Background on Returns and Risks
In evaluating the profitability of a firm, returns usually ignore the concept of time value of money. This is a big loophole in investment decisions as money received today is more valuable than money received later even if the amounts are equal. In effect, returns are displaced by the amount of cash flows to inject timing of cash concepts. Partly, the delay of receipt of returns is attributable to risks associated with them although risks can be positive at times of advanced payment. Risks is generally described as the extent that actual returns depart from expected returns posted earlier by shareholders. The relationship of risk and return is attributable in viewing them as a coin where two-tier evaluation is required for optimal decision. In this regard, the analysis of risk-return relationship will determine on how much shareholders would receive and how much the firm value.
Case Study of BHP to be Applied with Three ASX Companies
In computing for BHP Billiton historical mean returns, the formula ((Share Price End – Share Price Begin)/ Share Price Begin) + (Dividend/ Price Begin) is used wherein Yahoo! Finance historical prices and dividends are collated as variables. On the other hand, Hang Seng Index historical mean returns from 2002 to 2004 are derived from in an online data while 2005 and 2006 figures are merely trends due to lack of available information. As shown in the appendix, deriving annual dividends by extracting dividend yield to original dividend amount fails consistency. In effect, increase/ decrease trends from 2002 to 2006 figures are utilized. All the prices and dividends for two samples are gathered in Yahoo! Finance and Hang Seng Index Website. It is assumed that investors will buy share in the beginning of the year and reinvested their gains at the end of the same year. This will make the computation more simple and only based on the available share data.
As observed, BHP Billiton shares have higher expected mean value returns over the last five years than the Hang Seng Index as the latter exemplified continuous decline in total returns. BHP Billiton has 38.74% 5-year mean return in annual terms while Hang Seng Index has only 12.80%. In effect, the expected value of the future returns tagged on BHP Billiton is higher than Hang Seng Index. In addition, BHP also has lower risk in relation for investors to gain the expected return which is shown by having 10.77 standard deviation against Hang Seng Index 13.11. There is no need of getting the coefficient of variation of two investment destinations because the upper hand of BHP is very clear. It has high expected return with relatively lower risks associated with it.
As standard deviation is used to measure an asset’s total risk, beta coefficient measures the market risk of a certain asset (e.g. shares) which cannot be reduced through diversification ( 1999 . ). Because of this measure, the upper hand of BHP share against Hang Seng Index and the former being a more lucrative alternative investment becomes less useful. The focus now is how sensitive is BHP shares to Hang Seng Index. As shown in the appendix, Hang Seng Index and BHP shares have negative slope which is a very rare phenomena. This means that when the Hang Seng Index is decreasing on its return performance BHP share returns will have increasing trends in returns. This can mean that the two alternative investments are experiencing trade-offs and are determinants of investment decision (e.g. invest in Hang Seng Index if BHP shares are performing poorly).
Using the formula E(ri) = Rf + Bi (ERm – Rf) (wherein E(ri) is the required return, Rf is the risk-free rate of return, Bi is the beta coefficient and ERm – Rf as the risk premium) we can have broader look in intrinsic value of BHP shares. The 1-year Australian Government Bond or the risk-free rate of return has 6.11% annual yield, the beta coefficient for the 2006 for BHP is 22.68 and the market risk premium is 6%. With this we can fill the formula by E(ri) = 6.11% + 22.68 (6%) = 1.4219. When compared to the closing share price of BHP which is .07, the required rate of return for the BHP share is well below its actual price.
Appendix
REQUIREMENT 1 AND 2
BHP Billiton
Year (end of June)
Dividend for the Year
Stock Price (beginning)
Stock Price (ending)
Annual Rate of Return
in %
Historical Mean Returns (%)
Standard Deviation
2002
0.26
9.85
11.8
0.2244
22.44
38.74
10.77
2003
2.55
10.31
11.59
0.3715
37.15
2004
0.33
13
17.52
0.3731
37.31
2005
0.46
18.48
27.3
0.5022
50.22
2006
0.35
29.62
43.07
0.4659
46.59
*Figures in dollars except rate of return and sd
**Computed using the formula (((Price End – Price Begin)/ Price Begin)+ (Dividend/ Price Begin)
REQUIREMENT 1 AND 2
Hang Seng Index
Year (end of June)
Dividend Yeild (beginning)
Dividend Yeild (ending)
Average Annual Dividend Yeild
Index Price (Beginning)
Index Price (Ending)
Average Annual Index Price
Derived Dividend Value
Annual Rate of Return
Historical Mean Returns (%)
Standard Deviation
2002
2.49
3.08
2.79
14880.98
16267.62
15574.3
43374.426
26.5
12.80
13.11
2003
3.17
3.99
3.58
12238.03
14201.06
13219.55
47325.971
19
2004
3.78
3.34
3.56
10134.83
12285.75
11210.29
39908.632
10.9
2005
3.35
3.37
3.36
10267.36
9577.12
9922.24
33338.726
3.88
2006
3.21
3.39
3.3
12316.69
10598.55
11457.62
37810.146
3.72
26.5
19
-0.283019
10.9
-0.426316
0.506316
0.213164
7.02
3.88
0.639484
0.319742
3.72
0.959226
*Note: the red highlighted returns are from internet data
REQUIREMENT 3
New Beta for BHP
Year
BHP annual rate of return
Change
Hang Seng Index Return
Change
Slope
2002
22.44
26.5
2003
37.15
0.655526
19
-0.28302
-1.96133
2004
37.31
0.004307
10.9
-0.42632
-0.01975
2005
50.22
0.34602
3.88
-0.64404
-1.83903
2006
46.59
-0.07228
3.72
-0.04124
22.6875
Bibliography
Books
Electronic Sources
Credit:ivythesis.typepad.com
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