MMPC-014

MBA and MBA (Banking & Finance)

ASSIGNMENT
for
January 2022 and July 2022 sessions

MMPC-014: Financial Management

(Last date of submission for Jan 2022 Session is 15th May 2022 and for July 2022 Session
is 31st October 2022).

School of Management Studies

INDIRA GANDHI NATIONAL OPEN UNIVERSITY
MAIDAN GARHI, NEW DELHI – 110 068
 ASSIGNMENT
Course Code : MMPC-014
Course Title : Financial Management
Assignment Code : MMPC-014/TMA/JAN/2022
Coverage : All Blocks

Note: Attempt all the questions and submit this assignment to the coordinator of your study
centre. Last date of submission for January 2022 Session is 15th May 2022 and for July
2022 Session is 31st October 2022.

1. Discuss the various sources of risk and segregate them into systematic and unsystematic risk.
How is historical risk and expected return is measured.

2. Assume that a firm pays tax at the rate of 30%. Compute the after tax cost of capital in the
following cases:
(i) A 85% per cent preference share sold at par
(ii) A ten year, 10% Rs. 100 par bond sold at Rs. 95 less 4 per cent underwriting
commission.

(iii) A perpetual bond sold at par carrying 10% rate of interest.

(iv) An ordinary share selling at a current market price of Rs. 120 and paying a current
dividend of Rs. 9 per share which is expected to grow at the rate of 8%.

3. Explain the various ‘Relevance Theories’ of dividends and discuss the major differences among
Walter’s Model and Gardon’s Model.

4. Explain the concept of Behavioural Finance and discuss with suitable examples, the errors and
biases encountered while making financial decisions.

5. (a) A certain scheme of a bank offers an annuity of Rs. 1800 for 10 years, if you invest Rs. 12,000
today. What is the rate of interest in this scheme?

(b) A firm purchases a machinery for Rs. 80, 00,000 making a down payment of Rs. 15,00,000.
The rest of the amount along with the interest is to be paid in equal installments of Rs. 15, 00,000
for six years. What is the rate of interest to the firm?
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MMPC 14 Financial Management

Q1- Discuss the various sources of risk and segregate them into systematic and unsystematic risk.
How is historical risk and expected return is measured?
Ans – Various sources of risk
The risk associated with an investment is always a concern for an investor. He is confronted with
several inquiries. To comprehend risk, S/he needs to be aware of the following:
1-- What makes investment risky?
2-- What are the various elements or sources of risk that the investments are exposed to?
Variations in investment return can be attributed to a variety of factors. Each of these sources
carries a certain amount of danger. We have mentioned above that there are various causes for
future returns differing from predicted returns. Now, let us focus on understanding distinct risk
sources. The following are the several sources of risk in investments:

1-- Market Risk- Even though the company's earnings do not change, market prices of investments,
particularly equity shares, may fluctuate in a short period. The causes for this pricing change could
be several. Investors' attitudes toward equities may change as a result of one or more factors,
leading to a change in market price. The return on investment varies depending on the market price.
This is referred to as market risk. Market risk is the variation in return caused by changes in the
market price of an investment and arises as a result of investors' reactions to various key
occurrences. The market prices of equity shares are affected by a variety of social, political,
economic, and firm-specific events. Another aspect that influences market prices is market
psychology. Market prices for all shares tend to rise during bull periods, while prices tend to fall
during bear phases.
2-- Interest-Rate Risk.
The interest rate influences the return on securities in a variety of ways. Because investors always
compare risk-free return with expected return on investment, it has an impact on the expected or
required rate of return. When the interest rate rises, the expected or needed rate of return on other
assets rises as well. Thus, the interest rates on risk-free (government) securities and the general rate
of interest are linked. The rate of interest on other bond securities rises or falls in tune with the
riskfree rate of interest. Interest rate risk refers to the variation in return induced by market price
changes in fixed income products, such as bonds and debentures. The price of a security (bonds and
debentures) is inversely proportional to the level of interest rates. Existing securities' prices decline
when the interest rate rises, and vice versa. Changes in interest rates have a direct impact on bond
and debenture prices, as well as an indirect impact on equity share values.
3--Inflation Risk.
Inflation risk is the variability in the total purchasing power of an asset. It arises from the rising
general price level. Thus, it refers to the unpredictability of the buying power of cash flows expected
from an investment. It depicts how inflation or deflation affects an investment. Interest rates on
bonds and debentures, as well as dividend rates on stock and preference shares, are expressed in
money terms, and if the general price level rises in the future, the purchasing power of cash
interest/dividend income will certainly drop. If the money rate of return is equal to the rate of
inflation, the investor obtains a zero rate of return.
4-- Business Risk
Business enterprises work in a constantly changing environment, which makes expected income to
fluctuate. A change in government policy on fertilizer subsidies, for example, could harm a group of
fertilizer companies. Similarly, a competitor's conduct, whether domestic or foreign, might have an
impact on other businesses. While the aforementioned changes in the environment are the result of
specific entities, several other elements alter the operational environment but can not be traced to a
particular sources. For example, many businesses are affected by the business cycle, and their
earnings fluctuate dramatically from one year to the next
5-- Financial Risk.
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When the company capital structure includes debt, financial risk occurs. Debt creates a fixed liability,
which increases the income variability available to equity stockholders and it is not always a negative
thing. It will boost profitability when the company performs well, and stock investors receive a
higher return than would otherwise be available. Because of the fixed liability, debt causes problems
in poor times. If the company fails to satisfy its debt obligations, the managers will have to spend a
significant amount of time convincing lenders to accept a delayed payment, wasting valuable
managerial time in the process.
6-- Management Risk:- Management risk is the portion of total return variability caused by
managerial actions in companies where the owners are not the managers. Regardless of how
experienced the Management team is, there is always the risk of making a mistake or making the
wrong decision. Ownersinvestors are rightfully enraged when executives are paid large salaries and
bonuses and are given ego-boosting non-income spendings such as fancy automobiles and lavishly
equipped offices, but their poor decisions put the company in serious trouble.
7--Liquidity Risk- The inability of a seller to sell assets without offering price reductions and
commissions is known as liquidity risk. It is simple to rate assets based on their liquidity. A country's
currency unit is immediately saleable at par, with no requirement for a discount or other
concessions. The next most liquid asset class is government securities and blue-chip stocks. Some
tiny and lesser-known corporations' debt securities and equity shares are less liquid, if not illiquid.
Due to lack of liquidity, investors are forced to sell securities at a lower price than the current price,
especially when the quantity to be sold is significant. Therefore, when choosing securities, investors
must consider the liquidity risk also.
8-Social or Regulatory Risk - The social or regulatory risk emerges when an otherwise successful
venture is harmed by unfavorable legislation, a harsh regulatory environment, or, in the worst-case
scenario, nationalization by a socialist government. Price controls may lower the revenues of
industrial enterprises and rent controls may largely eliminate the value of rental property. The social
risk is essentially political and thus unpredictable, but no industry can expect to be immune to it
under a representative democracy based on rising government interference in corporate matters.
9-- Other Risks: The monetary value risk and the political environment risk are two further
categories of risk, particularly when investing in foreign assets. The investor who purchases foreign
government bonds or securities of foreign firms in the hope of obtaining a slightly better yield than
domestic issues.

TYPES OF RISK
The first three types of risk in investments, namely market risk, interest rate risk, and inflation risk,
are external to the firm and therefore cannot be managed. These are all pervasive and have an
impact on all businesses. The business and financial risk, on the other hand, are controlled and
internal to a certain corporation. Based on this analysis, the risk may be classified into systematic
and unsystematic risk.
Systematic Risk.
The portion of return variability induced by factors impacting all enterprises is referred to as
systematic risk. Diversification will not be able to mitigate such a risk. The following are some
examples of systemic risk:
1-- The government changes the interest rate policy.
2-- The corporate tax rate is increased.
3-- The government resorts to massive deficit financing.
4-- The inflation rate increased.
5-- The Central Bank of the Country promulgates a restrictive credit policy.
6-- Government fails to attract FIIs.
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Unsystematic Risk.
The unsystematic risk is the variation in the return of an investment owing to factors that are specific
to the firm and not to the market as a whole. Unsystematic, or unique risk, is a type of risk that can
be completely mitigated through diversification. The following are some examples of unsystematic
risk:
1-- Workers declare a strike in a company
2-- The R&D expert of the company leaves.
3-- A formidable competitor enters the market.
4-- The company loses a big contract in a bid.
5-- The company makes a breakthrough in process of innovation.
6-- The government increases custom duty on the material used by the company.
7-- The company is not able to obtain an adequate quantity of raw material used by the company.

Total risk is equal to systematic risk + non-systematic risk because the two components are additive.
In most cases, systemic risk is calculated by comparing the stock's performance to the market's
performance under various scenarios. For example, if the stock appreciates more than other stocks
in the market during a good period and depreciates more than other stocks in the market during a
poor period, the stock's systematic risk is more than the market risk. The market's systematic risk is
one, and systematic risk of all stocks is stated in terms of the market index's systematic risk. This is
accomplished by measuring a value known as beta. When stock returns are regressed on market-
index returns, the beta of the stock equals the beta of the regression coefficient. If a stock's beta is
1.50, it is likely to see a price increase of 1.5 times as compared to market return of 1. At the same
time, if the market falls by a certain percentage in a terrible period, the stock is predicted to fall 1.5
times as much as the market.
Risk Vs. Uncertainty:
Although the terms risk and uncertainty are sometimes used interchangeably, their perceptions
differ. Risk implies that a decision-maker is aware of the probable outcomes of a decision and its
associated probabilities. Uncertainty refers to a scenario in which the likelihood of a particular
occurrence is unknown. Investors strive to maximize Expected Returns while staying within their risk
tolerance. The degree of risk depends upon the basis of the features of assets, investment
instruments, and the mode of investment.

Causes of Risk
Some factors, which can be stated to cause risk in the investment arena, are given below:
1—Wrong method of investment,
2-- Wrong period of investment,
3-- Wrong quantity of investment,
4— Interest rate risk,
5-- Nature of investment instruments,
6-- Nature of industry,
7-- Nature of business in which investment is made,
8-- National and international factors,
9-- Nature calamities etc.
MEASURING HISTORICAL RISK
Risk refers to the possibility that the actual outcome of an investment will differ from the expected
outcome. Alternatively, risk refers to variability or dispersion. If an asset’s return has no variability, it
is riskless. Suppose you are analyzing the total return of an equity stock over some time. Apart from
knowing the mean return, you would also like to know about the variability in returns.
Variance and Standard Deviation:
The most commonly used measures of risk in finance are the Variance or its square root; the
Standard Deviation. The variance and the standard deviation of a historical risk are defined as
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follows:

MEASURING EXPECTED RETURN

We have just looked at historical (ex facto) return and risk so far. Now we will discuss the predicted
(ex-ante) return and risk.
1--Expected Rate of Return:
The expected rate of return is the weighted average of all possible returns multiplied by their
respective probabilities. In symbols:

2-- Standard Deviation of Return:

The dispersion of a variable is referred to as risk. The variance or standard deviation are usually used
to calculate it. The sum of the squares of the deviations of actual returns from the expected return,
weighted by the related probabilities, is the variance of a probability distribution. In terms of
symbols,

Q3- Explain the various ‘Relevance Theories’ of dividends and discuss the major differences among
Walter’s Model and Gardon’s Model?
Ans – Relevance Theories of Dividend
Relevance theory of dividends states that a well-reasoned dividend policy can positively influences a
firm’s position in the stock market. Higher dividends will increase the value of stock, whereas low
dividends will have the opposite effect.The relevance dividend theories support the view that the
dividend policy has profound impact on the value of a firm. There are three theories under this
school of thought. They are:
1-- Traditional Theory
2-- Walter’s Model
3-- Gordon’s Model
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A-- Traditional Theory

The traditional theory was expounded by B. Graham and D.L. Dodd. According to them, “….. the
stock market is overwhelmingly in favour of liberal dividends as against niggardly dividends”. As per
this model the importance attached to liberal current dividends by the shareholder is more. The
shareholders give less importance to capital gains that may arise in future. Therefore, firms which
pay more current dividends will have higher market value than the firms which pay less dividends.
The model is expressed in the following way-

In the above model earnings per share (E) is equal to the sum of dividend per share (D) and retained
earnings per share (R)
∴E=D+R
Substitute this expression in Equation-1

The weight attached to dividends is equal to four times the weight attached to retained earnings (R).
These weights provided by Graham and Dodd are based on their subjective judgement and not
derived from objective analysis. According to their view the liberal payout policy has favourable
impact on stock prices.
4--Walter’s Model
Professor James E. Walter emphasized that dividend policy is a critical factor affecting the firm’s
value. According to him, dividend policy hinges on firm’s internal rate of return (r) and the cost of
capital (k).
This model is based on the following assumptions:
1-- the firm finances new investments through retained earnings only.
2-- the firm’s internal rate of return, and cost of capital are constant.
3-- 100 % of earnings is either distributed as dividends or reinvested internally
4-- The initial earnings and dividends remain constant forever. The earnings per share (EPS) and
dividends per share (D) may be changed to determine results, but any given values of EPS, and the D
assumed to remain constant forever in determining a given value.
5-- The firm has a very long infinite life.
The following is the Walter’s formula to determine the market price (P) per share:
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Gordon’s Model-
Myron Gordon proposed a model of stock valuation, which is supporting the dividend relevance
decision in case of a growth firm [when r > k], and in case of a declining firm [when r < k] and
dividend irrelevance decision in case of a normal firm [when r = k]. This theory relating dividend
policy and the firm’s value, based on the following assumptions:

According to the Gordon’s model, the market value of a firm’s share will be equal to the present
value of future stream of dividends payable for that share. Accordingly, the value of share can be
obtained by the following equation:

Q4- Explain the concept of Behavioural Finance and discuss with suitable examples, the errors and
biases encountered while making financial decisions?
Ans – concept of Behavioural Finance- Traditional Finance, as developed and enriched by several
economists, has dominated the subject of finance since the mid-1950s. The main premise of the
traditional finance model is that individuals are rational. As a result, investors act rationally, and the
stock and bond markets are efficient. Financial economists assumed that people (investors) act
rationally when making financial decisions, whereas, psychologists have discovered that economic
decisions are made irrationally, challenging this premise of traditional finance. Investors can make
poor financial judgments because of cognitive mistakes and severe emotional bias, resulting in
irrational behaviour. The study of behavioural finance has expanded over the last few decades to
investigate how personal and social psychology influence financial decisions and investor behaviour
in general.
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Meaning of Behavioural Finance:

The study of the influence of psychological processes on the behaviour of financial practitioners and
the effect on the market is known as behavioural finance. Investors' market behaviour, according to
behavioural finance, is based on psychological decision-making concepts that explain why people
purchase and sell certain class of assets. Behavioural finance is concerned with how investors
interpret and act on data to make financial decisions.
Further, behavioural finance emphasises investor behaviour, which leads to a variety of market
anomalies. The study of investors' psychology when making financial decisions is known as
behavioural finance. Due to the use of emotions in financial decision-making, investors fall prey to
their own and occasionally others' blunders. Therefore, it is the study of the effects of psychology on
investors and financial markets. It focuses on explaining why investors often appear to lack self-
control, act against their own best interest, and make decisions based on personal biases instead of
facts.
Definitions: The behavioural aspects that are taken into consideration while making decisions are
varied. It is based on two concepts; cognitive psychology, and limits of arbitrage. Different authors
have tried to put this theory in their own words. Some of the definitions as given by different
authors are:
Sewell defined behavioural finance as “the study of the influence of psychology on the behaviour of
financial practitioners and the subsequent effect on markets”.
Shefrin defined Behavioural Finance as it is the application of psychology to financial behaviour – the
behaviour of investment practitioners.” He considers behavioural finance as a rapidly growing area
that deals with the influence of psychology on the behaviour of financial practitioners.
Thus, behavioural finance is defined as the field of finance that proposes psychological based
theories to explain asset market anomalies. Within behavioural finance, it is assumed that the
information structure and the characteristics of market participants systematically influence
individuals’ investment decisions as well as market outcomes.
SCOPE OF BEHAVIOURAL FINANCE
Behavioural finance is an area of study focused on how psychological influences can affect market
outcomes. It can be analysed to understand different outcomes across a variety of sectors and
industries. One of the key aspects of behavioural finance studies is the influence of psychological
biases. The following areas of behavioural finance are discussed:
A-- To understand the reasons for market anomalies: Even while normal finance theories can
explain the stock market to a large extent, there are still numerous market oddities, such as the
emergence of bubbles, the effect of any event, the calendar effect on stock market activity, and so
on. Standard finance leaves many market abnormalities unsolved, whereas behavioural finance
offers explanations and solutions to a variety of market irregularities.
B-- To identify investor’s personality: An in-depth look at behavioural finance can aid in recognising
the many types of investor personalities. Various new financial instruments can be devised to hedge
the unwanted biases caused in the financial markets once the biases of the investor's behaviours are
detected through the study of the investor's personality.
C-- To enhance the skill set of investment advisors: This can be done by providing a better
understanding of the investor’s goals, maintaining a systematic approach to advice, earning the
expected return, and maintaining a win-win situation for both the client and the advisor.
D-- Helps to identify the risks and develop hedging strategies: Because of various anomalies in the
stock markets, investments these days are not only exposed to the identified risks but also the
uncertainty of the returns

DECISION MAKING ERRORS AND BIASES

Let's us, now, have a look at some of the behavioural finance buckets or building components.
Investors are viewed as "normal" in behavioural finance, yet they are vulnerable to decision-making
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biases and errors. At least four buckets may be identified when it comes to decision-making biases
and errors.

FIG-- Diagram –Buckets of Behavioural Finance

1-- Self-Deception: The concept of self-deception is a barrier to learning. We tend to ignore the
knowledge that we need to make an informed decision when we incorrectly believe we know more
than we do.
2-- Heuristic Simplification: Another bucket that we can look into is a heuristic simplification.
Information-processing errors are referred to as heuristic simplification.
3-- Emotion: Emotion is another behavioural finance bucket. In behavioural finance, emotion refers
to our decision-making based on our current emotional state. Our current attitude may cause us to
make decisions that are not based on logic.
4-- Social Influence: The social bucket refers to how our decision-making is influenced by others.

Q5- (A) A firm purchases a machinery for Rs. 80, 00,000 making a down payment of Rs. 15,00,000.
The rest of the amount along with the interest is to be paid in equal installments of Rs. 15, 00,000
for six years. What is the rate of interest to the firm?
Ans- As we know that An annuity is defined as stream of uniform period cash flows. The payment of
life insurance premium by the policyholder to the insurance company is an example of an annuity.
Similarly, deposits in a recurring bank account is also an annuity. Depending on the timing of the
cash flows annuities are classified as:
1-- Regular Annuity or Deferred Annuity
2-- Annuity Due
The regular annuity or the deferred annuity are those annuities in which the cash flow occur at the
end of each period. In case of an annuity due the cash flow occurs at the beginning of the period.
In general terms the future value of an annuity (regular annuity) is given by the following formula:
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Future value of an annuity due

Where FVAn = Future value of an annuity which has a duration of n periods

as per appendix of that.

Now we put value of A= 1800

K= We will find
N= 10 Years
Fv = 18000

After calculation k= 8.15 %

Ans =8.15%
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Q5- (b) A firm purchases a machinery for Rs. 80, 00,000 making a down payment of Rs. 15,00,000.
The rest of the amount along with the interest is to be paid in equal installments of Rs. 15, 00,000
for six years. What is the rate of interest to the firm?
Ans –Step-by-step explanation:

Cost of machinery = 8,00,000 Rs.

Down payment given by the firm = 1,50,000 Rs.

Finance borrowed = 8,00,000 - 1,50,000 = 6,50,000 Rs.

In 6 years the amount paid = 1,50,000 × 6 = 9,00,000 Rs.

Total interest paid in 6 years = 9,00,000 - 6,50,000

= 2,50,000 Rs.

Rate of interest paid by the firm

= (Total Interest/ Total Loan) × 100

= (2,50,000/6,50,000) × 100

= 38.46%

Therefore, the rate of interest that the firm is paying is 38.46%