Relationship between risk and return The key elements for the relationship are:

1. Securities are risky because their returns are variable. 2. The risk of the security can be split into two parts: unique and market risk 3. Portfolio diversification washes away unique risk but not market risk. Hence the risk of a fully diversified portfolio is its market risk. 4. The contribution of a security to the risk of a fully diversified portfolio is measured by its BETA.

CONTD..
Since the beta is the relevant measure of a security risk, the next logical question arises: what is the relationship between the risk of the security, as measured by BETA and its Expected Return. The Capital asset pricing model answer this question. According to CAPM risk and return are related in a linear fashion: E(R) = Rf + B [ R(M) Rf ]

 Where E(R) = Expected rate of return. Rf= Risk free rate B = BETA of a security R(M)= Return on market portfolio.

Calculation of combined cost of capital

Calculation of specific cost of capital Calculation of overall cost of capital Calculation of weighted average cost of capital Cost of Debenture Cost of preference shares Cost of equity Cost of retained earning

Example The installed capacity of ABC Companys factory is 500 units. Actual capacity used is 300 units. Selling price per unit is Rs. 15. Variable per is Rs.77 per unit. Calculate the operating leverage in each of the following three situations. 1. When fixed costs are Rs. 500 2. When fixed costs are Rs.1000 3. When fixed costs are Rs. 1500

Solution:
Computing of operating leverage Situation 1 Total sales (300 units@ Rs.15) 4500 Less: Total variable cost (300*7) 2100 Contribution 2400 Less: fixed costs 500 Operating profit 1900 Operating leverage contribution 2400 DOL 1.3 Situation 2 Situation 3

4500
2100 2400 1000 1400 2400 1.7

4500
2100 2400 1500 900 2400 2.7

Calculation of operating leverage.

Operating leverage