Unit -2

2.1 CAPITAL ANALYSIS OF APPRAISAL TECHNIQUES

2.1.1 CAPITAL INVESTMENT ANALYSIS
INTRODUCTION
A budgeting procedure that companies and government agencies use to assess the potential
profitability of a long-term investment. Capital investment analysis assesses long-term
investments, which might include fixed assets like equipment, machinery or real estate. The goal
of this process is to pinpoint the option that is most likely to be the most profitable for the
business. usinesses may use techniques such as discounted cash flow analysis, risk-return
analysis, risk-neutral valuation and utility theory in a capital investment analysis.
Capital investments are risky because they involve large, up-front expenditures on assets
intended for many years of service and that will take a long time to pay for themselves. !f a
capital investment is financed, it must earn an even greater return, to compensate for the interest
the company must pay on the financed funds. "urthermore, a poor investment decision may not
be reversible. "or all of these reasons, it is crucial that a company perform a capital investment
analysis before making any high-stakes capital investment decision
2.1.2 COMPREHENSIVE CAPITAL ANALYSIS AND REVIEW
The Comprehensive Capital Analysis and #eview $CCA#% is an annual exercise by the "ederal
#eserve to ensure that institutions have robust, forward-looking capital planning processes that
account for their unique risks and sufficient capital to continue operations throughout times of
economic and financial stress. As part of the CCA#, the "ederal #eserve evaluates institutions&
capital adequacy, internal capital adequacy assessment processes, and their plans to make capital
distributions, such as dividend payments or stock repurchases. The CCA# includes a supervisory
stress test to support the "ederal #eserve&s analysis of the adequacy of the firms& capital. oards
of directors of the institutions are required each year to review and approve capital plans before
submitting them to the "ederal #eserve.
Comparison of the sums to be invested in a pro'ect with the earnings expected over the period of
the investment, expressed usually as return-on-investment $#(!% percentage per accounting
period.
2.1.3 OVERVIEW OF APPRAISAL TECHNIQUES
The basic purpose of systematic appraisal is to achieve better spending decisions for capital and
current expenditure on schemes, pro'ects and programmes. This document provides an overview
of the main analytical methods and techniques which should be used in the appraisal process.
These techniques can also be used in the evaluation process.
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An understanding of discounting and )et *resent +alue $)*+% calculations is fundamental to
proper appraisal of pro'ects and programmes. A good understanding of Cost enefit Analysis
$CA%, !nternal #ate of #eturn $!##%, ,ulti Criteria Analysis $,CA% and Cost -ffectiveness
Analysis $C-A% is also essential for economic appraisal purposes.
Analti!al "#t$%&'
The recommended analytical methods for appraisal are generally discounted cash flow
techniques which take into account the time value of money. *eople generally prefer to receive
benefits as early as possible while paying costs as late as possible. Costs and benefits occur at
different points in the life of the pro'ect so the valuation of costs and benefits must take into
account the time at which they occur. This concept of time preference is fundamental to proper
appraisal and so it is necessary to calculate the present values of all costs and benefits.
N#t P(#'#nt Val)# M#t$%& *NPV+
!n the )*+ method, the revenues and costs of a pro'ect are estimated and then are discounted
and compared with the initial investment. The preferred option is that with the highest positive
net present value. *ro'ects with negative )*+ values should be re'ected because the present
value of the stream of benefits is insufficient to recover the cost of the pro'ect.
Compared to other investment appraisal techniques such as the !## and the discounted payback
period, the )*+ is viewed as the most reliable technique to support investment appraisal
decisions. There are some disadvantages with the )*+ approach. !f there are several independent
and mutually exclusive pro'ects, the )*+ method will rank pro'ects in order of descending )*+
values. .owever, a smaller pro'ect with a lower )*+ may be more attractive due to a higher
ratio of discounted benefits to costs $see C# below%, particularly if there affordability
constraints.
/sing different evaluation techniques for the same basic data may yield conflicting conclusions.
!n choosing between options A and , the )*+ method may suggest that option A is preferable,
while the !## method may suggest that option is preferable. .owever in such cases, the results
indicated by the )*+ method are more reliable. The )*+ method should be always be used
where money values over time need to be appraised. )evertheless, the other techniques also
yield useful additional information and may be worth using.
The key determinants of the )*+ calculation are the appraisal hori0on, the discount rate and the
accuracy of estimates for costs and benefits.
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Di'!%)nt (at#
The discount rate is a concept related to the )*+ method. The discount rate is used to convert
costs and benefits to present values to reflect the principle of time preference. The calculation of
the discount rate can be based on a number of approaches including, among others1
The social rate of time preference
The opportunity cost of capital
2eighted average method
The same basic discount rate $usually called the test discount rate or T3#% should be used in all
cost-benefit and cost-effectiveness analyses of public sector pro'ects.
The current recommended T3# is 45. .owever, given the recent changes in economic
circumstances, the current discount rate needs to be updated. This task will be undertaken by the
C--/ and the revised discount rate will be published in section - of the code 6#eference and
*arameter +alues.
.owever, if a commercial 7tate 7ponsored ody is discounting pro'ected cash flows for
commercial pro'ects, the cost of capital should be used or even a pro'ect-specific rate.
Int#(nal Rat# %, R#t)(n *IRR+
The !## is the discount rate which, when applied to net revenues of a pro'ect sets them equal to
the initial investment. The preferred option is that with the !## greatest in excess of a specified
rate of return. An !## of 895 means that with a discount rate of 895, the pro'ect breaks even.
The !## approach is usually associated with a hurdle cost of capital:discount rate, against which
the !## is compared. The hurdle rate corresponds to the opportunity cost of capital. !n the case
of public pro'ects, the hurdle rate is the T3#. !f the !## exceeds the hurdle rate, the pro'ect is
accepted.
There are disadvantages associated with the !## as a performance indicator. !t is not suitable for
the ranking of competing pro'ects. !t is possible for two pro'ects to have the same !## but have
different )*+ values due to differences in the timing of costs and benefits. !n addition, applying
different appraisal techniques to the same basic data may yield contradictory conclusions.
-#n#,it . C%'t (ati% *-CR+
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The C# is the discounted net revenues divided by the initial investment. The preferred option is
that with the ratio greatest in excess of 8. !n any event, a pro'ect with a benefit cost ratio of less
than one should generally not proceed. The advantage of this method is its simplicity.
/sing the C# to rank pro'ects can lead to suboptimal decisions as a pro'ect with a slightly
higher C# ratio will be selected over a pro'ect with a lower C# even though the latter pro'ect
has the capacity to generate much greater economic benefits because it has a higher )*+ value
and involves greater scale.
Pa/a!0 an& Di'!%)nt#& 1a/a!0
The payback period is commonly used as an investment appraisal technique in the private sector
and measures the length of time that it takes to recover the initial investment. .owever this
method presents obvious drawbacks which prevent the ranking of pro'ects. The method takes no
account of the time value of money and neither does it take account of the earnings after the
initial investment is recouped.
A variant of the payback method is the discounted payback period. The discounted payback
period is the amount of time that it takes to cover the cost of a pro'ect, by adding the net positive
discounted cashflows arising from the pro'ect. !t should never be the sole appraisal method used
to assess a pro'ect but is a useful performance indicator to contextualise the pro'ect;s anticipated
performance.
S#n'iti2it anal'i'
An important feature of a comprehensive CA is the inclusion of a risk assessment. The use of
sensitivity analysis allows users of the CA methodology to challenge the robustness of the
results to changes in the assumptions made $i.e. discount rate, time hori0on, estimated value of
costs and benefits, etc%. !n doing so, it is possible to identify those parameters and assumptions to
which the outcome of the analysis is most sensitive and therefore, allows the user to determine
which assumptions and parameters may need to be re-examined and clarified.
7ensitivity analysis is the process of establishing the outcomes of the cost benefit analysis which
is sensitive to the assumed values used in the analysis. This form of analysis should also be part
of the appraisal for large pro'ects. !f an option is very sensitive to variations in a particular
variable $e.g. passenger demand%, then it should probably not be undertaken. !f the relative merits
of options change with the assumed values of variables, those values should be examined to see
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whether they can be made more reliable. !t can be useful to attach probabilities to a range of
values to help pick the best option.
7ensitivity analysis requires a degree of exploratory analysis to ascertain the most sensitive
variables and should lead to a risk management strategy involving risk mitigation measures to
ensure the most pessimistic values for key variables do not materialise or can be managed
appropriately if they do materialise.
!t is important to take into account the level of disaggregation of pro'ect inputs and benefits 6
sensitivity analysis based on a mix of highly aggregated and disaggregated variables may be
misleading.
S!#na(i% anal'i'
The scenario analysis technique is related to sensitivity analysis. 2hereas the sensitivity analysis
is based on a variable by variable approach, scenario analysis recognises that the various factors
impacting upon the stream of costs and benefits are inter-independent. !n other words, this
approach assumes that that altering individual variables whilst holding the remainder constant is
unrealistic $i.e. for a tourism pro'ect, it is unlikely that ticket sales and caf<-souvenir sales are
independent%. #ather, scenario analysis uses a range of scenarios $or variations on the option
under examination% where all of the various factors can be reviewed and ad'usted within a
consistent framework.
A number of scenarios are formulated 6 best case, worst case, etc 6 and for each scenario
identified, a range of potential values is assigned for each cost and benefit variable. 2hen
formulating these scenarios, it is important that appropriate consideration is given to the sources
of uncertainty about the future $i.e. technical, political, etc%. (nce the values within each scenario
have been reviewed, the )*+ of each scenario can then be recalculated.
S3it!$in4 2al)#'
This process of substituting new values on a variable-by-variable basis can be referred to as the
calculation of switching values. These can provide interesting insights such as what change$s%
would make the )*+ equal 0ero or alternatively, by how much must costs or benefits fall or rise,
respectively, in order to make a pro'ect worthwhile. The switching value is usually presented as a
5 i.e. a =95 increase in investment costs reduces pro'ect )*+ to 9.
5
This is very useful information and should be afforded a prominent place in any decision-making
process. ,oreover, given the importance of this information the switching values chosen should
be carefully considered and should be realistic and 'ustifiable. "or example, for capital pro'ects
requiring an -xchequer commitment over the medium to long-term, operating and maintenance
costs should always be examined. 7imilarly, any pro'ect reliant upon user charges should always
examine the impact of changes in volumes and the level of charges.
"inally, the -uropean Commission have suggested that when undertaking a sensitivity analysis a
useful determinant of the most critical variables is those for which a 8 per cent variation $>:-%
produces a corresponding variation of ? per cent or more in the )*+.
Di't(i/)ti%nal Anal'i'
The calculation of )*+;s makes no allowance for the distribution of costs and benefits among
members of society. This is an important drawback if the intended ob'ectives of a
programme:pro'ect aimed at specific income groups. 3ifferential impact may arise because of
income, gender, ethnicity, age, geographical location or disability and any distributional effects
should be explicit and quantified where appropriate. A common approach to take account of
distributional issues is to divide the relevant population into different income groups and analyse
the impact of the programme:pro'ect on these groups. 2eights can be attached to the different
groups to reflect @overnment policy. Carrying out a distributional analysis can be a difficult task
because costs and benefits are redistributed in unintended ways.
2.1.5 ECONOMIC APPRAISAL TECHNIQUES
-conomic analysis aims to assess the desirability of a pro'ect from the societal perspective. This
form of appraisal differs from financial appraisal because financial appraisal is generally done
from the perspective of a particular stakeholder e.g. an investor. 7ponsoring Authority or the
-xchequer. -conomic analysis also considers non-market impacts such as externalities.
C-A
The general principle of cost benefit analysis is to assess whether or not the social and economic
benefits associated with a pro'ect are greater than its social and economic costs. To this end, a
pro'ect is deemed to be desirable where the benefits exceed the costs. .owever, should the
benefits exceed the costs, this does not necessarily imply that a pro'ects will proceed as other
pro'ects with a higher net present value $)*+% may be in competition for the same scarce
resources. !n addition, there are affordability constraints which mean that pro'ects should not
proceed even if the )*+ is positive.
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!n cost-benefit analysis all of the relevant costs and benefits, including indirect costs and
benefits, are taken into account. Cash values, based on market prices $or shadow prices, where
no appropriate market price exists% are placed on all costs and benefits and the time at which
these costs:benefits occur is identified. The analytic techniques outlined above $i.e. )*+ method,
!## method, etc.% are applied using the T3#. The general principle of cost-benefit analysis is
that a pro'ect is desirable if the economic and social benefits are greater than economic and
social costs. !t is vital that cost-benefit analysis is ob'ective. !ts conclusions should not be
pre'udged. !t should not be used as a device to 'ustify a case already favoured for or against a
proposal. "actors of questionable or dubious relevance to a pro'ect should not be introduced into
an analysis in order to affect the result in a preferred direction.
A more detailed guide on how to carry out a CA is set out in *ublic 7pending Code 3.9A 6
@uide to -conomic Appraisal1 Carrying out a CA.
C%'t E,,#!ti2#n#'' Anal'i' *CEA+
!t is difficult to measure the value to society of public investment in social infrastructure because
the outputs may be difficult to specify accurately and to quantify, and are not frequently
marketed. !n cases like these, the cost of the various alternative options should be first
determined in monetary terms. A choice can then be made as to which of the options $if they all
achieve the same effects% is preferable. C-A is not a basis for deciding whether or not a pro'ect
should be undertaken. #ather, it is concerned with the relative costs of the various options
available for achieving a particular ob'ective. C-A will assist in the determination of the least
cost way of determining the capital pro'ect ob'ective. A choice can then be made as to which of
these options is preferable.
-valuating options in C-A is best done by applying the principles of the )*+ method to the
stream of cash outflows or costs. The recurring costs of using facilities as well as the capital
costs of creating them should be taken into account, particularly if they differ between alternative
options. /sually, the aim will be to select the option which minimises the net present cost.
There is a particular need for consistency in the assumptions and parameters adopted for CA
and C-A appraisals. C-A is most applicable to healthcare, scientific and educational pro'ects
where benefits can be difficult to evaluate.
C%'t Utilit Anal'i' *CUA+
C/A is a variant of C-A that measures the relative effectiveness of alternative interventions in
achieving two or more ob'ectives. !t is often used in health appraisals. !n a C/A, costs are
expressed in monetary terms and outcomes: benefits are expressed in utility terms e.g. outcomes
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are often defined in quality ad'usted life years $BACDs%. This outcome measure is a combination
of duration of life and health related quality of life. 2hereas in a CA, there is a requirement to
attempt to place a monetary value on all benefits, C/A allows for a comparison of the benefits of
health interventions without having to place a financial value on health states.
M)lti C(it#(ia Anal'i' *MCA+
,ulti-criteria analysis $,CA% establishes preferences between pro'ect options by reference to an
explicit set of criteria and ob'ectives. These would normally reflect policy:programme ob'ectives
and pro'ect ob'ectives and other considerations as appropriate, such as value for money, costs,
social, environmental, equality, etc. ,CA is often used as an alternative to appraisal techniques
because it incorporates multiple criteria and does not focus solely on monetary values.
,CAs often include Escoring and weightingF of the relevant criteria reflecting their relative
importance to the ob'ectives of the pro'ect. Care should be taken to try and minimise the
sub'ectivity of decision making in an ,CA as this is a common problem with carrying out
,CA;s. The relative importance of ob'ectives and criteria to achievement of the pro'ect will vary
from sector to sector. The 7ponsoring Agency should agree these with the 7anctioning Authority.
!n constructing a multi criteria analysis scorecard and determining the weightings to be given to
criteria the aim should be to achieve an ob'ective appraisal of pro'ect options and consistency in
decision making. Gudgments regarding the scoring of investment options should be based on
ob'ective, factual information. The 'ustification for scoring and weighting decisions must be
documented in detail. !n this regard, the system should be capable of producing similar results if
the selection criteria were applied by different decision makers.
The main steps in the ,CA process include1
8. !dentify the performance criteria for assessing the pro'ect
=. 3evise a scoring scheme for marking a pro'ect under each criterion heading
A. 3evise a weighting mechanism to reflect the relative importance of each criterion
4. Allocate scores to each investment option for each of the criteria
?. 3ocument the rationale for the scoring results for each option
H. Calculate overall results and test for robustness
I. #eport and interpret the findings
The importance of explaining the weights and scores fully, and interpreting the results carefully,
cannot be over-stressed.
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2.2 SI6NIFICANCE OF THE INFORMATION RE6ARDIN6 CAPITAL ANALYSIS
Capital investment appraisal involves the decision making process with respect to investment in
fixed assets specifically.
!t helps the manager to determining the long term ob'ective of the company business
The successful administration of capital investment appraisal involves
@eneration of investment proposal
7election of pro'ect budget
-xecution of pro'ect budget
-stimation of cash flow
!t help assist manager to improve and adopt strategies to reduce loss of capital in the
business operation.
!t ensure reliable methods of keeping records.
Capital investment decision implies taking decisions concerning big amount of capital
outlay.
!t also involves planning for improved performance.
@ood capital budgeting demands a comprehensive integrated and co-ordinate plan which
can provide guidelines for improved performance.
A firm;s decision to invest n long 6 term assets has a decision influence on the rate and
direction of growth. A wrong decision on investment adversely affects the progress of the
firm.
"uture events are assessed and these events are difficult to predict. Truly it is a complex
problem to correctly estimate future cash flow;s of an investment.
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The cash flow;s uncertainly is caused by economic, political social and technological
forces. !nvestment in capital assets might course firm to suffer for many years whole their
analysis is not properly done. enefit would accrue to a firm where investment in capital
has been properly analy0ed.
!t is therefore properly analy0ed budgeting process have to be well articulated for a firm
to derive good benefit from it.
2.3 PRO7ECT SELECTION
INTRODUCTION8
*ro'ect selection is the process of choosing a pro'ect or set of pro'ects to be implemented by the
organi0ation. 7ince pro'ects in general require a substantial investment in terms of money and
resources, both of which are limited, it is of vital importance that the pro'ects that an
organi0ation selects provide good returns on the resources and capital invested. This requirement
must be balanced with the need for an organi0ation to move forward and develop. The high level
of uncertainty in the modern business environment has made this area of pro'ect management
crucial to the continued success of an organi0ation with the difference between choosing good
pro'ects and poor pro'ects literally representing the difference between operational life and death.
ecause a successful model must capture every critical aspect of the decision, more complex
decisions typically require more sophisticated models.
*ro'ect 7election is a process to assess each pro'ect idea and select the pro'ect with the highest
priority. *ro'ects are still 'ust suggestions at this stage, so the selection is often made based on
only brief descriptions of the pro'ect. As some pro'ects will only be ideas, you may need to write
a brief description of each pro'ect before conducting the selection process.
7election of pro'ects is based on1
-#n#,it'8
A measure of the positive outcomes of the pro'ect. These are often described as Jthe reasons why
you are undertaking the pro'ectJ. The types of benefits of eradication pro'ects include1
o iodiversity
o -conomic
o 7ocial and cultural
o "ulfilling commitments made as part of national, regional or international plans
and agreements.
F#a'i/ilit8
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A measure of the likelihood of the pro'ect being a success, i.e. achieving its ob'ectives. *ro'ects
vary greatly in complexity and risk. y considering feasibility when selecting pro'ects it means
the easiest pro'ects with the greatest benefits are given priority.
W$ &% 3# 1lan 1(%9#!t:
(ften you will have a number of suggested pro'ects but not enough resources, money or time to
undertake all of the pro'ects. The ideas for eradication pro'ects may have come from many
sources including1 the community, funders, local and national governments and )on-
@overnmental (rgani0ations $)@(s%. Dou will therefore need a way of deciding on a priority
order and choosing a pro'ect.
!f your organisation has limited experience in conducting eradications then it is recommended to
concentrate on a small number of pro'ects, ideally one pro'ect at a time, until the people in your
organisation have developed the skills and experience. @row capacity and build up to
undertaking multiple pro'ects at any one time. 3o the easy pro'ects first. 2ork towards the most
difficult and rewarding pro'ects. /se the easy pro'ects to help answer questions:solve issues for
the more difficult pro'ects. /se the best opportunities to learn.
Dou may have a mix of straight forward and difficult eradication pro'ects and do not know where
to start. The *ro'ect 7election 7tage will assist you by providing a process to compare the
importance of the pro'ects and select the most suitable pro'ect to undertake.
y following the *ro'ect 7election 7tage you will follow a step by step ob'ective method for
prioriti0ing pro'ects - this can be used to explain to stakeholders the reasoning behind why you
selected a particular pro'ect.
The benefits of completing the *ro'ect 7election are1
a transparent and documented record of why a particular pro'ect was selected
a priority order for pro'ects, that takes into account their importance and how achievable
the pro'ect is.
W$#n t% &%:
/ndertake a *ro'ect 7election when you have more ideas than the number of pro'ects you can
undertake and need to select the pro'ect that should be given priority.
N%t#8 !f you only have 8 pro'ect, it may still be useful to score the pro'ect against a set of criteria
to identify the strengths and weaknesses of the pro'ect. The results may be useful later in the
"easibility 7tudy 7tage.
W$% '$%)l& /# in2%l2#&:
A4#n! Mana4#"#nt8
7et selection criteria to ensure the selection process aligns with agency strategies.
7election processes are often run as a management initiative before the implementing
*ro'ect ,anager is assigned.
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Sta0#$%l&#('8
7takeholder participation at the start of a pro'ect creates strong community ownership and
support, and increases the chances of a successful outcome.
7takeholder input should be included at the ideas stageK consult widely as you are
developing the ideas for pro'ects as the community will be the source of many of the best
pro'ect ideas.
7takeholders must be informed of the outcome of the *ro'ect 7election 7tage.
P(%9#!t Mana4#(8
!nvolving the *ro'ect ,anager in the *ro'ect 7election process will help build ownership in the
pro'ect and support a successful pro'ect in the long run.
There are various pro'ect selection methods practiced by the modern business organi0ations.
These methods have different features and characteristics. Therefore, each selection method is
best for different organi0ations.
Although there are many differences between these pro'ect selection methods, usually the
underlying concepts and principles are the same.
"ollowing is an illustration of two of such methods $enefit ,easurement and Constrained
(ptimi0ation methods%.
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As the value of one pro'ect would need to be compared against the other pro'ects, you could use
the benefit measurement methods. This could include various techniques, of which the following
are the most common.
Dou and your team could come up with certain criteria that you want your ideal pro'ect
ob'ectives to meet. Dou could then give each pro'ect scores based on how they rate in each of
these criteria, and then choose the pro'ect with the highest score.
2hen it comes to the 3iscounted Cash flow method, the future value of a pro'ect is
ascertained by considering the present value and the interest earned on the money. The higher the
present value of the pro'ect, the better it would be for your organi0ation.
The rate of return received from the money is what is known as the !##. .ere again, you
need to be looking for a high rate of return from the pro'ect.
The mathematical approach is commonly used for larger pro'ects. The constrained optimi0ation
methods require several calculations in order to decide on whether or not a pro'ect should be
re'ected.
Cost-benefit analysis is used by several organi0ations to assist them to make their selections.
@oing by this method, you would have to consider all the positive aspects of the pro'ect, which is
the benefits, and then deduct the negative aspects $or the costs% from the benefits. ased on the
results you receive for different pro'ects, you could choose which option would be the most
viable and financially rewarding.
These benefits and costs need to be carefully considered and quantified in order to arrive at a
proper conclusion. Buestions that you may want to consider asking are in the selection process
are1
2ould this decision help me to increase organi0ational value in the long runL
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.ow long will the equipment last forL
2ould ! be able to cut down on costs as ! go alongL
!n addition to these methods, you could also consider Choosing based on opportunity cost -
2hen choosing any pro'ect, you would need to keep in mind the profits that you would make if
you do decide to go ahead with the pro'ect.
*rofit optimi0ation is therefore the ultimate goal. Dou need to consider the difference between
the profits of the pro'ect you are primarily interested in, and the next best alternative.
I"1l#"#ntati%n %, t$# C$%'#n M#t$%&8
The methods mentioned above can be carried out in various combinations. !t is best that you try
out different methods, as in this way you would be able to make the best decision for your
organi0ation considering a wide range of factors rather than concentrating on 'ust a few. Careful
consideration would therefore need to be given to each pro'ect.
2.5 PRO7ECT DECISIONS
EThere is a simple solution to every complex problemK unfortunately, it is wrongF. This reality
creates a ma'or challenge for tool designers. *ro'ect decisions are often high-stakes, dynamic
decisions with complex technical issuesMprecisely the kinds of decisions that are most difficult
to model1
N *ro'ect selection decisions are high-stakes because of their strategic implications. The pro'ects
a company chooses can define the products it supplies, the work it does, and the direction it takes
in the marketplace. Thus, pro'ect decisions can impact every business stakeholder, including
customers, employees, partners, regulators, and shareholders. A sophisticated model may be
needed to capture strategic implications.
N *ro'ect decisions are dynamic because a pro'ect may be conducted over several budgeting
cycles, with repeated opportunities to slow, accelerate, re-scale, or terminate the pro'ect. Also, a
successful pro'ect may produce new assets or products that create time-varying financial returns
and other impacts over many years. A more sophisticated model is needed to address dynamic
impacts.
N *ro'ect decisions typically produce many different types of impacts on the organi0ation.
"or example, a pro'ect might increase revenue or reduce future costs. !t might impact how
customers or investors perceive the organi0ation. !t might provide new capability or learning,
important to future success. ,aking good choices requires not 'ust estimating the financial return
on investmentK it requires understanding all of the ways that pro'ects add value. A more
sophisticated model is needed to account for all of the different types of potential impacts that
pro'ect selection decisions can create.
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*ro'ect decisions often entail risk and uncertainty. The significance of a pro'ect risk depends on
the nature of that risk and on the other risks that the organi0ation is taking. A more sophisticated
model is needed to correctly deal with risk and uncertainty.
*ro'ect selection is the process of evaluating individual pro'ects or groups of pro'ects, and then
choosing to implement some set of them so that the ob'ectives of the parent organi0ation will be
achieved. This same systematic process can be applied to any area of the organi0ation;s business
in which choices must be made between competing alternatives. "or example1
A manufacturing firm can use evaluation:selection techniques to choose which machine
to adopt in a part-fabrication process.
A television station can select which of several syndicated comedy shows to rerun in its
I1A9 p.m. weekday time-slot
A construction firm can select the best subset of a large group of potential pro'ects on
which to bid
A hospital can find the best mix of psychiatric, orthopedic, obstetric, and other beds for a
new wing.
-ach pro'ect will have different costs, benefits, and risks. #arely are these known with certainty.
!n the face of such differences, the selection of one pro'ect out of a set is a difficult task.
Choosing a number of different pro'ects, a portfolio, is even more complex.
!n the following sections, we discuss several techniques that can be used to help senior managers
select pro'ects. *ro'ect selection is only one of many decisions associated with pro'ect
management. To deal with all of these problems, we use decision aiding models. 2e need such
models because they abstract the relevant issues about a problem from the plethora of detail in
which the problem is embedded. #eality is far too complex to deal with in its entirety. An
EidealistF is needed to strip away almost all the reality from a problem, leaving only the aspects
of the ErealF situation with which he or she wishes to deal. This process of carving away the
unwanted reality from the bones of a problem is called modeling the problem.
The ideali0ed version of the problem that results is called a model. The model represents the
problem;s structure, its form. -very problem has a form, though often we may not understand a
problem well enough to describe its structure. 2e will use many models in this bookMgraphs,
analogies, diagrams, as well as flow graph and network models to help solve scheduling
problems, and symbolic $mathematical% models for a number of purposes.
A model is an ob'ect or concept, which attempts to capture certain aspects of the real world. The
purpose of models can vary widely, they can be used to test ideas, to help teach or explain new
concepts to people or simply as decorations. 7ince the uses that models can be put are so many it
is difficult to find a definition that is both clear and conveys all the meanings of the word. !n the
context of pro'ect selection the following definition is useful1
EA model is an explicit statement of our image of reality. !t is a representation of the relevant
aspects of the decision with which we are concerned. !t represents the decision area by
15
structuring and formali0ing the information we possess about the decision and, in doing so,
presents reality in a simplified organi0ed form. A model, therefore, provides us with an
abstraction of a more complex realityF.
2hen pro'ect selection models are seen from this perspective it is clear that the need for them
arises from the fact that it is impossible to consider the environment, within which a pro'ect will
be implemented, in its entirety. The challenge for a good pro'ect selection model is therefore
clear. !t must balance the need to keep enough information from the real world to make a good
choice with the need to simplify the situation sufficiently to make it possible to come to a
conclusion in a reasonable length of time.
2.5.1 CRITERIA FOR CHOOSIN6 PRO7ECT MODEL8
8. #ealism1
=. Capability1
A. "lexibility1
4. -ase of /se1
?. Cost1
H. -asy Computeri0ation1
2.5.2 THE NATURE OF PRO7ECT SELECTION MODELS8
There are two basic types of pro'ect selection models, numeric and nonnumeric. oth are widely
used. ,any organi0ations use both at the same time, or they use models that are combinations of
the two. )onnumeric models, as the name implies, do not use numbers as inputs. )umeric
models do, but the criteria being measured may be either ob'ective or sub'ective. !t is important
to remember that the qualities of a pro'ect may be represented by numbers, and
that sub'ective measures are not necessarily less useful or reliable than ob'ective measures.
efore examining specific kinds of models within the two basic types, let us consider 'ust what
we wish the model to do for us, never forgetting two critically important, but often overlooked
facts.
N ,odels do not make decisionsMpeople do. The manager, not the model, bears responsibility
for the decision. The manager may EdelegateF the task of making the decision to a model, but the
responsibility cannot be abdicated.
N All models, however sophisticated, are only partial representations of the reality they are meant
to reflect. #eality is far too complex for us to capture more than a small fraction of it in any
model. Therefore, no model can yield an optimal decision except within its own, possibly
inadequate, framework.
16
2.5.3 TYPES OF PRO7ECT SELECTION MODELS8
(f the two basic types of selection models $numeric and nonnumeric%, nonnumeric models are
older and simpler and have only a few subtypes to consider. 2e examine them first.
N%n-N)"#(i! M%&#l'8
These include the following1
8. The 7acred Cow1
=. The (perating )ecessity1
A. The Competitive )ecessity1
4. The *roduct Cine -xtension1
?. Comparative enefit ,odel1
2.5.5 INVESTMENT DECISIONS
!nvestment decisions are made by investors and investment managers.
!nvestors commonly perform investment analysis by making use of fundamental analysis,
technical analysis and gut feel.
!nvestment decisions are often supported by decision tools. The portfolio theory is often applied
to help the investor achieve a satisfactory return compared to the risk taken.
(ne of the most important long term decisions for any business relates to investment. !nvestment
is the purchase or creation of assets with the ob'ective of making gains in the future. Typically
investment involves using financial resources to purchase a machine: building or other asset,
which will then yield returns to an organisation over a period of time.
Oey considerations in making investment decisions are1
8. 2hat is the scale of the investment - can the company afford itL
=. .ow long will it be before the investment starts to yield returnsL
A. .ow long will it take to pay back the investmentL
4. 2hat are the expected profits from the investmentL
?. Could the money that is being ploughed into the investment yield higher returns elsewhereL
DEFINITION OF INVESTMENT DECISION
17
A determination made by directors and:or management as to how, when, where and how much
capital will be spent on investment opportunities. The decision often follows research to
determine costs and returns for each option
Capital investments are funds invested in a firm or enterprise for the purposes of furthering its
business ob'ectives. Capital investment may also refer to a firm&s acquisition of capital assets or
fixed assets such as manufacturing plants and machinery that are expected to be productive over
many years. 7ources of capital investment are manifold and can include equity investors, banks,
financial institutions, venture capital and angel investors. 2hile capital investment is usually
earmarked for capital or long-life assets, a portion may also be used for working capital
purposes.
Capital investment encompasses a wide variety of funding options. 2hile funding for capital
investment is generally in the form of common or preferred equity issuance, it may also be
through straight or convertible debt. "unding may range from an amount of less than P899,999 in
seed financing for a start-up to amounts in the hundreds of millions for massive pro'ects in
capital-intensive sectors like mining, utilities and infrastructure.
To what extent do fnancing frictions constrain investments that frms woud
otherwise ma!e" This #uestion is argua$% one of the most im&ortant in
cor&orate fnance' and one a$out
which there continues to $e signifcant de$ate( )ince *a++ari'
,u$$ard' and -eterson .1988/ frst estimated the sensitivit% of investment to
interna cash 0ow generation' the iterature has argued a$out whether their
fnding that greater interna ca&ita corres&onds to greater investment was
driven $% the reaxing of fnancing constraints ena$ing investment that
woud otherwise have $een forgone or whether the higher interna cash 0ow
mere% &roxied for im&rovements in investment o&&ortunities $e%ond the
contros in their s&ecifcation .1a&an and 2ingaes' 2000' and 3ric!son and
4hited' 2000/(
*inance theor% &redicts' however' that frms with unfettered access to the
ca&ita mar!ets woud aread% $e o&timi+ing their investment( 5n other words'
a crucia and unstated assum&tion under%ing the 6ct is that frms were
una$e to raise su7cient funds from externa mar!ets at
reasona$e &rices and were not generating su7cient interna domestic funds
to fnance a avaia$e domestic investment o&&ortunities( 5f a frm can
access externa ca&ita or generate su7cient interna domestic ca&ita to
fu% fund their domestic investments' we woud not ex&ect the 6ct to have
an% e8ect on the frm9s investment(
Ca'$ in,l%3
Dou can see from the illustration above that the cumulative net cash inflow will pay back the
investment at the end of the fourth year. *ro'ects with the shortest payback periods are preferred
18
as longer payback periods increase the risk of unforeseen circumstances arising. .owever, the
problem of payback is that it gives no indication of the profitability of the pro'ect. An alternative
method that can be employed therefore to weigh up the investment is the Accounting rate of
return method.
2.; CAPITAL RATIONIN6
2.;.1 INTRODUCTION
Capital rationing is
N -normity of funds requirements
N Cimited availability of funds
N Capital rationing resorted to by firms who are not able to generate additional funds
N Ceiling is set on capital spendingMconsider only pro'ects with high )*+s
W$at i' !a1ital (ati%nin4:
Capital rationing has to do with the acquisition of new investments. ,ore to the point, it is all
about getting investments based on such factors as the recent performance of other capital
investments, the amount of disposable resources that are free to acquire a new asset, and the
anticipated performance of the asset. !n short, it&s a strategy employed by companies to make
investments based on the current relevant circumstances of the company.
@enerally, capital rationing is used as a means of putting a limit or cap on the portion of the
existing budget that may be used in acquiring a new asset. As part of this process, the investor
will also want to consider the use of a high cost of capital when thinking in terms of the outcome
of the act of acquiring a particular asset. Any responsible company will likely choose to employ
strategies that support the productive use of disposable funds built within a capital budget, but at
the same time, it is important to understand what benefits can reasonably be expected from
owing the asset in question.
7ince this strategy is all about setting criteria that any investment opportunity must meet before
the company will seriously entertain the purchase, many businesses choose it as their guiding
process for any acquisitions. /sing the basic principles of the technique, a company can develop
a list of standards that must be addressed before any capital purchase. !f the standards are drafted
in a manner that accurately reflects the current condition of the company, then there is a good
chance the right types of investments will be considered.
7ome of the more important factors to consider as part of a productive capital rationing approach
are the financial condition of the company, the long and short term goals of the business, and
proper attention to daily operations. (ne of the benefits of the strategy is that the approach helps
19
to ensure that funds for basic operations are not diverted in order to take advantage of a so-called
Ecan;t failF opportunity, which helps to maintain the stability of the business.
D#,initi%n %, Ca1ital Rati%nin4
The act of placing restrictions on the amount of new investments or pro'ects undertaken by a
company. This is accomplished by imposing a higher cost of capital for investment consideration
or by setting a ceiling on the specific sections of the budget.
Companies may want to implement capital rationing in situations where past returns of
investment were lower than expected.
"or example, suppose AC Corp. has a cost of capital of 895 but that the company has
undertaken too many pro'ects, many of which are incomplete. This causes the company&s actual
return on investment to drop well below the 895 level. As a result, management decides to place
a cap on the number of new pro'ects by raising the cost of capital for these new pro'ects to 8?5.
7tarting fewer new pro'ects would give the company more time and resources to complete
existing pro'ects.
2.;.1.1 W$ !a1ital (ati%nin4:
< E=t#(nal (#a'%n'
- (ccurs when firm has many options for investment but is unable to take them up either
because of insufficient funds or because capital markets are not favourable
- Cack of standing in the marketMcannot raise funds due to the credibility issues 6 .igh
floatation costs
Capital rationing is the process of selecting the most valuable pro'ects to invest available funds.
!n this process, managers use a number of capital budgeting methods such as cash payback
period method $C**,%, accounting rate of return $A##% method, net present value $)*+%
method and internal rate of return $!##% method.
Int#(nal (#a'%n'
- (ccur when the firm has self imposed restrictions on funds allocated for fresh
investmentsN Availability of funds or have the ability to procure funds from markets, but
they do not do so
- /se retained earnings to foster growth
- !mplies firms do not want to grow
2.;.2 St#1' in !a1ital (ati%nin48
#anking of different investment proposals
7election of most profitable proposal based on the ranks or highest )*+s
20
An effective capital rationing usually consists of the following steps1
St#1 18
"irst of all, the alternative pro'ects are screened using payback period and accounting rate of
return methods. ,anagement sets maximum desired payback period or minimum desired
accounting rate of return for all competing alternative pro'ects. The payback period or
accounting rate of return of various alternatives is then computed and compared to the
management;s desired payback period and accounting rate of return. $To know how payback
period and accounting rate of return are computed,
7tep =1
The pro'ects that pass the initial test in step 8 are further analy0ed using net present value and
internal rate of return methods. $To know how net present value $)*+% and internal rate of return
$!##% are computed,.
St#1 38
The pro'ects that survive in step = are ranked using a predetermined criteria and compared with
the available funds. "inally, the pro'ects are selected for funding.
The pro'ects that remain unfunded may be reconsidered on the availability of funds.
!n addition to quantitative techniques, management should also consider the qualitative factors
related to all pro'ects. "or example, the purchase of a new machine can increase customer
satisfaction by improving the quality of the product, reduce cost by eliminating several 'obs but
lower employee moral.
21
2.;.2.1 Ri'0 anal'i'
N #isk refers to the uncertain conditions under which a firm performs
N -xist because of the inability to forecast future situations
N "orecasts not done with precision
2.;.2.2 W$at i' Ri'0 Mana4#"#nt:
22
N #isk ,anagement is the logical and systematic method of identifying, analysing, treating and
monitoring the risks involved in any activity or process.
E2#nt' a,,#!tin4 in2#'t"#nt ,%(#!a't'- t$(## !at#4%(i#'
6 @eneral economic conditions
Mpolitical changes, monetary policies, taxation policies, lending conditions, social conditions
6 !ndustry factorsMspurt in employment and construction industry
6 Company factorsMchange in management, strike or lock out
T1#' %, (i'0'
N *ro'ect specific riskMwrong estimates, considering high discount rates, wrong estimates about
material and labour
N Competition riskMactions of competitors, price wars
N !ndustry specific riskMchanges in technology, changes in laws like change in service tax rates,
bringing in new services into the net
N !nternational riskMincrease:decrease in foreign currency, political connections
N ,arket riskMinflation, general economic conditions, change in bank lending rates
T#!$ni>)#' %, in!%(1%(ati%n %, (i'0 ,a!t%( in !a1ital /)&4#tin4 &#!i'i%n'
N Conventional techniques 6 *ayback method 6 #isk ad'usted discount rate 6 Certainty
equivalents 6 7ensitivity analysisN 7tatistical techniques 6 *robability distribution approach
6 3ecision tree approach
2.;.2.3 T1#' %, !a1ital (ati%nin4
Ha(& !a1ital (ati%nin4
An absolute limit on the amount of finance available is imposed by the lending institutions.
S%,t !a1ital (ati%nin4
A company may impose its own rationing on capital. This is contrary to the rational view of
shareholder wealth maximi0ation.
2.;.2.5 R#a'%n' ,%( !a1ital (ati%nin4
23
2.;.2.; M)lti 1#(i%& !a1ital (ati%nin4
Capital rationing can apply to a single period, or to multiple periods. 7ingle-period capital
rationing occurs when there is a shortage of funds for one period only. ,ulti-period capital
rationing is where there will be a shortage of funds in more than one period.
2.;.2.? D#alin4 3it$ 'in4l#-1#(i%& !a1ital (ati%nin4
1. Di2i'i/l# 1(%9#!t
2here potential pro'ects are able to be divided, ie any fraction of the pro'ect may be undertaken
and the returns from the pro'ect are expected to be generated in exact proportion to the amount of
investment undertaken, a calculation known as the profitability index $*!% is used. This a
variation on key factor analysis and the aim when managing capital rationing is to maximise
the )*+ earned per P8 invested in pro'ects.
This is done by1
$8%calculating a *! for each pro'ect $see below%
$=%ranking the pro'ects according to their *!
$A%allocating funds according to the pro'ects; rankings until they are used up.
The formula is1
24
!ndivisible pro'ects
!f pro'ects are indivisible it must be done in its entirety or not at all. To determine the optimum
use of capital investment, a t(ial an& #((%( approach must be used.
,utually excusive pro'ects
7ometimes the taking on of pro'ects will preclude the taking on of another, e.g. they may both
require use of the same asset.
!n these circumstances, each combination of investments is tried to identify which earns the
higher level of returns.
2.;.2.? D#alin4 3it$ ")lti-1#(i%& !a1ital (ati%nin4
Lin#a( 1(%4(a""in4
A solution to a multi-period capital rationing problem cannot be found using *!s. This method
can only deal with one limiting factor $i.e. one period of shortage%. .ere there are a number of
limiting factors $i.e. a number of periods of shortage% and linear programming techniques must
therefore be applied.
(b'ective function
The linear programming method can be applied to a multi-period capital rationing problem in
one of two ways. The ob'ective of the solution can be either1
to maximise the total )*+ from the investment in available pro'ects
to maximise the present value of cash flow available for dividends.
oth techniques result in the same pro'ect selections.
3ual values
The dual price is1
the amount by which one additional unit of scarce resource would increase the value of
the ob'ective function, or alternatively
the amount by which one fewer unit of scarce resource would decrease the value of the
ob'ective function.
25
!n capital rationing, the scarce resource is available funds, so the dual value expresses the
increase in the ob'ective function gained if one more dollar became available, or the reduction if
one less dollar were invested.
The amount of the dual value varies depending on which method is used to formulate the linear
programme1
)*+ method - the dual equals the change in )*+ earned if P8 more or less is available.
*+ of dividends method - the dual equals the change in the *+ of cash available to pay
dividends if P8 more or less is available.
2.;.2.@ H%3 t% S%l2# C%n,li!t' In2%l2in4 Ca1ital Rati%nin4:
Capital rationing is a method companies use to weigh different investment options. All firms
have money set aside for new investments. !f a firm is presented with more profitable pro'ects
than it has money to finance, a method must be used to decide where the available funds will go.
!n general, rationing uses the internal rate of return to decide this. The internal rate of return is a
figure that reflects the Etime valueF or Epresent valueF of proposed pro'ect funds over a period of
time. This method is used to solve most conflicts in rationing available capital funds.
7tep 8
3ecide what an acceptable rate of return is. This is the primary step because it is the basic
criterion by which an investment is seen as Erational.F !f different officers in the firm are arguing
over the proper investments for the company&s limited budget, the way to solve this problem is to
see which investments are likely to reach the desired rate or return the quickest.
7tep =
Consider the length of time it will take to see this expected or desired return. !nternal rate of
return calculations are really about the time value of money, or the actual worth of available
capital funds today. ,ore specifically, internal rate of return deals with the actual value of the
available capital as if it were already invested and came to its profitable maturity. !f conflicts are
about the amount of time that firm money will be tied up in a specific pro'ect, then this will solve
the conflict. !n other words, if the company needs money fast, using a short time frame to reach
the expected return rate would be the best option. The main variable used to solve the conflict
would therefore be those investments that would show the proper rate of return in the shortest
amount of time. These might not show the highest overall profit, but the profits they do make
will be seen very early.
7tep A
*erform the basic internal rate of return calculation for each investment option. The calculation is
simple1 divide the initial outlay of investment money by the cash flow expected from the
investment. This simple equation will give you the time value or present value of the current
investment funds earmarked for specific pro'ects.
26
7tep 4
!nclude the amount of time the money will be tied up in investments. This can be done in the
equation by including the factor of how many times the expected cash flow will be generated. !f
the funds will be tied up for two years and the cash flow is generated monthly, then you will use
the factor of =4 to come to the cash flow figure. Therefore, the cash flow variable used in the
equation should be the monthly cash flow figure multiplied by =4.
7tep ?
*rioriti0e the rationing of investment funds based on this conclusion. !f different officers in the
company are at odds over the use of company funds, then the internal rate of return should be
able to solve these conflicts with the use of reason. 7hareholders and employees will be satisfied
since the conflicts over the use of investment money will be based on time and profit
calculations, not personal interest.
2.? PORTFOLIO MANA6EMENT
INTRODUCTION
*ortfolio management is a process encompassing many activities of investment in assets and
securities. !t is dynamic and flexible concept and involves continuous and systematic analysis,
'udgement and operations. The ob'ective of this service is to help the novices and initiali0ed
investors with the expertise of professionals in portfolio management.
"irstly, it involves construction of a portfolio based upon the fact sheet of the investor giving out
his ob'ectives, constraints, preferences for risk and return and his tax liability.
7econdly, the portfolio is reviewed and ad'usted from time to time in tune with the market
conditions. The ad'ustment is done through the changes in the weighting pattern of the securities
and asset classes in the portfolio. The shifting of assets and securities will take advantage of
changes in market conditions and in prices in the securities and assets in the portfolio.
Thirdly, the evaluation of portfolio performances is to be done by the manager in terms of targets
set for risk and return and charges in the portfolio are to be affected to meet the changing
conditions.
2.?.1 ELEMENTS OF PORTFOLIO MANA6EMENT8
*ortfolio management is an on-going involving the following basic tasks.
8. !dentifications of the investor ob'ectives constraints and preferences which will help
formulate the investment policy
=. 7trategies to be developed and implemented in tune with the investment policy
formulated. This will help selection of asset classes and securities in each class depending
upon their risk-return attributed.
27
A. #eview and monitoring of the performance of the portfolio by continuous overview of
the market conditions, companies; performance and investors circumstances.
4. "inally, the evaluation of the portfolio for the results to compare with the targets and
needed ad'ustments have to be made in the portfolio to the emerging conditions and to
makeup for any shortfalls in achievement vis-Q-vis targets.
The collection of data on the investors; preferences ob'ectives etc. is the foundation of portfolio
management. This gives an idea of channels of investment in terms of asset classes to be selected
and securities to be chosen based upon the liquidity requirements, time hori0on, taxes, asset
preferences of investors, etc. these are the building blocks for construction of a portfolio.
According to these ob'ectives and constraints, the investment policy can be formulated. This
policy will lay down the weights to be given to different assets classes of investment such as
equity shares, preference shares, debentures, company deposits etc. and the proportion of funds
to be invested the investment strategy for a time hori0on for income and capital appreciation and
for level of risk tolerance.
The investment strategies developed by the portfolio managers have to be correlated with their
expectation of the capital market and the individual sectors of the country.
Then a particular combination of assets is chosen on the basis of investment strategy and
managers expectations of the market.
2.?.1.2 EAECUTION OF STRATE6Y8
The next stage, namely, implementation and execution of this investment strategy, is the most
critical process in the portfolio management. .ere the research, analysis and the 'udgment of the
manager are very essential inputs in the process his initiative, innovation and 'udgment would on
the basis of his success structuring of portfolios to improve the performance to make it optimal
and efficient. The changes in investor;s conditions and into eh conditions and in industry
performance are taken into account in the portfolio management.
The portfolio thus contractures may relate to the needs of a given level of income, a provision for
contingencies and a preference for fixed income, etc. of the investor. 7ome investors while a few
would prefer risk less investments in *7/ bonds-short term or long-term government securities,
etc. Certain risk-takers may prefer investment in high-yielding growth and venture equities.
M%nit%(in48
,onitoring of these portfolios is a continuous upgrading and changes in asset composition to
take advantage of the conditions and economic performance. *ortfolio monitoring is a
continuous assessment of the current portfolio to the goals, changes in investors; preferences,
capital market conditions and expectations. The monitoring requires a periodic meeting with
investors to know the changes in the conditions, continuous review of the investment policy
relative to investors; preference.
28
The current investment strategy reflects the capital market conditions and expectation and
changes in them will bring out the changes in optimal conditions in the portfolio. The portfolio is
thus sub'ected to the original review and assessment to change the composition of portfolio in
tune with the changing conditions in the market and of the investor.
To give specific examples, !f market conditions change and the prospects of the cement industry
are likely to be better in the coming year, as 'udged by the government policy changes vis-Q-vis
the steel industry, then the investor preferences can be better satisfied by shifting from steel
shares to cement shares.
esides, within the cement industry, a manager may shift from a poorly performing company
like orient. Cement to be better performing company like #asi cement.
7imilarly changes can take place as between different asset classes such as moving from
debentures to equities and vice versa or from income stocks to growth stock etc.
Thus portfolio changes can be about by the changes in market expectations and from the half6
yearly results or yearly results of the companies, along with changes in industry and economy.
PORTFOLIO ANALYSIS CHART
29
)&ecifcation
and
#uantifcation
of investor:s
o$;ectives'
constraints'
-ortfoio
&oicies and
strategies
<onitoring
investor =
reated in&ut
factors
-ortfoio seection'
construction' revision'
evauation' asset aocation'
&ortfoio o&timi+ation'
securit% seection'
6ttainment of
investor
o$;ectives


These ad'ustments of the portfolio may also be initiated due to changes in the managers;
expectations of the company and market or asset classes. Certain changes in asset classes may
have a time limit as a critical input. Thus purchases and sales of equity shares on the stock
market are to be well 6 timed based upon the assessment of the market technical position. This
requires technical analysis in addition to fundamental analysis. !n fact, any shift of the
investment from one type of asset to another requires a careful analysis of time, risk return and
host of other factors.
An important characteristic of the portfolio is risk reduction, which can be achieved by
diversification of the portfolio into the various asset classes and securities within the asset class.
Changes in security prices or market expectations of the manager may have necessitated changes
in the asset composition. The efficient frontier in terms of modern portfolio theory may itself
change the composition of the portfolio due to the change in the eta value in the longer time
hori0on. The composition has to be changed to being portfolio back to the optimal conditions and
back to the efficient frontier line.
2.?.1.3 THE INVESTMENT ALTERNATIVES FOR PORTFOLIO MANA6EMENT ARE
SET OUT -ELOW.
8% Asset classes1
a. -quity new issues
b. -quity old issues
c. *reference shares
d. 3ebentures
e. *7/ bonds
f. @overnment securities
g. Company deposits
=% !ndustry groups
a. Textiles
b. Cement
30
>a&ita
mar!et
ex&ectations
?eevant
economic'
socia' &oitica'
sectors' and
securit%
<onitoring economic
and mar!et in&ut
factors
c. Aluminum
d. *etrochemicals
e. "ertili0ers
f. *aper
A% .igh income yielding securities1 lue chips and growth stock. #egular dividend paying
companies at a stable rate are income yielding shares the blue chips are not only dividend
paying regularly but their performance is above the averages and the dividend
distributions may increase over time. The growth stocks are shares with a large scope for
capital appreciation in addition to good dividends.
4% Companies with export orientation and those with only domestic demand
?% Companies based on location as those in the west, south, east and north of !ndia.
H% Type of management, vi0, family type, professional type etc.
2.?.2 FACT SHEET-CLIENTSB DATA -ASE8
The following preferences of the investor are to be noted first in investment decisions. These will
constitute the data base of the investor or client..
8. !ncome and saving decisions-how much income can be saved for contingencies and for
transactions the present positions of wealth, income and savings of the investor.
=. Asset preferences profile-preferences for risk less assets like bank deposits or for risky
stock market investment1
a. the degree of risk the investor is capable of taking and willing to takeK
b. the risk aversion and preferences for safety and certaintyK
c. requirements of regular incomeK
d. ob'ective of capital appreciationK
e. (b'ectives of speculative gains.
A. !nvestor;s ob'ectives, constraints and financial commitmentsK
4. Tax brackets into which the investor fails and his preference for planning the tax liabilityK
?. Time hori0on in which investments should fructify or results expected.
These and other factors constitute the Efact sheetF of the investor on the basis of which the
individual portfolio is to be structured, constructed and managed.
The motives for saving are varied depending on the individuals. "or ex, provision for insurance,
contingencies contribution of *", pension funds etc., which are mostly contractual obligations,
provisions for future income etc. are some of the motives. 7ome of the savers are influenced by
interest return or stable income while others are by speculative gains or get-rich quick motive.
O/9#!ti2#' %, in2#'t%('8
The investors; ob'ectives are to be specified in the first place. The ob'ective may be income,
capital appreciation or a future provision for contingencies such as marriage, death, birth, etc.
provision for retirement and accident and accident could be covered by contractual obligations
like insurance and contributions to *" and pension funds. A certain amount of savings has to be
kept as cash with themselves or in deposit with banks or post offices to facilitate daily
31
transactions for purchase and sale. 2hile cash earns no interest, savings deposit with banks,
cooperatives and *(s would earn 4.?-H5 on account. ut when inflation is prevalent in the
economy at the rate of 895 this return 4.?5 will provide only a net negative return to savers.
7o the amounts kept in the form of cash and deposit with banks, etc. should normally be the bare
minimum. The rest of the amount has to spread in various investment avenues earning higher
returns than the normal inflation rate of R-895. These investment avenues are discussed in the
previous chapter.
2.?.2.1 MOTIVES FOR INVESTMENT8
The investor has to set out his priorities of investment keeping the following motives in mind.
All investors would like to haveK
8. capital appreciation
=. income
A. liquidity or marketability
4. safety or security
?. hedge against inflation

The investor gets his income from the dividend or yield or interest. There will be capital
appreciation also in the case of equities. The liquidity and safety of an investment will depend
upon the marketability and the credit rating of the borrower, namely, the company or the issuer of
the securities.
These securities vary between assets and securities. An investor is also concerned in having a tax
plan to reduce his tax commitments so as to maximi0e the take home income. "or this purpose,
etc. investor should specify his income bracket, his liabilities and his preference for tax planning.
The investment avenues have certain characteristics of risk and return and also of some tax
concessions attached to them. These tax provisions as such can influence the investors in a very
big way as these provisions will alter risk return scenario of investment alternatives. !t is,
therefore necessary that all these avenues should be assessed in terms of yields, capital
appreciation, liquidity safety and tax implications. The investment strategy should be based on
the above ob'ectives after a through study of the goals of the investor, in the background of
characteristics of the investment avenues.
Ta= 1(%2i'i%n'8
!t is apt to start with the tax-exempt incomes of the securities in which the investment can be
made. The income by way of interest on *7/ code bonds, ).7. certificates, securities of the
central government and those deposits specified by the central government are exempted from
income tax sub'ect to certain limits and conditions. The *.(. deposits, certificates and other
claims operated by the *(s are exempted from income-tax up to a limit. This exemption is,
32
however not applicable to !ndra +ikas *atra, Oisan +ikas *atra and )7C +!!! !ssue. 3eposits in
**" and )77 are exempted from taxes in the year of deposits sub'ect to some limits in the year
of withdrawal except in the case of )77, which is, however, taxable in the year of withdrawal.
/nder the category of insurance, in addition to C!C policies, the /C!* of $/T!% en'oys popularity
due to the tax shelters.
2ealth tax exemption for all investments in shares and debentures along with other
eligible investment.
.
!ncome-tax exemption up to #s.8=999 aggregate income from bank deposits, shares, /T!
units, *.( deposits, ,utual "unds and other specified categories of investment, including
dividends. 7ince 8SSI-SR, dividends from equity of the companies are tax exempt in the
hands of the investors.
Ca1ital 4ain'8
Capital gains refer to profits earned on the transfer of capital assets, sale or exchange, etc. these
gains are long-term gains, if they are held for more than AH months for all assets except shares of
the company for which the period is 8= months. Cong-term capital gains are taxable at a lower
rate of =95. /nder 7ections ?4- and ?4" of the !ncome-tax Act, the long-term capital gains are
exempt, !f these funds are invested in central government securities, /T!s and C@! 7chemes and
other specified bonds of semi-government bodies.
!ncome from interest on debentures and on company deposits is tax deductible at source, if it
exceeds #s.=?99 p.a. the exemption available from income tax for )77 deposits up to #s.49999
was since withdrawn in 8SS=-SA. Tax exemption is also available in respect of income from
government securities, semi-government bonds, bank deposits, income from mutual funds, etc.
!n the budget for 8SS9-S8, a new scheme called -quity linked 7aving 7cheme was announced by
the government under 7ection RRA of !ncome Tax Act to provide a tax rebate of =95 of the
investment made in the eligible assets new issues, or eligible ,." 7cheme up to #s.89,999.
2.?.2.2 PORTFOLIO SELECTION8
The selection of portfolio depends on the various ob'ectives of the investors. The selections of
portfolio under different ob'ectives are dealt subsequently.
O/9#!ti2#' an& a''#t' "i=8
!f the main ob'ective is getting adequate amount of current income. 7ixty per cent of the
investment is made on debts and 49 per cent on equities. The proportions of investments on debt
and equity differ according to the individual;s performance. ,oney is invested in short term debt
and fixed income securities.
33
6(%3t$ %, in!%"# an& a''#t' "i=8
The investor requires a certain percentage of growth in the income received from his investment.
The investor;s portfolio may consist of sixty per cent to hundred per cent equities and 0ero to
fourty per cent debt instruments. The debt portion of the portfolio may consist of concession
regarding tax exemption. Appreciation of principles amount is given third priority.
Ca1ital a11(#!iati%n an& a''#t' "i=8
Capital appreciation means that the value of the original investment increases over the years.
!nvestment in real estate;s like land and house may provide a faster rate of capital appreciation
but they lake liquidity. !n the capital market, the values of the shares are much higher than their
original issue prices.
Sa,#t %, 1(in!i1al an& a''#t' "i=8
According to the life cycle theory, people in the third stage of life also give more importance to
the safety of the principal. All the investors have this ob'ective in their mind. )o one likes to lose
his money invested in different assets. ut, the degree may differ. The investor;s portfolio may
consist more of debts instruments and within the debt portfolio more would be on short term
debts.
Di2#('i,i!ati%n8
(nce the asset mix is identified and the risk and return are analysed, the final step is the
diversification of portfolio. "inancial risk can be minimi0ed by commitments to top-quality
bonds, but these securities offer poor resistance to inflation. 7tocks provide better inflation
protection than bonds but are more vulnerable to financial risk. @ood quality convertible may
balance the financial risk and purchasing power risk. According to the investor;s need for income
and risk tolerance level of portfolio is diversified.
2.?.3 PORTFOLIO CONSTRUCTION8
*ortfolio construction refers to the allocation of funds among a variety of financial assets open
for investment. *ortfolio theory concerns itself with the principles governing such allocation.
The ob'ective of the theory is to elaborate the principles in which is the risk can be minimi0ed,
sub'ect to desired level of return on the portfolio or maximum the return, sub'ect to the
constraint of a tolerable level of risk.
Thus, the basic ob'ective of *ortfolio management is to maximi0e yield and minimi0e risk. The
other ancillary ob'ectives are as per the needs of investors, namelyK
8. regular income or stable return
=. safety of investment
A. minimi0ing of tax liability
34
4. appreciation of capital
?. marketability and liquidity
!n pursuit of these of ob'ectives, the *ortfolio manager has to set out all the various alternative
investments along with their pro'ected return and risk choose investments which satisfy the
requirements of the individual investor and cater to his preferences. The manager has to keep a
list of such of investment along with the return-risk profile, tax implications, yields and other
return such as convertible options, bonus, rights, etc. A ready reckoner giving out the analysis of
the risks involved in each investment and the corresponding returns should be kept.
2.?.3.1 RISC - RETURN ANALYSIS8
All investments have some risks. !nvestment in shares of companies has its own risks or
uncertainty. These risks arise out of variability of return or yields and uncertainty of appreciation
or depreciation of share prices, loss of liquidity etc. the risk over time can be represented by the
variance of the returns, while the return over time is capital appreciation plus payout, divided by
the purchase price of the share.
)ormally, the higher the risk that the investor takes, the higher is the return. There is, however, a
risk less return on capital of about 885 which is the bank rate in 8SSR charged by the #! or
long 6term yield on @overnment securities at around 8A5 - 845. The risk less return to the lack
of variability of returns and no uncertainty in the repayment of capital. ut other risks such as
loss of liquidity due to parting with money etc. my, however, remains but are rewarded by the
total return on the capital $risk premium%.
The risk-return relationship can be represented in a diagrammatic form as in "ig. =.8
#isk return is sub'ect to variation and the ob'ective of the portfolio manager is to reduce that
variability and thus reduce the risky by choosing an appropriate portfolio.
There are two types of risks, namely,
*a+ "a(0#t (i'0 %( ''t#"ati! (i'0'
*/+ !%"1an (i'0 %( )n''t#"ati! (i'0.
35
The unsystematic risk can be reduced by divesting the portfolio of scripts up to an optimum level
of about 8? shares for an individual. These crisp should be so chosen that the risks on each of
them are diverse and their variability of return is also different. y investing in such a diverse set
of scripts the total risk can be reduced as some of them may have positive and others negative
covariance and they may vary in the degree of risk as well. The risk that can be reduced is called
unsystematic risk and these risks are represented diagrammatically as in fig. =.=
The unsystematic risk can be lowered by divesting into basket of scripts. Thus at the level of 8?
scripts in the diagram, the lowest level of the risk is obtained at the point , on the A curve
representing the unsystematic risk of the investor. Thus a degree of diversification of investment
is a necessary perquisite of portfolio management and for reducing the risk. ut beyond the point
,, the portfolio becomes unmanageable and diseconomies operate as to increase risk rather than
reduce it.
!n the management of a portfolio, the problem of risk management is vital. @iven the individual
preference of portfolio holders, the portfolio is to be constructed in such a manner that it is
exposed to the minimum risks which market related the owner can carry, sub'ect to which the
returns are to be maximi0ed. Although the market 6 related - risks cannot be reduced, the
company related risks can be eliminated through a proper diversification. As shown in the above
diagram, a proper portfolio diversification into around 8? scripts of different groups of industries
and companies would be able to reduce the company related risks involved almost to a negligible
proportion. ut these companies and industries should not be unduly related or interdependent or
under the same umbrella of industry groups or family of industrialists. An optimum degree of
diversification can be secured which would minimi0e risk and optimi0e return, if the covariance
of scripts included in the portfolio is less than 8 or negative.
Ti"# $%(iD%n %, 't(at#48
-very investment strategy should have a time hori0on from a short period of one year to few
years. Capital gains is considered long-term if equity investment is for at least one year and
another types of investment for a least three years. !f investment is to be assessed every year, the
past experience shows that the equity prices, reflected by the 7- 7ensitive !ndex, may show
36
varying degree of rise or fall per annum, but over a period of A to ? years, the market index
invariably showed a rise of anything above the normal inflation rate of 895 per annum. 7o
investment strategy should be for a medium time period of A to ? years.
*ortfolio management encompasses three ma'or categories of activities1
8. Assets allocation-types of assets to be chosen among fixed income securities of the
government or private corporate units, preferred stock debentures or equities, etc. of various
groups of industries.
=. #e-view and shifts as between classes of assets to take advantage of risk return
characteristics, or changes in them.
A. 7ecurity selection within each asset class such as choosing a higher growth type of
companies $blue chips%
2.?.3.2 TYPES OF RISC8
The risk is measured statistically by the degree of variance or standard deviation of returns.
There is also risk involved in time period of holding $the longer the period the greater the risk%
called liquidity premium. The holding of security is sub'ect to the default risk in repayment of
principal called default premium. The risks also arise due to interest rate variability, purchasing
power changes, business default or financial failures. They can named as interest rate risk,
purchasing power risk, business risk and financial risk, which are all part of systematic risks
which lead to a risk premium. These are to be rewarded by a higher return in the market than can
be secured on risk free assets.
The above is the market-related risk. esides, there is also group-related risk pertaining to a
group of industries or firms. There is also a specific risk related to a company.
As per the ,arkowit0 model, the investors are generally risk-averse. To suit such investors, the
portfolio has to be so designed as to maximi0e return for a given level of risk. !t is theoretically
possible to identify an efficient portfolio which satisfies the requirements of risk-return for an
individual investor. This is possible through detailed analysis of information on each security in
each of the asset classes in term of expected risk $variance of return% and expected return, and
covariance of each of the security with every other security $through calculation of eta%.
!n simple language this efficient portfolio is a well-diversified portfolio comprising many
securities with low covariance so that the degree of risk is the lowest possible. Companies under
different industry groups and different industry groups and different family managements and
with difference characteristics are to be chosen in that portfolio, for the above purpose.
2.?.5 EFFICIENT PORTFOLIO8
To construct an efficient portfolio, we have to conceptuali0e various combinations of investments
in a basket and designate them as portfolio 8 to n. then the expected returns from these portfolios
37
are to be worked out. The risk on these portfolios is to be estimated by measuring the standard
deviation of different portfolio returns. To reduce the risk, investors have to diversify into a
number of securities whose risk-return profiles vary.
Thus portfolios carry returns to compensate for interest risk $risk-free returns% >a premium for
purchasing power risk, market risk, business risk and financial risk. All these risk constitute
unsystematic risks, which can be reduced or eliminated by diversification. Thus for each
individual security and for a combination of securities represented by the basket in the 7-
sensitive index of 7- sensitive index or national index, the expected returns and standard
deviations can be worked out.
The expected return has to be weighted by the probable chance of getting the return through
proper weights and the weighted average return should be worked out. The standard deviation
around the expected can also be worked out as shown below.
#eturn
in
percent
Chance of
getting
return
-xpected return in percent
7tandard deviation about expected
return in percent
89 9.=9 89 x 9.=9 T $=.9% $89-8A.4%
=
x 9.=9 >
8= 9.A9 8= x 9.A9 T $A.H% $8=-8A.4%
=
x 9.A9 >
8? 9.49 8? x 9.49 T $H.9% $8?-8A.4%
=
x 9.49 >
8R 9.89 8R x 9.89 T $8.R% $8R-8A.4%
=
x 9.89
8.99 2t. average 8A.4 =.?
The standard deviation signifies that, on an average, each possible return is =.?5 away from the
expected return of 8A.45. The deviation of =.?5 could be on either side of the expected return of
8A.45. The deviation of =.?5 could be on either side of the expected return. This is the risk
measure of a portfolio.
The efficient portfolio can be estimated by presenting the various portfolios in terms of expected
return and standard deviations as show in the following table.
*ortfolio )o. -xpected return in percent $#isk% 7tandard deviation
8 ? 8
= I =
A R A
38
4 89 ?
? 88 ?
H 8= ?
I 8= I
R 84 89
S 8R 8=
!f we compare portfolio )os. 4 and ?, we see that for the same standard deviation of ?, portfolio
)o. ? gives an expected return of 885 higher than on )o.4, thereby making it an efficient
portfolio. !f we compare portfolio )os. H and I, we see that with the same return of 8=5 in both
the portfolios, standard deviation is lower in portfolio )o. H than in I. Thus portfolio )o.H is an
efficient portfolio.
These points can be depicted as in "igure =.A. The expected return is shown as the tax and
standard deviation measuring on the y-axis. The points connecting the expected return with its
standard deviation can be shown as A group, constituting the feasible opportunity set. The
outermost point on this graph is the most efficient portfolio, say, , on the A graph while the
A graph is called the efficient frontier , is the most efficient combination for the individual
under consideration.
The individual investor is generally risk-averse according to the well known author ,arkowit0.
.is ob'ectives are influenced by the stage of life, his financial circumstances and psychological
makeup.
A young investor may have, for example, a higher level of tolerance of risk than a retired person
or a middle-aged person. The latter prefers a longer income with less risk.
There is a trade- off between risk and return.
39
According to the capital pricing model, efficient frontier is defined as a risk return trade off
curve. !t is efficient because it provides the maximum return at a given level of risk of the
investors. The investor capacity to take risk sets the point of optimum efficiency on this curve,
which is the best for him. 3iversification of securities and assets in the portfolio reduces the riskK
provided their covariance is low and they are dissimilar in nature.
The total risk is measured by the standard deviation of the return, and market risk by the concept
of eta. eta reflects that part of a portfolio;s return and variation in returns which is attributable
to the overall movement of the market rather than to any unique characteristics of the portfolio.
The efficient frontier of ,arkowit0 and the use of beta can be graphically represented as in "igs
=.4 and =.?. A is the capital market line, representing the market possibilities of risk and return
$given by the 7ensitive !ndex%. (n the same graph, the efficient frontier is drawn as -". At point
for the given risk of (# the return is maximi0ed for the investor at (C.
!n actual practice, can be derived by the formula1 *rice of 7crip A $5 age% : *rices of scripts
included in 7- !ndex $5 age% 6 the relation of the individual scrip to that of the basket of
scripts as represented by the 7- !ndex. !f eta is 8 $slope is 4?
9
%, then, on an average, one
percentage return on the market basket will be associated with a one percentage return on the
individual scrip. !f eta is greater than one it will give a larger return than the average market
return. These high eta scripts are very volatile and risk is also high.
(n the other hand, if eta is less than 8 $called defensive scripts%, the risk is low and the return
is also lower than the market return. 3epending on the investor;s choice, the eta is to be
selected and scripts with such eta should be held in the *ortfolio. "igure =.? depicts eta as the
angel made by the line of regression line between market return and the individual scrip return.
2E?E5E1 MARCET EFFICIENCY THEOREM8
7ince the behavior of the market is outside the control of the investor, he can only reduce the
specific component of risk by choosing the individual scripts with proper etas to achieve the
result of diversification and lower the risk. The comparative risks of alternative well-diversified
portfolios can be measured by their betas. !f the markets are efficient the performance of any
40
portfolio would average out to that of the performance of the market and nobody can be
outperform the market.
!n the real world there are three different levels of efficiency of the stock market, namely, the
weak form, the semi-strong and the strong form. These concepts are useful in portfolio
management for investors.
!n the weak form, the successive changes in stock prices are independent of each other and the
historical market data are already embedded in the existing price.
!n the semi-strong form, stock prices ad'ust rapidly to all new public information, both market
and non-market data, and action taken after the event will produce no more than random results.
!n the strong form, stock prices fully reflect not only public information but privately-held
information, which may later become public. !f, in the real world, the market efficiency is of a
strong form, then the performance of any basket of scrips in any portfolio is as good as any other
and no individual investor can outperform the market. !f however, the market efficiency is of a
weak form, there is scope for selection of a portfolio which is optimal for the investor in terms of
risk and return and yet outperforms the market by a proper choice of aggressive scrips with eats
suitable for the purpose.
Di2#('i,i!ati%n8
#isk in a portfolio can be reduced by a proper diversification into a number of scripts. The
companies chosen should not be too many or too few but of an optimum si0e as to be efficiently
manageable. The economies of scale in management apply to this analysis. !t will be seen in fig
=.H that the higher the risk, higher is the return in the normal process. The risk 6return
relationship is shown in the graph.
3epending upon the investor preferences and his income requirements, the strategy of
investments should be at A, or C respectively. Assuming that he takes risk at or C, this risk
can be reduced so far as it concerns the specific company risk, but the market risk is outside the
control of the portfolio manager. The risk can be reduced by a proper diversification of scripts
invested. !t is also possible to have a combination of A, and C positions in a portfolio so as to
have a diversified risk-return pattern.
41
!n order that this diversification secures the results in an optimal manner, the number of scripts
chosen be limited to 8=-8?.
As fig =.Ishows the risk is first reduced as the number of companies is increased but after a
point, the risk again increases due to the operation of disconnections of scale. The risk can be
lowered from (, to () by increasing the number of companies from ? to 8? after which risk
cannot be lowered as the curve A representing the unsystematic risk starts going up again.
The optimum number of companies should be such that they are of divergent qualities in terms
of performance, product line, management, marketing etc. 7uch a diversification only can secure
reduction of risk and maximi0ation of returns. !n this process, a proper selection of scrips with
eats of aggressive nature $ U 8% and some with defensive nature $ V 8% should be chosen,
depending upon the individual preferences of the investor, in the selection of these companies,
all the processes explained above under portfolio management should be followed and after
analysis and assessment, investment should be made.
2.?.; PORTFOLIO REVISION8
After fixing the target eta and duration of the portfolio, the investment activity starts with the
selection of 7cripts and onds, etc. ut the portfolio once constructed undergoes changes due to
changes in market prices and a reassessment of companies and the portfolio eta and for the
proportion in each asset class will change to bring back the *ortfolio to the targeted level of eta
and duration. *ortfolio revision will take place and composition of *ortfolio will change. A
change interest rate will also affect the *ortfolio through change in duration. Constant market
changes necessitate read'ustment of portfolio willing leading to purchase and sales of equities,
bonds, etc. which in turn will result in change in eta and duration.
Thus any portfolio requires a constant monitoring and revision. (peration on a portfolio will thus
take place on a daily basis, keeping in mind, the targeted eta, duration and return. Changes in
investor;s financial status, his preferences and market conditions.
42
!t is necessary to set out some theoretical tools like security analysis, ,orkowit0 model, risk
return evaluation etc. these are referred to below.
SECURITY PRICIN6 AND PORTFOLIO MANA6EMENT
*ortfolio management is based upon security analysis, which is an analysis of share prices.
8. Analysis at macro level of market =. Analysis at micro level of company
Theories explaining this analysis
"undamentalist theory chartist school random walk school
!nvestment decision prices move independent
,aking of what to of past trends
uy:sell and hence returns
2.?.;.1 MARCOWITF MODEL OF PORTFOLIO THEORY8
This portfolio model is based on the exposure to market risk and the degree of diversification of
the portfolio. The eta of the portfolio provides a measure of exposure to market risk and the
coefficient of determination, namely, #
=
$
=
% provides a measure of diversification.
Cross sectional measures are used for risk estimates for individual holdings that comprise the
portfolio. The individual scripts in the portfolio have their own etas, which are weighted by the
proportion of the funds invested in it. The Table below gives an example.
Company *roportion of
*ortfolio
etas of 7cripts 2eighted +alues
7crip A .88 8.H? .8R
7crip .88 8.49 .8?
43
7crip C .8I 8.=? .=8
7crip 3 .=A 8.9? .=4
7crip - .AR 9.R? .A=
8.99 8.89
3epending on the risk preference of the investor, weights can be changed to get the portfolio.
eta to less that 8.8 or more than 8.8 $got in the above Table%.
!n the same way the portfolio #
=
or # can be calculated and compared with the market return and
its #
=
or #. The standard error for the portfolio can be compared with that of the ,arket !ndex
return and its #8 to ensure that is # is suitable to the investor;s risk preferences.
2illiam 7harpe has suggested a new model. !nstead of comparing the risk of each scrip to every
other 7crip, it can be compared with market risk, which leads to the comparison of market return
to 7crip #eturn. .e takes into account only the systematic #isk on the *ortfolio $%
#i T > ! >e
is the intercept of the straight line.
is slope of the straight line of co-efficient.
! is expected return on ,arket !ndex, and e is the #andom component.
The 7harpe !ndex method has given us two components of #isk.
7ystematic #isk T
=
x +ariance of !ndex
T
=

=
/nsystematic #isk T Total +ariance of a 7ecurity #eturn 6 7ystematic #isk
Total #isk T
=

=
>e
=
Total #isk of ,arket T 7ystematic #isk covered by eta and unsystematic #isk covered by
diversification
Ri'0 anal'i'8
2hile the risks of fixed interest securities can be known as they are rated by agencies like !C#A
and C#!7!C, the risk on equities cannot be assessed and has to be borne by the investor. The risk
on equities is more than on bonds, debentures or fixed deposits and not amenable to
44
measurement. These risks may be due to inflation, interest rate changes, financial risk, business
risk, market risk, liquidity risks, and other risks. 7ome of them relate to the market and economy
and hence not controllable while the others are company specific in nature, which can be
controlled and reduced by diversification. Thus investment in more than one company and
industry is necessary for reducing risks. !nvestment in too many companies may not be desirable
but investment in two companies in steel industry is not having the same risks as investment in
one 7teel Company and one drug Company
2.@.EVALUATION OF PORTFOLIO8
2e have to measure the reward per unit of risk to compare the evaluation of the portfolios. There
are two measures, namely, that of 7harpe and treynor for this purpose. 2hile 7harpe chose the
standard division $total risk% of the portfolio reward, treynor used eta $systematic risk only% as a
measure of risk.
7harpe index is #eturn per unit of Total #isk. #isk premium on W*F is T I9 -8= $risk free return%
T ?R5 where total return is I9. ,arket #eturn is 48.
The 7tandard 3eviation $total risk% for *ortfolio is 48 and ,arket as a whole is 8S #isk *remium
for W*; *ortfolio is I9-8= T ?R 5. The 7harpe measure of evaluation is ?R:48 T 8.48.
"or the market the 7harpe measure of risk is 48-8=T=S, and =S:8ST8.?I. This shows that
portfolio Wp; did not perform as well as the market.
Treynor;s measure of #isk premium on portfolio is I9-8=T?R, divided by its own eta which is
8.=. This gives 4I.I. "or the market the risk premium is 48-8=T=S divided by 8, which is ,arket
eta, this gives =S.
This means that while the market earned =S per unit of #isk, the portfolio Wp; has earned more at
4I.I per unit of #isk, which is contrary to 7harpe;s measures.
Thus measures of 7harpe and treynor may not give similar results as one takes into account total
risk while the other takes only 7ystematic #isk.
Another measure is to calculate excess return of a portfolio on the market as measured with the
help of 7,C under treynor formula and C,C in 7harpe formula. The market return indicates the
required return for the given level of risk, while the actual #eturn of *ortfolio Wp; is what is
achieved. !t may be above the vertical distance from the required return as 'udged by the market
return.
The Genson and fama net selectivity measures may give opposite or different results. This is due
to use of the total risk in one case and the systematic risk on the other. !n both cases the actual
*ortfolio return is compared and evaluated as excess over market return or required return for a
given level of risk.
45
2.@.1 EVALUATION CRITERIA FOR PORTFOLIOS8
Treynor and 7harpe !ndex models provide measures for ranking the relative performances of
various portfolios on a risk-ad'usted basis. ut Gensen has constructed a measure of absolute
performance on a risk 6 ad'usted performance on a risk 6 ad'usted basis.
A simplified version of his basic ,odel is given by1
#Gt 6 #"t T G > G $#,t 6 #"t%
#Gi

T Average return on portfolio for period t
#"t T #iskless rate of return for period t
G T !ntercept that measures the forecasting ability of the ,anager
G T A measure of 7ystematic #isk
#,t T Average return on market for period t
@raphical #epresentation of Gensen;s ,easure is given below. "or 7harpe and Treynor, the
intercept of the line is at the origin but in the case of Gensen, it can be at any point, including the
origin. @raph =.R
!f G is positive it indicates superior performance. G is negative it indicates the inferior
performance and o

is neutral performance 6 something similar to ,arket average.
As compared to the normal evaluation of a portfolio as against the market portfolio in relative
terms by Treynor and 7harpe, the Gensen;s approach is more general and absolute in measure.
Thus 7harpe;s measure 7t is setout as 7t T rt 6 r
o
:
=
t, where it is the average return on portfolio
t and r
9
is the riskless return and
=
t

is variance $risk measure% of the returns on portfolio. .ere

=
takes the total risk while the same in formula of Treynor takes eta, instead
=
, and eta$%
is a measure of 7ystematic risk and not total risk.
46
T(#n%(B' "#a')(#
Tn T rn 6 r :n

, where m and r have the some meanings as under
7harpe;s formula
The graphical presentation of both is given below1
The chart is self explanatory, as the two graphs show the differences between them.
@raphs-=.S and =.89
TWO MARCS QUESTIONS AND ANSWERS
1. W$at i' !a1ital in2#'t"#nt anal'i':
A budgeting procedure that companies and government agencies use to assess the potential
profitability of a long-term investment. Capital investment analysis assesses long-term
investments, which might include fixed assets like equipment, machinery or real estate. The goal
of this process is to pinpoint the option that is most likely to be the most profitable for the
business. usinesses may use techniques such as discounted cash flow analysis, risk-return
analysis, risk-neutral valuation and utility theory in a capital investment analysis. Capital
investments are risky because they involve large, up-front expenditures on assets intended for
many years of service and that will take a long time to pay for themselves.
2. E=1lain !%"1(#$#n'i2# !a1ital anal'i' an& (#2i#3
The Comprehensive Capital Analysis and #eview $CCA#% is an annual exercise by the "ederal
#eserve to ensure that institutions have robust, forward-looking capital planning processes that
account for their unique risks and sufficient capital to continue operations throughout times of
economic and financial stress. As part of the CCA#, the "ederal #eserve evaluates institutions&
capital adequacy, internal capital adequacy assessment processes, and their plans to make capital
47
distributions, such as dividend payments or stock repurchases. The CCA# includes a supervisory
stress test to support the "ederal #eserve&s analysis of the adequacy of the firms& capital. oards
of directors of the institutions are required each year to review and approve capital plans before
submitting them to the "ederal #eserve.
3. E=1lain !a1ital a11(ai'al t#!$ni>)#':
The basic purpose of systematic appraisal is to achieve better spending decisions for capital and
current expenditure on schemes, pro'ects and programmes. This document provides an overview
of the main analytical methods and techniques which should be used in the appraisal process.
These techniques can also be used in the evaluation process.
5. W$at a(# !a1ital a11(ai'al t#!$ni>)#':
Analytical methods
)et *resent +alue ,ethod $)*+%
3iscount rate
!nternal #ate of #eturn $!##%
enefit : Cost ratio $C#%
*ayback and 3iscounted payback
7ensitivity analysis
7cenario analysis
7witching values
3istributional Analysis
;. W$at i' 1(%9#!t '#l#!ti%n:
*ro'ect selection is the process of choosing a pro'ect or set of pro'ects to be implemented by the
organi0ation. 7ince pro'ects in general require a substantial investment in terms of money and
resources, both of which are limited, it is of vital importance that the pro'ects that an
organi0ation selects provide good returns on the resources and capital invested. This requirement
must be balanced with the need for an organi0ation to move forward and develop. The high level
of uncertainty in the modern business environment has made this area of pro'ect management
crucial to the continued success of an organi0ation with the difference between choosing good
pro'ects and poor pro'ects literally representing the difference between operational life and death.
ecause a successful model must capture every critical aspect of the decision, more complex
decisions typically require more sophisticated models.
?. E=1lain 1(%9#!t &#!i'i%n'
EThere is a simple solution to every complex problemK unfortunately, it is wrongF. This reality
creates a ma'or challenge for tool designers. *ro'ect decisions are often high-stakes, dynamic
decisions with complex technical issuesMprecisely the kinds of decisions that are most difficult
to model1
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*ro'ect decisions are dynamic because a pro'ect may be conducted over several budgeting cycles,
with repeated opportunities to slow, accelerate, re-scale, or terminate the pro'ect. Also, a
successful pro'ect may produce new assets or products that create time-varying financial returns
and other impacts over many years. A more sophisticated model is needed to address dynamic
impacts.
@. E=1lain in2#'t"#nt &#!i'i%n'
!nvestment decisions are made by investors and investment managers.
!nvestors commonly perform investment analysis by making use of fundamental analysis,
technical analysis and gut feel. !nvestment decisions are often supported by decision tools. The
portfolio theory is often applied to help the investor achieve a satisfactory return compared to the
risk taken.
(ne of the most important long term decisions for any business relates to investment. !nvestment
is the purchase or creation of assets with the ob'ective of making gains in the future. Typically
investment involves using financial resources to purchase a machine: building or other asset,
which will then yield returns to an organisation over a period of time.
G. D#,in# in2#'t"#nt &#!i'i%n
A determination made by directors and:or management as to how, when, where and how much
capital will be spent on investment opportunities. The decision often follows research to
determine costs and returns for each option
Capital investments are funds invested in a firm or enterprise for the purposes of furthering its
business ob'ectives. Capital investment may also refer to a firm&s acquisition of capital assets or
fixed assets such as manufacturing plants and machinery that are expected to be productive over
many years. 7ources of capital investment are manifold and can include equity investors, banks,
financial institutions, venture capital and angel investors. 2hile capital investment is usually
earmarked for capital or long-life assets, a portion may also be used for working capital
purposes.
H. W$at i' !a1ital (ati%nin4:
Capital rationing has to do with the acquisition of new investments. ,ore to the point, it is all
about getting investments based on such factors as the recent performance of other capital
investments, the amount of disposable resources that are free to acquire a new asset, and the
anticipated performance of the asset. !n short, it&s a strategy employed by companies to make
investments based on the current relevant circumstances of the company.
1I. D#,in# Ca1ital Rati%nin4
49
The act of placing restrictions on the amount of new investments or pro'ects undertaken by a
company. This is accomplished by imposing a higher cost of capital for investment consideration
or by setting a ceiling on the specific sections of the budget.
Companies may want to implement capital rationing in situations where past returns of
investment were lower than expected.
11. W$at i' Ri'0 anal'i':
N #isk refers to the uncertain conditions under which a firm performs
N -xist because of the inability to forecast future situations
N "orecasts not done with precision
12. W$at i' Ri'0 Mana4#"#nt:
N #isk ,anagement is the logical and systematic method of identifying, analysing, treating and
monitoring the risks involved in any activity or process.
13. W$at i' 1%(t,%li% "ana4#"#nt:
*ortfolio management is a process encompassing many activities of investment in assets and
securities. !t is dynamic and flexible concept and involves continuous and systematic analysis,
'udgement and operations. The ob'ective of this service is to help the novices and initiali0ed
investors with the expertise of professionals in portfolio management.
15. W$at a(# t$# "%ti2#' ,%( in2#'t"#nt:
The investor has to set out his priorities of investment keeping the following motives in mind.
All investors would like to haveK
H. capital appreciation
I. income
R. liquidity or marketability
S. safety or security
89. hedge against inflation
.
1;. #=1lain (i'0 - (#t)(n anal'i'
All investments have some risks. !nvestment in shares of companies has its own risks or
uncertainty. These risks arise out of variability of return or yields and uncertainty of appreciation
or depreciation of share prices, loss of liquidity etc. the risk over time can be represented by the
variance of the returns, while the return over time is capital appreciation plus payout, divided by
the purchase price of the share. )ormally, the higher the risk that the investor takes, the higher is
the return.
50
REVIEW QUESTIONS
8. -xplain the importance of capital analysis and appraisal techniques.
=. -xplain the significance of information of data.$#egarding capital analysis%
A. 3escribe clearly about pro'ect selection.
4. 2hy investment decisions are needed under capital constraints.
?. 2hy capital rationingL -xplain the steps in capital rationing.
H. 2hat are the types of capital rationingL -xplain the reasoning for capital rationing.
I. -xplain the concept of portfolio.
R. -xplain risk and return concept in portfolio.
S. -xplain portfolio risk and diversified pro'ects.

51