Investment Risk and Return - Coursework Example

Investment Risk and Return Question a An investment decision is made to secure a future income stream or to acquire an asset that can be sold in future at a profit. The investor often has to make a choice between multiple investment opportunities that offer future cash flows that vary in timing and quantum. The present value method is a financial tool that permits the future cash flows to be discounted over their time periods and brought to their present value (Damodaran, 2002). Two of the reasons for an investor should be interested in the present value method are: The investor is able to determine whether he would make a profit or loss from the investment. The investor is able to compare alternative investment opportunities to select the one which will give him a higher profit. Question 1 (b): The three investment options have been compared by calculating the present value of future cash flows from each investment. The formula used for calculating the present value of the future cash flows is as shown below: (Mayes, 1995) Present Value = PV (rate, nper, pmt, fv) Where, “rate” is the discount rate which has been selected as 4 %, the annual inflation rate. The annual rate is prorated for quarterly and half-yearly periods. “nper” is the number of periods of interest or dividend receipts. “pmt” is the value of the interest or dividend “fv” is the terminal value of the bond or share The calculations are shown in Appendix-I. Product-3 is the most attractive with a profit of 49.74%. Product-2 gives a lower profit of 15.61% and investing in Product-1 results in a loss of 7.59%. Question 1 (c): When the purchase price increases from £ 105 to £ 140, the outflow increases but inflows do not change. The profit from the investment reduces to 37.31% but remains the most attractive of the three. The calculation is shown in Appendix-I. Question 1 (d): Government bonds cannot be termed risk-free after the Greek government’s default in March/ April 2012. Bonds of face value € 200 million were exchanged new bonds of only € 35 million by a retroactive change in applicable law. This default was fully backed by the European Union and the IMF creating a precedent (Zettelmeyer, et al). Two of the major risks in investment in government bonds are: (Curtis, 2014) Sovereign default risk. Call option risk. When interest rates fall, the Government may exercise a call option to retire high interest rate bonds. Question 2 Introduction The personal financial planning process depends on a number of factors that are individual to an investor. The first of these is the opportunity cost of money which is the trade-off between present and future consumption. A second key factor is the time horizon for investment, whether the individual is looking for immediate, near-term or long term returns. Every investment decision for an investor requires an evaluation of risk versus reward. Low risk investments generally have lower returns than higher risk investments (Christopher & Elu, 2001). Risks in Investment Three of the major types of risks associated with personal investments are: (Christopher & Elu, 2001) Capital Risk – This is the risk of the investor losing all or a part of the money invested. This could occur, for example, if the borrowing company becomes bankrupt Income Risk – This is the risk that the “real” value of future income from the money invested gets eroded due to rising inflation. Liquidity Risk – This is the risk that the investor may be unable to sell the investment to realize cash if he has a need before the planned maturity of investment. Analysis of risks in the five alternative investment options i. Savings account with New Bank, a former building society An instant savings account permits the depositor to deposit and withdraw money whenever he wants. This investment therefore has no liquidity risk. The UK government protects deposits up to £ 85,000 in a building society or bank. If the deposit is in a joint name account, the protection doubles to £ 170,000 eliminating capital risk. The interest rate of 2% is below the inflation rate causing income erosion. If the investor is an income-tax payer, there would be a 20% tax deduction. A further risk for the investor is that the interest rate could change 2 or 3 times a year based on a change in the Bank of England rate or due to the bank’s own decision. If the inflation rate reduces from 4% to 2%, there is no income erosion but the bank would certainly lower its interest rates. This investment therefore has a very high income risk. ii. Fixed term savings account In Fixed term savings accounts the interest rate does not change and therefore there is no income risk due to changes in interest rates. However, the interest rate of 1.25% is lower than the inflation rate of 4% and the investor suffers from erosion of income. The interest credited is also subject to 20% tax deduction if the investor is a tax payer. If the inflation rate reduces from 4% to 2%, the income erosion reduces. There is very little capital risk as investments in fixed term accounts are also protected by the UK government up to £ 85,000 for single name accounts and £ 170,000 for joint-name accounts. There is an element of liquidity risk in that many banks require a 30 day or longer notice to repay fixed term investments or will charge a penalty fee for early withdrawal. iii. Investment in 3% Government Bonds Treasury Bonds are by definition risk-free as the UK government has never defaulted on any government securities and the present economic outlook does not warrant any fears of a default occurring. The interest rate of 3% is typically paid half-yearly and there is no tax deduction. The interest rate of 3% is lower than the present inflation rate of 4% which indicates that the investor would see income erosion. If the inflation falls to 2%, the returns turn positive. UK government bonds are traded in the secondary market and have liquidity. iv. Investment in shares of e-Suits. Equity shares in any company are, by definition, risk capital. The e-Commerce industry has especially higher risks due to lower profitability than physical retailers, the risk of losing their customers to other start-ups and physical retailers moving into the electronic retail space building on their brand image (Atkins, 2013). Even if e-Suits makes profits as projected, these are likely to be retained in the company for business growth. Dividend payouts appear unlikely. Liquidity for the investment is possible through the stock exchange where these shares are listed. Stock prices would vary day-to-day and would depend not only on the company’s own performance but also the e-Commerce industry as a whole. v. Investment in farm house in France The purchase price of £ 300,000 is met by a mortgage of £ 250,000. This suggests that the investor needs to invest only £ 50,000 upfront leaving an equal amount available for other investments. The return on the investment of £ 50,000 at 25% a year would require the farm-house to generate an income of £ 10,000 per year after mortgage payment and maintenance expenses. There is capital risk in any real estate investment. The value of the farm-house depends on the supply-demand equation for similar properties in the area where the farm house is located. There is a high degree of income risk as the occupancy of the farm-house as a holiday-let could vary from year to year, again depending on competing options available in the area. The variable interest rate on the mortgage adds to the income risk. The liquidity risk is very high as the transfer of the property would be subject to paying off the mortgage amount or transfer of mortgage to the buyer. A change in inflation rate would impact primarily the income from the sub-let. A lower inflation rate would help reduce erosion of income and prevent the mortgage interest rate from going up. Conclusion Personal investment decisions require to be made after evaluation of the risks associated with them. Investments that promise higher returns usually have higher risks. For this reason, investors are often advised to choose an investment portfolio made up of a mix of low, medium and high risk investments based on the individual investor’s risk tolerance level. The risks and returns from various investments can also change over time with changes in the global economic outlook and the investor would need to monitor such changes and assess the impact on his investments. ************ Appendix – I (Calculations for Question 1b) Product 1 - Corporate bonds (in £) Outflow for purchase of bond 120.00 Present value of projected cash inflows 110.89 using the Excel formula =PV(rate, nper,pmt,fv)   where, rate is the inflation rate = 4 % per year   nper is the no. of periods = 4 years   pmt is the interest received = £ 7 per year   FV is the future value of bond = £ 100   Net Present Value (9.11) NPV as percentage of investment -7.59% Product 2- Samsung shares (in £) Outflow for share purchase 8.00 Present value of projected cash inflows 9.25 using the Excel formula =PV(rate, nper,pmt,fv)   where, rate is the inflation rate = 1 % per quarter   nper is the no. of periods = 24 quarters   pmt is the dividend received = £ 0.25 per quarter   FV is the future value of share = £ 5   Net Present Value 1.25 NPV as percentage of investment 15.61% Product 3 - Government bonds (in £) Outflow for bond purchase 105.00 Present value of projected cash inflows 157.23 using the Excel formula =PV(rate, nper,pmt,fv)   where, rate is the inflation rate = 2 % per half year   nper is the no. of periods = 20 half-years   pmt is the interest received = £ 5.50 per half-year   FV is the future value of bond = £ 100   Net Present Value 52.23 NPV as percentage of investment 49.74% (Calculations for Question 1c) Government Bonds at £ 140 price (in £) Outflow for bond purchase 140.00 Present value of cash inflows 157.23 Net Present value 52.23 NPV as percentage of investment 37.31% References: 1. Atkins, A., (2013). “The B2C e-Commerce Risk nobody talks about”, Centre for Digital Business, 17 April 2013. Accessed on 3 June 2014 at www. centrefordigitalbusiness.co.uk. 2. Christopher, J. E. and Elu J.U., (2001). “Personal Finance and Portfolio Management Strategies”, August 2001. Accessed on 2 June 2014 at www.tippie.uiowa.edu. 3. Curtis, G., (2014). “Six biggest Bond Risks”, Investopedia, 14 January 2014. Accessed on 1 June 2014 at www.investopedia.com. 4. Damodaran, A., (2002). “Investment Valuation”, Second Edition, John Wiley, 2002. 5. Mayes, T.R., (1995). “Microsoft Excel as a Financial Calculator”, TVMCalcls.com, 1995. Accessed on 1 June 2014 at www.TVMCalcs.com. 6. Zettelmeyer, J., Trebesch, C. and Gulati, M. “The Greek Debt Restructuring: An Autopsy”, Peterson Institute for International Economics, August 2013. Accessed on 1 June 2014 at www.iie.com. Read More