Capital Management & Portfolio Management

Ans wer: 1
Introduction:
Stock Investments: Stocks are an equity investment constitute a part ownership in an
organization and entitle us to be part of that organization’s earnings i.e., Profits and its
assets. Stocks are a share of the holding of an organization. Firstly, they are sold by the
original owners of an organization to gain secondary funds to help the organization grow.
The price of the stock increases when the organization shows a good performance in the
market and this will enable the stockholders to gain a return on their investment. The
organization uses the method of issuing and selling shares of stocks to raise its capital. This
is agreed in order to achieve the goals of the organization like floating a new company,
expansions and improvements. Stock investments help us to own a part of an organization.

Stock Market: Stock Market is a place where shares of the public are listed in companies
and are traded. The stock market is an organised system where we can buy and sell our
stocks and shares.
The stock market has a track of the overall stocks which are sold under the following
Sensex:
 National Stock Exchange (NSE).
 Bombay Stock Exchange (BSE).
 Over The Counter Exchange of India (OTCEI).
At present, there are in total 22 stock exchanges in India, which are approved by SEBI.
The stock market is managed and regulated by the Securities Exchange Board of India
(SEBI). These stock markets are located in different cities of India such as Kolkata, Kochi
Ahmedabad, Bangalore, Chennai, Delhi and Hyderabad.
Bombay Stock Exchange (BSE) is located in Mumbai and is one of the two major large
stock exchanges of India. National Stock Exchange of India (NSE) is also located in
Mumbai and is one of the two major large stock exchanges of India.
Mr Lalawani wants to invest in the share market. Mr Lalawani thinks that to understand
better about any industry, there should be an analysis done on the industry or company to
which we will be investing to get better returns. Below analysis will help us understand it
better how Mr Lalawani decides on the industry he will be investing.

Fundame ntal Analysis:

Fundamental analysis is an analytical and methodical approach to compute future
dividends and share price. In other words, fundamental analysis can be classified as a
comprehensive study of the basic factors like economy, industry and also which affects the
performance of an organisation. The main function in fundamental analysis is to
understand and interpret the financial statements of the organisations. By analysing this,
the company’s future performance can be concluded by the fundamental analysts.

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Fundame ntal analysis can be further divided into three type of analysis, they are as
follows:
A. The Economy Analysis.
B. The Industry Analysis.
C. The Company Analysis.
Explanation in detail:
A. Economy Analysis:
The economy’s performance of the market or state or country in which it operates is
directly related to the performance of a company. When the economy is raising high,
automatically, the income rises, demands for items increases, and therefore, it benefits to
both the industry and to the company. Possibly, the performance of the company will be
affected if there is a downfall in the economy.
Hence, the variables in the economy that has an impact on the performance of the company
which will be analysed. The forecast of company earnings and payments of dividends and
interest of the investors can all be analysed under this type of analysis which will help to
understand the overview idea about the analysis.
In macroeconomic analysis, the characteristics difference of the assets and their returns are
a business cycle, revenue and monetary scheme of the government, expenditure level
investment opportunities, exchange rates, inflation, unemployment level, etc.

B. Industry Analysis:
The regulatory power within the organisation and the phase of the industry’s development
cycle are identified and achieved. Industry analysis includes the nature of the industry. The
following factors influence the industry analysis:
 The demand for Assets in the Market.
 Pricing of Assets.
 Costs of the Asset for the Organisation.
 Impact of the Economics and Financial Aspects of the Market on the Assets’
Performance.
The life cycle of an industry mainly constitute four stages:
 Introduction: In this stage, the costs of the industry’s products are high and the demand
for the product is low. These stages of companies are often referred to as start-up firms.
The sales of this industry’s product will also be low.
 Growth: In this stage, the industry will be established in the market with little
competition and increased sales. The sales of the industry will grow faster than any
other stage of the life cycle.
 Maturity: After an industry enters the maturity stage, the product of the industry gets a
better standard. In this stage, companies challenge will be on the process of the price.
Additionally, the cash flows remain accurate and the chances for further growth are low
in this stage.

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 Decline: In this stage, the company’s sales begin to decline and the demand for the
substitute or other alternate new product increases. The buyers start to switch to other
new product which is available in the market because of many certain reasons and huge
competition in the market.

C. Company Analysis:
The investor chooses an industry where the profits are high. The investor gets this
assistance from the industry analysis. Once the industry is recognised for the investment
reason, the investor chooses a company in that industry on the basis of the company
analysis. Company analysis can be conducted used by disclosing publicly and inspect the
audited financial statements of a company for not less than three years of the period.
To understand the status of any company we need to have a minimum three years financial
statement to know how the company is performing. These financial statements include
Balance Sheet, Profit or Loss account Statement, Statement of Profit Distribution and Cash
Flow Statement. The company earnings have a direct and strong effect upon the share price
and this helps the analyst to predict the future earnings of the company in this stage.
Before we buy and sell stocks we need to consider a few factors. There are five factors
which we should keep in mind before buying any stock. The factors are as follows:
 First, we need to examine the company we would like to invest in and also the nature of
the stock market.
 Secondly, it is the dividends and their demands. This outstanding indicator will be the
percentage rate of return that we should be aware of. The higher the price of the stock,
the lower will be the demand.
 It is also an important factor to do research and analysis before buying stocks and
investing in common.
 Whenever we want to buy a stock, we need to invest in a co mpany for a long-term
period.
 The price-earnings ratio is another important factor that we should examine before
buying any stock. The PE ratio can be defined as the ratio of the market price of a stock
to the earning per share.

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Ans wer: 2
Introduction:
Expected Returns: There are many proposals to evaluate the expected return of an asset
or portfolio. It is good to approach for using the historical data for reference. There is also
another method which uses the probability of different return results. It is also important to
evaluate the return of independent assets in the portfolio precisely because the return of the
portfolio completely rely on return the independent assets.

To forecast the returns from the single securities we need to determine the possible returns
from the asset in future, which will be the actual expected return. Therefore, we can
forecast the returns from single security using expected returns formula. Moreover, the
investors himself will calculate the standard deviation in the probable returns so as to
recognize the risk related to an asset. As we have already studied both these concepts
earlier i.e., expected returns and standard deviation.

Let’s now directly do the calculation of returns from a single security with the help of Mr
Anand’s scenario where he wants to determine in two securities i.e., A and B, and decide
in which security he should invest. For this reason, Mr Anand needs to forecast the returns
on both of these securities.

Calculation of Expected Return (ER) of both the Securities A and B

Security A E (r) Security B E (r)
Return (r) Probability (p) Return (r) Probability (p)
0.15 0.2 0.03 0.12 0.15 0.018
0.1 0.05 0.005 0.1 0.05 0.005
0.12 0.1 0.012 0.08 0.45 0.036
0.05 0.4 0.02 0.09 0.15 0.0135
0.13 0.25 0.0325 0.1 0.2 0.02
Total 0.0995 Total 0.0925
The Expected Return for Security A is 0.0995 or 9.95% where as the Expected Return for
Security B is 0.0925 or 9.25%
Working Note:
Security A: Security B:

Formula to find Expected Return E(r): Formula to find Expected Return E(r):
E(r) = Return * Probability E(r) = Return * Probability
E(r) = r * p E(r) = r * p
a) 0.15 * 0.2 = 0.03 a) 0.12 * 0.15 = 0.018
b) 0.1 * 0.05 = 0.005 b) 0.1 * 0.05 = 0.005
c) 0.12 * 0.1 = 0.012 c) 0.08 * 0.45 = 0.036
d) 0.05 * 0.4 = 0.02 d) 0.09 * 0.15 = 0.0135
e) 0.13 * 0.25 = 0.0325 e) 0.1 * 0.2 = 0.02

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Standard Deviation (σ): Standard Deviation can be defined as the compute the dispersion
of a set of data from its mean. It shows about the level of liability of the assets. The square
root of variance will be as the higher the dispersion, the higher the standard deviation.

The expected return of a portfolio is computed by taking the weighted average of the
expected return of the stocks in the portfolio. The variance of a portfolio is to estimate the
liability or the risk related to it. Portfolio variance takes into account the standard deviation
of each asset of the portfolio as well as the covariance of each asset of the portfolio with
the others.

Calculation of Risk of Security A

Security A
Return (r) Probability (p) E(r) [r-∑E(r)] [r-∑E(r)]2 *p
0.15 0.2 0.03 0.0505 0.0005
0.1 0.05 0.005 0.0005 0.0000
0.12 0.1 0.012 0.0205 0.0000
0.05 0.4 0.02 -0.0495 0.0010
0.13 0.25 0.0325 0.0305 0.0002
Total 0.0995 0.0018

Formula to find the Standard Deviation risk of Security A:

σA = √∑ [r-∑E(r)]2 *p
σA = √0.0018
σA = 0.0424 or 4.24%

Calculation of Risk of Security B

Security B
Return (r) Probability (p) E(r) [r-∑E(r)] [r-∑E(r)]2 *p
0.12 0.15 0.018 0.0275 0.0001
0.1 0.05 0.005 0.0075 0.0000
0.08 0.45 0.036 -0.0125 0.0001
0.09 0.15 0.0135 -0.0025 0.0000
0.1 0.2 0.02 0.0075 0.0000
Total 0.0925 0.0002

Formula to find the Standard Deviation risk of Security B:

σB = √∑ [r-∑E(r)]2 *p
σB = √0.0002
σB = 0.0141 or 1.41%

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An overview of Expected Return and Standard Deviation Risk of both the Security A
and B:
Security Return Risk
A 9.95 4.20
B 9.25 1.41

Inte rpretation and Analysis:

 The Expected Return E(r) of Security A is 0.0995 or 9.95%.
 The Expected Return E(r) of Security B is 0.0925 or 9.25%.
 The Standard Deviation (σ) to find Risk of Security A is 0.0424 or 4.24%.
 The Standard Deviation (σ) to find Risk of Security B is 0.0141 or 1.41%.
 From the above calculation, we can make out that the Expected Return for both the
Security A and B is almost the same value.
 There is a lower risk in Security B than in Security A because the risk ratio of Security
A is higher than Security B.
 As I am being a financial research analyst I would advise Mr Anand to take the lower
risk Security i.e., Security B, because the return is almost the same for both Security A
and Security B.

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Ans wer: 3
3a) Computing the Expected Return based on CAPM with all the components of the
CAPM Model:

Capital Asset Pricing Model (CAPM): Capital Asset Pricing Model (CAPM) is a
financial model which is utilised to ascertain a suitable rate of return of an asset and risky
securities, if it needs to be included to a well-diversified portfolio, given the non
diversifiable risk. CAPM explain the relationship between Risk and Expected Return. The
asset is responsible for taking into the analysis of market variations, frequently shown with
quantity beta (β) and the Expected Return of the market and the return of hypothetical risk-
free asset.
The formula to compute the CAPM model is as below:
E(R i ) = R f + βi (E(R M) – Rf)

Components of Capital Asset Pricing Model (CAPM) are as follows below:

 All the investors should expect to utilize monetary features.
 All the investors should widely expand across a series of investments.
 All the investors should be able to offer and use endless sum under risk-free rate of
interest.
 All the investors should be operating with securities which are highly separated into the
tiny collection.
 All the investors are prices are absorbers and they will not be able to manipulate the
prices.
 All the investors are practical and indifferent.
 All the investors assume that all information is available to all the investors at the same
time.

Computation of expected return based on CAPM:

Given data,
Beta (βi) = 1.55
Market rate of return E(RM) = 15%
Risk free rate of return (Rf) = 8%
CAPM E(Ri) = ?

E(R i ) = R f + βi (E(R M) – Rf)

E(Ri) = 0.08 + 1.55 (0.15 - 0.08)
E(Ri) = 0.08 + 1.55 * 0.07
E(Ri) = 0.08 + 0.1085
E(R i ) = 0.1885 or 18.85%

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Working Note:
a) Risk- free rate of return (Rf) = 8%

Risk free rate of return (R f) = 0.08

b) Market rate of return E(RM = 15%

Market rate of return E(R M = 0.15

Inte rpretation and Analysis:

 The market rate of return E(RM) is 15% i.e., 0.15
 The risk- free rate of return (Rf) is 8% i.e., 0.08
 The beta (βi) value given for Pragati Ltd is 1.55.
 The Capital Asset Pricing Model CAPM E(Ri) of Pragati Ltd. is 0.1885 or 18.85%

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3b) The risk premium on the market goes up by 3.5% points so let's compute the
expected return on the stock will change for Pragati Ltd company:

Risk Premium: Risk Premium refers to the return in a surplus of the risk-free rate that an
investor is supposed to receive for taking a certain amount of risk. Risk- free assets are
always integrated with the market portfolio of high-risk assets by the investors. Returns
can be predicted from the investor’s investment as per risk.

Calculation of Risk Premium when the market price goes up by 3.5%

Risk Premium = Rm – Rf = 0.15 – 0.08 = 0.07

If the Risk Premium goes up by 3.5%,

New Risk Premium = 0.035 + 0.07
New Risk Pre mium (Rm – Rf)= 0.105

E(R i ) = R f + βi (RM – Rf)

E(Ri) = 0.08 + 1.55 (0.105)
E(Ri) = 0.08 + 0.1628
E(R i ) = 0.2428 or 24.28%

Inte rpretation and Analysis:

 The market rate of return E(RM) is 15% i.e., 0.15.
 The risk- free rate of return (Rf) is 8% i.e., 0.08.
 The beta (βi) value given for Pragati Ltd is 1.55.
 The new Risk Premium value is 0.105.
 The Risk Premium return of Pragati Ltd. is 0.2428 or 24.28%.
 If the risk premium goes up by 3.5% then the return will also go up to 24.28% as
compared to an earlier return of 18.85%.

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