Principles of Financial Investments

This document provides an overview of the principles of financial investments and their importance in making effective investment decisions. It covers topics such as payback period, net present value (NPV), internal rate of return (IRR), and strengths and weaknesses of investment techniques. The document also includes calculations and explanations for a new project and expected return on risk assets.

PRINCIPLES OF FINANCIAL
INVESTMENTS

TABLE OF CONTENTS
TABLE OF CONTENTS................................................................................................................2
QUESTION 1..................................................................................................................................1
a) Calculation of the payback period for new project..................................................................1
b) NPV for the new project..........................................................................................................1
c) IRR of the new project.............................................................................................................2
d) Financial acceptability of the proposed investment based over the three appraisal method
used..............................................................................................................................................4
e) Reasons for setting lower payback period by the company of three years..............................5
f) Strengths and weaknesses of investment techniques...............................................................5
QUESTION 4..................................................................................................................................6
a) Expected return on risk assets depend over three components...............................................6
b) Standard deviation and beta measures.....................................................................................7
c) Calculation of expected return using CAPM...........................................................................8
d) Calculation of risk and return..................................................................................................9
QUESTION 5................................................................................................................................10
a) Reasons why firm is hesitant in reducing the growth rate of the dividend...........................10
b) i) Ordinary equity and its features. ii) Preference shares and its features.............................11
c) Price willing to pay for stock.................................................................................................12
d) Price of the stock with required return of 9.6%....................................................................12
e) Required rate of return with share price of €79.4 per share,.................................................12
REFERENCES..............................................................................................................................14

QUESTION 1
a) Calculation of the payback period for new project.
Cost 210000
Terminal value 45000
Calculation of the cash
flows
Year 1 Year 2 Year 3 Year 4 Year 5
Sales 80000 96000 115200 92160 46080
Maintenance cost 20000 22000 24200 26620 29282
Net Cash Flows 60000 74000 91000 65540 16798
Computation of Payback period
Year
Cash
inflows
Cumulative cash
inflows
1 60000 60000
2 74000 134000
3 91000 225000
4 65540 290540
5 61798 352338
Initial
investment 210000
Payback
period 3
-0.2
Payback
period
2 years and 9.5
months
b) NPV for the new project
Computation of NPV
Year
Cash
inflows
PV factor
@ 15%
Discounted
cash inflows
1 60000 0.870 52173.913
2 74000 0.756 55955
3 91000 0.658 59834
4 65540 0.572 37473
1

5 61798 0.497 30725
Total discounted cash
inflow 236160
Initial investment 210000
NPV (Total discounted
cash inflows - initial
investment) 26160
c) IRR of the new project
Step 1 : Selecting discount rates for calculation of NPVs
The discount rates 15%(R1) and 20%(R2) are taken as discount rates.
Step 2 : Calculation of the NPVs for investments using 2 discount rates.
Net Present Value at 15%
Computation of NPV
Year
Cash
inflows
PV
facto
r @
15%
Discounte
d cash
inflows
1 60000 0.870 52173.913
2 74000 0.756 55955
3 91000 0.658 59834
4 65540 0.572 37473
5 61798 0.497 30725
Total discounted cash
inflow 236160
Initial investment 210000
NPV (Total discounted
cash inflows - initial
investment) 26160
Net Present Value at 20%
Computation of NPV
2

Year
Cash
inflows
PV
facto
r @
20%
Discounte
d cash
inflows
1 60000 0.833 50000
2 74000 0.694 51389
3 91000 0.579 52662
4 65540 0.482 31607
5 61798 0.402 24835
Total discounted cash
inflow 210493
Initial investment 210000
NPV (Total discounted
cash inflows - initial
investment) 493
Step 3 : Calculation of IRR
Internal Rate of Return
R1% + [(NPV1 * (R2-R1)%) / (NPV1 - NPV2)]
15% + [(26160 * (20-15)%) /(26160 - 493)]
15% + [(26160 * 5%) / 25667]
15% + 5.12%
20%
Alternate method.
Computation of IRR
Year
Cash
inflows
0 -210000
1 60000
2 74000
3 91000
4 65540
5 61798
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Internal rate of return
(IRR) 20%
d) Financial acceptability of the proposed investment based over the three appraisal method used.
Company is proposing to make investment in the new business having initial outlay of
£210,000. Machine will be having annual cost of 20000 which will be growing 10% every year.
This is the only cost associated with the project. The project is estimated to have useful life of 5
years. The viability of the project is assessed using investment appraisal techniques. It enables
the management to make more effective decisions regarding the projects or investment and to
make the choice from different options.
Payback Period
It is also used by the management and investors to identify the profitability of the project
or investment that company is planning to adopt. The technique requires the project to have
adequate payback period so that company can earn profits over investments. The technique is
used for assessing the time period within which the proposed investment will be covering the
cost of initial investment. It could be evaluated that company will be covering the cost of
investments in 2 years and 9.5 months where the total estimated life of the investment is 5 years.
The payback period is adequate but not shorter. It will be earning profits after covering the cost.
As per the outcomes it could be evaluated that project is viable and should be adopted.
Net Present Value
The method is used for measuring the profitability of the project. Applying this technique
over the investment appraisal it could be evaluated that the net present value of the project is
26160. As per this technique project is considered profitable if the NPV is positive and also it is
of adequate amount. The method considers discounting rate to identify whether the future cash
flows will be enough or not for covering the cost of investment or project. The technique shows
that NPV is adequate and positive from which it could be evaluated that the project is profitable
and company should adopt the proposed investment. Company can also compare it with other
investment options and choose the one which is having higher NPV at similar costing. As per the
approach investment is viable and should be adopted.
IRR
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It is known as internal rate of return of the project that states the return that will be
generated. It could be analysed that IRR of the above investment project is 20%. Project having
IRR above 7% are considered adequate. The project is having high IRR and it should be adopted.
e) Reasons for setting lower payback period by the company of three years
Payback period is an investment appraisal technique used by the management for knowing
the time within which it will be covering the costs of investment. The technique requires the
project to have adequate payback period so that company can earn profits over investments.
Company has set benchmark of 3 years as the life of project is 5 years. Payback period is kept
shorter as it is the point after which it starts earning profits. If project is having payback higher
than 3 years it will not earn adequate profits for company. it is also known as the break even
point which is beneficial if lower. If project only covers the cost of project it is not profitable for
company to make investments over such projects. The lower payback period will allow company
to earn sufficient profits after covering cost of project. In the present case payback period is 2
years and 9 months which is lower than the benchmark of 3 years which states the project is
profitable and should be adopted by company.
f) Strengths and weaknesses of investment techniques
i) Payback Period
It is an investment appraisal technique enables the management to identify the
profitability of the project. The method states project is considered profitable if the NPV is
positive and high.
Strengths
 It is simple and easy method used for calculating viability of project.
 It identifies the time taken by investment to cover the cost.
 The technique is highly beneficial for identifying the profitability of the proposed
investments.
 It allows investors to identify whether future cash flows are adequate for covering the
cost of investment.
Weaknesses
 The method does not consider other factors influencing cash flows.
 The investment technique does not consider time value of money which makes it less
reliable and accurate as compared with other technique.
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ii) Accounting Rate of Return
It the expected rate of return over projects or investments in comparison with initial cost
of investment which is determined in percentage terms.
Strengths
 The method is based over the accounting profits that do not require other special reports
to determine ARR.
 The method does not involve complex calculations which make it simple and easy to
understand.
 Management could identify whether the return generated by the investment is adequate or
not.
Weaknesses
 This investment technique does not account for time value of money in calculation.
 It does not consider cash flows generated after the investment period.
iii) Internal Rate of Return
It is an annual growth rate of the investment which is expected to be generated over investments.
Strengths
 The method calculates return rate using time value of money.
 The method is highly beneficial in comparing the return rates of different projects.
 It allows company to make informed decisions about the projects.
Weaknesses
 Size of the investment is not considered while comparing investments.
 It is not beneficial for long term projects with changing discount rates.
QUESTION 4
a) Expected return on risk assets depend over three components
In capital asset pricing model return over the risky assets is dependent over three
components. The components are essential for determining the expected return of the security.
These components are risk free rate of return, market risk premium and beta of the stock.
Risk free rate: It is described as risk free rate or the interest rate that investor could get over the
investment that carries zero amount of risk. Risk free rate are generally considered equivalent to
the government bonds or treasury bonds. If the investor does not wants to take risks it will invest
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at risk free rate where return will be received whatsoever may be the circumstances of the
project. It is used in CAPM for determining relationship between expected return and risk.
Market Risk Premium: Market risk premium in CAPM is difference between expected return
over market portfolio and risk free return. Market risk premium in capm is equal to slope of
security market line. It is used for measuring excess return that is demanded by the investors for
bearing greater risks of overall market as compared with risk free rate of return. It is mainly
concerned with determining relationship between the risks and rewards. In CAPM market risk
premium is multiplied with the beta of asset. it is not possible to determine expected return
without market risk premium as it will not be able to calculate the premium it should get for
taking the risk.
Beta: It is the most important component in CAPM for determining the expected return of asset.
It is measure of systematic risk or volatility of the portfolio or security as compared with market
as whole. Beta 1 implies that volatility of the asset is equal to market, beta higher than 1 is
considered more volatile where less than 1 implies less volatility. If beta of asset is higher than 1
investor is bearing increased risk as compared to market, for risk premium associated with asset
tends to be greater than overall market risk premium.
All the three components of the CAPM works in conjunction with one another for
measuring risk & return of assets to give formula in CAPM which is Er =Rf + (Rm-Rf)*Beta
b) Standard deviation and beta measures
i) What does a stock’s standard deviation measures?
The standard deviation is statistical measure of the market volatility which measures how
wide the prices of stock are dispersed from average prices. If the prices of stocks are trading in
narrower trading range, standard deviation will show lower value which implies lower volatility.
If the prices of stock swing up & down wildly then the standard deviation return high value
which indicates higher volatility. Standard deviation of stocks rise as the prices becomes more
volatile. If the prices are moving with increased S.D. it shows strengths & weakness above
average.
ii) What does a stock’s beta measures?
Beta is the numeric value which measures fluctuations of the stocks to changes in
occurring overall stock markets. The beta measures responsiveness of changes in stock prices in
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overall market. it enables the investors in taking decisions related to selecting riskier stock which
are correlated with market having beta above 1 or having less volatility with beta lower than 1.
iii) If a particular stock had no systematic risk, only unsystematic risk, what would be its
expected return?
Systematic risks are associated with the market returns. The risk is attributed to large
number of factors. It could not be attributed to specific risk of the single investment.
Unsystematic risk on the other is industry or company specific and risk is attributable to
individual investment. It is not related with market returns.
If stock has no systematic risk than the return will be equal to market return. The
unsystematic risk could be controlled which eliminate the risk from stock generating returns
equivalent to that of market.
c) Calculation of expected return using CAPM
Stock
Investe
d
Amoun
t Beta
XT 10000 1.01
BB 10000 1.43
PTL 20000 0.66
i) Expected return for each stock
Stock
Invested
Amount Beta Er =Rf +( Rm-Rf) *Beta Expected return
XT 10000 1.01 3.6+(9.4-3.6)*1.01 = 9.458
BB 10000 1.43 3.6+(9.4-3.6)*1.43 = 11.894
PTL 20000 0.66 3.6+(9.4-3.6)*0.66 = 7.428
ii) Beta of portfolio is based over invested amounts
beta of the portfolio = 1.01 + 1.43 +0.66 / 3
Portfolio beta 1.033
iii) Expected return of portfolio
Expected Return of the portfolio
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Er Rf +( Rm-Rf)Beta
Rf 3.6
Rm 9.4
Beta 1.033
Er = 3.6 + (9.4 - 3.6) * 1.033
9.591
d) Calculation of risk and return
i) Calculate
a) Expected Return
State of
econom
y
Probability
of state of
economy Rate of return if state occurs
p
Stock A
(x)
Stock B
(y) p(x) p(y)
Poor 0.25 -5 -8 -1.25 -2
Normal 0.45 8 10 3.6 4.5
Good 0.3 12 12 3.6 3.6
5.95 6.1
Expected Return
Stock A = 5.95
Stock B = 6.1
b) Variance
p(x)
p(y
) x-x̅ p(x-x̅) y-ȳ p(y-ȳ) (x-x̅)^2 p(x-x̅)^2 (y-ȳ)^2 p(y-ȳ)^2
-1.25 -2
-
10.95 -2.73
-
13.95 -3.4875 119.90 29.98 194.60 48.65
3.6 4.5 8 3.6 10 4.5 64 28.8 100 45
3.6 3.6 12 3.6 12 3.6 144 43.2 144 43.2
5.95 6.1 4.46 4.6125 101.976 136.851
10.0983 11.6983
Variance
Stock A = 101.976
Stock B = 136.851
c) Standard Deviation
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p(x)
p(y
) x-x̅ p(x-x̅) y-ȳ p(y-ȳ) (x-x̅)^2 p(x-x̅)^2 (y-ȳ)^2 p(y-ȳ)^2
-1.25 -2
-
10.95 -2.73
-
13.95 -3.4875 119.90 29.98 194.60 48.65
3.6 4.5 8 3.6 10 4.5 64 28.8 100 45
3.6 3.6 12 3.6 12 3.6 144 43.2 144 43.2
5.95 6.1 4.46 4.6125 101.976 136.851
10.0983 11.6983
Standard deviation
Stock A = √101.976
= 10.0983
Stock B = √136.851
= 11.9683
ii) Which stock is riskier
Stock B is riskier than Stock A.
QUESTION 5
a) Reasons why firm is hesitant in reducing the growth rate of the dividend.
Portion of net profits of company is allocated to the shareholders in form of dividends or
keeping within the retained earnings. Every company has its own dividend policy that has
significant influence over the image of company. A company is hesitant in reducing the dividend
growth rate as it directly impacts the stock prices. If company declines the dividend growth rate
it could lead to sharp decline in stock prices of the company. When a company declines the
growth rate it shows that company is facing issues in conducting business. It reflects weakening
financial position of the firm that makes less attractive to the investors. The declining growth is
generally seen due to the factors like weakening earnings or the limited funds that are available
for meeting dividend payments. Dividend is an essential aspect to be considered by the company
as it has direct impact over the stock prices. Investors do not make investment in stocks of
companies that are having lower dividend growth rate. Therefore companies are hesitant in
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reducing their dividend growth as it can represent the company position and performance
negatively among the investors.
b) i) Ordinary equity and its features. ii) Preference shares and its features
Ordinary equity shares
Ordinary equity shares represent equity ownership in the company in proportion to all the
other ordinary shareholders as per ownership percentage of the shareholders in company. Equity
shares of the company are called ordinary shares. Equity shares are issued for fractional part of
ownership in company. Equity share capital is vital source of raising capital used by the
companies. Equity shares have higher risk as compared with other types of securities and also
shareholders higher returns on equity shares in the event of rise in equity stocks. Payments of
dividend are not compulsory in equity shares. Equity shares have high risk and return therefore
most attractive field of investments. Prices of the equity shares are influenced by the market
forces. Shareholders get dividend on the shares on the basis of dividend declared by the
companies per share. Some of the drawbacks are that investors do not have steady income and
bears considerable risk investing in company shares.
Features of equity shares
 Holders of equity shares have the voting rights in meetings of company.
 Equity shareholders are paid last of all in case of liquidation as they are the owners of
company and they do not have any fixed payment in return.
Preference shares
Preference stocks are also known as preferred stocks are the shares of the company with
the dividends which are paid to shareholders before dividend for ordinary shares are issued.
Preference shares are the hybrid form of equity shares which includes features of debt like
guaranteed dividend. The different preference shares are convertible shares, callable shares,
participatory shares and cumulative shares. Preference shares have higher claims over company
as compared with the equity shareholders. In the event of liquidation they get preference in
repayment of capital above the ordinary shares. It does not gives the shareholders voting rights
which benefits common shareholders. Investors that propose to go longer in the market generally
go for preference shares. Dividends earned on preference shares are higher than the ordinary
shares. Investors could choose the type of preference shares they propose to take from different
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types. It does not allow preference shareholders to earn return higher than that fixed dividend
rate.
Features of preference dividend
 Preference shares have guaranteed amount of dividend by the company to be paid every
year.
 Preference shares are to be redeemed after a particular period of time unlike ordinary
shares.
c) Price willing to pay for stock
Year Dividend
1 0.12
2 0.15
3 0.2
4 0.5
5 0.6
6 0.63
Price = Dividend/(Re - growth)
0.63 / (0.092 - 0.05)
15
The price which company is willing to pay for the stocks is £15 per share with growth of 5%.
d) Price of the stock with required return of 9.6%
Dividend 2.5
Decline in growth 7%
Required rate of return 9.60%
Dividend 2.5/1.07
2.34
Price = Dividend / (Re + decline)
2.34 / (0.096 + 0.07)
14.096
The stock with the required return of 9.6% is £14.096 that could be paid for the stock.
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e) Required rate of return with share price of €79.4 per share,
Dividend 2.6
Growth 3.90%
Price 79.4
Dividend 2.6 (1.039)
2.7014
Required
return (Dividend/Price) + Growth
(2.7014/79.4)+0.039
7.30%
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REFERENCES
Books and Journals
Wambua, P.M. and Koori, J., 2018. Investment Appraisal Techniques and Financial Performance
of Small and Medium Enterprises in Nairobi City County, Kenya.
Ndanyenbah, T.Y. and Zakaria, A., 2019. Application of Investment Appraisal Techniques by
Small and Medium Enterprises (SMEs) Operators in the Tamale Metropolis, Ghana.
Adebimpe, O.A. and Bashir, O., 2018. Modern Approach to Property Development Appraisal.
Covenant Journal of Research in the Built Environment.
(Wambua and Koori, 2018)
Kuehn, L.A., Simutin, M. and Wang, J.J., 2017. A labor capital asset pricing model. The Journal
of Finance.72(5). pp.2131-2178.
Rossi, M., 2016. The capital asset pricing model: a critical literature review. Global Business and
Economics Review.18(5). pp.604-617.
Siddiqi, H., 2018. Anchoring-Adjusted Capital Asset Pricing Model. Journal of Behavioral
Finance.19(3).pp.249-270.
Bask, M., 2019. Pure announcement and time effects in the dividend-discount model. The
Quarterly Review of Economics and Finance.
Bao, G. and Feng, G., 2018. Testing the Dividend Discount Model in Housing Markets: the Role
of Risk. The Journal of Real Estate Finance and Economics, 57(4), pp.677-701.
Heaton, J.B., 2020. Takeovers and the Dividend Discount Model. Available at SSRN 3514044.
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