Nov 8, 2017 in Analysis

Assets Pricing Models and Prices Variability

Introduction

This paper presents a discussion and analysis on asset pricing variability, derivative pricing models and the Net Present Value relationship. Virtually, all organizations have machinery or assets that they use to carry out production of various products. The management is usually keen to understand the prices at which they can sell the assets in case they wish to dispose them (Barr 2004). It is also important to know their value for various reasons. For instance, there may be a need to insure the assets against perils of fire or theft, or the inclusion of the assets in the books of accounts at the end of each accounting period.

From the above discussed-reasons, it is of vital importance that the value or price of machinery or asset is ascertained at appropriate periodic intervals. The prices of assets often differ when determining the values and prices upon which certain assets should trade (Berezin 2005). Thus, it is common knowledge that prices of assets vary. This is known as Asset Price Variability. The reasons for the variability are numerous. The condition of an asset, the remaining useful life, running costs of an asset, revenues being generated by an asset and the demand and supply of an asset are some of the factors that play a role in determining prices.

Derivative Pricing Models are the techniques and methods of establishing prices at which assets should be sold. All the above-mentioned reasons account for the determination of the price. Owners of assets are interested in knowing the minimum price to accept for their interest in the assets. Buyers would also be keen on the worth assets. Therefore, they are informed about the maximum amount to offer (Caplin & Schotter 2008). In such a way, these models aim at determining the value or price at which the interest therein can exchange hands.

The Net Present Value is a valuation method that derives the value of an interest in an asset by discounting all the future net incomes accruing to a property. It holds that the value of an asset is equal to the future incomes that would be generated by the asset (Case & Fair 2007). It uses the concept of ‘Time Value of Money.’ In such a case, a dollar earned today is deemed much more in a year’s period. This is due to reasons of risk associated with lending the dollar. Hence, there is uncertainty as to whether it would be received or not. The costs of inflation, which are ever appreciating and the cost of postponing consumption for one year, are also considered. An appropriate discount rate is consequently used to discount the future sums into present values. In asset pricing models, the incomes that an asset can generate are discounted to convert them into present sums (Case & Fair 2007). Therefore, this entails calculation of their Net Present Values. This indicates that there is a close relationship between the Pricing Models and the NPV.

The NPV of assets greatly affects a firm. The value or worth of the firm is based on its capacity to generate revenues or incomes. Where the net incomes generated by a firm are higher, the value of the firm would be positive. Hence, a firm would be running at a profit and will be commended to continue operations. On the other hand, where the firm’s costs are higher than its incomes, the net operating income would be negative (Colander 2008). Thus, a negative present value is generated. In such a case, the firm would be advised to change its strategy, since the platform on which it is operating cannot be sustained. The advice on that is to shut down operations or institute some drastic changes in order to alter the way operations are done. The aim of every business is to make a return or profit. When this cannot be achieved, there would be a need for a change in strategy. Every business should be able to cater for its own costs. Where a firm is unable to guarantee that, changes must be made in order to ensure it makes profits.      

Literature Review

This section provides a discussion on the work done regarding the issues under discussion. It provides the benchmark or the expected standard of practice. This implies that the information contained here serves to provide the required norm. Assets Price Variability reflects a state where the prices of similar assets vary or have different values . The reasons for the differences are numerous. As it has already been mentioned, the age of the asset is important. Erich (2010) observed that newly purchased assets would be more expensive than old ones. This is because a new one has a longer useful or economic life than an old one. It would hence be in use for longer time spans.  Therefore, it generates revenues for longer periods than old assets with a short economic life. A new asset would also tend to have less costs or overheads. The costs associated with maintenance of the asset are lower for a new one than those for an old asset. Since costs are expenses and they reduce the Net Operating Income, they, therefore, reduce the value of the asset. For this reason, assets would have variances in the prices they fetch in the market when they are due for exchange. New and efficient assets would command higher prices and values than old and less efficient assets (Erich 2010).

Therefore, asset pricing variability takes into account the ability of an asset to generate revenue. To make a conclusion regarding the price, it is important that the necessary data concerning the asset is maintained (Ison and Wall 2007). Such information helps to set a fair price. The age, costs of maintenance within some period, income generated by the asset and the general demand and supply would indicate the likely price of an asset. Regarding the costs of maintenance, those assets with higher costs of maintenance would experience low demand and hence lead to their low prices. Therefore, the higher the maintenance costs of an asset as compared to other similar assets, the lower the price or value of the asset.

Derivative Pricing Models are techniques used to calculate a fair price or value of an asset. This takes into account aspects that are relevant to the functioning and economic life of the asset. Investors or buyers would be keen on the maximum amount to offer for the purchase of the asset. They would rely on various models. One of them is the ‘Black Scholes Option.’ This model takes into account six main factors. The period remaining to the due transaction date, the current price of the asset, the current associated costs of transaction, the gain being earned by the investor, earnings made by postponing the purchase to a future date, and the volatility of the underlying asset (Ison & Wall 2007).   

Based on the analysis of the above-mentioned factors, a fair price or value is then determined. This only marks as a guide on the price to accept for the seller and one to offer in case one is contemplating buying. In the analysis of the gains to be made from the future cash flows, it becomes necessary to make use of some valuation techniques. This is where the Net Present Value becomes necessary (Kirzner 2009). This technique converts future cash flows into present sums for ease for comparison. It thereby becomes easy for the investors to analyse any future cash flows and hence make a decision that is based on correct facts.

There is a close relationship between the Pricing Models and the Net Present Value. All these techniques strive to determine the fair price of a given asset. The major considerations are the capacity of an asset to generate income. Its economic life also becomes crucial (Khan 1993). The concept of salvage value is to be included too. This represents the price at which the asset would be sold at the end of its useful or economic life. This amount is then discounted at an appropriate discount rate into a present sum and added to the Present Value of net Operating Income to arrive at a value for some asset (Khan 1993). Net Present Value is, therefore, important in the determination of fair prices. It is also used in the Asset Pricing Models to discount future sums into present sums for ease of analysis and value determination. Asset Pricing Model cannot, therefore, be successful without the utilization of the valuation technique.

Methodology

To build on the arguments and information presented in this paper, the writer has relied on secondary sources of data. This is the utilization of previous works, books, journals, and articles regarding the issues under discussion (Mejia 2008). The arguments and facts presented in such sources were the only sources of data. The discussions made in this paper have, therefore, been drawn from the information already contained in previous studies and publications on the topic. The findings are then presented in a form of an essay.

Empirical Analysis

This section provides responses to the various points as presented below; the usefulness of NPV in assessing price variability. As it has been discussed, NPV discounts the cash flows accruing to an asset in order to arrive at a fair value or price (Nitzan 2009). This is based on the levels of revenues and expenses associated with the asset. The period the cash flows are experienced or the economic life of the asset is also critical in determining the value of an asset. Where there are differences in the mentioned factors regarding an asset, their prices or values would be different. This is because, when the figures are substituted in a predetermined formula for calculating the present value, the results would be different, and hence the price variability in assets. It should, however, be mentioned that the variability is occasioned by the differences in ages, revenues generated, expenses incurred and their salvage values at the end of their useful lives.

There are various advantages and disadvantages associated with the use of NPV in explaining price variability in assets and the determination of fair prices. The advantages include that the price of an asset is determined from its ability to generate income to a firm (Nagalingam 2000). This means that those assets that generate more income would command high prices in contrast to those whose input towards the income earned by the firm is minimal. Therefore, it is a fair determinant of a price or value to be attached to some property or asset since the value is pegged on the ability of the asset to generate income.

The NPV method, however, relies on forecasts into the future and other variables that are uncertain. The forecasted future cash flows may vary from those to be realized. This means that the calculations based on NPV are highly distorted and, therefore, not a clear indication of the fair price or value of the property or asset (O’Sullivan & Sheffrin 2005). The method also assumes that the cash flows would accrue as forecasted or envisaged. This may however prove to be incorrect in some cases. Therefore, reliance on the technique could result in misleading information to the investor. The method can only be effective where the inputs adopted are reliable and accurate. However, this is an uphill task to firms. For instance, firms that have just commenced operations may find it difficult to forecast their future cash flows.

Derivative Pricing Models and Portfolio Management

This part presents a discussion on how derivative pricing models relate to portfolio management, and the impact of those on the firm. Derivative models are financial agreements for the purchase or transfer of some interest in an asset (Rahnema 1994). The terms and conditions of a sale are determined on the date the transaction is made. The price is one of the factors to be determined. Portfolio management entails the planning and organizing of all the matters concerned with the assets for their effective operations with the aim of making a return out of it. To decide on the assets to maintain and those to be sold, it is important to understand numerous details concerning them. Through derivative pricing models, the management is informed on the prices that some assets would fetch given the above-discussed conditions.

The management too, would be interested in knowing those assets that earn the firm greatest revenues and those that cause the firm to suffer losses (Watson 2005). Those assets which have high costs of maintenance in repairs would be considered for disposal. The management would be prepared to sell them at some reasonable and fair price given their capability and salvage values. The derivative pricing models would thereby be of great importance.

There would also be those assets that earn the firm huge incomes or high revenues. The management may be keen on maintaining them for enhanced revenues. By utilising the techniques of derivative pricing models, the management would be aware of the costs of maintenance, and compare them against those of other assets in order to determine which assets to dispose and which to maintain. The aim is to maximize earnings to the firm (Barr 2004). Therefore, the importance of derivative pricing models to the firm cannot be overstated. On volatility, it becomes important to ascertain which assets are risky to the firm. Their values change often and in many cases to the adverse effect of the firm. The firm may end up selling them at  much lower prices than it bought them or below their reserved prices and hence causing a loss.

The derivative pricing models help the firm to determine the best course of action. It is a portfolio management tool. Those assets that would aid in maximum earning of profits to the firm would be desired and maintained to the exclusion of those that would require huge costs for maintenance (Berezin 2005). The management is also informed on the minimum prices to accept given the analysis of the factors that are critical in determining fair values and prices. Consequently, the models are of great relevance to the firm. They aid in making informed decisions. Therefore, a firm is informed on the correct choices to make given the facts presented using the models.

Volatility is the risk of not realizing a set return. It involves market changes that lead to a decrease in the demand for some asset. Where this is a common feature, then it means that the asset’s volatility is high. The effect of this is that it becomes difficult for future forecasting and analysis that is reliable given the volatility (Caplin & Schotter 2008). Volatility is a negative aspect in any market. It affects the ability of any business to plan adequately on the future. This would require allowance of a large margin during the forecasting and estimation of future cash flows.    

The following are recommendations for the business in terms of pricing assets under volatility situations. During the time when the market for some assets is considered volatile, great caution should be taken in order to avoid suffering of losses. On these occasions, there is no guarantee that the firm would attain the set prices. Prudent decisions to be made would entail a careful and thorough studying of the market conditions. This would establish the minimum and maximum price or value that an asset can fetch. Through market analysis, it would be established the prevailing rates for the price of any asset. Also through NPV method and other Asset Price Derivative models, a price or value is then determined. Then a comparison between the two can be drawn. This would guide on the value or price to set for some asset. The market value should however prevail over the derived asset price. It is further advised that where the derived price is higher than the price prevailing in the market, then there would be no need of disposing the asset. On the other hand, where the derived price is lower than the price being offered in the market, then the asset should be sold. This is because, the asset earns less in income to the firm than it would fetch in the open market.

The rate of return under uncertainty is the minimum profit sought by the investors given the risks involved. This is captured in a rate of return. It consists of the profit to be earned for the investment. This rate is highest during uncertainty periods based on the fact that the risk is high.  The rate sought must therefore compensate the investor for the risk through high rates of return. The beliefs or the prevailing market conditions dictate the rate of return to be sought by the investor. Investors are therefore influenced by the happenings in the market, which form their beliefs.

Summary

Various Asset Pricing Models are used to determine the fair prices of some assets. The sellers and buyers would be interested to know the worth of the assets before they commit themselves to transact. Asset Pricing Model relies on the ability of the asset to generate income. The net operating income of the asset is critical in determining the price. To convert future cash flows into present sums for ease of analysis and comparison, Net Present Value is greatly used. This technique relies on the concept of ‘Time Value of Money’ to convert sums earned at different periods into a current date sums. The pricing model, therefore, utilizes the NPV method for the analysis.

The NPV method is preferred, since it takes into account the issue of time value of money. It appreciates the fact that a dollar earned today is worthy more after a year. However, it relies on future forecasts. These figures are required to be accurate and reliable. Where they are subjective, a misleading conclusion may be reached. This could compromise the decisions made based on the findings of the NPV. However, where the magnitude of the factors used is reasonable and factual, the NPV arrived at would be realistic and thereby aid in appropriate decision-making process. It is also lauded for the effective consideration of the ability of the asset to generate some income during its lifetime as being crucial in establishing the fair price or value of an asset. This is important, since the income to be generated by the firm is the main consideration.

The derivative asset pricing models have a great role to play in portfolio management. The management is informed on the various critical issues concerning the assets owned by the firm. For instance, the revenues generated by the asset, expenses incurred, their salvage values and their current values or prices would be critical in guiding the management on the best decision to make concerning their assets portfolio. Any rational management team would prefer those assets that earn the firm maximum earnings. Those assets that constitute a liability towards the firm would be disposed. Through the techniques of asset pricing models, the management would be guided in decision-making.

Conclusion

Every business enterprise has some form of assets. These are the resources they utilize to carry out their operations. In the management of various assets, portfolio management, it becomes important to know their prices or values at given stages. To determine their fair prices, asset-pricing models are of huge benefit. The aim of determining the asset prices at some stages is for effective management. The management team is tasked to ensure that the organization earns a return. To achieve that, the firm would desire to reduce costs and maximize profits. One way of reducing the costs is by disposing assets that constitute a liability to the firm. Firms would undertake valuation of their assets before floating them for sale. 

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