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< *1=r)
6i
5
i
*2sed to find the present &alue of &ariance)
i<H
Where mi <Mean of cash flo" in the i
th
period > expected cash flo" for year i
i
< Kariance in the i
th
period#
r < %iscounting 1actor
M < $otal of Present &alue of mean
< $otal of present &alue of &ariance
8ench mar( < ProJect "ith lo"er ,% "ill be preferred#
1) 4eal Cash flo"s restated in terms of nominal cash flo"s as follo"s:6
*1 = inflation rate) 5 4eal cash flo"s
+fter this discounting cash flo" is applied to find 3PK#
) Con&erting nominal discounting rate into real terms
4eal discount rate < 1 = 3ominal discount rate 6 1
1 = inflation rate
With this real discount rate the Cash 'nflo"s are discounted to find 3PK#
9) Pay bac( reciprocal
< +&erage annual cash inflo"s *'t is used for reasonable approximation of
'nitial 'n&estment '44)
;) $he formula for deflation is
'ndex 3umber at the beginning 5 Cash 'nflo"s
'ndex 3umber at the end
EH
*or) Cash 'nflo"s - *1='nflation 4ate)
n
3ote: 'f in a problem 4eal cash flo"s are gi&en and 'nflation 4ate and Cost of
Capital is gi&en then
i) Con&ert 4eal Cash 1lo"s into 3ormal Cash 1lo"s by using formulae said in *1)
abo&e#
ii) +dJust for %epreciation and tax and find Cash 1lo" after $ax before %epreciation#
iii) %eflate the amount arri&ed abo&e by using formulae said in *;)#
i&) With the amount arri&ed abo&e find 3PK using C.C#
,ummary:6
i) 4is( +dJusted %iscount rate approach
< 3PK for C1+$ at 4is( adJusted %iscount 4ate#
ii) Certainty E0ui&alent +pproach
< 3PK for *Certainty E0ui&alent Coefficient 5 C1+$) at 4is( less 'nterest rate#
iii) Probality %iscount approach
< 3PK for *C1) at ris( less 'nterest rate#
E1
Ana&/$i$ %f Ri$0 an, Unc#rtaint/
1) ,ensiti&ity +nalysis: 6 't pro&ides different cash flo" estimates under 9
assumptions a# "orst
b# $he expected *Most li(ely)
c# $he best#
3PK is found under these three assumptions and decision is ta(en#
) Precise measure of ris(:6
a) ,tandard de&iation: 6 +bsolute measure of ris(#
n
< C d P
i
* C1 > C1 )
i<1
C1 < Cash flo" i < \ear
C1 < Mean cash flo" *C1 of particular proJects total di&ided by number of C1)
< d C1 5 P
P < Probability
n
b) Kariance < * )
< d P
i
* C1 > C1 )
i<1
c) Co > Kariance *a!b) < P
i
* C1
a
> C1
a
) * C1
b
> C1
b
)
d) Coefficient of correlation of t"o &ariable factor < Co > Kariance *a!b)
a
b
e) 4eturn of portfolio < W
a
5 4
a
= W
b
5 4
b
Where W > Proportion in&ested
4 > 4eturn
f) 4is( of portfolio < C P
a
5
a
= P
b
5
b
= P
a
5 P
b
5
a
5
b
5 Cor*a!b)
g) Co > Efficient of &ariation < + relati&e measure of ris(#
,tandard %e&iation
K< Expected cash flo"
*or)
mean *or) C1
*.r) Expected 3PK *3PK
)
E
3PK < 3PK 5 Probability
h) 4is( adJusted discount rate approach: 6 'n this ris( adJusted discount rate is ta(en
as PK factor and calculated as 3PK method#
<d *C1+$)
t
6 C. Where P
r
< 4is( adJusted discount rate
*1 = P
r
)
t
i) Certainty E0ui&alent *CE) approach < 4is( less Cash 1lo"
4is(y Cash 1lo"
J) 'f Correlation Coefficient VCor*a!b)W is
Cor*a!b)
p #
=1 *P
a
5
a
) = *P
b
5
b
) Vie# 'f it is perfectly positi&ely correlatedW
61 *P
a
5
a
) > *P
b
5
b
) Vie# 'f it is perfectly negati&ely correlatedW
H +bo&e
p
formula "ill apply
() Probability %istribution approach: 6
t
*,% of C1) < C d p *C1 > C1)
< d
C1
6 C. < 3PK
*1=i)
t
Where
C1 < Cash 1lo"
C1 < Mean i#e# $otal of cash flo" multiplied by probability
for the period *or) expected &alue for C1+$ in period t)
i < 4is( less rate of interest#
t
< ,% for period t *,% for particular period)
l) ,% for the probability distribution of 3PK is *ie# ,% of C1)
*3PK) < C d *
t
) - *1 = i)
t
*this is used for uncorrelated C1)
*3PK) < d *
t
) - *1 = i)
t
*used for perfectly correlated C1)
Where ' < 4ate of 4eturn#
m) .ptimum proportion at "hich ris( is minimum < ^
a
<
b
- *
a
=
b
)
*or)
a
^ 6
b
*16^) < H
3PK for the period is calculated by ta(ing C1 as C1 for respecti&e period and
calculated normally
3ote:6
i) 'n certainty E0ui&alent approach rate of discount is the ris( less rate of
'nterest as the ris( is adJusted "ith C1+$#
ii) 'n this case C1+$ is multiplied "ith certainty e0ui&alent and PK is
calculated by ris( less rate of interest#
iii) 'f proJects are ran(ed "ith respect of ris( and return# ProJect "ith respect
to ris( re0uires d 3PK *i#e# d*3PK 5 Probability)) and the proJect "ith respect to
E9
return find co6efficient of &ariation < - d 3PK
i&) Probability that 3PK "ould be ]ero or less
] < H > 3PK $he ] Kalue is con&erted "ith the _] $ableB
&alues and the probability of the 3PK being
Iero or less "ould be < H#: > *] Kalue)#
&) Probability that 3PK being greater than ]ero "ould be
1 > *Probability less than ]ero)
&i) Probability that 3PK "ithin the range ^ and \
]
1
< ^ > 3PK ]
))W
Where d
1
< l
n
*s-x) = *r
f
= Y
- Z) 5 t
Ct
l
n
< 3atural log
d
< d
1
6 Ct
s < Present spot rate
x < 1uture stri(e *excise) price
r
f
< 4is( free rate
,e&en step to sol&e the problem:6
i) 1ind log *s-x)
ii) 1ind d
1
iii) 1ind d
i&) 1ind 3 *d
1
)
&) 1ind 3 *d
)
i&) 1ind 3 *d
1
) 3ormal $able Kalue
= H#: &) 1ind 3 *d
)
&i) 1ind _eB &alue
&ii) +pply 8lac( ,chools Model#
,ub step to step 1:6
a) Log *s-x) < Log s > Log x
H#;9;9
b) 'f x and s are digit figure the &alue shall be *1 = Log table &alue)#
c) 'f x and s are 9 digit then the &alue shall be * = Log table &alue)#
,ub step to step @:6
a) 't is to find the po"er &alue of _eB#
b) e
6t5r
f
< 1 *or) 1 #
1 = r-9@: 5 3o# of days *t) 1 = r-9@: 5 3o# of Months *t)
E:
Kalue of Put option: 6
< V*x) 5 *e
6t5r
f
) 5 *3 *6d
))W 6 V, 5 3 *6d
1
)W
Excise price:6
't is the price at "hich the person "rites the prices on a share to buy after a
period#
Expected Kalue of the share:6
't is the total of estimate mar(et price of the share multiplied "ith the
respecti&e probability#
Expiration &alue: 6 Excise price > Expected Kalue
Expected *or) $heoretical &alue of the call option price at expiration *Pay off of Call
option) :6
< d *Estimated mar(et price > Excise Price) 5 Probability *or)
< VMax *s > x)! HW 5 Probability
Pay off of call option
Expected *or) $heoretical &alue of the put option price at expiration *Pay of put
option):6
< d *Excise Price 6 Estimated mar(et price) 5 Probability *or)
< VMax *x > s)! HW 5 Probability
Pay off of Put option
Where *Estimated mar(et price > Excise Price) is called pay off# 'f it is negati&e it is
ta(en as Iero#
s < Estimated Mar(et Price#
Put call parity < Put call parity e0uation is
*Kalue of call option = Present &alue of excise price) < *&alue of put option =
,pot rate)
3ote:6
i) Changes to be made in computation of 8lac( ,choles model for di&idend stoc(s:6
,ubstitute in all the places of LsM "ith Ls > PK of di&idendM
ii)'n the abo&e all PK is found at 4is( free rate#
E@
B#ta
8eta means! it measures the &olatility of securities to the changes in the
mar(et#
e *le&el of ris() <
s
5 Cor *s!m) "here
s
< ,% of return on securities
m
m
< ,% of return on mar(et portfolio
*or) Co&ariance*s!m) -
m
e should al"ays be applied on ris( premium and not to the entire return#
r
s
< r
f
= *r
m
> r
f
) 5 e Where r
f
< 4is( free rate
r
s
< Expected return on securities *or) VCapital
+ppreciation = %i&idend of the
companyW
r
m
< Expected return on mar(et portfolio *or)
VMar(et index YMar(et rateZ appreciation = Mar(et di&idend yield
DW
Portfolio $heory *P$):6
r
p
*expected return under CML) < r
f
= *r
m
> r
f
) 5 *
p
-
m
)
$he abo&e formula is based on total ris(#
Where
p
< ,% of efficient portfolio#
When expected return under efficient portfolio is as(ed then
r
p
*expected return under efficient portfolio) < Capital mar(et line*CML) >
Express e0uilibrium price relationship bet"een expected return and %,
Capital +sset Pricing Model *C+PM):6
r
s
*expected return portfolio in C+PM) < r
f
= *r
m
> r
f
) 5 V*
s
-
m
) 5
cor*s!m)W
*or) r
f
= V*r
m
> r
f
)W 5 e
Where r
m
< r
f
= Mar(et premium
8eta of the portfolio < * e
a
5 P
a
) = * e
b
5 P
b
)
Where P
a
! P
b
< Proportion of in&estment in Company + and Company 8#
EE
3ote:6
i) *r
m
> r
f
) < Mar(et ris( premium *or) Compensation per unit of ris(#
ii) Cor*s!m) is =1 under CML
iii) r
f
= *r
m
> r
f
) 5 V*
s
-
m
) 5 cor*s!m)W < $his portion in C+PM formula is
ris( premium
i&) *r
m
> r
f
) -
m
< Mar(et ris( return trade off *slope)#
3otes:6
$o find the in&estment to be made in ris( free in&estments to get a certain e is
e of expected portfolio < *W
1
5 e
1
) =*W
5 e
)
*or) < *W
1
5 e
1
) = *16W
1
) e
is e of r
f
securities *ie#H)
$his can also be use to find in&estment in other then r
f
securities# 'n that case
that e is substituted in e
#
$he "eitage *W
1
!W