Financial Market and Capital Budgeting Analysis

HI5002 Finance for Business: Financial Market and Capital Budgeting Analysis

Introduction

The research is about the Australian financial market and capital budgeting analysis. The Australian financial market is similar to all other markets available in the world, which has similar financial instruments such as stocks and bonds. The stock types are further categorized into two types i.e., preferred and common, while bonds can also be categorized by means of maturity and return. How the bonds and stocks are traded, we will look into detail further.

Part 1 – Research on financial markets

1.1-Comparison of three key financial products common stocks, bonds and preferred stocks from the perspective of an investor

Common stocks, bonds, and preferred stocks are three key financial instruments that investors choose to invest in. Bonds are known to be as debt while stock is the ownership stake of an organization. Preferred stocks on the other hand are different from common stock in terms of voting rights. Common stock allows voting rights to the owners. Hence when it is time for the election of the board of directors, only common stockholders can take part in voting not preferred stockholders, as they have no voice in the elections because of their limited powers. We can say that preferred stocks are similar to bonds for which a fixed dividend is paid out in perpetuity (Kettell, 2001).

The dividend payout of preferred stockholders is calculating by dividing the dollar figure of dividends with the stock price which is usually the par value of the stock. Common stock, on the other hand, does not have fixed dividends but variable dividends are given which are not always guaranteed. Common stockholders are only paid dividends when declared. Many organizations do not declare dividends for common stockholders at all. And others declare sometimes. In the case of preferred stocks, interest rates affect the par value of stocks similar to bonds. An increase in interest rates decreases the par value of preferred stocks and vice versa. Common stocks, however, do not get affected by interest rates but by the demand and supply position of the participants in the market (Mak, 2003).

When an organization is being liquidated, preferred shareholders are considered on a priority basis when making clams upon the assets and earnings of the business as we can see that in times of good profits, the preferred stockholders are given their share first in the form of dividends. Their dividend is usually higher than that of common stockholders. Hence, if a dividend payment is skipped for preferred shareholders, the company is bound to pay them in arrears before making any payment to preferred stockholders (Bilan et al., 2019).

The preferred stockholders have a right to redeem the share after a fixed period of time, but common stockholders have no such opportunity. After redemption, the owners of preferred stocks have the right to call back the shares and obtain a premium upon this. The bid price may rise in anticipation of callbacks.

Common stock is the stock that attracts most investors in the stock market. Most of the the company’s stock is issued in the form of common stock. Common stockholders can make claims over the profits of the company along with voting rights. Voting right is given per share of ownership; hence the stockholder with most common shares holds the highest voting rights for the election of board members and other decision-makers of the company. We can say that common stockholders are behind the corporate policymaking of the organization (Brown, 2010).

Common stock has the highest potential in terms of making gains in the long term as compared to bonds and preferred stocks. Preferred stockholders benefit by obta8ning dividends each time while common stockholders benefit from increasing prices of the stock when the company is performing well. Common stockholders are the last ones who have a share over the assets and earnings of the company in case of insolvency. This means that after liquidation, payments are made to bondholders and preferred stockholders first and common stockholders in the end. (Menkhoff & Tolksdorf, 2012)

Bonds are different from stocks in terms of ownership, risk, and returns. Bond is treated as dents of companies and bondholders are paid fixed interest for a deiced period. Investors lend money to the company by buying bonds that are treated as loans over which fixed interest is paid. After the decided period of time, the basic amount is returned in full to the bondholder. For new investors or short-term investment bonds are better opportunities as compared to stocks (Alexander & Moloney, 2012).

Moreover, bonds are not sold like stocks on stock markets but are found over the counter. Bondholders do not get a share in the company’s ownership as stockholders do. Bondholders have no claims over the assets and earnings of the company at the time of liquidation. Bonds do not give high returns when the company performs well but only get a fixed interest rate that is pre-decided. However, stockholders’ return increases when the company performs well. Bonds are considered less risky as compared to stocks of the company. Bonds are made available when a company is in need of creating finance for a new project or fund existing projects. Bonds are alternatives to bank loans that companies may use. Bonds do not have much potential for income as stocks do (Priolon, 2019).

Google is a search engine used worldwide. Its first issuance for the public was made in August 2004. At a price of $ 85 per share, 19,605,052 shares were offered initially. Google’s shares are traded on the Nasdaq stock market. By the end of 2019, Google 343.55 million shares and closed at $ 133.7 per share with a market capitalization of 459.33 billion (Markets.businessinsider.com, 2019).

Apple Inc. is another top performer of the Nasdaq stock market. The first public issuance of apple was made on December 12, 1980, by selling 4.6 million shares at a price of $ 22 per share. Apple closed at $293.6 per share by the end of 2019, with total shares of 4,443.2 million and market capitalization of 1,304.76 billion.

1.2-Analysis of five basic principles of finance

In order to understand finance, it is important to understand the below five principles:

• Cash Flow is what matters

In accounting, profits are focused upon, but these are different from cash flows. It is possible that a company which is cashless is gaining profits. The value of a business is determined by the cash flow it makes. Most financial decisions are made upon the cash flow situation of the company. Incremental cash flow is the difference between actual cash flow achieved from a project as compared to the projected cash flow of this project. For the decision-making process, incremental cash flows are considered (Babu, 2006).

For example, Disney is not only making money from the movies it produces but also toys, rides and parks attract customers and sales. Hence if the evaluation is made of the cash flow of Disney, then incremental cash flow from related sales must also be considered.

• Money has a time value

Money changes its value with the passage of time. Today’s dollar is worth more than the dollar in the future. Hence interest received on money invested today is greater in importance as compared to interest received in the future.

For example, if $100 is invested in the apple today for 1 year at an interest of 5%. At the end of the year, $105 is obtained which means $105 of tomorrow is equal to $100 today.

• Risk requires a reward

This concept is based on the theory that no one accepts risk when no reward is expected. Risk is only accepted when it comes with a reward. The higher the risk, the higher the reward and vice versa. In case of delayed consumption and taking additional risk, the investor needs a reward. Hence when an investor saves money in a bank rather than consuming it, the return is expected and when the investment is made into stocks of the company. This means a higher risk is taken so a higher reward is accepted as well.

For example, airlines are said to have a high risk of high rewards. As per an article on CNN the first commercial flight was made in Florida for which the mayor paid $400 which is $9000 today and became the first paying customer. Pan American world airways was one of the first booming airways company with high-class power room for women passengers ended up into financial failure. This proves that the highest returns turned into loss forever (Pisa, 2014).

• Conflict of interest cause agency problems

Ownership and management are two separate poles which create agency problem within a company. Owners tend towards making more wealth for the long term, while managers make decisions that are in their own benefit and are focused upon yearly bonuses. The goals of the owners are neglected by managers. Earnings management is an issue that is of concern in such cases. Agency problems can be monitored by means of regular reporting, compensation schemes which include stock options for managers and many more (Welfens & Ryan, 2011).

For example, the Enron Ponzi scheme is the biggest example of the agency problem due to which the giant energy company collapsed. By the use of false accounting reports, the management including senior directors and chairman, were selling the company’s stocks at higher prices than they actually were. After the scandal came into light, millions were lost by thousands of investors who were investing in Enron (Hanks, 2019).

• Market prices are generally right

In this concept, it is considered that prices of all financial assets reflect what information is available in the market. We can say that stock prices reflect the firm’s value. Changes in stock prices reflect changes in future cash flows of the organization. Stock prices increase with good decision making and vice versa. Price distortion usually occurs as a result of an inefficient market (Butron et al., 2010).

For example, in the case of IBM, there was an implication that the corporate rate of return would be 23.6%. The real cost of capital was 10% due to which 11.6% became the market expectation premium (Rappaport, 1987).

Part 2 – A fact-finding of the financial market of Australia

2.1. Fact-finding of the Australian Bond market

(1) Where are the bonds traded secondarily in Australia? What are the types of bonds traded in that marketplace?

The primary market is said to be the stock exchange market such as Nasdaq. Stock is all traded in this primary market. Unlike stocks, bonds are not traded in the primary market but are available in secondary markets and sold over the counter. There may be several reasons for bonds to be traded on the secondary market, but the major reason is the diversity that is provided to the investor. Stocks are only categorized into two types I.e. common and preferred; however, bonds have several based upon quality, maturity period and return yield. The type of issuer and interest decides the category of bonds (Aasx.com.au, 2019).

The categorization can be done as below:

1-Types of interest:

1. Fixed-Rate Bonds
2. Floating Rate bonds

• Indexed Bonds

2-Types of Issuer:

1. Government Bonds
2. Corporate Bonds

(2) Who provides bond rating service and what are ratings used for bonds in Australia?

Bond-rating was also known as a credit rating service. It is usually done by agencies for investors to perform a creditworthiness check of the bond issuer. The creditworthiness is the ability to repay the debt or loan to the lender within the agreed time period and also the chances of the bond issuer defaulting on their debt. These agencies are independent bodies that perform this assessment of the bond issuer for the investor in return for an amount of money.

The agencies also provide risk indicators of the bond issuer if any exists. In other terms, we can say that the higher the credit rating, the lower the risk and lower the credit rating, which means higher the risk.

Three things are considered by the investor looking into the creditworthiness of a bond:

1. The credit rating of the security
2. Product complexity

• Credit rating of bond

Unrated companies do not mean that risk is higher for the companies but is an indicator that investors must spend on their own to look for other means to check the credit worthiness of bonds in Australia. A broker or investment advisor may assist in searching for company data to provide a credit rating for them.

In Australia following alphabetical indicator are used as rating:

1. AAA
2. AA

• A

1. BBB
2. BB
3. B

And so on…

The Australian Government is assigned a rating of “AAA” which is considered to be the highest and means the lowest risk for the investor and high creditworthiness (ASX.Com, 2019) (Asic.gov.au, 2019).

There are 6 agencies which are licensed for providing credit ratings in Australia:

1. S&P Global Ratings Australia Pty Ltd
2. Moody’s Investor Services Pty Limited

• M Best Asia-Pacific Limited

1. Fitch Australia Pty Limited
2. Equifax Australasia Credit Ratings Pty Limited
3. Australia Ratings Pty Ltd

(3) Identify the key differences between Australian Government Bonds and Australian Corporate Bonds, using information and data from ASIC’s Money Smart (ASIC website)

Australian Government Bonds

Australian Government bonds are considered to be the least risky and highly secure investment as compared to any other bond. Returns obtained on these bonds are set as benchmarks for other bonds in the market. In these bonds, the Government is lent money by investors upon an agreed interest rate and return of principal upon maturity. Buying and selling of AGBs are done upon Australian stock exchange similarly to shares (Valentine et al., 2010).

Australian Corporate Bonds

Australian Corporate Bonds, on the other hand, are a high-risk investment as compared to AGBs. In this scenario, lending is made to companies not the government. An agreed interest is given to the lender and the principal amount is returned upon maturity. ACBs offer high returns as compared to AGBs because of their high risk. These can either be purchased in the primary market, that is a public offer, or stock exchange i.e. secondary market (Money Smart, 2019).

 (4) Explain the nature of yield to maturity (YTM), identify the relationship between coupon rate and YTM, using an example of bond evaluation with coupon rate, which is higher and then lower than YTM for illustration.

If an investor is about to purchase a bond, he might consider two possible pieces of information that are yield to maturity and coupon rate. Assuming that the bond is held till the time of maturity, the annual rate of return of the bond is known as yield to maturity.

The coupon rate, on the other hand, is the return obtained from holding a particular bond. Mostly bond purchase decisions are based upon yield to maturity rather than the coupon rate.

For example, if a bond is purchased at a premium, then its coupon rate will be higher than the yield to maturity.

(5) What is the interest rate risk, and how does it affect the bond price?

Interest rate risk is a chance that the value of a bond might fall due to a change in the interest rate. An increase in interest rate reduces the price of bonds and vice versa.

2.2. Fact-Finding of Australian Sharemarket

(1) What is the name of the listed stock market in Australia, how is it operated, how many shares are traded in the marketplace at the present?

ASX is the primary stock exchange of Australia, which is under the ownership of Australian securities exchange ltd. It was founded in 1987. Today’s average turnover of the ASX is A$4.685 billion with a market capitalization of A$1.9 million. ASX is counted as one of the top 16 security exchanges in the world.

(2) Using information and data from the ASX website, identify what is the market capitalization of a listed company, how is it computed?

Each listed company on the ASX publishes a figure on it’s the website named as market capitalization. An approximation of the market value of a listed company is known as market capitalization. It is calculated by previous days’ last traded price per share by the total shares issued.

(3) What is the oldest share index in Australia, what does it measures, how many listed stocks are there in the index at the present and how the index is calculated?

All ordinaries Index (AOI) is the oldest shares of the index in Australia. It measures share prices of the top 500 companies listed upon the ASX. The index has 5000 points currently. For measurement, if the index, a weighted average is used.

(4) Go to the ASX website and obtain a 3-year historical movement graph of that index.

(5) Comment on the trend, do research and identify the factors that may explain the trend (secondary data can be used for this question only).

The trend of All Ordinaries Index shows an immense level of improvement in the last three years. However, there was a decline by the end of 2018 but after this; the rise almost reached the price of 7000 by the end of 2019.

Part 3 – Risk analysis and project evaluation

3.1- Perform a sensitivity analysis with data provided

 

SCENARIO	NPV	DEVIATION IN NPV
Original	6,235,431
Unit sale decrease by 10%	5,347,869	(887,562)
Price per unit decreases by 10%	4,282,794	(1,952,637)
variable cost per unit increases by 10%	5,170,357	(1,065,074)
cash fixed cost per year increases by 10%	6,179,959	(55,472)

 

Original Scenario NPV Calculation
Particulars	Amount
Sales (400000*22)	8,800,000
Variable cost (400000*12)	4,800,000
cash fixed cost	275,000
Profit before depreciation and tax [A-(B+C)]	3,725,000
Depreciation	550,000
Profit before tax (D-E)	3,175,000
Tax @ 30%	952,500
Profit after tax (F-G)	2,222,500
Cash Flow after-tax (H+ E)	2,772,500
Calculation of PVF and PVAF @ 10%
Period	PVF	PVAF
1	0.91	0.91
2	0.83	1.74
3	0.75	2.49
4	0.68	3.17

 

Calculation of NPV
Present Value of cash inflows	9,129,959
Less PV of cash outflows	2,950,000
NPV	6,179,959
Calculation of PV of cash inflows
Particulars	Amount	Period	PVF	PVAF	PRESENT VALUE
Yearly cash flow after tax	2,772,500	1-4	–	3.17	8,788,452
Release of working capital at year 4	500,000	4	0.68	–	341,507
					9,129,959
Calculation of present value of cash flows
Particulars	Amount	Period	PVF	PVAF	PRESENT VALUE
Cost of equipment	2,450,000	0	1	–	2,450,000
Additional working capital	500,000	0	1	–	500,000
					2,950,000
3.2- Perform an NPV break even analysis for the case where price per unit decreases by 10 % to identify the number of unit sales that is needed for the project to get break-even Break-Even Analysis Fixed Cost              250,000 Sales per unit 19.8 Variable cost per unit                        12 Break-Even Point                32,051

Conclusion

In conclusion, we can say that the highest NPV deviation could be seen when there was a change in the price per unit of the product, and the least deviation was made when cash fixed cost per unit increased by 10%. Hence, we can say the project is most sensitive to price and least sensitive to cash fixed cost per unit. Moderate sensitivity can be seen where the unit sale and variable cost is changed.

References

Aasx.com.au, 2019. Types of bonds. [Online] Available at: https://www.asx.com.au/products/bonds/types-of-bonds.htm [Accessed December 2019].

Alexander, K. & Moloney, N., 2012. Law Reform and Financial Markets. 1st ed. Edward Elgar Publishing.

Asic.gov.au, 2019. Asic.gov.au/about-asic/news-centre/find-a-media-release/2018-releases/18-042mr-asic-reports-on-credit-rating-agencies/. [Online] Available at: https://asic.gov.au/about-asic/news-centre/find-a-media-release/2018-releases/18-042mr-asic-reports-on-credit-rating-agencies/ [Accessed 31 December 2019].

ASX.Com, 2019. Credit ratings. [Online] Available at: https://www.asx.com.au/products/credit-ratings.htm [Accessed 31 December 2019].

Babu, G.R., 2006. Financial Markets And Institutions. 1st ed. Concept Publishing Company.

Bilan, A., Degryse, H., O’Flynn, K. & Ongena, S., 2019. Banking and Financial Markets: How Banks and Financial Technology Are Reshaping Financial Markets. 2nd ed. Springer International Publishing.

Brown, O.W., 2010. Financial Markets Regulation: Financial Crisis Highlights Need to Improve Oversight of Leverage at Financial Institutions and Across System: Congressional Testimony. 1st ed. DIANE Publishing.

Butron, M., Nesiba, R. & Brown, B., 2010. Intro to Financial Markets and Institutions. 2nd ed. M.E. Sharpe.

Hanks, G., 2019. Examples of Agency Problems in Financial Markets. [Online] Available at: https://smallbusiness.chron.com/examples-agency-problems-financial-markets-70962.html [Accessed 2 January 2020].

Kettell, B., 2001. Economics for Financial Markets. 1st ed. Elsevier.

Mak, D.K., 2003. The Science of Financial Market Trading. 1st ed. World Scientific.

Markets.businessinsider.com, 2019. ALPHABET C (EX GOOGLE (GOOG). [Online] Available at: https://markets.businessinsider.com/stocks/goog-stock [Accessed 31 December 2019].

Menkhoff, L. & Tolksdorf, N., 2012. Financial Market Drift: Decoupling of the Financial Sector from the Real Economy? 2nd ed. Springer Science & Business Media.

Money Smart, 2019. Corporate bonds: Lending money to a company. [Online] Available at: https://www.moneysmart.gov.au/investing/investments-paying-interest/bonds/corporate-bonds [Accessed 31 December 2019].

Pisa, K., 2014. Why it’s high risk, high reward for airlines. [Online] Available at: https://edition.cnn.com/2014/06/03/business/why-its-high-risk-reward-airlines/index.html [Accessed 2 January 2020].

Priolon, J., 2019. Financial Markets for Commodities. 1st ed. John Wiley & Sons.

Rappaport, A., 1987. Stock Market Signals to Managers. Harvard business Review, 1(1).

Valentine, T., Ford, L.O. & Sundmacher, 2010. Fundamentals of Financial Markets and Institutions in Australia. 1st ed. Pearson Australia.

Welfens, P.J.J. & Ryan, C., 2011. Financial Market Integration and Growth: Structural Change and Economic Dynamics in the European Union. 1st ed. Springer Science & Business Media.