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Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security. Stocks—shares or equity in a publicly traded company, Bonds—government and corporate fixed-income debt instruments , Real estate—land, buildings, natural resources, agriculture, livestock, and water and mineral deposits, Exchange-traded funds (ETFs)—a marketable basket of securities that follow an index, commodity, or sector Commodities—basic goods necessary for the production of other products or services, Cash and short-term cash-equivalents (CCE)—Treasury bills, certificate of deposit (CD), money market vehicles, and other short-term, low-risk investments. DISADVANTAGES Reduced risk, a volatility buffer: The pluses of diversification are many. However, there are drawbacks, too. The more holdings a portfolio has, the more time-consuming it can be to manage—and the more expensive, since buying and selling many different holdings incurs more transaction fees and brokerage commissions. More fundamentally, diversification’s spreading-out strategy works both ways, lessening both the risk and the reward. Pros: Reduces portfolio risk, Hedges against market volatility, Offers higher returns long-term. Cons: Limits gains short-term, Time-consuming to manage, Incurs more transaction fees, commissions. The capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure. When analysts refer to capital structure, they are most likely referring to a firm’s debt-to-equity (D/E) ratio, which provides insight into how risky a company’s borrowing practices are. Usually, a company that is heavily financed by debt has a more aggressive capital structure and therefore poses greater risk to investors. This risk, however, may be the primary source of the firm’s growth. Debt is one of the two main ways a company can raise money in the capital markets. Companies benefit from debt because of its tax advantages; interest payments made as a result of borrowing funds may be tax deductible. Debt also allows a company or business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant and easy to access.Companies that use more debt than equity to finance their assets and fund operating activities have a high leverage ratio and an aggressive capital structure.Analysts use the debt-to-equity (D/E) ratio to compare capital structure. It is calculated by dividing total liabilities by total equity.
Netpresentvalue (NPV) isthecalculationusedtofindtoday’svalueofafuturestreamofpayments. Itaccountsforthetimevalueofmoneyandcanbeusedtocompareinvestmentalternativesthataresimilar. TheNPVreliesonadiscountrateofreturnthatmaybederivedfromthecostofthecapitalrequiredtomaketheinvestment, andanyprojectorinvestmentwithanegativeNPVshouldbeavoided. AnimportantdrawbackofusinganNPVanalysisisthatitmakesassumptionsaboutfutureeventsthatmaynotbereliable.Apositivenetpresentvalueindicatesthattheprojectedearningsgeneratedbyaprojectorinvestment – inpresentdollars – exceedstheanticipatedcosts, alsoinpresentdollars. ItisassumedthataninvestmentwithapositiveNPVwillbeprofitable, andaninvestmentwithaInternal rate of return (IRR) is very similar to NPV except that the discount rate is the rate that reduces the NPV of an investment to zero. This method is used to compare projects with different lifespans or amount of required capital.negative NPV will result in a net loss.
Weightedaveragecostofcapitalisanintegralpartofadiscountedcashflowvaluationandis, therefore, acriticallyimportantmetrictomasterforfinanceprofessionals, especiallythosewhooccupycorporatefinanceandinvestmentbankingroles. ,WACCisanimportantconsiderationforcorporatevaluationinloanapplicationsandoperationalassessment. CompaniesseekwaystodecreasetheirWACCthroughcheapersourcesoffinancing. Forexample, issuingbondsmaybemoreattractivethanis Costofequity (Re) canbeabittrickytocalculatesincesharecapitaldoesnottechnicallyhaveanexplicitvalue. Whencompaniespayadebt, theamounttheypayhasapredeterminedassociatedinterestratethatdebtdependsonthesizeanddurationofthedebt, thoughthevalueisrelativelyfixed. Ontheotherhand, unlikedebt, equityhasnoconcretepricethatthecompanymustpay. Yetthatdoesn’tmeanthereisnocostofequity.suingstockifinterestratesarelowerthanthedemandedrateofreturnonthestock. Calculating the cost of debt (Rd), on the other hand, is a relatively straightforward process. To determine the cost of debt, you use the market rate that a company is currently paying on its debt. If the company is paying a rate other than the market rate, you can estimate an appropriate market rate and substitute it in your calculations instead.WACCistheaverageofthecostsofthesetypesoffinancing, eachofwhichisweightedbyitsproportionateuseinagivensituation. Bytakingaweightedaverageinthisway, wecandeterminehowmuchinterestacompanyowesforeachdollaritfinances. Debtandequityarethetwocomponentsthatconstituteacompany’scapitalfunding. A firm’s WACC is the overall required return for a firm. Because of this, company directors will often use WACC internally in order to make decisions, like determining the economic feasibility of mergers and other expansionary opportunities. WACC is the discount rate that should be used for cash flows with the risk that is similar to that of the overall firm.