Section I: Introduction
The risk-return tradeoff is a concept fundamental to finance. The basic tenet is that rational investors expect higher rates of return for riskier investments; as such, stock returns should be a negative function of stock volatility. Two hypotheses: The “leverage effect” and volatility feedback, have been put forth in support of this view. The underlying notion behind the leverage effect is that a decrease in stock returns increases a firm’s leverage, resulting in higher equity volatility. Volatility feedback, on the other hand, reverses the causality and posits that a persistent increase in volatility causes investors to raise their expected returns. This leads to an immediate decline in share prices to allow for higher future returns. The intuition here is that increases in risks cause investors to raise their expected returns, resulting in higher discount rates, and thus lower firm values. This theory is in line with Treynor, Sharpe and Lintner’s Capital Asset Pricing Model (CAPM) and other multifactor models.
Contrastingly, real options theory suggests that the value of a firm’s real options should go up as the volatility of its underlying process increases (McDonald and Siegel (1986)). The reason for this is well-established: An increase in output price volatility widens the spread of future profits, and hence brings up the maximum possible value for a firm. Conversely, the potential downside of the option is limited to its initial investment value. Moreover, firms with high levels of operating and investing flexibility are able to take advantage of periods of economic prosperity by restarting or expanding operations, while mitigating poor economic conditions by scaling down, or temporarily ceasing op...
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...ce sheets maintain investment levels. In other words, firms with the ability to raise funds internally are still able to exercise their investment opportunities. To account for this, we pre-select firms with negative cash flow growth and split them into cash holding-terciles. We then divide firms within the bottom cash-holding tercile into leverage quintiles and perform separate regressions for each of the quintiles as per equation (2). If our hypothesis holds, we would expect to see a monotonic decrease in return-volatility sensitivity as leverage increases.
Following O’Connor Keefe and Tate (2013) and Duffee (1995), we define cash flow growth as the contemporaneous growth in operating cash flows of a firm; cash holdings as the ratio of cash and equivalents to total assets net of cash; and leverage as the ratio of book value of debt to the market value of equity.
In regards to the corporation’s balance sheet, it is necessary to place an importance on liquidity ratios to demonstrate the company’s ability to pay its short term obligations such as accounts payable and notes that have a duration of less than one year. These commonly used liquidity ratios include the current ratio, quick ratio, and cash ratio. All three ratios are used to measure the liquidity of a company or business. The current ratio is used to indicate a business’s ability to meet maturing obligations. The quick ratio is used to indicate the company’s ability to pay off debt. Finally the cash ratio is used to measure the amount of capital as well short term counterparts a business has over its current liabilities.
This is where the cash flow reaches its peak but also at the point of
Important factors of a company’s outlook are its financial strength and weaknesses. These factors can be evaluated by reviewing the firm’s financial statements and using ratios to help measure a company’s liquidity, leverage, activity, profitability, and growth. Financial ratios are computed by using the information found in a company’s financial statements: primarily income statement and balance sheet. The calculations from the current year, previous years, and other companies in the industry are used as a basis to identify and ev...
In turn everything in the present and the future is judged through the stocks as they hold a high importance in industrialized economies showing the healthiness of said countries economy. As investing discourages consumer spending over all decreases, it lead...
We analyzed the market for two weeks to determine when the equity market would turn from a bearish to bullish market. Without a change in the market and a declining bond price, we decided to invest in equities according to our investment strategy, which brought us into the second phase of our portfolio. Therefore, at the beginning of February we bought shares in Sirius, Microsoft, Neon, Washington Mutual, and Nike. As assumed, the equity market continued to plummet decreasing the value of all our stocks except for our Gold Corporation stock.
Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002).
The article addresses the issue of being successful in a highly uncertain business environment. Some managers prefer to play it safe by adopting a wait-and-see strategy while others may invest in flexibility that allows their companies to adapt quickly as the market evolves. The companies sometimes neglect the fact that having a successful strategy depends on several factors, including their industry position, assets, or their willingness to take a risk in investing in such strategies. The paper introduced some of the tips and terminologies that could help managers facing uncertainty decide on whether to play safe or bet big. The traditional practice is to put a vision of predicted future events
Everyone in the investment world is constantly looking for ways to insulate themselves from the volatility surrounding the markets in terms of strategizing investments and diversification. Most investors look to the markets for common stock options and mutual funds with hesitancy to global volatility facing today’s financial markets. Another investment market option to considered, although not immune to outside volatility, is the bond market. Ross stated the bond market is larger in scope than the stock market (2011). A bond is an investment option wherein the investor loans money to large organizations such as corporations, state and local municipalities, the US government and governments abroad (Parker, 2014). The Securities and Exchange Commission (SEC) classify a bond as a debt instrument. The bond, also known as a debt security, is issued to the public (creditor) who holds the bond until they are repaid by the borrower in interest-only payments over a particular period (Ross, Westerfield and Jordan, 2011). At the end of the bond term and only then is the principal of the loan paid in full as a balloon payment. It is similar to an IOU held by the creditor until the borrower fulfills their pro...
Today financial corporate managers are continually asking, “What will today’s investment look like for the future health of the company? Should financial decisions be put on hold until the markets become stronger? Is it more profitable to act now to better position the company’s market share?” These are all questions that could be clearly answered if the managers had a magical financial crystal ball. In lieu of the crystal ball, managers have a way of calculating the financial risks with some certainty to better predict positive financial investment outcomes through the discounted cash flow valuation (DCF). DCF valuation is a realistic approach, a tool used, to “determine the future and present value of investments with multiple cash flows” over a particular period of time which is incurred at the end of each period (Ross, Westerfield, & Jordan, 2011). Solutions Matrix defines DCF as a “cash flow summary adjusted so as to reflect the time value of money (The Meaning of Discounted Cash Flow, 2014).” The valuation of money paid or rec...
The capital structure of a firm is the way in which it decides to finance its operations from various funds, comprising debt, such as bonds and outstanding loans, and equity, including stock and retained earnings. In the long term, firms seek to find the optimal debt-equity ratio. This essay will explore the advantages and disadvantages of different capital structure mixes, and consider whether this has any relevance to firm value in theory and in reality.
There are many techniques used to manage cash including, the nature of asset growth, controlling assets, patterns of financing, the financing decision, a decision process and shifts in asset structure. For any company the growth of asset results in a growth in wealth if managed effectively. The typical firm usually forecast the rate of sales to ensure that the production of goods match sales so there is not an overflow if inventory. As a company expands and produces more items they will acquire permanent current assets. Permanent current assets can be described as a constant inventory of items because it is almost impossible to predict the market and the demands of the consumer.
Should financial decisions be put on hold until the markets become stronger? Is it more profitable to act now to better position the company’s market share?” These are all questions that could be clearly answered if the managers had a magical financial crystal ball. In lieu of the crystal ball, managers have a way of calculating the financial risks with some certainty to better predict positive financial investment outcomes through the discounted cash flow valuation (DCF). DCF valuation is a realistic approach, a tool used, to “determine the future and present value of investments with multiple cash flows” over a particular period of time which is incurred at the end of each period (Ross, Westerfield, & Jordan, 2011). Solutions Matrix defines DCF as a “cash flow summary adjusted so as to reflect the time value of money (The Meaning of Discounted Cash Flow, 2014).” The valuation of money paid or received in the future has less monetary value if that same money was to be received or paid today (The Meaning of Discounted Cash Flow, 2014). This cash flow evaluation helps managers in their determination whether or not to invest in research and development, purchase more equipment, enlarge floor space, and increase laborers, or instead, retain net profits. Either way, the DCF valuation gives
When analyzing Coca-Cola’s statement of cash flow, the first thing to note is a steady increase in operating activities within the past few years. These transactions affect the net income. From 2001 to 2003 the cash from net income increased from $4.1 million to $5.5 million. The operating activities is often the most important cash flow of a business because it shows the cash from revenue compared to the payments made for expenses (2).
Cash flow statements provide essential information to company owners, shareholders and investors and provide an overview of the status of cash flow at a given point in time. Cash flow management is an ongoing process that ties the forecasting of cash flow to strategic goals and objectives of an organization. The measurement of cash flow can be used for calculating other parameters that give information on a company 's value, liquidity or solvency, and situation. Without positive cash flow, a company cannot meet its financial obligations.
This paper will define and discuss five financial theories and how they impact business decisions made by financial managers. The theories will be the Modern Portfolio Theory, Tobin Separation Theorem, Equilibrium Theory, Arbitrage Pricing Theory (APT), and the Efficient Markets Hypothesis.