Question

Question 1)

a. Explain the assertion that the relationship between the standard deviation on a portfolio and standard deviations of the assets in the portfolio is not a simple one.

b. Briefly discuss the concept of the Security Market Line (SML), and explain why all assets must plot

directly on it in a competitive market.

c. The dividend debate is inconclusive and still on-going in the corporate world. In your view, briefly

discuss some real world factors that may support the payment of high and low dividends

Answer 1

A

Conversely, the standard deviation of a portfolio measures how much the investment returns deviate from the mean of the probability distribution of investments. The standard deviation of a two-asset portfolio is calculated by squaring the weight of the first asset and multiplying it by the variance of the first asset, added to the square of the weight of the second asset, multiplied by the variance of the second asset.

Then, add this value to 2 multiplied by the weight of the first asset and second asset multiplied by the covariance of the returns between the first and second assets. Finally, take the square root of that value, and the portfolio standard deviation is calculated.

The standard deviation of the portfoliois always equal to the weighted average of the standard deviations of the assets in the portfolio.

b The security market line (SML) is a line drawn on a chart that serves as a graphical representation of the capital asset pricing model (CAPM)—which shows different levels of systematic, or market risk, of various marketable securities, plotted against the expected return of the entire market at any given time. Also known as the "characteristic line," the SML is a visualization of the CAPM, where the x-axis of the chart represents risk (in terms of beta), and the y-axis of the chart represents expected return. The market risk premium of a given security is determined by where it is plotted on the chart relative to the SML.The security market line is an investment evaluation tool derived from the CAPM—a model that describes risk-return relationshipfor securities—and is based on the assumption that investors need to be compensated for both the time value of money (TVM) and the corresponding level of risk associated with any investment, referred to as the risk premium.The concept of beta is central to the CAPM and the SML. The beta of a security is a measure of its systematic risk, which cannot be eliminated by diversification. A beta value of one is considered as the overall market average. A beta value that's greater than one represents a risk level greater than the market average, and a beta value of less than one represents a risk level that is less than the market average.

All assets must plot directly on line because investors actions will adjust prices of assets to fall on that line. ... The ER is the sum of the risk free rate and the market premium multiplied by the beta coeff of that asset.

c

A low dividend payout is when a company keeps the majority of its profits and reinvests it in the business and then gives out the rest as dividends. For example, if a company reinvests 60% of its profits back into the business and then pays out the rest in dividends, it has a dividend payout of 40%. If the company only keeps 10% of the profits and pays out the rest, then this company has a payout of 90%, which is high.
While some companies will pay out the majority of its profits as dividends, others choose to keep most of the profits and pay out a small portion of its profits as dividends. Also, some investors even look specifically for companies that have a low dividend payout

Taxes

First, there is a tax advantage to be had by companies who reinvest the majority of company earnings. Why? This is because when companies reinvest their earnings, it becomes capital gains for them, and capital gains are taxed at a lower rate than dividends are. So, when a company has a low dividend payout, its tax liability is less. It costs the company less to have a low dividend payout than it does to have a high dividend payout.

Is the company's income stable?
Income stability is one of the top factors in determining dividend policies. Specifically, established companies with stable, predictable income streams are more likely to pay dividends than companies with growing or volatile income.

Newer and rapidly growing companies rarely pay dividends, as they prefer to invest their profits back into the company to fuel even more future growth. And, companies with unstable revenue streams often choose not to pay dividends, or pay small dividends in order to make sure the payout will be sustainable.

It looks terrible to investors when companies are forced to suspend or reduce dividend payments, so most like to err on the side of caution when deciding to implement a new dividend, waiting for several years of stable profits before doing so.

Can profits be put to better use?
Another factor that can influence management's dividend policies is the potential for better returns through capital reinvestment. In other words, if a company feels that it would be in the best interest of its shareholders to use its profits for other business activities besides paying dividends, it could choose not to pay – even if its revenues are stable and predictable.

Legal requirements
It's also worth noting that some companies have no choice but to pay dividends. For example, real estate investment trusts receive some pretty nice tax benefits, but they are legally required to pay at least 90% of their income to shareholders.

On the other hand, some companies need to obtain approval before paying or increasing their dividends. Since the financial crisis, many banks need to submit capital plans for regulatory approval for any plans to boost their payouts.

Economic conditions
Finally, another major factor that influences dividend policies is the market environment. If a certain sector is having trouble and anticipates profits falling, it's common for companies to get quite defensive when it comes to their dividends.

This can be seen currently in the energy sector, where low oil prices have wreaked havoc on many companies' profitability, which has led to several major companies slashing their dividends recently.

The Foolish bottom line
As I mentioned earlier, this isn't an exhaustive list, and there can be many company-specific reasons for implementing, increasing, and cutting dividends, in addition to those mentioned here. For example, New York Community Bank paid out uncharacteristically high dividends for a few years in order to remain under the $50 billion regulatory threshold.