Investment & Investing :
Investment refers to the concept of deferred consumption, which involves purchasing an asset, giving a loan or keeping funds in a bank account with the aim of generating future returns. Various investment options are available, offering differing risk-reward trade offs. An understanding of the core concepts and a thorough analysis of the options can help an investor create a portfolio that maximizes returns while minimizing risk exposure.
Types of Investments
The various types of investments are:
Cash investments: These include savings bank accounts, certificates of deposit (CDs) and treasury bills. These investments pay a low rate of interest and are risky options in periods of inflation.
Debt securities: This form of investment provides returns in the form of fixed periodic payments and possible capital appreciation at maturity. It is a safer and more 'risk-free' investment tool than equities. However, the returns are also generally lower than other securities.
Stocks: Buying stocks (also called equities) makes you a part-owner of the business and entitles you to a share of the profits generated by the company. Stocks are more volatile and riskier than bonds.
Mutual funds: This is a collection of stocks and bonds and involves paying a professional manager to select specific securities for you. The prime advantage of this investment is that you do not have to bother with tracking the investment. There may be bond, stock- or index-based mutual funds.
Derivatives: These are financial contracts the values of which are derived from the value of the underlying assets, such as equities, commodities and bonds, on which they are based. Derivatives can be in the form of futures, options and swaps. Derivatives are used to minimize the risk of loss resulting from fluctuations in the value of the underlying assets (hedging).
Commodities: The items that are traded on the commodities market are agricultural and industrial commodities. These items need to be standardized and must be in a basic, raw and unprocessed state. The trading of commodities is associated with high risk and high reward. Trading in commodity futures requires specialized knowledge and in-depth analysis.
Real estate: This investment involves a long-term commitment of funds and gains that are generated through rental or lease income as well as capital appreciation. This includes investments into residential or commercial properties.
Capital, Capital Accumulation :
Capital is wealth that may be in the form of money or property (including real estate, stocks and bonds) owned by an entity (a person or business). In the world of investing, the term capital can be used for assets that are invested in order to gain from a rise in their value. Capital accumulation is the growth in the total value of the capital.
Capital: Related Terms
Here are some terms associated with the concept of capital:
Capital Asset: Any asset used for wealth creation.
Capital Gains: The profits made on selling an asset.
Capital Market: This is the marketplace for securities, such as shares and bonds, where businesses try to raise long term funds.
Financial Instruments: Contracts of various combinations of capital assets, serving as a store of value, unit of account, medium of exchange or standard of deferred payment.
Capital Budgeting: Also known as investment appraisal, it is the planning process that determines the profitability of long term investments.
Cost of Capital: The cost to a borrower when they are loaned money, or the interest rate on a principal amount that has been loaned.
Capital Appreciation: The rise in the market value of an asset above the original investment in it.
Capital Risk: The risk of losing the whole or part of the principal amount spent on an investment.
Connotations of Capital Accumulation
The term capital accumulation can have various connotations in different contexts:
spending less than what one earns (accumulation in the form of savings).
making investments in physical assets such as plants, equipment, machinery and raw materials.
investing in contracts of assets on paper.
training human capital and increasing its skill base.
There is always a possibility that the return on an investment will differ from expectations. The amount of risk that investors are willing to take is directly proportional to the potential returns on their investments. This is because investors have to be rewarded for taking additional risk. For example, US Treasury bonds are one of the safest and lowest yielding investments. The capital appreciation on stocks is much higher, since they are much more risky (a corporation is more likely to declare bankruptcy than the US government).
Cost of Capital :
Cost of capital is the minimal return that investors intend to earn on their investments. For shareholders, the cost of capital is the dividend and capital gains on the share value, while for bondholders it is the interest rate quoted on a bond.
While investing, it is essential to consider the opportunity cost of the invested capital, as it represents the return that is foregone by investors by choosing an alternative investment opportunity that has similar or comparable risk. So, this factor may be considered while calculating the cost of capital.
Calculating Cost of Capital
There are two ways to calculate the cost of capital:
Weighted Average Cost of Capital (WACC)- This is the minimum return that a company must realize from an existing asset base in order to fulfill the needs of its creditors, owners and investors. Weighted average cost of capital (WACC) for the invested capital contains equal proportions of equity and debt, which is calculated as:
WACC = (E/F) Re + (D/F) Rb (1-tc)
Where Total capital invested (F) = D + E
and,
Re = Expected rate of return on equity or cost of equity (%)
Rb = Expected rate of return on borrowings or cost of debt (%)
tC = Corporate tax rate (%)
D = Current value of the firm’s total debt and leases
E = Total market value of equity and equity equivalents
However, if a part of the capital comprises of a preferred stock or an asset with a different cost of invested equity, then the formula may be modified as follows:
WACC = Wd (1-T) Rd + We Re
Wd = Debt portion of value
T = Tax rate
Rd = Cost of debt (rate)
We = Equity portion of the total value of a firm
Re = Rate (Cost) of internal equity
Capital Asset Pricing Model (CAPM) – This model states that investors must be compensated for the risks associated with an investment and time value of money. So, the CAPM calculates the expected return from a security (Es) as follows:
Es = Rf + ßs (Rm-Rf)
Where:
Rf = Expected risk-free return from the security
ßs = Sensitivity of the security to market risk
Rm = Historical returns from financial markets
(Rm-Rf) = Risk premium of market assets over risk-free assets
Investors are advised to refrain from investing when the expected return falls short of the required return.
Investment refers to the concept of deferred consumption, which involves purchasing an asset, giving a loan or keeping funds in a bank account with the aim of generating future returns. Various investment options are available, offering differing risk-reward trade offs. An understanding of the core concepts and a thorough analysis of the options can help an investor create a portfolio that maximizes returns while minimizing risk exposure.
Types of Investments
The various types of investments are:
Cash investments: These include savings bank accounts, certificates of deposit (CDs) and treasury bills. These investments pay a low rate of interest and are risky options in periods of inflation.
Debt securities: This form of investment provides returns in the form of fixed periodic payments and possible capital appreciation at maturity. It is a safer and more 'risk-free' investment tool than equities. However, the returns are also generally lower than other securities.
Stocks: Buying stocks (also called equities) makes you a part-owner of the business and entitles you to a share of the profits generated by the company. Stocks are more volatile and riskier than bonds.
Mutual funds: This is a collection of stocks and bonds and involves paying a professional manager to select specific securities for you. The prime advantage of this investment is that you do not have to bother with tracking the investment. There may be bond, stock- or index-based mutual funds.
Derivatives: These are financial contracts the values of which are derived from the value of the underlying assets, such as equities, commodities and bonds, on which they are based. Derivatives can be in the form of futures, options and swaps. Derivatives are used to minimize the risk of loss resulting from fluctuations in the value of the underlying assets (hedging).
Commodities: The items that are traded on the commodities market are agricultural and industrial commodities. These items need to be standardized and must be in a basic, raw and unprocessed state. The trading of commodities is associated with high risk and high reward. Trading in commodity futures requires specialized knowledge and in-depth analysis.
Real estate: This investment involves a long-term commitment of funds and gains that are generated through rental or lease income as well as capital appreciation. This includes investments into residential or commercial properties.
Capital, Capital Accumulation :
Capital is wealth that may be in the form of money or property (including real estate, stocks and bonds) owned by an entity (a person or business). In the world of investing, the term capital can be used for assets that are invested in order to gain from a rise in their value. Capital accumulation is the growth in the total value of the capital.
Capital: Related Terms
Here are some terms associated with the concept of capital:
Capital Asset: Any asset used for wealth creation.
Capital Gains: The profits made on selling an asset.
Capital Market: This is the marketplace for securities, such as shares and bonds, where businesses try to raise long term funds.
Financial Instruments: Contracts of various combinations of capital assets, serving as a store of value, unit of account, medium of exchange or standard of deferred payment.
Capital Budgeting: Also known as investment appraisal, it is the planning process that determines the profitability of long term investments.
Cost of Capital: The cost to a borrower when they are loaned money, or the interest rate on a principal amount that has been loaned.
Capital Appreciation: The rise in the market value of an asset above the original investment in it.
Capital Risk: The risk of losing the whole or part of the principal amount spent on an investment.
Connotations of Capital Accumulation
The term capital accumulation can have various connotations in different contexts:
spending less than what one earns (accumulation in the form of savings).
making investments in physical assets such as plants, equipment, machinery and raw materials.
investing in contracts of assets on paper.
training human capital and increasing its skill base.
There is always a possibility that the return on an investment will differ from expectations. The amount of risk that investors are willing to take is directly proportional to the potential returns on their investments. This is because investors have to be rewarded for taking additional risk. For example, US Treasury bonds are one of the safest and lowest yielding investments. The capital appreciation on stocks is much higher, since they are much more risky (a corporation is more likely to declare bankruptcy than the US government).
Cost of Capital :
Cost of capital is the minimal return that investors intend to earn on their investments. For shareholders, the cost of capital is the dividend and capital gains on the share value, while for bondholders it is the interest rate quoted on a bond.
While investing, it is essential to consider the opportunity cost of the invested capital, as it represents the return that is foregone by investors by choosing an alternative investment opportunity that has similar or comparable risk. So, this factor may be considered while calculating the cost of capital.
Calculating Cost of Capital
There are two ways to calculate the cost of capital:
Weighted Average Cost of Capital (WACC)- This is the minimum return that a company must realize from an existing asset base in order to fulfill the needs of its creditors, owners and investors. Weighted average cost of capital (WACC) for the invested capital contains equal proportions of equity and debt, which is calculated as:
WACC = (E/F) Re + (D/F) Rb (1-tc)
Where Total capital invested (F) = D + E
and,
Re = Expected rate of return on equity or cost of equity (%)
Rb = Expected rate of return on borrowings or cost of debt (%)
tC = Corporate tax rate (%)
D = Current value of the firm’s total debt and leases
E = Total market value of equity and equity equivalents
However, if a part of the capital comprises of a preferred stock or an asset with a different cost of invested equity, then the formula may be modified as follows:
WACC = Wd (1-T) Rd + We Re
Wd = Debt portion of value
T = Tax rate
Rd = Cost of debt (rate)
We = Equity portion of the total value of a firm
Re = Rate (Cost) of internal equity
Capital Asset Pricing Model (CAPM) – This model states that investors must be compensated for the risks associated with an investment and time value of money. So, the CAPM calculates the expected return from a security (Es) as follows:
Es = Rf + ßs (Rm-Rf)
Where:
Rf = Expected risk-free return from the security
ßs = Sensitivity of the security to market risk
Rm = Historical returns from financial markets
(Rm-Rf) = Risk premium of market assets over risk-free assets
Investors are advised to refrain from investing when the expected return falls short of the required return.
