The real interest rate can be described as the theoretical rate of return on investment an investor is expecting to receive after allowing for inflation. On the other hand, the nominal interest rate (risk-free) can be described as the rate of return on investment attained before inflation adjustments.
The two differ in the sense that with the real interest rate, the effects of inflation have been accounted for, whereas with the nominal interest rate, the effects of inflation have not been factored in. The real interest rate is calculated by adjusting the nominal rate that has been charged to factor in inflation. The real interest rate is roughly the nominal rate less the inflation rate. This can be illustrated mathematically as:
Real interest rate = Nominal Interest rate – Inflation
Therefore, the above explanation shows that the Nominal interest rate is measured in monetary terms, while the real interest rate is measured in real terms. The relationship that exists between;
(1+r) (1+i)= (1+R)
Total risk is a combination of systematic risk and unsystematic risk, as indicated below:
Total risk = systematic risk + unsystematic risk.
Where systematic risk is the total risk of a diversified portfolio while the unsystematic risk is the risk that can be removed by combining assets into a portfolio
The expected rate of return on a portfolio of shares does not depend on the percentage of portfolio investment of each share. This is because the main elements that affect expected return are the time value of money, the reward for bearing systematic risk, and the amount of systematic risk. Therefore the percentage of portfolio investment of each share does not imply the expected rate of return on the portfolio.
The riskiness of the entire portfolio affects the expected return since it is equivalent to the systematic risk, which is one of the factors affecting the expected return.
The capital asset pricing model is a model that explains the relationship between risk and expected return, which is employed in the pricing of risky portfolios (Shapiro, 2010, Pp5). The capital asset pricing model postulates that all investors:
- have equal access to all securities
- are price takers (investors behave competitively)
- have sufficient investment information available to them at the same time
- trade devoid of taxation costs
- are rational as well as risk-averse
- aim at maximizing economic utilities
- are diversified mainly across a range of investments.
- can lend as well as borrow unrestricted amounts under risk-free interest rates
There is a difference between real asset investment and financial asset investment. This is because, in real asset investment, there is no fluctuation in returns while in financial asset investments, the expected returns always fluctuate depending on the market conditions.
The above statement relates to real asset investment decisions in a way that managers usually prefer to invest in real asset investments as opposed to financial investments. This is because when making corporate budgeting decisions, managers prefer investing more in assets that have stable returns.
The discounted cash flows (DCF) concepts are so crucial to corporate financial analysis because nearly all financial decisions made by a corporation involve future cash flows. The DCF concept applies to every situation in which money is paid and received and is, therefore, one of the essential ideas to any corporation’s financial decision making.
The four steps carried out in a DCF analysis are:
- Estimating future cash flows: This is the first step carried out in a DCF analysis and involves projecting the expected cash flow for the corporation for a given period based on the corporate income growth rate, fixed investment requirement, income tax rate, net operating profit margin, and annual demand for working capital.
- Assess the riskiness of the cash flows: The next step performed in a DCF analysis is assessing the riskiness of the cash flows. Assessing the riskiness of the cash flows is essential as risk is a significant factor, mainly when the financial decision being reflected on involves some statistically considerable probability of loss. Risk assessment is typically done under the principle that investments ought to compensate the investor in proportion to the level of risk taken as a result of investing.
- Incorporate the risk assessment into the analysis
- Find the present value of the flows: In this step, the corporation’s weighted average cost of capital is used to discount the projected cash flows during the Excess Return Period to obtain the corporation’s Cash Flow from Operations. The weighted average cost of capital is also used to calculate the corporation’s Residual Value. To this, to obtain the Corporate Value, the value of the Short-Term Assets on hand is added.
The value of an asset can be determined by the use of a dividend growth model. In the divided growth model, dividends are normally expected to increase at a fixed percentage per period. Determination of value of an asset can, therefore, be illustrated as:
Po = D1 ∕ (1+R) + D 2 ∕ (1+2)2 + D3 ∕ (1+3)3 …………
Po = Do (1+g) ∕ (1+R) + Do (1+g) 2 ∕ (1+R) 2 + Do (1+g) 3 ∕ (1+R) 3 + ……………
The above illustration can be illustrated as:
Po = Do (1+g) ∕ R-g = D1 ∕ R-g where Po is the current value of an asset, Do is the dividend to be paid, g the percent gain on dividends and R the rate of return on assets.
The opportunity cost concept refers to the best option that is forgone when a particular decision of investment is made. For instance, if a person a certain amount of money like $40,000 that they want to invest, the person can select Share A or Share B; the difference in the dividends that exists between the two shares is the opportunity cost. For instance, if share A has 8% divided, and B has 3% divided, the opportunity cost is 4%.
A perfect capital market can be described as a market in which there are no opportunities for arbitrage(when the sale and purchase of security co-occur within diverse markets intending to make a profit that is risk-free through the exploitation of price differences that exist between markets).In a capital market, costless and sufficient information available is to all investors, and no firm or individual is big enough to affect prices since assets are priced with full efficiency (Harley & Shall, 1979, Pp 15).
The concept of a perfect capital market is used in the financial theory, principally in an opinion by Modigliani and Miller. According to Modigliani and Miller, an ideal capital market is characterized by investors having information upon which they can act rationally to arrive at similar expectations concerning future earning and risks.
The following features mainly characterize bonds:
- Interest Payments: bonds usually offer some form of interest payments. However, this depends on the structure of the relationships. For instance, the Floating Rate Bonds have regular interest rates that are periodically adjusted while the Zero-Coupon Bonds make no periodic interest payments at all.
- Specified maturity dates: bonds have specified maturity dates on which the principal (par value) has to be paid.
- Credit Ratings: One can evaluate the default risk (the probability that the issuer won’t be able to make principal payments) of a bond by checking the ratings as provided by the bond rating agencies such as Moody’s Investors Service or Standard and Poor’s.
The Efficient Market Hypothesis (EMH) is a hypothesis of financial economics that argues that prices of traded assets such as bonds, properties, and stocks within financial markets should always reflect the available information and are therefore unbiased based on the fact that they reflect shared beliefs of all investors regarding prospects.
There are three primary forms of the hypothesis: weak, semi-strong, and secure. The weak form of the theory argues that current prices on traded assets such as bonds, properties, and stocks fully reflect all past readily-available information. The semi-strong way argues that prices reflect all the publicly available data and that prices on traded assets instantaneously change to reflect new public information. The secure form of the hypothesis additionally contends that asset prices immediately reflect even privately-held information.
The key features of a common share or stock include;
- Limited Liability; In case a person invests in stocks, his or her liability is limited to invested stocks. They are not obliged to pay any other amount in case of bankruptcy occurs.
- Voting Rights: Each stock carries a voting right. As a result, ordinary shareholders are entitled to vote on various issues concerning the corporation, with every share allowing the shareholder to a vote.
- Dividends: Common shareholders are also entitled to receive bonuses if /when approved by the company’s board of directors.
- Dissolution and Liquidation: In the case of dissolution or liquidation of the company/corporation, its common shareholders always have a final claim on the corporation’s assets.
- Merger Consideration: Incase a corporate merger endorsed by shareholders, they are entitled to receiving final consideration for the shares that they own.
Common stock and preferred stocks are different in two significant aspects. First, selected stakeholders have a greater entitlement to a corporation’s assets and earnings. Second, the dividends of preferred stocks are generally more substantial as well as different from those of the common stock (King, 1999, PP1).
A project’s NPV can simply be described as the sum of the individual present value of the yearly cash flows. It consists of the summation of a series of discounted cash flows after the cash flows that occur throughout the projected life of a particular project. A project NPV can be illustrated as mathematical as:
NPV = ∑Tt-1 Ct ∕ (1+r) t – Co, Where Ct is the current cash flow, Co, the initial cash flow, T time, and r the interest rate.
- Io = the initial outlay
- Ct = the net cash receipt at the end of year t
- r = Rate of return on investment
- n = Duration of the investment in years
The rationale behind the NPV method is to enable a particular project to generate enough cash flows so that it can recover the cost of the investment as well as to allow the investors to earn their required rates of return.
According to NPV, projects that add to the shareholder’s wealth ought to be accepted if they qualify as independent. If the plans are mutually exclusive, then the one that adds more value to a firm should be taken as an independent.
Capital budgeting is an investment decision-making process used by corporations (or a business) to evaluate whether a potential project, for instance, developing a new plant, is worth undertaking; by assessing their cash flows and inflows so as establish whether the returns generated meet sufficient target levels (Drake, 2007, Pp1). Within the context of the capital budgeting process,” Risk” means the uncertainty with a project’s future profitability (Drake, 2007, Pp 2).
The three types of risk relevant to capital budgeting are; Market risk, the standard alone risk, and the portfolio risk.
- Market risk is a risk that causes a decrease in the value of an investment or a portfolio. Some of the market risk factors include economic changes, changes in interest rates, and inflation. The market risk is measured using the impact of the project on the firm’s beta.
- The stand-alone risk is a project risk in a situation whereby the project is perceived in Isolation. The independent risk is measured by evaluating the inconsistencies that exist in the project’s expected returns.
- Portfolio risk is a project portfolio that has a certain level of risk. The portfolio risk is measured by the degree of change that occurs in a new project and the difference in the portfolio of the existing project.
The three risks are related in the sense that they can yield several possible outcomes when making capital budgeting decisions. Chances are uncertain conditions in which firms are supposed to operate under. As a result, capital budgeting decisions are using not based on precise forecasts because the forecasts can change due to the influence of any of the three types of risks.
Yes. Other subjective risk factors that are supposed to be considered before making the final decision include; the option to abandon the project, contingency planning, the opportunity to wait, the opportunity to expand, and strategic opportunities.