Research Topics: Corporate Investment Portfolio Management

CORPORATE INVESTMENT PORTFOLIO MANAGEMENT RESEARCH PROPOSAL SAMPLE

1.0  Title The working title of this research is initially drafted as – Multi-Objective Project Finance Using Fuzzy Approach: Corporate Investment Portfolio Management.   2.0  Background of the Research Multi-objective optimization (or programming) refers to the process of simultaneous optimization of two or more conflicting objectives subjected to certain constraints. Multi-objective optimization is applied to various fields including product and process design and aircraft design as well as in the industry of finance, oil and gas, automobile or where optimal decision-making must be consider despite of the evident trade-offs between two conflicting objectives. Multi-objective optimization follows the fuzzy logic to deal with reasoning that is approximate rather than precise. Compared to the classic predicate logic, in fuzzy logic, the degree of truth to a statement can range between 0 and 1 and not true or false. The net present value (NPV) is given in the form of a fuzzy number. As such, an efficient fuzzy approach could minimize the cost-time quality of the project and support the decision-maker. Investment portfolio, on the other hand, is created through asset allocation across different classes of investments including cash and equivalents, fixed income investments and equity investments. Basically, investment portfolio purports on spreading the risk and diversification. Apart from professional money managers and financial planners, investors’ decision-making could be supported by technical know-how.  The multi-objective of corporate portfolio management is to balance high/low risks investments while also maximising returns. Capital budgeting, capital structure and payout decision will be addressed. This research maintains that the Monte Carlo Simulation is the most appropriate fuzzy technique in managing corporate investment portfolio since this project valuation technique considers NPV, profitability index, internal rate of return and payback. On a fuzzy basis, investment portfolios and the associated are usually measured based on Pareto analysis. With due respect to the Pareto technique, the paper proposes a computer-based Monte Carlo Simulation in investment analysis. For the case we are going to consider, Monte Carlo method could provide a greater number of scenarios to be analysed as well as of probabilities of NPV scenarios that could be estimated.   3.0  Objectives of the Study The main aim of the study is to apply the Monte Carlo Simulation fuzzy technique to the case of multi-objective corporate investment portfolio management. In lieu with this, the research will seek to address the following specific objectives.   §         To evaluate the efficiency of Monte Carlo Simulation technique when applied to corporate investment portfolio management §         To distinguish possible risks, challenges and limitations of the Monte Carlo Simulation technique §         To compare the Monte Carlo Simulation technique with other fuzzy technique that corporate investors are using §         To analyse how Monte Carlo Simulation technique benefits the corporate investors in managing their investment portfolio and decision-making   4.0  Research Methodology Generally, the purpose of the research is to conduct an experimental study on determining the applicability and extent of utilisation of the Monte Carlo Simulation technique for the corporate investors. The experimental method is the method that can be used to establish cause-and-effect relationships. One group, called the experimental group gets the treatment that the researcher believes will cause something to happen (this treatment is formally called the independent variable). The experimental and control groups are compared on some variable that is presumed to reflect the effects of the treatment, or outcome. This is formally referred to as the dependent variable. In this case the independent variable is the Monte Carlo Simulation technique. The researcher will sample 2 corporate investors. The research will be presented in written form with the addition of data charts which will present the project’s results. Pie charts and network charts will be needed to illustrate some of the analyzed data. This cannot be confirmed, however, until the research data have been analyzed.   Credit:ivythesis.typepad.com

CORPORATE INVESTMENT PORTFOLIO MANAGEMENT RESEARCH PROPOSAL SAMPLE

1.0 Title The working title of this research is initially drafted as – Multi-Objective Project Finance Using Fuzzy Approach: Corpora...

Sample Business Essay Morgan Stanley Corporation Report the company acquired a reputation for being the best market advice and market execution

Morgan Stanley Corporation Report Morgan Stanley The company Morgan Stanley has acquired a reputation for being the best in market advice and market execution. Its 53,218 employees in 28 countries connect people, ideas, and capital to help clients achieve their financial objectives (Morgan Stanley online 2000).  The company is one of the top investment banks, in addition to it being a traditional corporate investment banking services that offers services like securities underwriting, mergers, and acquisitions advice, it also offers brokerage and investment management products  and services for institutions and wealthy individuals (Hoovers online 1994).   Location of Headquarters The company’s headquarters is located in Broadway, New York City in the US. Stanley Morgan has 600 offices in 28 countries. It has offices in Africa, Asia, Europe, North and South America (Morgan Stanley online 2000).    Industry products and services The company offers its services for individual investors and it gives institutional services. Included in the individual investor services it gives are optimization of individual investor’s asset collection, private wealth management, platinum and gold benefits of individual investors, and assistance in finding the nearest local branch the clients can make business with.  Included in the institutional services it offers are securities, investment banking, investment management and researches. As mentioned earlier from Hoovers online (1994), the company is one of the top investment banks, in addition to it being a traditional corporate investment banking services that offers services like securities underwriting, mergers, and acquisitions advice, it also offers brokerage and investment management products  and services for institutions and wealthy individuals. The company is covered by a regulatory structure. Regulatory Structures are rules and regulations of the different types of investments in different parts of the world.  Products have different life cycles. Life Cycle is the Birth of products, its growth, maturity, and downside of products. The company’s products have no life cycles since these are consultancy services.   Amount and date of company’s last annual dividend and current market value per share The company’s annual dividend is 6,488,819 (net of $ 109,733 foreign withholding tax) for the year ended February 28, 2005.  The current market share of the company is .15 as of 2004.   Key executives of the corporation The company’s board of directors includes John J. Mack who is the chief executive officer and the chairman of the board of the company, Roy J. Bostock, Erskine B. Bowles, Sir Howard J. Davies, C. Robert Kidder, Charles H. Noski, O. Griffith Sexton, Dr. Laura D’Andrea Tyson, and Dr. Klaus Zumwinkel (Morgan Stanley Online 2000).   These are the persons that ensure the operations of the company run well. They ensure that the company is traveling within its objectives and it is successful in its industry. The members of the board of directors have experienced so many things and can show a wide range of accomplishments. They had different experiences with various companies; this experience they acquired assists them in making sure the company is following a right path. The experience they acquired assists them to make vital decisions.   Global exposure: political and economic risks Any company operating at any country may experience problems both politically and economically. Since the company is operating at many branches in different parts of the world there is a big risk that they might encounter political and economic problems. Risks are part of the daily things that companies must overcome and Morgan Stanley is capable and can overcome such risks.   Through the use of demographics problems can be given proper action. Demographics are the distribution of facts and information needed in a study. It answers questions mostly beginning with who, where, and what. It is used to measure adaptability of products from place to place and person to person. It is also used to measure worldly influences effecting company profits and growth. Problems can be given proper action.  Through analyzing the demographics, the political and economic situation in a country measures can be made to give proper solution to problems. Financial report analysis The first table will show the financial report of Morgan Stanley from Hoovers online (1994).  All amounts are in millions of U.S. dollars except share amount. 		Year 		Revenue 		Operating Income 		Total Net Income 		Diluted EPS     (Net Income) 		Nov. 05 		,770.0 		,224.0 		,939.0 		4.57 		Nov. 04 		,549.0 		,216.0 		,486.0 		4.06 		Nov. 03 		,933.0 		,297.0 		,787.0 		3.45   A. Major changes from the previous year The table shows that from the 2003 to 2005 the revenue, operating income, total net income and the diluted Earnings per share (EPS) of the company increased. This shows how good the company is doing during these 3 years. It also shows how well the company was managed during these years. The improvements that happened during these 3 years can be well commended, as seen in the table significant increases in each category happened during these years. The table showed that during these years there were slight increases in the amount of each category.   B. Causes of these changes These changes can be due to many things. One is due to the continuous struggle of the company to be the best in its industry. The company constantly improves it services and because of that consumers achieve satisfaction. Customer satisfaction leads to encouragement of more costumers to avail the services of the company and this affects the categories stated in the table. Another cause of these changes is the admirable management of the company.  If a company is well managed good results can come out. Through the good effort of the management team the goals and objectives of the company is realized. Lastly a cause of these changes is the dominance of the company against its competitors. The competitive advantage a company has towards its rivals can lead to positive changes in the status of the company.   C. Financial strengths and weaknesses of the company The company’s financial strength is its ability to increase its revenue, operating income, total net income and the diluted EPS. The capacity of the company to make increase in the said category helps it to have a favorable image in the financial market. It also assists in giving it a high market value. The financial weakness of a company is its inability to create huge increase its revenue, operating income, total net income and the diluted EPS. As stated earlier these were significant increases in the amount of each category but it was not that huge. Some things within the company can still be improved so that huge increase in the categories can be realized.   Global Competition Global Competition is competition between companies throughout the world and how it changes from one area to the next. Within global competition a smaller scope exists and this is called Industrial Organization. Industrial Organization is the competition between companies to ease difficulty getting into the industry with the use of similar alternative investment products at varying prices, top companies use this as a way to achieve success through the different products offered.   The financial performance of the company compared with competitors The second table will show the financial performance of the company against competitors from Hoovers online (1994). All amounts are also in millions of U.S. dollars. 		  		Morgan Stanley 		Citigroup Global Markets 		Goldman Sachs 		Merrill 		Lynch 		Annual Sales 		,770.0 		,065.0 		,391.0 		,467.0 		Market Capital 		,874.2 		0.0 		,451.7 		,500.5   As shown in the table the company is doing well against its competitors. Among all the companies it has the largest annual sales followed by Goldman Sachs, Merrill Lynch, and Citigroup Global Markets. The company has used a huge sum of capital market and it benefited the company through its annual sales unlike Goldman Sachs and Merrill Lynch who used larger amounts of market capital but still acquired lesser annual sales.   Current issues (positive and negative) facing this company Positive The positive issue the company is facing is the merging of Morgan Stanley and Dean Witter (Horvitz 42). The union of these two companies can lead to benefits for both companies. Through the union of these two companies the problems they are experiencing can be jointly solved, more people can be used to think about ways to solve problems and how to improve the services offered by both companies. The union of these two companies can lead to better status and realization of the goals and objectives for both companies.   Negative The negative issue the company is facing is the resignation of the some of the best employees of the company and their defection to rival companies (Richardson 32). Employees’ leaving a company is a bad thing but what adds to it being worsened is the defection of these employees to rival companies. Employees that defect to other companies may be used against the former company through the rival company learning from the employee that defects the company’s strategies and other information about the company.  The company should be prepared for the different problems that may arise out of this and for future events that might be caused by such.   Issues that the company must address in the future An issue that the company must address in the future is a wider consumer target. The company is currently offering services mostly to other companies and other people who are well off. This consumer group is a small part of any population. Most population in any country is on the middle class group and the poor group. The company can try to focus on other groups to attain more profits, have huge increase in its consumer population, and boosts the company’s image in its industry. The company being a good investment at this time If a person wants to invest, Morgan Stanley is a good company that should be invested at this time. The company is doing well financially and hasn’t had any big problems. A person who wants to invest his/her money can acquire benefits from this company. Credit:ivythesis.typepad.com

Sample Business Essay Morgan Stanley Corporation Report the company acquired a reputation for being the best market advice and market execution

Morgan Stanley Corporation Report Morgan Stanley The company Morgan Stanley has acquired a reputation for being the best in market advic...

CORPORATE FINANCE

Weighted Average Cost of Capital (WACC)             (See requirement 1)   Analysis and Recommendations on Each Project             Using the net present value (NPV) method, the following implications are obtained.  It should be noted that all the projects (e.g. from project 1 to 5) have positive NPVs which mean that they are all worthwhile investments.  In the contrary, our concern is to assess their associated business risk or perhaps the “preferential” timing of cash flows.  Project 1 provides an NPV of 31,470 (see requirement 2) but there is risk in not having a sure market as cash flow will rely on membership fees and time spent on the site.  In addition, the continuous service of the system is also at risk of interruption if troubleshooting is going-on because only one server, which is the minimum resource required in the project, is in function.  If inconvenience happens, the market would pull-out membership and support.  The initial outlay of ,000 may not be fully recovered knowing that the bulk of cash flows are at the terminal year of the project.               Project 2 has almost the same NPV as project 1 at 30,092 (see requirement 2).  Their risk difference and timing of cash flows, however, makes project 2 more lucrative.  First, the project intends to cater to already developed market and said to easily reach market maximum.  Such scenario only makes the project continuously profitable, might be increasing and less risky.  This statement is concretized as project 2 can recoup the initial outlay as early as the second year netting by 11,000.  This timing of cash, considering the matured market targeted by project 2, will positively pressured year-on-year until the product reach its declining phase.  The bottleneck of project 2 is also the same as project 1 in which significant risk lies on having single server which is the minimum resource requirement for such projects.               Therefore, it is recommended that project 1 should undergo market research to assure the presence and subsistence of the market.  Further research is also helpful for project 2 to determine the extended cash flow period for the project and determine when will be the market decline.  For both projects, it is a must that when they are planned to be implemented, at least two servers or more are running.  This is a business strategy and will make their product more competitive due to faster, reliable and efficient access that can be experienced by the customers.  In the contrary, installing a new system especially for project 1 would create a need to hire additional employees and construct offices.  There is a substantial psychic risk (e.g. losing jobs) at stake and this should be noted when evaluating the two projects.                  For project 3 and 4, there is minimal risk involved as the future suggests continuous generation of income from the DVD market.  Further, both projects incurred NPVs of 331,600 (for project 3) and 383,500 (for project 4) (see requirement 2).  If any, the timing of cash flows could be pondered in terms of investment deferral or shift to a more lucrative investment (e.g. engaging in project 5).  As observed, both projects necessitate huge capital outlay amounting to 500,000 which the firm may find “too much” or “too risky”.  As a result, since there is an old burner as well as the fact that each project would result to mass production of DVDs, the more efficient burner in project 3 should be prioritized over the less efficient and less cash flow producer (outlay is covered only after year 5) project 4 burner.  In the end of year 3, the second burner would then be bought only after the outlay for project 3 is obtained and with a net of 49,900.  The recouped outlay of project 3 will finance project 4 at 500,000.               Project 5 (the version of marketing department) tops the NPV of the five projects at 1,545,951.96 with average cash flow timing of five years (see requirement 2).  It makes NPVs of project 1 and 2 relatively insignificant despite the two projects being ahead two years in terms of time value of money while it is 4.66 times bigger than project 3 and 4-times bigger than the 10-year cash flow period of project 4.  Clearly, it adheres to lucrative size, timing and risk of investments.  However, to be able continue the compliments of project 5, the management should double-check the reliability of the initial market research in terms of costing, sales projection and depreciation.  Marketing people are undoubtedly good in sales talk and are naturally optimistic in which their conclusion can be polished by prudent financial managers and visionary leadership.                   This is what exactly reflected in the succeeding computation (see requirement 2) when projected unit sales is reduced by 20% as well as increase in variable costs of 20%.  As a result, NPV is reduced by 1,133,817.29 from the marketing version to 412,134.67 of the management version.  With this, project 5 is comparable to project 3 with the latter being the safer investments because of continuous generation of income in the DVD market.  The recommendation would be to study further project 5 and perhaps do a business plan before its approval.  As observed, the project requires almost 2M in initial investments which can sufficiently finance (not to mention substantial savings) project 1 to 4.  However, if the firm persists and they are more inclined in developing their learning curve, organizational cohesion and mindset should be allotted in the exporting project while exchange currency fluctuations and risks should be hedge by investing in securities markets.                                  Analysis and Recommendations on Working Capital Management             As shown in requirement 3, Eager has an elapse time of 297 days (its operating cycle) in 2005 between the time raw materials are delivered and when payment for the finished product manufactured from those materials is received from customers.  However, Eager cannot operate its day-to-day activities within this 297 days cycle without the 77 days spontaneous financing received from its suppliers.  The net financing requirement of 221 days is the period that is used to compute the required funds that should be available to bridge the financing gap otherwise Eager cannot continue to operate.  Requirement 3 shows that the firm should have access to short-term financing of approximately 45M and essentially having to finance 221 days worth of sales valued at their cost price.                In 2006, Eager has prolonged its financing gap to 270 days perhaps by having attractive contracts with longer payment dates (56 days, in terms of credits) and also with shorter ones (in terms of debts).  However, it increased the required short-term financing at 53M.  This situation is the usual tenet of financial management which is the trade-off of returns to risks.  As financial risks decrease due to longer credit days, returns decrease due to longer operating cycle (at 327 days), longer debtor days (at 100 days) and slower inventory turnover (at 226) which affect availability of stocks and payment of debtors which reduce working capital.  It is therefore apparent that for the succeeding years it is important to effectively market the product (for faster inventory turnover), efficiently produce the product (for faster semi-finished inventory turnover) and creation of harmonious relationship with both debtors and creditors (to obtain reconciliation settlements in times of working capital bottleneck).   Recommendations for Appropriate Short-term Financing             Since Eager has high beta, it is ideal to use equity financing.  Investors require a rate of return higher than the market average and a beta of 1.5 is simply an indication that Eager shares provide returns 50% higher on every dollar return in the market average.  Complementarily, debt refinancing can be obtained easily as the company has historically no loan renewal problems but the firms should be able to settle a fixed-interest rate.  Refinancing is common in mortgages and the competition result in offering fixed-interest rates in which Eager can exploit when it has ongoing obligation over a fixed asset.  This will lessen interest payments and increase working capital momentarily.    Overall Strengths and Weaknesses             The decline in 2006 EBIT indicates that the company is having difficulty in selling its products as well as the major costs associated in producing and distributing them.  Investments should be made in product development and product diversification rather than marketing.  Borrowing costs is increasing which could mean that the firm is not shielded with interest rate fluctuations and transaction costs.  Equity financing should be focused.  Since ordinary share capital is not increased for two consecutive years, the firm can issue additional shares to mitigate rising borrowing costs.  A fall in income tax is a supportive account in equity financing but the firm should study because this would be the effect of tax-deductible debt which is mitigated herein.  Retained profits on the other hand support product diversification and development.  Using Du Pont analysis and strategy, product development is rationalized.  Du Pont intends to focus on science-based innovation wherein returns are expected to kick-off in 2010.  With this mindset, Eager can use its substantial assets and retained earnings to finance product development without the worry of timing of money even it takes five years at most.  Commercialization of the developed/ diversified product is also easy because the company do business virtually.  Bibliography Appendix (See attached spreadsheet)                                                                                         Credit:ivythesis.typepad.com

CORPORATE FINANCE

Weighted Average Cost of Capital (WACC) (See requirement 1) Analysis and Recommendations on Each Project Usin...

CORPORATE FINANCE ASSIGNMENT

Overview of Capital Asset Pricing Model (CAPM) Theory Cost of equity capital is the most complicated component of firm’s cost of capital.  It is definition as the rate of return required on a firm’s shares by the investors in the financial markets is also the source of the problem because there is no direct method to discover the require return of investors ( 1999).  In effect, there are two main methods like the constant dividend growth and CAPM that are used to estimate it.  The use of the former leads to simplicity and ease of application of deriving the cost of equity which makes it a practical method to consider.  But disadvantages arise in its assumptions.  One is that the assumption of constant dividend growth which not all companies is doing.  Second is deriving the value of a firm by its dividend payments which undermine other indications of growth and stability like investments that caused retained earnings to raise.  In addition, data that is used to install growth rate is based on past information which is not appropriate in estimating the future returns.   With these disadvantages comes the capital asset pricing model (CAPM).  The systematic risk which comprised of business and financial risks is represented by beta coefficient which is one of the key variables the CAPM ( 1999).  In determining beta, business and financial risks of a company should be studied in order to give a reliable estimate of beta.  Beta is important in the formula of CAPM because it serves as the multiplier for risk premium attached to a certain class of security.  It will determine how an individual security or portfolio return is sensitive on overall market return.  CAPM advantages are derived from its ability to include analysis on both dividends and capital gains which are undermined by constant dividend model.  In effect, although more complicated, CAPM is a more accurate measure of cost of equity capital.  CAPM heavily relies on scanning business and financial risks to estimate beta coefficient which able to recognize risks unlike constant dividend model.               Through Capital Asset pricing Model (CAPM), the portfolio risks are decomposed into systematic and specific risk.  The former are the risks in the market portfolio which reflects how sensitive individual assets can perform as a result of being affected by market movements.  It is to note that the beta coefficient of the market is equal to 1 because it is the basis.  On the other hand, the latter is not included because it is already taken into account through the creation of portfolio and in both efficiency frontiers and capital market line.  Overall, the conclusion of CAPM is that the assets expected returns depends on the beta (systematic risks) and not on its volatility (total risks).  Ultimately, CAPM is the one that predicts the equilibrium price of an asset, however, it is only a theoretical perspective and has less to say about the level of risk an investor should put in every decision-making.            As it is said that CAPM is merely an economic theory, risk reduction is able to be achieved through the use of portfolio manipulation.  But the greater chance to really pinpoint it is in the hands of the individual investors, that is, their level of risk and uncertainty regarding their investments.  It is therefore concluded that objective analysis of risk reduction strategies can offer results that can minimize the risk of investors.  In the contrary, when subjective analysis is involved, such risk reduction strategies will ultimately be despised because it focuses on investor tolerance or perhaps its personal investment decision.   Evidence Supposed that Esprit condition assumed in the preceding examples do not hold.  The global firm will be viewed by investors as a good investment destination but there is the need to determine the expected rate of return from the cost of capital.  Using CAPM, the following Esprit information can be calculated: risk-free rate of 3%, beta (risk measure) of the stock is 2 and the expected market return over the period is 10%.  The stock is expected to return 17%.  This can be then used by investors in assessing the profitability of Esprit investment and in turn used by Esprit to entice capital into its coffers ( 1999).    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 Bi (ERm – Rf) as the risk premium) we can have broader look in intrinsic value of Esprit shares.  The 1-year Hong Kong Government Bond or the risk-free rate of return has 6.11% annual yield, the beta coefficient for the 2006 for Esprit is 22.68 and the market risk premium is 6%.  With this we can fill the formula by E(ri) = 6.11% + 6% = 12.11%.  However, CAPM merely represents the expected return fro an asset/ share while investor’s required return is the ultimate measure of investment decisions.  In effect, the 12.11% can be compared to the investor’s required rate of return.       Considerations Time value of money (TVM) is an investment principle in which investors prefers to receive the money as early as possible and that the value attached to present money holdings is greater than future or expected money holdings even they have the same nominal values ( 1999;  2006).  TVM is the foundation of discounting cash flows (DCF) although applied in most big business that plans to undergo huge financing for a project or several projects.   DCF methods relies on discounting tables wherein a specific year of cash inflow/ outflow as well a specific cost of capital (e.g. CAPM) are used to determine the rate in which net income or net loss will be discounted in present values (e.g. the discount rate).  Without acceptable criteria that intend to measure these variables, the determined rate will not be objective weakening coherence of DCF derivation.  Therefore, CAPM as a measure of cost of capital should be able to reflect the costs associated with certain investments (e.g. bonds, stocks, etc.) to maintain the integrity of DCF analysis.    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 . ).  Beta represents systematic risks that cannot be diversified because the risks in individual assets within a portfolio are correlated with other assets ( 2007).  When a company has high beta, it is ideal to use equity financing.  Investors require a rate of return higher than the market average and a beta of 1.5 is simply an indication that company’s shares provide returns 50% higher on every dollar return in the market average.    Individual betas are equal to the covariance between the share returns and the market returns divided by the variance of the market returns.  For the portfolio beta, the same procedure as getting the expected return and standard deviation of portfolios in which the weighted average of betas of individual securities are calculated.  The risk premium is represented by “beta multiplied by the difference of market return and risk free rate”.  This is the compensation a risk-taking investor is compensated for.  As securities should be competitive and it will not provide returns below risk free rate of return, CAPM can derive the required rate of return on an asset/ share of investors because it represents the sum of risk-free rate (i.e. the risk-averse option) and risk premium (i.e. the risk-taking compensation).               CAPM can be graphed and expressed in a straight line equation such as y = ax + c which is referred as security market line (SML).  In SML equation, expected market return (y), risk-free rate (c), systematic risk or beta (x) and market risk premium (a) are components of CAPM that are represented.  SML is a line that shows the positive relationship of systematic risk and its expected return and identifies the level of return expected in the market for each level of share’s systematic risk or beta.  Market equilibrium is achieved when supply equals demand and asset/ share prices remain stable.  As an illustration, when one share is currently undervalued, rational investors would buy this share that will cause its price to rise and consequently driving its returns down (e.g. inverse relationship of price and return).  The opposite scenario is also true for overvalued shares, that is, mis-pricing cannot last in the long-term.                   In addition, there are several assumptions that CAPM is limited that should be tallied into the real world.  One is that it relies on historic data (e.g. beta) to forecast future returns which are flawed as to predict future variability.  Second is the inclusion of expectations and subjective judgments of investors in the model which is difficult to quantify.  Third is the presence of perfect capital market where it is composed of several small rational investors and that financial markets have no transaction costs, no taxes and no limitations when it comes to investment.  Fourth is that investors are fully diversified.  Fifth is the complexity of deriving CAPM components.  Lastly is the one-time horizon assumption in SML.  However, even with these limitations, CAPM remains an expectational predictive tool particularly the aspect of relating risk to return and not just return per se which is often the investor’s stance.    Cadbury Schweppes: Application of CAPM             Operating for over 200 years, Cadbury is an international manufacturer and distributor of major confectionary and beverage brands ().  In its 2005 financial performance, Cadbury achieved at least 6% revenue growth and increases in underlying profit (+12%), profit before tax (+9%) and cash flows (₤404 Million).  It is also on the verge of acquiring Adams that performs strong and growth ahead of the intention and also sold its European Beverages for ₤1.26 Billion.  Up to 2007, Cadbury is bounded by five main goals; namely, delivery of superior shareowner performance, profitably and significantly increasing global confectionary share, profitably secure and grow regional beverages share, ensure capabilities are best in class and nurture the trust of their colleagues and the communities which they do business.                          Cadbury has the highest total dollar share for three brand categories such as chocolate, sugar and gum among competitors like Mars, Nestle and Hershey.  Although, on individual category (e.g. gum), Cadbury is trailing.  Confectionary and beverage markets are growing with the support of increasing global population, consumer health consciousness and product innovation.  Its supplier is diverse around 40,000 and no more than 10% of its raw materials are from a single supplier.  As a result, it is possible to avoid the impact of price fluctuations and discontinuity of supplies that may halt production facilities.  Its core purpose is to deliver superior returns to investors but also admitted that the management is operating with other stakeholders (e.g. customers, employees, etc.).  Derivation of CAPM Components             To measure the total risk of a portfolio, correlation and covariance will be used ( 1999).             The first step to do is to get the return of the portfolio.  This is merely the sum of expected returns of single-asset multiplied with their proportional share in the investment amount.  Say I have 00 and opted it to invest in stocks and bonds in two different companies.  If I will invest 50:50 on each financial instrument, their earlier computed single-asset expected values should be reduced to 50% and be totaled.  In the same manner, their earlier computed standard deviation should be reduced to 50% or their share of the 00 investment.  However, the problem of the preceding statement is that the standard deviation or the risk could lead to inaccurate decision information.  Due to complexity of two-factor and much of the multi-factor portfolio than single-asset, the procedure requires further information about stocks and securities.  Are they positively, negatively or no relation at all?  Due to this, the correlation (the underlined one) in the formula Varp =(w1 )2(σ1 )2+(w2 )2(σ2 )2+2(w1 w2 ρ12 σ1 σ2 ) should be determined if will be indicated by +, – or zero values ( 1999).    Business risk is related to operating features of a firm while financial risk is related to the strategies behind the capital structure of a firm ( 1999).  The former is a type of risk that is outside the control of firms and hardly affected by certain tactics and strategies because business risk is very dynamic and uncertain.  On the other hand, the latter involves factors within the scope of managerial control because it arises from borrowed funds the company is bound to pay unlike equity funds.  However, they are both under the definition of systematic risk or inherent risks of companies that cannot be reduced by diversification strategies.  Business risks includes example such as the sensitivity of competitive structure of an industry to changes in macroeconomic variables such as inflation and interest rates.  On the other hand, the more debt a firm has a greater level of financial risk or inability to meet such obligation.   Valuation can come directly to the firm.  This is referred to as business risk ( 2000).  For example, its integration effort has indicators of failing (partly indicated in high employee turn-over from a proposed merger), thus, requires greater returns for the heightened risks of integration failure.  On the other hand, electric utilities initially have relatively lower business risk compared to aggressive and expanding firms.  This is so the expected earnings will not largely depart from the original due to business risks.              Lastly, financial risk basically provides valuation of investors that the firm can control ( 2000).  By merely looking in its financial statements, an investor can decipher financial risk involve in his stock investment.  In the similar manner, he can assume his position of its value.  For example, in capital structuring, common stock price will be undervalued when the firm is over- or under-leveraged.  Although leveraging is good for the health of the firm, this suggest relatively complex forecast of future earnings of investors.  This may also mean that debt servicing requirements might not be met, and as a result, it can affect the dividend pay-out or long-term goals of investors in their stakes on the firm.  In additional, the level and duration of loan repayments is taken into consideration to calculate financial risk.  Another, leverage buy-outs can dramatically pull the price of common stock.              For example, every stock in London Stock Exchange is uncorrelated with every stock; the beta coefficient is zero ( 2006).  In this case, it will be possible to hold a portfolio in LSE that has risk-free.  Investors would be acting like a casino owner having to only wait at the end of the day to receive fees from the players.  The owner will accumulate earnings without any risks in playing rather only responsible for maintaining the venue.  With zero betas, game theory will not hold and stock markets will never exist as correlated risk is the source of all risk in the diversified portfolio.  On individual assets, beta represents volatility and liquidity of the market place while on portfolio perspective it refers to investor’s level of risk adversity.  Beta is estimated through times series analysis and linear regression models ( 2006) like estimating ninety trading days of simple returns used as estimators for covariance and variance.  Negative betas can be derived by holding securities that move against the market, shorting stocks and putting on options.    However, betas are limited because they are only based on historical market data ( 2006).  As such, future implications to investments cannot be inserted in the decision-making criteria.  Variables are identified based on their past performance and any future or expected changes are not taken into consideration.  In effect, investors that accept and address this limitation often lead to speculation for a possible war, major earthquake, political scandal and other stock market related events due to the inability of the beta to represent the overall perception of the market about the future trends.  In effect, it can be said that the limitation of the beta caused the stock market bubbles and other economic crisis that adversely affected the lives of the people; both rich and poor as over-speculation in the market lead to distorting the real performance of the market rather mere expectations of market participants without any proven level of superior output.         Implications As observed above, portfolio of stocks need to only consider systematic risk.  This is because the total risk of their holdings is already diversified by investing in different firms; therefore, unsystematic risk becomes irrelevant.   However, total risk becomes important when the company decided to hedge their risks by holding government bonds which is said to be risk-free asset.  In this regard, focusing only on systematic risk is limited in gaining the minimum level of risk.  In addition, when expected return is smaller than the whole market the security in question is underperforming while when it is smaller than the risk-free asset the trade-off between risk and return is not optimized.  Cadbury Schweppes should consider these notes in investment decisions.  Conclusions Like any decision-making strategy, corporate objectives should be initially emphasized.  In this specific case, Cadbury Schweppes should center its concentration in the immediate and long-term financial gains/ looses of the replacement and its contribution to overall corporate objectives.  On the verge of determining the rationality behind the replacement decision, there is a need for asset comparison between the old and potential machines which can only be derived in performance, dollar and timeframe terms.  In this respect, appropriate valuation techniques (e.g. NPV, IRR, Equity Annuity Method, etc.) would be identified and selected with reference to corporate standards, conditions and legal provisions.  On the other hand, decision-makers can be suggested to perform real option methods to eliminate the overly financial focus of budgeting.  The reporter can solicit guide from his supervisor to determine the organizational hierarchy that can perform the method.  After the monetary and non-monetary approaches to budgeting has been applied, the favored option would be provided with clear cash flow analysis including any depreciation, betas and other factors that can affect estimates.  At the end, responsibilities will be distributed to respective staff and managers in order to monitor and carry out contingency actions until the life of the asset lapses.    Bibliography Books   Electronic Sources                            Credit:ivythesis.typepad.com

CORPORATE FINANCE ASSIGNMENT

Overview of Capital Asset Pricing Model (CAPM) Theory Cost of equity capital is the most complicated component of firm’s cost of capital...

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