Discuss the risk and return characteristics of a portfolio in terms of correlation and diversification, and the impact of international assets on a portfolio.
The degree and direction of correlation between return have far reaching effects on the reduction of portfolio through diversification. The value of correlation takes value or varies between the positive and negative entity. Positive correlation between returns pays a direct relationship between risk and return of portfolio and on the other side, when assets with negative correlated between their returns are combined in different ratios, the relationship between the risks and return characteristic of a portfolio shapes a ‘V’ image. The more negative and less positive is the correlation between assets returns the greater risk reducing benefits of diversification. If the investor invests its wealth in more than one security reduces portfolio risk. This is attributed to diversification effects. The international assets have positive impact on assets because it increases the international assets on portfolio that ultimately reduce the risk and offer higher return.
The more diversified a portfolio, the less risk that is inherent. Diversifying between markets, brands, and company type decreases the affect of a market downturn in one industry. If I was invested heavily in only pharmaceutical companies, and those companies were levied with new restrictions, the industry could suffer. My portfolio in the pharmaceutical companies would suffer greatly. Diversifying across multiple industries and several companies (separate companies, not subsidiaries) will lower the risk while maintaining higher yields. Having portfolios in multiple countries will have a similar effect in diversification. A slump in the U.S. stock market may cause international stocks to change, but they may respond slowly or not at all to the downturn. An investment in a multinational corporation will also diversify the portfolio, as one economy’s changes may not bother the corporation as greatly.
An example of portfolio diversification is investments in Google, CISCO, Wal-Mart, Pfizer, Fiat, Wells Fargo, McDonalds, and Burlington Northern Santa Fe Corporation is an example of several multinational companies and domestic companies that are spread over several industries. There are two tech stocks, one railway shipping, one banking, one automaker, one pharmaceutical, and one restaurant chain. This portfolio is diverse in industries so that the entire portfolio will not fail should an industry have trouble. If the Food and Drug Administration should place new regulations on all food manufacturers, distributors, and retailers; only McDonalds (as a restaurant chain) and Wal-Mart (as a distributor and retailer) are going to be effected.
Time Value of Money
Discuss the concept of future value and present value, their calculation for single amounts, and the relationship between them.
Future Value: Future value of money refers to a particular amount of money to be matured in future by calculating on the basis of a specified interest rate.
FV = PV(1+k)^n. For calculating the future value of single cash low compounded annually is as follows: Here, FV n = Future value of the initial flow n years, PV= Initial cash flow, k= Annual rate of interest, n= life of investment. Present Value: In the present value approach, money is received at some future date and will be worth less because representing interest is lost during the interest. It is the current value of a future amount. The present value approach is the commonly followed approach for evaluating the financial viability of projects. For calculating present value for single amount, four components are required i.e. present value & future value amount and length of time before the future value amount occurs, interest rate used for discounting.
There is an inverse relationship between the future value single amount and present value single amount. Future value equals a present value plus the interest that can be acquired by having stake of the money. On the other side, present value equals the future value deducting the interest that comes from ownership of the money.
Discuss the management of receipts and disbursements, including floats, speeding collections, slowing payments, cash concentration, zero-balance accounts, and investing in marketable securities.
• Floats: The term float refers to the amount of money tied up in checks that have been written, but have yet to be collected and cash. Float represents the difference between the bank balance and book balance of the cash of the company.
• Speeding collections: The crucial strategy for the efficient cash management, in which cash is collected as quickly as possible without losing future sales. This strategy is applied effectively by making changes in the credit terms, credit standards and collections policies.
• Slowing payments: Slowing payment is the basic strategy of effective cash management in which the firm makes delay or late payment to its payables without spoiling its credit standards.
• Cash concentration: In this technique of cash and disbursements, automatically funds are transfer from the various accounts to the main accounts in order to make better efficiency of the cash management (Cash Concentration).
• Zero balance accounts: Zero balance account is also amending the effectiveness of the cash management by offering the companies to open their balance account without any mandatory balance in their accounts.
• Investing marketable securities: In this alternative, firm makes investment in the marketable securities such as equity and debt on the temporary basis, so that it will able to offer good returns to its shareholders.
Discuss the return and risk of alternative capital structures, their linkage to market value, and other important considerations related to capital structure.
Many firms to make comparison with debt- equity ratio utilize the approach of capital structure decisions. The risk and return of the capital structure varies with the several of options of debt- equity. If the ratio of debt is higher in the formation of capital structure, then the safety to the investors is very low and this is a high financial distress for the company. In the other alternative capital structure, the ratio of debt is too low in comparison to the equity; it means that the owner’s share in the capital structure is high, which reduces the risk and increases the return for the firm. Risk and return has positive linkage with the market value. If the proportion of debt is more in the capital structure means high level of risk factor that negatively affects the market value and vice versa. The adequate balance between equity and debt must be maintained which is the important consideration related to capital structure.
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