Course: CORPORATE FINANCE(8524)

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Semester: Autumn, 2022

ASSIGNMENT-01
Q. 1 Critically discuss the role of finance manager in modern
corporate business with examples.

A financial manger is a person who takes care of all the important financial
functions of an organization. The person in charge should maintain a far
sightedness in order to ensure that the funds are utilized in the most efficient
manner.
His/Her actions directly affect the Profitability, growth and goodwill of the firm.
Following are the main functions of a Financial Manager:
1. Raising of Funds
In order to meet the obligation of the business it is important to have
enough cash and liquidity. A firm can raise funds by the way of equity
and debt. It is the responsibility of a financial manager to decide the
ratio between debt and equity. It is important to maintain a good balance
between equity and debt.
2. Allocation of Funds
Once the funds are raised through different channels the next important
function is to allocate the funds. The funds should be allocated in such a
manner that they are optimally used. In order to allocate funds in the
best possible manner the following point must be considered
 0. The size of the firm and its growth capability

1. Status of assets whether they are long-term or short-term

2. Mode by which the funds are raised

These financial decisions directly and indirectly influence other

managerial activities. Hence formation of a good asset mix and proper
allocation of funds is one of the most important activity
3. Profit Planning
Profit earning is one of the prime functions of any business organization.
Profit earning is important for survival and sustenance of any
organization. Profit planning refers to proper usage of the profit
generated by the firm.
Profit arises due to many factors such as pricing, industry competition,
state of the economy, mechanism of demand and supply, cost and
output. A healthy mix of variable and fixed factors of production can
lead to an increase in the profitability of the firm.
Fixed costs are incurred by the use of fixed factors of production such as
land and machinery. In order to maintain a tandem it is important to
continuously value the depreciation cost of fixed cost of production. An
opportunity cost must be calculated in order to replace those factors of
production which has gone thrown wear and tear. If this is not noted
then these fixed cost can cause huge fluctuations in profit.
4. Understanding Capital Markets
Shares of a company are traded on stock exchange and there is a
continuous sale and purchase of securities. Hence a clear understanding
of capital market is an important function of a financial manager. When
 securities are traded on stock market there involves a huge amount of
risk involved. Therefore a financial manger understands and calculates
the risk involved in this trading of shares and debentures.
Its on the discretion of a financial manager as to how to distribute
the profits. Many investors do not like the firm to distribute the profits
amongst share holders as dividend instead invest in the business itself to
enhance growth. The practices of a financial manager directly impact the
operation in capital market.

Q. 2 What is Capital Asset Pricing Model? Discuss the

applications of Capital Asset Pricing Model in discussion
making.

The Capital Asset Pricing Model (CAPM) describes the relationship

between systematic risk, or the general perils of investing, and expected return for
assets, particularly stocks. It is a finance model that establishes a linear
relationship between the required return on an investment and risk. The model is
based on the relationship between an asset's beta, the risk-free rate (typically
the Treasury bill rate), and the equity risk premium, or the expected return on the
market minus the risk-free rate.
CAPM evolved as a way to measure this systematic risk. It is widely used
throughout finance for pricing risky securities and generating expected returns for
assets, given the risk of those assets and cost of capital.
 The capital asset pricing model - or CAPM - is a financial model that
calculates the expected rate of return for an asset or investment.

 CAPM does this by using the expected return on both the market and a
risk-free asset, and the asset's correlation or sensitivity to the market
(beta).

 There are some limitations to the CAPM, such as making unrealistic

assumptions and relying on a linear interpretation of risk vs. return.

 Despite its issues, the CAPM formula is still widely used because it is simple
and allows for easy comparisons of investment alternatives.

 For instance, it is used in conjunction with modern portfolio theory (MPT)

to understand portfolio risk and expected return.

The formula for calculating the expected return of an asset, given its risk, is as
follows:
Investors expect to be compensated for risk and the time value of money.
The risk-free rate in the CAPM formula accounts for the time value of money. The
other components of the CAPM formula account for the investor taking on
additional risk.
The goal of the CAPM formula is to evaluate whether a stock is fairly valued
when its risk and the time value of money are compared with its expected return.
In other words, by knowing the individual parts of the CAPM, it is possible to
gauge whether the current price of a stock is consistent with its likely return.
The beta of a potential investment is a measure of how much risk the investment
will add to a portfolio that looks like the market. If a stock is riskier than the
market, it will have a beta greater than one. If a stock has a beta of less than one,
the formula assumes it will reduce the risk of a portfolio.
A stock’s beta is then multiplied by the market risk premium, which is the return
expected from the market above the risk-free rate. The risk-free rate is then added
to the product of the stock’s beta and the market risk premium. The result should
give an investor the required return or discount rate that they can use to find the
value of an asset.
For example, imagine an investor is contemplating a stock valued at $100
per share today that pays a 3% annual dividend. Say that this stock has a beta
compared with the market of 1.3, which means it is more volatile than a broad
market portfolio (i.e., the S&P 500 index). Also, assume that the risk-free rate is
3% and this investor expects the market to rise in value by 8% per year.
The expected return of the stock based on the CAPM formula is 9.5%:
\begin{aligned} &9.5\% = 3\% + 1.3 \times ( 8\% - 3\% ) \\ \end{aligned}
9.5%=3%+1.3×(8%−3%)
The expected return of the CAPM formula is used to discount the expected
dividends and capital appreciation of the stock over the expected holding period.
If the discounted value of those future cash flows is equal to $100, then the CAPM
formula indicates the stock is fairly valued relative to risk.
Unrealistic Assumptions
Several assumptions behind the CAPM formula have been shown not to hold up in
reality. Modern financial theory rests on two assumptions:
1. Securities markets are very competitive and efficient (that is, relevant
information about the companies is quickly and universally distributed and
absorbed).

2. These markets are dominated by rational, risk-averse investors, who seek

to maximize satisfaction from returns on their investments.

As a result, it’s not entirely clear whether CAPM works. The big sticking point is
beta. When professors Eugene Fama and Kenneth French looked at share returns
on the New York Stock Exchange, the American Stock Exchange, and Nasdaq,
they found that differences in betas over a lengthy period did not explain the
performance of different stocks. The linear relationship between beta and
individual stock returns also breaks down over shorter periods of time. These
findings seem to suggest that CAPM may be wrong.2
Including beta in the formula assumes that risk can be measured by a stock’s
price volatility. However, price movements in both directions are not equally
risky. The look-back period to determine a stock’s volatility is not standard
because stock returns (and risk) are not normally distributed.
The CAPM also assumes that the risk-free rate will remain constant over the
discounting period. Assume in the previous example that the interest rate on U.S.
Treasury bonds rose to 5% or 6% during the 10-year holding period. An increase
in the risk-free rate also increases the cost of the capital used in the investment
and could make the stock look overvalued.
Estimating the Risk Premium
The market portfolio used to find the market risk premium is only a theoretical
value and is not an asset that can be purchased or invested in as an alternative to
the stock. Most of the time, investors will use a major stock index, like the S&P
500, to substitute for the market, which is an imperfect comparison.
The most serious critique of the CAPM is the assumption that future cash flows
can be estimated for the discounting process. If an investor could estimate the
future return of a stock with a high level of accuracy, then the CAPM would not
be necessary.

The CAPM and the Efficient Frontier

Using the CAPM to build a portfolio is supposed to help an investor manage their
risk. If an investor were able to use the CAPM to perfectly optimize a portfolio’s
return relative to risk, it would exist on a curve called the efficient frontier.
Modern portfolio theory (MPT) suggests that starting with the risk-free rate, the
expected return of a portfolio increases as the risk increases. Any portfolio that fits
on the capital market line (CML) is better than any possible portfolio to the right
of that line, but at some point, a theoretical portfolio can be constructed on the
CML with the best return for the amount of risk being taken.
The CML and the efficient frontier may be difficult to define, but they illustrate an
important concept for investors: There is a tradeoff between increased return and
increased risk. Because it isn’t possible to perfectly build a portfolio that fits on
the CML, it is more common for investors to take on too much risk as they seek
additional return.
Considering the critiques of the CAPM and the assumptions behind its use in
portfolio construction, it might be difficult to see how it could be useful. However,
using the CAPM as a tool to evaluate the reasonableness of future expectations or
to conduct comparisons can still have some value.
Imagine an advisor who has proposed adding a stock to a portfolio with a $100
share price. The advisor uses the CAPM to justify the price with a discount rate of
13%. The advisor’s investment manager can take this information and compare it
with the company’s past performance and its peers to see if a 13% return is a
reasonable expectation. Assume in this example that the peer group’s performance
over the last few years was a little better than 10% while this stock had
consistently underperformed, with 9% returns. The investment manager shouldn’t
take the advisor’s recommendation without some justification for the increased
expected return.
An investor also can use the concepts from the CAPM and the efficient frontier to
evaluate their portfolio or individual stock performance vs. the rest of the market.
For example, assume that an investor’s portfolio has returned 10% per year for the
last three years with a standard deviation of returns (risk) of 10%. However, the
market averages have returned 10% for the last three years with a risk of 8%.
The investor could use this observation to reevaluate how their portfolio is
constructed and which holdings may not be on the SML. This could explain why
the investor’s portfolio is to the right of the CML. If the holdings that are either
dragging on returns or have increased the portfolio’s risk disproportionately can
be identified, then the investor can make changes to improve returns. Not
surprisingly, the CAPM contributed to the rise in the use of indexing, or
assembling a portfolio of shares to mimic a particular market or asset class,
by risk-averse investors. This is largely due to the CAPM message that it is only
possible to earn higher returns than those of the market as a whole by taking on
higher risk (beta).
R. 3 What is sensitivity analysis/How is sensitivity analysis
conducted? Discuss with examples.

Sensitivity Analysis is used to understand the effect of a set of independent

variables on some dependent variable under certain specific conditions. For
example, a financial analyst wants to find out the effect of a company’s net
working capital on its profit margin. The analysis will involve all the variables that
have an impact on the company’s profit margin, such as the cost of goods sold,
workers’ wages, managers’ wages, etc. The analysis will isolate each of these fixed
and variable costs and record all the possible outcomes.
 Sensitivity analysis determines how different values of an independent
variable affect a particular dependent variable under a given set of
assumptions.

 This model is also referred to as a what-if or simulation analysis.

  Sensitivity analysis can be used to help make predictions in the share
prices of publicly traded companies or how interest rates affect bond
prices.

 Sensitivity analysis allows for forecasting using historical, true data.

 While sensitivity analysis determines how variables impact a single event,

scenario analysis is more useful to determine many different outcomes for
more broad situations.

Advantages of Financial Sensitivity Analysis

There are many important reasons to perform sensitivity analysis:
 Sensitivity analysis adds credibility to any type of financial model by testing
the model across a wide set of possibilities.

 Financial Sensitivity Analysis allows the analyst to be flexible with the

boundaries within which to test the sensitivity of the dependent variables
to the independent variables. For example, the model to study the effect of
a 5-point change in interest rates on bond prices would be different from
the financial model that would be used to study the effect of a 20-point
change in interest rates on bond prices.

 Sensitivity analysis helps one make informed choices. Decision-makers use

the model to understand how responsive the output is to changes in
certain variables. Thus, the analyst can be helpful in deriving tangible
conclusions and be instrumental in making optimal decisions.

Sensitivity analysis is a financial model that determines how target variables are
affected based on changes in other variables known as input variables. It is a way
to predict the outcome of a decision given a certain range of variables. By creating
a given set of variables, an analyst can determine how changes in one variable
affect the outcome.1
Both the target and input—or independent and dependent—variables are fully
analyzed when sensitivity analysis is conducted. The person doing the analysis
looks at how the variables move as well as how the target is affected by the input
variable.
Sensitivity analysis can be used to help make predictions about the share prices
of public companies. Some of the variables that affect stock prices include
company earnings, the number of shares outstanding, the debt-to-equity
ratios (D/E), and the number of competitors in the industry. The analysis can be
refined about future stock prices by making different assumptions or adding
different variables. This model can also be used to determine the effect that
changes in interest rates have on bond prices. In this case, the interest rates are the
independent variable, while bond prices are the dependent variable.
Sensitivity analysis allows for forecasting using historical, true data. By studying
all the variables and the possible outcomes, important decisions can be made
about businesses, the economy, and making investments.
Financial models that incorporate sensitivity analysis can provide management a
range of feedback that is useful in many different scenarios. The breadth of the
usefulness of sensitivity analysis includes but is not limited to:
 Understanding influencing factors. This includes what and how different
external factors interact with a specific project or undertaking. This allows
management to better understand what input variables may impact
output variables.
  Reducing uncertainty. Complex sensitivity analysis models educate users
on different elements impacting a project; this in turn informs members on
the project what to be alert for or what to plan in advance for.

 Catching errors. The original assumptions for the baseline analysis may

have had some uncaught errors. By performing different analytical
iterations, management may catch mistakes in the original analysis.

 Simplifying the model. Overly complex models may make it hard to

analyze the inputs. By performing sensitivity analysis, users can better
understand what factors don't actually matter and can be removed from
the model due to its lack of materiality.

 Communicating results. Upper management may already be defensive or

inquisitive about an undertaking. Compiling analysis on different situations
helps inform decision-makers of other outcomes they may be interested in
knowing about.

 Achieving goals. Management may lay long-term strategic plans that must

meet specific benchmarks. By performing sensitivity analysis, a company
can better understand how a project may change and what conditions
must be present for the team to meet its metric targets.

Q. 4 Juaind investment Group invested 30% in stock A,

25% in stock B, and 35% in stock C. It is expected
that returns on stock A, B and C might be 10%, 12%
and 13% respectively according to financial history
 and calculations based on past data of returns on
investment. You are advised to calculate the
expected return son portfolio investment for the
aforementioned investment group and write
analytical comments in your view.
p(boom) = 2/3 and p(recession)=1/3 (Note that probabilities always add up to 1)

E(RA) = 2/3 × 0.10 + 1/3 × 0.06 = 0.0867 (8.67%)

E(RB) = 2/3 × -0.02 + 1/3 × 0.40 = 0.12 (12%)

SD(RA) = [2/3 × (0.10-0.0867)2 + 1/3 × (0.06-0.0867)2]0.5= 0.018856 (1.886%)

SD(RB) = [2/3 × (-0.02-0.12)2 + 1/3 × (0.40-0.12)2]0.5 = 0.19799 (19.799%)

Portfolio weights: WA=0.5 and WB=0.5:

E(RP) = 0.5 × 0.0867 + 0.5 × 0.12 = 0.10335 (10.335%)

Portfolio weights: WA=0.1 and WB=0.9:

E(RP) = 0.1 × 0.0867 + 0.9 × 0.12 = 0.11667 (11.667%)

Q. 5 What is debt financing? Critically discuss the

importance of debt financing for corporate organization.

Debt financing occurs when a firm raises money for working capital or capital
expenditures by selling debt instruments to individuals and/or institutional
investors. In return for lending the money, the individuals or institutions
become creditors and receive a promise that the principal and interest on the
debt will be repaid. The other way to raise capital in debt markets is to issue
shares of stock in a public offering; this is called equity financing.

 Debt financing occurs when a company raises money by selling debt

instruments to investors. 

 Debt financing is the opposite of equity financing, which entails issuing

stock to raise money. 

 Debt financing occurs when a firm sells fixed income products, such as
bonds, bills, or notes.

 Unlike equity financing where the lenders receive stock, debt financing
must be paid back.  

 Small and new companies, especially, rely on debt financing to buy

resources that will facilitate growth.

When a company needs money, there are three ways to obtain financing: sell
equity, take on debt, or use some hybrid of the two. Equity represents an
ownership stake in the company. It gives the shareholder a claim on future
earnings, but it does not need to be paid back. If the company goes bankrupt,
equity holders are the last in line to receive money.
A company can choose debt financing, which entails selling fixed
income products, such as bonds, bills, or notes, to investors to obtain the capital
needed to grow and expand its operations. When a company issues a bond, the
investors that purchase the bond are lenders who are either retail or institutional
investors that provide the company with debt financing. The amount of the
investment loan—also known as the principal—must be paid back at some agreed
date in the future. If the company goes bankrupt, lenders have a higher claim on
any liquidated assets than shareholders. 
Cost of Debt
A firm's capital structure is made up of equity and debt. The cost of equity is the
dividend payments to shareholders, and the cost of debt is the interest payment to
bondholders. When a company issues debt, not only does it promise to repay the
principal amount, it also promises to compensate its bondholders by making
interest payments, known as coupon payments, to them annually. The interest rate
paid on these debt instruments represents the cost of borrowing to the issuer.
The sum of the cost of equity financing and debt financing is a company's cost of
capital. The cost of capital represents the minimum return that a company must
earn on its capital to satisfy its shareholders, creditors, and other providers of
capital. A company's investment decisions relating to new projects and operations
should always generate returns greater than the cost of capital. If a company's
returns on its capital expenditures are below its cost of capital, the firm is not
generating positive earnings for its investors. In this case, the company may need
to re-evaluate and re-balance its capital structure.
The formula for the cost of debt financing is:
KD = Interest Expense x (1 - Tax Rate)
where KD = cost of debt
Since the interest on the debt is tax-deductible in most cases, the interest expense
is calculated on an after-tax basis to make it more comparable to the cost of equity
as earnings on stocks are taxed.
Measuring Debt Financing
One metric used to measure and compare how much of a company's capital is
being financed with debt financing is the debt-to-equity ratio (D/E). For example,
if total debt is $2 billion, and total stockholders' equity is $10 billion, the D/E ratio
is $2 billion / $10 billion = 1/5, or 20%. This means for every $1 of debt
financing, there is $5 of equity. In general, a low D/E ratio is preferable to a high
one, although certain industries have a higher tolerance for debt than others. Both
debt and equity can be found on the balance sheet statement.

Debt Financing vs. Interest Rates

Some investors in debt are only interested in principal protection, while others
want a return in the form of interest. The rate of interest is determined by market
rates and the creditworthiness of the borrower. Higher rates of interest imply a
greater chance of default and, therefore, carry a higher level of risk. Higher
interest rates help to compensate the borrower for the increased risk. In addition to
paying interest, debt financing often requires the borrower to adhere to certain
rules regarding financial performance. These rules are referred to as covenants.
Debt financing can be difficult to obtain. However, for many companies, it
provides funding at lower rates than equity financing, particularly in periods of
historically low-interest rates. Another advantage to debt financing is that the
interest on the debt is tax-deductible. Still, adding too much debt can increase the
cost of capital, which reduces the present value of the company.

Debt Financing vs. Equity Financing

The main difference between debt and equity financing is that equity financing
provides extra working capital with no repayment obligation. Debt financing must
be repaid, but the company does not have to give up a portion of ownership in
order to receive funds.
Most companies use a combination of debt and equity financing. Companies
choose debt or equity financing, or both, depending on which type of funding is
most easily accessible, the state of their cash flow, and the importance of
maintaining ownership control. The D/E ratio shows how much financing is
obtained through debt vs. equity. Creditors tend to look favorably on a relatively
low D/E ratio, which benefits the company if it needs to access additional debt
financing in the future.

Advantages and Disadvantages of Debt Financing

One advantage of debt financing is that it allows a business to leverage a small

amount of money into a much larger sum, enabling more rapid growth than might
otherwise be possible. Another advantage is that the payments on the debt are
generally tax-deductible. Additionally, the company does not have to give up any
ownership control, as is the case with equity financing. Because equity financing
is a greater risk to the investor than debt financing is to the lender, debt financing
is often less costly than equity financing.
The main disadvantage of debt financing is that interest must be paid to lenders,
which means that the amount paid will exceed the amount borrowed. Payments on
debt must be made regardless of business revenue, and this can be particularly
risky for smaller or newer businesses that have yet to establish a secure cash flow.
Advantages of debt financing

 Debt financing allows a business to leverage a small amount of capital to

create growth
 Debt payments are generally tax-deductible
 A company retains all ownership control
 Debt financing is often less costly than equity financing
Disadvantages of debt financing

 Interest must be paid to lenders

 Payments on debt must be made regardless of business revenue
 Debt financing can be risky for businesses with inconsistent cash flow