Discuss about the Financial Forecasting in Investment Analysis.
The business environment is full of uncertainty and changes with the due passage of time. There are various factors that influence the operations of the business. The external and the internal factors play a predominant role in that. The internal factors can be attributed to the change in the policy of management, internal policies, etc. However, there are external factors that can result in a change and may be difficult to tame like the change in the demand for sales due to the implementation of new government policy. This might not go in the best interest of the company and hence might lessen the profit leading to a loss for the company. To keep such situation at bay it is important that the company need to evaluate the external environment on a regular basis. By keeping a strong focus on the external environment, important steps can be taken into consideration to avoid any potential losses. To avoid such a situation, the company need use a method that will help in ascertaining the sales sensitivity, cost as well as variations in the pattern of income (Berk et. al, 2015). This method is called as a sensitivity analysis. It helps in determine the variations that happen in the variables that are quantifiable in nature so that the viability of the project can be determined.
In the case of sensitivity analysis, the changes that are unfavorable in nature are accounted for so that the effect of the changes can be considered on the project profitability. The main utilization of the process is in the case of capital budgeting when a decision needs to be undertaken regarding the selection of a project (Kan & Zhang, 1999). The main advantage it provides is that of the identification of the key variables that helps in influencing the cost, as well as the benefit of the project. In this scenario demand, costs in terms of operations and legal are contained in this stage. The effect of the bad amendments are determined through it (Brigham & Daves, 2012). Moreover, the entities are able to assess whether the changes will impact the decision of the project.
Sensitivity analysis enables a person to know the impact on the project or a variable in particular if the estimation turns out to be correct or wrong. The evaluation tends to provide a strong measurement of the influence of the variations in the estimation part on the finances or the variable proportion (Ferris et. al, 2010). This provides a helping hand to the project managers in terms of reasoning because they are able to chalk out the reason why the event did not lead to a result that was expected. Moreover, it helps in the future course of activities to consider the decision of doing an investment. When it comes to the process of capital budgeting, sensitivity analysis traces the variation that happens in one assumption or estimation on the overall project. For example, a project can provide $1000 annually for three continuous years and thereby, the investor invests $3000 at the starting of the initial year. However, some variations in the estimates project that the project will provide a return of $ 1500 in other two years (Kandel & Stambaugh, 1995). Considering this factor the investment will be split into two equal halves. Hence, sensitivity helps in knowing the variables and provides a better explanation of the situation. The decision making is easier with the help of sensitivity analysis.
Scenario analysis can be defined as a mechanism that helps in assessing the vague in the current scenario by considering the projected results. It provides the function as a predictive tool and even as a tool for analysis. The analysis can be done in the form of three cases that is the base case, the best case, and the worst case. The base case can be said to be the case where the level of probability stands high. The best case is the case where it is considered that the things will proceed in a favorable manner and the worst case is the one where every assumption fails (Northington, 2011). Hence, this will alert the analyst and will take preventive actions so that the worst can be avoided. However, it needs to be noted that it does not describe the entire situation rather provide an idea of the problem.
This is highly helpful when it comes to the mechanism of capital budgeting where a strong level of analysis is needed. The Net present value of a project can be supported through it under the situation of high, moderate and low inflation. It is even helpful for the financial institution because it helps to predict the state of the economy and the financial market can be forecasted through it. Therefore, it helps to know the possible scenario of the economy that further helps the institution in allocating the resources in an effective manner.
There is always a level of uncertainty when it comes to variables and taking assumptions in the case of capital budgeting. Therefore, scenario analysis is a potent tool when it comes to making a decision and removing the level of uncertainty. The decision regarding the change of an assumption and the extent of change depends entirely on the scenario. The best, as well as the worst case, is differentiated so that steps can be taken or steps to be taken to yield a positive outcome (Parrino et. al, 2012). When the real result of the project goes wrong then the scenario analysis supports the investors by taking up of steps so that improper situations can be avoided.
Both the mechanism are vastly important when it comes to the process of capital budgeting as it enables to know the best investment plan. However, there is a difference between the two. A scenario analysis might involve the concept of sensitivity analysis, on the contrary, it is not compulsory that the sensitivity analysis will require the usage of scenario analysis. The sensitivity analysis will enable the investor to know the problem linked to the investment plan that is proposed while the scenario analysis will aid in evaluating the uncertainties and the manner in which the investment is affected.
The CAPM establishes a formula that computes the return that is expected and is based on a security depending on the risk level. It is a model that provides an answer to the fair value of an investment. The prime role of CAPM is twofold that is to provide a rate of return that features like a reference when it comes to evaluation and then helping in knowing the return that is expected (Da et. al, 2012). The formula for CAPM is the risk-free rate added with the beta times the difference that appears between the market return and the risk-free rate. The CAPM can be projected in a better fashion if a clear understanding of the investment risk is present. It needs to be noted that the securities on an individual level are burdened with the depreciation risk that is investor’s loss in terms of investment. The investor faces two kinds of risk that are a systematic risk and the unsystematic risk. Systematic risk is the overall risk and the unsystematic risk is the stock specific risk. The model of CAPM establishes the fact the investor are needed to be repaid in dual ways that are the time value and the risk. The risk-free rate is denoted by rf and it is the bonds of the government like the U.S Treasuries. By the application of CAPM, the calculation of the return that is expected for specific stock can be done (Guerard, 2013).
The CML is stated as a graph that owes its origin from the CAPM. It is used to extract the rate of return from a particular portfolio. The CLM is the line utilized in the CAPM model to project the return rates for the portfolio that are efficient in nature. The rates vary in tune with the risk level and the rate of return (Damodaran, 2012). The CML provide a linear relationship between positive nature between the return, as well as the beta of the portfolio. It is even known by the name of the market line. The CML can be true for a portfolio that holds an efficient feature and determines the behavior of the investor pertaining to the market portfolio and the self-portfolio.
The CML comes from the merge of the market portfolio with that of the risk-free asset (indicated as L). All the points along the CML can be said to be having a strong risk-return relationship to any portfolio that lies on the efficient frontier. When it comes from the point of view of the CML then the portfolio M is comprised of the total assets that are risky in nature, the market and contains no holding of the asset that is risky that implies no money is invested or borrowed from the money market account (Bodie et. al, 2014).
The major similarity is that the Capital Market Line (CML) appears in the Capital Asset Pricing Model (CAPM) in order to portray the rates of return for effective portfolios that are highly subject to the standard deviation (risk level) for a risk-free rate and market portfolio. In a CAPM, the securities are priced and hence, the anticipated risks neutralize the anticipated returns. CML is one of the relevant components that are required to generate a CAPM (Bodie et. al, 2014). It conveys the investor’s return for a portfolio by assuming that every investor can own market portfolios. Non-effective portfolios and single assets are not taken into account by the CML and therefore, in this case, the SML (Security Market Line) would be more beneficial.
The CML is generated by drawing a tangent line at the point of interception on the efficient frontier to an area wherein the expected rate of return is equal to the risk-free rate of return. Moreover, it is more effective than the efficient frontier as it takes into consideration the introduction of a risk-free asset concept in the market portfolio (Brealey et. al, 2011). In relation to the CAPM, it portrays that the market portfolio is only the efficient frontier. Therefore, this makes it clear that the CML is a significant component of the CAPM and is utilized to denote the rates of return for the effective portfolios that dwell on the level of risk and risk-free rate. In simple words, the attributes of CAPM are clearly implanted in the CML (Graham & Smart, 2012).
Capital Asset Pricing Model (CAPM) can be applied to any security whether it is non-diversified or diversified, whereas the Capital Market Line (CML) can be applied only to those portfolios that are diversified in nature. Furthermore, because of this, the CAPM is able to depict a proper interconnection betwixt expected returns and total risk, while CML can only be explained as an element and a significant factor for establishing the CAPM (Arnold, 2010). In other words, the CAPM is a model as a whole whereas CML is just one of its components.
Secondly, the CAPM can be considered as the most efficient tool to determine the return of an investor wherein the compensation can be done for the systematic risk, as diversification is not possible. Moreover, considering the involved risk in the investment, the expected return becomes ascertainable (Vaitilingam, 2010). Furthermore, in the case of a potential return, systematic risk becomes more relevant than any other risk. In addition, the business cycle appears at the front line when the potential of stock holding is high and hence, the return is determined on an aggregate basis (Arnold, 2010). In relation to CML, it takes into consideration asset addition that is risk-free in nature and therefore, as mentioned above, it is more beneficial than the efficient frontier. In comparison to the market portfolio, each portfolio possesses an indistinguishable Sharpe Ratio. Both the Sharpe ratio and the CML of the portfolio must be determined when it comes to investment or purchase in the market.
References
Arnold, G 2010, The Financial Times Guide to Investing, Prentice Hall.
Berk, J., DeMarzo, P. & Stangeland, D 2015, Corporate Finance, Canadian Toronto: Pearson Canada.
Bodie, Z., Kane, A. & Marcus, A. J 2014, Investments, McGraw Hill
Brealey, R., Myers, S. & Allen, F 2011, Principles of corporate finance, New York: McGraw-Hill/Irwin.
Brigham, E. & Daves, P 2012, Intermediate Financial Management , USA: Cengage
Da, Z., Guo, R.J. & Jagannathan, R 2012, ‘CAPM for estimating the cost of equity capital: Interpreting the empirical evidence’, Journal of Financial Economics vol. 103, pp. 204–220
Damodaran, A 2012, Investment Valuation, New York: John Wiley & Sons.
Ferris, S.P., Noronha, G. & Unlu, E 2010, ‘The more, merrier: an international analysis of the frequency of dividend payment’, Journal of Business Finance and Accounting, vol. 37, no. 1, pp. 148–70.
Graham, J. & Smart, S 2012, Introduction to corporate finance, Australia: South-Western Cengage Learning.
Guerard, J. 2013, Introduction to financial forecasting in investment analysis, New York, NY: Springer.
Kan, R. & Zhang, C 1999, ‘Two-pass tests of asset pricing models with useless factors’, Journal of Finance, vol. 54, pp. 203-235.
Kandel, S. & Stambaugh, R.F 1995, ‘Portfolio inefficiency and the cross-section of expected returns, Journal of Finance’, vol. 50, pp. 157-184.
Northington, S 2011, Finance, New York, NY: Ferguson’s.
Parrino, R., Kidwell, D. & Bates, T 2012, Fundamentals of corporate finance, Hoboken,
Vaitilingam, R 2010, The Financial Times Guide to Using the Financial Pages, London: FT Prentice Hall.
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