Business Finance Assignment

Introduction

As a 65 years old retiree who required a stable income, may prefer a low-risk low return portfolio. She invested all of her saving $1m into XYZ Company’s stock is too risky. She should have a balanced portfolio with a proper planning because it can have a large impact on long-term performance.

Portfolio theory

One of the basic rules of financial planning is not to put too many of yours assets in one investment- the old “don’t keep all your eggs in one basket” rule of money management. Investors can diversify portfolio and select the optimum risk-return trade-off for themselves, depending on the extent of personal risk acceptance.

Benefits of diversification in portfolio

Diversification means distribute your capital to different investments to reduce your overall investment risk. If one investment performs poorly over a certain period, other investments may perform better over that same period, and then it may reduce the overall losses of your investment portfolio (Arnold, 2013). The Exhibit1 shows the benefit of diversification portfolio. The greater the number of securities, the lower the risk is justified. Portfolio 1, share market volatility is relatively high which is15.60%; the share portfolio may suffer a loss of 42.90%. Portfolio 2 spread assets to a high risk investment such as UK Equities, Gilts and Property; portfolio 3 spread assets to a low risk investment such as Global Equities, Bonds and Property. Higher riskis associated with greater probability ofhigher return, vice versa. In portfolio 4 which also hold investments in other asset classes such as property, bonds and commodities that give the volatility of 6.30% and a return of 11.60%. It is obvious that these investments may perform better over the same period and these returns will smooth the returns of the overall investment portfolio.

Investment Advice and Plan

There are many investment options like bank savings account, annuity, certificate of deposits, bonds, stocks and so on. At the first step, i recommend holding a minimum of 3-12 months’ worth of living expenses in cash and money markets. You can put your money in the savings account that typically with lowest interest rates. However, it is safe to put some of the savings in the bank savings account as you can deal with emergency. Subsequently, you can purchase an annuity which pays you a stable stream of income for a specific length of time or the rest of your life. Therefore, you will have a guaranteed retirement income to cover your general expenses such as transportation, groceries and those basic necessities of life. On the other hand, you can also use the social security income by purchasing an immediate annuity. The cost of delaying social security is considerably cheaper than the cost of buying an immediate annuity in the marketplace as the low interest rate. For example, assume that one plans to take social security at full retirement age with annual payments of $20,000.

If you defer social security for one year, the payments increase by 10% to $22,000. If you purchase an annuity of $20,000 with an annual payments of $2,000but it will adjust with inflation.Hence, using the $20,000 to purchase an annuity in the market would provide substantially less than $2,000withoutany adjustments for inflation. In addition, you can deposit your money with a bank and promise not to touch the cash for certain period of time that is a Certificate of deposit (CDs) (Opdyke, 2006). In return of promise, the bank will pay you interest based on the interest rate it offers on saving products. CDs generally lock up the money for a period of time: three months, six months, nine months, one year, two years and five years.

The longer the periods of time, the higher the interest rate earned. On the other hand, CDs may impose penalties if you withdraw your money before the contract’s stated time period expires (Opdyke, 2006). Therefore, you should evaluate your near-term cash needs before lock up your money for a long period. Next, investing your savings in debt and equity instruments is the best choice of making money as it will give you better returns. Debt finance is less expensive than equity finance; due to the lower rate of return required by finance provider, lower transaction costs of raising the funds and tax deductibility of interest.

Debt holders can receive payment and have the rights to demand their contractual return before shareholders receive anything (Arnold, 2013). Therefore, you can structure a portfolio of bond that provides a higher return. A bond is a long-term contract in which the bondholders lend money to a company (Arnold, 2013). The company will pay the bond owners predetermined payment which is called coupon usually every six months until the bond mature. At the maturity date, bondholders will receive a specified principal sum called the par value of the bond. The time of maturity is typically seven years and thirty years and a number of firm issue 100-year bonds. The payment received can be used for your holiday and other entertainment expenses. Bonds also offer risks that are credit risk and interest risk. Companies can do default on their bonds in troubled times (Opdyke, 2006). The Exhibit2 shows the default rate of different grades of bond in 1999-2013. The higher the ratings like ratings of AAA to BBB, the more unlikely that the default risk may face. The ratings of BBB or above is regarded as ‘investment grade’, the bonds rated below this are called junk bonds (Arnold, 2013). After two years only 0.01 per cent of A bonds defaulted, whereas 9.52 percent of B bonds defaulted.

Sources: (Ratings, 2014) With some bonds, a company or a government agency will put up collateral, an assets that secure the debt so that if the company or the government agency unable to repay the loan, then you and all others lenders have a right to claim some portion of the collateral to recoup your investment (Arnold, 2013). This kind of bond is more secured. At last,you can invest in the company’s share, distribute your assets to the riskier common stock with a small proportion that may provide higher returns and sweeten the portfolio for the future (Spitzer & Houge, 2012). To invest in a stock is to become part owner of a business. Stockholders are entitled to a share of any dividends as a company may pay (Opdyke, 2006). If the business perform well then high return will be earned and the share price tends to rise.

It is uncertainty that the amount of dividend received in the future and also the market value of the share at the end of the period. Thus, stockholders have the greatest potential for reward but also accept the most risk for loss. Stocks are priced based on the earnings. As the earning grows, the stock price grows even quicker because of the relationship between the price and earnings (Opdyke, 2006). If a stock has a price earnings ratio (P/E) of 10, then every 10% increase in the earnings generally moves the stock price by $1.10. The higher P/E ratio indicate the greater the growth potential of a stock, the more likely its high stock price is justified (Way, 2007). Conversely, if the company was not doing well then the stock price is low and the stock could still be considered expensive such as the XYZ Company because a positive relationship exists between the stock's market price and its intrinsic worth. Besides that you can invest in preferred stock of company.

It designed to pay a set of dividend every quarter and the risk bearing is less than do common stock. As a preferred stockholder, you will be received payment before the company pay for common stockholders but you have no voting rights unless dividends are in arrears. The dividend is based on the price at which the shares were originally sold to the public, par value. Moreover, the fluctuated earnings don’t directly affect the share price as they do with common stock. Shareholders are interested in a flow of dividends over a long period. Dividend policy is the determination of the proportion of profits paid out to shareholders, usually periodically. The promise of a flow of cash in the form of dividend attracts investors to sacrifice immediate consumption and used it to purchase shares. In the case, the XYZ Company is going to cut dividend for the next few years.

Dividends act as an important conveyor of information. It can be assumed that, the firm needs funds to invest in the high-yielding project. In such circumstances, investors should be well-informed that the cash retained will be going into positive NPV project which will generate future dividend increases for shareholders. It can also be assumed that company’s earnings declined overtime so that company unable to meet the dividend payment. However, others information could assist investors to determine whether the company’s stock is still worthwhile to invest. For instances, the company’s earnings ability, the pre-interest profit, dividend yield and 52weeks high and low stock price in the recent years. Otherwise, investors can sell a portion of their shares to other investors if they need an income or have no confidence in the company. In conclusion, you should sell off your company share and spread your assets to difference investments that may provide you a stable income. 

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