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REVISION II Financial Management

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Assumptions -Comparison What are CAPM assumptions ? Investors are rational & risk adverse Investors seek to maximize utility Risk is measured by standard deviation of returns No transactions costs Market is efficient There is no taxation Unlimited borrowing & lending possible All investors are efficiently diversified What are MM assumptions ? · The capital markets are perfect and the investors behave rationally. · All information is freely available to all the investors. · There is no transaction cost. · Securities are divisible and can be split into any fraction. No investor can affect the market price. · There are no taxes and no flotation cost.

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Modigliani and Miller Theory According to Modigliani and Miller (without taxes) the share price will remain the same irrespective of the level of gearing. SHARE PRICE

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Portfolio Theory A risk seeker likes risk and derives greater utility undertaking high risk investments An investor who is risk neutral does not care about risk and the level of risk will not affect the utility of investments A risk investor dislikes risk, therefore higher risk leads to lower utility

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Two fund separation The notion that there is a market portfolio of risky investments and a risk-free investment leads to a phenomenon known as two-fund separation

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Efficient portfolio A portfolio is said to be efficient when all the specific risks has been diversified away. An efficient portfolio provides the lowest level of risk possible for a given level of expected return. If a portfolio is efficient, then it is not possible to construct a portfolio with the same, or a better level, of expected return and a lower volatility.expected returnvolatility An efficient portfolio also provides the best returns achievable for a given level of risk. If a portfolio is efficient it is not possible to construct a portfolio with a higher expected return and the same or a lower level of volatility with the securities available in the market, excluding risk free assets. Adding the latter allows one to construct portfolios that lie on the securities market linerisk free assetssecurities market line

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Coefficient of correlation Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random. In real life, perfectly correlated securities are rare, rather you will find securities with some degree of correlation

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capital market line Capital market line is the straight line on the graph of return against risk (as measured by standard deviation) that runs from risk free rate tangentially to the efficient frontier and above. A line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio. The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier. This is achieved visually through the security market line (SML). Indifference curve. A diagram depicting equal levels of utility (satisfaction) for a consumer faced with various combinations of goods.

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Diagram

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This consumer would be most satisfied with any combination of products along curve U 3. This consumer would be indifferent between combination Q a1,Q b1,and,Q a2,Q b2

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Stock Exchange Weak efficiency – Share prices fully reflect information implied by past share prices Semi strong efficiency – share price will adjust in an unbiased manner to reflect new information which is publicly available Strong efficiency – shares prices reflect all information Not efficiency at all -Investors who use charts of previous price movements of particular securities as the basis of their investment decisions believe that the relevant stock market

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Accounting rate of return Uses annual profits (losses) rather than annual cash flows when evaluating investment opportunities

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When inflation is present When assessing an investment project using NPV where inflation is present, it is necessary to discount money cash flows using Nominal cost of capital

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What rate of return to use ? When evaluating investment projects using the net present value method of investment appraisal, the appropriate discount rate to use is the rate of return required by investors in the business

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A company will require the use of a crane that cost £600,000 when it was acquired four years ago and which has a current written down value of £370,000. If the project is not undertaken, the crane could be sold for £180,000 or it could be used for another project. If it is used for the other project, the business will not have to purchase another crane for £250,000. The business uses the net present value (NPV) method to appraise investment projects. What is the relevant cost of the machine when calculating the NPV of the project?

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The relevant cost of the machine is 250,000 pounds

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Advantages and disadvantages of putting money in the bank When you put money into a bank (or building society), you are lending money to them. They use this cash to make loans to other people and businesses. The bank will pay you interest on your deposit to encourage you to do so. It charges interest to those to whom it lends. On this aspect of its business the bank makes a profit from this. You are a customer of the bank and the reward (interest) that you get is not linked to the profit that the bank makes. There is very low risk that you will lose your money. At the same time the rates of interest are very low. This partly reflects the fact that returns are safe. Risk and return tend to be linked.

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Advantages & Disadvantages of investing shares When you buy shares in a company, you become a part owner of that business. The benefits that you get from ownership depend entirely on how profitable the company is. Company profits and dividends Shareholders share in the profits made by the company in proportion to how many of the total shares that they own individually. If the company is not profitable, the investors may not receive any dividends and may lose all the monies invested.

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