Financial Market And Investment Analysis Theoretical Validity - Empiri

Question: Discuss about the Case Study on Financial Market And Investment Analysis for Theoretical Validity, Empirical Intractability and Practical Applications? Answer: Introduction Carnival Corporation Plc is the British cruise company and it is one of the largest Cruise ship operators. It is a dual listed company. The company is composed of two separate companies one is Carnival Corporation and the other one is the Carnival Plc. It is the only company which is listed both on the FTSE 100 and SP 500 indices. In the year 2015 they have more than doubled income than the previous quarter as reported in their financial statement. The company is now operating in the most lucrative market like the market of UK where almost half of the cruises passengers are used the passengers ships. The performance of the share market for the last 10 years is not very much stable as in the year 2008 the share price were very low but from 2014 onwards the market is moving upward. UK yield curve The yield curve is the curve that provides a quick view of the relationship between the yield and the maturity of fixed interest bearing securities. As per several economists, there are different shapes of a yield curve depending upon the trend of the yield payment. Some important yield curve shape is discussed below, Normal yield curve This curve is generally an upward sloping curve. This yield curve represents that as the maturity period increases the demand for yield is also started to increase. Generally in a growing economy the shape of the yield curve is like this (Traficanti, 2014). Inverted yield curve This curve is just opposite to the normal yield curve. Here the yield for the shorter maturity bearing security is more than the long-term security. The shape of the curve is as follows: When the investors find a bearish trend in the market and have the opinion that the economy is going to crash in the near future then they want to lock their money in longer-term bonds and as a result the price of the long-term bonds are getting higher and the yield become low. Flat Yield Curve Flat yield curve represents whatever may be the maturity the yield from the investment is remaining the same. This curve indicates that the economy is under depressing trend, and the investors expect slow economic growth. So they want to tie up their money in the longer maturity investment. The Shape of the UK yield curve It is very difficult to predict the shape of the yield curve of any particular economy because the shape does not always match with the accurate shape given by the economists in their research. There is also exists the possibility of more than one yield curves as the economy is continuously changing. Here the UK Treasury yield curve for the year June 2014 is taken into consideration (Todorov, 2009). Explanation The above yield curve is based on the US Treasury security and the data is plotted on the UK gilt market. Here the data are plotted starting from 3 moths and ending in 30 years. The yield curve shows the following trends. Initially from the three months up to the 2nd year the curve is following a decreasing trend and looks like the inverted yield curve. May be at that point of time the investors were not confident about the market, and so they try to secure their money investing in higher maturity bond(Rzakhanov, 2012). On the other, after the 2nd year to the 30th year initially the curve is in growing trend as the percentage of yield is going up with the longer maturity period. After 10th year the trend of growth is stagnant. It shows that the economy is growing, but at this particular point the investors are indifferent about the growth so the shape is stable now but shape also suggests that in future the investors will be more confident about the market and will purchase more of long term bonds for book the profit. So from the above discussion it can be said that the UK yield curve is passing through three stages initially an inverted shape, then normal shape and at last the shape of the normal yield curve. (Ranganatham and Madhumathi, 2006). UK market risk premium Individual investor wants to invest in that market which yield a good return for them. Now if he is investing in a risk-free asset, then he will get an assured return. The risk premium is the extra return that an investor expects in order to take more risk. In UK market, the risk premium implies the additional return over and above the UK Treasury and gilt market. The risk premium in the UK market is calculated by the incorporation of CAPM method, Dividend discount model, Sharpe Index as well as on the basis of some historical data, etc. In this method, the cost of capital is calculated first and then it is multiplied by the market risk that is known as the beta (). The UK market is considered to an efficient market, and so the premium offered by the market is satisfactory for the investors. Any return over and above the calculated value is treated as the risk premium. All these concepts are relevant to the prevalent market economy of UK. If we analyze the data of UK economy, then it is observed that their personal income and international investment is in increasing direction. There is also an increase in the real and nominal GDP in 2014. All these indicate that there is a growing trend in the UK economy. So the incorporation of the above methods is very necessary for an economy like the UK. There should not be any single method for the valuation as each and every method has some advantages and disadvantages. Since 1928 to 2013 there are an increasing percentage of implied risk premiums of UK market. In 2013 the implied risk premium of UK market reached at 4.20% (Londonstockexchange.com, 2015). Estimation of market model Here evaluation is made on the basis of Carnival Corporation plc whose share listed in the London Stock Exchange. The benchmark index for the Carnival PLC sector is taken as FTAS The regression between FTAS and the Carnival PLC are as follows SUMMARY OUTPUT Regression Statistics Multiple R 0.497444 R Square 0.247451 Adjusted R Square 0.234476 Standard Error 0.015604 Observations 60 ANOVA df SS MS F Significance F Regression 1 0.004644 0.004644 19.07137 5.26E-05 Residual 58 0.014123 0.000243 Total 59 0.018767 Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept -0.00043 0.002042 -0.20992 0.834463 -0.00452 0.003658 -0.00452 0.003658 X Variable 1 0.269999 0.061826 4.367078 5.26E-05 0.146241 0.393757 0.146241 0.393757 From the regression statistics the model is not properly fitted as the value of R square is less than 0.5, but the p value of the model signifies that it is less than 0.05 so the model is justified. The coefficient of the variables is 0.269999, but the intercept is negative. So it can be stated that there is a negative co relation between market return and the stock return (Annualreports.com, 2011). The entire model is not justified as valid as the F significance is 0.05. The R square is less than 30% so it is not a good estimator of beta. Estimation of the cost of equity capital The beta from the market regression model is 0.269999 The risk free rate of return (Rf) is 0.74 The market rate of return (Rm) is 0.000959335 The calculation is shown as follows: CAPM method Ra = Rf+ (Rm-Rf) [where Rf = Risk free rate of return, = market risk, Rm= expected rate of return, Ra = cost of the equity] Ra = 0.74+ 0.269999(0.000959335-0.74) Ra=0.350659 Cost of equity capital is 0.350659 iii) Valuation of share as per Dividend value Model From the annual report of the Carnival Corporation Plc following observation for the dividend payment is made: 2010 2011 2012 2013 2014 d-4 d-3 d-2 d-1 d0 0.40 1.00 1.50 1.00 1.00 The growth rate of the company is in fluctuating trend so the growth rate can be calculated by taking the average yearly growth rate 2010 0.4 2011 1.00 1.5 2012 1.5 0.5 2013 1 -0.333333333 2014 1 0 1.666666667 g 0.333333333 Under the Dividend value model the price of the share is P0= D0(1+g)/(Ke-g) [where D1 = Expected dividend, k = cost of equity, g = growth rate, P0 = price of the shares] P0 = 1(1+0.333333)/( 0.350659-0.3333333) P0 = $ 76.9548965 Price of the Carnival Corporation PLC share on June 2015 is $ 5.7495. Note : Here the overall calculation is made on the weekly stock prices commencing from November 2013 to May 2015. The risk free rate of return is assumed to be 0.74. This assumption is based on the rate of UK treasury market. The rate of dividend per share represented in the annual reports of Carnival Corporation PLC is taken into consideration (Annualreports.com, 2014). There is more than one method under the dividend discount model, but here the commonly used method is taken into account (Hrdahl, Tristani and Vestin, 2008). All the relevant calculations for beta are shown in the appendix. (Hiriyappa, 2008). Recommendation From the calculation made it is found that the expected price of the equity share is 76.9548965 whereas in the stock market it is traded at $ 57-58 on May 2015 (daily). The price that is calculated is the actual value of the shares based on the dividend expectation of the shareholders (Kozul, 2014). As the market value is less than the actual value of the shares, then an investor should take his decision as follows- If the investor is willing to invest in the share but not yet invested then it is the right time for him to select the shares because the actual value of the shares is much more than the market value. When the actual and the market value are not same, then there is always a tendency that market value moves towards the intrinsic value. If this situation is true then it can be predicted that very soon the price of the share will go up and if the investor buy the shares right now then he can make a gain by selling those shares at a future date. If the investor already holds the shares then it would be better for him to hold these for some more times as the price will go up in near future and if he sells those at that time then he can make some gain (RAHEJA, 2011). So in brief it can be said that the investors should either buy or hold the shares, but they should not sell the shares. Moreover, the existing share price also indicates a bulling trend of the market; it implies that at present there will be more of buying and less selling. Assumptions and criticisms All the assumptions in the recommendation are made by keeping the efficient market theory in mind. The relevant data are extracted from the annual report and the data available in London stock exchanges. Following are some of the assumptions- Most of the investors invest in the security of getting profit. The economy is in growing trend. There is no unpublished price sensitive information that affects the price of the shares The market is an efficient market. The investors are behaving in a rational way (Brown and Walter, 2012). Criticism of the CAPM and Dividend Discount Model These two models are based on the assumption that there is an efficient capital market but in practice there is no existence of the perfectly efficient market (De Graeve, Emiris and Wouters, 2009). The expectations for all the investors are not same, but when the calculation is made it is assumed that all the investors have a similar expectation. This assumption is not true in the practical situation. The CAPM model assumes that there is no transaction cost and no tax rates, but in the actual scenario no such condition exists. The price of shares is such a variable that changes regularly. So if the investor invests today on the basis of the dividend valuation model it is not assured that he will get a certain return as expected. In dividend evaluation model, the growth rate is estimated by following the historic records and the share price is calculated on the basis of that estimation but it is a very complex task to make an accurate estimation. In CAPM, only the beta is taken as the indicator of risk measurement but beta only indicates the systematic risk portion. So from the above discussion and the criticism made it can be concluded that there is no accurate method for calculating the value of the share. It depends on the investors and the market situation at a particular point in time. References Brown, P. and Walter, T. (2012). The CAPM: Theoretical Validity, Empirical Intractability and Practical Applications.Abacus, 49, pp.44-50. De Graeve, F., Emiris, M. and Wouters, R. (2009). A structural decomposition of the US yield curve.Journal of Monetary Economics, 56(4), pp.545-559. Hiriyappa, B. (2008).Investment management. New Delhi: New Age International (P) Ltd., Publishers. 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