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The real interest rate can be described as the theoretical rate of return on investment an investor is expecting to receive after allowing for inflation. On the other hand, the nominal interest rate (risk free) can be described as rate of return on investment attained prior to inflation adjustments.
The two differ in the sense that with the real interest rate, the effects of inflation has been accounted for whereas with the nominal interest rate, the effects of inflation have not been factored in. The real interest rate is calculated by adjusting the nominal rate that has been charged to factor in inflation. The real interest rate is roughly the nominal rate less the inflation rate. This can be illustrated mathematically as:
Real interest rate = Nominal Interest rate – Inflation
Therefore, the above explanation shows that Nominal interest rate is measured in monetary terms while real interest rate is measured in real terms. The relationship that exists between
(1+r) (1+i)= (1+R)
Total risk is a combination of systematic risk and unsystematic risk, as indicated below
: Total risk = systematic risk + unsystematic risk.
Where systematic risk is the total risk of a diversified portfolio while the unsystematic risk is the risk that can be removed by combining assets into a portfolio
The expected rate of return on a portfolio of shares does not depend on the percentage of portfolio investment of each share. This is because the main elements that affect expected return are time value of money, reward for bearing systematic risk and amount of systematic risk. Therefore the percentage of portfolio investment of each share has no implication on the expected rate of return on portfolio.
The riskiness of the entire portfolio, affects the expected return since it is equivalent to the systematic risk, which is one of the factors affecting the expected return.
The capital asset pricing model is a model that explains the relationship between risk and expected return which is employed in the pricing of risky portfolios (Shapiro, 2010, Pp5). The capital asset pricing model postulates that all investors:
- have equal access to all securities
- are price takers (investors behave competitively)
- have sufficient investment information available to them at the same time
- trade devoid of taxation costs
- are rational as well as risk-averse
- aim at maximizing economic utilities
- are largely diversified across a range of investments.
- can lend as well as borrow unrestricted amounts under risk-free interest rates
There is a difference between real asset investment and financial asset investment. This is because in real asset investment there is no fluctuation in returns while in financial asset investments, the expected returns always fluctuate depending on the market conditions.
The above statement relates to real asset investment decisions in a way that managers usually prefer to invest on real asset investments as opposed to financial investments. This is because when making corporate budgeting decisions managers prefer investing more on assets that have stable returns.
The discounted cash flows (DCF) concepts are so important to corporate financial analysis because nearly all financial decisions made by a corporation involve future cash flows. The DCF concept applies to every situation in which money is paid and received and is therefore one of the most essential concepts to any corporation’s financial decision making.
The four steps carried out in a DCF analysis are:
- Estimating future cash flows: This is the first step carried out in a DCF analysis and involves projecting the expected cash flow for the corporation for a given period of time based on postulations regarding the corporation’s revenue growth rate, fixed investment requirement, income tax rate, net operating profit margin, and incremental working capital requirement.
- Assess the riskiness of the cash flows: The next step performed in a DCF analysis is assessing the riskiness of the cash flows. Assessing the riskiness of the cash flows is important as risk is a significant factor especially when the financial decision being reflected on involves some statistically considerable probability of loss. Risk assessment is normally done in accordance to the principle that investments ought to compensate the investor in proportion to the level of risk taken as a result of investing.
- Incorporate the risk assessment into the analysis
- Find the present value of the flows: In this step, the corporation’s weighted average cost of capital is used to discount the projected cash flows during the Excess Return Period in order to obtain the corporation’s Cash Flow from Operations. The weighted average cost of capital is also used to calculate the corporation’s Residual Value. To this, the value of Short-Term Assets on hand is added to obtain the Corporate Value.
The value of an asset can be determined by the use of divided growth model. In divided growth model, dividends are normally expected to increase at a fixed percentage per period. Determination of value of an asset can therefore be illustrated as:
Po = D1 ∕ (1+R) + D 2 ∕ (1+2)2 + D3 ∕ (1+3)3 …………
Po = Do (1+g) ∕ (1+R) + Do (1+g) 2 ∕ (1+R) 2 + Do (1+g) 3 ∕ (1+R) 3 + ……………
The above illustration can be illustrated as:
Po = Do (1+g) ∕ R-g = D1 ∕ R-g where Po is the current value of an asset, Do is the dividend to be paid, g the percent gain on dividends and R the rate of return on assets.
The opportunity cost concept refers to the best option that is forgone when a particular decision of investment is made. For instance if a person a certain amount of amount of money like $40,000 that they want to invest , the person can select Share A or Share B, the difference in the dividends that exists between the two shares is the opportunity cost. For instance if share A has a 8% divided and B has 3% divided the opportunity cost is 4%.
A perfect capital market can be described as a market in which there are no any opportunities for arbitrage(when the sale and purchase of a security occurs simultaneously within diverse markets with the objective of making profit that is risk free through exploitation of price differences that exist between markets).In a capital market , costless and sufficient information available is to all investors and no firm or individual is big enough to affect prices since assets are priced with full efficiency (Harley & Shall, 1979, Pp 15).
The concept of a perfect capital market is used in the financial theory essentially in the theory by Modigliani and Miller. According to Modigliani and Miller a perfect capital market is characterized by investors having information upon which they can act ration.............
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