550 words except yellow marked and reference

Rate of Return for Stocks and Bonds

Introduction

In this assignment rate of return of equity and debt instruments will be calculated. This will help to understand how dividends, inflation rates, nominal rate of return and capital gains affect the value and price. To understand the what influence debt and equity has, concepts like CAPM, WACC and flotation costs will be applied.

Dividends, Capital Gains and Nominal Rate of Return

Dividends are a portion of a company’s earnings that is distributed. This is decided by the board of directors and paid to shareholders. Dividends can be stock, cash or property. These dividends can be issued over the period of different timeframes and the rates of payout can be different as well. The payouts are usually monthly or quarterly.

Capital gains are a rise capital asset value because it raises the value to more than the purchase price. Once the asset is sold then the gain is recognized. These gains can be short-term or long-term. Any security can have capital gains if it is sold for higher than the purchase price but normally capital gains are associated with stock.

Nominal rate of return is the amount of money produced by an investment before adding expenses such as taxes and inflation. Investors should look pass this rate in order to get a real idea of how much earning potential an investment has.

CAPM, WACC and Flotation Costs

Capital asset pricing model defines the relationship between systematic risk and expected return for assets. This is used to price risky securities. The idea behind this is that time value of money back and risk are the two kinds of compensation needed by investors.

Weighted average cost of capital calculates a company’s capital so it can be proportionally weighted. This calculation includes and long-term debt. As the return of return on equity and the beta increases, so does the WACC because an increase in WACC represents a decrease in the value and risk increase.

Flotation costs are costs a publically traded company incurs when new securities are issued including fees such as legal, registration and underwriting. These fees can impact how much capital a company can raise from new securities.

Calculations

1. Stock Valuation

Percentage total return is (25 + 2)/100 = 27/100 = 0.27 which is 27%

Capital gains yield is 25/100 = .25 which is 25%

Dividend yield is 2/100 = 0.02 which is 2%

2. Total Return:

Total return is [(120 – 100) + 4]/100) = [(20) + 4]/100 = 24/100 = 0.24 which is 24%

3. CAPM

Expected rate of return is 0.05 + [1.20(0.12 – 0.05)] = 0.05 + [1.20(0.07)] = 0.05 + (0.084) = 0.134 which is 13.4%

4. WACC

Weighted average cost capital is (80% * 12% * (1 -30%)) + (20% * 7%) = (6.72% + 1.4%) = 8.12%

5. Flotation Costs

% of debt is 0.75 / (1 + 0.75) = 42.86%

% of equity is 100% - % of debt = 100% - 42.86% = 57.14%

Plant funded through debt is 42.86% * 125 million = $53,575,000

Flotation cost on debt = $53,575,000 * 4% = $2,143,000

Plant funded through equity: 57.14% x $125 million = $71,452,000

Flotation cost on equity = $71,425,000 x 10% = $7,142,500

Total Flotation cost = $2,143,000 + $7,142,500 = $9,285,500

Conclusion

In conclusion, companies can make financial decisions using the calculations in this assignment which are stock valuation, total return, CAPM, WACC and flotation cost. Stock valuation is used to predict things that will cause stock prices to change. Total return is used to evaluate a company’s total income earned over a certain period of time by an investment. CAPM is used because beta is factored in and a beta of less than 1 means the stock is safer to invest in. WACC is used to determine the rate of return that has to be made on money invested to prevent investors from investing somewhere else. Flotation cost are used to factor in associated fees to ensure they do not negatively affect the amount of capital to be earned. These are just a few ways companies use to make financial decisions.

References

Ross, S. A., Westerfield R. W., Jaffe, J., Jordon, B. D. (2016) Corporate Finance, 11th Edition, McGraw-Hill Education, New York, NY