# Financial Investment Decision (Term Paper Sample)

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This individual coursework consists of two main parts, A and B. Part A has two main questions. This part brings 60

points. You must discuss your answers within the context of finance theory and discuss the economic meaning of your

estimates. Part B has two open questions that bring a total of 40 points. Please answer all questions.

Part A

1. a) You are offered the following investment opportunity: in exchange for $40,000 today, you will receive 2,500

shares of stock in the Ford Motor Company and 10,000 euros today. The current market price for Ford stock is

$9 per share and the current exchange rate is $1.50 per €. Should you take this opportunity? Would your

decision change if you belived the value of the euro would rise over next month?

Marks [15]

b) Suppose you estimate that Wal-Mart’s stock has a volatility of 16.1% and a beta of 0.20. A similar process

for Johnson & Johnson yields a volatility of 13.7% and a beta of 0.54. Which stock carries more total risk?

Which has more market risk? If the risk-free interest rate is 4% and you estimate the market’s expected return

to be 12%, calculate the equity cost of capital for Wal-Mart and Johnson & Johnson. Which company has a

higher cost of equity capital?

Marks [15]

2. Table 1 (below) shows the financial statement and stock price data for Mydeco Corp:

ADVANCED CORPORATE FINANCE

STUDENT NAME:

STUDENT ID:

DATE:

Part A

1a) You are offered the following investment opportunity: in exchange for $40,000 today, you will receive 2,500 shares of stock in the Ford Motor Company and 10,000 euros today. The current market price for Ford stock is $9 per share and the current exchange rate is $1.50 per €. Should you take this opportunity? Would your decision change if you belived the value of the euro would rise over next month?

Should one take the opportunity?

When making a decision one should have consideration of time value of money. Returns on the opportunity should outweigh the amount being presented in cash today. Otherwise the opportunity is not viable (Constantinides et.al, 2011). The option are;

1) Is to take 40,000 today

2) Or 2500 shares and £10,000 today. Market price of the firm is $9

Exchange rate: 1£ = $1.50.therefore £10,000 is equivalent to $15,000 dollars.

The market value of the shares that were offered is equivalent to = shares*market price

Thus giving a market value of 2500*9 = 22,500.

Hence option 2 value = 22,500+15,000 = $37,500.

In financial investment decision, a rational investor will take investments that give then higher returns on investment. What you get for investing fuels one investment decision. Similarly, when opportunities rise, one will take opportunities that offer higher value and forego those with lower value. In the current scenario, opportunity one will have a value of $40,000, while opportunity 2 will have a value of $37,500. Thus, option one create more value and hence a better option. Thus, one should not take the opportunity presented to them in exchange of $40,000 as they will lose $2,500.

Change of opinion due to rise of exchange rate.

If the exchange rate rise for instance to 2.0 per £. Thus, we have 1£ = $2, this means that £10,000 is equivalent to $20,000 dollars. Thus, the worth of the opportunity in one month’s times would be $42,500 (20,000+22,500). We need to determine the present value of this opportunity to determine its worthiness. Taking a cost of investment of 10%

Future value = present value (1+rate)

20,000 = X(1+0.1) = 20,000/1.1 = 18,182. Therefore the present value of the opportunity is given by 18,182+22,500 = $40,682. Therefore, making the investment opportunity worth. Hence, with a speculation that the exchange rate would improve as high as $2 and more, one would consider taking the opportunity as it possess higher returns. In other words, taking the opportunity will leap more revenue than taking $40,000 today.

1b) suppose you estimate that Wal-Mart’s stock has a volatility of 16.1% and a beta of 0.20. A similar process for Johnson & Johnson yields a volatility of 13.7% and a beta of 0.54. Which stock carries more total risk? Which has more market risk? If the risk-free interest rate is 4% and you estimate the markets expected return to be 12%, calculate the equity cost of capital for Wal-Mart and Johnson & Johnson. Which company has a higher cost of equity capital?

In risk and returns trade off, following the CAPM model, assets with higher beta have higher returns. In addition, they have higher systematic risk associated with them. On the other hand, assets with higher standard deviation, and variance pose higher total risk (Asteriou and Begiazi, 2013). Volatility if given by; annualize volatility = standard deviation*√252

Thus, in the current scenario standard deviation for the two stock is

Wal-Mart’s = annualize volatility = standard deviation*√252

16.1%= standard deviation*√252; thus δ = 0.161/√252 = 0.161/15.87451=0.0101

Johnson & Johnson = annualize volatility = standard deviation*√252

13.7%= standard deviation*√252; thus δ = 0.137/√252 = 0.137/15.87451=0.0086

stock

Standard deviation

Beta

Wal-Mart’s

1.01%

0.20

Johnson & Johnson

0.86%

0.54

Total risk

Looking at total risk, we imply that overall an asset has high systematic and unsystematic risk. Total risk is addition of the two components. The systematic risk is risk given by the beta. Systematic risk is the risk that cannot be controlled for, while unsystematic can be controlled for through diversification (Asteriou and Begiazi, 2013). The standard deviation has both components of systematic and unsystematic risk, and thus a measure of total risk. Higher deviations are an indication of more total risk. In the current case as shown on the table above, Wal-Mart’s has a deviation of 1.01%, while Johnson & Johnson has a deviation of 0.86%. Thus, Wal-Mart’s with a higher standard deviation, has higher total risk compared to Johnson & Johnson.

Market risk

This are risks due to changes in market prevailing prices. This uncertainties are also referred to as systematic risk as they come with decisions to invest. Thus, firms in their investment decisions will risk loss of position in the market due to this type of risk exposure (Asteriou and Begiazi, 2013). The CAPM model depicts systematic risk as the beta and it is not diversified unlike the unsystematic risk that can be diversified. In our current analysis Wal-Mart’s has a beta of 0.20, while Johnson & Johnson has a beta of 0.54. The higher the beta value, the higher the market risk. Thus Johnson & Johnson, has a higher market risk associated with its stock compared to Wal-Mart’s.

Cost of equity capital

Cost of equity is mainly assessed through the CAPM model. It is given by cost of equity= Rf + market premium

Ke = Rf + β(Rm – Rf)

Where Ke is the cost of equity, Rf is the risk free return, Rm is the market return.

In the current case, if the risk-free interest rate is 4% and you estimate the markets expected return to be 12%, then the equity cost of capital for Wal-Mart and Johnson & Johnson are 5.6% and 8.32% respectively as shown on the table below. A higher value is an indication of a higher cost of equity. Thus, from the analysis, Johnson & Johnson has a higher cost of equity compared to Wal-Mart’s. A higher cost of equity will imply that the owners are able to get higher returns from the investment they make. Thus investors taking the stock of Johnson & Johnson have higher returns for the investments they make compared to Wal-Mart’s.

Stock

Rf

Beta

Rm

Rm- Rf

β(Rm – Rf)

Ke = Rf + β(Rm – Rf)

Wal-Mart’s

4%

0.20

12%

8%

1.6%

5.6%

Johnson & Johnson

4%

0.54

12%

8%

4.32%

8.32%

2a) Suppose Mydeco repurchases 2 million shares each year from 2010 to 2013? What would its earnings per share be in 2013?

Earnings per share of a firm is given by net profits or otherwise the earnings after interest and tax, divided by the number of shares. A repurchase of shares means that the firm is buying back its shareholding from the shareholder (Khan et.al, 2013). One thing we need to understand is that shares come about when firms want to raise capital. Thus, the firm will get capital in exchange of ownership. In a buyback also known as the share re-purchase, the firm wants to return monies given as capital to the owners, and in return get its ownership. Hence in a repurchase, the shares outstanding reduces. Consequently, affecting the earning per share of the firm. The repurchase also has an effect on the balance sheet amounts as it reduces the amount of cash available.

In the current case, from 2009 to 2013, the shares outstanding has remained the same at $55 million. Thus, with a share repurchase of $2 million from 2010. This means that as shown on the table below, the outstanding shares as of 2013 will have reduced to $47 million from $55 million. Remember EPS = EAITshares outstanding = 21.7/47 = $0.462. Thus, the EPS will have improved from $0.39 (without re-purchase), to $0.462 (with re-purchase). Hence we can conclude that the repurchase creates more value to the investors as their return on investment and wealth increases. On the other hand it returns control to the firm as firm ownership improves. Besides, the amount of stock reduces in the market which creates supply shocks. Consequently, improving the market share price of the said stock.

Year

Initial shares outstanding

Repurchase

Closing shares

2010

55,000,000

2,000,000

53,0000

2011

53,000,000

2,000,000

51,000,000

2012

51,000,000

2,000,000

49,000,000

2013

49,000,000

2,000,0...

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