CMAUSA PART 2 SECTION B
The security market line:
The security market line the graphical representation of the
capital asset pricing model.
It would represent the predict required return to an average
security in the market at each level of beta according to the capital asset
pricing model theory.
Note: beta is a co-variance between the securities return
and general market.
Dividend payout ratio measures the percentage of earnings paid
to shareholders as dividend payout ratio would not have much impact on its beta.
Using the SML:
Since stock A is above the SML, stock A currently a good investment for investors
with this SML.
The investor requires a 2% return when beta is .5% , but stock
A providing a 4% return with a beta of .5%.
Stock C however, is below the SML and this indicates that it
is not a good investment. The return for stock C is less than the investors
required rate of return for an investment with a beta of 1.5.
A change in the risk free rate :
note: RF changed from .5 % to 1.5 %, therefore RM also changed from 4 to 5%. Then
market risk premium never change.
Investor risk awareness increases return increase.
Ø
Portfolio risk and return:
A portfolio is a collection of asset that are managed as a
group for an individual investor a
portfolio would probably consist of a group of stock and other marketable
security.
The portfolio has a whole should be managed so that it maximized
the return of the portfolio given the risk of the portfolio. This process of
managing the portfolio is called portfolio management.
An efficient portfolio is one that gives the highest
possible rate of return for a given level of risk or the lowest possible level
of risk or the lowest possible level or risk for a given rate of return.
Portfolio theory also called modern portfolio theory is an
investment philosophy that seeks to construct an optimal portfolio of
securities according to the investors preference with respect to risk and return.
The co efficient of co relation® in portfolio theory:
Co relation measures the relationship between two variance. Its
value range -1 to +1.
Order of lowest risk to highest risk:
1.
US treasury bill [ risk free investment].
2.
First mortgage bond
3.
Second mortgage bond
4.
Debentures
5.
Income bond
6.
Preferred share
7.
Convertible preferred share
8.
Common share.
Ø Rising capital and capital marketing:
If a company requires new capital such as for a capital
expansion project. It has seversl sources of the capital.
1.
Retained earnings
2.
Commercial bank or finance company loans
3.
Lease financing
4.
Venture capitalists
5.
Equity issues [ common or preferred stock]
6.
Debt issues [ issuing bonds]
Ø
Commercial bank or finance company loans:
Commercial bank or finance companies offer long term
commercial loans for long term needs. Term loans that mature in more than one
year. They are usually used to purchase fixed assets such as equipment when
they are used to purchase fixed assets. the purchased fixed assets often function
as the collateral for the loan.
Ø
Lease financing :
A lease Is a contractual agreement between a lessor [ owner of
the asset] and a lessee [ user of the asset] that gives the lessee the right to
use specific property for a specified period of time in return for stipulated [ cash payment] and generally periodic cash
payments [ rent].
Ø
Lease v/s purchase analysis:
If cashflows are occur at the end of the year , we can use
present value ordinary annuity. If cashflow are occur at beginning of the year
. we can use present value annuity due.
Ø
Venture capitalists:
If the owners of the company are able to convince a venture
capital firm or firms that their idea has good potential for growth and
enrichment the venture capitalists, may make an investment in the company. In exchange
for the money, venture capitalists receive a percentage of ownership in the
business and usually seats on the board of directors. There is usually no
required minimum time period that the venture capitalists must hold the shares.
Ø
Equity ( common stock ) issues:
Initial public offering ( IPO):
When a company first offers its common shares for sales to
the public. The issuance is called on initial public offering. [ IPO].
However the process of going public can be both expensive
and time consuming, floatation cost such as filling fees, atony and accountants
fees must be paid.
The IPS provide a source of new capital establishes the
company value in the market and increases and increases in the liquidity of its
stock.
When a newly issued securities are sold to the public the
offering is called a primary offering.
Ø
Subsequent offering:
It is an offering of additional shares to the public after
the issuing company has had its initial public offering. [ a follow on
offering].
Secondary offering:
It’s a sale of existing securities by one or more major
stakeholders who want to liquidate all or part of their personal holding.
Ø
Primary market:
When newly issued securities either IPO or subsequent
offering are first offered to the public by a company they are issued in the primary
market. Usually through an investment bank.
Ø
Investment bank:
Investment banks are intermediaries that bring together
business in search of new capital with investments in search of new
investments.
They investment bank plays a triple role in assisting a
company issues its shares.
Ø
Roles: helps it customer assign to deal and the
securities by advertising the company. Underwrites new issue of securities. Markets
the issue to the public.
Ø Underwriting the issues:
When an investment bank underwrites an issue the investment
bank agrees to purchase some or all of the shares of the issuance and then re
offer the shares to the public.
Ø
Firm commitment:
If the entire issues underwritten in what is called firm commitment,
the investment bank absorbs any securities that they are not able to resell.
Ø
Best effort:
When the underwriters simply markets the new issues , it is
called a best effort issue. In this case of there are shares that are not sold
they are retained to the issuing company.
Ø
Underwriting spread:
The underwriters will purchase the securities from the
company at one price and sell them at a higher price. The underwriting fees or
underwriting spread Is the difference between the offering price to the public and the price
at which the underwriter will purchase the securities from the company.
Ø
Secondary market:
After securities have been initially issued and sold, they
are traded I the secondary market. It facilitate the trading of existing securities
and consists of exchange were buyer and seller of financial instruments are
brought together to execute transactions.