Portfolio Management - Return Objectives and Investment Constraints

Return objectives can be divided into the following needs:

1. Capital Preservation - Capital preservation is the need to maintain capital. To accomplish this objective, the return objective should, at a minimum, be equal to the inflation rate. In other words, nominal rate of return would equal the inflation rate. With this objective, an investor simply wants to preserve his existing capital.

2. Capital Appreciation -Capital appreciation is the need to grow, rather than simply preserve, capital. To accomplish this objective, the return objective should be equal to a return that exceeds the expected inflation. With this objective, an investor's intention is to grow his existing capital base.
3. Current Income -Current income is the need to create income from the investor's capital base. With this objective, an investor needs to generate income from his investments. This is frequently seen with retired investors who no longer have income from work and need to generate income off of their investments to meet living expenses and other spending needs.

4. Total Return - Total return is the need to grow the capital base through both capital appreciation and reinvestment of that appreciation.

Investment ConstraintsWhen creating a policy statement, it is important to consider an investor's constraints. There are five types of constraints that need to be considered when creating a policy statement. They are as follows:

1. Liquidity Constraints - Liquidity constraints identify an investor's need for liquidity, or cash. For example, within the next year, an investor needs $50,000 for the purchase of a new home. The $50,000 would be considered a liquidity constraint because it needs to be set aside (be liquid) for the investor.
2. Time Horizon - A time horizon constraint develops a timeline of an investor's various financial needs. The time horizon also affects an investor's ability to accept risk. If an investor has a long time horizon, the investor may have a greater ability to accept risk because he would have a longer time period to recoup any losses. This is unlike an investor with a shorter time horizon whose ability to accept risk may be lower because he would not have the ability to recoup any losses.
3. Tax Concerns - After-tax returns are the returns investors are focused on when creating an investment portfolio. If an investor is currently in a high tax bracket as a result of his income, it may be important to focus on investments that would not make the investor's situation worse, like investing more heavily in tax-deferred investments.

4. Legal and Regulatory - Legal and regulatory factors can act as an investment constraint and must be considered. An example of this would occur in a trust. A trust could require that no more than 10% of the trust be distributed each year. Legal and regulatory constraints such as this one often can't be changed and must not be overlooked.

5. Unique Circumstances - Any special needs or constraints not recognized in any of the constraints listed above would fall in this category. An example of a unique circumstance would be the constraint an investor might place on investing in any company that is not socially responsible, such as a tobacco company.

The Importance of Asset AllocationAsset Allocation is the process of dividing a portfolio among major asset categories such as bonds, stocks or cash. The purpose of asset allocation is to reduce risk by diversifying the portfolio. 

The ideal asset allocation differs based on the risk tolerance of the investor. For example, a young executive might have an asset allocation of 80% equity, 20% fixed income, while a retiree would be more likely to have 80% in fixed income and 20% equities.
Citizens in other countries around the world would have different asset allocation strategies depending on the types and risks of securities available for placement in their portfolio. For example, a retiree located in the United States would most likely have a large portion of his portfolio allocated to U.S. treasuries, since the U.S. Government is considered to have an extremely low risk of default. On the other hand, a retiree in a country with political unrest would most likely have a large portion of their portfolio allocated to foreign treasury securities, such as that of the U.S.

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Portfolio Management - The Portfolio Management Process

The portfolio management process is the process an investor takes to aid him in meeting his investment goals.

The procedure is as follows:

1. Create a Policy Statement -A policy statement is the statement that contains the investor's goals and constraints as it relates to his investments.
2. Develop an Investment Strategy - This entails creating a strategy that combines the investor's goals and objectives with current financial market and economic conditions.
3. Implement the Plan Created -This entails putting the investment strategy to work, investing in a portfolio that meets the client's goals and constraint requirements.
4. Monitor and Update the Plan -Both markets and investors' needs change as time changes. As such, it is important to monitor for these changes as they occur and to update the plan toadjust for the changes that have occurred.

Policy StatementA policy statement is the statement that contains the investor's goals and constraints as it relates to his investments. This could be considered to be the most important of all the steps in the portfolio management process.The statement requires the investor to consider his true financial needs, both in the short run and the long run. It helps to guide the investment portfolio manager in meeting the investor's needs. When there is market uncertainty or the investor's needs change, the policy statement will help to guide the investor in making the necessary adjustments the portfolio in a disciplined manner.

Expressing Investment Objectives in Terms of Risk and ReturnReturn objectives are important to determine. They help to focus an investor on meeting his financial goals and objectives. However, risk must be considered as well. An investor may require a high rate of return. A high rate of return is typically accompanied by a higher risk. Despite the need for a high return, an investor may be uncomfortable with the risk that is attached to that higher return portfolio. As such, it is important to consider not only return, but the risk of the investor in a policy statement.

Factors Affecting Risk ToleranceAn investor's risk tolerance can be affected by many factors:

• Age- an investor may have lower risk tolerance as they get older and financial constraints are more prevalent.
• Family situation - an investor may have higher income needs if they are supporting a child in college or an elderly relative.
• Wealth and income - an investor may have a greater ability to invest in a portfolio if he or she has existing wealth or high income.
• Psychological - an investor may simply have a lower tolerance for risk based on his personality.

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Equity Investments - Analyzing a Company - Types of Stock

1. Growth Company and Growth StockA growth company is a company that consistently grows by investing in projects that will generate growth. A growth stock, however, is a stock that earns a higher rate of return over stocks with a similar risk profile.
   
   Feasibly, a company could be a growth company, but its stock could be a value stock if it is trading below its peers of similar risk.

2. Defensive Company and Defensive StockA defensive company is a company whose earnings are relatively unaffected in a business cycle downturn. A defensive company is typically reflective of products that we "need" versus "want". A food company, such as Kellogg, is considered a defensive company. A defensive stock, however, will hold its value relatively well in a business cycle downturn.

3. Cyclical Company and Cyclical StockA cyclical company is a company whose earnings are affected relative to a business cycle. A cyclical company is typically reflects products we "want". A retail store, such as The Gap, is considered a cyclical company. A cyclical stock, however, will move with the market in relation to the business cycle.

4. Speculative Company and Speculative Stock.A speculative company is a company that invests in a business with an uncertain outcome. An oil exploration company is an example of a speculative company. A speculative stock, however, is a stock that has potential for a large return, as well as the potential for considerable losses. An example of speculative stocks can be found in the tech bubble, where investors put money into speculative stocks, but the investor could have been hurt financially or made large gains depending on the stock the investor invested in.

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Corporate Finance - Dividend Growth Rate and the Effect of Changing Dividend Policy

Signaling An Earning's Forecast Through Changes in Dividend PolicyMuch like a company can signal the state of its operations through its use of capital-financing projects, management can also signal its company's earnings forecast through changes in its dividend policy. 

Dividends are paid out when a company satisfies its internal needs for cash. If a company cuts its dividends, stockholders may become worried that the company is not generating enough earnings to satisfy its internal needs for cash as well as pay out its current dividend. A stock may decline in this instance. 

Suppose for example Newco decides to cuts its dividend to $0.25 per share from its initial value of $0.50 per share. How would this be perceived by investors?

Most likely the cut in dividend by Newco would be perceived negatively by investors. Investors would assume that the company is beginning to go through some tough times and the company is trying to preserve cash. This would indicate that the business may be slowing or earnings are not growing at the rate it once had. 

To learn more about dividends, please read: The Importance of Dividends

The Clientele Effect.A company's change in dividend policy may impact in the company's stock price given changes in the "clientele" interested in owning the company's stock. Depending on their personal tax situation, some stockholders may prefer capital gains over dividends and vice versa as capital gains are taxed at a lower rate than dividends. The clientele effect is simply different stockholders' preference on receiving dividends compared to capital gains.

For example, a stockholder in a high tax bracket may favor stocks with low dividend payouts compared to a stockholder in a low tax-bracket who may favor stocks with higher dividend payouts.

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Corporate Finance - Earning Growth Rate and Dividend Growth Rate

 Calculating a Company's Implied Dividend Growth Rate

Recall that a company's ROE is equal to a company's earnings growth rate (g) divided by one minus a company's payout rate (p).

Example:Let's assume Newco's ROE is 10% and the company pays out roughly 20% of its earnings in the form of a dividend. What is Newco's expected growth rate in earnings?

Answer:g = ROE*(1 - p)
g = (10%)*(1 - 20%)
g = (10%)*(0.8)
g = 8%

Given an ROE of 10% and a dividend payout of 20%, Newco's expected growth rate in earnings is 8%.

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Corporate Finance - Dividend Theories

Dividend Irrelevance TheoryMuch like their work on the capital-structure irrelevance proposition, Modigliani and Miller also theorized that, with no taxes or bankruptcy costs, dividend policy is also irrelevant. This is known as the "dividend-irrelevance theory", indicating that there is no effect from dividends on a company's capital structure or stock price. 

MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. For example, suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over the investor's expectations. Likewise, if, from an investor's perspective, a company's dividend is too small, an investor could sell some of the company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors, meaning investors care little about a company's dividend policy since they can simulate their own.

Bird-in-the-Hand TheoryThe bird-in-the-hand theory, however, states that dividends are relevant. Remember that total return (k) is equal to dividend yield plus capital gains. Myron Gordon and John Lintner (Gordon/Litner) took this equation and assumed that k would decrease as a company's payout increased. As such, as a company increases its payout ratio, investors become concerned that the company's future capital gains will dissipate since the retained earnings that the company reinvests into the business will be less. 

Gordon and Lintner argued that investors value dividends more than capital gains when making decisions related to stocks. The bird-in-the-hand may sound familiar as it is taken from an old saying: "a bird in the hand is worth two in the bush." In this theory "the bird in the hand' is referring to dividends and "the bush" is referring to capital gains.

Tax-Preference TheoryTaxes are important considerations for investors. Remember capital gains are taxed at a lower rate than dividends. As such, investors may prefer capital gains to dividends. This is known as the "tax Preference theory". 

Additionally, capital gains are not paid until an investment is actually sold. Investors can control when capital gains are realized, but, they can't control dividend payments, over which the related company has control. 

Capital gains are also not realized in an estate situation. For example, suppose an investor purchased a stock in a company 50 years ago. The investor held the stock until his or her death, when it is passed on to an heir. That heir does not have to pay taxes on that stock's appreciation. 

The Dividend-Irrelevance Theory and Company ValuationIn the determination of the value of a company, dividends are often used. However, MM's dividend-irrelevance theory indicates that there is no effect from dividends on a company's capital structure or stock price. 

MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. 

For example, suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over his or her expectations. Likewise, if, from an investor's perspective, a company's dividend is too small, an investor could sell some of the company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors, meaning investors care little about a company's dividend policy since they can simulate their own. 

The Principal Conclusion for Dividend Policy

The dividend-irrelevance theory, recall, with no taxes or bankruptcy costs, assumes that a company's dividend policy is irrelevant. The dividend-irrelevance theory indicates that there is no effect from dividends on a company's capital structure or stock price. 

MM's dividend-irrelevance theory assumes that investors can affect their return on a stock regardless of the stock's dividend. As such, the dividend is irrelevant to an investor, meaning investors care little about a company's dividend policy when making their purchasing decision since they can simulate their own dividend policy.

How Any Shareholder Can Construct His or Her Own Dividend Policy.

Recall that the MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. As a result, a stockholder can construct his or her own dividend policy. 

• Suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over the investor's expectations.
• Likewise, if, from an investor's perspective, a company's dividend is too small, an investor can sell some of the company's stock to replicate the cash flow the investor expected.

As such, the dividend is irrelevant to an investor, meaning investors care little about a company's dividend policy since they can simulate their own.

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Corporate Finance - Effects of Debt on the Capital Structure

Using Greater Amounts of DebtRecall that the main benefit of increased debt is the increased benefit from the interest expense as it reduces taxable income. Wouldn't it thus make sense to maximize your debt load? The answer is no.

With an increased debt load the following occurs: 
Interest expense rises and cash flow needs to cover the interest expense also rise.
Debt issuers become nervous that the company will not be able to cover its financial responsibilities with respect to the debt they are issuing.

Stockholders become also nervous. First, if interest increases, EPS decreases, and a lower stock price is valued. Additionally, if a company, in the worst case, goes bankrupt, the stockholders are the last to be paid retribution, if at all. 

In our previous examples, EPS increased with every increase in our debt-to-equity ratio. However, in our prior discussions, an optimal capital structure is some combination of both equity and debt that maximizes not only earnings but also stock price. Recall that this is best implied by the capital structure that minimizes the company's WACC.

Example:The following is Newco's cost of debt at various capital structures. Newco has a tax rate of 40%. For this example, assume a risk-free rate of 4% and a market rate of 14%. For simplicity in determining stock prices, assume Newco pays out all of its earnings as dividends.

Figure 11.15: Newco's cost of debt at various capital structures

At each level of debt, calculate Newco's WACC, assuming the CAPM model is used to calculate the cost of equity.

Answer:At debt level 0%:
Cost of equity = 4% + 1.2(14% - 4%) = 16%
Cost of debt = 0% (1-40%) = 0%
WACC = 0%(0%) + 100%(16%) = 16%
Stock price = $18.00/0.16 = $112.50

At debt level 20%:
Cost of equity = 4% + 1.4(14% - 4%) = 18%
Cost of debt = 4%(1-40%) = 2.4%
WACC = 20%(2.4%) + 80%(18%) = 14.88%
Stock price = $22.20/0.1488 = $149.19

At debt level 40%:
Cost of equity = 4% + 1.6(14% - 4%) = 20%
Cost of debt = 6% (1-40%) = 3.6%
WACC = 40%(3.6%) + 60%(20%) = 13.44%
Stock price = $28.80/0.1344 = $214.29

Recall that the minimum WACC is the level where stock price is maximized. As such, our optimal capital structure is 40% debt and 60% equity. While there is a tax benefit from debt, the risk to the equity can far outweigh the benefits - as indicated in the example.

Company vs. Stock ValuationThe value of a company's stock is but one part of the company's total value. The value of a company comprises the total value of the company's capital structure, including debtholders, preferred-equity holders and common-equity holders. Since both debtholders and preferred-equity holders have first rights to a company's value, common-equity holders have last rights to a company value, also known as a "residual value".

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Video on WACC
Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality
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