...explained in this ahort lecture. Principle 1. The risk-return trade-off Principle 2. The time value of money Principle 3. Cash—Not Profits—is King Principle 4. Incremental cash flows Principle 5. The curse of competitive markets Principle 6. Efficient Markets Principle 7. The Agency Problem Principle 8. Taxes bias business decisions Principle 9. All risk is not equal Principle 10. Ethical dilemmas persistTen principles of finance are listed and explained in this ahort lecture. Principle 1. The risk-return trade-off Principle 2. The time value of money Principle 3. Cash—Not Profits—is King Principle 4. Incremental cash flows Principle 5. The curse of competitive markets Principle 6. Efficient Markets Principle 7. The Agency Problem Principle 8. Taxes bias business decisions Principle 9. All risk is not equal Principle 10. Ethical dilemmas persistTen principles of finance are listed and explained in this ahort lecture. Principle 1. The risk-return trade-off Principle 2. The time value of money Principle 3. Cash—Not Profits—is King Principle 4. Incremental cash flows Principle 5. The curse of competitive markets Principle 6. Efficient Markets Principle 7. The Agency Problem Principle 8. Taxes bias business decisions Principle 9. All risk is not equal Principle 10. Ethical dilemmas persistTen principles of finance are listed and explained in this ahort lecture. Principle 1. The risk-return trade-off Principle 2. The time value of money Principle 3...
Words: 853 - Pages: 4
...was talk- ing about. Over time, high-risk investments tend to earn higher returns than do low-risk investments. When managers invest corporate funds, or when individuals decide how to allocate their money between different types of investments, they must weigh the trade-off between risk and return. The purpose of the next four chapters is to explore that trade-off in depth. We begin in Chapters 4 and 5 by describing two of the most common types of investments available in the market—bonds and stocks. The bond market is vast, and it plays an extremely important role in the economy. Federal, state, and local governments issue bonds to finance all kinds of public works projects and to cover budget deficits. Corporations sell bonds to raise funds to meet daily operating needs and to pay for major investments. Chapter 4 describes the basic bond features and explains how investors value bonds. Chapter 5 examines the stock market. Valuing stocks is more complex than valuing bonds because stocks do not promise fixed payment streams as do bonds. Therefore, Chapter 5 discusses methods that investors and analysts use to estimate stock values. The chapter also provides a brief explanation of how firms work with investment bank- ers to sell stock to the public and how investors can trade shares of stock with each other. With the essential features of bonds and stocks in hand, Chapter 6 explores the historical returns earned by different classes of investments...
Words: 420 - Pages: 2
...Risk and Return Tradeoff Memo The construction portfolio process concludes to be very complex. Statistical past performance, industry knowledge, future potential and relying on insights that are personal are typically what analysts rely on within the market in order to arrive at the final list. Maximizing returns while minimizing risk is the goal every investor aims for. An evaluation of individual securities as well as risk return trade off within isolation and the risk return trade off contribution of the entire portfolio. The managing and constructing of a portfolio simulation outlining the fundamentals within the construction of the portfolio in regards to the risk return trade off as well as the relationship among investment performance and strategy will be the structure of this memo. Casa Bonita Ceramics has selected me as the treasury analyst to determine the best stocks and allocate company resources in order to construct a successful portfolio. My decision will be detailed within this memo of the simulation, communicate the Sharpe ratio in the relation it has to investment decision as well as give recommendations for organization changes in the investment strategy to improve the investment performance. Simulation Decisions Given the excess cash generated in the previous year, Casa Bonita is considering the invest $800,000 in the stock market. Eight stocks have already been chosen. Given the high return consideration without the risk of capital loss in sight, narrowing...
Words: 1147 - Pages: 5
...Inexpensive labor and slight raise in the price of the furniture had Guillermo making a good profit. The business was going well for Guillermo until a new competitor entered the furniture market. At the same time one of the largest retailers in the nation’s headquarters had a considerable influence on the communities in Sonora. The rise in population and jobs increased the cost of labor causing Guillermo’s business to suffer. This paper will discuss and define the six foundational principles associated with the context of this scenario. The six foundational principles related to the context of the scenario are: the behavioral principle, principle of valuable ideas, options principle, principle of incremental benefits, principle of risk-return trade-off, and the principle of diversification. The Behavioral Principle The behavioral principle states if a person is unsure of what to do look at what everyone else is doing for guidance. Guillermo needs to determine what would be best for his business to be just as successful as or better than his competitors. Guillermo should consider making changes to his business, such as coordinating his existing distributor network and essentially becomes a representative for this other manufacturer (University of Phoenix, 2010). Guillermo should also reconstruct his company from a manufacturing company to a distribution. When applying the behavioral principle the first step is to decide whether the company you want to imitate is the best company...
Words: 875 - Pages: 4
...primarily in convergence and relative value strategies. Relative value strategy : It is a spread trade and it involves two assets whose prices or yields tend to converge with time . it involves long and short positions of similar instruments. This often happens when a company has more than one holding company listed in different markets (e.g. Royal Dutch and Shell). The price divergence in these different markets creates profitability. Although the price may not completely converge, but the premium tends to narrow over time. Convergence Strategy: In case of convergence strategy the two asset prices or yields must converge. when there was a specifiable future date(usually medium-term fixed maturities) by which convergence of offsetting short and long positions in similar instruments should occur. An example would be a strategy consists of buying off-the-run high yield bonds and shorting on-the-run low yield bonds. Once the newly issued on-the-run bonds become off-the run, the yields on the two bonds converge and LTCM makes a profit. This is a simple strategy and not necessarily a risky trade since it is very likely that the yields will converge once the on-the-run bonds become off-the-run. Since the yield spread between on- and off-the-run bonds is very narrow, it is possible to make significant profits only with large positions. It also involved in directional trades, which were un-hedged positions like long on French Government bonds. Their trading opportunities arose...
Words: 2745 - Pages: 11
...Ch 13 dq 1. If corporate managers are risk-averse, does this mean they will not take risks? Explain. Risk averse corporate managers are not unwilling to take risks, but will require a higher return from risky investments. There must be a premium or additional compensation for risk taking. 3. When is the coefficient of variation a better measure of risk than the standard deviation? The standard deviation is an absolute measure of dispersion while the coefficient of variation is a relative measure and allows us to relate the standard deviation to the mean. The coefficient of variation is a better measure of dispersion when we wish to consider the relative size of the standard deviation or compare two or more investments of a different size. 4. Explain how the concept of risk can be incorporated into the capital budgeting process? Risk may be introduced into the capital budgeting process by requiring higher returns for risky investments. One method of achieving this is to use higher discount rates for riskier investments. This risk adjusted discount rate approach specifies difference discount rates for different risk categories as measured by the coefficient of variation or some other factor. Other methods, such as the certainty equivalent approach, also may be used. 5. if risk is to be analyzed in a qualitative way, place the following investment decisions in order from the lowest risk to the highest risk: a. new equipment (2) b. new market...
Words: 592 - Pages: 3
...the trade-off theory, pecking-order theory and agency cost. Besides, capital structure may influence towards the shareholders and the company taxes. An argument also occurred since there is different explanation about capital structure between Miller Theorem and Myer Theorem. The purpose of the literature review is to gain our knowledge and have a truly...
Words: 2761 - Pages: 12
...ACFI 2005 Finance. 3. A customer has approached your commercial bank seeking to invest funds for a period of six months. The customer is particularly worried about risk following the GFC and the market volatility that continues to characterise world financial markets. Explain the features of call deposits, term deposits and CDs to the customer and provide advice on risk-reward trade-offs that might be associated with each product. Answer: Commercial banks are the main type of financial institution operating in all major international financial systems. They control a significant proportion of the financial asset within the financial system. Recently, the majority of developed economies have significantly reduced the level of bank regulation and there has therefore been a considerable growth in the commercial bank sector. Following the GFC, this deregulatory phase was criticised for having contributed to the crisis. Thus, it is natural for the customer to be worried about risk following the GFC and the market volatility that continues to characterise world financial markets. Since the core function of commercial banks is to gather savings from depositors and investors and use those funds in the provision of loans to customers this customer’s approached towards our commercial bank seeking to invest funds for a period of six months can be recognised. Call deposits- call or demand deposits are funds held in a savings account that can be withdrawn on demand. Features of call...
Words: 1038 - Pages: 5
...is the amount of risk undertaken in the trade. Typically, high-risk trades that are almost akin to gambling fall under the umbrella of speculation, whereas lower-risk investments based on fundamentals and analysis fall into the category of investing. Investors seek to generate a satisfactory return on their capital by taking on an average or below-average amount of risk. On the other hand, speculators are seeking to make abnormally high returns from bets that can go one way or the other. It should be noted that speculation is not exactly like gambling because speculators do try to make an educated decision on the direction of the trade, but the risk inherent in the trade tends to be significantly above average. As an example of a speculative trade, consider a volatile junior gold mining company that has an equal chance over the near term of skyrocketing from a new gold mine discovery or going bankrupt. With no news from the company, investors would tend to shy away from such a risky trade, but some speculators may believe that the junior gold mining company is going to strike gold and may buy its stock on a hunch. This would be speculation. As an example of investing, consider a large stable multinational company. The company may pay a consistent dividend that increases annually, and its business risk is low. An investor may choose to invest in this company over the long-term to make a satisfactory return on his or her capital while taking on relatively low risk. Additionally, the...
Words: 1115 - Pages: 5
...or bonds issued by the companies. The secondary market is that part of the capital market that deals with the securities that are already issued in the primary market. The investors who purchase the newly issued securities in the primary market sell them in the secondary market. The secondary market needs to be transparent and highly liquid in nature as it deals with the already issued securities. In the secondary market, the value of a particular stock also varies from that of the face value. The resale value of the securities in the secondary market is dependent on the fluctuating interest rates. | Higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return. This trade off which an investor faces between risk and return while considering investment decisions is called the risk return trade off. | Conflicts of interest and moral hazard issues that arise when a principal hires an agent to perform specific duties that are in the best interest of the principal but may be costly, or not in the best interests of the agent. The principal-agent problem develops when a principal creates an environment in which an agent has incentives to align its interests...
Words: 269 - Pages: 2
...the stock return would be affected when the factor of your choice changes. d) Describe a scenario where one can benefit from trading on the factor of your choice. a) There is a variety of factors that can determine the returns on security. The market based factor is the return on the broad market index such as S&P 500. This market return is one of the factors in the model. Other factors include the following: • GDP growth rate. This factors shows overall macroeconomic conditions that tend to affect a stock’s performance. • Risk free rate of return. • 10 year T-bond interest rate that shows the required return on 10-year government bonds. • A company’s ROE as an indicator of its profitability. Therefore, the model will look like this: [pic], where betas show the sensitivity of return to the factor, rm is the market rate of return, rf is the risk-free rate, T-bond is the 10-year T-Bond rate and ROE is the return on equity (ROE). Generally, GDP has a positive effect on a stock return. Higher economic growth leads to more business opportunities and potentially higher profits. This positively affects a stock’s return. Market rate of return has a positive effect assuming a positive beta. Risk-free rate has a negative impact on a stock’s performance. Higher rate leads to lower return on a company’s stock. The same effect comes from 10-year T-Bond rate. Higher rate leads to lower expected return on a stock...
Words: 2090 - Pages: 9
...29 Using Microsoft Corporation to Demonstrate the Optimal Capital Structure Trade-off Theory John C. Gardner, Carl B. McGowan Jr., and Susan E. Moeller1 ABSTRACT In this paper, we apply the trade-off theory of capital structure to Microsoft. We use data for bond ratings, bond risk premiums, and levered CAPM betas to compute the cost of equity and the weighted average cost of capital for Microsoft at different debt levels. This study shows the impact of increasing financial leverage on WACC. As financial leverage increases, the WACC decreases until the optimal debt ratio is reached, after which, the WACC begins to rise. At this debt ratio, the value of Microsoft will be maximized. Our results indicate the optimal debt ratio for Microsoft is 37.5 percent. Introduction One of the most difficult concepts for finance students to learn and for faculty to teach is how a firm determines its optimal capital structure. While most corporate finance textbooks stress the importance of maximizing the value of the firm by minimizing its opportunity cost of capital, how a firm can actually achieve the appropriate debt–to–capital ratio is often a mystery. Brigham and Ehrhardt (2008) in Financial Management: Theory and Practice outline a framework that can be used by financial practitioners to determine a firm’s optimal capital structure. Modigliani and Miller (1958 and 1963) provide the basis for the trade-off theory which is how firms can conceptually determine their optimal capital structure...
Words: 4181 - Pages: 17
...market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate appropriate to its class. “This model depends on two keys, arbitrage and homemade alternative (borrowing on personal account). Arbitrage is the process that ensures that two firms differing on laying their capital structure must have the same performance. At the same time the homemade alternative describes that an investor holding an equity stake in a levered firm can sell his stake, raise a personal loan equal to the share that he held in the levered firm, spend the proceeds in a firm that is not levered and increase his income without additional cost. They assume that the shares of the firms within a given class both have the same expected return and the same probability distribution of expected return, and therefore can be considered perfect substitutes for each other. Modigliani and Miller proposition two This proposition is derived from the first one and it concerns he performance of a Common stock in companies whose capital structure contains some debt. The expected rate of return of a stock of any company belonging to a class is a linear function of the firm's leverage. “The expected yield of a share of stock is equal to the appropriate capitalization rate for a pure equity stream in the same risk class, plus a premium related to financial risk equal to the debt-equity ratio times the spread between the capitalization rate and the cost of debt...
Words: 7319 - Pages: 30
...CHAPTER 6 The Meaning and Measurement of Risk and Return CHAPTER ORIENTATION In this chapter, we examine the factors that determine rates of return (discount rates) in the capital markets. We are particularly interested in the relationship between risk and rates of return. We look at risk both in terms of the riskiness of an individual security and that of a portfolio of securities. CHAPTER OUTLINE I. Expected Return Defined and Measured A. The expected benefits or returns to be received from an investment come in the form of the cash flows the investment generates. B. Conventionally, we measure the expected cash flow, [pic], as follows: [pic] = [pic]XiP(Xi) where n = the number of possible states of the economy Xi = the cash flow in the ith state of the economy P(Xi) = the probability of the ith cash flow II. Risk Defined and Measured A. Risk can be defined as the possible variation in cash flow about an expected cash flow. B. Statistically, risk may be measured by the standard deviation about the expected cash flow. III. Rates of Return: The Investors’ Experience A. Data have been compiled by Ibbotson and Associates on the actual returns for various portfolios of securities from 1926-1998. B. The following portfolios were studied: 1. Common stocks of large firms 2. Common stocks of small firms 3....
Words: 1939 - Pages: 8
...Pictet-Absolute Return Fixed Income: unlocking the potential of a rapidly-changing bond market Pictet Asset Management May 2014 For professional investors only Overview From 16 to 9. Over the past decade, the number of sovereign borrowers rated triple-A by Standard and Poor's has almost halved. There is probably no clearer testament to the damage caused by the financial crisis. But it is not the only momentous change facing fixed income investors. In another break with the past, policymakers in the developed world no longer worry about the moral hazard of intervening in the capital markets. Driving down real interest rates close to zero has been the policy of choice in the US, UK and Japan, while in the euro zone it has become de rigueur to encourage banks to buy the bonds of those governments with the weakest credit credentials. If dealing with unorthodox monetary and fiscal policies is not challenging enough for fixed income investors, traditional bond benchmarks – and the strategies tied to them – do not help matters. In fact, they often amplify risks. Because these indices are capitalisation- or, perhaps more accurately, liability-weighted, they expose investors to the governments and corporations that issue the most debt. This not only leaves participants vulnerable to the potentially unfavourable shifts in borrower creditworthiness, it also restricts their access to more attractive investment opportunities elsewhere. The bond investor’s plight is further complicated...
Words: 3856 - Pages: 16
