Answer the 5 questions of investment portfolio management Essay

Answer the 5 questions of investment portfolio management - Essay Example Present value of Dividends employs the cost of equity as the discount figure. Operating free cash flow is the cash residue after eliminating direct costs, working capital and capital expenditure needed for future growth, but before any payments to suppliers of capital. The firm’s weighted average cost of capital (WACC) is the discount rate employed in determining operating free cash flow. Free cash flow to equity refers to operating free cash flow less payment to debt holders (Strong, 2008). The firm’s cost of equity is used as the discount rate. Present value of Cash flow allows a degree of flexibility for changes in sales and expenses, which implies varying rates of growth over time. However, present value of cashflow valuation approach has a weakness in that it is heavily dependent on growth rates of cash flows and the discount rate estimates. Relative valuation approach to security valuation offers information on how the market is presently valuing the stock. Compon ents measured using the relative valuation technique include the price earning ratio, price to sales ratio, price to book value and the price to cash flow. Unlike the present value of security valuation, relative valuation approach does not offer insights as to whether current valuations are appropriate. Thus, valuations could be too low or high at a certain point in time. As such, Relative valuation is suitable when there are comparable firms in terms of the risk, industry and size in the market. It is also appropriate when the aggregate market and the entity’s industry are not under valuation extreme. That is to mean that the collective market and the firm’s industry should not be acutely overvalued or undervalued (Strong, 2008). Both cash flow approach and relative valuation approach have several factors in common. One is that they are both affected by the investor’s required return on the stock since this return rate becomes a significant element of the disc ount rate. Secondly, the two valuation approaches are affected by the growth rate estimation employed in the valuation technique such as dividends, sales or earnings. Therefore, the two approaches may be considered as complementary. 2. The concepts of systematic and unsystematic risk, variance, covariance, standard deviation and beta as each of these relate to investment management. Unsystematic risks refer to the kind of uncertainty that is associated with the industry in which a company operates. Unsystematic risks are also referred to as specific risks or diversifiable risks for they are specific in each industry, and they are reduced through diversification. Unsystematic risks arise as a result of factors particular to an industry or the firm such product category, marketing, research and development and pricing. Systematic risks refer to the kind of uncertainty that is inherent in the whole market segment. They are also referred to as market risks or non-diversifiable risks bec ause they are inherent in the entire market and diversification do not result in their reduction. Systematic risks are such as war, inflation, change in taxation, global security perils and political instability that affect the functioning of firms in all industries. Total risk is a combination of systematic and unsystematic risks. Variance is the measure of volatility from the mean. Variance helps an investor to establish the risk involved in purchasing a certain security. A higher variance indicates greater variability and thus greater risk. A greater variance also