Financial Management

INDEX

Module Module Description Weight

No.

1 Fundamentals of Financial Management 5%

2 Institutions and Instruments in Financial Markets 10%

3 Tools for Financial Analyses 15%

4 Sources of Finance and Cost of Capital 10%

5 Capital Budgeting 15%

6 Working Capital Management 15%

7 Financing Decision of a Firm 10%

Financial Management
Fundamentals of Financial Management 1
Finance is called “The science of money”. It studies the principles and the methods of
obtaining control ofmoney from those who have saved it, and of administering it by those into
whose control it passes. Financeis a branch of economics till 1890. Economics is defined as
study of the efficient use of scarce resources.
The decisions made by business firm in production, marketing, finance and personnel matters
form the subject matters of economics. Finance is the process of conversion of accumulated
funds to productive use. It is sointermingled with other economic forces that there is difficulty
in appreciating the role of it plays.
Howard and Upton in their book Introduction to Business Finance define Finance “as that
administrative area orset of administrative functions in an organisation which relate with the
arrangement of cash and credit so that the organisation may have the means to carry out its
objectives as satisfactorily as possible”.
In the words of Parhter and Wert, “Business finance deals primarily with raising,
administering and disbursing funds by privately owned business units operating in
nonfinancial fields of industry”.
Corporate finance is concerned with budgeting, financial forecasting, cash management,
credit administration, investment analysis and fund procurement of the business concern and
the business concern needs to adopt moderntechnology and application suitable to the global
environment.
Financial Management is managerial activity which is concerned with the planning and

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controlling of the firm’sfinancial resources.

Objectives of Financial Management

Financial management as the name suggests is management of finance. It deals with planning
and mobilization of funds required by the firm. There is only one thing which matters for
everyone right from the owners to thepromoters and that is money. Managing of finance is
nothing but managing of money.
The main objectives of financial management may be classified into: (i) Profit maximization
(minimization ofloss) and (ii) Value/Wealth maximization.

Objectives of Financial
Management

Profit Maximisation Value/Wealth

(Minimisation of loss) Maximisation

(i) Profit Maximization: In the economic theory, the behaviour of a firm is analysed in
terms of profit maximization. It implies that a firm either produces maximum output
for a given amount of input or uses minimum input for producing a given output. So,
profit is considered to be the main driving force in business. A firm should manage all
aspects of the business in such a way that revenues are maximised and costs are minimised
to obtain maximum profit. Arguments in favour and against of profit maximisation are
discussed in subsequent section of this chapter.
(ii) Value/ Wealth Maximization: The earlier objective of profit maximization is now
replaced by value/ wealth maximization. Since profit maximization is a limited one it
cannot be the sole objective of a firm.Value creation is the driving force behind financial
management. Creating wealth for shareholders by increasing the value for their
investment is the key goal of financial management today. Maximising the market value
of the firm can be calculated by using the formula

MV= MVE+MVD
Where,
MV = Market value of the firm
MVE = Market value of equity
sharesMVD = Market value of debt;
if any

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 When the book values and market values of debts are the same, value or wealth maximization
essentially reflects maximization of market value per equity share.
Arguments in favour and against of profit maximization are discussed in subsequent section
of this chapter.
Another objective of financial management is to trade-off between risk and return. For this,
the firm has to makeefficient use of economic resources mainly capital.

Scope and Functions of Financial Management

A. Scope of Financial Management

Financial management is concerned with managing financial resources in the most optimal
manner.
Modern financial management focuses three important decisions of a firm. These three
decisions are discussedbelow:
B. Functions of Financial Management
The functions of financial management involve acquiring funds for meeting short term and
long-term requirements of the firm, deployment of funds, control over the use of funds and to
trade-off between risk and return.
The modern approach to the financial management is concerned with the solution of major
problems like investment financing and dividend decisions of the financial operations of a
business enterprise. Thus, the functions of financial management can broadly be classified into
three major decisions, namely: (a) Investment decisions. (b)Financing decisions. (c) Dividend
decisions.

Functions of
Financial Management

Investment Financing Dividend

Decisions Decisions Decisions

Working
Capital Dividend Retained
Capital
Budgeting Policy Earnings
Management

Capital
Cost of
Structure Leverages
Capital
Decisions

Based on the above decisions, functions of financial management are discussed below:

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(i) Determining Financial Needs
One of the most important functions of the financial management is to ensure availability of
adequate fi- nancing. Financial needs have to be assessed for different purposes. Money may
be required for initial pro- motional expenses, fixed capital and working capital needs.
Promotional expenditure includes expenditureincurred in the process of company formation.
Fixed assets need depend upon the nature of the business enterprise – whether it is a
manufacturing, non-manufacturing or merchandising enterprise. Current asset needs depend
upon the size of the working capital required by an enterprise.
(ii) Determining Sources of Fund
The finance manager has to choose sources of funds. He may issue different types of
securities and de- bentures. He may borrow from a number of financial institutions and the
public. When a firm is new and small and little known in financial circles, the finance
manager faces a great challenge in raising funds. Even when he has a choice in selecting
sources of funds, that choice should be exercised with great care and caution.
(iii) Financial Analysis
The Finance Manager has to interpret different statements. He has to use a large number of
ratios to analyse the financial status and activities of his firm. He is required to measure its
liquidity, determine its profitability, and assets overall performance in financial terms. The
finance manager should be crystal clear in his mind about the purposes for which liquidity,
profitability and performance are to be measured.
(iv) Optimal Capital Structure
The finance manager has to establish an optimum capital structure and ensure the maximum
rate of return on investment. The ratio between equity and other liabilities carrying fixed
charges has to be defined. In the process, he has to consider the operating and financial
leverages of his firm. The operating activities
leverage exists because of operating expenses, while financial leverage exists because of the
amount of debt involved in a firm’s capital structure.
(v) Cost-Volume-Profit Analysis
The finance manager has to ensure that the income of the firm should cover its variable costs.
Moreover, a firm will have to generate an adequate income to cover its fixed costs as well.
The Finance Manager has to find out the break-even-point-that is, the point at which total
costs are matched by total sales or total revenue. He has to try to shift the activity of the firm
as far as possible from the break-even point to ensure company’s survival against seasonal
fluctuations.
(vi) Profit Planning and Control
Profit planning ensures attainment of stability and growth. Profit planning and control is a
dual function which enables management to determine costs it has incurred, and revenues it
has earned, during a partic-ular period, and provides shareholders and potential investors with
information about the earning strength of the corporation. Profit planning and control are
important be, in actual practice, they are directly related to taxation. Profit planning and
control are an inescapable responsibility of the management.
(vii) Fixed Assets Management
Fixed assets are financed by long term funds. Finance manager has to ensure that these assets
should yieldthe reasonable returns proportionate to the investment. Moreover, in view of the

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 fact that fixed assets are maintained over a long period of time, the assets exposed to changes
in their value, and these changes mayadversely affect the position of a firm.
(viii) Capital Budgeting
Capital budgeting forecasts returns on proposed long-term investments and compares
profitability of dif-ferent investments and their cost of capital. It results in capital expenditure
investment. The various pro- posal assets ranked on the basis of such criteria as urgency,
liquidity, profitability and risk sensitivity. Thefinancial analyser should be thoroughly familiar
with such financial techniques as pay back, internal rate ofreturn, discounted cash flow and net
present value among others because risk increases when investment is stretched over a long
period of time. The financial analyst should be able to blend risk with returns so as to get
current evaluation of potential investments.
(ix) Corporate Taxation
Corporate taxation is an important function of the financial management, for the former has a
serious impact on the financial planning of a firm. Since the company is a separate legal
entity, it is subject to an income-tax structure which is distinct from that which is applied to
personal income.
(x) Working Capital Management
Working capital is the excess of current assets over current liabilities. This is an important
area in the financial management because it is compared to the nervous system of the human
body. Current assets consist of cash, inventory, receivables. Current liabilities consist of
payables and bank overdraft. A prudent finance manager has to formulate a policy in such a
way that there is a balance between profitability and liquidity.
(xi) Dividend Policies
A firm may try to improve its internal financing so that it may avail itself of benefits of future
expansion. However, the interests of a firm and its stockholders are complementary, for the
financial management

Illustration 1
If a person invests `1,50,000 in an investment which pays 12% rate of interest, what will be
the future value of the invested amount at the end of 10 years?
Solution:
The future value (FV) of the invested amount at
the end of 10 years will beFV = PV (1+r)n

FV = `1,50,000
(1+0.12)10
FV = `1,50,000 × 3.106
FV = `4,65,900
Doubling Period
Investor wants to know how long would take to double the investment amount at a given rate
of interest. If we look at the future value interest factor table, we find that when the interest
rate is 12% it takes about 6 years to double the amount. When the interest rate is 6%, it takes
about 12 years to double the amount, so on and so forth. There is a thumb rule of 72 that helps

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to find out the doubling period. According to this rule of thumb, the doubling period is
obtained by dividing 72 by the interest rate.
However, an accurate way of calculating the doubling period is the Rule of “69”.
𝟔𝟗
Under this Rule, doubling period = 0.35 +
𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆

Illustration 2
How long it will take for ` 20,000 to double at a compound rate of 8% per annum
(approximately)?
Solution:

The rule of 72 is r = 72
𝑛

Where,
r = rate of interest or return
n = number of investment years
72
No. of years =
Annual rate of Interest

72
No. of years (n) =
8

No. of years (n) = 9 years

Future value of single and multiple cash flows can be calculated by using the following
formulae:
Table 1.1 Future Value of Single and Multiple Cash Flows

Annually single cash FV= PV(1+r)n PV= Present

flow valueFV=
Future value
Or, FV= PV (FVIFr,n) r= Interest
rate
n= Number of years
FVIFr,n=Future Value Interest
Factor
Multiple times say m PV= Present value
no.
of times compounding FV= Future value
done r= Interest rate
mn

FV  PV1
r 

 n= Number of years
m
  m= Number of times
compounding done say
quarterly then m=4, half-yearly
m=6 and so on.

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 Cash flows of different FV = PV × (1+r)1+ PV × (1+r)2 PV= Present value
1 2

amounts over years i.e. FV= Future value

aseries of payments +….+PV × (1+r)n i.e.
n r = Interest rate
n

 A 1  r  t n = Number of years

t1
t t = 1, 2, 3, 4….
At = Cash flow occuring at time t

(i) Present Value of a Single Flow

Present Value can be calculated by using the following formulas:
Table 1.2: Future Value of Single and Multiple Cash Flows

1. Annually single  1  PV = Present value

PV  FV 
cash flow n FV = future value
 1 r  r = discount
n = no of years
 or, PV = FV(1+r)-
PVI = Present Value Interest Factor
n
F r,n
or, PV =
FV(PVIFr,n)
2. Multiple P = Present value
times,say m   V = future value
  = discount rate
no of times PV  FV 1
discount-ing  r mn  = no of years
  F
done  1 
 m  V
   r

n
m = no of times discounting done say
quarterly then
m = 4, half-yearly m=6 and
so on.
3. Cash flows P = Present value
of different PV= V = future value
amounts = discount rate
overyears n At t F = duration of the cash flow stream
t1
1
r V
r
n
t = indicates years of extending from
oneyear to n years
A = cash flow occuring at time t
The process of discounting, used for finding present value, is simply the reverse of
compounding. The present value formula can be readily obtained by manipulating the
compounding formula:
FV = PV(1+r)n

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Dividing both sides of above Eq. by (1+r)n we get

To find out the present value (FV) of a single cash flow, we can use the MS Excel’s
built-in function.The PV is given below:

PV (RATE, NPER, PMT, FV, TYPE)

RATE is the discount or the interest rate for
a period.NPER is the number of periods.
PMT is the equal payment (annuity) each period
FV is the Future value
TYPE indicates the timing of cash flow, occurring either at the beginning or at the end of the
period.

Illustration 3
Suppose someone promise to give you ` 1,000 three years hence. What is the present value
of this amount if theinterest rate is 10%?
Solution:
The present value can be calculated by discounting ` 1,000, to the present point of time, as
follows:
Value of three years hence = ` 1,000

Annuity and Perpetuity

(A) Annuity

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An annuity is a series of equal payments or receipts occurring over a specified number of
periods. The time period between two successive payments is called payment period or rent
period. The word annuity in broader sense includes payments which can be annual, semi-
annual, quarterly or any other length of time. For example, when a company set aside a fixed
sum each year to meet a future obligation, it is using annuity Future Value of Ordinary
Annuity
In an ordinary annuity, payments or receipts occur at the end of each period. In a ten-year
ordinary annuity, the last payment is made at the end of the tenth year.

Where,
FVAn = Future value of an annuity which is the sum of the compound amounts
of all payments and a du-ration of n periods
A = Amount of each instalment or constant periodic flow
r = Interest rate per period
n = Number of periods

Illustration 4
Apex Ltd. has an obligation to redeem `50 crore bonds 6 years hence. How much should the
company deposit annually in a sinking fund account wherein it earns 12% interest, to
accumulate `50 crore in 6 years’ time?
Solution:
The future value interest factor for a 6-year annuity, given an interest rate 12% is:

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 Present Value of Ordinary Annuity
Present Value of Ordinary Annuity can be calculated by using the following formula:
PVA = A [{1- (1/1+r) n}/r]

where,
PVAn = Present value of an annuity which is the sum of the compound amounts of all
payments and aduration of n periods
A = Amount of each instalment or constant periodic flow
r = Discount rate
n = Number of periods
[{1- (1/1+r)n}/r] is called present value interest factor.

(B) Perpetuity:

Perpetuity is an annuity that occurs indefinitely. The stream of cash flows continues for an
infinite amount of time. Fixed coupon payments on permanently invested (irredeemable) sums
of money are prime examples of perpetuities. Scholarships paid perpetually from an
endowment fund. The value of the perpetuity is finite because
receipts that are anticipated far in the future have extremely low present value.
By definition, in a perpetuity, time period, n, is so large (i.e., mathematically n approaches
infinity) that tends to become zero and the formula for a perpetuity simply becomes
Present value of a perpetuity may be written as follows:

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 Compound Annual Growth Rate (CAGR)
Compound Annual Growth Rate (CAGR) is the annual growth of investments over a
specific period of time. In other words, it is a measure of how much an investor earned from
the investments every year during a given interval.
This is one of the most accurate methods of calculating the rise or fall of your investment
returns over time.
Steps involved in calculating the CAGR of an investment:
Step 1: Divide the value of an investment at the end of the period by its value at the
beginning of that period.Step 2: Raise the result to an exponent of one divided by the number
of years.

Step 3: Subtract one from the subsequent result.

Step 4: Multiply by 100 to convert the answer into a percentage. The Compound Annual
Growth Rate (CAGR) formula is:

Where,

EV= Ending balance is the value of the investment at the end of the investment period.

BV= Beginning balance is the value of the investment at the beginning of the investment
period.

N = Number of years amount invested. CAGR may be used in the following cases:

Calculating and communicating the average returns of investment funds.

(ii)Demonstrating and comparing the performance of investment advisors.

(iii)Comparing the historical returns of stocks with bonds or with a savings account.

(iv) Forecasting future values based on the CAGR of a data series.

(v) Analyzing and communicating the behavior, over a series of years, of different business
measures such as sales, market share, costs, customer satisfaction, and performance.

For example, X Ltd. had revenues of `100 crore in 2010 which increased to ` 1,000 crore in
2020. What was the compounded annual growth rate?

Solution:

The Compounded Annual Growth Rate (CGAR) can be calculated as follows:

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 Practical Applications
An important use of present value concepts is in determining the payments required for an
instalment-type loan. The distinguishing feature of this loan is that it is repaid in equal
periodic payments that include both interest and principal. These payments can be made
monthly, quarterly, semi-annually, or annually. Instalment payments are prevalent in
mortgage loans, auto loans, consumer loans, and certain business loans.
The future value of an annuity can be applied in different scenarios by different organizations and
individuals such as:
(i) One may able to know the accumulated fund at the certain period (i.e., Deposit in Public
Provident Fund)
(ii) How much should one person save annually if his or her savings earn a compound return
(i.e., annualsavings to buy a house after certain period, deposit in sinking fund).
(iii) The present value of an annuity can be applied in case of loan amortization by a borrower.

Illustration 5
Find the present value of ` 1,000 receivable 6 years hence if the rate of discount is 10%.
Solution:
` 1,000 × PVIF10%, 6 = `1,000 × 0.5645 = `564.5

Illustration 6

Find the present value of `1,000 receivable 20 years hence if the discount rate is 8%.
Solution:
We obtain the answer as follows:

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Illustration 7
An individual deposited `1,00,000 in a bank @ 12% compound interest per annum. How much
he would receiveafter 20 years ?
Given, FVIF12, 20 = 9.646
Solution:
FV= PV (1+r) n
Or, FV= PV (FVIFr, n),
Where,

P = Present value or sum invested

V = `100,000Future value
F = Interest rate i.e 12% or 0.12
V = Number of years i.e., 20

r
n
FV = PV (FVIFr, n)
FV = `100,000 × 9.646
FV = `9,64,600

Illustration 8
Mr. X is depositing `20,000 in a recurring bank deposit which pays 9% p.a. compounded
interest. How much amount Mr. A will get at the end of 5th Year.
Solution:
Formula for calculating future value of annuity
FVA = A[{(1+r)n-1}/r]
n

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where,
FVAn = Future value of an annuity which is the sum of the compound amounts of all
payments and a durationof n periods.
A = Amount of each instalment or constant periodic flow
r = Interest rate per period
n = Number of periods
= `20,000 ×1 [{(1+0.09)5-1}/0.09]
= `1,19,694

Illustration 9
A Person is required to pay annual payments of `8,000 in his Deposit Account that pays 10%
interest per year. Findout the future value of annuity at the end of 5 years.
Solution:
Amount Term of the
At the end Future Value (` )
Deposit deposit
of
ed(`) (Years)
1st year 8,000 4 8,000 × 1.464 = 11,713

2nd year 8,000 3 8,000 × 1.331 = 10,648

3rd year 8,000 2 8,000 × 1.210 = 9,680

4th year 8,000 1 8,000 × 1.110 = 8,800

5th year 8,000 - 8,000 × 1.000 = 8,000

Future Value of annuity at the end of 5 years 48,841

Alternatively, the future of annuity can be obtained by using the following formula:
Formula for calculating future value of annuity
FVA = A[{(1+r)n-1}/r]
where,
FVAn = Future value of an annuity which is the sum of the compound amounts
of all payments and a durationof n periods
A = Amount of each instalment or constant periodic flow
r = Interest rate per period
n = Number of periods
= `8,000 × 6.1051 = `48,841
Future Value of Annuity at the end of 5 years = `48,841

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Illustration 10
Ascertain the future value and compound interest of an amount of `75,000 at 8%
compounded semi-annuallyfor 5 years.
Solution:
Amount Invested = `75,000
Rate of Interest = 8%
No. of Compounds = 2 × 5 = 10 timesRate of Interest for half year
= 8%/2 = 4% Compound Value or Future Value
= P (1+i)n
Where,
P = Principal Amount
i = Rate of Interest (in the given case half year interest)n = No. of years (no. of compounds)
= `75,000 (1+4%)10
= `75,000 × 1.4802
= `1,11,018
Compound Value = `1,11,018
Compound Interest = Compound Value – Principal Amount

= `1,11,018 – `75,000 = `36, 018.

Illustration 11
An investor expects a perpetual sum of `5,000 annually from his investment. What is the
present value of theperpetuity if interest rate is 10%?

Solution:

Time Value of Money

Most financial decisions, personal as well as business, involve time value of money
considerations. Money of the financial problems involves cash flows occurring at different
points of the time. For evaluating such cash flows an explicit consideration of the time value
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 of money is required.
Money has time value. A rupee today is more valuable than a rupee a year hence.
So, the time value of money is an individual’s preference for possession of a given amount of
money now, rather than the same amount at some future date.
Mainly there are three reasons may be attributed to the individual’s time preference for
money.
v) Risk: We are not certain about future cash receipts. In an inflationary period, a rupee today
represents a greater real Purchasing Power than a rupee a year hence. So, an individual
prefers receiving cash now.
(v) Preference for consumption: Individuals, in general, prefer current consumption to future
consumption.
Investment opportunities: Capital can be employed productively to generate positive returns.
An investment of one rupee today would grow to (1+r) a year hence (r is the rate of return
earned on the investments).

Techniques
There are two methods of estimating time value of money which are shown below figure.

Time Value of Money

Compounding (Future Value) Discounting (Present Value)

● Single Flow ● Single Flow
● Multiple Flows ● Uneven Multiple Flows
● Annuity ● Annuity
● Perpetuity

Discounting

Future Value Present Value

Compounding

Future Value Present Value

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 Risk and Return
Return and risk are the two critical factors in investment decisions. They are closely linked. If
high risk is involved, the required return on the project should also be high. So, the level of
risk is measured first and then the level of return.

Various Connotations of Return

Return is the motivating force and the principal reward in the investment process and it is the
key method available to investors in comparing alternative investments. Returns may have
different meanings depending uponthe investors’ perceptions.
Return on a typical investment consists of two components. The basic component is the
periodic cash receipts and (or income) on the investment, either in the form of interest or
dividends. The second component is the change in the price of the – commonly known as
capital gain or loss.
Realised return is after the fact return -return that was earned or could have been earned.
Realised return is called historical return.
Expected return is the return from an asset that investors anticipate they will earn over
future period. It may ormay not occur.
The term yield is often used in connection this component of return. Yield refers to the
income component in relation to some price for a security.
Some investors may measure return by using financial ratios- Return on Investment (ROI),
Return on Equity (ROE) etc. Further, investors may assign more values to cash flows rather
than to distant returns such as InternalRate of Return (IRR).

Ex–ante and Ex–post Return

Ex-ante Return:
Ex-ante refers to future events. Ex-ante return is the prediction of returns that investor can
get from a securityor a portfolio.
(i) It helps investor to predict future return and to take right decision from investment.
(ii) Ex-ante predictions help companies to attract investors and raise capital.
It helps company to effectively plan inflation, deflation, or serious situations like a recession.

Ex-post Return:
Ex-post means after the event. Ex-post returns are the returns that investor has already got
from investment, i.e.,historical return.
It is useful for prediction of future trend, price

Types of Risk
According Horne and Wachowicz, risk is the variability of returns from those that are
expected. The greaterthe variability, the riskier the security is said to be.
Risk in an investment asset may be divided into: (i) Systematic Risk and (ii) Unsystematic
Risk.

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 ● Systematic Risk: It represents that portion of Total Risk which is attributable to factors that
affect the market as a whole. Economic, political and siciological changes are sources of
systematic risk. Beta is a measure of Systematic Risk.
● Unsystematic Risk: It is the position of total risk that is unique to a firm or industry.

Risk

Systematic Risk Unsystematic

● Market Risk ● Business Risk

● Interest Rate risk ● Financial Risk
● Purchasing Power Risk ● Default Risk

A. Systematic Risk:
It represents that portion of total risk which is attributable to factors that affect the market as
a whole. It arises out of external and uncontrollable factors, which are not specific to a
security or industry to which such security belongs. It is that part of risk caused by factors
that affect the price of all the securities. Beta is a measure of Systematic Risk. It cannot be
eliminated by diversification. Systematic risks are discussed below:
(i) Market Risk: These are risks that are triggered due to social, political and economic events.
For example, when CBDT issued a draft circular on how to treat income from trading in
shares, whether as Capital Receipts or Business Receipts, the stock prices fell down sharply,
across all sectors. These risks arise due tochanges in demand and supply, expectations of the
investors, information flow, investor’s risk perception, etc. consequent to the social, political
or economic events.
(ii) Interest Rate Risk: Uncertainty of future market values and extent of income in the future,
due to fluctuations in the general level of interest, is known as Interest Rate Risk. These are
risks arising due to fluctuating rates of interest and cost of corporate debt. The cost of
corporate debt depends on the interest rates prevailing, maturity periods, credit worthiness of
the borrowers, monetary and credit policy of RBI, etc.
(iii) Purchasing Power Risk: Purchasing Power Risk is the erosion in the value of money due to
the effects ofinflation.

Calculation of Return and Risk

Determination of the acceptability of the investment proposals of a firm involves a trade-off
between risks and returns. So, risk -return analysis is used for capital budgeting decisions,
purchase of shares, bonds and any readilyidentifiable capital or financial investments.

Calculation or Measurement of Return:

Returns across time or from different securities can be measured and compared using the

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 total return concept. The total return of a security for a given holding period relates all the cash
flows received by an investor during any designated time period to the amount of money
invested.
(i) Total Return
Total return is calculated as:

The total return is used to measure of return for a specified period of time. Further, this return
can be split in two components: dividend and capital gains. The percentage (%) of return can
be expressed in mathematical terms.
Assume, P0 is the initial price, D1 is the dividend in the period 1, and P1 is the price at the
end of period 1, and the total return for one period as follows:

However, investing in a particular stock for ten years or a different stock in each ten years
could result in 10 total returns which must be calculated separately by using statistical tools.

Illustration 12

The current market price of a share is `600. An investor buys 100 shares. After one year he
sells these shares at a price of `720 and also receives the dividend of `30 per share. Find the
total return (%) of the investor.

Solution:
Initial investment = `600 × 100 = `60,000

Dividend earned = `30 × 100 = `3,000

Capital Gains = `(720-600) × 100 = `12,000

Total return = `3,000 + `12,000 = `15,000

Total return (%) = [(`3,000 + `12,000) / `60,000] × 100 = 25%

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 (ii) Average Annual Return

There are two commonly methods used in calculating average annual returns: (a)
Arithmetic Mean and
(b) Geometric Mean.

When an investor wants to know the central tendency of a series of returns, the arithmetic
mean is the appro-priate measure. It represents the typical performance for a single period.
If you want to calculate the average compound rate of growth that has actually occurred over
multiple periods,the arithmetic mean is not appropriate. Then geometric mean is used.
(iii) Expected Rate of Return

The expected return is simply a weighted average of the possible returns, with the weights
being the probabil- ities of occurrence. The expected rate of return can be calculated by using
the formula given below:
E(R) = R1 × P1+ R2 × P2+ R3 × P3+ R4 × P4+ + Rn × Pn
R is the rate of returns and
P is the probability
The following table shows how to calculate expected rate of return:
Expected Rate of Return

Economic Conditions Rate of Return Probability Expected Rate of Return (4) =

(1) (%)(2) (3) (2)×(3)
Growth 18.0 0.25 4.5

Expansion 11.0 0.25 2.75

Stagnation 1.0 0.25 0.25

Decline -5.0 0.25 -1.25

Expected Rate of Return 6.25

(i) Expected Return on Portfolio

The expected return on a portfolio is the weighted average of the expected returns on the
assets comprising theportfolio. When a portfolio consists of two securities, its expected return
would be:
E(RP)= wAE(RA) + (1-wB) E(RB)
where,
E(RP) = Expected Return of the Portfolio
WA = Weight or Proportion of a portfolio invested in Security A E(RA) = Expected Return

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 on Security A
1-WB = Proportion of a portfolio invested in Security B E(RB) = Expected Return on
Security B When a portfolio consists of n number of securities, the expected return of
portfolio would be:E(RP) = ∑wnE(Rn)
where,
E(RP) = Expected Return of the Portfolio
Wn = Weights of proportion of portfolio invested in Security n
E(Rn) = Expected Return on Security n

Calculation or Measurement of Risk:

Risk may be defined as the variability of returns from an investment. Since it indicates
variation in expected
return, therefore statistical techniques may be used to measure risks. Generally, the following
methods are used to measure risk of an investment.
(i) Subjective Estimates: Risk analysis is ‘generic’ and may be applied to any situation and any
form of decision-making, from determining policy and strategy, through all levels of planning
to tactical decision- making. In different situations, risk may be expressed as low, moderate
and high. When variations of returnswill not be wide, it may be called low level of risk; when
forecast returns are likely to vary widely, it may state as high-risk level and variability of
returns is likely to moderate in nature then it may represent as moderate level of risk. This
method of risk assessment has its own limitations.
(ii) Standard Deviation and Variance: The standard deviation is a measure of how each
possible outcome deviates from the expected value. It measures the risk in absolute terms.
The higher the value of dispersion, the higher is the risk associated with the Portfolio and
vice-versa. Generally, Standard Deviation of a specified security or portfolio is considered to
be the Total Risk associated with that security or portfolio.
Standard Deviation is generally considered as the total risk of a particular security. It can be
measured as follows:

Where,
x = Expected rate of return = E(R)
x = ith rate of return from an investment proposal
p = Probability of occurrence of the ith rate of return
n = Number of outcomes

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 The standard deviation when compared with the expected returns is known as the coefficient of variation

Standard Deviation
Coefficient of Variation (CV) =
Expected Value

Illustration 13

X Ltd. has forecasted returns on its share with the following probability distribution:

Return (%) Probability

-20 0.05
-10 0.05
-5 0.10
5 0.10
10 0.15
18 0.25
20 0.25
30 0.05
Find out the following: (a) Expected Rate of Return (b) Variance (c) Standard Deviation
Solution:
(a) Expected Rate of Return
Expected Return can be calculated by using the following formula:
E(R) = R1 × P1+ R2 × P2+ R3 × P3+ R4 × P4+ .....................+ Rn × Pn
= (-20 × 0.05) + (-10 × 0.05) + (-5 × 0.10) + (5 × 0.10) + (10 × 0.15) + (18 × 0.25) + (-20 ×
0.05) + (20 × 0.25) + (30 × 0.05) = 11%
(b) Variance of Return
Variance can be calculated by using the following formula

σ 2 = [R -E(R)]2 × p + [R -E(R)]2 × p + [R -E(R)]2 × p + [R -E(R)]2 × p ................... [R -

E(R)]2 × pn

= (-20-11)2 × 0.05 + (-10-11)2 × 0.05 + (-5-11)2 × 0.10 + (5-11)2 × 0.10 + (10-11)2 × 0.15
+ (18-11)2 × 0.25 + (20 - 11)2 × 0.25 + (300-11)2 × 0.05 = 150%
(c) Standard Deviation of Return

(i) Coefficient of Variation: Variance or standard deviation are the absolute measure of

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 risk. Standard devia-tion can sometimes be misleading in comparing the risk.

The standard deviation when compared with the expected returns is known as the coefficient of variation

Standard Deviation
Coefficient of Variation
Expected Value

Thus, the coefficient of variation is a measure of relative dispersion (risk) – a measure of risk
“per unit of expect-ed return.” The larger the CV, the larger the relative risk of the
investment.

Illustration 14
Consider, two securities, A and B, whose normal probability distributions of one-year returns
have the following characteristics:
Security A Security B
Expected return, [E(R)] 0.08 0.24
Standard deviation, (σ) 0.06 0.08
Coefficient of variation, (CV) 0.75 0.33
Comment on the above information.
Solution:
From the above information it is found that the standard deviation of Security B is larger than
that of Securty A. So, Security B is the riskier investment opportunity with standard deviation
as risk measurement tool.
However, relative to the size of expected return, Security A has greater variation. So, Security
A is higher riskyinvestment than Security B.
(ii) Beta: The sensitivity of a security to market movements is called beta (β). When an
investor wants to invest his money in a portfolio of securities, beta is the proper measure of
risk. Beta measures systematic risk i.e., that which affects the market as a whole and hence
cannot be eliminated through diversification.
Beta depends on the following factor:
(i) Standard Deviation (Risk) of the Security or Portfolio.
(ii) Standard Deviation (Risk) of the Market.
(iii) Correlation between the Security and Market.

According to the Capital Asset Pricing Model, the required rate of return is equivalent to the
risk-freereturn plus risk premium.
E(RP) = RF + { βP × (RM -RF)}
Where,

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E(RP)= Expected Return on Portfolio
RF = Risk Free Rate of Interest/ ReturnβP = Portfolio Beta or Risk Factor

RM Expected Return on Market PortfolioBeta is measured as follows:

If the value of changes in different ranges, accordingly, risk of the security would be
changes. Inferences areshown below:
Inferences

Beta Value Security

is is
Less than 1 Less risky than the market portfolio.
Equal to 1 As risky as the market portfolio. Normal Beta security. When security beta
= 1 then if marketmove up by 10% security will move up by 10%. If market
fell by 10% security also tend to fall by 10%.
More than 1 More risk than the market portfolio. Termed as Aggressive Security/High
beta Security. A Security beta 2 will tend to move twice as much as the
market. If market went up by 10% security tends to rise by 20%. If market
fall by 10% Security tends to fall by 20%.
Negative Beta. It indicates negative (inverse) relationship between security
return and marketreturn. If market goes up security will fall and vice versa.
Normally gold is supposed to havenegative beta.
Means there is no systematic risk and share price has no relationship with
market. Risk free
security is assumed to be zero.

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 Illustration 15

From the following data, compute the beta of Security X.

Solution:

Illustration 16

The stock price and dividend history of X Ltd. are given below:

Year Closing Share Price (`) Dividend per Share (`)

2015 312 5.50
2016 389 6.75
2017 234 4.60
2018 345 5.90
2019 367 3.78
2020 389 4.10
2021 412 5.98

Using the above data, compute the following:

(i) Annual rates of return
(ii) Expected average rate of return
(iii) Variance
(iv) Standard deviation

Solution:
(i) Computation of annual rates of return

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 Closing Share Dividend per Annual rate of
Year
Price (`) Share (`) return [(St/St-
(St) (Dt) 1)-1) + Dt
2015 312 5.50 -
2016 389 6.75 7.00
2017 234 4.60 4.20
2018 345 5.90 6.37
2019 367 3.78 3.84
2020 389 4.10 4.15
2021 412 5.98 6.03
Total 31.58

(i) Average rate of return = Arithmetic mean of annual rates of returnTotal Annual
Returns = 31.58

So, Average return = 31.58/6 = 5.27%

(i) Calculation of Variance

2
Year Annual Return (Rt) Average Return (%) (Rt- Rm) (Rt – Rm)
(Rm)
2016 7.00 5.27% 1.73 2.89

2017 4.20 5.27% -1.07 1.14

2018 6.37 5.27% 1.10 1.22

2019 3.84 5.27% -1.43 2.03

2020 4.15 5.27% -1.11 1.23

2021 6.03 5.27% 0.77 0.59

Total 9.20

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 Capital Asset Pricing Model
William F. Sharpe and John Linter developed the Capital Asset Pricing Model (CAPM). The
model is based onthe portfolio theory developed by Harry Markowitz. The model emphasises
the risk factor in portfolio theory which is a combination of two risks, systematic risk and
unsystematic risk. The model suggests that a security’s return is directly related to its
systematic risk which cannot be neutralized through diversification.
CAPM explains the behavior of security prices and provides a mechanism whereby investors
could assess the impact of a proposed securities are determined in such a way that the risk
premium or excess return are proportion- al to systematic risk, which is indicated by the beta
coefficient.
A. Features of CAPM:
(i) CAPM explains the relationship between the Expected Return, Non-Diversifiable Risk
(Systematic Risk)
and the valuation of securities.
(ii) CAPM is based on the premise that the diversifiable risk of a security is eliminated when
more and more
securities are added to the Portfolio.
(iii)All securities do not have same level of systematic risk and therefore, the required rate of
return goes with the level of systematic risk. It considers the required rate of return of a
security on the basis of its (System-atic Risk) contribution to the total risk.
(iv) Systematic Risk can be measured by Beta, which is a function of the following:
Total Risk Associated with the Market Return
(a) Total Risk Associated with the Individual Securities Return,
(b) Correlation between the two.
B. Assumptions:
(i) With reference to Investors:
(a) Investment goals of investors are rational. They desire higher return for any acceptable level
of risk and lower risk for any desired level of return.
(b) Their objective is to maximize the utility of terminal wealth.
(c) Their choice is based on the risk and return of a security.
(d) They have homogenous expectations of risk and return over an identical time horizon.
(ii) With reference to Market:
(a) Information is freely and simultaneously available to all investors.
(b) Capital Market is not dominated by any individual investors.
(c) Investors can borrow and lend unlimited amount at the risk-free rate.
(d) No taxes, transaction costs, restrictions on short-term rates or other market imperfections.
(e) Total asset quantity is fixed, and all assets are marketable and divisible.

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We can use CAPM to understand the basic risk-return trade-offs involved in various types of
investment decisions. Using Beta as the measure of non-diversifiable risk, the CAPM is used
to define the required rate of return on a security

E(RS) = RF + { βS × (RM -RF)}

Where,
E(RS) = Expected Return on the Security or Investment
RF = Risk Free Rate of Interest/ Return
βS = Security Beta or Risk Premium
RM = Expected Return on all securities or Market Return

Illustration 17
The following information is given:
Security Beta: 1.2
Risk-free rate: 4%
Expected market return: 12%
Calculate expected rate of return on the security.

Solution:
E(RS) = RF + { βS × (RM -RF)}
Substituting these data into the CAPM equation, we get
E(RS) = 4% + [1.20 × (12% - 4%)

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