Risk and Return

Risk and Return

Discussion 1: Risk and Return
(A). Monks and Reed (2011) asserts that profit is the driving force in business organizations’ urge to invest. When the profits are not realized, there is disappointment and resentment by the investor or investors and as normal as it may sound in business, an investment that makes a loss is not the need of an investor. An individual corporate project may fail to an extent that its effect or effects are super damaging. This can happen because of any one of the following reasons; the amount of money available for the project to be offset is not enough or the amount of money that was initially projected for use in the project was too much when compared to the actual returns (Monks & Reed, 2011). Such a situation usually results to disillusionment on the part of the project implementers who might fail to recoup the money that has gone into implementation of the project. When it is a stand alone project, then either way the returns are not going to be expected from anywhere as the project stalls (Monks & Reed, 2011).

On the other hand, a stand alone project is highly risky also due to the fact that competitors are running the same project in a similar manner for the same market or they run it better. Laro and Pratt (2011) points out the overall implication of a stand alone project is that a stand alone is subject to stiff and at times unsustainable competition from similar outfits. This therefore results to a reduction in the profitability of such projects due to the fact that stiff competition might result to price wars whereby individual players undercut one another in terms of their pricing strategy in order to enhance their market position. This affects the flow of cash in our projects negatively in most cases (Laro & Pratt, 2011). Though this can be anticipated, the competitors’ reactions may not or when they are, they may be contrary to what was anticipated. This makes it hard for the project implementers to keep on keeping on. All these things may not have much effect on the stockholders when they are benefiting from many other projects apart from the stand alone one (Laro & Pratt, 2011). To them, the risks are much diversified and the effect very minimal.The effect of a portion of an investment is minimized in a diversified arena.

(B) A market bubble is a situation where an optimistic notion moves prices of commodities up abnormally beyond the real value of the given commodities. A bubble market usually results to firms present in the market experiencing abnormal profits due to the fact that such firms are usually in a position to reap sales revenue that are significantly higher than the real costs of actually producing the products or services. However, Balm (2009) notes that such a situation usually lasts for a short period before the market forces compel the market to revert to its normal position. At such a point, the ‘bubble’ is usually said to have busted implying that artificial optimistic market outlook has ceased to exist (Balm, 2009). Anchoring bias is a case where we are made aware of a value and use the same anywhere when asked to value anything even if it is not related to the number are aware of; we incline ourselves to the number and make our judgments based on the same. Anchoring bias contributes so much to market bubbles when the valuation is highly abnormal and the commodity being valued does not even come close to the value. A typical example is when a person hears a value like a car is $ 300. The person immediately thinks $ 250 is too little and $ 400 is too much (Balm, 2009). This estimative valuation leads to market bubbles and is not very necessary.

American Bar Association Committee (2009) explains that herd behavior is a case where we mimic or copy the actions or behavior of other people who in most cases are the majority. This is group thinking and the decision is usually that of the majority. Aggregate decisions are the ones taken and they also lead to market bubbles because mob intelligence is always exaggerated (American Bar Association Committee, 2009). To a group, buying a car needs just a few dollars from the members, but for an individual it is the whole cost. When you think of it from the group angle, you get excited and may tend to think it easy to accomplish many things with minimal resources (American Bar Association Committee, 2009). This is a good illustration of the market bubble under discussion.

Discussion 2: Valuation of Stocks and Corporations
(A). Stocks of a company, once issued into the market at the beginning through the initial public offer (IPO0, do not affect the company in any way. The company’s only interest is the IPO value and this is what their concern is (Whaley, 2006). IPO prices are mostly got by the organizational management and the next set of prices is set by the traders in the stock exchange market. However stock prices are affected more by the short term performance of the company than the long term (Whaley, 2006). Things like inflation and interest rates, exchange rates, release of new products and services are just but among the short term occurrences that alter the performance of the company and there and then the prices of stocks in the stock exchange markets (Whaley, 2006).

(B) Dividend discount model (DDM) is a way of assessing the value of a company’s stock price based on the theory that its stock is worth the sum of all of its future dividend payments, discounted back to their present value (Whaley, 2006). In other words, it is used to value stocks based on the net present value of the future dividends (Whaley, 2006). The equation most widely used is called the Gordon growth model.

The variable parameters are:

: is the current stock price.

: is the constant growth rate in perpetuity expected for the dividends.

: is the constant cost of equity capital for that company.

: is the value of the next year’s dividends.

There is no reason to use a calculation of next year’s dividend using the current dividend and the growth rate, when management commonly disclose the future year’s dividend and websites post it.

The equation can also be understood to compute the value of a stock such that the sum of its dividend yield (income) plus its growth (capital gains) equals the investor’s required total return. Consider the dividend growth rate as a proxy for the growth of earnings and by extension the stock price and capital gains. Consider the company’s cost of equity capital as a proxy for the investor’s required total return.

This can be rewritten as

References

American Bar Association Committee. (2009). The Corporation answer book (7^th Ed.). New York: Aspen publishers.

Balm, M. (2009). An empirical analysis of stock option valuation methodologiesin closely held U.S. corporations. Florida: Boca Raton Publishers.

Laro, D., & Pratt, S. (2011). Business Valuation and Federal taxes, second edition. New Jersey: John Wiley and Sons Inc.

Monks, R. & Reed, L. (2011). Corporate valuation for portfolio investment. New Jersey: John Wiley and Sons.

Whaley, R. (2006). Derivatives, Markets, Valuation and Risk Management. New Jersey: John Wiley and Sons.