Question

What does it mean a firm cash flow to investors in negative?

2) '' by fully diversifying a portfolio , we can completely all types of risks , therapy creating a synthetic Treasurury bill''. Explain the statement

Answer 1

Firm cash flow to investers is defined in terms of FCFE

FCFE: Free cash flow for equity

PAT: Profit after tax

Dep: depreciation: Dep is added back to PAT as it is a noncash expense.

FC: Change in net fixed capital investment, if money is spent on fixed assets then it is positive & vice-versa

WC: Change in working capital (inventories + receivables - payables). If WC is increased then it is positive & vice-versa

Debt: If debt is raised by the firm, then it is positive or if it is paid back, it is negative.

From the above equation it is clear, even though the company may be making profits (PAT > 0), but still it might be spending money to increase fixed assets or working capital or using it to pay debt, which may cause negative cash flows to investors

(2) Full diversified portfolio

s: standard deviation of the portfolio

Let x1, x2, x3.......xN be n securities in a portfolio

Let w1, w2, w3......wN be the respective weights of the portfolio

Let s1, s2, s3......sN be the respective weights of the portfolio

Let p1,2; p13.............p1N be the correlation between security 1 & other securities

Let p2,1; p23.............p2N be the correlation between security 2 & other securities

.................................................................................................................

Let pN1, PN2.............PN,N-1 be the correlation between security N & other securities

Where

By selecting such securities whose correlation are negative ie p(i,j) is negative, we can create a portfolio whose s^2 is very close to zero. Hence we have created a synthetic t-bill