Financial Crisis Occurs Every 3 To 20 Years

Financial Crisis Occur About Every 3 5 Years7 10 Years15 20 Yearsthe

Financial Crisis Occur About Every 3 5 Years7 10 Years15 20 Yearsthe

Identify the frequency at which financial crises typically occur, considering the common causes attributed to such crises, and analyze the contributing factors to notable financial downturns such as the Asian financial crisis of 1997/8 and the 2008 global financial crisis. Discuss the mechanisms like mark-to-market accounting and their roles during financial crises, and evaluate the lessons learned from these crises regarding borrowing and investment strategies. Examine the drivers behind dividend growth in the context of the Dividend Discount Model (DDM), the characteristics of firms with competitive advantages, and the assumptions underlying the DDM. Furthermore, analyze statements regarding the Gordon model, the implications of an over-priced security, and the effects of additional debt on Free Cash Flow to the Firm (FCFF). Finally, interpret investor behavior in the absence of dividends, especially concerning earnings growth expectations and required rates of return.

Paper For Above instruction

Financial crises are complex phenomena that tend to recur at irregular intervals, often approximately every 7 to 10 years, although some experts suggest they can occur every 3 to 5 years or even every 15 to 20 years. The cyclical nature of these crises has been extensively studied, revealing that systemic issues, regulatory failures, and macroeconomic imbalances contribute significantly to their timing and severity (Reinhart & Rogoff, 2009). These recurring financial downturns underscore the importance of understanding their causes, impacts, and the lessons they impart to policymakers, investors, and financial institutions.

One of the primary causes consistently identified in financial crises is excessive leverage, often driven by the pursuit of higher returns and inadequate risk assessment. Leverage amplifies market fluctuations, making economies vulnerable to sudden collapses when asset prices decline sharply (Brunnermeier, 2009). Additionally, bubbles in housing markets, fueled by speculative behavior and lax lending standards, have historically precipitated crises, as seen in the 2008 subprime mortgage meltdown (Case & Shiller, 2003). Other factors contributing to financial instability include greed among market participants, misaligned incentives of CEOs and executives, and regulatory gaps that fail to contain systemic risks (Acharya & Richardson, 2009).

The 1997/8 Asian financial crisis exemplifies how lack of transparency in markets, especially regarding currency bonds and banking sector vulnerabilities, can trigger widespread instability. Contributing to the 2008 crisis was the extensive use of credit default swaps (CDS), which created a web of interconnected risks and a false sense of security among investors (Longstaff, 2010). Another significant factor was the failure of financial regulation to adapt swiftly to innovative financial products, compounded by the repeal of the Glass-Steagall Act, which allowed banks to engage in riskier activities, increasing the fragility of the financial system (Crockett, 2000).

Tracing back the origins of the 2008 crisis points to multiple interconnected factors: the proliferation of subprime lending, securitization of mortgage-backed securities, and speculative trading. Investors, financial institutions, and governments failed to heed the warning signs, emphasizing that lessons from past crises should promote cautious borrowing, establishment of emergency reserves, and prudent investment strategies rather than aggressive risk-taking (Mian & Sufi, 2014). The crisis also highlighted that stocks are not inherently safe investments during turbulent times, emphasizing the need for robust risk management and diversification strategies.

In dividend valuation models like the Dividend Discount Model (DDM), the driver for dividend growth is typically the growth in earnings per share (EPS), which reflects the company's profitability and capacity to return value to shareholders. According to Gordon’s growth model (Gordon, 1959), the key assumption is that dividends grow at a constant rate, mirroring sustainable earnings growth. The model presumes that shareholders seek intrinsic value based on expected future dividends, discounted at a required rate of return. Thus, the growth in EPS directly influences dividend growth and, consequently, stock valuation (Damodaran, 2012).

A firm with a competitive advantage over its peers generally exhibits an Return on Equity (ROE) higher than its competitors’ ROE, enabling it to generate superior profits and sustain growth (Porter, 1985). An ROE exceeding the expected growth rate (g) and the cost of equity (k) indicates a firm’s ability to reinvest earnings at high rates, gaining an edge over competitors (Penman, 2012). This superiority often translates into higher stock prices and market valuation, rewarding investors with capital gains and dividend income.

The assumptions underpinning the DDM hold that the firm consistently pays dividends, dividends grow at a steady rate, and the dividend payout ratio remains constant. These assumptions are critical because deviations, such as irregular dividend payments or fluctuating payout ratios, can render the model unreliable (Goyal & Welch, 2003). Additionally, the model presumes that dividends are a proxy for firm value, which may not hold for firms that retain most earnings for growth or debt reduction.

Statements about the Gordon (or Gordon-Shapiro) model highlight its nature as a perpetuity, where the intrinsic value is derived from steady dividend payments growing at a constant rate. The model is fundamental in equity valuation, assuming dividends are stable and growth is predictable (Gordon, 1959). The assertion that the required return (K) can never exceed the expected growth rate (g) is inaccurate; in fact, for valuation to be meaningful, the required return must be greater than the growth rate, ensuring a finite valuation (Damodaran, 2012).

When a security is over-priced, its required return (K) exceeds its expected return, reflecting a mispricing where market sentiment or speculative factors inflate its price beyond intrinsic value (Shiller, 2015). Conversely, if a security’s return on equity exceeds its required return, it suggests the stock is undervalued. Understanding these relationships is vital for investors aiming to identify attractive investment opportunities and avoid overvalued assets.

The impact of additional debt on Free Cash Flow to the Firm (FCFF) depends on the nature of the debt and company cash flows. Generally, taking on more debt increases FCFF initially by providing additional capital for investment, but over time, the increased interest expenses may decrease FCFF (Modigliani & Miller, 1958). Debt also influences the firm's capital structure and risk profile, affecting its valuation and cost of capital (Myers, 2001). Therefore, the effect on FCFF is dynamic, contingent upon how effectively leverage is employed and managed.

In the absence of dividends, investors’ expectations hinge on earnings growth and the firm’s overall return on invested capital (ROIC). These investors anticipate earnings to grow at a rate aligned with the company's growth prospects, the stability of its cash flows, and its ability to generate sustained returns. The required rate of return incorporates the risk expectations of investors, including market risk premiums, and reflects their demand for compensation relative to that risk (Fama & French, 2004). Ultimately, investors analyze future earnings potential and the firm’s capacity to reinvest earnings profitably rather than simply relying on dividend payouts.

References

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  • Reinhart, C. M., & Rogoff, K. S. (2009). This Time Is Different: Eight Centuries of Financial Folly. Princeton University Press.
  • Shiller, R. J. (2015). Irrational Exuberance. Princeton University Press.

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