ACST252 Lecture Notes - Lecture 6: Cash Flow, Risk Premium, Capital Asset
11 May 2018
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Week 6
The Objective of Investing
Financial managers allocate resources to maximise the wealth of shareholders, while considering the
sustainability of the business as well as the welfare of a broader economy. Good investment
decisions are reflected by allocating resources to assets that generate a positive future return and
such return exceeds that of alternatives.
A well-known investing principle is to u lo ad sell high - investing an asset that is cheaply
priced in the market relative to its future investment potential and then selling it when its price
exceeds that value. But how do we estimate its value?
Asset Pricing / Valuation
A asset’s value (future investment potential) is determined by its future cash flows – its size, timing
and riskiness. These cash flows may be estimated by the asset’s udelig stegth ad the
economy (how likely the asset is to pay the cash flows as they fall – profit, size of returns – market
position).
In a normal economy with positive interest rates, the principle of the time value of money states
that a dollar today is worth more than a dollar in the future. The return earnt on an investment is
therefore the reward for delaying gratification and compensation the that the borrower cannot
repay their investment principal with interest (risk premium).
Return on different types of investments:
• Debt instruments (bank accounts, bonds, mortgages and debentures) give interest.
• Equity instruments (company stocks) gives dividends.
• Property assets give rental income.
• Infrastructure assets (toll roads, power/water treatment plants) give tolls, duties or fees.
• Commodities (precious metals, base metals, oil) give a payment of carry costs.
Investment assets give two types of income: capital gain and periodic income.
The price that an investor pays to purchase an asset reflects the present value of the future
expected cash flows to be received, discounted by a risk-adjusted rate of return. To calculate this:
1. Draw a time diagram of cash flows (interest rate and cash flow frequency much match)
2. Determine the value for the cash flows as at the valuation date.
Measuring Risk
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Risk preferences:
• Risk adverse: Require a higher rate of return to compensate for taking higher risk. – most
financial managers are risk adverse
• Risk Seeking: Will accept a lower return for a greater risk.
• Risk Indifferent: Required return does not change in response to a change in risk.
How much did you earn from your investment? How much risk did you take to earn that return?
These two questions are important as we want to evaluate our decisions and consequent outcomes.
Approaches to analysing historical returns:
• Convert price to returns or change of price.
Business - The chance that the firm will be unable to cover its operating
osts. Leel is die the fi’s eeue stailit ad the stutue of its
operating costs (fixed vs variable).
Firm Specific
Financial - The chance that the firm will be unable to cover its financial
obligations. Level is driven by the
peditailit of the fi’s opeatig ash flos ad its fied-cost financial
obligations.
Interest Rate - The chance that changes in interest rates will adversely
affect the value of an investment. Most investments lose value when the
interest rate rises and increase in value when it falls.
Shareholder Specific
Liquidity - The chance that an investment cannot be easily liquidated at a
reasonable price. Liquidity is significantly affected by the size and depth of
the market in which an investment is customarily traded.
Market - The chance that the value of an investment will decline because
of market factors that are independent of the investment (such as
economic, political and social events). In general, the more a given
iestet’s alue espods to the aket, the geate its isk; ad the
less it responds, the smaller its risk.
Event - The chance that a totally unexpected event will have a significant
effect on the value of the firm or a specific investment. These infrequent
events, such as government-mandated withdrawal of a popular
prescription drug, typically affect only a small group of firms or
investments.
Firm and
Shareholder
Exchange power - The exposure of future expected cash flows to
fluctuations in the currency exchange rate. The greater the chance of
undesirable exchange rate fluctuations, the greater the risk to the cash
flows and therefore the lower the value of the firm or investment
Purchasing power - The chance that changing price levels caused by
inflation or deflation in the economy ill adesel affet the fi’s o
iestet’s ash flos ad alue. Typically, firms or investments with
cash flows that move with general price levels have a low purchasing-
power risk, and those with cash flows that do not move with general price
levels have high purchasing power risk.
Tax - The chance that unfavourable changes in tax laws will occur. Firms
and investments with values that are sensitive to tax law changes are more
risky.
Moral
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