Advanced finance concepts and theory

¶ … finance such as present value and capital asset pricing model to name a couple. This paper will explore three business models in order to better understand present value and discount rates. This paper will look at the security of equity future and more specifically Wal-Mart's performance. This paper will also examine the relationship between CAPM vs. APT and discuss the method used when determining a rate of return and capital budgeting purposes.

You inherit an oil well. This oil well is believed to have three years worth of oil left before it dries up. Here is how much income this oil well is projected to bring you each year for the next three years: Year 1: $160,000; Year 2: $210,000; Year 3: $320,000. Compute the present value of this stream of income for a discount rate of 5%, 12%, and 17%. First of all, it is understood the equation for computing present is as follows:

PV = CF r) t CF equals the amount expected to be made. "R" is the discount rate.

Year One:

Discount Rate of 5%: PV = $160,000 or 160,000 = $152,380.95

Discount Rate of 12%: PV = $160,000 or 160,000 = $142,857.14

Discount Rate of 17%: PV = $160,000 or 60,000 = $136,752.13

Year Two:

Discount Rate of 5%: PV = $210,000 = $190,476.19

Discount Rate of 12%: PV = $210,000 = $167,416.71

Discount Rate of 17%: PV = $210,000 = $153,407.85

Year Three:

Discount Rate of 5%: PV = $320,000 = $276,428.03

Discount Rate of 12%: PV = $320,000 = $227,769.68

Discount Rate of 17%: PV = $320,000 = $199,798.58

Part 2: Three Sample Business Plans

There are Missing Materials for this section. Unable to complete without Business Plans)

Module 2: Session Long Project

One type of security is called an equity future. This is a contract guaranteeing your shares of a company to be delivered to you not today, but sometime in the future. What you would pay for such a contract? It depends on what price you expect the shares to be at in the future, and how volatile the stock is at the time of purchase or in other words what discount rate you should value this future payment of stocks). By looking at Yahoo Finance.com and at the five-year chart for Johnson and Johnson, the reference company I chose, one can learn a lot about the company.

In comparison with Johnson and Johnson, what would you pay for 100 shares of Wal-Mart to be delivered to you in one year? Is it like comparing apples to orange or do the two companies have more in common than thought?

Johnson and Johnson is a diverse corporation specializing in the production of pharmaceuticals and first aid care products.. One can take a look at the stock price to see any trends or changes during the last five years. Below, from Yahoo Finance is Johnson and Johnson's latest stock chart.

From this chart, one can see how Johnson and Johnson's stock has progressed over the year from about $50 to $63.58 on Thursday. This means the company's stock not only reflects the company's growth and sales but also has shown improvement over time. Because the stock has grown in price, many may hesitate to buy if one is looking for a deal. As a result, financial analysts on Yahoo Finance rate the stock at 2.3 on a scale of 1 to 5 (1 being a strong buy and 5 being a strong sell). Right now the stock would be considered a seller's market. Still the price could continue in its upward trend making it more desirable to buyers. Overall, drug company stock is usually a safe investment.

Walmart is a retail giant. Wal-Mart's five-year chart is slightly different from Johnson and Johnson's. Their stock price starts out a lot higher and falls in the beginning of the chart and then gains momentum to gain ground. Still the stock manages to remain in the high fifty-dollar range and steady for the last year. These radical changes in stock suggest it has adjusted with the times and the economy. The stock may have continued to climb but not soar due to various issues within the company like employee relations and union problems out west. Analysts at Yahoo Finance give a recommendation of 2.2 on a scale of 1 to 5 (1 being a strong buy and 5 being a strong sell). Right now the stock would be considered a seller's market. Still the price could continue in its upward trend making it more desirable to buyers.

Overall, both stocks are considered volatile because of these middle ground ratings. This means the stock is unstable in the mind of the analyst because the stock could go either way in the future. This makes deciding to purchase, as am equity future difficult because no one can predict how the market will change over the next year. People can make educated guesses especially with respect to Wal-Mart that consumer spending and confidence is on the rise more than in recent years but still there are a lot of other factors to consider like rising energy costs and the war in Iraq. All of these things help determine if the consumer will spend money.

So should the consumer purchase a hundred shares of Wal-Mart stock to be delivered a year from now? Judging from the five-year chart and the fact the stock closed at $52.32 one year ago and it is currently trading at $52.97; it is safe to say despite analyst opinion, Wal-mart is a safe buy because if anything not much will change. However, if one is looking for a moneymaker, this is not the stock to expect much future returns. Still analysts are anticipating the stock will reach $63.85 in one year but this is only a guess. If one is a risk taker and willing to ride it out, then this is a stock to consider.

Module 3, Part 1: CAPM VS. APT

The Capital Asset Pricing Model or CAPM is not the only asset-pricing model around. One of the competing approaches asset pricing is called the Arbitrage Pricing Theory or APT, which was developed to address some of the criticisms of the CAPM. Do you think APT or the CAPM is the best approach for a financial professional to use?

There seems to be two schools of though on the validity of CAPM and APT. There are people who use CAPM as a method to analyze risk and others who believe APT is a better approach because it builds upon the CAPM theory. This is a positive when understanding risk because APT does not leave room for mistakes. For financial professionals it is of utmost importance to assess risk as accurately as possible in order to sell a stock idea to a client. Clients are more than often risk adverse and do not want to take a loss with the money invested. In this respect most clients enjoy a conservative approach, which means the less risk involved the better. Because APT builds upon CAPM and takes the theory to a new level, it requires further analysis to prove the point. Still first in order to understand APT, one must first have a grasp of CAPM works.

First of all, CAPM is not at versatile as APT. CAPM can only work to assess risk in the long run scenario. Where does this leave the short run for an investor who only wants a six-month period? Still CAPM "states that the return on a stock depends on whether the stock's price follows prices in the market as a whole" (Anonymous, p. 1). The more a stock follows the market, the greater the return. CAPM divides risk into two categories, systematic and unsystematic. CAPM also assumes the investor does not have inside knowledge and that the Beta is known. This is the only way an expected return can be determined with CAPM. Mark McCracken defines Beta as "equals 1.0000. 1 exactly. Each company also has a beta. A company's beta is that company's risk compared to the risk of the overall market. If the company has a beta of 3.0, then it is said to be 3 times more risky than the overall market" (par. 1). The amount of risk and the type of risk can be determined by diversification. Systematic risk, which is market risk or undiversafiable risk, is the portion of an asset's risk that cannot be eliminated via diversification. The systematic risk indicates how including a particular asset in a diversified portfolio will contribute to the riskiness of the portfolio. Unsystematic risk, which is firm-specific or diversifiable risk, is the portion of an asset's total risk that can be eliminated by including the security as part of a diversifiable portfolio (Mathis, CAPM, par. 1). So obviously there are some stocks that will not be included in a diverse portfolio because of its defined risk under this theory. CAPM digs deeper to assess for an expression, which relates the expected return on an asset to its systematic risk. This in turn gives the financial professional better idea of the stock's risk behavior.

The equation used in this security market line relationship is as follows:

Mathis, CAPM, par. 3)

The measure of systematic risk is considered Beta or bi while E[Ri] is equal to the expected return on asset I and Rf is the risk-free rate. E[Rm] is the expected return on the market portfolio and E[Rm] - Rf is the market risk premium for the stock. Once the Beta is known then the risk and rate of return can be found.

APT is different because not only can forecast for the long-term, it can also work for the short-term scenario. This fact makes it the better of the two theories because it gives the financial professional more tools to assess risk and the rate of return. APT does this by using a model that captures all the data. All model estimations are based wholly on the Arbitrage Pricing Theory, make no parametric assumptions, do not rely on ad hoc suppositions, do not fall prey to data mining, and are built using only the most clean and widely-available data, giving the most accurate, stable and comprehensive risk models available.

Running this model one can also calculate for medium range of return. Other things this model can perform for risk assessment take into account user needs. Risk Estimates such as Tracking Error, Value-at-Risk (VaR), forecast volatility, systematic active risk, beta to benchmark, correlation with benchmark. Normal distribution assumed for traditional measures such as tracking error, but non-normal assumptions for innovative extensions. Forecast the user can choose periods, and risk models are available with optimal forecast periods of between one week and six months. Risk decomposition can also be analyzed, including traditional position-based risk attribution, marginal contribution of factors to risk, beta to factor, and innovative decompositions, all based on any of the hundreds of explanatory factors available in APT (country, sector, currency, style, economic factors, and user-defined factors). APT carries out these calculations in a linear framework with a number of different variables. This is how different time frames can be used. This theory also allows for different market trading and in today's seamless global market this is a plus for the investor. It allows for flexibility for individuals.

Further reasoning on impossibility of arbitration portfolio creation leads to basic equation of asset pricing, which can be considered as a practical result of this theory. It is interesting to note the fact that APT equation is a generalization of CAPM equation, although the arbitration theory has been created as its alternative. According to this equation, asset value fluctuation is influenced not only by the market factor (market portfolio value), but by other factors as well, including non-market risk factors - national currency exchange rate, energy prices, inflation and unemployment rates, etc. If only one factor is considered as risk factor, market portfolio value, the equation will coincide with that of CAPM.

APT model provides for a possibility of taking into account several factors. Now asset is characterized with a number of beta parameters, each of them representing asset sensitivity to a particular factor and characterizing systematic risk associated with this factor, and, as before, residual yield E. However, now the amount of specific, not factor explained, risk has become lesser. This multi-factored model brings up many questions for the financial professional. How many factors are enough for the assessment? What if too many were used? It is absolutely clear that not all parameters available for analysis influence asset price behavior. However, it is not so easy to understand, which and how many of them do. It is not constructive to build a model of all factors available at once because insignificant factors will play a role of noise and may considerably distort any results received with the model. So it very important the financial professional understand which factors are significant to the risk and weigh them carefully against the model.

Part 2: Session Long Project

The Beta for Wal-mart stock according to Pcquote.com is 0.648 or less than 1. With Beta, risk is defined as anything being higher than 1. The fact that Wal-Mart's Beta is less than 1 is a good sign for the investor. It also leads the financial professional to believe that risk is very small if not non-existent. Risk would be a factor when picking the stock. If anything, an investor would want Wal-mart stock to diversify the portfolio. In this respect-using Beta would be a desirable method of determination. It is simple as well to look up. It assess the risk involves without going into too much detail or computations. This keeps it simple for the every day investor or the novice. Wal-mart's Beta reading also makes the company a strong stock choice.