Types of Instruments and Securities for Investment

This report provides an insight on the various types of instruments and securities available for investment, their risk, valuation methods, and impact of market fluctuations. Includes analysis and discussion on return on debt and equity securities, yield change in bonds, types of risk, and the use of CAPM model for pricing risky securities.

Business Finance project

TABLE OF CONTENTS
EXECUTIVE SUMMARY.............................................................................................................3
INTRODUCTION...........................................................................................................................4
ANALYSIS AND DISCUSSION...................................................................................................4
Difference between return on debt securities and equity securities............................................4
Yield change through time but the coupon rate remains same....................................................5
Types of risk and how it is affected by increase in the number of shares in the portfolio..........5
Capital Asset Pricing Model (CAPM) to price risky securities...................................................6
Clients Investments......................................................................................................................7
Investment decision.....................................................................................................................8
Determining the internal rate of return........................................................................................9
Investing into bonds...................................................................................................................11
CONCLUSION AND RECOMMENDATION............................................................................12
REFERENCES..............................................................................................................................14

EXECUTIVE SUMMARY
This report provides an insight on the various types of instruments and securities which are
being available for the investment purpose. This involves identifying the risk associated with
different instruments, methods for valuation of eth same, impact of fluctuation in the market over
the value of investment. It includes the mathematical calculation pertaining security valuation.

INTRODUCTION
This report is based on providing information along with certain calculations in in respect
to the various forms of investment option available for the purpose of financing business. There
are certain limitation pertaining to the report which are:
 The financial position of client is not available.
 The client is having only intermediate level of financial knowledge.
 No information in respect to how many of these investments the client can purchase or
invest into.
This report provides a clear insight into the various aspects of the investment in both
theoretical and the mathematical calculations.
ANALYSIS AND DISCUSSION
Difference between return on debt securities and equity securities
Both the forms of investment provide a good return but the they are different from each
other in terms of return. In case of debt securities which involves bonds, mortgages and so forth,
includes the return in terms of fixed percentage or the fixed amount in relation to interest. While
the equity investment which involves stocks comes along with a claim on the income of the
company. The debt instrument is less risky in comparison with the equity instrument but it offers
lower return and is consistent in nature (Cheung and et.al.,2017). It is less volatile as compared
to the equity securities. with less highs and lows than the securities exchange. The security and
loan market generally encounter less value changes, regardless, than stocks. Likewise, at the time
of liquidation the bondholders or the debt holders are paid first. Mortgage ventures, as other
obligation instruments, accompanied with the interest costs and are backed up by real estate
security.
On the other hand, in the equity investment, fortune can be made or lost. Any financial
exchange can be unstable, with the fast changing value of the stocks. Regularly, these wide value
swings are not founded on the strength of the association backing them up however is because of
political, social or legislative issues in the nation of origin of the organization. Equity securities
are an exemplary case of taking on higher danger of misfortune as a byproduct of possibly higher

prize. In the event of closure of business or winding up, the equity holders are paid after meeting
up with all the obligations of the business including payment to debt holders.
The debt funds are invested into the fixed income bearing securities while the equity funds
are invested in the share market. Each of these funds are having different characteristics which
determines how they behave (Grundy and Verwijmeren, 2020). It is dependent upon the need of
the investor before making an investment. For instance, some investors are interested in gaining
higher return in order to accomplish their goals which also includes undertaking higher risk. On
the other hand, some investors are least interested in taking risk for which they use debt
securities and it is also used for meeting the short term to medium term goals. Equity investment
can possibly offer better yields, yet with risk, while debt securities offer generally stable however
moderate to low returns.
Yield change through time but the coupon rate remains same
The investor is required to look into two important aspect before buying the bond which
are- yield to maturity and the coupon rate. Yield to maturity (YTM) refers to the rate of return on
the bond on the assumption that investor will hold the bond till its maturity. It is the whole of the
entirety of its residual coupon payment. A bonds YTM rises or falls relying upon its fairly
estimated worth and the number of installments left to be made. The coupon rate is the yearly
measure of interest amount that the owner of the security will get (BARKLEY, 2019). To
confuse things the coupon rate may likewise be called as the yield from the bond. The coupon
rate of eth bond security is fixed even if there is any change in the par or the face value of bond.
For example, the bond of $1000 face value (FV) issued at the semiannual payment of $10 each.
In order to determine the coupon rate, the yearly interest amount will be divided by the FV,
which is $10*2=$20, so the coupon rate is $20/$1000 = 2%. No matter what is the price of the
bond trades, but the interest amount will remain the same $20 and of the interest rate goes up the
value of bond will reduce to $980 but the 2% coupon rate will remain as is it is. This is the
reason why the yield changes with change in time but the coupon rate remains constant.
Types of risk and how it is affected by increase in the number of shares in the portfolio
There are majorly two types of risk, one is systematic risk and other is unsystematic risk.
The former is associated with the market return. It is considered as an inherent risk associated
with the stock market and is applicable all the sectors and industry and over which less or no

control can be exercised. The main source of such risk could be macroeconomic factors, for
example, inflation, changes in loan costs, variances in monetary standards, downturns, wars, and
so on Large scale factors which impact the direction and unpredictability of the whole market
would be systematic risk (Hassas and Sattari, 2017). An individual organization can't control the
risk. For example, if eth govt bonds is providing 5% yield as compared to share market which is
offering minimum 10% of return. Then all of a sudden, govt. announces additional tax of 1 per
cent on the stock market transaction. This is a systematic risk having an influence over all the
stocks consequently making the government bonds look more attractive. Thus, increasing the
number of shares leads to increase in risk.
Unsystematic risk is firm specific. These are the risk which are already existing but is very
much unpanned and can occur at any pint of time leading to disruption widely (GHALIBAF and
Salmalian, 2019). For instance, an investor purchases the shares of $10000 of 10 companies and
if any uncertain event occurs, leading to setback and few companies faces the reduction in the
share price, the investor will experience the loss. But on the other side, an investor, buys
$100000 worth of stock of just one company, would will experience 10 times loss because of the
occurrence of these events. It will result into increase in loss or gain which is uncertain.
applying the
Capital Asset Pricing Model (CAPM) to price risky securities
This model is based upon the principle that the only reason an investor would earn higher
on an average by making an investment into 1 stock instead of another. It offers the investors the
way of measuring the return that they deserve on an investment in return of putting their money
on risk. This model presents a relationship between the required rate of return and the systematic
risk associated with it, by using the formula Eri =Rf+βi * (ERm−Rf). The risk-free rate takes into
consideration the time value of money while the other factor accounts for the additional risk. The
beta in CAPM measures the level of risk in the investment (Rossi, 2016). If the stock is riskier
than the market then the beta will be more than 1 and on the other hand, if the beta is lower than
one, it means that the investment will minimize the risk of the portfolio. This help the investor in
evaluating whether the stock is overvalued or undervalued which is because of the volatility
existing n the market. Thus, investor makes use of CAPM model while evaluating the risky
securities.

Clients Investments
The decision in respect to making an investment or not into Douwe Ltd is entirely based
upon the cost of capital and from the point of view of investors, the rate of return, that they
would be getting from the investment made (Frank and Shen, 2016). It is being assumed that the
cost of equity does not varies in relation to the life of the project and along with that growth rate
is also constant over the project life.
Number of bonds on issue = $3,000,000 / $100 = 30,000.
Value of Debt:
FV = 100, years till maturity = 3 years, coupon rate = 7%, cost of debt= 8.5%
Value of debt = 7*((1-(1/((1+8.50)^3)))/8.50)+(100/(1+8.50)^3) = 96.17
Market Value of Debt:
Current market price × Number of bonds
$96.17 × 30,000 = $2885069
Market Value of Preference Shares:
Current market price × Number of shares
$2.50 × 1,000,000 = $2500000
Market Value of Ordinary Shares:
Current market price × Number of shares
$0.95 × 6,000,000 = $5760000
Market Value and portion of total finance for each security
Market value Weight
Debt $2885069 25.88%
Preference shares $2500000 22.43%
Ordinary shares $5760000 51.68%
Total $11145069 100%

Cost of Debt:
New debt cost (Kd,BT): 9%
After Tax cost of debt (Kd,AT) = Before tax cost of debt (Kd,BT) * (1-Tc):
After Tax cost of debt: 9 * (1 - 0.3) = 6.30%
Cost of Preference Shares:
Kp = D / P0 = 0.17 / 2.50 = 6.8%
Cost of Ordinary Shares:
Ke = D1 / P0 + g = D0 * (1+g) / P0 + g
= 0.05 * (1+ 7%) / 0.95 + 7%
= 12.63%
Weighted costs of each source of finance and the WACC
Weight Cost Weighted cost
Debt 25.88% 6.30% 1.63%
Preference shares 22.43% 6.8% 1.53%
Ordinary shares 51.68% 12.63% 6.53%
Total 100% 9.69%
Since the company is looking for 12% return but in the absence of the return, the WACC
will be utilized for determining the expected return. In the given situation, the return is only
9.69% which depicts that this investment is not suitable for the client.
Investment decision
Payback period of project X
Year Cash
Flow
Prese
nt
value
Prese
nt
value
Net
Discounte
d Cash

factor
@12
% Flow
0 -1200 1 -1200 -1200
1 250 0.8929 223.21 -976.79
2 290 0.7972 231.19 -745.6
3 460 0.7118 327.42 -418.18
4 470 0.6355 298.69 -119.49
5 510 0.5674 289.39 169.9
Payback period = 4 + 119.49/289.39 = 4 years and 4 months
Payback period of project Y
Year
Cash
Flow
Prese
nt
value
factor
@12
%
Prese
nt
value
Net
Discounte
d Cash
Flow
0 -1200 1 -1200 -1200
1 320 0.8929 285.71 -914.29
2 500 0.7972 398.6 -515.69
3 450 0.7118 320.3 -195.39
4 270 0.6355 171.59 -23.798
5 260 0.5674 147.53 123.73
Payback period = 4 + 23.79 / 147.53 = 4 years and 1.6 months
On comparing both the projects, it is better for the company to invest in Project Y as it is
having lower payback period.
Determining the internal rate of return
The IRR is financial analysis metric which is utilized in estimating the profit in association
with the potential investment (Patrick and French, 2016). It is the discounting rate at which the
NPV of the project is equivalent to 0. Basically, higher the IRR, the more desirable it is for
investment.
Year Cash
Flow
PV
factor
PV of
cash

@15% inflow
0 -74515 1 -74515
1 15000 0.869565 13043.48
2 15000 0.756144 11342.16
3 15000 0.657516 9862.743
4 15000 0.571753 8576.299
5 15000 0.497177 7457.651
6 15000 0.432328 6484.914
7 15000 0.375937 5639.056
8 15000 0.326902 4903.527
NPV -7205.18
Year Cash
Flow
PV
factor
@10%
PV of
cash
inflow
0 -74515 1 -74515
1 15000 0.909091 13636.36
2 15000 0.826446 12396.69
3 15000 0.751315 11269.72
4 15000 0.683013 10245.2
5 15000 0.620921 9313.82
6 15000 0.564474 8467.109
7 15000 0.513158 7697.372
8 15000 0.466507 6997.611
NPV 5508.893
IRR = (Cash flows) / (1+r)n – Initial investment
IRR = 10% + (5508.89 / (5508.89 – (-7205.18)) * (15%-10%)

IRR = 12%
The IRR of the project is 12% which is not acceptable as it is less than the acceptable level of
15% or more.
Using the below formula, it can be identified how many additional years it would require to
make the project acceptable.
Annual proceeds = Initial investment*(1+15%)n
= 15000 = 74515 * (1+15%) n
= 9.78 years = 10 years
Thus, the additional years will be 2 years to attain the IRR of 15% which will result into
accepting the project.
For achieving the IRR of 15% with the life span of 8 years, the annual cash inflow required is
computed below.
Initial amount invested = $74515
Number of years = 8 years
Expected internal rate of return = 15%
The formula for calculating the required annual cash inflow is given below:
A = P * ((r(1+r)n) / (1+r)n – 1)
= 74515*((15%*(1+15%)^8)/((1+15%)^8-1))
= $16605
Therefore, the acceptable level of cash inflow is $16605 which will help in attaining the desired
IRR of 15% with the life of project to be 8 years.
Investing into bonds
Pricing of bonds is an important aspect in the field of financial instruments. The pricing is
based upon several aspects such as the coupon rate, par value, yield to maturity and the period to

maturity (What is Bond Pricing? 2020). Each bond comes with a price which is required to be
repaid at the maturity. Without the par value or the principle value the bond will be of no use.
Price of the bond is determined using the below formula:
Price of Bond = Coupon rate * PVAF(r, n)+ Face value * PVIF(r, n)
Price of bond P = 100 / (1.075) + 100 / (1.075) ^2 + 100 / (1.075) ^3 + 100 / (1.075) ^4 +
100000 / (1.075) ^4
= $75214.99
Price of bond Q = 100 / (1.075) + 100 / (1.075) ^2 + 100 / (1.075)^3 + 100 / (1.075)^4 +
100/(1.075)^5 + 100/(1.075)^6 + 100/(1.075)^7 + 100/(1.075)^8 + 100000 / (1.075)^8
= $56655.95
Under the situation when the rate of interest increases to 12%,
Price of bond P = 100 / (1.12) + 100 / (1.12) ^2 + 100 / (1.12) ^3 + 100 / (1.12) ^4 + 100000 /
(1.12) ^4
= $63855.54
Price of bond Q =100 / (1.12) + 100 / (1.12) ^2 + 100 / (1.12) ^3 + 100 / (1.12) ^4 +
100/(1.12)^5 + 100/(1.12)^6 + 100/(1.12)^7 + 100/(1.12)^8 + 100000 / (1.12)^8
= $40885.09
Based on the above, it can be clearly seen that there is an inverse relationship between the
interest rate and the value of the bond. As the interest rate increased, the value of bonds
decreased. Under both the scenarios, it is better to make an investment in Bond P as it is having
higher value.
CONCLUSION AND RECOMMENDATION
In this report, the various types of investment instruments were studied which are
explained in both theoretical and practical manner along with the relevant mathematical
calculations. The key aspect covered are:

 The different between the return on debt and equity.
 Reason why yield change and coupon rate being constant.
 Identifying various types of risks and its impact.
 Use of CAPM model to price the risky securities.
It is recommended that for the purpose of investment, it is better to gain more knowledge and
understanding along with important calculations in order to make a right decision pertaining to
the investment to be made.

REFERENCES
Books and Journals
BARKLEY, T., 2019. Interest Rate Risk, Measurement, and Management. Debt Markets and
Investments, p.41.
Cheung, W. M., and et.al.,2017, April. The effect of stock liquidity on debt-equity choices.
In China International Conference in Finance.
Frank, M. Z. and Shen, T., 2016. Investment and the weighted average cost of capital. Journal of
Financial Economics. 119(2). pp.300-315.
GHALIBAF, A. H. and Salmalian, S., 2019. A comparison of fundamental and historical beta in
assessment of systematic risk Evidence from Tehran Security Exchange.
Grundy, B. D. and Verwijmeren, P., 2020. The external financing of investment. Journal of
Corporate Finance. p.101745.
Hassas, Y. Y. and Sattari, H., 2017. Studing the relationship between unsystematic risk
fluctuations and noise trading.
Patrick, M. and French, N., 2016. The internal rate of return (IRR): projections, benchmarks and
pitfalls. Journal of Property Investment & Finance.
Rossi, M., 2016. The capital asset pricing model: a critical literature review. Global Business
and Economics Review. 18(5). pp.604-617.
Online
What is Bond Pricing? 2020. [Online]. Available Through:<
https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/bond-
pricing/ >.