The purpose of the report is to analyze the risk and return measure of the shares for a hypothetical company named ABC ltd involved in manufacturing kitchen accessories and listed on the stock exchange of Australia. The report also analyses the viability of two investment products which the management of the company wishes to undertake based on the profitability aspect of both products. The management of the company analyses the viability of an investment opportunity using investment appraisal techniques like NPV analysis, Internal Rate of Return analysis, Profitability Index, and Discounted Payback period. The preliminary part of the report contains the risk and return analysis of the stock of the ABC ltd using risk and return measures like arithmetic mean, standard deviation and variance. The second part of the report contains analysis of the two products that the company wishes to invest into. A discussion about the relevant metrics like NPV, IRR, PI and payback period has been presented and discussed in a comprehensive manner. Finally, based on the scrutiny of all the above-mentioned investment appraisal techniques, a recommendation is provided as to whether the product should be invested into or not. All the calculations regarding all the above discussed investment appraisal techniques were provided in the appendix of the report.
A return of an investment goes hand in hand with the risk of the investment as an increase in return is not possible without taking appropriate levels of risk. The return of a stock is represented as a percentage value and can be assessed for a period of time. The stock of ABC ltd is listed on the Australian Stock Exchange and has been compared with the characteristics of the All Ordinary Share Index. The metrics that we will be using in analyzing are discussed in detail below:
- Arithmetic average return – The arithmetic average return calculates a stock's average return using daily, weekly, monthly, or annual stock price data. The annual return on the company's stock price was computed using the formula (Stock price1/Stock price0)-1. The arithmetic mean is calculated by dividing the entire sum of all returns for the analysis period by the total number of observations (Fuhr 2019). The average return on the company's shares was 3.03 percent, which was lower than the 6.76 percent return produced by the index for the same time period. The stock has underperformed the index by delivering returns that are more than half of those of the index.
- Standard deviation – The standard deviation of a return is an essential metric for measuring return volatility. The standard deviation is used to calculate the percentage departure of stock returns from the average value (Bergstrom and Carlsson 2020). The greater the standard deviation, the riskier the stock returns are thought to be. Simply subtract the number from the average of the numbers and square the value to get the standard deviation of a data series. The annual standard deviation for the ABC ltd stock was roughly 16.21 percent, compared to a standard deviation of 10.47 percent for the All Ord share index returns. As a result, ABC Limited's stock returns are more spread than the All Ord Share index's returns. In comparison, an investor would be better off investing in the All Ord index than the stock of ABC ltd since the risk adjusted return potential of the index is higher.
- Variance – Similar to the standard deviation, variance is a risk analysis measures which helps an investor to asses the riskiness of a stock. Variance is the average of the squared differences of the returns from their mean (Pyun 2019). Standard deviation is a standard measure which is used by a trader to assess how spread the returns are from their mean, on the other hand variance assigns an actual value to the individual returns assessing the distance of the return from its mean. Variance is a better measure of calculating the risk of an investment opportunity compared to the standard deviation of the stock. The variance of the stock was calculated to be equal to 2.63% which was higher compared to a variance of 1.10% of the All Ord index.
According to the results of the preceding study, the stock of ABC ltd underperformed the benchmark, which was represented by the All Ord share index, from 2016 to 2021. The company's stock has underperformed the index, with greater returns dispersed around the mean, indicating a poor risk-reward ratio. An investor's cash would be better served by investing in the index than the stock.
The process of facilitating the selection of acceptable investment opportunities and products for an organization is known as capital investment appraisal. Equipment, property, advertising campaigns, research and development initiatives, new machinery, new buildings, and many other factors will be reviewed during the capital investment evaluation. Capital investment analysis allows the firm to make informed decisions about its future endeavors, such as entering new markets with new products that will lead the company to expansion and rapid growth. The key determinants of capital investment assessment elements will be the aims and requirements of stakeholders as well as decision makers.
The management of ABC ltd is assessing the viability of two investments; Product A and Product B. As the products were not mutually exclusive both the products have been analyzed combinedly evaluating the combined effect of the cash flows of the products on the firm. The cash flows of product A was already assessed and provided while the cash flows of product B have been calculated and presented in the appendix (table 1). The investment appraisal techniques used in evaluating the viability of the product are discussed below:
- NPV analysis – The difference between the cash outflow and the cash inflow of a product is the profit for a company and NPV helps to measure the same. it calculates the present worth of future cash flows that will be created as a result of a certain product or investment (Wu et al 2019). The discount rate and the number of time periods will determine the net present value. If a NPV of a product is greater than zero, the product is considered to be viable as it indicates that the management of the company would be able to earn more than what is required by the investors of the company (Pawlak and Zarzecki 2020). The NPV of the products was equal to $6,106,634, which is considered to be significantly profitable (refer table 2 in appendix).
- IRR – Internal rate of return is the discount rate that reduces the product's net present value to zero and is also referred to as the investment's rate of return (Patrick and French 2016). When calculating the IRR of a product, factors such as cost of capital, interest rates, and others are ignored, and just the product's cash outflow and cash inflow data are used (Mellichamp 2017). The IRR of a product is considered to be acknowledged by the company's management if it is larger than the company's cost of capital. ABC ltd.’s cost of capital was assessed using the Capital Asset Pricing Model to be 9.62 percent, and the IRR for all of the products was calculated to be 9.21 percent. Hence, based on the above parameter it is not advisable for the company to invest in the products (refer table 2 in appendix).
- Profitability index – This metric measures the attractiveness of the investment opportunity and is arrived at by dividing the net present value of the products by the initial investment of the product. A higher profitability index is a guarantee of a profitable product and a product with higher PI should be chosen to invest. The PI of the products combined was less than 0.87 which is less than 1.
- Discounted payback period – Payback period of project measures the time taken by a project to return the capital invested in terms of years (Gorshkov et al 2018). The break-even point is the precise point at which the initial expenditure is covered. The payback period will undoubtedly have a greater impact on the attractiveness of an investment or project. The payback period of the products was equal to 4.51 which was just about equal to the total investment horizon.
Hence, from the above evaluation it can be concluded that investing in both products is not viable for the company. Although, both the projects have a positive NPV, the IRR is less than the required rate of return of the company. The PI of the projects was also less than 1 which is not considered viable. The payback period of the projects is almost equal to five year which is not warranted by the company.
The goal of this research is to look at the risk and return measures of shares for a fictitious firm called ABC ltd that makes kitchen accessories and is listed on the Australian stock exchange. The three risk return metrics used for evaluating the stock were arithmetic mean, standard deviation and variance. It was found that the stock of ABC ltd has underperformed the index in terms of returns, standard deviation and variance. The study also examines the viability of two investment products that the company's management wants to pursue based on their profitability potential. Analyzing the NPV, IRR, PI, and Discounted payback period of the projects revealed that it was not financially viable for the corporation to invest in management.
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