 50-63 Brooks, C. & H. Kat (2002) ‘The Statistical Properties of Hedge Fund Indes Returns and Their Implications for Investors. ’ Journal of Alternative Investments 5, 26-44