California clinics: organization, services, and healthcare delivery

California Clinics

To estimate the stock's value, the best approach given the information at hand is to use the dividend discount model. This model assumes that the value of the stock is based on the future value of the cash flows to the shareholders. The only cash flows that are considered are the dividends, plus the expected growth in those dividends (Investopedia, 2011). The formula for the stock price is:

Thus in this situation, the value of the stock is as follows:

Value = 2.00 / (.15-.05) = 2 / .1 = $

If the riskiness of the stock decreases such that the discount rate falls to 13%, the new stock value is calculated as follows:

Value = 2.00 / (.13-.05) = 2.00 / (.08) = $

If the dividend growth rate is expected to be 7% and the discount rate 15%, then the stock value under these conditions is calculated as follows:

Value = 2.00 / (.15-.07) = 2.00 / (.08) = $

The four factors that affect the supply and demand for investment capital are productive opportunities, time preferences for consumption, risk and inflation all can have an impact on the cost of money. The cost of money is essentially determined by the demand for investment capital and each of these factors affects that demand.

Productive opportunities reflect the prevailing market conditions in which a company operates. If the company is faced with high levels of demand and low levels of free capacity, for example, it will demand investment capital in order to build additional capacity. Time preferences for consumption reflects the choice that consumers make between consuming in the short-term or the long-term. For example in times of economic contraction consumers will often delay major purchases. In each of these two situations, the demand for capital is going to be impacted by the prevailing demand conditions in the marketplace and it is that demand for capital that will drive the cost of money.

Risk is another driver of the cost of money. The riskier a project is, the higher the cost of money for that project will be. This is because riskier projects will need a higher rate of expected return in order to justify investment. For the lender, this means higher rates must be charged -- the higher cost of money for the project. The fourth driver of the cost of money is inflation. The time value of money is determined in part by the current value of money and in part by the expected change in the future value of the money. Inflation essentially erodes the value of money in the future, so the higher the rate of inflation, the less valuable future money will be in today's dollars. Thus, lenders account for expected inflation by charging higher rates. As a result, the expectation of future inflation is directly related to the cost of money today, as this expectation is built into the cost of money today.

5. Risk is an important factor in financial decision making for a couple of reasons. All other factors being equal, an investor will seek to maximize return for equivalent risk levels. This means that the investor will choose the investment that offers the best risk-return ratio. It is believed that for the most part, investors tend towards risk aversion. Often, decisions are made under conditions of uncertainty, and in this situation they will use perceived risk as their guidepost rather than objective risk, as thought do not know the latter (ScienceDaily, 2010). Risk aversion is often assumed in financial modeling.

The most important thing about risk aversion, however, is that the degree of risk aversion is critical to setting the desired rates of return. The more risk averse an investor is, the higher the rate of return that will be demanded in order to undertake the investment. Thus, risk aversion is critical to the investment decision and to determining the rate of return that a project will require.

6. There are a number of different techniques for solving problems that involve time value. The first is the breakeven point or payback period. This analysis helps to determine when the project will break even. The idea behind this is that the faster the investment pays for itself, the better the investment is. The worry is that investments which do not pay until well into the future are riskier, because there is less certainty associated with those cash flows.

The second method is the internal rate of return. This technique is based on the assumption that the IRR must be greater than the discount rate. This reflects the idea that the returns associated with the project are going to be higher than the cost of financing the project. In order for a project to be accepted, the IRR needs to be higher than the discount rate. The IRR itself is based on the expected future cash flows, relative to the costs related to the project.