ANSWER 1

DIVIDEND DECISIONS AND VALUATION

OF FIRM: WALTER’S MODEL
Professor James E. Walter argues that the choice of dividend policies always
affect the value of the firm. Walter’s model shows the importance of the
relationship between the firm’s rate of return and it’s cost of capital in
determining dividend policy that will maximise the wealth of the shareholders.

Assumptions of Walter’s Model are as follows:

1.Infinite time
2. Constant EPS and DPS
3. 100% Payout/ Retention
4. Constant return and cost of capital
5. Internal Financing

Formula to calculate market price per share is as follows:

P = D/k + {r*(E-D)/k}/k,

Where,

P = market price per share

D = dividend per share

E = earning per share

r = internal rate of return of the firm

k = cost of capital of the firm

To understand the model better we shall consider an example -

 GROWTH FRIM( r > k) NORMAL FIRM ( r = k) DECLINING FRIM ( r < k)

r = 0.15 r = 0.10 r = 0.08

k = 0.10 EPS = Rs.10 k = 0.10 EPS = Rs.10 k = 0.10 EPS = Rs.10

Pay-out ratio = 0% Pay-out ratio = 0% Pay-out ratio = 0%

D = Rs.0 D = Rs.0 D = Rs.0

P = 0 + (0.15/0.10)(10-0)/0.10 = P = 0 + (0.10/0.10)(10- P = 0 + (0.08/0.10)(10-
Rs.150 0)/0.10 = Rs.100 0)/0.10 = Rs.80

Pay-out ratio = 40% Pay-out ratio = 40% Pay-out ratio = 40%

D = Rs.4 D = Rs.4 D = Rs.4

P = [4 + (0.15/0.10)(10-4)]/0.10 P = [4 + (0.10/0.10)(10- P = 4 + (0.08/0.10)(10-
= Rs.130 4)]/0.10 = Rs.100 0)/0.10 = Rs.88
Pay-out ratio = 100%
Pay-out ratio = 100%
Pay-out ratio = 100%
D = Rs.10
D = Rs.10
D = Rs.10 P = [10 + (0.08/0.10)(10-
P = [10 + (0.15/0.10)(10-
P = [10 + (0.10/0.10)(10- 10)]/10
10)]/0.10
10)]/0.10 = Rs.100 = Rs. 100
= Rs.100

From the above table we observe the following-

Relationship between Decrease in Dividend

Increase in Dividend Payout
r and k Payout

r>k Value of the firm decreases Value of the firm increases

r<k Value of the firm increases Value of the firm decreases

No change in the value of the No change in the value of

r=k
firm the firm

Criticism of Walters model-

No External Financing

Walter’s assumption of complete internal financing by the firm through

retained earnings is difficult to follow in the real world. The firms do
require external financing for new investments.

Constant r and k

It is very rare to find the internal rate of return and the cost of capital to
be constant. The business risks will definitely change with more
investments which are not reflected in this assumption.

Conclusion of retaining 100 % of earning

Conclusion of Walter Model that, if r exceeds ke, than retain 100 % of

earning is unrealistic. Considering dividend payment by other companies,
it is necessary to make equity dividend payment otherwise company’s
stock will be out of favor. Cash return will give psychological more
satisfaction, in comparison to change in price of security.

Other unrealistic assumptions

Assuming that there is no debt financing, preference share capital

financing, no flotation costs, transaction cost, capital market is perfect
are impractical assumptions.
CONCLUSION & IMPLICATIONS-
Growth Firm

Growth firms are characterized by an internal rate of return > cost of the
capital i.e. r > k. These firms will have surplus profitable opportunities to
invest. Because of this, the firms in growth phase can earn more return
for their shareholders in comparison to what the shareholders can earn
if they reinvested the dividends somewhere else. Hence, for growth firms,
the optimum payout ratio is 0%.

Normal Firm

Normal firms have an internal rate of return = cost of the capital i.e. r = k.
The firms in normal phase will make returns equal to that of a
shareholder. Hence, the dividend policy is of no relevance in such a
scenario. It will have no influence on the market price of the share. So,
there is no optimum payout ratio for firms in the normal phase. Any
payout is optimum.

Declining Firm

Declining firms have an internal rate of return < cost of the capital i.e. r <
k. Declining firms make returns that are less than what shareholders can
make on their investments. So, it is illogical to retain the company’s
earnings. In fact, the best scenario to maximize the price of the share is to
distribute entire earnings to their shareholders. The optimum dividend
payout ratio, in such situations, is 100%.
 MODILGILANI AND MILLER (MM) THESIS
WITH NUMRICAL EXPLAINATION

They have argued that the market price of a share is affected by the earnings
of the firm and is not influenced by the pattern of income distribution.
Therefore, the dividend policy is immaterial and is of no consequence to the
value of the firm. Modigliani – Miller theory is a major proponent of ‘Dividend
Irrelevance’ notion. According to this concept, investors do not pay any
importance to the dividend history of a company and thus, dividends are
irrelevant in calculating the valuation of a company. This theory is in direct
contrast to the ‘Dividend Relevance’ theory which deems dividends to be
important in the valuation of a company.
If the investor needs more money than the dividend he received, he can
always sell a part of his investments to make up for the difference. Likewise, if
an investor has no present cash requirement, he can always reinvest the
received dividend in the stock. Thus, the Modigliani – Miller theory firmly
states that the dividend policy of a company has no influence on
the investment decisions of the investors.

This theory also believes that dividends are irrelevant by the arbitrage

argument. By this logic, the dividends distribution to shareholders is offset by
the external financing. Due to the distribution of dividends, the price of the
stock decreases and will nullify the gain made by the investors because of the
dividends.

Assumptions of MM approach-

1. Perfect Capital markets

2. No taxes
3. No risks
4. Investment policy is independent of financing policy

Modigliani – Miller’s valuation model is based on the assumption of same

discount rate/rate of return applicable to all the stocks.
P 1 = P0 * (1 + ke) – D 1

Where,

P 1 = market price of the share at the end of a period

P 0 = market price of the share at the beginning of a period

ke = cost of capital

D1 = dividends received at the end of a period

For example,

A firm has 1,00,000 shares outstanding and is planning to declare a dividend of

Rs.5 at the end of current financial year. The present market price of the share
is Rs.100. the cost of equity capital is 10%. The expected market price at the
end of the year 1 may be found under two options:

1. If dividend paid is Rs.5

2. If dividend is not paid

CASE 1

If dividend of Rs.5 is paid

Po = (D1 + P1)/(1 + ke) P1 = Po(1+ke) – D1 =100 (1.10) – 5

= Rs.105
Total worth of share
= 105 + 5
=110

CASE 2

If dividend of Rs.5 is not paid

Po = (D1 + P1)/(1 + ke)

P1 = Po(1+ke) – D1 =100(1.10)
= Rs.110

ARBITRAGE PROCESS

Value of firm
nPo = 1/(1+ke) * [(n+m)P1 – I + E]

I = total investment made in the year 1

E = total earnings of the firm
n = number of shares outstanding
m = new shares issued

Let the firm has total profits of Rs.10,00,000 during year 1 and is planning to
make investment of Rs.20,00,000 in the end of year 1.

CASE 1 CASE 2
Total Earnings 10,00,000 10,00,000
Dividend Paid 5,00,000 -
Retained earnings 5,00,000 10,00,000
Fund requirement 20,00,000 20,00,000
Fresh capital to be issued 15,00,000 10,00,000
MP at the end of year 1 105 110
Number of shares to be 14285.71 9090.9
issued
Total number of shares 114285.71 109090.9

Value of firm in case 1

nPo = 1/(1+ke) * [(n+m)P1 – I + E] = 1/(1+0.10) * [(1,14,285.71)105 – 20,00,000

+ 10,00,000]
= Rs.1,00,00,000

Value of firm in case 2

nPo = 1/(1+ke) * [(n+m)P1 – I + E]

= 1/(1+0.10) * [(1,09,090.9)110 – 20,00,000 + 10,00,000]
= Rs. 1,00,00,000

So, the value of the firm remains the same at Rs.1,00,00,000 whether the
dividend is paid or not. With the help of arbitrage process, as explained above,
it can be shown that the dividend policy is irrelevant for the valuation of the
firm.
CRITICISM
Modigliani – Miller theory on dividend policy suffers from the following
limitations:

 Perfect capital markets do not exist. Taxes are present in the capital
markets.
 According to this theory, there is no difference between internal
and external financing. However, if the flotation costs of new issues
are considered, it is false.
 This theory believes that the shareholder’s wealth is not affected by
the dividends. However, there are transaction costs associated with
the selling of shares to make cash inflows. This makes the investors
prefer dividends.
 The assumption of no uncertainty is unrealistic. The dividends are
relevant under the certain conditions as well.
 MYRON GORDAN’S DIVIDEND THEORY
Gordon’s theory on dividend policy is one of the theories believing in
the ‘relevance of dividends’ concept. It is also called as ‘Bird-in-the-
hand’ theory that states that the current dividends are important in
determining the value of the firm. Gordon’s model is one of the most
popular mathematical models to calculate the market value of the
company using its dividend policy. Myron Gordon’s model explicitly
relates the market value of the company to its dividend policy. The
determinants of the market value of the share are the perpetual
stream of future dividends to be paid, the cost of capital and the
expected annual growth rate of the company.

Assumptions of Gordon’s model-

1. No Debt
2. No External Financing
3. Constant IRR
4. Constant Cost of Capital
5. Perpetual Earnings
6.No Corporate Taxes
7. Constant Retention Ratio
8. K>g

Formula for calculating market value of share -

Po = EPS(1-b)/k-br
Where,
EPS = Earnings per share
b = retention ratio
k = firm’s cost of capital
r = Firm’s Internal rate
GROWTH FIRM ( r > k) NORMAL FIRM ( r = k) DECLINING FIRM ( r < k)
r = 0.15 r = 0.10 r = 0.08
k = 0.10 EPS = Rs.10 k = 0.10 EPS = Rs.10 k = 0.10 EPS = Rs.10
Pay-out ratio P = 40% Pay-out ratio P = 40% Pay-out ratio P = 40%

g = br = 0.6*0.15 = 0.09 g = br = 0.6*0.10 = 0.06 g = br = 0.6*0.08 = 0.048

P = 10(1-0.6)/0.10-0.09 P = 10(1-0.6)/0.10-0.06 P = 10(1-0.6)/0.10-0.048
= Rs.400 = Rs.100 = Rs.77
Pay-out ratio P = 60% Pay-out ratio P = 60% Pay-out ratio P = 60%

g = br = 0.4*0.15 = 0.06 g = br = 0.4*0.10 = 0.04 g = br = 0.4*0.08 = 0.032

P = 10(1-0.4)/0.10-0.06 P = 10(1-0.4)/0.10-0.04 P = 10(1-0.4)/0.10-0.032
= Rs.150 = Rs.100 = Rs.88

Implications-

Gordon’s model believes that the dividend policy impacts the company in
various scenarios as follows:

Growth Firm

A growth firm’s internal rate of return  (r) > cost of capital (k). It

benefits the shareholders  more if the company reinvests the dividends
rather than distributing it. So, the optimum payout ratio for growth firms
is zero.

Normal Firm

A normal firm’s internal rate of return (r) = cost of the capital (k). So, it
does not make any difference if the company reinvested the dividends or
distributed to its shareholders. So, there is no optimum dividend payout
rati o for normal firms.
However, Gordon revised this theory later and stated that the dividend
policy of the firm impacts the market value even when r=k. Investors will
always prefer a share where more current dividends are paid.

Declining Firm

The internal rate of return (r) < cost of the capital (k) in the declining
firms. The shareholders are benefitted more if the dividends are
distributed rather than reinvested. So, the optimum dividend payout ratio
for declining firms is 100%.

Criticism of Gordon’s Model

Gordon’s theory on dividend policy is criticized mainly for the unrealistic

assumptions made in the model.

Constant Internal Rate of Return and Cost of Capital

The model is inaccurate in assuming that r and k always remain constant.

A constant r means that the wealth of the shareholders is not optimized.
A constant k means the business risks are not accounted for while valuing
the firm.

No External Financing

Gordon’s belief of all investments being financed by retained earnings is

faulty. This reflects sub-optimum investment and dividend policies.
 JOHN’S LINETER MODEL OF DIVIDEND
Lintner's dividend policy model is a model theorizing how a publicly-traded
company sets its dividend policy. The logic is that every company wants to
maintain a constant rate of dividend even if the results in a particular period
are not up to the mark. The assumption is that investors will prefer to receive a
certain dividend payout.
The model states that dividends are paid according to two factors. The first is
the net present value of earnings, with higher values indicating higher
dividends. The second is the sustainability of earnings; that is, a company may
increase its earnings without increasing its dividend payouts until managers
are convinced that it will continue to maintain such earnings. The theory was
adopted based on observations that many companies will set their long-run
target dividends-to-earnings ratios based upon the amount of positive net-
present-value projects that they have available.

The following formula describes a mature corporation’s dividend payout:

Dt=k+ PAC (TDt−Dt−1)+et where:

D= Dividend

Dividendt  is the dividend at time t, the change from the previous dividend at

period (t -1)

PAC= PAC<1 is a partial adjustment coefficient

TD=Target Dividend

k = A constant

et = The error term

Lintner observed the following important facets of corporate dividend policies:

 1. Companies tend to set long-run target dividends-to-earnings ratios
according to the amount of positive net present value (NPV) projects
they have available.
2. Earnings increases are not always sustainable. As a result, dividend
policy will not materially change until managers can see that new
earnings levels are sustainable.

While all companies wish to sustain a constant dividend payout to maximize

shareholder wealth, natural business fluctuations force companies to project the
dividends in the long run, based on their target payout ratio. From Lintner’s formula,
a company’s board of directors thus bases its decisions about dividends on the firm’s
current net income, yet adjusts them for certain systemic shocks, gradually adapting
them to shifts in income over time.

The Lintner Model and Setting Corporate Dividends 

A company’s board of directors sets the dividend policy, including the rate of

payout and the date(s) of distribution. This is one case in which shareholders
are not able to vote on this corporate measure (in contrast with cases like a
merger or acquisition, and additional critical issues like executive
compensation).

The three main approaches to corporate dividend policy are as follows:

1. The residual approach, in which dividend payments come out of the

residual or leftover equity only after specific project capital
requirements are met. (In such cases, companies rely on internally
generated equity to finance any new projects.) Companies using the
residual dividend approach usually attempt to maintain balance in their
debt-to-equity ratios before making any distributions.
2. The stability approach, in which the board often sets quarterly dividends
at a fraction of yearly earnings. This reduces uncertainty for investors
and provides them with a steady source of income.
3. A hybrid of both the residual approach and stability approach, in which a
company’s board views the debt-to-equity ratio as a longer-term goal. In
these cases, companies usually decide on one set dividend that is a
relatively small portion of yearly income and can be easily maintained,
as well as an extra dividend payment to distribute only when income
exceeds general levels.
 ANSWER 2

PORTFOLIO THEORY
Introduction

The portfolio theory, popularly known as Markowitz Model, provides a logical

and analytical tool for the selection of an optimal portfolio. This model is based
on expected return (i.e. mean) and risk (i.e. variance) and, hence, is also
termed as Mean-Variance Optimization Model. The model was put forth by
Harry Markowitz in a paper titled “Portfolio Selection” in Journal of Finance in
1952.

Assumptions

This model is based on certain assumptions such as:

1. Investors are risk averse.
2. Portfolios can be analyzed in terms of their risk and return.
3. The decision regarding selection of an optimal portfolio by an investor is
based only on return and risk.
4. Investors are rational, i.e., they attempt to have maximum return for a given
risk and minimum risk for a given return.
5. Different investors have different risk-return preferences.

Using above assumptions, the Markowitz Model of portfolio selection can be

presented in following steps:

Step 1: Setting the portfolio opportunity set (or investment opportunity set)

First of all, we need to prepare a portfolio opportunity set. The graphical

presentation of feasible portfolios is termed as Portfolio (or Investment)
Opportunity Set. It shows the risk and returns of all possible portfolios which
can be made from a set of available securities. For example, in case of two
securities A and B, we can form a number of portfolios just by changing their
weights or proportion of funds invested in each. We can have 1% in A and 99%
in B, 2% in A and 98% in B and so on. In real life we have many securities,
hence the portfolio opportunity set comprises of an infinite number of feasible
portfolios which can be constructed using the available securities.

Step 2: Determining the Efficient Set of portfolios (i.e. Efficient Frontier):

Once the region of all feasible portfolios has been identified, the next task is to
find out those portfolios which are efficient. All feasible portfolios are not
efficient. An efficient portfolio is one:

(i) which has maximum return for a given level of risk or

(ii) which has minimum risk for a given level of return.

A set of these efficient portfolios is known as Efficient Frontier. It is the

graphical presentation of all efficient portfolios out of the feasible portfolios.

Step 3: Constructing indifference curves of the investor

The efficient frontier which we derive in step 2 shows all efficient portfolios
from which the investor will choose his optimal portfolio. But efficient frontier
alone cannot help an investor to select the optimal portfolio. The basic
criterion for the selection of optimal portfolio is that the satisfaction or utility
of the investor is maximized. For this we construct Indifference Curves for the
investors. An indifference curve shows all those combinations of risk and
return which generate same utility for an investor. Since all investors are risk
averse, the indifference curves of the investor will be upward sloping. It must
be noted
that a less risk averse investor will have rather flatter indifference curves while
a more risk averse investor will have steeper indifference curves. Furthermore,
indifference curves for a particular investor cannot intersect.

Step 4: Selecting the optimal portfolio

The last step is the selection of optimal portfolio and, for that, we superimpose
indifference curves of the investor on the efficient frontier. The indifference
curves show the utility that an investor
derives using different combinations of risk and returns. The higher the
indifference curve the greater is the utility. On the same indifference curve
utility is same. Efficient frontier shows all efficient portfolios from which the
investor has to choose his Best or Optimal Portfolio. Hence, selection of the
optimal or best portfolio must meet the following two conditions:
 a. The portfolio is efficient, i.e., it must lie on efficient frontier, and
b. The utility of the investor is maximized, i.e., it should lie on the
highest possible indifference curve.

It can be generalized that the optimal portfolio for an investor under

Markowitz model is the point of tangency between the efficient frontier and
the highest possible indifference curve. This is also referred to as the point of
equilibrium.

1. Selection of Optimal Portfolio (P)

Limitations of Markowitz Model

Markowitz model suffers from the following limitations:

1. Markowitz model is quite demanding in terms of data requirements. In

order to analyze ‘n’ securities, we need (3n+n 2)/2 data inputs. It
becomes very cumbersome and complex to handle such a large data set.
For example, in order to analyze 100 securities, we need 100 returns,
100 variances and 4950 co variances i.e. a total of 5150 data inputs. This
is substantial.
2. As per Markowitz Model, there are as many optimal portfolios as there are
number of investors. However, this limitation is removed when we introduce a
risk free asset in the capital market.
 CAPITAL ASSET PRICING MODEL
Introduction:

Capital Asset Pricing Model is a popular model used to predict expected return
on a security or portfolio. As per this model, an investor gets rewarded only for
bearing the systematic risk (or non-diversifiable risk) as the unsystematic risk
can be diversified away. CAPM is built on the premise that in market portfolio
there is no unsystematic risk because it is efficiently diversified portfolio.
Hence, Capital Market Line which shows the relationship between expected
return and total risk should in fact show a relationship between expected
return and systematic risk indicated by β factor. Therefore, it shows that there
is a positive and linear relationship between expected return and systematic
risk.

Assumptions of CAPM

CAPM is based on several simplified assumptions which are given below:

i. All investors are risk averse.

ii. Investors make decisions solely on the basis of risk and return assessments.
This implies that expected return and variance are the only factors considered
in investment decisions.
iii. Securities are infinitely divisible. One can buy or sell securities even in
fractions.
iv. There are no restrictions on short selling.
v. There are many investors and buy or sell transaction of any investor will not
affect the price of the securities. There is perfect competition in capital market.
vi. There are no transaction costs or taxes. The capital market is efficient and
frictionless.
vii. Investors can borrow or lend unlimited amount at the same risk free rate.
viii. Investors have identical or homogeneous expectations about expected
returns, variances, and covariances.
ix. All the investors hold efficiently diversified portfolios having no
unsystematic risk. The only relevant risk in estimating return is systematic risk.

The CAPM Model

As per CAPM,
Expected Return = Risk Free Rate + Market Risk Premium X Systematic Risk
ERi = Rf + (Rm-Rf)β
where,
1. Risk free rate of return: Risk free rate is rate of return on a security which
does not have any risk. Hence, risk free rate is not a reward for bearing any
risk. It is a compensation for time. It is therefore also termed as time value of
money.
2. Market risk premium or the market price for risk: This is the reward an
investor must get for bearing one unit of market risk or systematic risk.
3. Amount of systematic risk indicated by β: β measures the sensitivity of a
security’s returns to the returns of market portfolio. It must be noted that
securities differ in terms of their sensitivity to market portfolio. Some securities
are less sensitive while others are more sensitive. Hence, β of different
securities and portfolios are also different. The higher the β, the higher will be
the sensitivity of a security return to market portfolio and higher will be its
impact on security return.

Uses of CAPM

Two important uses of CAPM are:

1. In wealth management industry, CAPM is used to find out securities which
are underpriced or overpriced. So that a prospective investor can make
investment in underpriced security and an existing investor
can sell overpriced securities.
2. In Capital Budgeting decisions in Financial Management, we calculate
weighted average cost of capital (WACC) as the appropriate discount rate. An
important component of WACC is cost of equity. CAPM can
be used to determine the cost of equity which is nothing but required rate of
return from the investor.

Criticism of CAPM

CAPM is criticized on the following grounds:

1. CAPM is based on many simplified and unrealistic assumptions which may
not hold true in real life. In real life securities are not infinitely divisible, there
are transaction costs and taxes, unlimited lending and borrowing is not
possible at the same risk free rate and so on.
2. The estimation of β factor is not a simple task. We may calculate β using
historical data. But past β values may not be valid in future. Hence, β is not
constant overtime. Therefore, any estimation error in β factor will result in an
incorrect estimation of expected return.
 ARBITRAGE PRICING THEORY
Introduction

As per the Arbitrage Pricing Theory (APT), an asset’s returns can be forecasted
with the linear relationship of an asset’s expected returns and the
macroeconomic factors that affect the asset’s risk. Unlike the Capital Asset
Pricing Model (CAPM), which only takes into account the single factor of the
risk level of the overall market, the APT model looks at several macroeconomic
factors. The theory was developed in 1976 by American economist, Stephen
Ross.

Working of the Model

The theory assumes that market action is less than perfectly efficient, and
therefore occasionally results in assets being mispriced – either overvalued or
undervalued – for a brief period of time. However, market action should
eventually correct the situation, moving price back to its fair market value. To
an arbitrageur, temporarily mispriced securities represent a short-term
opportunity to profit.

Typically, arbitrage is considered as the practice of the simultaneous purchase

and sale of an asset on different exchanges, taking advantage of slight pricing
discrepancies to lock in a ‘risk-free’ profit for the trade. However, the APT’s
concept of arbitrage is different from the classic meaning of the term. In the
APT, arbitrage is not a risk-free operation – but it does offer a high probability
of success. What the arbitrage pricing theory offers traders is a model for
determining the theoretical fair market value of an asset. Having determined
that value, traders then look for slight deviations from the fair market price,
and trade accordingly.

ER(x) = Rf + β1RP1 + β2RP2 +…+ βnRPn

where,
ER(x) – Expected return on asset
Rf – Riskless rate of return
βn (Beta) – The asset’s price sensitivity to factor
RPn – The risk premium associated with factor
Comparison with CAPM

The APT is a more flexible and complex alternative to the Capital Asset Pricing
Model (CAPM). The theory allows investors and analysts to customize their
research. However, it is more difficult to apply, as it takes a considerable
amount of time to determine all the various factors that may influence the
price of an asset.
 RISK AND RETURN
Return

Return may be defined as total income generated by an investment expressed

as a percentage of the cost of investment. Income from an investment may be
revenue income and capital income. Revenue income is generated on regular
basis say every year. Capital gain (or loss) is the difference between the selling
price (or closing price) and the purchase price (or beginning price) of the
investment.
Computation of Return:
Return on a security = (Income from Asset + (Selling price- Purchase
price))/Purchase Price

Risk

Risk is defined in terms of the variability in expected return. All investments

are subject to risks, however, the level of risk differs from security to security.
Risks arises because the investment may generate return different than the
expected return.
Depending upon the causes of risks, total risk can be classified as:
1. Systematic Risk: Systematic risk is that part of total risk which is caused
by factors beyond the control of a specific company or individual.
Systematic risk is caused by factors such as economic, political, socio-
cultural etc. All the investments or securities are subject to systematic
risk and therefore it is non-diversifiable risk, i.e., it cannot be diversified
away by holding a large number of securities. Systematic risk includes:
a. market risk,
b. interest rate risk,
c. purchasing power risk, and
d. exchange rate risk.

2. Unsystematic risk: It is the risk caused by factors within the control of a

specific company such as issues related to management, assets, labor or
capital. Unsystematic risk can be diversified away by holding an efficient
portfolio of securities which are not correlated. Hence unsystematic risk
is also called ‘diversifiable risk’. Unsystematic risk includes:
a. business risk, and
 b. financial risk.
Computation of Risk:
Risk of a security = standard deviation of returns from the security