Market prices, Valuation Principle, Net present Value, interest rates, and bonds - Essay Example

Market prices, Valuation Principle, Net present Value, Interest rates, and Bonds Market prices, Valuation Principle, Net present Value, Interest rates, and BondsYour Name:School Affiliation:Market prices, Valuation Principle, Net present Value, Interest rates, and BondsIdentify the components of a stock’s realized return.Realized return is the value of actual gains that owner of the stock earned on the value of investment over specific period of time. Stock’s realized return has the components of stock value (value that it was bought, value that it was sold) and dividend, and can be calculated by dividing dividend by value that it was bought and adding it to the difference between value that it was sold and value that it was bought and dividing it by the value that it was bought.

When portfolio includes bond issues, realized return calculations need to focus on actual interest amounts earned on bond coupon for the period cited. For several reasons investor would be interested in periodically checking value of actual return on investment, primary reason has to do with stability of portfolio itself. If the overall rate of return is low or is likely to decrease, it signals that diversification in investment types would be needed. Despite diversification, loss in return on investment indicates that one or more investment types are composed of higher percentage of total investment than desired.

In both cases, lower than expected value of realized return can convince investor to make changes in order to avoid incurring further losses.Contrast systematic and unsystematic risk.Systematic risks are fluctuations in stock’s return due to factors beyond market control and it can not be eliminated through diversification. Systematic or non-diversifiable risk is a common risk affecting all stock; causes include wars, inflation, political events and international incidents. Risk free rate of return is used to compensate this risk type.

On contrary, unsystematic risks are fluctuations of stock’s return associated with random causes that can be eliminated through portfolio diversification. Unsystematic or diversifiable risk is a firm-specific risk, contributing factors include lawsuits, strikes or regulatory actions and market risk premium is used to compensate such risk.Explain why the total risk of a portfolio is not simply equal to the weighted average of the risks of the securities in the portfolio.Total risk of portfolio is not simply equal to the weighted average of the risk of individual securities in the portfolio because of continuous diversification.

Such diversification reduces portfolio’s total risk though all risks cannot be diversified. Risk factors (economic conditions, interest rates) of all stocks, bonds, securities are almost same and cannot be eliminated, whereas investors can eliminate systematic risk to some extent by portfolio diversification. Addition of more securities drops down unsystematic risk, until total risk approaches to systematic risk. The fact that diversification is unable to eliminate market’s systematic risk, causes total risk of portfolio to be unequal to the weighted average risk of individual securities.

State what beta measures and its uses.Beta coefficient is the measure of relative risk of a portfolio or security to overall market risk benchmark. Beta determines variability of return on investment to variability of return on market index benchmark varying over market business cycle. Beta can be considered as appropriate weight of market wide risk premium. Many data sources provides historical sources based beta, representing beta as average exposure to systematic riskState what WACC measures and explain the WACC assumptions used to value a project.

The weighted average cost of capital is firm’s actual value and calculation of firms capital cost such that each of the capital categories is weighted respectively. Calculation of Weighted average cost of capital involves all capital sources including preferred stock, common stock, bonds and any other long-term debt. Beta and rate of return on capital increases with increase in weighted average cost of capital and increase in WACC leads to a decrease in high risk and valuation.. WACC reflects various activities such as risks taken during firm’s operations.

WACC is subject to variance and is dependent on firms risk history, risk free rate and funding policy. REFERENCESElton, E. J.(1999). Expected return, realized return, and asset pricing tests. The Journal of Finance.Retrieved from: http://www.onlinelibrary.wiley.com/Beja,A.(1972). On systematic and unsystematic components of financial risk. The Journal of Finance.Retrieved from: http://www.jstor.org/pss/2978501Fama,E.F.(1972). Components of investment performance. The Journal of Finance.Retrieved from: http://www.jstor.org/pss/2978261Miles,J.A.,Ezzell,J.R.(1980).

The weighted average cost of capital, perfect capital markets, and project life: a clarification. Journal of Financial and Quantitative.Retrieved from: http://journals.cambridge.org/Malkiel,B.G.(2003). The efficient market hypothesis and its critics. The Journal of Economic Perspectives.Retrieved from: http://www.jstor.org/pss/3216840