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Finance For Business

University: HOLMES INSTITUTE

  • Unit No: N/A
  • Level: High school
  • Pages: 25 / Words 6179
  • Paper Type: Assignment
  • Course Code: HI5002
  • Downloads: 139
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INTRODUCTION

The finance industry is extensive, offering numerous investment products through which investors can earn profits. These investment avenues come with varying risk and return profiles. For some financial instruments, such as equities, these profiles fluctuate, while for others, like debt and bonds, they remain relatively stable.

The main objective of this research study is to identify the differences between various financial instruments, including common stocks, bonds, and preferred stocks, and to assess their risk profiles. Sections 2 and 3 provide a detailed analysis of bonds and equities. Section 2 specifically focuses on Australian government and corporate bonds, examining the relationship between coupon rates and yield to maturity (YTM), as well as defining interest rate risk and its impact on bond prices. The final section of the report analyzes 3-year historical data from an index to identify trends and their underlying reasons.

The analysis reveals that equities are riskier than bonds and offer more rights to investors compared to debt instruments. To ensure safe and timely investments, it is crucial to adhere to five key financial principles, including the time value of money, profitability, and liquidity. The relationship between interest rates and bond values is significant: as interest rates rise, bond values typically decline. Since 2016, the ASX has been on a consistent upward trend, although a decline was noted in 2020.

The report is divided into three main sections: the first part explains the differences between financial instruments and the five principles of finance; the second part provides an in-depth discussion of bonds and equities; and the third section includes sensitivity and breakeven analyses.  

PART 1

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

Common stock

Bonds

Preferred stock

Ownership status

Common stock refers to the equity stock under which one by making investment in the company obtained ownership into it. One can also sale ownership to any other individual if want to exit from the company (Chuen, 2015). Equity shareholder are considered as real owner of the company and entitled to receive dividend from the profit earned by the company.

Bond are basically a debt instrument and under this company by issuing bond take debt from the general public and financial institution. In return firm pay interest of specific rate to the bond holders. In this mode of investment holders do not have ownership status in the firm because they are creditors of the company.

Preference shares are those where priority is given to the specific holders who own preference shares in terms of receipt of dividend over equity shareholders. In case of winding up of company preference shareholders first receive amount then equity shareholders.

Nature of funding

It is capital or equity funding under which investors make an investment in the company by purchasing shares from the stock exchange.

It is debt funding and under this firm take debt from public and mutual fund houses.

Same of common stock.

Risks

Risk on equity is high as with change in market conditions and improvement or decline in the company performance price of shares fluctuate. Many time investor loss entire value of investment. Thus, it can be said that investment on equity is risky.

Risk on debt is low because interest rate remains fixed and it is basically rate of return on the investment. Irrespective of market fluctuations interest remain same (Foster, Ker and Characklis, 2015).

If dividend is issued then in that case preference shareholders receive dividend before equity shareholders. Thus, risk of not receiving dividend is less in case of preference shares then equity shares.

However, risk of market fluctuations is same for both equity and preference shares.

Income

Rate of return is very high in case of equity then debt. As company earn high profit higher percentage of return is given by the company to its shareholders.

In case of debt rate of return is quite low as it is debt instrument and there is security of investment. Hence, due to low risk return is quite low.

Same of common stock.

Voting right

Equity shareholders have voting rights and in annual general meeting they pass or reject proposal put forth by the CEO of the company.

There is no voting rights as bond holders are creditors of the company.

Preference shareholders do not have any sort of voting right.

Maturity

There is no maturity of holding in equity. One can sale shares and exit from the company (DÄ…browski, 2015).

Maturity period of bond is determined while issuing it. Maturity period may be 5 to 10 years or more. 

Same of common stock.

Priority in liquidation

In case of liquidation least priority is given to the equity shareholders.

In case of bond higher priority is given to its holders in terms payback of investment amount.

After making payment to bond holders and other creditors payment is made to the preference shareholders.

Common stock example: Microsoft launch its IPO in the year 1986 on March 13 at rate of $21 per share. Total volume of trade of units was 3 million shares. Total market value of shares was $21000000. Microsoft was listed in the NASDAQ. On 31st December total shares traded of Microsoft were 18369400 and close price was $157.70, open price was $156.77. Overall, market capitalization was $2896854380.

Figure 1Microsoft 5 years data

Bond: Bond of National Australia Bank was issued on 13th January 2020 for five year which will matured in 2025. Par value of the bond is 1000 AUD. Overall value of the bond is 1,850,000,000 AUD. Total traded volume is 2896854380.

1.2 Analysis of five basic principles of finance

Five basic principles finance are explained below.

  • Principle of risk and return: This principle state that if risk of higher level is taken in the investment amount then return percentage is high. Inverse to this, if risk level is low then return percentage also remain low. Thus, it become important for the investor to make investment in such a way that risk remain low and moderate return can be gained. In this regard risk and return both need to be compared and by making comparison investor make better investment decisions (Hudson, 2017). Example, Warren Buffett is known for making wise investment decisions. He invests only in those stocks where return is up to expected level considering risks. On media many times it repeatedly states that even share of the company perform good in the past but if he think that in the future time period stock will not be able to give sufficient return after considering risk then he do not prefer to make investment in stock of particular company.
  • Time value of money principle: Time value of money is the one of the most important principle as it states that worth of money whatever today is does not always remain same. It keeps on decreasing consistently with passage of time. This is because price of commodity increase with passage of time and whatever quantity of items one buy today can not be purchased in same quantity in the future time period. Hence, before making investment in any security one need to consider future inflation rate and accordingly required rate of return must be determined so that loss can be compensate which originate due to elevation in the inflation rate (Keown, 2019). Example, Warren Buffett if think that in future time period particular company stock will grow then it makes investment in that in today time period and not wait for observing growth in it. This is because in future time period if inflation increase then same investment may prove costly because return on stock may be low or share may be overvalued due to overpurchased.
  • Cash flow principle:  This principle state that when investment is made cash inflow and outflow both happened. If cash flow is higher in the earlier time period then the end time period of investment then it is good for the investor. This principle takes into consideration time value of money concept. Venture capitalist follow this principle and under this at initial stage they make investment in new business idea. There are no competitors and due to this reason profit is very high in early stage. Latter, when competitors comes in market profit growth decline.
  • Principle of profitability and liquidity: This principle state that investor must make investment in the security which is highly profitable and in demand in the market. If security will have higher demand the investor can easily sale it in the market and if profit will be high then return more then inflation rate can be gained (Profitability and liquidity principle., 2020). In BSE there were not buyers for Uniflex Cables because company shares were not generating return for the investors. Thus, there was no profitability and liquidity. Due to no demand there was no liquidity of company shares in the BSE.
  • Principle of diversity: This principle state that entire investment must not be made in the single security because that strategy will lead to facing of huge loss in the business. Hence, one must prepare portfolio of stocks and other securities so that loss faced in one can be offset by the profit gained on the investment. ABN Amro operate varied diversified debt equity funds through which it gives option to the investors to make diversified investment and minimize risk as well as maximize profit for them.

PART 2

2.1 Fact finding of the Australian Bond Market

1) Where the bonds are traded secondarily in Australia?

Transactions in financial markets are either organized in exchanges, Australian Securities exchange in primary market and New York Stock Exchange or over-the-counter as secondary market. An OTC trade is executed directly between two parties and is not overseen or subject to the rules of major exchanges. It has been analysed that exchange trading is really risky for the investors. Major loss can be bear by them by investing in financial market.

What are the types of bonds are traded in that market place?

There is various type of bonds that can be traded in Australian market place, it includes the following:

Fixed rate bonds: In this type of bond the interest rate is fixed for full life time. In this high amount of risk is been associated like for example maintaining credit quality risk.

Index Bond: These are basically medium term bond, in this bond it makes sure that payer receives the value which is more than inflation rate.

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

Bond rating services are provided by three independent agencies that are Moody's, S& P and Fitch who controls around 95 % of market share in bonds rating business. Every rating agency uses their own system of grading (Qizam and Fong, 2019). All the ratings system classify the bonds investments by the quality grade and risks. Bonds of investment grade are considered safer investment having minimal risks with minimal yield. Non investment bonds have risk with high yield.

Standard & Poor's (S& P) is oldest rating agency and accredited by Australian Securities & Investment Commission. It issues both long and short term bond's credit rating. Ratings are

  • AAA, AA, A
  • BBB, BB, B
  • CCC, CC, C
  • D

Moody's Bond rating agency is also accredited by ASIC. Primary motive of the Moody's Raating is to evaluate projected loss in default.

  • Aaa, Aa, A
  • Baa, Ba, B
  • Caa, Ca, C

3) Difference between Australian government and corporate bonds

Australian Government Bonds

Australian Corporate Bonds

  • In this money is lend to the government at agreed rate of interest for defined period of time
  • These are highly secured investment products.
  • The returns over government bond are regarded as the benchmark for market returns.
  • It is a low risk investment.
  • Corporate bonds are used as source of raising money for financing business.
  • It is raised from the pubic , in return of fixed rate of interest till the bonds are matured.
  • Corporate bonds provide higher returns in comparison with the government bonds or the bank deposits.
  • It is a high risk investment.

4) Nature of Yield to maturity

Yield to maturity refers to total return which is anticipated on bond if bond is held till it is matured. It is considered as the long term yield and is expressed as annual rate (Becker, Fang and Wang, 2016). It is also termed as internal rate of return of the investments in bonds if bonds are held by the investors till maturity, where each payments is made as the scheduled & reinvested at same rates.

Relationship between YTM and the coupon rate

Coupon rates are set when the bonds are first issued and remains fixed for life of bond. It is the rate at which the interest will be paid by the borrower company. The coupon rates are paid annually. Yield to maturity is rate of return over bond at the current market prices if they are held at maturity. They are both are related in terms of return to be provide over the borrowed funds to investors.

5) What is interest rate risk & how it affects bond price ?

The risk is danger that value of bonds or the fixed interest investment will be suffering due to change in rates of interest. Risks can be reduced by the investors by purchasing the bonds which are maturing at different time periods. The risk may also be reduced by companies using interest rate swaps.

Interest rate risks mat be termed as potential that change in the overall rates of interest will be reducing the value of bonds or fixed rate investments. Bond prices tend to be affected with the change in market rates of interests (Bergmann and Nitschke, 2016). Price of bond will rise with fall in market interests and the rise of market interests will reduce the bond price.

2.2 Fact Finding of Australian Share Market

1) Name of the Australian Stock Exchange Market

Australian stock exchange market is Australian Securities Exchange (ASX) that is also referred outside Australia as Sydney Stock Exchange. Stock exchanges provide the platform to marketers for buying & selling the securities. They are regulated by government agencies. Companies list their shares on stock exchange for raising money through sale of shares to the investors who make profit on performance of company (Kent, 2017). There are 2 trading platforms that are ASX Trade for equity securities on ASX & ASX Trade 24 for the derivatives securities. There are 2258 companies listed on ASX till may 2018 with the market cap of $2.153 trillion.

2) Market Capitalization of listed company and its computation ?

Market capitalization refers to the value of company as per the stock market. Market capitalization is computed by multiplying current market price of company with its outstanding shares. The market cap is used by the experts for determining the size of company. To determine the size of company market capitalization is important because it determines various characteristics of interest of the investors including risk.

Market Capitalization = Total shares outstanding * Market price of shares

Market Capitalization of APA Group

Number of shares outstanding = 1.18 billion

Market price of share = 11.370

Market Capitalization = 1.18 * 11.370 => 13.42 billion.

3) Oldest share in the Australian index, its measure, number of listed stock and computation of index.

The oldest listed was a banking company Bank of New South Wales that was listed on the stock exchange in 1817. The All Ordinaries known as ''All Ords'' is oldest Index of shares in Australia.

It is made of 500 biggest companies that are listed over ASX. Market cap of companies in All Ords index amounts to 95% of shares listed on ASX.

Value of stock indices are calculated by using prices of the underlying individual shares. Prices of all the shares are added and divided by total number of companies, outcome is multiplied by average trading turnover of every underlying single stock (Roca, 2018).

4) 3 year historical movement in graph of that index.

5) Trend of the movement in index.

The trend of the index between 2016 to 2019 has been fluctuating but has shown an increasing trend. The index started declining from mid 2018 and hit lowest in end of 2018. However it started raising back from 2019 till the date.

PART 3

3.1 Sensitivity Analysis.

1) Units decrease by 10%

Unit sales decrease by 10%

Units

400000

Decrease by 10%

360000

Calculation of Cash Flows

Particulars

Year 1

Year 2

Year 3

Year 4

Cash In-flow

7920000

7920000

7920000

7920000

(-) Cash out-flow

5050000

5050000

5050000

5050000

Net Cash flow

2870000

2870000

2870000

2870000

(-) Depreciation (on the basis of straight line method @ 15%)

606250

606250

606250

606250

Net Cash flows after depreciation

2263750

2263750

2263750

2263750

Tax Rate (30%)

679125

679125

679125

679125

Net Cash flow after tax

1584625

1584625

1584625

1584625

Working Note:

Calculation of depreciation:

cost of machine

2450000

scrap value

25000

Life of machine

4

Depreciation

606250

Initial Investment

Cost of Machine

2450000

Working Capital

500000

Total Investment

2950000

Year

Net Cash flow

PV factor @ 12%

Discounted cash flow

1

1584625

0.909

1440568.18

2

1584625

0.826

1309607.44

3

1584625

0.751

1190552.22

4

1584625

0.683

1082320.20

Residual value

250000

0.683

170753.36

Working Capital

500000

0.683

341506.73

Total

5535308.12

NPV= Discounted cash flow – initial investment

Discounted Cash Flow

5535308.1

Initial investment

2950000

Npv

2585308.1

Calculation of Break Even point

Break even = (Fixed cost / Sales price – Variable cost)

Fixed Cost

250000

Selling Price

22

Variable Cost

12

Break even

25000

2 ) Price per unit decreases by 10%

Price per unit decreases by 10%

Price per unit 

22

Decrease by 10%

19.8

Calculation of Cash Flows

Particulars

Year 1

Year 2

Year 3

Year 4

Cash In-flow

7920000

7920000

7920000

7920000

(-) Cash out-flow

5050000

5050000

5050000

5050000

Net Cash flow

2870000

2870000

2870000

2870000

(-) Depreciation (on the basis of straight line method @ 15%)

606250

606250

606250

606250

Net Cash flows after depreciation

2263750

2263750

2263750

2263750

Tax Rate (30%)

679125

679125

679125

679125

Net Cash flow after tax

1584625

1584625

1584625

1584625

Working Note:

Calculation of depreciation:

cost of machine

2450000

scrap value

25000

Life of machine

4

Depreciation

606250

Initial Investment

Cost of Machine

2450000

Working Capital

500000

Total Investment

2950000

Year

Net Cash flow

PV factor @ 12%

Discounted cash flow

1

1584625

0.909

1440568.18

2

1584625

0.826

1309607.44

3

1584625

0.751

1190552.22

4

1584625

0.683

1082320.20

Residual value

250000

0.683

170753.36

Working Capital

500000

0.683

341506.73

Total

5535308.12

NPV= Discounted cash flow – initial investment

Discounted Cash Flow

5535308.1

Initial investment

2950000

Npv

2585308.1

3) Variable Cost Increases by 10%

Variable cost per unit increases 10%

Variable Cost

12

Increase by 10%

13.2

Calculation of Cash Flows

Particulars

Year 1

Year 2

Year 3

Year 4

Cash In-flow

8800000

8800000

8800000

8800000

(-) Cash out-flow

5530000

5530000

5530000

5530000

Net Cash flow

3270000

3270000

3270000

3270000

(-) Depreciation (on the basis of straight line method @ 15%)

606250

606250

606250

606250

Net Cash flows after depreciation

2663750

2663750

2663750

2663750

Tax Rate (30%)

799125

799125

799125

799125

Net Cash flow after tax

1864625

1864625

1864625

1864625

Working Note:

Calculation of depreciation:

cost of machine

2450000

scrap value

25000

Life of machine

4

Depreciation

606250

Initial Investment

Cost of Machine

2450000

Working Capital

500000

Total Investment

2950000

Year

Net Cash flow

PV factor @ 12%

Discounted cash flow

1

1864625

0.909

1695113.64

2

1864625

0.826

1541012.40

3

1864625

0.751

1400920.36

4

1864625

0.683

1273563.96

Residual value

250000

0.683

170753.36

Working Capital

500000

0.683

341506.73

Total

6422870.45

NPV= Discounted cash flow – initial investment

Discounted Cash Flow

6422870.4

Initial investment

2950000

Npv

3472870.4

4) Increase of fixed cost by 10%

Cash fixed cost per year increases by 10%

Fixed Cost

250000

Increase by 10%

275000

Calculation of Cash Flows

Particulars

Year 1

Year 2

Year 3

Year 4

Cash In-flow

8800000

8800000

8800000

8800000

(-) Cash out-flow

5075000

5075000

5075000

5075000

Net Cash flow

3725000

3725000

3725000

3725000

(-) Depreciation (on the basis of straight line method @ 15%)

606250

606250

606250

606250

Net Cash flows after depreciation

3118750

3118750

3118750

3118750

Tax Rate (30%)

935625

935625

935625

935625

Net Cash flow after tax

2183125

2183125

2183125

2183125

Working Note:

Calculation of depreciation:

cost of machine

2450000

scrap value

25000

Life of machine

4

Depreciation

606250

Initial Investment

Cost of Machine

2450000

Working Capital

500000

Total Investment

2950000

Year

Net Cash flow

PV factor @ 12%

Discounted cash flow

1

2183125

0.909

1984659.09

2

2183125

0.826

1804235.54

3

2183125

0.751

1640214.12

4

2183125

0.683

1491103.75

Residual value

250000

0.683

170753.36

Working Capital

500000

0.683

341506.73

Total

7432472.59

NPV= Discounted cash flow – initial investment

Discounted Cash Flow

7432472.6

Initial investment

2950000

Npv

4482472.6

3.2 NPV Break even analysis when unit price decrease by 10%

Calculation of Break Even point

Break even = (Fixed cost / Sales price – Variable cost)

Fixed Cost

250000

Selling Price

19.8

Variable Cost

12

Break even units

32051.28

Interpretation

It could be interpreted from the above calculations that the project is viable as it is producing adequate cash flows. NPV shows the project will be profitable as the present value is in positive terms. The project incomes instalment of new machine and working capital for carrying out the transactions. This is essential for the business enterprise to have positive returns from the project it is planning to adopt. The break even point at which the company will be recovering its cost of initial investment at sales of 25000 units. If the price per unit decreased by 10% then the break even units will be 32051 units. Company should adopt the project as returns generated are adequate and will help in the growth of company.

CONCLUSION

Based on the above discussion, it is concluded that there is a significant difference between equity and bonds across various parameters. Investors should make investment decisions based on their risk and return profiles. Additionally, it was noted that from 2016, the ASX has performed excellently, leading to high returns on stocks. Interest rates and bonds are highly correlated; when interest rates increase, bond values decrease. This is because higher interest rates mean firms must pay more to investors, which is detrimental to the bond value. For those using an essay typer or seeking assignment help UK, this analysis provides a clear understanding of these financial dynamics.

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