Professional Documents
Culture Documents
Covers chp. 1
The Firm
Association of people for the provision of
goods and services with an intention of
making a profit.
Legal forms are: Sole Proprietorship
Partnership
corporations
Corporate Structure
Sole Proprietorships
Unlimited Liability
Personal tax on profits
Partnerships
Limited Liability
Corporations
ENVIRONMENTAL FACTORS
ENVIRONMENTAL FACTORS
Important for Financial Manager to
understand the External Environment in
which he has to operate.
Some of the dominant factors are : Government/Financial Market Regulations
Forms of Business organisation.
Taxation etc.
ENVIRONMENTAL FACTORS
Regulatory Framework
FERA/FEMA
MRTP/COMPETION POLICY
COMPANYS ACT ( salient features)
FERA/FEMA
FERA(73) : for MNC operating in India.
More than 40% share holding has to be
reported.
Delay in implementation, (by 1979 only
50% of the companies diluted its equity
holdings below 40%).
Liberalization put forth a new Industrial
and trade Policy (91) and in 1993
ordinance to amend FERA was passed.
FEMA
FEMA was introduced in 1998, with a
motive to facilitate exchange market in
India.
There was a regime shift from exchange
control
to exchange
management.
1993,exchange rate of rupee was made
market determined. 1994, accepted article
VIII of IMF.
Objective/ goal
(1)
Financial
manager
Firm's
operations
(4a)
(4b)
(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
Financial
markets
Goal Of Financial
Management
What should be the goal of a corporation?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the companys
stock?
The Goal
Maximize profit Are we talking about long-run
or short-run profits? Do we mean accounting
profits or some measure of cash flow?
Minimize costs We can minimize costs today
by not purchasing new equipment or delaying
maintenance, but this may not be in the best
interest of the firm or its owners.
Maximize market share This has been a
strategy of many of the dotcom companies. They
issued stock and then used it primarily for
advertising to increase the number of hits to
their web sites. Even though many of the
companies have a huge market share (i.e.
Amazon) they still do not have positive earnings
and their owners are not happy (1996).
Managers dilemma
Capital Market
EQUITY MARKETS
Common Stock
Ownership in a Corporation
One vote per share.
Have a residual (last) claim on income
and assets in liquidation, thus a
riskier position than bonds and
preferred stockholders.
Shareholders liability for the debts
of the corporation is limited to their
investment in the common stock.
Preferred Stock
A Preferred or prior claim on earnings and
assets compared to common stock
Dividends paid ahead of common if declared.
Preferred stockholders are usually excluded
from voting for board of directors and
shareholder issues.
Many corporations buy preferred stock.
Convertible Securities
Convertible preferred stock -- convertible to
common stock at specific common price or
number of shares (conversion ratio).
Dividends received until conversion
Investor may participate in growth of firm.
Secondary Markets
Bring Buyers/ Sellers Together Four Ways:
A buyer may incur search costs and find a seller
on their own, called a direct search.
A broker may bring buyer and seller together,
charging a commission.
A dealer may sell/buy (bid/ask) securities from an
inventory of securities, reducing search costs.
The dealers return is the bid/ask spread.
An auction market allocates the selling shares to
the highest bidder, providing a buyer/seller.
Inventory model
Capital Market
Defined as : the market of financial assets
that has long or indefinite maturity.
Nerve centre of the industrial development
of any economy.
SEBI regulates it.
Composition/Structure of Capital
Market
P&S
DFI
VC
CM
IFI
FIIs
CB
MF
HERE:
HERE
P & S : Primary/sec.
markets
DFI:development
financial inst.
IFI:Investment fin. Inst.
MF: Mutual Funds
CB: commercial Banks
Transactions
Hiccups
Efficiency
Insider trading / information efficiency
Volatility
Liquidity
Reach
Date
1992
1994
Amount
involved
Rs. 54
Billion
Rs. 170
Million
1995
Rs. 61.8
Million
1997
Rs. 7
Billion
1998
BPL, Videocon,Sterlite
Rs. 0.77
Billion
2001
Rs. 1
Billion
Instinet
Reuters
Lehman
Heine
Strike
Herzog
JP Morgan
E-Trade
Archipelago
PaineWeber
Townsend
Bear Stearns
CNBC
DLJ
Merrill Lynch
SLK
Schwab
Goldman Sachs
REDIBook
Knight Trinkmark
BRUT
Nasdaq
Fidelity
TD Waterhouse
ASC Sunguard
Morgan stanley Dean Witter
Datek
ISLAND
Attain
All Tech
NextTrade
PIM
TradeBook
LVMH
TA Associates
Bloomberg
Volatility
Daily Returns on BSE Sensex(1995-2004)
10
Daily Returns(%)
BSE
-5
-10
Volatility clustering
-15
325- 21- 19- 1292- 24- 17- 10731- 26- 20- 17- 138429- 20525Jun- Oct- Mar- Aug- Jan- Jun- Nov- Mar- Aug- Jan- Jun- Oct- Mar- Aug- Jan- Jun- Nov- Apr- Aug- Jan- Jul- Nov96
96
97
97
98
98
98
99
99
00
00
00
01
01
02
02
02
03
03
04
04
04
Date
To conclude
Financial management is more influence
by external factors than firm specific
problems
CFOs/CEOs are expected to add value to
the investments trusted upon them rather
than just showing profits .
Capital market in India is volatile and
shows seasonality.
Solution # 1
(i) time preference (discount rate) = 9%
investments = 15,000
time period = 4 yrs.
CVF(4,9%) = 1.4116 (appox.)
FV = 15,000*(1.09)4 = 15,000* 1.4116
= 21,173.72
(ii) Investments = 6000 (now) & 6000( 1 yr after)
period (eoy) = 5 yrs
compouning period = 5 & 4 yrs
CVF = 1.5386 & 1.4116
FV = 9231.74 & 8469.49
Solution # 1
(iii) Annual investments (eoy) = 18,000
time period = 8 yrs.
CVAF = 11.0285 (appox.)
FV = 18,000* 11.0285 = 198,513
(iv) Investments (b0y)= 18000
period = 8 yrs
CVAF (annuity due) = 12.0210
FV = 18000 * 12.0210 = 216378
Solution # 1
withdrawal
(v)
Balance
18000
82316.32
89724.79
12000
77724.79
84720.02
12000
72720.0211
79264.82
12000
67264.823
73318.66
73318.65707
Solution#2
Rate of interest = 15 %
sum received now = 100
period = 10 yr
PVAF = 5.0188
therefore 1/ PVAF = 0.1993
100 = 5.0188A
Hence A = .1993*100= 19.93
For Annuity due , PVAF(1+.15) = 5.7716
Hence A = 100/5.7716 = 17.33
Solution#3
Needed future sum after 15 yr= 300,000
periods = 15 yrs
interest rate = 12%
CVAF = 37.28
Therefore , A*37.28 = 300000
A = 8047.22
Solution#4
Price of the house = 500,000
Cash payment = 100,000
Balance = 400,000
Installment period = 20 yrs
Interest rate = 12%
PVAF = 7.4694
A*7.4694 = 400,000
A = 53551.51 (appox)
year
Balance
Installment
interest
Repayment
400000.00
394448.49
53,551.51
48000.00
5,551.51
388230.80
53,551.51
47333.82
6,217.69
381266.98
53,551.51
46587.70
6,963.81
373467.51
53,551.51
45752.04
7,799.47
364732.10
53,551.51
44816.10
8,735.41
354948.45
53,551.51
43767.85
9,783.66
343990.75
53,551.51
42593.81
10,957.70
331718.13
53,551.51
41278.89
12,272.62
317972.80
53,551.51
39806.18
13,745.33
10
302578.02
53,551.51
38156.74
15,394.77
11
285335.87
53,551.51
36309.36
17,242.15
12
266024.67
53,551.51
34240.30
19,311.21
13
244396.12
53,551.51
31922.96
21,628.55
14
220172.14
53,551.51
29327.53
24,223.98
15
193041.29
53,551.51
26420.66
27,130.85
16
162654.74
53,551.51
23164.95
30,386.56
17
128621.79
53,551.51
19518.57
34,032.94
18
90504.90
53,551.51
15434.62
38,116.89
19
47813.98
53,551.51
10860.59
42,690.92
20
0.15
53,551.51
5737.68
47,813.83
Solution # 5
Answer??
An Example
A dividend stream commencing one year
hence at Rs 66 is expected to grow at
10% annum for 15 Yrs and then ceases. If
the discount rate is 21%, what is the PV of
the expected series.
soln: P = A/(1+g)[ ( 1-(1+i*)-n) /i*]
Where, i* = (i-g)/(1+g)
i* =(0.21-0.10)/1.10 = 0.10
A/(1+g) = 66/1.10 = 60
Example (contd.)
Refer to table of PVAF (15,10%)= 7.606
P = 60 * 7.606 = Rs 456.36
Some terms
Capital Recovery: it is the annuity of an
investment for a specified time at a
given rate.
If you make an investment today for a
given period of time at a specified rate
of interest you may like to know the
annual income generated from it.
The reciprocal of PVAF is CRF ( capital
recovery factor).
An Example
If you plan to invest Rs 10,000 today for a period
of 4 years. The interest rate is 10%. How mush
income per year should you receive to recover
your investment?
Soln : PV = A (PVAFn,i)
A = PV (CRFn,i)
A = 10,000 (0.3155) = Rs 3155
problems
Suppose you have taken a 3 yr loan of Rs
10,000 @ 9% from your employer to buy a
motorcycle. If your employer requires
three equal end-of-year repayment ,then
what will be the annual installments?
problems
PV = A (PVAF n,i)
using the given values, we obtain..
10000 = A (2.531)
A = Rs 3951
i.e. paying Rs 3951 each year, for three yrs ,
you shall completely pay off your loan with
9% interest rate.
problems
Exactly ten yrs from now Sri Chand will
start receiving a pension of Rs 3000 a
year. The payment will continue for 16 yrs.
How much is the pension worth now, if Sri
Chands interest rate is 10%?
problems
Soln: Sri Chand will receive the first payment at
the end of 10th Year and last payment at the end
of 25th year.
Assuming an Annuity for 25 yrs @ 10%, PVAF25
= 9.077 but we know that he will not receive
anything till the end of 9th yr. therefore we
subtract PVAF @ 10% for 9 yrs.
i.e. PVAF25 PVAF9 = 9.077 5.759 =3.318
Therefore, the present value of the pension will be
= 3.318* 3000 = Rs 9954
problems
How long will it take to double your money
if it grows at 12% annually ?
If a person deposits Rs 1000 on an
account that pays him 10% for the first 5
yrs and 13% for the following eight yrs,
what is the annual compound rate of
interest for the 13 yr period?
problems
Amount = 1000
interest rate for (1-5)yr = 10%
interest rate for (6-13) yrs = 13%
compound value for 13 yr period
= 1000 * (1.15)5 * (1.13)8 = 4281.45
the compound interest rate will be
= [ ( 4281.45/1000)1/13 1 ] = 11.84%
problems
A finance company makes an offer to
deposit a sum of Rs 1100 and then
receive a return of Rs 80 p.a. perpetually.
Should this offer be accepted if the rate of
interest is 8% ? Will the decision change if
the rate of interest is 5%?
Problems
The person should accept the offer if the
present value (PV) of the perpetuity is
more than the initial deposit of Rs 1100
If the rate of interest is 8%
PV = A/i = 80/.08 = RS 1000 ( reject)
If the rate of interest is 5 %
PV = 80/.05 = Rs 1600( accept)
problems
What is the minimum amount which a
person should be ready to accept today
from a debtor who otherwise has to pay a
sum of Rs 5000 today, Rs 6000, Rs 8000
and Rs 9000 and Rs 10000 at the end of
yr 1,2,3,4 respectively from today. The
rate of interest is 14%.
problems
Soln : the minimum amt. is the PV of the series of amt.
due ,discounted at 14% , as follows:
year
Amt due
PVF(n,14%)
PV
5000
5000
6000
0.877
5262
8000
0.769
6152
9000
0.675
6075
10000
0.592
5920
28409
problems
A company is expected to declare a
dividend of Rs2 at the end of first year
from now and this dividend is expected to
grow 10% every year . What is the PV of
this stream of dividends if the rate of
interest is 15%?
problems
Soln : PV = A /(i - g). Eqn #1
it is a perpetuity which is growing @ 10% p.a.
The formula
P = A/(1+g)[ ( 1-(1+i*)-n) /i*]
Here, n = , hence we get Eqn # 1
Solving for PV we obtain,
PV = 2/(0.15-0.10) = Rs 40
WORKBOOK
PART -1
Page 25 onwards , questions109,120,123,134,133,131
PART II
Page 109 onwards, questions 9,12,18,21,33,43,50,85,103
summary
The concept of TVM refers to the fact that
the money received today is different in its
worth from the money receivable some
time in the future.
Some business & personal decisions like
Capital recovery, Loan Amortization ,
returns from bonds etc can be effectively
determined using TVM.
Topics
Concept of Risk & Return
Sources of risk
Portfolio and risk
CAPM ( Capital Asset Pricing Model)
Concept of returns
Required Returns (Ex post) are
statistically derived from historical
observations.
Expected Returns (Ex ante) are
statistically derived expected values from
future estimates of observations.
Probability
(3)
E(R)
(4)=(2)*(3)
Growth
18.5
0.25
4.63
Expansion
10.5
0.25
2.62
Stagnation 1.0
0.25
0.25
Decline
0.25
-1.50
-6.0
6.00
Sources of Risk
Sources of Risk
3. Liquidity Risk: ease with which a
security can be bought or sold without
much transaction cost.
4. Financial Risk: influenced by the
degree of financial leverage
Sources of Risk
5. Interest Rate Risk: changes in the
interest rates.
6. Inflation Risk: change in the inflation
influences the purchasing power of
the investors.
Measuring Risk
Risk of an asset can be measured in
terms of its variance.
More the deviation from the expected
value , more riskier the asset.
DIV (Rs)
1.53
1.53
1.53
2.0
2.0
2.0
AMP (Rs)
31.25
20.75
30.88
67.00
100.00
154.00
solution
Div1 P1 P0
Expected Return = r =
+
P0
P0
R88 = [1.53 + 20.75-31.25]/ 31.25 = -0.287
Similarly,
R89 = 56.2%,R90 = 123.4%,R91 = 52.2%,R92 = 57%
Rm = 1/5 {-28.7+56.2+123.4+52.2+57} = 52%
To determine the riskness of the share, we calculate the
variation of the returns :
2 =1/5{ (-28.7-52)2 + (56.2-52)2 + (123.4 52)2 + (52.2-52)2 +
(57-52)2} = 2330.63 or S.D = 48.28
Firm Y
-70
15
100
Rate of
Return (%)
Investment alternatives
Economy
Prob.
GOI
HLL
HNC
ACC
MP
Recession
0.1
8.0%
-22.0%
28.0%
10.0%
-13.0%
Below avg
0.2
8.0%
-2.0%
14.7%
-10.0%
1.0%
Average
0.4
8.0%
20.0%
0.0%
7.0%
15.0%
Above avg
0.2
8.0%
35.0%
-10.0%
45.0%
29.0%
Boom
0.1
8.0%
50.0%
-20.0%
30.0%
43.0%
k = k i Pi
i=1
Exp return
17.4%
15.0%
13.8%
8.0%
1.7%
= (k i k ) Pi
i=1
GOI
ACC
HLL
13.8
17.4
Risk,
GOIs
8.0%
0.0%
HLL
17.4%
20.0%
HNC*
1.7%
13.4%
ACC*
13.8%
18.8%
Market
15.0%
15.3%
Security
Std dev
CV =
= ^
Mean
k
Risk rankings,
by coefficient of variation
GOI
HLL
HNC.
ACC
Market
CV
0.000
1.149
7.882
1.362
1.020
ACC Ltd
courtesy: J P Morgan
300
250
200
150
40000
30000
20000
10000
x100
Dominant principle
Markowitzs Portfolio theory
Two asset portfolio
Efficient frontier
The CAPM
3%
4%
15%
3%
12%
Markowitz Diversification
Although there are no securities with
perfectly negative correlation, almost all
assets are less than perfectly correlated.
Therefore, you can reduce total risk (p)
through diversification. If we consider
many assets at various weights, we can
generate the efficient frontier.
Risk revisited
Unsystematic Risk
... is that portion of an assets total risk which
can be eliminated through diversification
Systematic Risk
... is that risk which cannot be eliminated
Inherent in the marketplace
Diversification
Risk
75% of Co.
Total Risk
Unsystematic
Risk
25% of Co.
Total Risk
Systematic Risk
1
10
20
30
No. of Assets
Efficient Frontier
The Efficient Frontier represents all the
dominant portfolios in risk/return space.
There is one portfolio (M) which can be
considered the market portfolio if we
analyze all assets in the market. Hence,
M would be a portfolio made up of assets
that correspond to the real relative weights
of each asset in the market.
Expected
Portfolio
Return, kp
Efficient Set
Feasible Set
Risk, p
Expected
Return, kp
IB2 I
B1
IA2
IA1
Optimal Portfolio
Investor B
Optimal Portfolio
Investor A
Optimal Portfolios
Risk p
E(R)
Tangent Portfolio
4
I
3
I
2
I
2
I
=
=
=
Market portfolio
Risk free rate
Market risk premium
= Slope of the CAPM
^
k
M
kRF
.
M
Risk, p
^
kp = kRF +
Intercept
^
kM - kRF
M
Slope
p.
Risk
measure
Expected
Return, kp
CML
I2
^
k
M
^
k
I1
.
.
R = Optimal
Portfolio
kRF
R M
Risk, p
Cost of Capital
Cost of capital
Returns from the firms perspective
Firm raises money from both equity investors
and lenders. Both group of investors make their
investments expecting to make a return .
Firms average cost of funds, which is the
average return required by firms investors
What must be paid to attract funds
Long-Term
Debt
Preferred Stock
Retained
Earnings
Common Stock
New Common
Stock
Cost of equity/debt
Expected returns for the equity investors,
would include a premium for the risk in the
investment.. Cost of equity
Expected returns the lenders hope to
make on their investments, includes a
premium for default risk .. Cost of debt.
wd
k dT
w ps
k ps
ws
ks
Basic Definitions
Capital Component
Types of capital used by firms to raise
money
kd = before tax interest cost
kdT = kd(1-T) = after tax cost of debt
kps = cost of preferred stock
ks = cost of retained earnings
ke = cost of external equity (new stock)
k ps =
D ps
NP
D ps
P0 Flotation costs
D ps
P0 (1 F)
D
1
k =k
+ RP =
+ g = k
s
RF
s
P
0
= 0.35(15%)
= 5.25%.
Estimate
CAPM
14.2%
DCF
13.8%
kd + RP
14.0%
Average
14.0%
Rs 4.40
Rs 42.50
+ 5.0% = 15.4%.
Market conditions.
Level of interest rates
Tax rates
The firms capital structure and dividend
policy.
The firms investment policy. Firms with
riskier projects generally have a higher
WACC.
Acceptance Region
W ACC
12.0
8.0
Rejection Region
10.5
10.0
9.5
B
L
Risk L
Risk A
Risk H
Risk
Project H
11.0
10.0
9.0
7.0
WACC
Division Hs WACC
Project L
Composite WACC
for Firm A
Division Ls WACC
RiskL
Risk Average
RiskH
Risk
Take note
Use of current cost of debt : the interest
rate the firm would pay if it issues the debt
today.
when determining the market risk
premium, use current rate in both the
cases . i.e. current risk free rate & current
expected rate of return on the stock.
Revision session
Intro to FM
Time value of Money
Valuation of securities
Risk & return
Cost of capital
Introduction to FM
1.
2.
3.
Introduction to FM
THE FIRM
Introduction
Future value of a single cash flow
Present value of a single flow
Multiple flows and Annuity
Introduction
The most important concept in finance
Time preference for money
Risk or uncertainty of future cash flows
Preference for present consumption (PPP)
Investment opportunities
PV = ?
10%
100
k%
PMT
PMT
PMT
PMT
3
PMT
Annuity Due
0
k%
PMT
10%
100
100
100
110
121
FV
= 331
100
300
300
-50
10%
100
300
300
-50
10%
90.91
247.93
225.39
-34.15
530.08 = PV
Problems
1. Mahesh deposits $5,000 in a savings
account earning 8% interest annually.
(a)
(b)
solution
(a) Future value
FV = PV(1 + i)n
FV = $5,000(1 + .08)12
FV = $5,000(2.518)
FV = $12,590
(b)
4 = (1.08)n
Read down the 8% column of the future value table until
the value 4 is found. The value 4 is not found exactly,
but it can be determined that N is approximately 18
years.
Solution # 1
(i) time preference (discount rate) = 9%
investments = 15,000
time period = 4 yrs.
CVF(4,9%) = 1.4116 (appox.)
FV = 15,000*(1.09)4 = 15,000* 1.4116
= 21,173.72
(ii) Investments = 6000 (now) & 6000( 1 yr after)
period (eoy) = 5 yrs & 5yrs
compounding period = 5 & 4 yrs
CVF = 1.5386 & 1.4116
FV = 9231.74 & 8469.49
Solution # 1
(iii) Annual investments (eoy) = 18,000
time period = 8 yrs.
CVAF = 11.0285 (appox.)
FV = 18,000* 11.0285 = 198,513
(iv) Investments (b0y)= 18000
period = 8 yrs
CVAF (annuity due) = 12.0210
FV = 18000 * 12.0210 = 216378
Solution # 1
withdrawal
(v)
Balance
18000
82316.32
89724.79
12000
77724.79
84720.02
12000
72720.0211
79264.82
12000
67264.823
73318.66
73318.65707
problems
A company is expected to declare a
dividend of Rs2 at the end of first year
from now and this dividend is expected to
grow 10% every year . What is the PV of
this stream of dividends if the rate of
interest is 15%?
problems
Soln : PV = A /(i - g). Eqn #1
it is a perpetuity which is growing @ 10% p.a.
The formula
P = A/(1+g)[ ( 1-(1+i*)-n) /i*]
Here, n = , hence we get Eqn # 1
Solving for PV we obtain,
PV = 2/(0.15-0.10) = Rs 40
An Example
A dividend stream commencing one year
hence at Rs 66 is expected to grow at
10% annum for 15 Yrs and then ceases. If
the discount rate is 21%, what is the PV of
the expected series.
soln: P = A/(1+g)[ ( 1-(1+i*)-n) /i*]
Where, i* = (i-g)/(1+g)
i* =(0.21-0.10)/1.10 = 0.10
A/(1+g) = 66/1.10 = 60
Valuation of Securities
Bond valuation
Equity valuation
Concepts of valuation
In general, the value of an asset is the
price that a willing and able buyer pays to
a willing and able seller
Note that if either the buyer or seller is not
both willing and able, then an offer does
not establish the value of the asset
Intrinsic Value
Intrinsic Value - The present value of the
expected future cash flows discounted at the
decision makers required rate of return
INT
INT
M
VB =
+ ... +
+
1
N
N
(1 + k d )
(1 + k d )
(1 + k d )
Where,
INT = annual coupon payment
Kd = req. rate of return/discount rate
N = time period.
VB = INT *PVAFn,i + M* PVFn,i
Yield To Maturity
Yield to maturity (YTM) : rate of return earned on
bond held until maturity
The IR when:
Price of the bond = PV of all cash flow
receivables
Eg : par value : Rs 1000, CI = 9%,time to maturity
= 8and currently priced at Rs 800. what will be
the yield to maturity?
sol: An appox.
= INT + (M-P)/n
0.4M + 0.6 P
= 13.06%
examples
#1: the govt. is proposing to sell a 5-year
bond of Rs 1000 @ 8% IR per annum. The
bond amount will be amortized equally
over its life. If an investor has a minimum
required rate of return of 7%, what is the
bonds present value for him?
solution
Sol #1:the amt of interest will go on reducing
because of amortization. The amount of
interest for five years will be :
Rs 1000 * 0.08 = Rs 80
Rs (1000 200)*.08 = Rs 64
P = 280/(1+0.07) +264/(1+0.07)2
+216/(1+0.07)5
= Rs 1025.66
Div1
Div2
Div H + PH
P0 =
+
+...+
H
1
2
(1 + r ) (1 + r )
(1 + r )
3.00
3.24
3.50 + 94.48
PV =
+
+
1
2
3
(1+.12 ) (1+.12 )
(1+.12 )
PV = Rs 75
Div1
P0 =
rg
Given any combination of variables in the
equation, you can solve for the unknown
variable.
Concept of returns
Mean Returns (Ex post) are statistically
derived from historical observations.
Expected Returns (Ex ante) are
statistically derived expected values from
future estimates of observations.
Sources of Risk
Sources of Risk
3. Liquidity Risk: ease with which a
security can be bought or sold without
much transaction cost.
4. Financial Risk: influenced by the
degree of financial leverage
Sources of Risk
5. Interest Rate Risk: changes in the
interest rates.
6. Inflation Risk: change in the inflation
influences the purchasing power of
the investors.
Measuring Risk
Risk of an asset can be measured in
terms of its variance.
More the deviation from the expected
value , more riskier the asset.
Dominant principle
Markowitzs Portfolio theory
Two asset portfolio
Efficient frontier
The CAPM
Diversification
Risk
75% of Co.
Total Risk
Unsystematic
Risk
25% of Co.
Total Risk
Systematic Risk
1
10
20
30
No. of Assets
Firm Y
-70
15
100
Rate of
Return (%)
^
k
M
kRF
.
M
Risk, p
^
kp = kRF +
Intercept
^
kM - kRF
M
Slope
p.
Risk
Measure
Expected
Return, kp
CML
I2
^
k
M
^
k
I1
.
.
R = Optimal
Portfolio
kRF
R M
Risk, p
ABOUT BETA ..
Question # 3
The risk free rate is 8%. The expected
return on the market portfolio is 16%.
Calculate the expected return on the
following securities.
security
A
B
beta
0.4
1.0
C
D
2.6
2.0
Solution # 3
Given, risk free rate
8%. R(f)
The expected return
on the market
portfolio 16%... R(m)
security
0.4
2.6
11.20%
16.00%
28.80%
24.00%
Question # 4
Calculate the beta
factor of the following
investments. Is
acceptance of the
investment worthwhile
based upon its level
of risk? The risk free
rate = 6%.
Prob.
Market Invest.
1/3
9%
6%
1/3
12%
30%
1/3
18%
18%
Solution # 4
prob(P)
P*(Rm-Avg(Rm))^2
P(1)(2)
Rm -Avg(Rm)
Ri -Avg (Ri)
(1)
(2)
0.33
-4.00
-12.00%
5.28
0.33
-1.00
12.00%
0.33
0.33
5.00
0.00%
8.25
13.86
0.12
0.158
-0.036
Question # 5
Solution # 5
Beta = Cov(s,m)/ m2 = sm cor(s,m)/ m2
Solving for the given values, we obtain
1. 20*15*0.7/225 = 0.93
2. 0.53
3. -0.33
Question # 6
1.
2.
Solution # 6
Solution # 6
2.
Effect on price :
(i) if the risk premium increases by 2%,
Then R = 13.8% +2%
Therefore the equilibrium price (P) = Rs. 24.32
(ii) g=10%
We obtain, P =Rs. 57.9
(iii) Beta = 1.3 then, R = 14.2%
Hence , P = Rs. 29.72
Multiple choice
1.
2.
3.
4.
Multiple choice
1.
2.
3.
4.
Multiple choice
1.
2.
3.
4.
5.
Multiple choice
1.
2.
3.
4.
5.
Multiple choice
An economic survey
suggests that an
economic boom is in
offering. The following
data are available with
regards to asset A and B
Asset Beta
Correlation Residual
with market variance
returns
(%
squared)
1.5
0.9
0.1
0.1
1. Buy A
2. Sell A
3. Invest half of funds in A & other half in B
4. Buy B
CAPM-Assumptions
Individual investors are price takers.
Single-period investment horizon.
Investments are limited to traded financial
assets.
No taxes and transaction costs.
Assumptions (contd)
Information is costless and available to all
investors.
Investors are rational mean-variance
optimizers.
There are homogeneous expectations.
Cost of capital
Returns from the firms perspective
Firm raises money from both equity investors
and lenders. Both group of investors make their
investments expecting to make a return .
Firms average cost of funds, which is the
average return required by firms investors
What must be paid to attract funds
Long-Term
Debt
Preferred Stock
Retained
Earnings
Common Stock
New Common
Stock
Cost of equity
Expected returns for the equity investors
would include a premium for the risk in the
investment.. Cost of equity
Expected returns the lenders hope to
make on their investments includes a
premium for default risk .. Cost of debt.
Basic Definitions
Capital Component
Types of capital used by firms to raise
money
kd = before tax interest cost
kdT = kd(1-T) = after tax cost of debt
kps = cost of preferred stock
ks = cost of retained earnings
ke = cost of external equity (new stock)
k ps =
D ps
NP
D ps
P0 Flotation costs
D ps
P0 (1 F)
D
1
k =k
+ RP =
+ g = k
s
RF
s
P
0
wd
k dT
w ps
k ps
ws
ks
A Pictorial View
WACC lowest
Market conditions.
Level of interest rates
Tax rates
The firms capital structure and dividend
policy.
The firms investment policy. Firms with
riskier projects generally have a higher
WACC.
mistakes to avoid
Use of current cost of debt : the interest
rate the firm would pay if it issues the debt
today.
when determining the market risk
premium, use current rate in both the
cases . i.e. current risk free rate & current
expected rate of return on the stock.
Important !!!
Important!!
See problem number 64 and 71 of
workbook . (page # 583 and page# 585)