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Active equity management

The security analyst always faced with the problem of buy hold or sell decision.He/she must evaluate the past performance of the security for forecasting the future performance.

Valuation of preference share and bond is straight forward because return generally constant and certain.Equity valuation is different because return on equity is uncertain and it can change time to time.therefore analysis and forecasting of equity is crucial.Stock market is not totally efficient.

Active Equity investment style:
Active equity management has two styles top-down and bottom-up.In top-down equity management style begins with overall  economic environment forecasting near term outlook and make a general asset allocation decision.Top-down managers analyses the stock market is an attempt to identify economic sector after identifying attractive and unattractive sectors and industries top-down managers finally select a portfolio of individual stock.

Bottom-up equity management style:
In bottom-up styles managers focuses analysis of individual security instead economic and environmental analysis using financial analyst or computer screening bottom-up managers analyses company performance ratio analysis,price earning ratio other financial ratio,management efficiency.

Financial Leverage

Financial leverage refers to debt a firm’s capital structure. Firms with debt in the capital structure is called levered firms. The inter firm’s irrespective of the firm’s earnings. Hence, interest charges are fixed costs of debt financing. The fixed financial costs result in financial leverage and cause profit after tax to vary with change in EBIT.

Hence, the degree of financial leverage defined as the change in the company’s profit after tax due to change in the EBIT. Since financial leverage increases the firm’s (financial) risk. It will increase the equity beta of the firm.

            USE OF FIXED CHARGE FUND

The use of the source of the fixed charge funds.Such as debt and preference capital along with the owners’ equity in the capital structure financial leverage or gearing or trading on equity. The use of term trading on equity derived from the fact that is the owner’s equity that is used as a basis to raise debt.

Every time firm makes an investment decision. It is at the same time making a financial decision also. A decision to build a new plant or to buy a new machine implies a specific way of financing that project. A company finances its investment by debt and equity. The rate of return an asset.The company has a legal binding to pay interest on the debt.

The use of the fixed charges source of funds such as debt and preference share capital with the owner’s equity in the capital structure. Describe as financial leverage employed by a company intended to earn more return on the fixed charge funds than their cost.
Financial leverage at once provides the potential of increasing the shareholder earning as well as creating the risk of loss to them.

IMPACT OF FINANCIAL LEVERAGE ON SHAREHOLDER RETURN

Financial leverage is managing the shareholder return fixed charge funds (loan from financial market institutional bank and debenture can be obtained at a cost lower than the firm’s rate of return on net assets (RONA &ROI).

Based on assumption EPS or return on equity (ROE) increases EPS ROE  will fall. The company obtains the fixed charge fund at a cost higher than the rate of return.

                MEASURES OF FINANCIAL LEVERAGE

The most commonly used measures of financial leverage.
1) Debt Ratio:-The ratio of debt to total capital.
L_{1}=\frac{D}{D+E}=\frac{D}{V}
Where
D=debt
E=value of share holder’s equity
V=Value of capital

2)The debt-equity ratio-The ratio of debt to equity.
L_{2}= \frac{D}{E}

3)Interest coverage ratio= The ratio of net operating income(or EBIT) to interest charges.
L_{3}= \frac{EBIT}{Interest}

The firm two measures of financial leverage expressed either in terms of book value reflects. The current attitude of an investor.

                       Role of financial leverage

->The financial leverage or trading on equity is derived from the fact that it is the owner’s equity that is used as a basis to raise debt.
->The supplier of debt has limited participation in the company’s profit and therefore.it will insist on protection in earnings and protection in values represented by ownership equity.
->The surplus or deficit will increase for a decrease in the return on the owners’ equity is levered above or below the rate of return in total assets for example if a company borrows Rs.100 at 8 percent interest.(that is rs.8  per annum).

The balance of 4 percent (rs.4 per annum ) after payment of interest will belong to the shareholder. It constitutes the profit from financial leverage. On the other hand, if the company could earn only a return of 6 percent on Rs.100(rs.6 per annum). The loss to the shareholders would be rs. 2 per annum.
Thus financial leverage at once provides the potentials of increasing the shareholder’s earning as well as creating the risk of loss of to them.

 

 

 

Derivative and risk management

A company faces several kind of risk.Unanticipated change in selling price,cost taxes,demand,interest rate technology fluctuated profitability of a firm.Sometime managers are not able to reduce risk.They try many strategies.All financial difficulties and risk can reduce their risk entering into financial contracts.

Risk hedging by derivatives 

The topic will explain what is derivatives and how to hedge risk by it.Derivatives mans those items that do not have their own independent value it is a financial instrument derived from some other asset which is called underlying asset. In the firm risk always remain firm can avoid cash flow fluctuation by reducing the risk.Itwill increase value of their asset or investment.Firm always seeking the way to reduce risk derivative are tools to reduce a firm’s risk exposure.

Firm risk can hedge by four derivatives these are future,forward,option and swap.

Hedging by option

Option is one of  the most complex financial instrument.Firm can use option to minimize risk.Option has two type call option and put option.If a firm purchase new product in large quantity most of firm’s capital invested.In this type of deal always risk remain,to reduce risk firm can buy option in stock market only premium have to pay if strike price more than spot price firm will make profit but unfortunately if price opposite each other firm will loose option premium amount.

Hedging by forward

Forward contract is non-standardized contract between two parties.In this contract assets buy or sell in future at predetermined price.Forward contracts are similar to option in hedging but there is a difference both buyer and seller are bounded by the contract both must have exercise the contract at the agreed price on the specified due date forward contracts are flexible suits the need of buyer and seller.We can enter into a forward contract for any good commodities and asset.We can choose any delivery date and quantity of goods. 

Hedging by future 

Future contract are same as a forward contract.Future contracts are not different from forward contracts.The difference is in terms of standardisation and method of operation.Future contracts have standardised contract size and they trade only the organised exchanges.In future contract both parties should agreed as same price,duedate and time.In future contracts like in the forward contracts one party will loose and other will gain.

Hedging by swap

Swap are same as future and forward contracts.It is also providing hedge against risk.Swap also a agreement between two parties called counter parties most popular swap are currency swap and interest rate swap.This two swap can be combined when interest on loan can be swapped between two currency.

1)Currency swap :- In currency swap exchange of cash payment done between two currency most of companies want overseas investment but they find difficulties entering in new market currency swap is an alternative to overcome this problem.

2)Interest rate swap:-The interest rate swap allows a company to borrow capital at fixed and exchange its interest payment at floating rate or fixed rate LIBOR is the market determined interest rate for banks to borrow from each other in the euro dollar market.

 

Beta Estimation

The security ‘s beta, which measures the sensitivity of the security ‘s return to those of the market because beta captures the market risk of security as opposed to its diversifiable risk, it is the appropriate measure of risk or a wealth diversified investor.
                 Using historical returns
We would like to know a stock’s beta in the future that is how sensitive will its features returns to market risk. In practice, We estimate beta based on the stock’s historical sensitivity. This approach makes sense if a stock is a beta that remains relatively stable over time, which appears to be the case for most firms.
               Many data sources provide estimates of beta based on historical data. Typically those data sources estimate. Correlation and volatilities from two or five years of weekly or monthly returns.
Beta estimation has two method.           
                                          

                                                      Direct method


Beta is the measures of systematic risk and it is a ratio of covariance between market return variance.
\beta _{j} =\frac{Covarj,m}{\sigma ^{2}m}

=\frac{\sigma _{j}\sigma _{m}corj,m}{\sigma _{m}\times \sigma _{m}}=\frac{\sigma _{j}}{\sigma _{m}}\times cor_{j,m}

Let’s consider an example suppose that percent return on the market. Represented by the BSE Sensex(sensitivity index) and the share of ABC Infotech limited for recent five years.
                                Return on Sensex and ABC Infotech

Year Market return(%) ABC infotech(%)
1 18.60 28.46
2 -16.50 -36.15
3 63.85 52.64
4 -20.65 -7.29
5 -17.80 -12.95

Beta estimation for ABC infotech limited

year r_{m} r_{j} (r_{m}-\bar{r}_{m}) (r_{j}-\bar{r}_{j}) (r_{m-}\bar{r}_{m} )\times(r_{j}-\bar{r}_{j}) (r_{m}-\bar{r}_{m})^{2}
1 18.60 23.46 13.11 19.51 255.91 171.98
2 -16.50 -36.13 -21.98 -40.08 880.83 483.08
3 63.83 52.64 58.35 48.69 2841.35 3404.85
4 -20.65 -7.29 -26.13 -11.24 293.64 682.96
5 -17.87 -12.95 -23.35 -16.90 394.57 545.35
  \bar{r}_{m}=5.48 \bar{r}_{j}=3.95     sum=4666.30 sum=5288.23

i)Average return on market
cov_{m.j}=\frac{4666.30}{5}=933.26

ii) Square deviations of market return
\sigma ^{2}=\frac{5228.23}{5}=1057.65

iii) Divide the covariance of market and ABC infotech by the market variance to get beta.
\beta _{j}=\frac{cov_{j,m}}{\sigma ^{2}m}=\frac{933.26}{1057.65}=0.88

The intercept term is given by the following formula
\alpha _{j}=\bar{r}_{j}-\beta _{j}\times\bar{r}_{_{m}}
3.95-0.88\times 5.48=-0.89
   The characteristic line of ABC Infotech p=0.89+0.88

                           

The market model or Index model


Another procedure of calculating beta is the use of market model.In the market model, we regress return on a security against returns of the market index.The market model is given by the following regression equation.
                                       R_{j}=\alpha+\beta _{j}R_{m}+e_{j}
where
R_{j}=expected market return
\alpha= intercept
e_{j}=error term
\beta _{j}=regression measures the variability of the security’s beta

Beta is the ratio of the covariance between the security returns and the market returns and it is the covariance between the security returns and the market returns to the variance of the market return.\alpha indicates the return on a security when the market return is zero. It could be interpreted as the return on security on account of unsystematic risk. Over a along given the randomness of unsystematic risk .
                            The observed return on market and ABC share and a regression line. The regression line of the market model is called the characteristics line.
The characteristics line
The value of \alpha is 0.89 and the value of \beta is 0.88.
The value of \beta and \alpha in the regression equation are given by the following equations.

\beta = \frac{N\Sigma XY-(\Sigma X)(\Sigma Y)}{N\Sigma X^{2}-(\Sigma X^{})^{2}}

\beta _{j}=\frac{(5)4,774.49)-(27.42)(19.73)}{(5)(5,438.58)-(27.42)^{2}}

      =\frac{23,872.45-541.00}{27,192.90-751.86}
    
      =\frac{23,331.45}{26,441.04}   =0.88


Alpha=\alpha=\bar{Y}-\beta \bar{X}
Alpha=\alpha _{j}=3.95-(0.88)(5.48)= -0.89

 Estimation for the regression equation

Year X_{m}(X) r_{m}(Y)  XY X^{2} Y^{2}
1 18.60 23.46 436.30 345.88 550.37
2 -16.50 -36.13 595.99 272.10 1305.38
3 63.83 52.64 3360.26 4074.86 2770.97
4 -20.65 -7.29 150.54 426.42 53.14
5 -17.87 12.95 231.41 319.31 167.70
Sum \Sigma X=27.42 \Sigma Y=19.73 \Sigma XY=4774.49 \Sigma X^{2^{}}=5438.58 \Sigma Y^{2}=4847.56
Average \bar{X}=5.48 \bar{Y}=3.95      

Beta estimation in practice
In practice, the market portfolio is approximate by a well-diversified share price index. Portfolio should include all risky assets shares, bonds,gold, silver real estate art objects, etc.
                   In computing beta by regression .We need data on return market index and the security for which beta is estimating over a period of time.There are no theoretical determined time intervals for calculating beta. The time period and the time interval may vary. The returns may be measured on daily,weekly, or monthly basis.
              The return on a share and market index may be calculated as a total return that is, divided yield plus capital gain.

 Rate of return=Current dividend+(share price in th beginningshare price at the endshare price in the beginning

                               r=\frac{D_{t}+(P_{t-1})}{P_{t-1}}=\frac{D_{t}}{P_{t-1}}+[\frac{P_{t}}{P_{t-1}}-1]

In practice, one may use capital gain/loss or price return that is  p_{t}/p_{t-1}-1 rather total return to estimate beta of the company’s share. A further modification may be made in calculating the return.