It is to be analytical rather than descriptive. It should reflect a good understanding of the aid-growth theories and empirical methodologies
It is a research intensive exercise and involves identifying and discussing the relevant papers in the literature.
Articles like Burnside and Dollar(2000), Levine and Roodman (2003) should be used along side other journals and papers
SAMPLE ANSWER
Introduction
In our context today, many argue that financial developments measured in the eyes of a monetary indicator and credits are imperative in economic growth. These allegations have led economist to find a balance in the pursuit of financial liberalization for countries to grow faster. In as much as it may be empirically proven that there is a strong connection between growth and finance, there is no proper base that ascertains that the two antecedents spur growth. It is against this background that this paper seeks to explicitly analyze the finance-growth relationship through an empirical approach that incorporates other methods (Burnside, & Dollar, 2000).
Burnside and Dollar in their attempt to find out the impact of aid on the economy discovered that aid would only be effective in an economy that has a sound fiscal, trade and monetary policies. This has caused many donors to only focus their aid on good economic policies (Burnside, & Dollar, 2000). This dissertation aims to analyze the hypothesis behind aid as the most efficient agent in the growth of an economy. The paper will also address the impact that foreign aid intrigues in the economic growth of a country.
The Neo- Classical Model of Exogenous Growth
This approach introduces the components involved in sustaining a positive growth rate of a country per capita over a period. According to Burnside and Dollar, continual improvements in technological knowledge that in turn affects the forms of new goods, markets and processes are critical to sustaining growth. On the other hand, they allege that in the event that a country lacks technological progress, the fruits are most likely to decrease the impact of economic growth. In his approach, he describes the production function through a theory below;
Y-F {K} (Burnside, & Dollar, 2000).
In this theory, he explains that K is the capital stock while Y determines the aggregate stock that is determined only by a given state. This also entails a range of available approaches under different capital. K is a cumulative indicator that identifies the various capital goods and includes human, as well as physical capital (Burnside, & Dollar, 2004). This model puts into assumption the aspects of capital and labour as fully employed. The central purpose of the cumulative production function is that it diminishes returns to the accumulation of capital.
In order to ascertain that the rate of capital stock increases in a country in a given period, the Solow and Swan theory is incorporated. This approach assumes that people save a stable fraction S of their total gross income Y. However, this approach puts into assumption that taxes are not included in order to identify the national income and output (Burnside, & Dollar, 2004). A depreciated level of capital stock is connoted as δ. The rate at which capital accumulates is Sy, while the rate of the old capital that wears out is QK. The rate of the net increase of capital inclusive of the net investment is;
K=SF (K)-δK (Burnside, & Dollar, 2004).
According to this theory, savings and investments can only be identical when taxes and government expenditures, and international trade are excluded since they both represent the flow of income spent on investments goods rather than on consumed goods.
However, in the absence of a growth in technology and technological changes within a nation, the returns are more likely to diminish, this affecting the state of an economic growth (İnce, 2011). According to this author, boosting savings with the objective of increasing growth is considered void since an increase in s will only raise the rate of capital accumulation temporarily and will not affect the growth rate of a country (Batraga, Brasliņa, & Viksne, 2014). When S is however increased, the levels of output and capital are likely to increase thus changing the savings schedule to an increase.
Endogenous Growth Models
The use of endogenous growth model is a main alternative to the neoclassical growth approach. This model slightly varies from the neoclassical method of growth since it includes a couple of inputs such as technology, physical capital, human capital, social capital, intermediate goods, organizational capital and institutional design (Batraga . et al 2014). The increase of output according to this model changes with the other mentioned inputs, thus making it difficult to find stability in the linear relationship between investment and growth.
The neoclassical approach depicts that aid fills the financial gap and allows for greater investment and growth opportunities in a country. However, this assumption only finds base if the investment is liquidated and constrained and the incentives that should be invested are favourable (Boreham, 2008). In a nutshell, then the incentives to invest are low, the investments level also fall low. Aid, on the other hand, may also cause a negative effect on investment incentives, a factor that could cause a country to seek for more aid in the future. It is, therefore, imperative to consider the fact that aid can finance consumption rather than investment (Abdessatar, & Rachida, 2013). Burnside and Dollars allegation that aid increases growth under a good policy is substantial and does not ascertain if aid can lead to investments.
Theory of Aid and Growth
The standard model that has been in use for years now to justify aid is that of two-gap model that is attributed to Chenery and Stout. In this approach, the first gap is inferred to as that between the investment amounts required to achieve a growth rate and the available savings (Rajan, & Subramanian, 2008). The second gap is that which describes the import requirements that are needed for a given level of production, inclusive of the foreign exchange earnings. In this approach, economic growth is tied to the investments as shared in the GDP. This growth is adjusted to factors that reveal the state of the investment, whether high or low (Hansen, & Tarp, 2001). The amount of investments, therefore, sums the domestic savings and foreign aid of a country.
In summary, Burnside and Dollar, in their pursuit to find the balance in the relationship between foreign aid, economy and growth found that aid has a positive impact on growth and development of a country. This can only be possible is such a country has a good fiscal, trade and monetary policy and has few pressures on poor policies (Burnside & Dollar, 2000). These factors can be achieved when empirical ideologies that are growth oriented are introduced.
Conclusion
This dissertation focused on Burnside and Dollar (2000) ideologies that viewed the relationship between aid and GPA per capita of a country. In as much the results have faced a wide debate from empirical researches; aid has a significant negative impact on a countries GDP per capita growth (Gupta, 2004). However, when a good policy environment is cultivated, aid has a significant impact on the economy of a country. It is important that donors understand and create frameworks that provide them with better tools to improve developmental agendas in different countries (Easterly, Ross, & Roodman, 2003).
Works Cited.
Abdessatar, A., & Rachida, B. J. (2013). Institutional Quality and Financial Stress: Experience From Emerging Country. Studies In Business & Economics, 8(3), 5-20.
Batraga, A., Brasliņa, L., & Viksne, K. (2014). Identification of Innovation Ideas in Its Development Process. Management of Organizations: Systematic Research, (70), 23-40. https://www.doi:10.7220/MOSR.1392-1142.2014.70.2
Boreham, G. F. (2008). The Financial Markets Approach to Economic Development in LDCs. Service Industries Journal, 6(1), 22-41.
Burnside, C., & Dollar, D. (2000). Aid, policies, and growth. The American Economic Review, 90 (4), 847-868.
Burnside, C., & Dollar, D. (2004). Aid, Policies, and Growth: Reply. American Economic Review, 94(3), 781-784.
Easterly, W., Ross, L., & Roodman, D. (2003). New data new doubts: A comment on burnside and dollar’s “aid, policies, and growth” (2000). National Bureau of Economic Research Working Paper Series,
Gupta, K. L. (2004). Foreign capital and domestic savings: A test of Haavelmo’s hypothesis with cross-country data: A comment. Review of Economics & Statistics, 52(2), 214-216.
Hansen, H., & Tarp, F. (2001). Aid and growth regressions. Journal of Development Economics, 64 (2), 547-570. doi:DOI: 10.1016/S0304-3878(00)00150-4
İnce, M. (2011). Financial Liberalization, Financial Development and Economic Growth: An Emprical Analysis for Turkey. Journal of Yasar University, 6(23), 3782-3793.
Rajan, R. G., & Subramanian, A. (2008; 2008). Aid and growth: What does the cross-country evidence really show? Review of Economics and Statistics, 90 (4), 643-665.
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1. Briefly explain the concepts of expected return, standard deviation, and correlation (in the context of share prices), and discuss their importance in
portfolio management. (Issues you should consider here are the relationship between risk and return, and how portfolio risk can be reduced through
diversification)
2. Create a spreadsheet model to find efficient portfolios of shares, and derive the efficient frontier. Give a full explanation of your modelling procedures
and the results that you obtain.
3. Introduce a risk-free asset into the model and find the optimal portfolio of shares. Discuss what happens to this portfolio as the risk-free rate of return changes.
4. Introduce a risk aversion factor into the model and discuss its effect upon the optimal complete portfolio.
5. Discuss the limitations of this approach to portfolio selection.
As well as a spreadsheet file, you need to submit a report (in Word) explaining all five parts of the answer. Credit will be given for demonstrating that you have understood the procedures and the results. The word limit is 1500 words.
***About referencing number i really dont know you chose the right number.
Referencing Requirements:
BooK, journal, article.
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This International Finance order consist 2 works:
1.summary less than 1 page writing about what financial issue my research paper is going to investigate and in what aspects. Due on March 24.
2.Research paper is Due on March 31 (6-7 pages in text)
If use charts or graph or any data more than 6-7 pages, I will pay more for the extra.
Topic is decide by you to choose what issue to writ about.
More detail is in attached file-“Instructions”
Materials covered in class is in the attached file – ‘Material Covered in Class” Chapter 13 to Chapter 19, Chapter 16 to 18 is more important.
The issue selected must closely related to the material covered in class!
Number of sources can be slightly varied as needed.
I am an international student, so please keep the grammar and sentence structure relatively simple.
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One method utilized by companies to obtain the long-term capital necessary to run and grow their businesses is by providing the general public with the option to purchase stocks. The company’s first sale of stock is known as the initial public offering (IPO). When a company first offers the IPO, stocks are, on average, underpriced.
• Discuss the implications of such underpricing to established theories of market efficiency.
• Explain the role market efficiency might play in the underpricing theories presented by Loughran and Ritter.
Include a reference list hear 4 references minimum
SECTION B ( 2 pages minimum)
International Finance
Critics of the field of international finance charge that the field is simply “corporate finance with an exchange rate.”
• Critique this statement.
• Do you agree or disagree with it? Why?
• Justify your answer with specific details.
Include a reference list at the end hear 4 references minimum
Resources
• Article
• Loughran, T., & Ritter, J. (2004). Why has IPO underpricing changed over time? Financial Management (Blackwell Publishing Limited, Autumn), 33(3), 5–37. Retrieved from Business Source Premier database.
The authors of this article research the common practice of underpricing IPOs and how it has drastically fluctuated over the last several decades. They then propose and discuss three hypotheses to explain the level of changes that have occurred.
• Cohen, G., & Yagil, J. (2007). A multinational survey of corporate financial policies. Journal of Applied Finance, 17(1), 57–69. Retrieved from Business Source Premier database.
This article reviews findings from a six-country survey of corporate financial policies where it finds that investments were considered the most important financial decision and the internal rate of return was the most commonly used evaluation method.
• Ahern, K., & Weston, J. (2007). M&As: The good, the bad, and the ugly. Journal of Applied Finance, 17(1), 5–20. Retrieved from Business Source Premier database.
This article analyzes and rates the different theories surrounding the goals of mergers and acquisitions.
• Rhodes-Kropf, M., & Robinson, D. (2008). The market for mergers and the boundaries of the firm. Journal of Finance, 63(3), 1169–1211. Retrieved from Business Source Premier database.
In this article, the authors describe a new model they have developed that helps explain the process companies use for decision making on potential mergers and from using this model, they conclude that like-buys-like in terms of financial ratios.
• Statman, M. (2007). Local ethics in a global world. Financial Analysts Journal, 63(3), 32–41. Retrieved from Business Source Premier database.
In an increasingly global market, this article discusses the importance of evaluating ethics and fairness in different countries and seeking to improve the level at which is business occurs.
• Poulsen, A., & Stegemoller, M. (2008). Moving from private to public ownership: Selling out to public firms versus Initial Public Offerings. Financial Management, 37(1), 81–101. Retrieved from Business Source Premier database.
Throughout this research, the authors study over 1700 firms to determine the characteristics of those private companies that choose to sell out to a public company versus those who choose to become public by issuing an Initial Public Offering.
• Gondat-Larralde, C., & James, K. (2008). IPO pricing and share allocation: The importance of being ignorant. Journal of Finance, 63(1), 449–478. Retrieved from Business Source Premier database.
In making decisions on investing in IPOs, the authors discuss how banks and investors often form coalitions where both groups share the risk and in return the banks give lower-priced offerings to those in the coalition.
SAMPLE ANSWER
Section 1
Initial public offering (IPO) is mostly underpriced or below the market value. Usually, IPOs are in most cases underpriced because of issues relating to liquidity and the uncertainty on the level at which the stock is expected to trade. Low liquidity results to low uncertainty; hence, the need to under price to compensate investors for taking the risk. A company may be aware of the value of shares; however, the investor may not be aware. Therefore, the company must offer a lower price with the intent of encouraging investors. On the other hand, if IPO is offered at a higher price, investors are likely to reject. As such, the company is forced to give low prices to attract as many investors as possible (Gondat-Larralde & James, 2008).
IPOs are less understood by some investors. In fact, there are two types of investors, the informed and the uniformed. The informed investors are knowledgeable about the true value of shares while the uniformed only invest randomly without the knowledge on the value of shares. Usually, the price of fluctuates by the changes in demand as the stock is held constant. The demand is separated in two: informed and uniformed investor demand. If companies had IPOs that reflect their true value, then the uninformed investors would break or lose money as the informed investors would only invest in good IPOs. This would crowd out uninformed investors and be the only people turning profits. The law allows investment banks to allocate shares of oversubscribed that crowds out uninformed investors (Loughran & Ritter, 2004).
Ritter and Loughran stipulate that riskier IPOs are underpriced as compared to less risky ones. This attracts many investors as opposed to overpriced IPOs that discouraged informed investors. Further, it has been observed that IPOs stocks over the long seem to underperform the market. The long term underperformance is an anomaly that shows inefficient market hypothesis with inherent challenges. There is an argument that IPOs have a track record of earnings by the time they go public. The participants fail to realize that earnings growth reverts the stick prices before going public are quite high. It is claimed that SEOs have good returns three years before the issue. The past earnings are then corrected over time slowly (Schwert, 2003). To increase market efficiency, the uninformed investors should reduce uncertainties and gain the necessary information and increase market efficiencies. Analyzing of information can help traders to make informed decisions about IPOs.
Market efficiency refers to the availability of relevant information on stock prices is reflected. This view stipulates that it is not possible for investors to outperform the market since all the information is in stock prices. The concept of efficient markets relies majorly on the ideals of random walk that stipulates that price changes of today are independent of the past (Fama, 1998). This means that the flow of information should be uninterrupted and should not incur any cost. The information should reflect on the prices immediately. The price of tomorrow will change in anticipation to tomorrow’s news, which is unpredictable. Therefore, the prices of tomorrow are also unpredictable and random. This same view claims that efficient markets fails to allow investors to earn high profits without taking high risks.
It is arguable that market efficiency is the function of information cost. Information determines the distribution of IPOs. Thus, the analysis of information market is critical to understand anomalies that might emerge in the market.
References
Fama, E. F. (1998). Market efficiency, long-term returns, and behavioral finance. Journal of financial economics, 49(3), 283-306.
Gondat-Larralde, C., & James, K. (2008). IPO pricing and share allocation: The importance of being ignorant. Journal of Finance, 63(1), 449–478. Retrieved from Business Source Premier database.
Loughran, T., & Ritter, J. (2004). Why has IPO underpricing changed over time? Financial Management (Blackwell Publishing Limited, Autumn), 33(3), 5–37. Retrieved from Business Source Premier database.
Schwert, G. W. (2003). Anomalies and market efficiency. Handbook of the Economics of Finance, 1, 939-974.
Section 2
International finance is a body that deals with monetary economics at international levels. It is a body of financial system that protects the framework of finance institutions and legal agreements. The evolution of international finance has led to the development of central bank and other institutions such as multilateral agreements. The central bank is the major player in international finance (Ocampo, 2007). It is charged with the role of currency exchange between various countries. It determines the value of differing currencies in differing countries in relation to another. The foreign exchange rate is open and is determined by many factors. Buyers and sellers must know the value of currency of the countries they are trading with in order to determine the price and exchange rates. The international traders must also understand the fluctuations in the exchange rates.
International finance determines the value of currency for each country depending on factors. The currency for a particular country has more value if its demand is greater than the supply. On the other hand, when the demand is less that supply, the currency becomes weaker. This does not mean that people will not value that money anymore; rather, they prefer keeping their wealth in another form. The international finance helps people and corporations to determine when to trade and make more profits at international levels depending on the value of currency of the trading countries. The transaction demand for money leads to increased demand for stronger currency. This demand for transaction is determined by the country’s level of GDP, employment and business activities. The lesser the employment level, the less the people will get involved in trade and transactions; hence, weaker currency. Other factor that the international finance is charged with is the adjusting of interest rates. The higher the interest rates, the more the demand for currency and vice versa. For carrier companies, information on exchange rates is crucial in carrying out businesses. Therefore, such companies need to seek the expertise of international finance in order to maximize profits and determine when to trade and when to hold on (Greuning, Scott & Terblanche, 2011).
Even though the exchange rate is crucial in financial market of international communities, this does not mean that corporate finance is all about exchange rates. The basic domestic corporate finance is crucial in the foreign exchange. Likewise, international corporations are greatly influenced by cultural, political, and environmental regulations and changes (Madura, 2011).
Exchange rate is a process in which the pricing system and currency exchange takes place at international levels. Exchange rate changes over time depending on the changes in domestic and international market. Corporations at international levels use critical information availed in the foreign exchange market to help in capital budgeting and making critical decisions necessary for future growth. The managers in the financial sector accept decisive factor of market efficiency and act in the interests of all shareholders. In cases where the exchange rate matters most, international finance corporations purchase power parity to balance the risks inherent in exchange rates and capital budgeting.
It is true that international finance deals with currency exchange; however, there are many more roles than that. It is responsible for advising international traders in order to determine when it is best to trade (Sercu, 2009). As such, international finance is not just exchange rate.
References
Greuning, H. ., Scott, D., & Terblanche, S. (2011). International financial reporting standards: A practical guide. Washington, D.C: World Bank.
Madura, J. (2011). International Financial Management. Florence, KY: Cengage Learning, Inc.
Ocampo, G. J. A. (2007). International finance and development. New York, NY [u.a.: Zed Books.
For this paper, I will send the file that contains the case study to be use for this paper via the files upload. it is important to respond to the questions mentioned detail.
Mini-Case Study: Your 401(k) Account at East Coast Yachts
This case study, found on page 472 of your course text, is a continuation of the one you began last week. After carefully reading the new information presented, briefly respond to the three questions at the end (4 to 6 sentences each).
SAMPLE ANSWER
Mini-Case Study at East Coast Yachts
What implications do you draw from the graph for mutual funds?
According to Bruce (2003), mutual funds help investors to save for their retirements and other financial goals due to huge benefits that come from investment diversification and professional management. The initial implication from the graph is that different funds perform differently over time and the investor has the option of choosing the best fund in accordance with his own analysis. From the graph, it is evident that the performance of mutual funds increases with time based on the level of investment. From the date of inception, a considerable growth is realized in mutual funds over time. In the above graph, the performance of the equity mutual funds is higher than the Vanguard 500 Fund. With this regard, an investor is likely to reap huge for investing in equity mutual fund than Vanguard 500 Fund. However, an investor who invests in the Vanguard 500 Fund is still able to realize considerable level of growth for despite it being relatively lower than the equity mutual fund.
Is the graph consistent or inconsistent with the market efficiency?
When the money is put in the market, the aim is to generate more profits in return for the capital invested (Bailey & Lopez-de-Prado, 2013). In addition to making profitable returns, the investors in the market also try to outshine other markets. If the markets became less efficiency there would then be fewer returns on average and very high volatility when it comes to investment (Wilmott, 2007). The liquidity would not be able to impend the market approach and this would end up changing efficiency in terms of production of goods and services (Ross & Westerfield, 2013). On the other side, if US market became less efficient, then there would be no accurate information on market issues and there benefit in the market would be very low. When the market is not efficient, the market would become very unpredictable for investment and this is likely to affect the rate of investment. This graph is in consistent with the market efficiency curve since different investment portfolios compete efficiently in the market. Due to high returns on the equity mutual fund, the markets seem very efficient since such returns can only be achieved by less market volatility. A graph that is inconsistent with the market forces portrays irregular lines that have are can hardly be predicted by the investors.
What investment decision would you make for the equity portion of your 401(k) account?
In my opinion, the best investment decision to roll over some portion of the 401(K) so that it can be invested in individual stocks. Since the investor has a sizeable amount tied to the company’s 401(K), there is high likelihood that such investment will gain good benefits in return. According the historic performance, the funds are doing reasonably well and it is somehow safe for the investor to take a portion and gamble with some portfolio investment. In this arrangement, the investor can roll over more funds to the equity mutual fund that allows him to invest in high yielding portfolio. On the other hand, I would avoid investing in the Vanguard 500 Fund since it gives less return in the long run when compared to equity mutual funds. Despite having high fees, the equity mutual funds are profitable since the anticipated returns will cater for the high fees involved.
References
Bailey, D. &Lopez-de-Prado, M. (2013): “The Strategy Approval Decision: A Sharpe Ratio Indifference Curve approach”, Algorithmic Finance 2 (1): 99-109
Bruce J. F. (2003). Investment Performance Measurement. New York: Wiley
Ross, S. R., Westerfield, R. W., & Jaffe, J. (2013). Corporate finance (10th ed.). NY: McGraw-Hill.
SOP – Assignment – Part 2
You have managed to acquire the last two years accounts for your fierce rival LMM Ltd. Your CEO has heard that you are studying Finance at Napier University and has asked for a report on how the opposition has been performing in that time span. Total words should not exceed 2,000, excluding any calculations.
LMM Ltd
Income Statements for the year ended 31 July
2014
2013
£000
£000
Continuing operations
Revenue
22,600
19,800
Cost of sales
(10,735)
(10,890)
Gross profit
11,865
8,910
Distribution costs
(5,424)
(3,960)
Administrative expenses
(4,068)
(2,574)
Profit from operations
2,373
2,376
Finance costs
(770)
(280)
Profit before tax
1,603
2,096
Tax
(294)
(133)
Profit for the period from continuing
operations attributable to equity holders
1,309
1,963
LMM Ltd
£000
£000
Statements of financial position as at 31 July
2014
2013
£000
£000
ASSETS
Non-current assets
Property, plant and equipment
22,916
16,200
Current assets
Inventories
1,932
1,525
Trade and other receivables
1,808
1,386
Cash and cash equivalents
582
0
4,322
2,911
Total assets
27,238
19,111
EQUITY AND LIABILITIES
Equity
Share capital
8,000
8,000
Retained earnings
6,334
5,025
Total equity
14,334
13,025
Non-current liabilities
Bank loans
11,000
4,000
11,000
4,000
Current liabilities
Trade payables
1,610
1,307
Tax liabilities
294
133
Bank overdraft
0
646
1,904
2,086
Total liabilities
12,904
6,086
Total equity and liabilities
27,238
19,111
REQUIRED:
a) Write a report (no more than 2 sides of A4) with your view on how LMM has performed in the two year period. You should show supporting calculations of at least SIX ratios (for each year) to back up your findings. (60%)
b) It has been rumoured that LMM is planning an expansion of their production facilities which will cost £5.5million. Discuss how this might be financed and any problems associated with the methods you have chosen. (40%)
Academic literature should be referred to in your answers.
Donald MacAskill Sept 2014
SAMPLE ANSWER
Finance
Write a report (no more than 2 sides of A4) with your view on how LMM has performed in the two year period. You should show supporting calculations of at least SIX ratios (for each year) to back up your findings. (60%)
In 2013, the Working Capital Ratio which is ascertained by Current Assets / Current Liabilities, in was 1.4. This increased to 2.3 in 2014. The working capital ratio is an important ratio in determining the health of the company under scrutiny (Paradi, Rouatt & Zhi, 2011, 102). It helps one determine the liquidity of a company. The liquidity represents the ability of a company to rapidly turn assets into cash in order to meet its short-term obligations as they fall due. Between 2013 and 2014, the company increased the component of liquid cash it held from 0 in 2013 to 582,000. This arrangement is beneficial to the company as it places it in a stronger position with regards to competitors, in being able to pay off its debts quicker (Paradi, Rouatt & Zhi, 2011, 100).
The Quick ratio also called the acid test ratio is an important ratio. When inventories are removed from the current assets figure, the true position of the company is cleared (Lazaridis & Tryfonidis, 2006, 28). It should not be lost that inventory is held by the organization for trading or facilitating the operations of the company. It is thus very important to determine how the cash and other items that can be easily and rapidly converted into a ready cash value. In 2013 the ratio is 0.7 and improves significantly in 2014 to 1.3. Two issues emerge in the analysis of this ratio. In 2013, when the ratio stood at 0.7 the company could have been said to have a ratio lower that the ideal position by all companies. All companies will seek to have at least a ratio of 1:1. The position of 0.7 could not be so dire if the inventory is rapidly turned-over. A high inventory turn-over makes available ready cash to the company within a short period of time (Paradi, & Zhu, 2013, 62). In 2014 the ratio improved very significantly to 1.3. This position places the company at a pedestal when it comes to taking advantage of emerging opportunities in the industry. Taking the argument that the inventory has a high turn-over, it makes the company highly liquid (Lazaridis & Tryfonidis, 2006, 30). This highly liquid position may however make the company a prime target for a takeover by a company that is looking to improve its liquidity position (Paradi, & Zhu, 2013, 62).
Quick Ratio = (Current assets – Inventory) / Current liability
The debt-to-equity ratio determines the level a company’s financial leverage (Paradi, Rouatt & Zhi, 2011, 102). This is what is arrived at when the total liabilities and divided by the shareholders equity. This is an important indicator of what proportion of a company’s assets is financed by equity and which part is by debt. When a company has a huge debt, it reduces the margins which it operates under and which allow it to respond to market stimuli by adjusting fixed charges and manipulating the earnings available for dividends (Uyar, 2009). This latitude is important as it could allow a company facing challenging stimuli adjust accordingly to ensure sustainability. The risk of using this data to orchestrate a financial crisis is not remote. In 2013 the ratio was 0.5 improving significantly to 0.9 in 2014. In both years, the company reports very robust ratios. The improvement from 0.5 to 0.9 further shows the strong position the company holds. The improvement is on the basis of the loan that grew from 4,000,000 to 11,000,000
Debt-to-equity ratio = Total Liabilities / Shareholders Equity
The return on equity ratio is important as it allows ordinary shareholders determine individually how profitable their capital is in the business venture they have invested in (Uyar, 2009). The profitability of a company is important as it has a direct effect of its shareholders. When the return on equity is calculated, it reveals the estimated profitability of the company. This return on equity reveals the amount of profit generated by the company with the money invested by the shareholders. In 2013, the return on equity was 15.07%. This fell to 9.13% in 2014. The decline in return could be attributed to the additional costs that were incurred by the company in 2014. Distribution costs and administrative costs grew significantly. Despite the increased operational costs that the company incurred, it was able to smooth this by making additional income from its operations. However, the finance costs increase with such that the profitability of the year could not cover it (Scott, & Jacka, 2011). As a result the profits fell by almost 600,000. This had the overall effect of reducing the shareholders return of equity.
Return on Equity = Net Income / Shareholder’s Equity
The net profit margin is an indication of how efficient the company is in controlling the cost surrounding its operations. When the net profit margin is high, it exhibits a company that is efficiently converting its revenues into actual profits (Reiner, Turley & Willekens, 2008). It shows that the company is able to turn its sales into income. For 2013 the profit margin was 5.8% improving to 9.9% in 2014. The increase in profit margin could be as a result of two factors. To begin with, the company increased it’s from 19,800,000 to 22,600,000. This growth is sales ensured the company had a strategy that was able to convert revenue into actual profits. The second factor could be a reduction in the operational expenses (Scott, & Jacka, 2011). The company was able to employ the same resources but milk greater profits from the same investment.
Profit margin = Net income / Net sales
Another set of ratios that examine how a company is performing are the solvency ratios. This ratios are important as they determination point the long-term risk (Reiner, Turley & Willekens, 2008). Shareholders and long-term creditors find these ratios important in assisting them make investment decision regarding the company. Given that in business, there are only two ways to finance the acquisition on an asset; debt (using borrowed funds) and equity (using funds raised by shareholders or funds retained from the company’s internal operations – retained earnings). The ratio determined for a company shows the percentage that each asset it financed by (Eljelly, 2004, 51). Ideally, the level of debt that a company takes on is a subjective issue. For a company that is has a high debt could be viewed as one that is able to leverage greatly. In the same face, for a company that relies on heavy investment in fixed plants and equipments, the level of debt financing will similarly be bigger with aspects such as insurance and advertising agencies being some of the components that will see this figure grow. Given that total debt of a company is made up of both long and short term debt. For creditors, emphasis and special interest will be on the long-term debt, specifically seeking to determine how the company used this facility (Eljelly, 2004, 51). In 2013, the 46.7% while in 2014, it was 90.0%. By taking on additional debt, the ratio grew from 46.7 to 90.0.
Debt to total assets ratio = total debt / total assets
b) It has been rumoured that LMM is planning an expansion of their production facilities which will cost £5.5million. Discuss how this might be financed and any problems associated with the methods you have chosen. (40%)
Currently, LMM has on its books a debt of 11 million. In 2013 the debt ratio stood at 32 cents. When it raised its loan from 4,000,000 to 11,000,000 the debt ratio rose to 47 cents to the dollar. By adding an additional 5,500,000 to finance the expansion LMM will further raise its debt ratio to 68 cents to the dollar. This sudden growth of the debt ratio would be alarming to someone looking at the figures without knowledge of the industry LMM operates in. Before changing its debt strategy and adopting one that intentionally set out to manage debt over the long term as opposed to the short term, was based on a number of reasons. LMM could have been looking at managing its debt better in the long term resulting in lower costs. Though the short term would experience a growth in the overall debt, this is only an accounting growth (Paradi, & Zhu, 2013, 62).
Overall LMM will have gained by lowering its debt cost in the long term. By getting the additional loan to expand its operations, the anticipated additional capacity will mean higher economies. The expanded economies of scale will allow LMM to manage the additional debt with only raises the debt ratio marginally despite raising the debt level by almost 50 percent. This could thus be interpreted to mean the LMM operations are very efficient. This is an important factor when considering taking on additional debt to finance growth (Abdul & Mohamed, 2007, 280). Overall LMM is in a strong position in its industry. For the shareholders, the additional debt would mean better returns to them since the taxation system is kinder to debt financing for companies as opposed to refinancing or shareholders having exclusive rights to purchasing additional shares in the company.
LMM’s debt to equity ratio for 2013 was 47 cents to the dollar. When LMM almost tripled its loan from 4,000,000 to 11,000,000 the debt to equity ratio rose almost doubled to 90 cents to the dollar. By saddling LMM with the additional debt of 5,500,000 to finance its expansion then the ratio will raise to 1 dollar to the dollar. This means that debt and equity equally finance the operation of LMM (Abdul & Mohamed, 2007, 280). For the industry LMM operates in, the ratios point to a very efficient operation. Despite the upward movement of the debt to equity ratio to the current 1.0 LMM is still below the industry ratio. From its operations, LMM is able to generate profits that cover the repayment of the loans interest and principle. As stated earlier, additional debt is beneficial to LMM shareholders. Given the tax plans, LMM gains by getting debt to finance its expansion as opposed to floating shares to current shareholders exclusively (Htay, Arif, Soualhi, Zaharin, & Shaugee, 2013).
There are a few options that LMM could choose from when seeking to finance its 5,500,000 expansion in operations. There are number of loan option and designs that LMM could adopt in order to strengthen its position in the industry. A bank loan; depending on how it is designed, how it is paid out and repaid and the terms of the loan will determine the value it adds to the company.
Line-of-credit loans: This finds great favor with small businesses because all they need to do is walk into their bank, have a good talk with the credit or bank manager and if they have operated their accounts well, have a line-of-credit (over draft facility) extended (Narware, 2004,123). This arrangement is best suited for securing a business’s operating costs for working capital, meeting inventory needs or business cycle needs. Since the business only pays interest on the advanced money only, the knowledge that a pool exists which the company can access should the need arise, allows the company more room for maneuver in its operations. A line-of-credit would not be ideal for financing LMM’s expansion (Narware, 2004,123).
Installment loans: This design of loan will allow LMM to repay equal installments over the loan period (Chowdhury & Amin, Md, 2007, 77). The equal monthly installments are designed to meet both the interest and principle equitably. The repayment will determined on loan uptake and clearly captured in the loan contracts. It also allow for early repayment of loans. In some cases, it actually rewards early repayment of loans.
Balloon loans: By their nature, the interest is paid over the lifetime of the loan in equal regular installments with the principle paid as a lump sum on maturity of the loan. The balloon loans are ideal for businesses that get payments on specific periodic dates (Cascarino, 2007, ). LMM would find this arrangement most suitable given the nature of its business is such that incomes are period.
Secured and unsecured loans: LMM has the choice of either a secured or unsecured loan to finance the planned expansion. For the unsecured loan, LMM will not be required to pledge any collateral in lieu of defaulting the loan (Abdul & Mohamed, 2007, 288). This is the option available to those considered by lenders as being low risk. The definition of low risk is relative and will vary from person to person and situation to another (Raheman, & Mohamed, 2007, 280). However the perception of low risk has the advantage of having to pay very low interest on loans. On the other hand, for the secured loan, LMM will have to provide some form of collateral to secure the loan. For the expansion that LMM plans, the collateral will the equipment to be purchased. This is based on the fact that the collateral is related to the purpose of the loan (Chowdhury & Amin, Md, 2007, 77). By LMM using the loan to purchase receivable, the bank will consider this as having being used to finance growth. This classification will allow LMM access the great pool of resources the financier avails to its customers. Most banks will lend up to 75 percent of the amount due (Padachi, 2006, 51). This particular loan will thus not be ideal for LMM. Not being able to access the whole amount will undermine the planned expansion.
Bankers are looking for interest income from a loan, along with a high likelihood that the loan will be repaid (Padachi, 2006, 55). They don’t want to control the business other than making sure it meets loan covenant standards, and they take collateral in lieu of repayment only as a last resort.
References
Paradi, J. C., Rouatt, S. & Zhi, H., 2011. ‘Two-stage evaluation of bank branch efficiency using data envelopment analysis, Omega, Vol. 39, No. 1, pp 99-109
Paradi, J. C. & Zhu, H., 2013. A survey on bank branch efficiency and performance research with data envelopment analysis, Omega, Vol. 41, No. 1, pp 61-79.
Abdul R & Mohamed N., 2007. Working capital management and profitability – case of Pakistani firms. International Review of Business Research Papers, Vol.3 (2), pp. 275 – 296.
Chowdhury, A & Amin, Md. M., 2007. Working capital management practiced in pharmaceutical companies listed in Dhaka stock exchange. BRAC University Journal, Vol. IV, No. 2, 2007, pp. 75-86
Eljelly, A., 2004. Liquidity-profitability tradeoff: an empirical investigation in an emerging market, International Journal of Commerce and Management, Vol.14, No. 2, pp. 48- 61.
Lazaridis I & Tryfonidis, D., 2006. Relationship between working capital management and profitability of listed companies in the Athens stock exchange, Journal of Financial Management and Analysis, Vol.19, No. 1, pp 26 – 35.
Narware P. C., 2004. Working capital and profitability- an empirical analysis. The Management Accountant, Vol. 39, No. 6, pp 120-127.
Padachi, K., 2006. Trends in working capital management and its impact on firms’ performance: an analysis of Mauritian small manufacturing firms. International Review of Business Research Papers, Vol. 2, No. 2, pp. 45 – 58.
Raheman, Abdul & Mohamed Nasr., 2007. Working capital management and profitability- case of Pakistani firms. International Review of Business Research Paper, Vol. 3, No.1 ,pp.279-300.
Uyar, A., 2009. The relationship of cash conversion cycle with firm size and profitability: an empirical investigation in Turkey. International Research Journal of Finance and Economics, ISSN 1450-2887 Issue 24, EuroJournals Publishing, Inc.
Cascarino, R., 2007. ‘Intenal Auditing: An Integrated Approach,’ 2nd Ed, Lansdowne, South Africa.
Htay, S. N., Arif, M., Soualhi, Y., Zaharin, H. R & Shaugee, I., 2013. ‘Accounting, Auditing and Governance for Takaful Operations,’ John Wiley & Sons, Hoboken, NJ.
Reiner, Q., Turley, S & Willekens, M., 2008. ‘Auditing, Trust and Governance: Regulation in Europe,’ Routledge.
Understanding Financial Decision Making: Tools for Evaluation
Order Instructions:
For this paper, it comes in 7 parts and the writer must label each parts and complete a minimum of one page summary as indicated for each part. The writer must follow critically the instructions and the requirements for each part. The writer must use in text citations for each part , as each part must have a minimum of two sources or two different in text citations. The paper must have a minimum of 10 pages in total excluding any diagrams of presentations that the writer may use. Also remember that you will also have to write an executive summary at the end to conclude the paper as mentioned in the instructions.
In this paper, you will examine theoretical and empirical points of view and apply the knowledge you have gained from your study and research in order to understand how financial decisions are made within a large publicly traded company that you choose as an exemplar. You will utilize financial tools to evaluate current financial data and use your calculations to justify those decisions. Approach this exercise as though you were a financial consultant who has been asked to analyze the value of the company as a potential investment. This assignment will require access to in-depth financial information, so selecting a company for which this information is easily obtainable will be most beneficial.
You will conduct a detailed analysis of the financial dealings of your selected organization. Each week you will focus on a different aspect of the company’s financial information. You will explore the monitoring capabilities of the Board of Directors and use financial tools to compare ratios with one of the firm’s competitors. You will establish an estimated growth rate and predict future dividends. In addition, you will use annual reports as a tool in capital budgeting to determine potential real options, establish a market risk premium, calculate the weighted average cost of capital, and compare the mix of debt and equity that the firm uses to an industry average. Finally, you will prepare an executive summary of the company, complete with current stock prices and a recommendation on investing in the business you select. Your paper will contain topics unique to the company chosen, but will incorporate the themes covered in each section.
The Investment Analysis and Recommendation Paper will comprise a minimum of 10 pages in APA style format. Three to five diagrams and presentation slides may be included, but they will be additional to the required length of the paper
Part one
• This week, select a publicly traded company that you wish to analyze for this paper. Submit the name to your Instructor for approval. Obtain the company’s financial statements (annual report) and the most recent proxy statement.
Using the information on the proxy statement:
• Evaluate the monitoring potential of the firm’s Board of Directors.
• Identify the strengths and weaknesses of how the board is structured, as well as any ethical concerns.
Write a 1-page summary of your findings.
Part two
• Investment Analysis and Recommendation Paper
For this part, you will assess the company you selected for your Investment Analysis and Recommendation Paper relative to its competitors in terms of financial ratios. Financial ratio reports are available on numerous Web sites (examples: Reuters, Google, Finance, Hoovers). Remember, different Web sites may use slightly different definitions.
Using income statements and balance sheets for your company AND at least one of its main competitor’s, respond to the following:
•Calculate the DuPont identity for both companies for the past three years.
•Discuss any differences and/or trends that emerge.
Write up a 1-page summary of your findings, including any calculations you made, and how you gathered your information.
Part three
Investment Analysis and Recommendation
• This part of the Investment Analysis and Recommendation Paper requires you to establish an estimated growth rate in earnings and dividends for your company. Note, in the dividend growth model, “g” is the growth rate for earnings AND dividends. You might want to check historical growth rates for the company (in terms of earnings and dividends). Also, many people rely on analyst forecasts. Be sure to justify your growth rate selection and explain how you arrived at the number. Assume your company is a constant growth stock. Use your estimated growth rate to solve for the required rate of return using the dividend discount model. After completing your calculations, respond to the following:
• Does the number you arrived at seem logical or feasible?
• Did you face any problems or issues using the dividend growth model? Does your company pay a dividend?
• Is it reasonable to assume constant growth for your company?
Write up a 1-page summary of your findings, including any calculations you made, and how you gathered your information.
Part four
• For this part, you will read the text portion of your company’s annual report. As you do so, focus on the following:
• Identify potential real options that might arrive in this firm’s business.
• Are these options industry specific or company specific?
• How would these options affect their capital budgeting process?
• Justify your answers.
Write up a 1-page summary of your findings, including any calculations you might have made, and relate how you reached your conclusion.
Part five
• For this part of your Investment Analysis and Recommendation Paper, find an estimate of beta for your company. You might consider examining/using an industry average beta, especially if the reported beta you find seems unrealistic or inappropriate. Note: You should probably check your beta across a few different sources, because sometimes they vary. Find the current interest rate (yield) for 3-month Treasury bills. Determine an appropriate market risk premium. Be sure to consider the size of your firm when estimating an appropriate premium.
After making your calculations:
• Using all this information, what is the expected return for your company using CAPM?
• In Week 3, you estimated a required rate of return using the dividend discount model. How does your CAPM number compare?
Write up a 1-page summary of your findings, including any calculations you might have made.
Part six
• For this part, your assignment is to calculate the weights (proportions) of debt and equity for your company. For equity you can use the market value of stock (number of shares times the current stock price). For debt, you can use the book value of long-term debt (from the balance sheet). While market values of debt are “better,” they are rather difficult to obtain. Estimate the required rate of return on debt for your company. The following are three possible approaches: a) You can use the credit rating provided by Standard & Poor’s or Moody’s. Use the ratings to find current yields above risk-free rates. b) Go to FINRA Market Data. This will give the yield to maturity for EACH bond. You need one measure of the cost of debt, so you will have to figure out an appropriate way to handle multiple debt issues. c) If your company does not have publicly traded debt (and/or both the previous two approaches did not work), you will need to read the footnotes to the annual report. You may be able to get their estimated borrowing rate. After gathering the information:
• Estimate your company’s weighted average cost of capital. You can use the income statement information to estimate the tax rate.
• If your company uses this in the capital budgeting process (i.e., as the discount rate in NPV and IRR), what assumptions are they making?
• Does your company face any particular difficulties in using this rate? For example, does your company have different divisions or units that might have differing levels of risk?
Write up a 1-page summary of your findings, including any calculations you might have made, and describe which method you used to find the required rate of return on debt for your company.
Part seven
• For this part you will prepare the final section of your Investment Analysis and Recommendation Paper, consisting of the capital structure choices, as well as an executive summary of your research.
You will examine the mix of debt and equity that your firm uses. After finding this information:
• Compare this to an industry average or a main competitor. What are the differences?
• Based on what you know about your selected company, do these differences seem appropriate?
• Relate your company’s capital structure choices to the appropriate capital structure theory (ies).
Also, as a component of your executive summary, obtain the current stock price for your company and use it as an additional calculation. Based upon all of your research, would you recommend investing in this company? Justify your answer.
SAMPLE ANSWER
Ford Motor Group is a multinational public company that’s based in Michigan in the USA. Its shares are traded in NYSE under the initial F. It majors in automotive production and its current Executive chairman is William C. Ford, Jr. while the CEO is Mark Fields. The current brands or models are Ford Focus, Ford Escort, Ford Cortina, Ford Sierra and Ford Capri. There are several other brands that Ford manufactures besides an array of trucks and other automobiles. The Ford Family owns 2% of the company while the employees number about 181,000. It has a market capitalization of $54.65 Billion and its shares are currently trading at $14.09 dollars with a yield of 3.5%. Ford has 9 million outstanding shares while the market prices of its shares are currently costing 14.1 which amounts to a total of $126.9 million in outstanding stock valuation.
Part One
Board of Directors
The directors of Ford Motor Group have impeccable academic backgrounds and experience that warrant their positions. The executive management of the Ford board as at the end of July 2014 was chaired by William Clay Ford Jr., the executive chairman while the CEO was Mark Fields (CEO & President). For the other members of the board see appendix D.
Monitoring Potential of the Firm’s Board of Directors
Mark Fields, the current CEO and President, was initially appointed as the America’s President of operations in the year 2012. (Adams, 2008, p. 46) The board is mostly concentrated in running the operations of the company from the head office. Almost 50% of its annual turnover is achieved in North America while the rest are from South America, Europe, Asia, pacific and Africa. The duties of each director are not included in the reports together with the salaries of other senior staff. The academic background for the senior positions office holders is not available on the 2014 proxy annual report. The performance of Ford Motor Group has not been very impressive and it was expected that it would have more financial problems in the current financial period. However, Ford has endured hard times before and it’s expected that it will come out of financial woes on its own.
Strengths and Weaknesses of Board Structure
The major strengths of the Ford Motor Group board are the wide experience and skills the director’s posses. The executive chairman has been a director since 1988 and has also been the vice president at the commercial truck center before his recent promotion. He has also been the chair of the finance committee and the chairman of eBay Inc. The other board members are also equally skilled and experienced in automobile industry.
The board has also professional structures that vet all the qualifications of the directors before they are appointed. The nominating and governance committee scrutinizes all the background information on all the nominees before their names are forwarded to the board.
The major weaknesses of the board are the lack of clearly defined organization structures that spell out the role of each director and the hierarchy of the functions of their offices and their occupants. The structures are not clear and maybe they have their own system of operations but the structures have to be clearly drawn and the functions of each department clearly defined and addressed. (Corporate Ford Website)
Ethical Concerns
The other ethical issues that may arise is that some directors like Gerald L. Shaheen who may have served as the president of the Caterpillar Inc before he retired may be having the connections with the group hence his interests may also be linked to the company. H e should be allowed to serve the interests of one company only.
The other issue is that the company has some former politicians in the board like the former governor Jon M. Huntsman Jr. It reflects a little unprofessionalism to include some politicians in the board and who may have had different policies that may have been unpopular with some people hence it can influence the performance of the company negatively.
Part Two
Competitive Financial Ratio Comparison
Ratio analysis provides a diagnostic tool that identifies the areas prone to create problems for the company and evaluates the opportunities within the company and its competitors. The ratios of Ford Motor Group provide a relatively positive view of the company. Appendix C provides all the comparisons and ratio summaries for Ford and GM.
The net assets turnover for Ford Motor Group decreased by 2.5% in the year 2013 as compared to a 50% increase in the year 2012. GM registered a decrease of 13% in its net assets turnover in the year 2013 while in the year 2012 it experienced an increase of 6.5%. (Vance, 2003, p. 19)
DuPont Identity
The following is the Dopont model breakdown for Ford and GM. The profit margin for Ford amounted to 13% of sales for both 2013 and 2012. The return on Equity was 27% in 2013 while in2012 it was 36%. The profit margin on sales for GM amounted to 12% in 2013 while in 2012 it was 7%. The ROE for GM amounted to 13% and 17% respectively for the years 2013 and 2012 respectively. The return on assets amounted to 3 and 4% respectively. The earnings per share for Ford in 2013 and 2012 were 1.54 and 1.48 respectively while the dividends per share amounted to 0.4 and 0.2 respectively. Both companies are heavily leveraged and Ford is the one that has the highest concentration of debt compared to GM.
The interest expenses for Ford increased by 16.3% in 2013 while in 2012 it had decreased by 12.7%. The interest expense for Ford in the year 2013 and 2012 were 829 million and 713 million respectively. GM interest expenses decreased by 31.7% in 2013 while in 2012 the expenses decreased by 9.4%. The interest expenses for 2013 and 2012 were 334 Million and 489 Million respectively.
The net assets turnover for Ford’s decreased by 2.5% in the year 2013 as compared to the 50% increase in the year 2012. GM registered a decrease of 13% in its net assets turnover in the year 2013 while in the year 2012 it experienced an increase of 6.5%. The dividend per share for Ford in 2013 and 2012 was 0.4 and 0.2 respectively. (See appendix E) This represented a return of 22% to the shareholders in 2013 while in 2012 it was 23%. (Luenberger, 1997)
Financial Data of Ford Motor Group
The financial performance of Ford Motor Group seems to be better than General Motors for the years 2013, 2012 and 2011. (See table 1
Table 1
Ford (Billions)
Year 2013
Year 2012
Year 2011
Net income
7.15
5.67B
20.21
Revenue
146.92
195.06
135.61
Assets
202.03
189.41
178.35
Equity
26.38
15.95
15.03
GM (Billions)
Year 2013
Year 2012
Year 2011
Net income
5.35
6.19
9.19
Revenue
155.43
152.26
150.28
Assets
166.34
149.42
144.60
Equity
42.61
36.24
38.12
Differences or Trends
The equity multipliers for Ford are higher than those of GM which means that Ford is more levered than GM. (See table 2) and Appendix C for GM.
Table 2
DuPont Analysis
ROE
Profit Margin
Asset Turnover
Equity Multiplier
Ford
Year 2013
0.07
0.72
0.75
7.66
The ratios of Ford Motor Group for ROE and Profit margins are better than those of GM. (See Table 1 & 2 above) The equity multiplier for Ford Motor group is 7.66%. However, the asset turnover for GM is higher than Ford. (See Appendix C) The net assets turnover for Ford’s decreased by 2.5% in the year 2013 as compared to a 50% increase in the year 2012. GM registered a decrease of 13% in its net assets turnover in the year 2013 while in the year 2012 it experienced an increase of 6.5%. The current ratios for Ford Motor group for 2013, 2012 and 2012 were 2.11, 2.32 and 2.26 respectively compared to Gm’s 1.31, 1.3 and 1.22 for the same period respectively. The quick ratios for Ford Motor group for the same period were 1.98, 2.18 and 2.15 compared to GM’s 1.08, 1.02 and 0.95 respectively. Ford Motor Group seems to have higher and better liquidity ratios than GM. The financial stability of Ford Motor Group is more promising that GM’s. The other competitive ratios are attached on the appendix.
Part Three
The information was gathered from the Yahoo’s business finance websites
Dividend Growth Model
The dividend growth model is also known as the Gordon Model. The dividend growth model is a concept that determines the value of stock or a business firm. It utilizes the dividend yield as an investment strategy. Companies with reasonable payouts ratios and profitable dividend yields are considered safe investment. The following are the calculations for obtaining the Dividend Growth model;
Table 3
Growth Rate for Ford Motor Group
Analysis
Formula %
Year 2013
ROE
Net income/ Equity
0.27 %
Retention ratio
1 – (cash dividends/ net income)
0.78 %
Growth rate in earnings (g)
Retention ratio x ROE
0.21 %
For the formula used to calculate the ratios above see appendix E.
The Financial Information and Important Growth Trends for Ford Motor Group for 2013
Ford Motor Group
2013
ROE
Net Income/Equity
0.27
Retention Ratio
1-(cash dividends/net income)
0.78
Growth rate in earnings
Retention rate X ROE
0.21
Dividend Discount Model
Return rate R = Dividend /price of stock + g
0.24
Price of Stock
Dividend/Return Rate R – Growth Rate g
14.07
Issues with Using the Growth Model
The growth model is only an indicator and it cannot guarantee the performance of the company in future. However, it can be used to construct the investment portfolio of a business firm. The dividend earnings growth model for Ford has been calculated on average per year. There are financial periods where the dividend pay rate and amounts are similar hence the growth trend is not reliable as the average is very low. The general average however is 0.212%.
Reasonableness of Constant Growth
The growth rate number is logical as it reflects the general performance on the ground. The major problems with the calculation are the constant figures payable as dividends reflects a constant growth trend and the calculations reflect a zero growth trend. The company pays dividend as shown in the table above. It would be fair assume a constant growth trend for Ford Company.
Part Four
Annual Report
Potential Real Options
The potential real option analysis (ROV) refers to the valuation techniques that are applied in capital budgeting. To undertake some business initiatives or activities such as expansion or investment in capital projects or even abandon some projects is the objective of real call or even put option. Real options are different from the finance options as they are not traded on the securities and the option holders can also influence the real value of the options projects.
Stock Options for Employee compensation for the year 2013
Fair value per stock option
2013
2012
2011
5.03
5.88
8.48
Assumptions made
Annualized Dividend yield
3%
2%
–
Expected volatility
52.20%
53.80%
53.20%
Risk free interest rate
1.50%
1.60%
3.20%
Expected stock option (yrs)
7.7
7.2
7.1
Company stock options as at December 31 2013 (millions)
Outstanding options
Exercisable options
Shares
weighted av life yrs
weighted av Exc price
Shares
weighted av life yrs
Range Prices available in $
1.96 -2.84
15.5
5.2
2.16
15.5
2.16
5.11 – 8.58
23.2
3.1
7.29
23.2
7.29
10.11 – 12.98
29.1
5.3
12.58
19.1
12.56
13.07 – 16.64
11.3
2.8
13.86
9.8
13.71
Total stock options
79.1
67.6
Real options are also known as stock valuations. Several options in investment valuation and analysis depend on the objective of the project. The following is an example of employee stock valuation.
These options are company specific and they are payable on the range of prices available and the average years the employee has spent in the company. The share prices are weighted as shown on the table above. (Garrison, Noreen & Brewer, 2009, p. 65) The stock options would have to be provided for as their prices are usually provided for employees only and not for the general investors.
Capital Budgeting Process
The options would have to be provided for when budgeting for capital projects. All projects with average returns that are less than the weighted average cost of capital should be rejected as the cost of capital would be more the profits of the project.
Part Five
Beta
Beta is used in business finance a means of measuring the investment portfolio risk. A beta of 2 means that for every 1% change in the benchmarks value, the value of a given portfolio changes by 2%. The beta for Ford is 0.88%.
Expected Return – CAPM
The beta for Ford Motor Group according to yahoo business finance is 0.88%. The current risk free market rate is 0.03%. The rate of risk premium is the amount that the expected asset’s rate of return is extra or exceeds the market risk free rate of interests. The risk premium for trading companies is the company stocks or their expected rate of return less the risk free rate of return.
Capm =
rf + β (rm -rf)
rf = risk free rate
3.00%
β = Beta
0.88
rm = return on the market
10.00%
Capm =
9.16%
The average historical equity premium is 6.9%, so 7% is an estimate for the risk premium (Ross, Westerfield & Jaffe, 2013).
The average Capm rate is equal to 6.52% as calculated in the excel formula which is attached. The expected return for Ford Motor Group is 7%. Using the model, the rate of return is 6.52%.
The cost of equity using the capital asset pricing model = Risk Free Rate + Beta * Market Risk Premium = 3+0.88*3= 11.64 (French, 2003, p. 65)
Ford has outstanding shares numbering 3.88 Billion while the market prices of its shares were costing 14.07 which amounts to a total of $54.59 Billion. (Black, Jensen and Scholes, 1972)
The Capital Asset Pricing theory suggests that the cost of capital depends largely on how the asset was initially. The cost of the debt capital, the cost of the equity capital and the weighted average of the two depending on the debt and equity financing represents the actual cost of capital.
Dividend Growth Model versus CAPM
The CAPM is 0.916% compared to the 0.21 %. The differences are not so high but the most logical one is CAPM which is about 1%. However the general trend for the Ford Motor Group has been retrogressive trend at around -0.3. (Appendix B)
Part Six
Debt and Equity
Equity
According to Modigliani and Miller (1958, p. 260) the cost of equity capital is mostly determined by the asset’s cost of capital and not the other way round.
Ford has outstanding shares numbering 3.88 Billion (see table 5) while the market prices of its shares were costing 14.07 which amounts to a total of $54.59 Billion. The Capital Asset Pricing theory suggests that the cost of capital depends largely on how the asset was initially financed (Bierman & Smiddt, 1966). The cost of the debt capital, the cost of the equity capital and the weighted average of the two depending on the debt and equity financing represents the actual cost of capital. (Black, Jensen and Scholes, 1972, p.80)
Table 5
Ford’s Market Value of Equity
Company name
Year 2013
Shares outstanding
3.88B
Price as of 14.07 per share
Market value of equity
54.59B
26.83B
CAPM
6.52%
The rate of Capital Asset Pricing model for Ford Motor Group is 6.52%.
Debt
Interest payments that are payable by lenders are all deductible from the ones or a company’s taxable income while the payments to shareholders as dividends are not. Most tax systems encourage the companies to use debt financing instead of equity. (Black, Jensen and Scholes, 1972, p.118) The higher the interest rates the higher the incentive. The interest expenses for Ford increased by 16.3% in 2013 while in 2012 it had decreased by 12.7%. The interest expense for Ford in the year 2013 and 2012 were 829 million and 713 million respectively. GM interest expenses decreased by 31.7% in 2013 while in 2012 the expenses decreased by 9.4%. The interest expenses for 2013 and 2012 were 334 Million and 489 Million respectively. (Bodie, Kane, Marcus, 2008, p. 303)
The capital structure for Ford is mostly made up of borrowed money. In 2013, the long-term debts amounted to $114, 688 million while in 2012 and 2011 the debts amounted to 105, 058 and 99488 respectively. The total stockholder equity amounts to $26,383 Million and $15,947 million for the same period. Ford Company is highly levered and it needs to cut down on borrowing. General Motor’s long term debts amounted to $6573 Million and $3424 Million for the year 2013 and 2012 while the total stockholders equity amounted to $42,607, $36,244 and $38120 for the years 2013, 2012 and 2011. Gm is relatively levered. (Markowitz, 1959, p. 78)
The credit ratings for Ford currently are CCC+ from S & P performance of CC in 2012. Ford managed to pay its 9.9 Billion debts in the year 2014 and it helped to boost its credit rankings. Ford credit rankings place it in front of GM and Chrysler and they are currently fitting hard to avoid bankruptcy petition. (Luenberger, 1997, p. 48)
Table 6
Cost of Debt for Ford Motor Group for the year 2013
Company name
2013
Long term debt
Current Portion of Debt
Total Debt
114.69B
–
114.69B
Cost of Debt %
7%
Tax Rate
40
The cost of debt for Ford Motor Group is 7%, a rate which is fairly affordable. Given the current ratio of 2.11 Ford can comfortably afford to pay its debts.
Table 7
Calculations for Weighted Average Cost of Capital for Ford Motor Group
Ford
Value $
%
Equity (Rs)
26.38B
18.7
Debt (Rb)
114.69
81.3
Total Value
141.07
100Rs
The formula for calculating the weighted average cost of capital is:
Ford
Value
%
Equity(Rs)
26.38
0.87
Debt(Rb)
114.69
0.13
Total Value
141.07
1
Rwacc
3.98%
The WACC for Ford Motor Group is 3.98% which reflects a favorable position compared to its cost of debt which is 7%. (See Table 6 & 7 above)
Capital Budgeting Assumptions
The major assumptions are that the tax rate is 40%. Following the losses incurred by ford in its foreign branches no taxes were chargeable in 2013.
Competitive Review of Debt and Equity Mix
The average weighted cost of capital is higher for Ford than GM. In 2013, the WACC for Ford has a WACC of 3.98% while for GM it was 3.16%. Ford Motor Group seems to have slightly more debts compared to GM.
Competitive Review
GM
Value
%
Equity(Rs)
42.61
0.87
Debt(Rb)
6.57
0.13
Total Value
49.18
1
Rwacc
3.16%
Part Seven
Capital Structure Theories
According to Modigliani and Miller (1958, p. 261) the cost of equity capital is mostly determined by the asset’s cost of capital and not the other way round.
Ford has outstanding shares numbering 3.88 Billion while the market prices of its shares were costing 14.07 which amounts to a total of $54.59 Billion. The Capital Asset Pricing theory suggests that the cost of capital depends largely on how the asset was initially financed (Bierman & Smidt, 1966, p. 300). The cost of the debt capital, the cost of the equity capital and the weighted average of the two depending on the debt and equity financing represents the actual cost of capital. (Black, Jensen and Scholes, 1972, p. 120)
Some theories of the Capital assets pricing model, have been applied in relation to heterogeneous beliefs and risk free lending rate elimination (Black, 1997, p. 444).
Summary
Ford Motor Group financial performance seems to be improving as in the year 2013 it had a Gross Profit 7.9% as opposed to 2012 when it decreased by 5% from the previous year. The GP for General Motors on the other hand increased by 70% in the year 2013 while in the year 2012 it decreased by 43%. The net profit for Ford for the same period increased 26% in 2013 while in 2012 it decreased by 72%. GM registered a 13.7 % reduction in 2013 while in 2012 it registered a further reduction of 32.7%. The total shareholder’s equity for Ford increased by 65.5% in 2013 while in 2012 it increased by 6%. General Motor’s shareholders equity increased by 17.6% in 2013 while in 2012 it decreased by 4.9%. In 2012 Ford Motor Group reduced its total liabilities by almost 70% while GM increased its total liabilities by 15.6% in 2013. The sales revenue for Ford increased by 10% in 2013 while GM sales for the same period increased by 2.1%. Ford total sales revenues increased from $133,559 million in 2012 to $146,917 million in 2013. GM sales for the same period were 152256 million and 155427 million from the same period respectively. The interest expenses for Ford increased by 16.3% in 2013 while in 2012 it had decreased by 12.7%, GM interest expense decreased by 31.7% in 2013 while in 2012 it decreased by 9.4%. (Bodie, Kane, Marcus, 2008, p. 303)
The ratios for Ford also indicate that the liquidity ratios are above average for all the years for Ford Motor Group. The current ratios were 2.11, 2.32, 2.26 for the years 2013, 2012 and 2011. The quick ratios also indicated a positive trend. The Times interest earned for the year 2013 for Ford were 9.45, 11.83 and 11.63 for the years 2013, 2012 and 2013. The interest cover for the same period indicated the same results like Times interest earned. (Drucker, 1999, p. 155)
The ford Family owns 2% of the company while the employees number about 181,000. It has a market capitalization of $54.65 Billion and its shares are currently trading at $14.09 dollars with a yield of 3.5%. (Ross, Westerfield & Jaffe, 2013, p. 175) The net asset turnover for Ford decreased by 2.5% in the year 2013 as compared to a 50% increase in the year 2012. GM registered a decrease of 13% in its net assets turnover in the year 2013 while in the year 2012 it experienced an increase of 6.5%. The dividend per share for Ford in 2013 and 2012 was 0.4 and 0.2 respectively. This represented a return of 22% to the shareholders in 2013 while in 2012 it was 23%.
Ford Motor Group has a great potential to return to great profitability and also be able to pay off all its outstanding debts. The Current ratios and the quick acid test ratios indicate that Ford Motor Group has a stable liquidity and with the right leadership it would be able to make more profits like the earlier years. Given all these factors I would definitely invest my money in Ford Motor Group but I would be cautious besides I would also be requiring a plan on how the management of the company would be proposing to settle the huge loans that it owes several financiers. Ford may be earning some profits but it has a lot of debts that are four or five times its total equity. The classification of shares as common shares and also class B shares that have unequal voting rights is also some disquietedness among the shareholders.
Reference
Adams, S. (2008) Fundamentals of business economics. Financial Management (UK), 46–48.
Bierman, H. and Smidt. S. (1966).The Capital Budgeting Decision—Economic Analysis and Financing of Investment Projects. New York, NY: Macmillan Company. 300-55
Black, F. (1997) Capital Market Equilibrium with Restricted Borrowing, Journal of Business, July, 45:3, 444–55.
Black, F., Jensen, M.C. and Scholes, M. (1972) “The Capital Asset Pricing Model: Some Empirical Tests,” in Studies in the Theory of Capital Markets. Michael C. Jensen, ed. New York, NY: Praeger, 79–121.
Bodie, Z., Kane, A., Marcus, A. J. (2008). Investments (7th International Ed.) Boston: McGraw-Hill. 303.
Drucker, F. (1999) Management Challenges of the 21st Century. New York, NY: Harper Business. 150 – 55
Ford Motor Company Annual Report (2013) Delivering Profitable Growth for All, www. corporate ford.com
Fama, E. F, French, K. R (2004). “The Capital Asset Pricing Model: Theory and Evidence”. Journal of Economic Perspectives 18 (3): 25–46.
French, C. W. (2003). “The Treynor Capital Asset Pricing Model” Journal of Investment Management 1 (2): 60–72.
Garrison, R., Noreen, W. & Brewer, P. (2009) Managerial Accounting, New York, NY: McGraw-Hill Irwin. 65 -70
Gordon, M. J. (1962). The Investment, Financing, and Valuation of the Corporation. Homewood, IL: R. D. Irwin.
General Motors Company Annual Report (2013) www. corporate gm.com
Khan, M. (1993) Theory & Problems in Financial Management, New York, NY: McGraw Hill
Luenberger, D. (1997). Investment Science, Oxford University Press, Oxford: 48 – 75.
Markowitz, H. (1959) Portfolio Selection: Efficient Diversifications of Investments. Cowles Foundation Monograph No. 16. New York, NY: John Wiley & Sons, Inc. pp. 77 – 91.
Modigliani, F. and Miller, M. (1958) “The Cost of Capital, Corporation Finance, and the Theory of Investment,” AmericanEconomic Review, June, 48:3, 261–97.
Ross, S. A., Westerfield, R. W., & Jaffe, J. (2013) Corporate finance (10th Ed.) New York, NY: McGraw-Hill Irwin. 175.
Vance, D. (2003) financial analysis and decision making: tools and techniques to solve financial problems and make effective business decisions. New York, NY: McGraw-Hill.
Appendix A
The Historical Share Prices for Ford Motor Group
Date
Shares
2013
Low
High
Average
% Trend
1-Sep
16.21
17.35
16.78
8-Sep
17.1
17.68
17.39
3.63528
15-Sep
17.3
17.7
17.5
0.632547
22-Sep
16.69
17.34
17.015
-2.77143
6-Oct
16.35
17.12
16.735
-1.64561
13-Oct
16.92
17.55
17.235
2.98775
20-Oct
17.39
18.02
17.705
2.727009
27-Oct
16.76
17.72
17.24
-2.62638
4-Nov
16.55
17.2
16.875
-2.11717
11-Nov
16.64
17.2
16.92
0.266667
18-Nov
16.82
17.18
17
0.472813
2-Dec
16.42
17.2
16.81
-1.11765
9-Dec
16.2
16.79
16.495
-1.87388
16-Dec
15.17
16.99
16.08
-2.51591
23-Dec
15.1
15.5
15.3
-4.85075
30-Dec
15.25
15.64
15.445
0.947712
2014
6-Jan
15.35
16.11
15.73
1.845257
13-Jan
16.08
16.78
16.43
4.450095
20-Jan
15.78
16.68
16.23
-1.21729
27-Jan
14.9
16.01
15.455
-4.77511
3-Feb
14.4
15.13
14.765
-4.46457
10-Feb
14.78
15.36
15.07
2.065696
24-Feb
15.07
15.46
15.265
1.293962
3-Mar
15.03
15.83
15.43
1.080904
16-Mar
15.16
15.74
15.45
0.129618
30-Mar
15.48
16.49
15.985
3.462783
6-Apr
15.59
16.17
15.88
-0.65687
20-Apr
15.71
16.44
16.075
1.22796
27-Apr
15.75
16.2
15.975
-0.62208
4-May
15.43
15.95
15.69
-1.78404
11-May
15.55
15.9
15.725
0.223072
25-May
16.05
16.56
16.305
3.688394
8-Jun
16.5
17.12
16.81
3.097209
15-Jun
16.38
16.87
16.625
-1.10054
22-Jun
16.68
17.29
16.985
2.165414
29-Jun
17.07
17.4
17.235
1.471887
6-Jul
17.05
17.49
17.27
0.203075
20-Jul
17.51
18.12
17.815
3.155761
27-Jul
16.72
17.85
17.285
-2.97502
3-Aug
16.74
17.14
16.94
-1.99595
10-Aug
17.11
17.49
17.3
2.125148
17-Aug
17.51
17.52
17.515
1.242775
24-Aug
17.19
17.49
17.34
-0.99914
31-Aug
16.94
17.87
17.405
0.374856
7-Sep
16.5
16.87
16.685
-4.13674
14-Sep
16.16
16.77
16.465
-1.31855
28-Aug
14.44
16.4
15.42
-6.3468
5-Oct
13.52
14.7
14.11
-8.49546
12-Oct
13.26
14.25
13.755
-2.51595
19-Oct
13.65
14.49
14.07
2.290076
-15.6592
Trend
-0.31957
Source: www. Yahoo business Finance
Appendix B
The Financial Ratios of Ford Motor Group
Ford Motor Group
2013
2012
2011
Current Ratio
Total Current Assets/Total current liabilities
2.11
2.32
2.26
Quick Ratio
TT C/ Assets – inventories /TT/ C Liabilities
1.98
2.18
2.15
Receivable turnover
Annual credit sales/average receivables
Inventory Turnover
Cost of goods sold/Average inventory
17.00
17.51
19.87
Asset turnover
Sales/Average total assets
0.75
0.73
0.76
Dividend yield
Div per Share / Current Share price
0.03
0.01
Dividend cover
EPS/ Dividend per Share
3.70
7.40
Net assets turnover
Net assets / total sales
1.24
1.27
0.85
Times interest earned
EBIT/Annual Interest Expense
9.45
11.83
11.63
Debt to total Asset
Debt/Assets
0.57
1.03
0.56
Book value per share
9.17
9.17
9.17
Interest cover
EBIT/Annual Interest Expense
9.45
11.83
11.63
Profit margin on sale
GP/sales
0.13
0.13
0.14
R.R return on assets
EAT/Total Assets
0.04
0.03
0.11
R.R com stock equity
Profit after taxes/Shareholders equity
0.27
0.36
1.35
Earnings per share
Profit after taxes-pref div)/No. of comm O/S
1.54
1.48
Payout Ratio
cash dividends/income
0.00
0.00
0.00
ROE
Return On Equity (ROE)
0.27
0.36
1.35
ROA
Return on average Assets
0.04
0.03
0.11
Source: (Ford Motor Group Annual Report, 2013)
Appendix C
The Financial Ratios for General Motors
GM
2013
2012
2011
Current Ratio
Total Current Assets/Total current liabilities
1.31
1.30
1.22
Quick Ratio
TT C/ Assets – inventories /TT/ C Liabilities
1.08
1.02
0.95
Receivable turnover
Annual credit sales/average receivables
Inventory Turnover
Cost of goods sold/Average inventory
9.56
9.74
9.16
Asset turnover
Sales/Average total assets
0.93
1.02
1.04
Dividend yield
Div per Share / Current Share price
Dividend cover
EPS/ Dividend per Share
Net assets turnover
Net assets / total sales
0.27
0.24
0.25
Times interest earned
EBIT/Annual Interest Expense
23.33
-57.68
17.99
Debt to total Asset
Debt/Assets
0.04
0.02
0.02
Book value per share
Interest cover
EBIT/Annual Interest Expense
23.33
-57.68
17.99
Profit margin on sale
GP/sales
0.12
0.07
0.13
R.R return on assets
EAT/Total Assets
0.03
0.04
0.06
R.R com stock equity
Profit after taxes/Shareholders equity
0.13
0.17
0.24
Earnings per share
Profit after taxes-pref div)/No. of comm O/S
2.92
Payout Ratio
cash dividends/income
ROE
Return On Equity (ROE)
0.13
0.17
0.24
ROA
Return on average Assets
0.03
0.04
0.06
Source: General Motors Annual Report.
The data was obtained from the annual reports but the calculations were done using excel while applying the formulas shown on the tables.
Appendix D
Members of the Ford Motor Group Executive Board
Richard A. Gephardt, Ellen Marram, Stephen Butler, Kimberly Casiano, Edsel Ford, Homer Neal, Antony F. Earley, James P. Hackett, John L. Thornton, Gerald L. Shaheeen, James H. Hance, Jr., William W. Helman John C. Lechieter, James H. Hance and Jon M. Huntsman.
(Ford Annual Report, 2013, p.7)
Appendix E
The formula for calculating the Return on Equity (ROE) for Ford Motor Group
The formula for calculating the Dividend Discount Model for Ford Motor Group
Dividend Discount Model (DDM) =
Financial Data for Ford Motor Group
Ford Motor Group (Billions)
Year 2013
Net income
$ 7.16
Equity
$26.38
Total dividends paid
$1.57
Outstanding shares
3.88
Earnings per share (EPS)
$1.82 (dollars)
Dividends paid per share
$0.4 (dollars)
Stock price as of 2/11/2014
$14.07
Source: Ford Group Annual Report for 2013
We can write this or a similar paper for you! Simply fill the order form!
This paper is critical and it is a continuation of the policy change proposal paper that you have been written for me . Take a look at the details below and most importantly base on the two examples provided complete the paper. It is critical that it must be written in expository style , that’s part of the requirement of this paper and the writer must follow that . You will use chose one of the examples below and write the paper base on my propose amendment that is also included hear below. I will strongly advice that the writer read my previous paper with references below to fully understand the other parts of the paper. I will also send the instructions as a word document in the file section just if the table doesn’t come out when I copy and paste as it will be very important to also include the table in the completed paper since it is the scorecard.
I will send the details of the assignment as an attached file under the file upload instead of copying and pasting hear.
SAMPLE ANSWER
Scoring the Financial Criteria Against the Policy Change Options
Policy change option
These policy change options include, major changes, incremental changes and do-nothing change. Incremental changes are best when the issue is complex and takes place in stages (Mason, Lavitt & Chaffee, 2013). Do nothing change is where things are left to run as usual while major changes happens ones as here is no re-evaluation stages.
Measurable goals
Public education in regard to use of the contraceptives as well their side effects and other benefits
Worker engagement to determine whether or not they understanding the implication of the amendments
Engagement of organizations opposed to the bill to enable them support the bill
Financial Criteria
Instituting policy change requires financial support. Substantive funding stream is the funds available to support policy amendment. For the federal government to amend section 5316 of PL 111-148, it will be obliged to fund the amending section through taxes, Medicaid and Medicare. Taxes will directly affect the middle class while other category of population will be indirectly affected through higher insurance premiums, increased cost of goods and low wages. Taxpayers and government agencies will continue to support the funding for section 5316 of PL 11-148 n to meet both current and future demands. Political feasibility is a situation where a bill is sustainable after legislation to warrant its enactment. The bill must therefore have enough votes to pass a legislative body to be implemented within a certain period for it to be considered politically feasible (Sullivan, 2014).
Pros and Cons for Policy Change Options
Pros for Doing Nothing
If nothing is done, the plan cannot precede immediately, hence time to ponder about its viability again
If nothing is done, funding of the previous programs will go on as earlier planned
Cons for Doing Nothing
If nothing is done, there will be no funding, hence, status quo remains
If nothing is done, workers will shoulder the burden of paying for their birth control cover.
If nothing is done, birth control would not be provided to workers as part of their employment insurance cover.
Pros for Incremental Change
An incremental change will allow continuous evolution of the policy during the phases
An incremental change will increase the number of workers under insurance cover
An incremental change will maintain productivity hence impact positively on employment opportunities
Cons for Incremental Change
An incremental change means high expenses through evaluations and institutions of other changes.
This will require more time compared to major changes
With this kind of changes, policy makers have adequate time to repeal
Pros for Major Change
Major changes will makes it easier for the workers to take cover
Major changes will help the workers and the employee to agree on the modalities quickly
Major changes will ensure regulation of birth among workers
Cons for Major Change
Major changes may not be well thought ought to take longer to create.
Major changes may require long period to develop
Major change will result in increased employee deductions.
Policy Option Analysis Scorecard
Do Nothing Option
Incremental Change
Major Change
Criteria
Substantive Funding Stream
+
+
–
Likelihood of Ongoing Funding
+
+
–
Ability to Meet Current/Future Demands
–
+
+
Political Feasibility
+
+
–
3+/1-
4+
1+/3-
Score for Each Alternative
2
4
-2
(Mason, Leavit, & Chaffee, 2012)
Summary
As based on the scorecard analysis provided above and pros and cons analysis, the incremental change policy option will be used to implement the proposed amendment because the option totaled a plus four. Implementing the policy through incremental change policy will ensure that all the stakeholders understand the process and appreciate the same. They will therefore render their support to the process.
Part A
James Cookie is a ship’s officer employed by Sails International Inc, a company incorporated in Bermuda that owns cruise boats and operates passenger cruises in the Pacific Ocean.
James owns a house in Sydney which was formerly his family home but his estranged wife and children now live in Singapore. James rents the house to his cousin and family. The house is let fully furnished; the furniture belongs to James. Whenever he is in Sydney, James stays in the house and has his own room in which are stored his personal belongings. In the current income year James spent 80 days in the house. The remainder of the time was spent on a cruise ship except for 20 days spent visiting his children in Singapore.
The ship on which James serves visits a variety of ports, mainly in the South Pacific. James’s employment contract was negotiated and signed in Hong Kong.
Required 1: For Taxation purposes, is James a resident of Australia? What is the source of his salary from Sails International? Required 2: If James sold his house, would he be entitled to the main residence exemption in Subdiv 118-B?
Part B
On 1 July 2012 Lee commenced business as an architect. He operated as a sole proprietor from a converted garage at the rear of his residence. Much of his work consisted of preparing building designs and specifications for local council building permits but he quickly gained a reputation for quality drawings prepared within tight timeframes. By the end of 2012/13 he had a small client base of local builders and private referrals and billings (fees) of $75,000.
During the year Lee submitted a design as part of a national competition for the Citadel, the centrepiece of an urban redevelopment. His visionary design and revolutionary use of local materials left the judging panel speechless with admiration and, to national acclaim, he was awarded the prize and commissioned to build the structure. Immediately he borrowed $1 million, rented premises on Main Terrace, acquired state of the art equipment and employed six draughtsmen and two administrative staff. During 2013/14 his billings were $1.75 million.
Required Should Lee return on a cash or accrual basis in 2012/13 and 2013/14?
You must refer to appropriate case law. Your answer must include (but should not be limited to) a discussion of the following: • What factors affect the choice of a cash or accrual basis? • Does Lee have a choice of the basis he adopts? • Does the Commissioner of Taxation have a right to insist on a particular basis? • Should Lee’s basis be the same in both years?
SAMPLE ANSWER
Part A.
Introduction
Income tax is generally payable annually by residents or non residents who are receiving income in Australia provided the income was derived, earned or accrued while living in Australia. The returns earned from a business operated partly in or out of the country i.e. Australia are considered to have accrued in totality from Australia. All the income earned from investments, sale of personal property or any other income is subject to taxation. (Renton, 2005)
The residents of Australia are basically taxed on their global income and from all sources but temporary residents mostly have their income from foreign exempted. Foreign residents are basically taxed on the income whose source is n Australia for example on the income they have earned while working in Australia. The residents of Australia pay lower rates of taxes than their foreign counterparts. (Centrelink website, 2013)
For tax purposes one is considered an Australian resident if one has lived in Australia entirely or has come to live in Australia permanently or if one is an Australian but travelling abroad temporarily and has not built or bought a permanent home in a different country or out of Australia. The other situations refer to students who have travelled to Australia to study for more than six months continuously or if a foreigner has been working in Australia continuously for more six months or even more and mostly living and working in the same place or one has been living in Australia for at least more than half of the financial year unless a person has an oversees home and does not intend or plan to live in Australia. The income tax assessment ruling IT 2650 of permanent place determination which is also related to case IT 2607 under the ATO ID 200/179 puts more emphasis on the place of resident.
It defines a resident as a person who is domiciled in Australia unless the commissioner is convinced and satisfied that the permanent place is not Australia as was illustrated in the case of Henderson v Henderson (1965) 1 All E.R.179.
James Cookie works for a foreign company that has been registered in Bermuda that owns and operates passenger cruises across the Pacific Ocean. He owns a house that he inherited from his parents in Sydney, Australia. By virtue of his inheritance and parentage he is an Australian citizen. But he has rented the family house to his relatives who live in the house but the furniture and one of the rooms belongs to him. In the current year he spent only eighty days in the house while most of the other days he was away. For tax purposes he will be considered as a resident as he has no other permanent home even though the company he works for is foreign based. All his income will be subjected to taxation in Australia together with the rent that he receives from his inherited house that he rents for his relatives. If the salary is taxed by the Bermuda tax authorities then he has to apply to be considered for tax reduction if there are tax treaties under the Australian Treaty Series agreements between the two countries. Australia has tax agreements with close to forty countries globally. If an Australian resident receives income or any kind of benefits from these countries, he can apply for a reduction in his withholding tax or alternatively to be exempted from the payment of tax in these other countries. These can be achieved by supplying the Australian tax office with a tax relief form and or a certificate of the status of residency.
The determination of the permanent place of abode is important. The taxpayer’s permanent, fixed and also habitual place of residence or abode is his home. James home is in Australia and he has no other permanent home. As in the case of F.C. of T v Jenkins (1982) ATC 4098, a permanent abode connotes an enduring relationship that develops as an attachment to a particular place of abode. The residency will determine his tax liability and not the length of stay in Australia for a particular year.
The tax liability is usually determined annually and a person must have a place of permanent residence. James will be taxed by the Australian authorities because his place of abode is in Australia not withstanding that his earnings are from a different country and he hardly lives in Australia. James intentions are to return to Australia eventually at the end of the transitory stay abroad qualifies him to be an Australian resident for tax purposes.
However, if James had been working and living in Bermuda, he would be considered a non resident for tax purposes but his income from the inherited properties that he has rented to his relatives would still be subjected to taxation in Australia as in the case of F.C of T V Applegate (1979) ATC 4307.
The source of his income is from Bermuda and its subject to taxation in that country if he resides their or has some residence in that country.
The circumstances are similar to the case of ATO ID 2005/249 where the taxpayer was present in Australia for less than 183 days. The decision under section 6-5 of the income Tax assessment Act of the year 1997 (ITAA 1997) was that he was not obliged to pay any taxes as he was a non resident.
If James sold his house in Australia then he would be a non resident for tax purposes and he would not be entitled to the main residence exemption in Subdivision 118-B. (ATO, 2005) The case of ABB Australia Pty Ltd V FC of T (2007) ATC 4765 illustrates the withholding of tax by a non resident company which was also a shareholder of resident, the ABB of Australia who was also the applicant. The facts are also similar to the case of Federal Commissioner of Taxation v French (1957) 98 CLR 398. The case emphasized that the exertion of an employee must be at the place where the exertion took place and it’s the source of the earnings where the operations of a business take place. For this case it’s Bermuda.
Part B
Lee should make his returns based on the cash basis for the year 2012/13 and 2013/14.
Taxes collected or even paid can either be reported as cash or accrual to the Australian Tax Office. The major difference between the two is determined or connected with the liability of recording the tax implications and payments.
When receipt of income is reported in cash basis then no taxes will be payable to ATO until all the amounts have been collected from the customers. One will also not be allowed to claim any tax benefits or claims that have been charged by the suppliers until one pays the suppliers. The reported amounts will actually represent 1/11th of the monies paid or even received during the financial or tax period.
Accrual based payments is when the tax liability is recognized when the invoice is received and one has legal obligation to pay all the suppliers and also to receive the payment after supplying goods to the customers.
For example, in cash basis, one is liable to pay the tax after receiving payments from the debtor. If one sells a TV set for ten thousand dollars on credit and the tax is 1000 dollars, the tax will be paid when the client pays for the TV set regardless whether it takes six months or one year. If he doesn’t pay for the TV set then the GST on the TV set will not be paid. The accounting system is based on the receipt system.
On accrual basis is the opposite, one is obliged to make the payments once the invoice has been raised regardless whether the client has paid for the TV set or not also one can claim the GST from the suppliers even if he has not paid them. The accounting system is based on the earnings method.
The factor that may determine is basically the nature of the trade or industry involved. The service industry bases most of their payments on the cash basis especially such fields as engineering and architecture whose payments are materially large and are paid in phases. It’s not practical to use the accrual basis of making the tax payments. Lee may have a choice on what basis to use but the accrual basis is basically not practical. If the money to support his operations have been borrowed it’s not possible for him to pay the tax when he has not received the payments.
The commissioner has a right to insist on the mode of tax payments if the systems as companies in the fast moving consumer goods industry have no reason to use the cash basis as most of their products are paid on delivery or on scheduled periods that can be synchronized to allow the accrual basis to operate effectively. Under sec 29-45 of the Australian GST Act, provides that a person can apply to the commissioner for authority to use the cash basis only after some requirements under the act have been met. The case of Lee is applicable as first, the nature and size of his business cannot allow him to use the accrual basis. He actually had to borrow some money from the bank to facilitate his operations as he is anticipating to be paid in future and as such there is no way he can make the tax payments before he has been paid his monies.. The tax is also on the higher side he cannot afford to make the payment before he has been paid for the work done. The nature of the accounting system applicable is also different.
Lee has little choice on the basis of accounting procedure to adopt unless he applies to the commissioner for approval while also outlining the appropriateness and the need for the change. The commissioner may also find it appropriate to allow him to use the cash basis. The case of ABB Australia Pty Ltd V FC of T (2007) ATC 4765 illustrates the withholding of tax by a non resident company which was also a shareholder of resident, the ABB of Australia who was also the applicant. The commissioner, submitted that for the purposes of identifying the right accounting basis, a company has to be classified as a trading company as in the case of Carapark Holdings Ltd v Commissioner of taxation (1966) 115 CLR 653 and Broken Hill Pty Co. Ltd v Federal Commissioner of Taxation (1999) 99 ATC 5193. A company such as the ABB Zurich that had over 1000 subsidiaries was actually a prima facie type accruals basis taxpayer as the nature of its trading activities are solely conducted for the major purpose of earning dividends which is the major objective of the company. The commissioner contended that the basis of making taxation returns must be the actual appropriateness of business operations and the mode of receiving the income.
The consistency of the accounting method adopted should be upheld until it’s no longer applicable or appropriate. These may occur when the tax payer’s business circumstances reflect that the cash method of accounting is more appropriate for determination of income tax. It may occur mostly because of business expansion or change in the operations or nature of the business.
In the case of FCT v Dunn, Davies J, mentioned that it was the appropriateness of the circumstances of the business operations and how the books and records are maintained that determines the relevant accounting practice to be adopted. The same case applied when Dixon J, in the case of Carden’s case, said that the considerations of each case are important as the nature of the profession or trade have to be considered as to the mode of accounting method to be adopted. The earnings method or the accruals basis largely applies where circumstances are not clear and also where there are conflicting indicators as to the method of accounting to be adopted subject to subsections 6-5(1) to (3) of the ITAA of the year 1997. The weight that should apply to the method of accounting largely depends on the course, appropriateness and the relevance of the specific case as illustrated by the case of Broken Hill Pty Co. Ltd v Federal Commissioner of Taxation (1999) 99 ATC 5193.
The commercial and also the general accounting principles, guidelines and practices that are maintained by companies require all companies to adopt the accrual or the earnings method of accounting or book keeping.
For example, Keith who is a plumber is normally contracted to perform repair broken pipes and drainages in personal homes while at times he has to purchase some materials. He accounts for his income from his business on receipt or cash basis. The material he purchases are not directly bought from his income and does not affect his work so much as his work is mostly from his services and not from the resale of materials. The method of cash basis suits his nature of work. For tax purposes, it’s substantially correct as it reflects the nature of Keith’s business income.
In ATO ID 2014/1 changing from cash basis to accrual basis accounting, the relevant sections of the case where the taxpayers business had grown and it was imperative for him to change the nature of the accounting method as in the case of Arthur Murray (1965) 14 ATD 98.
Combining assets to obtain a superior balance between risk and return
Combining assets to obtain a superior balance between risk and return
How an investor can combine different assets to obtain a superior balance between risk and return
Order instruction
We aim to improve your understanding of how, in theory, an investor can combine different assets to obtain a superior balance between risk and return, and how traded options (one of the most common forms of derivative) work. You will also apply what you have learned to comparing the relative merits of investment funds.
Hints: Part A
In Part A, Question 1 is designed to help you build up your understanding of Markowitz efficiency and portfolio theory. You will find it useful to look back at Online Unit 3 and Chapter 3.
In your answers to Questions 1c(ii) and 1d, you are recommended to first practise using the Portfolio segment of the Investment Tool by working through the teaching and activities in Online Unit 3. You need to consider data from both the Performance and the Risk/Return tabs in the Portfolio segment, and you are advised to try different combinations of the securities specified before deciding on your answer. You could use diagrams to illustrate your reasoning either by copying and pasting the relevant diagram(s) from the Investment Tool (the Investment Tool guidance instructs you how to do this) or, if you prefer, by making your own copy of the diagram(s) shown in the Investment Tool.
Question 2a requires you to briefly explain the type of option that best fits each objective and how this would work. For Question 2b, you are not expected to give precise calculations, but an answer could be illustrated with actual numbers if you wish. A similar example, for the alternative case of put options, is provided in Activity 4.3 of Online Unit 4.
Question 2c requires you to think about the profile of investors described in the extract (age, goals, life-stage, expertise). You may find it useful to refer back to some of the investment risks considered in Chapter 2 of the module textbook. You do not need to write long answers. Question 2d does not require you to use the extract but instead to use material in the module to provide some explanation about the wider risks of trading options and derivatives.
Hints: Part B
Question 3 requires you to write an essay that draws on the information provided in Table 2, showing that you have thought about what an investor might expect from investment funds. This essay should include definitions of the terms ‘active’ and ‘passive’, as well as comments and definitions of the different performance indicators; it should also describe how these relate to relevant theory, such as the Capital Asset Pricing Model.
Part A – Question 1 – 1000 Words
a. Explain what is meant by an efficient frontier in portfolio theory. (4 marks)
b. Briefly explain what would be the rationale for a tyre manufacturer, in a relatively wet country like the UK, to keep producing tyres that are needed in dry weather. (2 marks)
c. Gemma has just been given some shares in easyJet. She would initially like to combine these in a portfolio with another share.
i. If she has only the information in Table 1 available, identify which asset would be sensible to choose and why. (2 marks)
ii. Using the Investment Tool (Portfolio segment), calculate the optimal proportions of such shares in Gemma’s portfolio to minimise its risk. Report the risk and the expected annualised return of such a portfolio. (5 marks)
d. Gemma is not happy with this outcome and would like to use one of the shares in Table 1, in combination with easyJet, to construct a portfolio with a much greater expected return (above 20%) but a risk no greater than 5%. Using the Investment Tool (Portfolio segment), identify:
i. which of the four remaining shares would allow such a combination
ii. the minimum risk that can be achieved for this portfolio while still reaching an expected annualised return of at least 20%
iii. the proportion of easyJet shares in this new portfolio. (6 marks)
e. Briefly explain why Gemma would not adopt a stock-picking strategy, of the type described in 1c and 1d above, if she believed in the semi-strong form of the Efficient Markets Hypothesis? (6 marks)
Table 1: Correlation coefficients between monthly real returns
BSkyB
Glaxo
Diageo
Rolls-Royce
Tesco
easyJet
0.15
0.12
0.37
0.40
0.22
Question 2
Read the extract below and answer the following questions.
a. Briefly explain which options could be used by Mark Brisley and Evie Petrikkou to:
i. protect their portfolio of shares (3 marks)
ii. increase their income. (3 marks)
b. The last two paragraphs of the extract give an example of the potential gains and losses that can be made from issuing a call option. Explain how the potential loss per share would increase if the issuer of the call option no longer owned the shares. (7 marks)
c. Describe two risks of option trading for ‘do-it-yourself investors’: baby boomers such as those described in the extract. (6 marks)
d. Considering the entire market of derivatives, briefly explain how they could affect systemic risk. (6 marks)
New baby boomer hobby: trading options
After the financial crisis of 2008 hit their stock portfolio hard, Colorado Springs information technology contractor Mark Brisley and his wife Evie Petrikkou were worried. Casting about for a way to make up big losses, the two hit upon a strategy often considered the purview of Wall Street insiders: They could trade options.
Brisley began with the basics, buying and selling ‘puts’ – contracts that convey the right to sell a stock – to earn a little bit extra and protect the family portfolio from another debacle. Initially, he didn’t dabble in ‘calls’ – contracts that convey the right to buy a stock.
Now, five years later, he is a habitual trader who has embraced increasingly arcane options strategies. ‘We treat it almost like a business,’ says Brisley, 51.
Brisley may be the new typical options player – a do-it-yourself investor with a touch of gray. The average options trader now is 53 years old; 28 per cent of all options users are between the ages of 55 and 64, according to the Options Industry Council, a trade group. And those mom-and-pop enthusiasts have pushed trading volume up 16 per cent a year (by number of contracts) for the past decade, according to the Chicago-based OCC, the world’s largest equity derivatives clearing organization
When Fred Tomczyk, chief executive of brokerage firm TD Ameritrade, recently went to an investor education class on options trading, he noticed the crowd around him. ‘It was all people who look like me,’ Tomczyk, 58, told Reuters in a recent interview. ‘It was older people who are about to retire or just retired.’
Jared Levy, author of ‘Your Options Handbook’ and managing partner at Belpointe Alternative Investments in Greenwich, Connecticut, says it is no surprise that baby boomers are driving the options train. ‘A lot of the increasing volume has been coming from boomers with high net worth who have gained the ability to trade from home.’
But retirees should think twice before trading in their tennis rackets or bridge games for an options-trading hobby. Options are complex derivative instruments that may protect your portfolio and let you squeeze in some extra earnings – or cause you to lose your shirt and your pants along with your stock holdings.
Most share options allow traders in effect to place bets on the movement of share prices, and individual investors are notoriously bad about timing those bets in the first place. In fact, a recent analysis of more than 200,000 investors done for Reuters by online financial planning platform SigFig revealed that those who did not trade options thumped those who did. Investors who stayed away from options racked up 13.2 per cent in portfolio gains for the year ended June 25, while those who embraced the options trade lagged by 6 percentage points, with returns of 7.3 per cent.
In their basic form, options contracts are known as puts and calls. The buyer of a put has a right to sell the asset (like 100 shares of a stock or exchange-traded fund) at an agreed-on price. That could provide downside protection if the asset plummets in value. A call conveys the right to buy shares at an agreed-on price.
Say, for example, you own 100 shares of a company trading at $50 a share. You could sell a 90-day call at a $60-per-share strike price, for $200. If the stock goes down, you’ll keep the $200 and the call will expire. If the stock goes up to $58, you’ll keep the shares, the $200 and the $800 gain (on 100 shares). Again, the call will expire.
If the stock goes up to $75, you’ll keep the $200 and the $10 per-share gain between $50 and $60. But you’ll lose the extra $15 per share in gains because you’ll have to sell the stock at $60 a share – it will have been ‘called’.
Word limit Part B: 1000 words
Part b -Question 3
Compare the performance, risk and charges for the three funds reported in Table 2. To what extent might this data provide useful evidence to guide an investor in choosing between an active or passive approach to investing?
Table 2: Fund performance data
Fund
Type of fund
Annualised returns %
3-year data
OC (% pa)
1 year
3 year
5 year
Volatility
Alpha
Beta
Sharpe ratio
R-squared
Baillie Gifford UK Equity Alpha
Active
28.79
14.38
18.92
14.42
2.05
1.07
0.72
0.91
1.55
F&C UK Alpha
Active
10.96
2.14
12.83
13.44
–6.79
0.99
0.08
0.92
1.72
HSBC FTSE All-Share Tracker
Passive
23.22
10.52
15.29
13.19
–0.67
1.03
0.46
0.92
0.17
FTSE All-Share Index
22.20
10.63
16.94
Source: www.trustnet.com and www.morningstar.co.uk (Accessed 29 October 2013)
Notes: OC stands for ongoing charges. HSBC FTSE All-Share Tracker tracks the FTSE All-Share Index.
Annualised total returns are calculated per annum on the bid price of 29 October over the respective period of 1 year, 3 years and 5 years (with net income reinvested).
SAMPLE ANSWER
Combining assets to obtain a superior balance between risk and return
Introduction
Correlation coefficient is applied when analyzing different types of stocks and asset behavior. Asset correlation in personal investing guards against exposure to excessive risks. It however doesn’t account for the reasons, causes or effect of the risks. (Markowitz 2009)
1a. Efficient frontier in the portfolio theory
It’s a theory in modern portfolio management that was initiated by Markowitz and it involves various combination of assets or portfolio in a way that brings out the best level of expected returns in an efficient way considering its level of risks. The standard deviation of the asset returns is plotted against the portfolios expected return which is obtained against the tangent of a risk free rate. The part of the hyperbola that represents the opportunity with the highest amount of expected return for a particular level of risk is known as the efficient frontier. (Elton & Gruber 2011)
1b. The rationale would be that the tyre manufacturer basically produces enough tyre for the UK market and also enough for export to other countries that would have a different kind of weather some may be dry. UK tyre manufacturer would have to satisfy even the markets that require the tyres that are needed in dry weather.
1c. i) The best assets would be Rolls-Royce and BSkyB stock. The stock represents very high returns but the risks are also high. The relationship that exists between the above stocks and the gains in the FTSE are very strong and positive relationship with the portfolio. For example a positive relationship shows a positive gain in the FTSE and the portfolios while a negative correlation coefficient shows that could actually lose some portfolio value as the FTSE gain gains value.
1c. ii) investors prefer investments with higher returns as well as investments with low risks. The best option is to select the most suitable and profitable option from the efficient frontier. The best way to point out the best option is by evaluating the indifference curves which represent the preference of the investors on different combination of risks and returns.
Optimal Performance calculations of EasyJet
Easyjet
Glaxo
Port
BSkyB
Port
Diageo
Port
Expected Val mon %
2.32
0.30
1.31
1.22
1.77
1.07
1.70
Expected Ret (ann %)
31.72
3.60
16.89
15.72
23.48
13.60
22.35
Variance
71.50
22.94
26.04
45.54
33.43
16.01
28.12
STD %
8.46
4.79
5.10
6.75
5.78
4.00
5.30
5 yrs Beta
0.86
0.45
0.65
0.49
0.67
0.52
0.69
5 yr Alpha %
27.20
0.42
13.04
12.42
19.57
10.20
18.39
5 yr Sharpe ratio
3.55
0.40
2.98
2.08
3.77
2.98
3.90
5 yr total return
222.44
11.51
102.10
81.98
160.65
80.28
152.56
HSBC
port
Roll Ro
Port
Tesco
Port
Expected Val mon %
0.17
1.25
1.95
2.14
-0.18
1.07
Expected Ret (ann %)
2.10
16.05
26.06
28.86
-2.11
13.66
Variance
37.17
31.31
36.96
37.50
37.31
32.78
STD %
6.10
5.60
6.08
6.12
6.11
5.73
5 yrs Beta
0.26
0.56
0.91
0.88
0.73
0.79
5 yr Alpha %
-0.43
12.52
21.38
24.26
-6.22
9.34
5 yr Sharpe ratio
0.07
2.57
4.01
4.44
-0.06
2.09
5 yr total return
-0.78
92.07
186.51
219.17
-19.70
72.23
The minimum risk is 5%
1d. i) Diageo
Expected returns
Risks
Tesco
14%
6%
Rolls Royce
29%
6%
HSBC
15%
5.50%
Glaxo
17%
5%
Easy jet
31.72%
8.46%
Diageo
22.35%
5.30%
BSkyB
23%
5.78%
1d. ii) 5.3%
1d. iii) The proportion of Easyjet shares would be 50%.
1e. The lowest standard deviation and the average return of the portfolio and the capital allocation line gives the Sharpe ratio. The optimal portfolio balance is usually where the line’s slope is highest.
2a. i) The major challenge in the management of investment is basically the choosing of a convenient and appropriate investment while also designing a particular unit that will meet the expectation and the objective of the investor while also considering his constraints. These constraints could be the liquidity, need for regular monthly or periodical income, age, the risk tolerance or even the tax liability. Investments can be classified broadly as financial or real investments while financial investment can be further classified as fixed income or variable income investments.
To protect their shares portfolio, Mr. Mark Brisley and EviePetrikkou should sell a call that’s covered. For example, if they owned 100 or more shares that they intended to sell as stock (writes) that’s a call option. The buyer of the option would pay a premium so as to gain the right to buy the 100 shares at an agreed price known as the strike price for a certain limited time that’s until the options expire. If the stock’s value appreciates the option owner gains otherwise all the gains would have all ended up with the stockholder. The cash ensures protection from the stock price devaluation. They can also protect their shares portfolio by buying puts. For example during the 2008 economic crisis, the value of puts would generally have increased as the stock’s value deteriorated. The put owners have a right to sell their shares at the agreed strike price. The main advantage of buying puts is that the losses are mostly limited. The owner is allowed to pick a strike price that can match the risk tolerance and the minimum selling price is also guaranteed. The value of the portfolio cannot be allowed to fall beyond a certain amount. The other alternative is to replace all the stocks with options.
2a. ii) They can increase their chances of getting more income by taking options with a longer period of time that the option can be exercised.
2b) The potential loss per share would increase if the value of the shares reduces to 45 per share or less. After buying the options for 50 per share, the potential loss would increase to 5 per share which will culminate to a loss 500 for the 100 shares excluding the 200 premium.
2c) The risks in the extract can be analyzed from two approaches, the sellers and the buyers. When a trader purchases an asset that has a three months expiration and within that period the potential stock remains at a price that is lower than its original purchase price, then the risk of getting losses is inevitable.
The sellers also incur losses as there are some options that have unlimited risks or possibility of ending up in losses which largely depend on the movement of the potential stock. There are instances where the sellers are under obligation to sell even when the trading is not profitable.
Risks are inherent to any form of trading as the higher the risk the higher the profits.
2d) Derivatives have contributed largely to the need of increased risk management procedures. Derivatives have to led to the growth of the financial economy which had been preceded by the production economy in the late 1960,s and early years of 1970’s. (Ciner 2006)
Derivatives can affect systematic risks as its nature and implication go beyond the realms of the entire financial economy, social and also political framework of most economies. (Dodd 2005) This is possible as derivatives do not affect the underlying asset but only the price change of the asset which predisposes the assets to wide range of systematic risks. (Williams 2010) With increased innovations derivatives have evolved into new forms which have created cross-linkages in different asset valuation and price changes through different forms of automated digital platforms like swaps. (Blackburn 2008) Swaps provide the means and capacity to exchange one asset risk which is in a different class to another without actually gaining ownership of any asset with the investors. Such innovation has increased systematic risks that are associated with different forms of derivatives and has contributed to the interdependency of several different assets and their relative price changes. (Zeyu, Podobnik, Feng and Baowen 2012) Instability in only one class of a certain assets can cause a very widespread effect on the systematic stability several other related assets hence create a complex manifestation of associated risk in a financial economy. (Brownlees, Engle 2010)
3b) Alpha is also known as the Jensen index and it measures the risk adjusted return of an equity security while beta measures the volatility of the security as compared to its benchmark index. It basically indicates the securities or the stocks ability to gain value and it’s based on the company’s rate of earnings growth. Volatility measures the riskiness of a particular stock compared to the market. R-squared determines the exact proportion of a stock or security’s return. The F&C r-squared of 0.92 indicates that 92% of the returns of the security are basically due to the gains in the market while 8% is due to other factors related to the security. Sharpe ratio compares the overall relationship of risks and related rewards while exploring different investment strategies. Its Sharpe ratio is 0.08 or 8% and it’s the most risky security among the three as its ratio is the lowest. A higher ratio indicates a less risky investment. The F & C beta of 0.99 shows that the market has similar risks as the security while the r squared of 0.92 indicates that the bench mark index is almost wholly determined by the portfolio’s performance. It’s very high and it’s also referred to as the coefficient of determination. The volatility for F & C shows that its lower than 50% hence its acceptable as the beta is also close to 1.
The Baillie r-squared of 0.91 indicates that 91% of the returns of the security are basically due to the gains in the market while 8% is due to other factors related to the security. Sharpe ratio compares the overall relationship of risks and related rewards while exploring different investment strategies. Its Sharpe ratio is 0.72 or 72% which is the best among all the portfolio and it’s the safest to invest in as it’s less risky than all the rest of the securities. A higher ratio indicates a less risky investment. The Baillie beta of 1.07 shows that the market has similar risks as the security while the r squared of 0.91 indicates that the bench mark index is almost wholly determined by the portfolio’s performance. The volatility for Baillie shows that it’s lower than 50% hence it’s acceptable as the beta is also close to 1. (Elton & Gruber 2011)
The HSBC r-squared of 0.92 indicates that 92% of the returns of the security are basically due to the gains in the market while 8% is due to other factors related to the security. Sharpe ratio compares the overall relationship of risks and related rewards while exploring different investment strategies. The 0.46 or 46% shape ratio indicates that its return is risky. A higher ratio indicates a less risky investment. The HSBC beta of 1.03 shows that the market has similar risks as the security while the r squared of 0.92 indicates that the bench mark index is almost wholly determined by the portfolio’s performance. The volatility for Baillie shows that it’s lower than 50% hence it’s acceptable as the beta is also close to 1.
Reference
Brownlees, C.T., Engle, R.F., 2010. Volatility, correlation and tails for systemic risk measurement,
Blackburn, R., 2008, The Subprime Crisis, New Left Review, 50 Mar- Apr 2008.
Ciner, C., 2006, Hedging and Speculation in Derivatives Markets: the Case of Energy Future Contracts, Applied Financial Economics letters, 2, 189-192
Dodd, R., 2005, Derivatives Markets: Sources of Vulnerability in US Financial markets, In Gerald A. Epstein (Ed) Financialization and the World Economy, Edward Elgar: Cheltenham
Gray, D. F. and Andreas A. J., 2011, “Modeling Systemic and Sovereign Risk,” in: Berd, Arthur (ed.) Lessons from the Financial Crisis (London: RISK Books), pp. 143–85.
Markowitz, H.M., 2009, Harry Markowitz: Selected Works. World Scientific-Nobel Laureate Series: Vol. 1. Hackensack, New Jersey: World Scientific. p. 716
Zeyu, Z., Podobnik, B., Feng, L. and Baowen L., 2012, “Changes in Cross-Correlations as an Indicator for Systemic Risk” (Scientific Reports 2: 888 (2012))
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