4 pages/≈1100 words
Mathematics & Economics
Understanding the concepts (Coursework Sample)
This paper encompasses a discussion of key financial terms and concepts that are commonly used in the investment and portfolio theory.source..
Understanding Key Concepts in Finance
Financial concepts have widely been applied in a number of instances, particularly in making investment decisions. Ideally, the paper presents the reader with an opportunity to understand key concepts in finance such as net present value (NPV), payback rule, debt financing, equity financing (shares),bonds, investment returns, financial risks (systematic and unsystematic), beta, and risk diversification.
Net present value and payback rule
Based on investment theory, there are two broad techniques for evaluating project investement returns: discounting and non-discounting techniques. One of the discounting techniques commonly applied in the net present value (NPV). The technique takes into account the current value of investment returns from at particular investment less initial investment outlay. The future cashflows are discounted using a particular discounting rate (cost of capital). In making an decision whether to invest or not using NPV, I will select an investment with positive NPV (Dayananda, 2002). However, considering other factors, I may also invest in projects with zero NPVs.
One of the non-discounting approaches used elauating projects in the payback rule. The concept takes into account the time taken by an investment project to payback (recover its initial investment). When using this approach, I am likely to prefer investing in projects with less payback periods to those that take more time to payback coniderating the time value of money.
Debt financing (advantages and disadvantages)
Broadly, there are two key sources of business financing: debt financing and equity financing. Debt financing is coupled with a number of advantages and setbacks. In terms of benefits/advantages debt financing allow owners to retain business control and ownership (Seidman, 2005). This is because; debt holders have no voting rights. Research also confirms that debt financing is cheaper than other financing options such as issuing stocks. Moreover, debt financing is said to provide tax advantages to a business. In addition, debt financing gives lenders not future claim over business earnings. Another advantage of debt financing is that it can easily be secured. Additionally, debt financing has resource utilization benefits. The critics of debt financing reveal the approach as being limited to established businesses due to credit ratings. Also, debt financing obligates businesses to make regular debt repayments (Seidman, 2005). This implies that a business can easily go insolvent if it lacks funds to make repayments of debt.
Today, some organizations prefer stocks (equity financing) to bonds (debt financing) for some reasons. First, unlike bonds, by issuing stocks the company is not obligated to pay back the borrowed money. Thus, the borrowed amount can be reinvested in other areas to bring about organizational growth. Also, as opposed to issuing of bonds, stocks provide a company with an opportunity to share liabilities and risks with new stock holders.
Relationship between risk and financial returns
From the investment theory, the security market line, it is precise that there is direct relationship between risk (Î²) and expected returns (ER) from financial securities (positively correlated). This implies that the higher the risk associated with a particular asset or security, the higher the expected return (Brigham & Ehrhardt, 2008). However, it is important to note that the relationship between risk and return is not always linear. In some securities, the return may increase with increase in risk up to a certain level from where the return remains constant.
Figure: Tradeoff between risk and return
Concept of beta (Î²) and its application
The concept of beta (Î²) is widely applied in finance to measure the systematic risk of an individual investment portfolio (Daves et. al, 2009). It is computed by dividing the covariance of the return of an asset with that of the market portfolio (Covim) with the variance of the market portfolio (Ïƒ2 m).
Î² = Covim Â Â Â Â Â Â Â Â Â Ïƒ2 mÂ Â
Basically, beta measures how volatile or risky are an individual asset relative to the market portfolio. The greater the value of beta, the greater the volatility (systematic risk) of the security returns (Brigham & Ehrhardt, 2008). This implies that the value of an assetâ€™s beta can be used to predict how much an assetâ€™s return can go up or down relative to the market portfolio.
Using Capital Asset Pricing Model (CAPM), beta is can be applied in computing the expected rate of return from an asset such that: Expected return = Risk free rate + Beta (Market risk premium). Using beta, we can classify assets into defensive assets (Î²<1), aggressive assets (Î²>1), and risk-free assets (Î²=0).
Systematic verses Unsystematic risks
Systematic risk is the financial risk that affects the entire securities market. This type of risk is caused by factors or forces outside the control of an investor such as global security threats, changes in taxation policies of the government, natural disasters, changes in investment policies, and fluctuations in social-economic parameters. Systematic risk cannot be reduced through portfolio diversification (Butler, 2012).
Conversely, unsystematic risk refers to an investment risk that arises from factors, which are specific to a company or industry such as pricing, R & D, marketing strategy and trade unions. Unsystematic risks facing securities can largely eliminated through adequate diversification of securities within a particular class (Butler, 2012).
Maximizing investment returns through risk diversification
One of the approaches that can reduce the severity of the investment risk is through portfolio risk diversification. This concept its essential based on the well know saying: â€˜Do not put all your eggs in one basket.â€™ Ideally, in this context, portfolio diversification simply means spreading the risk over a large number of financial assets cash, bonds, stocks and mutual funds, such that each asset will be faced with insignificant amount of risk....
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