Financial management: Essay Example

Financial management:

Question one a)

It’s a model that gives you an apt expected cost of capital for each project given the project’s relevant risk features. Consequently, it clearly describes correlation between risks with respect to expected return. It’s commonly used to establish pricing models for risky securities.

CAPM is the most complicated method of establishing risk return relationship of a given individual security that will form part of a portfolio. According to CAPM the total risk of a portfolio can be subdivided into systematic and unsystematic risk. It further assumes that the investor holds an efficient portfolio i.e. all unsystematic risk has been diversified and systematic risk (commonly denoted by Beta factor) is the only prevailing risk.[CITATION BRP12 p 68 l 1033 ]

Its equation is mathematically represented as follows:

E (RI) =RFR +β [E (Rm)-RFR] where; RFR >Risk Free Rate

E (Rm) > Market Return

E (RI) > Expected Rate of Return

β > Beta Factor

CAPM involves the following three aspects;

  • Stock prices-these are affected by both firm specific and market wide risks. However, most investors care for only non-diversifiable risk.

  • Beta Factor- This is the risk measuring factor of non-diversifiable risk of a stock i.e. a measure of the systematic risk. Beta factor of any portfolio refer to it’s weighted average of the individual securities.

  • Expected or required returns- These are linear functions of betas (market premium) difficulties applying the model

Being a complicated method, most financial managers experience difficulties when applying the model due to the following factors;

-It is difficult to measure a security’s beta. In investment appraisal using CAPM raises difficulties that include the obtaining of proxy betas. The subjectivity of the beta poses a challenge. As a result, estimates that are derived for a firm may not be accurate leading to poor decision making in the long run if not corrected in due time.

-Secondly, the relationship between risk and return is a more complex matter than the simple linear relationship defined by the CAPM. Theoretically, the model is very easy to understand but when put to reality situations, it becomes a headache. It thus requires strategic analysis for its maximum efficiency by the managers.

-The assumption that all market participants have equal market power does not hold in practise. The model is based on the utopian assumption which poses a big challenge when it comes to real life capital decision making. In reality, due to political interference and competitiveness, firms do not have equal market power.

-It also assumes that the capital markets are perfect and efficient i.e. no transaction costs, no corporate & personal taxes, free flow of information in the market and risk averse investors. However, these assumptions are irrelevant in practise as capital markets are not perfect in real world.

— Another disadvantage is that the assumption of a single period time horizon is contrary to the multi-period nature of investment appraisal.

-Finally, capital structure information that is needed in the ungearing of proxy betas is not usually readily available.

Question 1b)

It is a graphical representation showing the relationship between the expected return and risk using the measure of systematic risk.[CITATION Str12 p 70 n l 1033 ]The equation of the line is the equation of the CAPM i.e. it is the graphical representation of CAPM. It helps show under or overpriced securities. If a security lies above the SML, it’s regarded as underpriced and the converse is true.

Financial management:Financial management: 1

Financial management: 2

Market portfolio

RFR Systematic Risk

Where; RFR >Risk Free Rate

E (Rm) > Market Return

E (RI) > Expected Rate of Return

β > Beta Factor

Question 1c)

Systematic risk is the uncertainty that arises due to external factors which are beyond the control and scope of an organization and innate to the entire market. This kind of risk is usually macro and affects all the organizations within a given industry. The different types if this risk includes the interest rate risk, the market risk and the inflationary risk.[CITATION BRP12 p 69 n l 1033 ]

Unsystematic risk on the other hand is also referred to as specific risk is controllable .Its majorly as a result of prevailing factors within an organization. Therefore, it can be foreseen and the organization cans pre-plan actions to be taken to mitigate the risk. This various types of unsystematic risk include the business risk (also known as liquidity risk), financial risk (also known as credit risk) and operational risk. It can be reduced through diversification of portfolio.[CITATION BRP12 p 69 n l 1033 ]

Question 1d)

Business cycles refer to the undulations in economic action over different spans of time which impact differently on organizations .for instance it can result to a flux or a major reduction in returns in an organization. All economic activities operate around certain cycles and most times management decisions revolve around the company’s standing in a given cycle.

The understanding of business cycles enables financial managers to be able to make viable capital budgeting decision and capital structure decisions in investment appraisal.

In addition it allows them to predict both foreseen and unforeseen risks and mitigate them by putting up strategic short, medium and long-term plans.

This insight also enables the managers to determine the risk tolerance of the organization. It is usually problematic to gauge the length of any part of the cycle and by having an understanding of these cycles, therefore, financial managers can help organizations cultivate apt strategies to survive in each cycle. [CITATION BRP12 p 70 l 1033 ]

The financial managers are also able to manage the cash cycle of the organization which is core to the success of any organisation thus enhances solvency and liquidity status. A solvent company is more likely to attract investors due to its low financial risk compared to one experiencing key liquidity problems.[ CITATION Dav12 l 1033 ]

References:

BR Proffessional Education. (2012). BR Financial Management Study Pack. Nairobi: BR Proffessional Education publisher.

McGraw-Hill Higher Education. (2014). Financial management. In The Efficient Market Hypothesis Sample (pp. 231-232). McGraw-Hill.

Petty. (2012). Financial Management (6th Edition ed.). Australia: Pearson.

Strathmore University. (2012). Financial Management Study Pack. Nairobi,Kenya: Strathmore Edu.

The Open University. (2014). The financial markets context;3 The Efficient Markets Hypothesis (EMH). Retrieved May 15th, 2014, from http://www.open.edu: http://www.open.edu/openlearn/money-management/money/accounting-and-finance/the-financial-markets-context/content-section-3

Question 2a)

In general economics, a perfect market is one in which; Information flow is easy, readily available and free to acquire, there no entry or exit barriers, no market player can manipulate prices, Prices reflect all information that is relevant and available and there no transaction costs.

An ‘efficient’ market is defined as a market where there are large numbers of rational, profit ‘maximisers’ actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.[CITATION Edu14 p 3 l 1033 ].
In an efficient market, stocks prices reflect past,present and future information .[CITATION Edu14 l 1033 ].In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.[CITATION Fam70 p «para 2» l 1033 ].

Efficient markets are not necessarily perfect markets because;

They do not command that the market price should be equal to the true value at all times i.e. they allow a margin error as long as these deviations are arbitrary. This means that stocks may be over or under valued at some point in time. Furthermore, if deviations are random investors should be unable to find over or undervalued stocks in consistency i.e. it is a game of chance rather than one of skill.

Efficient markets do not also require the condition of no transaction cost but that the transaction cost is less than the expected gains from the investment.

On the other hand perfect markets can be affirmatively referred to as efficient markets because they fulfil the conditions of an efficient market by their characteristic nature.

Question 2b)

There three distinct levels in which the market efficiency is categorised. They are discussed below.

The Strong-form efficient market-In this form the EMH dictate that the market price quickly and precisely reflect all the information both public and private available in the market to all the participants whether whole or not. In addition, Market nonmarket and inside information are also input in the security prices.It makes an assumption of a perfect market and that excess gains are impossible to get steadily. Subsequently, no market player has monopolistic access to information that’s relevant.
It is the most satisfying and compelling form of EMH in a theoretical sense, but it suffers from one big drawback in practice.[CITATION The142 p «para 6» l 1033 ].

Semi strong EMH-This form adopt that a market is efficient if the market price swiftly fine-tune to the distribution of new public information (all relevant financial statements ,patents held, news reports).It also includes available market and non-market information in its security prices. If all investors gain access to such public information, it should be presumed that it’s already reflects accordingly in the stock prices. A major disadvantage of this hypothesis lies where identification of the most appropriate public data is a concern.

Finally, the weak EMH markets .It asserts that stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices, trading volume, or short interest.[CITATION Edu14 p 231 l 1033 ]
In this, obtaining information is costless as its publicly known and easily available making signals valueless as they result to immediate changes in prices of securities. It thus shows clearly that studying a company’s past history trend is an ineffective affair.

Question 2c)

Efficient market hypothesis usually has two assumptions from which it derives its conclusion, which is correct if and only these assumptions are correct. The assumptions are that of fair disclosure i.e. information dispatched on stocks is complete and fairly released on a timely basis and that of rational analysis; investors analyse available information on stocks and their markets rationally. In short, if the latter assumptions hold its assumed stocks are fairly priced. In summary, efficient markets are characterized with many rational investors competing by trying to predict the future value of securities and current information is available to all freely.

From the journal we will assume the weak form of market efficiency is irrelevant to discuss as it dwells on past/historical information while the article centres on current information in form of News in the media. On the other hand we cannot assume the semi strong form as it is inclusive of reported data in companies such as financial statements announcements in media. Furthermore the form stipulates that stock prices adjust quickly and unbiasedly to new publicly available information in that no profits can be gained from selling such information because logically one should not be able to profit from what everybody else knows. Even in the presence of analysts in this form of market they cannot attain consistent higher results. However, the publicly available information due to high positive media coverage in a semi strong form of efficient market will affect stock returns but in an extremely short term as the market once absorbs the information does not allow investors to gain abnormal profits. In fact it is the insider who stands to gain in the short term price change and not the investor who buys and hold the stock.

Another form to be considered in relation to the abstract is the strong form of market efficiency hypothesis which stipulates that the stock’s current price reflects all existing information i.e. public and insider information (private). Contrary to the latter form, no gains can be obtained from the trade of any information even the unknown insider information. The assertion to this is that the market does expect unbiasedly all future developments and all information may have already been incorporated in a more objective way than that of insiders

. On the other hand researchers have lately become more and more convinced that the stock market is not, as earlier considered, characterized by fully rational investor behavior. Instead the stock markets from time to time show a somewhat bias behavior more likely based upon a psychological influences rather than rational ones. (Forssten, 2005)

In the journal, the writer has shown that media coverage has an effect on how the consumers perceive the product

The price of securities responds to the news announcements. Furthermore, the more the positive the coverage is, the more investors raise their expectation on profitability of the securities in question. The fact that they mostly rely on the media to a larger extent for them to critically analyse the economically viable information regarding their securities means that they are rational. A rational investor will always chose securities that yield maximum gains. As such, the writer of the journal establishes that media coverage spinning of positive news by IR firms raises future expectation of higher gains which makes the investors rely on the news coverage. The subjectivity of which publicly available information is worth noting is what distinguishes a rational investor in an efficient market.In other words, investors form expectations based on their interpretation of the statistical releases of macroeconomic variables, which then affect their demand for securities and leads to changes in stock price[ CITATION Gen08 l 1033 ].

Greater coverage of good news relative to bad news is thus interpreted as indicating that the good news is more economically significant.[CITATION Dav12 p 631 l 1033 ].Clearly, past and future information reflects in the current prices of the securities which avoid chances of traders and investors making arbitrage gains. This is a major attribute of efficient market that the writer tries to show in this journal.

Full disclosure is yet another attribute of efficient market. However, IR firms sometimes influences the kind of information to spin to the public by the media coverage. This raises a problem of biasness which makes efficient market hypothesis a hypothetical model in this scenario. It’s however not possible to link a certain stock report in the newspaper to IR firms.

The journal also states that IR firms incur low cost almost costless. In an efficient market, it’s assumed that there are low transaction costs. This thus shows that the influencing media coverage of positive news at low costs is an efficient market scenario. Although it does not all reflect in the stock prices, it reflects in other economic activities of the firm consequently positive feedback in the long run.

References

BR Proffessional Education. (2012). BR Financial Management Study Pack. Nairobi: BR Proffessional Education publisher.

David H. Solomon. (2012, April 2). The journal of Finance. Selective Publicity and Stock Prices, LXVIII,No 2, 631.

Fama. (1970). The financial markets context;3 The Efficient Markets Hypothesis (EMH). Retrieved May 15th, 2014, from http://www.open.edu: http://www.open.edu/openlearn/money-management/money/accounting-and-finance/the-financial-markets-context/content-section-3

Gene Birz, J. R. (2008). The Effect of Macroeconomic News on Stock Returns. New Evidence from Newspaper Coverage, 3.

McGraw-Hill Higher Education. (2014). Financial management. In The Efficient Market Hypothesis Sample (pp. 231-232). McGraw-Hill.

Petty. (2012). Financial Management (6th Edition ed.). Australia: Pearson.

Strathmore University. (2012). Financial Management Study Pack. Nairobi,Kenya: Strathmore Edu.

The Open University. (2014). The financial markets context;3 The Efficient Markets Hypothesis (EMH). Retrieved May 15th, 2014, from http://www.open.edu: http://www.open.edu/openlearn/money-management/money/accounting-and-finance/the-financial-markets-context/content-section-3