Finance

 Risk of a Single Asset: The concept of risk can be developed by first considering a single asset held in isolation. We can look at expected-return behaviors to assess risk, and statistics can be used to measure it.  Risk Assessment: Sensitivity Analysis (Scenario Analysis) and Probability Distributions can be used to assess the general level of risk embodied in a given asset. Sensitivity Analysis: Sensitivity analysis uses several possible-return estimates to obtain a sense of the variability among outcomes. One common method involves making pessimistic (worst), most likely (expected), and optimistic (best) estimates of the returns associated with a given asset. In this case, the asset’s risk can be measured by the range of returns. The range is found by subtracting the pessimistic outcome from the optimistic outcome. The greater the range, the more variability, or risk, the asset is said to have. Although the use of sensitivity analysis and the range is rather crude, it does...

Types of Risk: To understand the basic types of risk, consider what happens to the risk of a portfolio consisting of a single security (asset), to which we add securities randomly selected from, say, the population of all actively traded securities the standard deviation of return, kp, to measure the total portfolio risk, depicts the behavior of the total portfolio risk (y axis) as more securities are added (x axis).  With the addition of securities, the total portfolio risk declines, as a result of the effects of diversification, and tends to approach a lower limit. Research has shown that, on average, most of the risk-reduction benefits of diversification can be gained by forming portfolios containing 15 to 20 randomly selected securities.              The total risk of a security can be viewed as consisting of two parts:                      Total security risk = Nondiversifiable...

Sources of Risk:   Inflation Risk: The purchasing power risk is the factor that affects all the securities. It also refers as the likelihood that the purchasing power of the invested dollars will fall. Even if the nominal return is safe, the real return involves risk with uncertain inflation. The risk is associated with the interest rate risk because the increase in inflation results in the increase in the interest rates. The reason behind this fact is that additional inflation premiums are demanded by the lenders in order to compensate for the loss of purchasing power. Business Risk: Business risk is the risk of conducting business in certain industry or environment. For example the traditional telephone powerhouse  AT&T  confronts many challenges in quickly changing telecommunication industry. Financial Risk: The utilization of debt financing by companies includes the  financial risk . When more assets of the company are financed through debt then the variabili...

  What Is Risk? Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment. Summary : Risk takes on many forms but is broadly categorized as the chance an outcome or investment's actual gain will differ from the expected outcome or return. Risk includes the possibility of losing some or all of an investment. There are several types of risk and several ways to quantify risk for analytical assessments. Risk can be reduced using diversification and hedging strategies. For example: A $1000 government bond that guarantees it's holder $5 interest after 30 days has no risk because there is no variability associated with the return. A $1,000 investment in a firm's common stock is very risky because the value of that stock may move up or down substantially over the same 30 days. Sources of Risk in Business:   There ar...

Gordon Growth Model Formula Assumptions Before applying the Gordon Model, there are certain assumptions you need to consider. Otherwise, the model may not produce the expected outcome. Below are some of those assumptions: It is assumed that the company’s life is indefinite. We also have to assume that the growth of the firm is at a constant rate. The firm’s financial leverage is stable, or it doesn’t have any financial leverage attached to it. The required rate of return is higher and better than the growth rate. The required rate of return of the firm remains constant. The company’s free cash flow is paid out as dividends at consistent growth rates. Key inputs of the GGM:                                               This growth takes into account three critical inputs, which are growth rate in dividends per share, dividends per share, and the required rate of return. They...

Constant-Growth Model The most widely cited dividend valuation approach, the constant-growth model, assumes that dividends will grow at a constant rate, but a rate that is less than the required return. The constant-growth model is commonly called the Gordon model. The Gordon Growth Model – otherwise described as the dividend discount model – is a stock valuation method that calculates a stock’s intrinsic value. Therefore, this method disregards current market conditions. Investors can then compare companies against other industries using this simplified model. The Gordon Growth Model (GGM) is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of the dividend discount model (DDM). The GGM assumes that dividends grow at a constant rate in perpetuity and solves for the present value of the infinite series of future dividends. Because the model assumes a constant growth rate, it i...

  Features of Preferred Stock A number of features are generally included as part of a preferred stock issue. These features, along with the stock’s par value, the amount of dividend payments, the dividend payment dates, and any restrictive covenants, are specified in an agreement similar to a bond indenture. Restrictive Covenants: The restrictive covenants in a preferred stock issue are aimed at ensuring the firm’s continued existence and regular payment of the dividend. These covenants include provisions about passing dividends, the sale of senior securities, mergers, sales of assets, minimum liquidity requirements, and repurchases of common stock.  The violation of preferred stock covenants usually permits preferred stockholders either to obtain representation on the firm’s board of directors or to force the retirement of their stock at or above its par or stated value.  Cumulation:  Most preferred stock is cumulative with respect to any dividends passed. That is,...

Preferred Stock The term "stock" refers to ownership or equity in a firm. There are two types of equity common stock and preferred stock. Preferred stockholders have a higher claim to dividends or asset distribution than common stockholders. The details of each preferred stock depend on the issue. Preferred stock gives its holders certain privileges that make them senior to common stockholders. Preferred stockholders are promised a fixed periodic dividend, which is stated either as a percentage or as a dollar amount.  How the dividend is specified depends on whether the preferred stock has a par value, which, as in common stock, is a relatively useless stated value established for legal purposes. Par-value preferred stock has a stated face value, and its annual dividend is specified as a percentage of this value. No-par preferred stock has no stated face value, but its annual dividend is stated in dollars. Basic Rights of Preferred Stockholders: The basic rights of preferred...

What is a Common Stock? Common stock is an equity instrument that represents a small portion of company ownership. The stockholders enjoy dividends once or twice a year. Not like preferred stocks or bonds, the common stock declares a high dividend. As this type of investment has a high dividend yield, it is also a risky investment. The owner can lose the value of the stocks. Also, if there is any downtime, the common stockholders may not enjoy any dividend, unlike preference shares. As it represents ownership, the stockholders have the rights to elect the board of the directors and voting rights. So, the common stock holders elect the board of the directors of a company. Features of Common Stocks One of the most popular features of common stock is that anyone can buy and own it, hold it, and sell it when in profit. Also, if anyone wants, s/he can hold it forever and enjoy the yearly dividend for a lifetime. Common stocks have many unique and popular characteristics; this is why its ver...

What are Unsecured Bonds? Unsecured bonds or debentures are bonds that are not backed by some type of collateral. In other words, the bond is only secured by the bond issuer’s good credit standing. There are no building, equipment, vehicles, or other assets backing up the bond. If the bond issuer defaults on the unsecured bond, the bond holders could receive nothing from their investment. They would be left up to the court system to sue the bond issuer for their investment.  A bond that has no specified source of collateral is considered an unsecured debt instrument. Therefore, unsecured debt often pays higher yields than secured debt due to lack of a direct collateral coverage. There are three types of unsecured debt: debentures, Income bonds and subordinated debentures. Debentures A debenture is a type of bond that does not use collateral. It's otherwise recognized as any unsecured long-term debt. Because the bonds are unsecured, it's imperative for the issue to be profitable...

What are Secured Bonds? A secured bond is a  bond  that requires the issuer to pledge specific assets as collateral in the case of default. Secured bonds are usually more popular with businesses or governments that are less likely to be able to pay their debts in the future. Interest on these bonds isn’t enough to attract investors. Companies and local governments will less than stellar past financial track records usually need to assure inventors that they will not default on their future principle and interest payments. And if they do default, ensure the investors don’t walk away empty handed.   Example A good example of a local government that will probably need to issue secured bonds in the future is the city of Detroit. Since its 2013 bankruptcy, its difficult to believe an investor would want to put his or her money at risk purchasing a bond issued by the city of Detroit. I doubt it will ever be able to issue a bond without having some kind of secured collateral agr...

    Legal Aspects of Corporate Bonds: Certain legal arrangements are required to protect purchasers of bonds. Bondholders are protected primarily through the indenture and the trustee. Bond Indenture:  A bond indenture is a legal document that specifies both the rights of the bondholder's and the duties of the issuing corporation. Included in the indenture are descriptions of the amount and timing of all interest and principal payments, various standard and restrictive provisions, and, frequently, sinking-fund requirements and security interest provisions. Standard Provisions: The standard debt provisions in the bond indenture specify certain record-keeping and general business practices that the bond issuer must follow. Standard debt provisions do not normally place a burden on a financially sound business.  The borrower commonly must:  (1) maintain satisfactory accounting records in accordance with generally accepted accounting principles (GAAP)  (2) peri...