Financial Management 1 To 30

Financial Management
Notes for 1-10 sessions

Topics Number of Sessions Covered
Introduction to Financial Management 1
Overview of Financial Markets 3
Sources of Long-term Fund 1
Time Value of Money 5
Introduction to Financial Management: Objectives - Functions and Scope - Evolution - Interface of

Financial Management with Other Functional Areas - Environment of Corporate Finance.
Total no of sessions allotted -1 Total no of sessions covered-1
Objectives
The purpose of the course is to provide an understanding of basic functions of finance
and its interface with other functional areas. The course aims to familiarize students
with finance markets and instruments, develop working knowledge of fundamental
tools and apply them in investment and financing decision.
Scope of Financial Management
The major impetus is provided on shareholders' wealth maximization in Financial
Management. The shareholders' wealth can be maximized when market price of the
shares of the company are going up. This is only possible when there is an increase in
demand or buying pressures for the shares. Increasing buying pressure can take place
when investors have positive sentiment about the company (provided company has
increased its sales turnover, market share or profit margin with respect to its peers as
per its annual report, half yearly report or quarterly financial report). Shareholders are
the owners of the company. They are interested about dividend income and capital
gain. Shareholders are electing the board of directors and broad is headed by
chairperson. Board of directors is mainly formulating strategies and policies of the
organization. Board of directors is appointing management where management team
is headed by Chief Executive Officer (CEO). Management is looking after the day to
day activity of the organization. Management is accountable to the board and board is
accountable to the shareholders.
Major Financial Decisions
Investment Decision Investment decisions can be categorized into two groups.
1) Working Capital Management: Working capital is required to finance the day to
day activity of the organization. Working capital is measured by excess of current
assets over and above the current liability. Current assets are the assets which can be
converted into cash within one year. For example- cash in hand, cash in bank, debtors,
bills receivables, prepaid expenses, inventory etc. Current liabilities are the
liabilities for
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which expense will be incurred within one year. For example- creditors, bills payables
and bank over draft, outstanding expenses etc. High working capital implies more
current asset and less current liability. More current asset implies lesser investment in
fixed assets but return generating capacities of fixed assets are higher than the current
assets. Lesser current liability indicates more long-term liability for the company. So,
the company has to incur more expenditure to meet the payment requirement of long-
term liability. Hence higher working capital implies liquidity is high but profitability
is low. The company is attractive for creditors and suppliers but the same is not true
for investors. Lower working capital implies liquidity is low but profitability is high.
Investor’s sentiment becomes positive for the company but suppliers and creditors are
not willing to make deal with the company. Therefore, working capital management is
the strike off balance between the liquidity and profitability of the company.
2) Capital Budgeting: Capital budgeting implies long term strategy to decide the
investment worthiness of the project. Since capital is scarce factor, it is not possible
for the company to select all the projects which are available to it. Any rational
investor will prefer to invest in a project where it is expected that a significantly large
amount of inflow will be generated in future over and above its current outflow.
Financial feasibility study has to conducted and depending on that the top
management will come to the conclusion which projects should be accepted for
investment or which assets should be acquired for the long-term benefit of the
organization. Capital budgeting is depending on two principles- earlier the return,
project is good and more the return project is good. Payback period implies the
number of years by which company will realize its initial investment. Hence earlier
the payback period, project is good. Payback period method is following the first
principle.
Problem
A project requires an initial cash outflow of Rs 100 crore. It is expected to generate
following cash inflows in the upcoming years.
Year 1 2 3 4 5
Inflow 30 40 40 20 30
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Solution
Year Inflow Cumulative Inflow
1 30 30
2 40 70
3 40 110
4 20 130
5 30 160
Payback period is between 2nd and 3rd year. Payback period is = 2+(30/40) = 2.75
years= 2 years 9months
The average rate of return method of evaluating proposed capital expenditure is also
known as accounting rate of return. Average rate of return of a project = Average
annual profit after taxes/ average investment over life of the project. Higher the ARR,
project is good. ARR is following the second principle. The average investment is
determined by dividing the net investment by two. The averaging process assumes
that the firm is using straight line deprecation, in which case the book value of the
asset declines at a constant rate from its purchase price to zero at the end of its
depreciable life. This means that on an average, firms will have one half of their initial
purchase price in the book. If the firm has salvage value, the only the depreciable cost
(cost minus salvage) of the machine should be divided by two in order to ascertain
average net investment as the salvage money will be recovered at the end of life of the
project. Therefore, an amount equivalent to the salvage value remains tied up in the
project throughout its lifetime. If any additional net working capital is required in the
initial year which is likely to be released only at the end of project's life, the full
amount of working capital should be taken in determining relevant investment for the
purpose of calculating ARR. Average investment = Net working capital +salvage
value +1/2(Initial cost of machine –salvage value) Alternatively ARR= Average
income/Average investment.
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Problem
Particulars Machine A Machine B
Cost 56125 56125
Annual estimated
income after
depreciation and tax
Year
1 3375 11375
2 5375 9375
3 7375 7375
4 9375 5375
5 11375 3375
Estimated life (in 5 5

Years)
Estimated salvage value 3000 3000
Determine ARR of both the machines.
Solution
ARR= Average income/Average investment
Average income of both the machines are =36875/5= 7375
Average investment =salvage value+1/2(cost of machine- salvage value)
=3000+1/2(56125-3000) =29562.5, ARR = 7375/29562.5= 24.9%
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Financing decision
It is to be decided to which extent company will be financed by debt or borrowed
capital and equity or owners’ capital. The optimal capital structure for the
organization should be appropriately determined
According to the balance sheet,
Total asset= total liability, Fixed asset+ current asset= long term liability +current
liability +Net worth, Or Fixed asset+ (current asset- current liability) =Net worth+
long term liability
Or Fixed asset+ working capital = Net worth +long term liability .Net worth is
shareholder’s fund and long-term liability is borrowed fund. So Right Hand Side is
known as source of fund. Left hand side is application of fund. Because either it can
be spent to incur capital expenditure (purchasing or upgrading fixed asset) or for
operating expense (to meet the daily requirement of finance which is working capital)
Debt Capital
Debt capital includes bond and debenture. Bond and debentures are redeemable in
nature. They have certain maturity period. Bondholders and debenture holders enjoy
interest over the life of bond and debenture and receive the redemption price at the
end of the maturity period. Irrespective of the fact whether company earns profit or
incurs the loss, the company is bound to pay the interest to the debt holders.
Share Capital
Share capital are of two types- preference share and equity share. Preference
shareholder enjoys preference in case of distribution of dividend and repayment of
capital when company goes on liquidation. All Preference shares are redeemable in
India. Preference share holder has no voting right and it is not market traded.
Therefore, preference shareholders only can enjoy dividend gain. Equity share is not
redeemable. Equity shareholders are owner of the company. Equity shareholder has
voting right in selection of board of directors of company. Equity shares are market
traded. Equity shareholders will enjoy both dividend and capital gain. Individuals
whose risk appetite is low, they will prefer to subscribe debt capital. Individuals
whose risk appetite is high they will go for equity capital. Usually banks opt for
preference share. When banks are providing loan to any company, they will receive
interest which is taxable. Often, they ask the borrower companies to covert certain
portion of the loan into preference share. From the preference share, they will receive
the dividend which is tax free in the hand of assesses.
Comparative Analysis of debt and equity
Debt is cheaper than equity. But debt is riskier than equity from company's
perspective. As company issues debt, it has to accept the obligation of paying coupon
and redemption price to the debt holder irrespective of the company’s financial health.
In case of equity, dividend is payable only when company earns profit. Since there is
no redemption price for equity, company has no financial obligation to its
shareholders as such. Debt is less risky from investor’s perspective as it will
receive coupon and
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redemption price irrespective of the profit or loss of the company. Equity is risky
because dividend and capital appreciation will be enjoyed only when company earns
profit. When company issues debt capital, it has to pay interest mandatorily to the
debt holders irrespective of the fact whether the company earns profit or loss. The
logic is simple cost of debt is cheaper than cost of equity. An illustration can be taken
to explain the same.
The company wants to pay 10% interest to debenture holder where face value of
debenture is Rs 10. Similarly, the company wants to pay 10% dividend to equity share
holder where face value of equity share is Rs 10. Corporate profit tax is 30% and
dividend distribution tax is 20%.
When company is paying interest to debt holder, company is eligible to enjoy the tax
shield. The cost of debt is 0.1(1-0.3) =0.07. Alternatively, it can be stated that in order
to pay 10% interest to the debenture holder, company has to earn effectively 7%.
Dividend is the appropriation of profit. When company is earning profit, first
company has to pay corporate profit tax .After that it may distribute certain portion of
profit as dividend to the equity shareholders .In that case, company has to pay
Dividend Distribution Tax(DDT).In order to pay dividend of 10% company is
required to earn 0.1(1+0.2) =0.12 or 12% as 20% is DDT. Since corporate profit tax
is 30% so company has to earn 0.12/(1-0.3) =0.1714 or 17.14 %Hence to pay 10%
dividend , company has to earn 17.14%. This clearly shows equity is expensive than
debt.
Trading on Equity
Generally, it is assumed high debt equity ratio is not good sign for a company. Too
much dependence on debt sends negative signal to different stakeholders such as
banks are not willing to sanction the loan, credit rating agencies provides adverse
rating to the company and investors don’t not want put their hard earn money in the
stock as a result likelihood is more the share of the company will underperform in
secondary market. But there is another side of the coin also. In few cases, companies
intentionally depend more and more on debt capital and it enhances their earning per
share. This is known as trading on equity. If the return on capital employed of a
company is greater than the cost of debt, the company can increase its EPS by
depending excessively on debt capital. These phenomena can be explained by a
simple illustration.
Let us assume there are two companies A and B. For the sake of simplicity, it is
assumed both the company have Rs 5,00000 capital. Company A has equity capital of
Rs 1,00000 and debt capital of Rs 4,00000.
Company B has equity capital of Rs 4,00000 and debt capital of Rs 1, 00000.Face
value of debt and equity capital is Rs 10 for both the companies. Both the companies
are offering 10% interest rate per annum to the debt holders.
The number of outstanding shares for company A is 10000 and company B is 40000.
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Case-1
PBIT= Rs 40000 for both the companies
For company A
PBIT =40000
Less Interest = 40000
--------------------------
PAT= Nil
EPS=Nil
For company B
PBIT =40000
--------------------------
PAT= 30000
N= 40000
EPS=Rs 0.75
Case-2
PBIT= Rs60000 for both the companies
For company A
PBIT =60000
--------------------------
PAT= 20000
N=10000,
EPS =Rs 2
For company B
PBIT =60000
--------------------------
PAT= 50000
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N= 40000
EPS=Rs 1.25
ROCE in Case I = 40000/500000= 8%, ROCE in Case II = 60000/500000= 12%, Cost
of debt is 10%.
In case I, ROCE is less than cost of debt. So, company depending on more equity has
done well. In case II, ROCE is greater than cost of debt. So, company depending on
more debt has done well.
Dividend decision
When company earns profit, company may distribute certain portion of its profit to
the shareholders in the form of dividend. So, it is a crucial decision for the
management whether dividend will be payable at all, if it is paid what will be the
dividend payout ratio, to decide whether to opt for cash dividend or stock dividend
and what will be the impact on the company due to dividend payment.
Interface of Financial Management with Other Functional
Areas Accounting Finance Interface
Accounting focuses on systematic record of financial transactions. Major emphasis
has been provided on identifying sources and applications of funds. It takes into
account analysis of income statement, balance sheet, cashflow statement and financial
ratios. Financial management aims shareholders wealth maximisation. It incorporates
dividend policy, working capital management, capital budgeting, cost of capital,
capital structure, leverage etc.
Economics Finance Interface
Economics focuses on efficient utilisation of scarce resources. All the resources such
as land, labour and capital are scarce in nature. It takes into consideration consumer
behaviour, production function, cost function, market structure, demand supply
analysis. Any financial decisions will be implemented after incorporating cost benefit
analysis. If marginal benefit is higher than marginal cost for an activity, it will be
undertaken and vice versa.
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Overview of Financial Markets: Financial Markets - Functions and Classifications of Financial
Markets – Introduction to Money Market - Forex Market - Government Securities Market-
Primary & Secondary market for G.sec, Call money market: Money Market, Treasury Bill
Market, Commercial Paper and Certificate of Deposits, Discount and Finance House of India,
Corporate Debt market Recent Developments. -Capital Market - Derivatives Market -
International Capital Markets – Participants.
Total no of sessions allotted -3 Total no of sessions covered -3
Money Market
Market is a mechanism through which forces such as demand and supply interact with
each other. Money market is a mechanism through which funds can be borrowed and
lent for short term period. Different money market instruments are call and notice
money, treasury bill, commercial paper, certificate of deposits, REPO and Reverse
REPO. The RBI is the apex body of money market in India. The scheduled
commercial banks are major participants in money market.
Role of Commercial Banks
Banks are the major players in money market. Every nation prefers to achieve higher
growth rate. Growth implies sustained increase in per capita income. To achieve
satisfactory growth rate, industrialization is required. Investment is necessary
condition for industrialization. The source of investment is savings. Savings come
from household as well as corporate. Banks play the role of intermediary to convert
the savings of household and corporate into productive investment. Banks perform a
lot of activities simultaneously. The main activity of bank is credit creation. Banks
accept the deposits from the households and corporate and lend the same to corporate
borrower at higher interest rate. The excess of interest bank is earning over and above
the interest payment to the depositors are known as net interest margin.
Structures of Indian Banking Sector

Indian banking sector players can be broadly categorized into two groups – scheduled
banks and nonscheduled banks. Scheduled banks are of two types- Scheduled
Commercial banks and Scheduled Cooperative Banks.
Scheduled commercial banks are classified into four major heads- the Public Sector
Undertaking banks, the Private sector banks, the foreign banks and the Regional Rural
Banks. The private sector banks are classified into old generation private sector banks
and new generation private sector banks.
Scheduled Commercial Bank
A scheduled bank is so called because it has been included in the second schedule of
the Reserve Bank of India Act,1934 to be eligible for this inclusion, a bank must
satisfy the following conditions
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1) It must have a paid-up capital and reserve of an aggregate value of at least Rs
500000.2) It must satisfy the RBI that its affairs are not conducted in a manner
detrimental to interest of depositors. 3)It must be a corporation and not a partnership
or single owner firm. Scheduled banks enjoy certain privileges such as free remittance
facilities through the offices of the RBI and its agents as well as they are eligible to
borrow from the RBI. In return, the scheduled banks are under obligation to maintain
an average daily balance of cash reserve with the RBI and submit stipulated periodical
return to the RBI
.Nonscheduled banks are also subject to maintain statutory cash reserve ratio but they
are not required to keep these with the RBI, they may keep the balance with
themselves. They are not entitled to borrow from the RBI for the normal banking
business, they may approach the RBI under the abnormal condition.
Difference between Banks and NBFC
Banks accept deposit from household and corporate and lend it to the borrower at a
higher interest rate. NBFC cannot collect deposits. After successful operation of two
years, few NBFCs can collect term deposits subject to the regulatory approval of the
RBI. But they cannot collect current, savings and recurring account deposit. Banks
can issue cheque -books, NBFC cannot do the same. Banks have to maintain CRR,
SLR but the same is not true for NBFC.Banks can provide different types of loans to
both the household and corporate. NBFC can provide loan for particular purpose such
as SREI, Magma provides loan for lease financing and infrastructure financing and
LIC Housing and HDFC provides loan for housing finance.
Role of the RBI in Money Supply
If any bank provides the credit more than or equal to its deposit mobilization, it
becomes vulnerable to liquidity risk. It may happen some of the depositors are
compelled to withdraw their funds from bank due to unforeseen contingency at pre
mature level. If banks don’t maintain any safety cushion, it may fail to return the fund.
In that case the news will spread like fire. All the depositors will rush to the particular
branch of the bank and prefer to withdraw their funds simultaneously at a particular
point of time. Hence bank can go for bankruptcy. The Reserve Bank of India has
made it mandatory that all scheduled commercial banks should maintain certain
reserve with the RBI such as Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio
(SLR). CRR is the fraction of total demand deposit and time deposit which the
commercial banks have to maintain with the Reserve Bank of India in terms of
cash. As on date CRR is 3% (31st May
,2020). SLR is the fraction of total demand deposit and time deposit which the
commercial banks have to maintain with the Reserve Bank of India either in terms of
cash or gold or eligible Government securities. As on date SLR is 18% (31st
May,2020). Hence for every deposit of Rs100, bank has to maintain Rs 3 as CRR and
Rs 18 as SLR with the RBI. Commercial banks are creating credit by offering loan
and advances. The RBI is controlling credit by regulating the key interest rate. If the
RBI speculates inflation will go up in near future, it will raise the rate. On the
contrary, if it anticipates economy is likely to be caught in recession, the RBI will
reduce the rate to increase money supply in the economy.
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For the sake of simplicity, it is assumed Mr. X has deposited Rs 100 in Bank A. Bank
A will lend Rs 97 to Mr. Y after keeping Rs 3 as CRR. Mr. Y will deposit Rs 97 in
bank
B. Bank B will lend Rs 94.09 and so on.
When CRR=3%, Money supply will be =100+97+94.09+..................= 100/ (1-0.97) =
3333.33
So Rs 100 loan can create money supply of Rs 3333.33 when CRR=3%.
2500
5000
Intermediaries of the RBI
STCI
STCI (Security Trading Corporation of India) Finance Limited is a systematically
important non deposit taking NBFC registered with the RBI. It was promoted by the
RBI in May 1994 with the objective of fostering an active secondary market in GOI
securities and Public sector bonds. In 1999, the STCI was authorized by the RBI as
one of the primary dealers in India. A primary dealer is a firm that buys government
securities directly from a government, with the intention of reselling them to others,
thus acting as a market maker of government securities. As the leading primary dealer
of the country, the company was a market maker in Government securities, corporate
bonds, and money market instruments apart from carrying trading in equity.
DFHI
Discount Finance House of India (DFHI) was set up in March 1988 by the RBI jointly
with public sector banks to develop money market. With the introduction of new
money market instruments such as certificate of deposits and commercial paper,
DFHI began trading with this.
Instruments of Money
Market Call Money
Call Money market is a mechanism where daily surplus funds of the banks are being
traded. If the maturity period is 1 day it is known as call money market and when the
duration is more than 1 day but less than 14 days it is known as notice money. The
participants in call money market are classified into groups. For example- The
Reserve Bank of India, scheduled commercial banks and the different intermediaries
of RBI such as Security Trading Corporation of India (STCI) and Discount Finance
House of India (DFHI) can both lend and borrow from money market. On the other
hand, mutual funds and other financial institutions can only lend to the money market.
The commercial banks require assistance from call money market due to the
following reasons-1) To meet the CRR and SLR requirement during the first week of
the month.2)
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Often banks overextend credit than the deposit they have mobilized.3) There is huge
withdrawal by corporate in order to pay the advance tax.4) Banks are investing in
government securities which are illiquid in nature.
Treasury Bill
Treasury Bill (T bill) is issued by the RBI every fortnight. It is issued at multiple of
Rs. 25000. It is issued at discount and redeemable at face value. There are different
maturities of treasury bills such as 7 days, 14 days, 91 days,182 days and 364 days.
Bidding takes place for the subscription of T bill. After bidding is over, a committee
is formed under the chairmanship of the Deputy Governor of the RBI. The committee
members decide a cut off price and investors who bid greater than or equal to cut off
price, are allocated T bills. The yield of the Treasury bill can be calculated by using
the formula
y= {(F-P)/P}x364/N, F= face value of T bill, P= purchase price of T bill, N= maturity
period of T bill
Commercial Paper
Commercial paper is issued at discount and redeemable at face value. Any
organizations can issue commercial paper provided 1) Organization has a net worth of
at least Rs 4 crore 2) Organization has a net working capital of at least Rs 4 crore 3)
Organization must obtain good credit rating from the credit rating agencies.
Commercial papers are issued at multiple of Rs 5 lakh.
Certificate of Deposits
Certificate of Deposit is issued at discount and redeemable at face value. It is issued
by mainly the banks and financial institutions. It is issued at multiple of Rs 1 lakh
REPO
REPO means repurchase offer. Often commercial banks borrow from RBI by selling
their securities with an agreement to repurchase it after a certain period of time at a
higher price. The rate the commercial bank has to pay to RBI is called repo rate. As
on day (31st May,2020) REPO rate is 4%. For the sake of simplicity, it can be said that
if commercial banks borrow from RBI by selling their securities at Rs 100 , the
commercial bank has to repurchase the same at Rs104.
Reverse REPO
When RBI is borrowing from the commercial banks, the commercial bank will
receive the interest from the borrowers. The rate commercial banks receive from the
RBI is known as the reverse repo. As on day (31 st May ,2020) Reverse REPO rate is
3.35%.
Role of Ministry of Finance and the RBI
Ministry of Finance is continuously creating pressure for the interest rate cut. The
basic objective is to increase the productive investment by reducing the cost of
borrowing. On the other hand, the RBI often is reluctant to reduce the interest rate as
they believe
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reduction of rate will lead to increase in inflation rate which reduces the purchasing
power of the common people.
Concept of Derivative
Derivative is a financial instrument where price of the instrument depends on the
price of underlying asset. Concept of derivative is comparatively new in India. Once
insurance policy is being considered, quite similarity will be observed between
insurance and derivative though insurance is not at all a derivative instrument. After
the terrorist attack in Taj Hotel, it has become a common tendency that all Five-star
multistoried hotels are insuring their assets against the terrorist attack. It needs no
explanation that premium paid by those hotels will be much more than the premium
paid by an individual who is willing to insure the risk of his two-wheeler against theft.
The similarity between insurance and derivative lies in the fact that price of both will
depend on price of underlying asset.
Participants in the Derivative Market
Participants in the derivative market can be categorized into three broader groups-
hedger, speculator and arbitrageur. Hedgers are the players willing to minimize their
risk. Speculators are trying to maximize their short-term profit by continuous buying
and selling securities in the market. Arbitrageurs are willing to maximize their
riskless profit by taking the advantage of price differentials. One thing is very clear
any transaction can take place if there are two parties that is buyers and sellers.
Therefore, both the party cannot gain from the contract. It is like a two-person zero
sum game.
Forward Contract
The forward contract is an agreement between buyers and sellers to deliver a
particular product at a predetermined a future price at a predetermined future date.
Forward contract has been in existence for quite some time. The organized
commodity exchanges started in Japan in the early eighteenth century. The
establishment of Chicago Board of Trade in 1948 led to the start of a formal
commodity exchanges in the USA. The concept of forward contract originated from
the commodity market. Previously wheat sellers were experiencing a risk that price of
wheat might fall in near future as wheat would not be made available for delivery
unless and until cultivation process was complete. Simultaneously wheat buyers are
facing risk of price hike. Therefore, both the parties prefer to enter into a forward
contract to fix the price today in order to hedge their risk. Hedging is not aiming for
profit maximization. Goal of hedging is to reduce the extent of loss. Which party will
gain from hedging, depends on the speculation power? If spot price is greater than
forward contract on the maturity date, forward buyer will be the gainer. If he has to
buy from the spot market, higher amount is required to be paid. But forward seller has
to incur loss because he has to sell at a lower price than the open market. Vice versa is
also true if spot price is lesser than forward price on the maturity date.
Limitations of the Forward Contract
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Forward contract is suffering from certain loopholes.1) Forward is not market traded.
Therefore, liquidity is almost nil.2) Counter Party risk is quite high in forward
contract.
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The party which is incurring the loss will always have the tendency to make the default.
3) Forward contract is a tailor-made contract. Therefore, it is highly customized rather
than standardized. 4) There is no third party between buyer and seller. No margin
money is required to enter into the contract. This makes successful execution of the
contract more uncertain.
Futures
Futures is nothing but a modified version of forward. Future is an agreement between
the buyer and the seller to deliver a product at a predetermined market price at a
predetermined future date. Futures is market traded. Liquidity is very high. Price of
futures is determined by the free movement of market forces such as demand and
supply. Apart from the price, all other attributes such as quality, quantity, time &
place of delivery are mentioned in the contract. Therefore, it is highly standardized.
Default risk is nil because clearing house exists between the buyer and seller. Both the
party has to deposit certain amount of margin money into the clearing house in order
to enter into the future contract. Each party initially has to deposit a certain amount
(approximately 10% of the total valuation of the contract) in the clearing house which
is known as Initial Margin. The margins are adjusted on daily basis to account for the
gains and losses, depending upon the price at which the future contracts are traded in
the market. This is known as Marking to the market and involves giving a credit to
the buyer of the contract if the price of the contract rises and debiting the seller’s
account by an equal amount. Similarly, the buyer’s balance is reduced when the
contract price declines and the seller’s account is accordingly updated. Maintenance
margin is the minimum amount of fund that has to be deposited in each trader’s
account. If due to adverse market movement, Margin falls below the maintenance
margin, investor will get a margin call from clearing house. He has to deposit the fund
to restore the initial margin. The additional amount he has to deposit to reach the
initial margin is known as variation margin.
Option
Option is an agreement which gives right to the buyer of option but no obligation to
buy or sell any asset at a predetermined future price on or before a predetermined
future date. Seller of option is getting a premium from the buyer and seller of option
is obliged to sell or buy the asset if buyer of the option is willing to exercise the
contract. The predetermined price is known as strike price or exercise price. Call
option offers the right to buy the underlying asset to the buyer of the call. Put option
offers the right to sell the underlying asset to the buyer of the put. European option
can be exercised only on the maturity date. American option can be exercised any day
on or before the maturity date.
Intrinsic value of call option=Max [ S-E,0] Where S= spot price E= Exercise price.
Intrinsic value of put option= Max [ E-S,0].
Buyer of the call will exercise the option if intrinsic value of call is positive. Buyer of
the put will exercise the option if intrinsic value of put is positive.
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Profit of Call buyer= Max[ S-E,0]- Pc, Profit of Call seller= Pc- Max[ S-E,0],Profit of
Put buyer= Max[ E-S,0]-Pp, Profit of Put seller= Pp- Max[ E-S,0],Pc= Premium of
call Pp= Premium of put
Forex Market
The major participants in the foreign exchange market are the large commercial
banks; foreign exchange brokers in the interbank market; commercial customers,
primarily multinational corporations; and central banks. The major participants in the
forward market can be categorized as arbitrageurs, traders, hedgers, and speculators.
Arbitrageurs seek to earn risk-free profits by taking advantage of differences in
interest rates among countries. They use forward contracts to eliminate the exchange
risk involved in transferring their funds from one nation to another. Traders use
forward contracts to eliminate or cover the risk of loss on export or import orders that
are denominated in foreign currencies.
Hedgers, mostly multinational firms, engage in forward contracts to protect the home
currency value of various foreign currency-denominated assets and liabilities on their
balance sheets that are not to be realized over the life of the contracts. Arbitrageurs,
traders, and hedgers seek to reduce (or eliminate, if possible) their exchange risks by
"locking in" the exchange rate on future trade or financial operations. Speculators
actively expose themselves to currency risk by buying or selling currencies forward in
order to profit from exchange rate fluctuations. Their degree of participation does not
depend on their business transactions in other currencies; instead, it is based on pre-
vailing forward rates and their expectations for spot exchange rates in the future.
International Capital Markets
There are different risks in international capital market.
Economic Risk Factors
Economic Risk is the significant change in the economic structure or growth rate that
produces a major change in the expected return of an investment. It arises from the
changes in fundamental economic policy goal. It incorporates diversification of the
economy, degree of reliance on a few key exports and the effects of a decline in the
worldwide prices of those exports, exchange rate devaluation, frequency of
government intervention in the money market and the ceilings of interest rates,
possibility of recession etc.
Exchange Rate Risk
It is all about an unexpected adverse movement in the exchange rate. Exchange risk
includes an unexpected change in currency regime such as a change from a fixed to a
floating exchange rate. A country's exchange rate policy may help isolate exchange
Risk. Managed floats, where the government attempts to control the currency in a
narrow trading range, tend to possess higher risk than fixed or currency board
systems.
16
Country Specific Risk
A macro-assessment of country risk is an overall risk assessment of a country without
consideration of the MNC’s business. A micro-assessment of country risk is the risk
assessment of a country as related to the MNC’s type of business.
Key Success Variables of Investment in International Capital Market
The investors in international capital market has to take into account three major
decisions – country selection, stock selection and international diversification.
Primary Markets and Secondary Markets: Procedural Aspects of Primary Issues –

Pre Issues Decision Making - SEBI Guidelines for Public Issues – IPO -Pricing and
Timing of Public Issues - Pre-Issue Management – Regulatory aspects -Advertising and
Marketing, Post-Issue Management - Rights Issues, Scope, management of debt and
equity, corporate advisory services, project advisory services, loan syndication, venture
financing, private equity, M&A, financial engineering, structural analysis of investment
banking industry
Total Number of sessions allotted -1 Total Number of sessions covered- 1
Capital market is a mechanism through which funds can be borrowed and lent for
long term period. Capital market instruments are categorized into three groups- debt
capital, share capital and derivatives.
Investors in Capital Market
Investors can be categorized into three groups- retail investors, High Net worth
Individuals (HNIs)and Qualified Institutional Buyers (QIBs). At a particular time at a
particular scheme if the amount of investment is less than Rs 2 lakh, the investor is
known as retail investor for that scheme as per the SEBI guideline. At a particular
time at a particular scheme if the amount of investment is more than Rs 2 lakh, the
investor is known as High Net worth Individuals for that scheme. QIB means a )
Public financial institution b)A scheduled commercial bank c) A mutual fund
registered with the Board
d) A foreign institutional investor and sub-account registered with SEBI, other than a
sub-account which is a foreign corporate or foreign individual e) A multilateral and
bilateral development financial institution f) A venture capital fund registered with
SEBI g)Foreign venture capital investor registered with SEBI h) A state industrial
development corporation i) An insurance company registered with the Insurance
Regulatory and Development Authority (IRDA) j) A provident fund with minimum
corpus of Rs. 25 crores k) A pension fund with minimum corpus of Rs. 25 crores
17
Classifications of Capital market
Market can be categorized into two parts Primary market and Secondary market.
Primary market is the mechanism through which fund is raised for the long term
from the market. Primary market includes IPO (Initial Public Offer), FPO (Follow on
Public Offer), Right issue and Depository Receipt.
Initial Public Offer implies when the company wants to raise the fund from the
market by issuing equity shares for the first time.
Follow on Public Offer indicates when the company wants to raise the additional
fund from market by issuing more equity shares but the company’s shares are already
being traded in the market.
Right issue implies when the company wants to raise the additional fund from market
by issuing more equity shares to the existing shareholders.
Depository receipt is a negotiable certificate that usually presents a company’s
publicly traded equity or debt. Depository receipts are created when a broker
purchases the company’s share on the home stock market and deliver those to the
depository’s local custodian bank which then instructs the depository bank to issue a
depository receipt. Depository receipts are quoted and traded in the country in which
they trade and are governed by trading and settlement procedure of the market. All the
depository receipts including GDR are essentially equity instrument created or issued
abroad, not by the companies but by the oversea depository’s bank which are
authorized by the company in say India to issue them to non-resident investors against
their shares. These shares are physically held by domestic custodian banks nominated
or appointed by Overseas Depositories Banks (ODB).In the company’s book the
ODBs’ name appear as the holder of their shares When an Indian company is willing
to raise the fund from USA without being listed in the New York Stock Exchange, the
company can do so by issuing ADR. On the other hand, if an Indian company is
willing to raise the fund from rest of the globe apart from USA, it can do so by issuing
GDR. When a foreign company is willing to raise fund from Indian market without
being listed in the Indian stock exchanges, the company can go for issuing IDR.
Secondary market implies where already issued shares are being traded. Examples
of the secondary market are stock exchanges such as Bombay Stock Exchange and
National Stock Exchange.
SEBI Guidelines for Public Issues
No company shall make public or rights issue or an offer for sale of securities, unless
it conforms with any one entry norm out of three entry norms as per the SEBI DIP
(Depositor and Investor Protection) guidelines.
Entry norm I
a) The company has net tangible assets of at least Rs. 3 crores in each of the preceding 3
full years (of 12 months each)
b) The company has a track record of distributable profits for at least three (3) out of
immediately preceding five (5) years
18
c) The company has a net worth of at least Rs. 1 crore in each of the preceding 3 full
years (of 12 months each)
d) In case the company has changed its name within the last one year, at least 50% of
the revenue for the preceding 1 full year is earned by the company from the activity
suggested by the new name; and
e) The aggregate of the proposed issue and all previous issues made in the same
financial year in terms of size (i.e., offer through offer document + firm allotment +
promoters’ contribution through the offer document), does not exceed five (5) times
its pre-issue net worth as per the audited balance sheet of the last financial year.)
Entry norm II
a) The issue is made through the book-building process, with at least (50% of net offer
to public) being allotted to the Qualified Institutional Buyers (QIBs), failing which the
full subscription monies shall be refunded
b) The minimum post-issue face value capital of the company shall be Rs.10
crores. Or
There shall be a compulsory market-making for at least 2 years from the date of listing
of the shares, subject to the following
a) Market makers undertake to offer buy and sell quotes for a minimum depth of 300
shares
b) Market makers undertake to ensure that the bid-ask spread (difference between
quotations for sale and purchase) for their quotes shall not at any time exceed 10%
(c) The inventory of the market makers on each of such stock exchanges, as on the date
of allotment of securities, shall be at least 5% of the proposed issue of the company
Entry norm III
a) The “project” has at least 15% participation by Financial Institutions/Scheduled
Commercial Banks, of which at least 10% comes from the
appraiser(s). In addition to this, at least 10% of the issue size shall be allotted to QIBs,
failing which the full subscription monies shall be refunded.
b) The minimum post-issue face value capital of the company shall be Rs.10
crores. Or
There shall be a compulsory market-making for at least 2 years from the date of listing
of the shares, subject to the following
a) Market makers undertake to offer buy and sell quotes for a minimum depth of 300
shares;
b) Market makers undertake to ensure that the bid-ask spread (difference between
quotations for sale and purchase) for their quotes shall not at any time exceed 10%
c) The inventory of the market makers on each of such stock exchanges, as on the date
of allotment of securities, shall be at least 5% of the proposed issue of the company
19
Time Value of Money: Introduction - Types of Cash flows - Future Value of a Single Cash Flow,
Multiple Flows and Annuity - Present Value of a Single Cash Flow, Multiple Flows and Annuity,
Growing Annuity, Perpetuity and Growing Perpetuity
Total Number of sessions allotted -5 Total Number of sessions covered- 5
Time Value of Money (TVM)

The time value of money is based on the idea that rational investors prefer to receive money
today rather than the same amount of money in the future because of money's potential to
grow in value over a given period of time. For example, money deposited into a fixed deposit
account earns a certain interest rate and is therefore said to be compounding in value.
Time Value of Money is governed by factors like
Inflation - fall in the purchasing power of money over periods of time
Risk – there is always an element of risk associated with any future cash flow
Interest – an amount invested at present would earn interest and grow to a larger amount in
future
Based on Time Value of Money, two important concepts arise

Future Value – it is the value, in future, of an amount of money at present. Considering that
an amount invested at present would earn interest, its future value would be more
Present value – it is the value, at present , of an amount of money in future.
Considering inflation and the associated risk factor, the present value of a future cash flow
would be less
Future Value
The Future Value is calculated through the equation
where :
The Future Value, when compounding is over broken periods, is calculated through the
equation
20
Future Value
The Present Value is calculated through the equation
What is the present value of Rs.1,000 receivable after 6 years, considering a rate of discount of
10%?
21
22
Here,
FV= Rs.1,000
r = 10%
n=6
Therefore, PV= 1000 {1/(1+0.1)6} = 1000 x 0.565 = Rs. 565
More examples on Future and Present Values
The Future Value is calculated through the equation
#What is the future value of Rs.1,000 after 5 years when the rate of interest is 10%?
FV= 1000 x (1+0.1)5

= 1000 x 1.6105
= 1610.5
Here, FVIFi,n = Future Value Interest Factor (at an interest rate ‘i’ of 10%, for a period
of ‘n’ 5 years).
#What is the future value of Rs.7200 after 11 years when the rate of interest is 8%?
FV= 7200 x (1+0.08)11

= 7200 x FVIF8%,11
= 7200 x 2.3316
= 16788
# What is the future value of Rs.102400 after 9years when the rate of interest is 12%?
FV= 102400x (1+0.12)9

= 102400x FVIF12%,9
= 102400x 2.7731
= 283965
23
# What is the present value of Rs.10000 after 6 years when the discounting rate is
10%? PV= 10000 {1/(1+0.1)6}

= 1000 x PVIF10%,6
= 10000 x 0.5645 = 5645

Here, PVIFr,n = Present Value Interest Factor (at an discounting rate ‘r’ of 10%, for a
period of ‘n’ 6 years).
# What is the present value of Rs. 77435 after 13 years when the discounting rate is
11%?
PV= 77435 {1/(1+0.11)13}
= 77435 x PVIF11%,13
= 77435 x 0.2575
= 19940
Here, PVIFr,n = Present Value Interest Factor (at an discounting rate ‘r’ of 11%, for a
period of ‘n’ 13 years).
#What is the future value of Rs.2800 after 6 years when the rate of interest is 12%?
FV = 2800 x FVIF12%,6
= 2800 x 1.9738
= 5527
#What is the present value of Rs.5527 after 6 years when the rate of discounting is
12%?
PV= 5527 x PVIF12%,6
= 5527 x 0.5066
= 2800
Annuity
Annuity is a series of equal cash flows occurring at equal intervals
There are 3 types of Annuity
 Ordinary Annuity
 Annuity due
 Perpetuity
Ordinary Annuity is a series of equal cash flows which occur at the end of each period
#Formula for the future value of an Ordinary Annuity:
Where:
FVN – future value
r – periodic interest rate
N – number of periods
A – annuity amount
# Formula for the present value of an Ordinary Annuity:
Where:
PV – present value
Examples on Future and Present Values of Ordinary Annuities

# A person decides to put in Rs.30000 at the end of every year into his PPF account for
a period of 30 years.
What would be the accumulated amount at the end of the period if the associated rate
of interest was 11% per annum
Formula for the future value of an Ordinary Annuity
= 30000 x FVIFA11%,30
= 30000 x 199.02
= 5970600
Where:
FVN – future value=?
r – periodic interest rate =11%
N – number of periods = 30 years
A – annuity amount = 30000
Here, FVIFAr,N = Future Value Interest Factor Annuity (at an interest rate 'r' of 11%,
for a period of 'N' 30 years).
# A person decides to put in Rs.40000 at the end of every year into an account for a
period of 10 years.
of interest was 8% per annum
FVN = 40000 x FVIFA8%,10
= 40000 x 14.487
= 579480
Where:
FVN – future value=?
A – annuity amount = 40000
Here, FVIFAr,N = Future Value Interest Factor Annuity (at an interest rate 'r' of 8%, for
a period of 'N' 10 years).
# A company has borrowed a sum of Rs. 1000000 at an interest rate of 15%

The loan has to be repaid in 5 equal installments payable at the end of each of the next
five years
What would be the annual installment payable by the company?
Formula for the present value of an Ordinary Annuity:
PV = A x PVIFA15%,5
1000000 = A x 3.3522
A= 1000000 / 3.3522 = 298312
Where:
PV – present value = 1000000
r – periodic interest rate = 15%
N – number of periods = 5
A – annuity amount = ?
Here, PVIFAr,N = Present Value Interest Factor Annuity (at an interest rate 'r' of 15%,
# A company has borrowed a sum of Rs. 500000 at an interest rate of 9%
The loan has to be repaid in 5 equal installments payable at the end of each of the next
five years
PV = A x PVIFA9%,5
500000 = A x 3.8897
A= 500000 / 3.8897 = 128545
Where:
PV – present value = 500000
Annuity due is a series of equal cash flows which occur at the beginning of each
period #Formula for the future value of an Annuity due:
Where:
FVN – future value
# Formula for the present value of an Annuity due:
Where:
Examples on Future and Present Values of Annuity Due

# A person decides to put in Rs.1,000 at the beginning of every year into an account
for a period of 4 years.
of interest was 6% per annum?
Formula for the future value of an Annuity due:
FVN = A x FVIFAr,N x (1 + r)
= 1,000 x 4.3746 x (1 + 0.06)
= 1,000 x 4.3746 x 1.06 = 4,637
Where:
FVN – future value = ?
A – annuity amount = 1,000
Here, FVIFAr,N = Future Value Interest Factor Annuity (at an interest rate ‘r’ of 6%,
for a period of ‘N’ 4 years).
# A person decides to put in Rs.5,000 at the beginning of every year into an account
for a period of 6 years.
of interest was 8% per annum?
FVN = A x FVIFAr,N x (1 + r)
= 5,000 x 7.3359 x (1 + 0.08)
= 5,000 x 7.3359 x 1.08 = 39,614
Where:
FVN – future value = ?
Here, FVIFAr,N = Future Value Interest Factor Annuity (at an interest rate ‘r’ of 8%,
#What would be the Present Value of an annuity of Rs. 1,000 at the beginning of each
year, for a period of 4 years, the associated rate of interest being 10%
Formula for the present value of an Annuity due:
Where:
PV = 1000 x PVIFAr,N x (1 + r)
= 1,000 x 3.169 x (1 + 0.10)

= 1,000 x 3.169 x 1.10 = 3,487
Where:
PV – present value = ?
Here, PVIFAr,N = Present Value Interest Factor Annuity (at an interest rate ‘r’ of 10%,
SINKING FUND is a fund formed by periodically setting aside money for the
repayment of a debt or replacement of a wasting asset
# A company has debentures amounting to Rs. 45,00,000 which have to be redeemed
after a period of 6 years.
How much would the company have to deposit annually in a sinking fund, for the
period, if the applicable rate of interest is 14%?
Formula for the future value of an Ordinary Annuity:
FVN = A x FVIFA14%,6
45,00,000 = A x 8.5355
A= 45,00,000 /8.5355 = 5,27,210
Where:
FVN – future value= 45,00,000
A – annuity amount = (sinking fund) =?
Here, FVIFAr,N = Future Value Interest Factor Annuity (at an interest rate 'r' of 14%,
Perpetuity is a never-ending series of equal cash flows which occur at the end of each
period indefinitely
Formula for the present value of a Perpetuity:
Where:
#What will be the present value of a perpetuity of Rs 10,000 every year when the rate
of interest is 10%
Formula for the present value of a Perpetuity:
PV = 10,000 / 0.1
= 1,00,000
Where:
PV – present value = ?
DOUBLING PERIOD:
There are some rule of thumb methods which are used to calculate the period of time
required to double an investment.
These methods do not give totally accurate results, but are fairly indicative.
Some of the methods commonly used in this respect are
 Rule of 72 –
Under this method the doubling period is considered to be 72/r , where ‘r’ is the rate of
interest.
e.g. if the rate of interest is 8%, the doubling period would be 72/8 = 9 years.
 Rule of 69 –
This is a comparatively more accurate method of estimating the doubling period.
Under this method the doubling period is considered to be 0.35+69/r, where ‘r’ is the
rate of interest.
e.g. if the rate of interest is 10%, the doubling period would be 0.35+69/10 = 7.25
years. CAPITAL RECOVERY FACTOR
The capital recovery factor is the ratio used to determine the present value of a series
of equal annual cash payments
# A person has borrowed a sum of Rs. 10,000 at an interest rate of 9%
The loan has to be repaid in 3 equal instalments payable at the end of each year
PV = A x PVIFA9%,3
10,000 = A x 2.5313
A= 10,000 / 2.5313 = 3,951
Where:
PV – present value = 10,000
Here, PVIFAr,N = Present Value Interest Factor Annuity (at an interest rate 'r' of 9%, for
a period of 'N' 3 years).
Capital Recovery Factor = 1/ PVIFA9%,3
Here, Capital Recovery Factor = 1/ 2.5313 = 0.3951
A = 10,000 x 1 / 2.5313 = 10,000 x 0.3951 = 3,951
This is used to calculate the Loan Amortization Schedule
End of Total Interest Principal Outstanding

year payment payment repayment balance
0 10,000
1 3,951 900 3,051 6,949
2 3,951 625 3,326 3,623
3 3,951 326 3,625* 0
*Rounding off error
# A person has borrowed a sum of Rs.15,00,000 at an interest rate of 10%

The loan has to be repaid in 5 equal instalments payable at the end of each year
PV = A x PVIFA10%,5
15,00,000 = A x 3.7908
A= 15,00,000 / 3.7908 = 3,95,695
Where:
PV – present value = 15,00,000
Capital Recovery Factor = 1/ PVIFA10%,5
Here, Capital Recovery Factor = 1/ 3.7908 = 0.2638

A = 15,00,000 x 1 / 3.7908 = 15,00,000 x 0.2638 = 3,95,700
This is used to calculate the Loan Amortization Schedule
End of year Total payment Interest Principal repayment Outstanding

payment balance
0 15,00,000
1 3,95,700 1,50,000 2,45,700 12,54,300
2 3,95,700 1,25,430 2,70,270 9,84,030
3 3,95,700 98,403 2,97,297 6,86,733
4 3,95,700 68,673 3,27,027 3,59,706
5 3,95,700 35,971 3,59,729* 0
*Rounding off error

Nominal / Stated interest rate and Effective interest rate
#When Rs.1,000 is invested for 1 year at an interest rate of 12% compounded
annually, accumulated amount at the end of the year is
FV = 1,000 x (1 + 0.12)1 = 1,000 x 1.12 = 1,120

Here,
the Nominal interest rate = 12%
the Effective interest rate = (1 + 0.12) -1
= (1.12 – 1) x 100% =12%
# When Rs.1,000 is invested for 1 year at an interest rate of 12% compounded semi-
annually,
accumulated amount at the end of the year is
FV = 1,000 x (1 + 0.12/2)2 = 1,000 x 1.1236 = 1,123.6

Here,
the Effective interest rate = (1 + 0.12/2)2 -1
= (1.1236 – 1) x100% =12.36%
# When Rs.1,000 is invested for 1 year at an interest rate of 12% compounded

quarterly, accumulated amount at the end of the year is
FV = 1,000 x (1 + 0.12/4)4 = 1,000 x 1.1255 = 1,125.5

Here,
= (1.1255 – 1) x100% =12.55%
#When Rs.1,000 is invested for 1 year at an interest rate of 12% compounded monthly,
accumulated amount at the end of the year is
FV = 1,000 x (1 + 0.12/12)12 = 1,000 x 1.1268 = 1,126.8

Here,
= (1.1268 – 1) x 100% =12.68%
FUTURE/PRESENT VALUE TABLES
TIME VALUE OF MONEY – tables - FVIF

TIME VALUE OF MONEY – tables - FVIFA
TIME VALUE OF MONEY – tables - PVIFA

References
1) Pnadey, I.M, (2007), Financial Management, Viskash Publishing House Private
Limited, New Delhi
2) Khan,M.Y and Jain,P.K(2005), Financial Managements, Text , Problems and
Cases ,Tata McGraw Hill, New Delhi
3) Chandra Prasanna (2005), Investment Analysis and Portfolio Management Tata
McGraw-Hill Publishing, New Delhi
4) Bodie Zvi, Kane Alex, Marcus Alan J and Mohanty Pitabus(2011),Investments,
Tata McGraw-Hill Publishing, New Delhi
5) Financial Managemnt, ICMR Study Material
Chapter 6: Session 11 – Raising Finance from International Markets
International Financial Markets:

The International Financial Market is the place where financial wealth is traded
between individuals and typically between the countries. It is a wide set of rules and
institutions where assets are traded between agents in surplus and agents in deficit
and where institutions lay down the rules.
When funds flow across national boundaries and the transfer is between parties
residing in different countries, there comes into existence the international financial
markets.
The Participants of International Financial Markets (Wholesale Markets):
The wholesale segment is also known as the interbank market as the exchange
transactions take place between banks, that are primary dealers.
Commercial Banks:
Originally commercial banks used to buy and sell foreign currencies for their
customers as part of their financial services. They later to come foreign exchange
trading as their principal business. Commercial banks have also found it useful to
trade with each other. As commercial banks trade in large volumes of foreign
exchange, the wholesale segment of the foreign exchange market has become an
interbank market.
Investment Banks and other Financial Institutions:
Although the interbank foreign exchange market was the exclusive domain of
commercial banks for a long time. Investment banks, insurance companies, pension
funds, mutual funds, hedge funds and other financial institutions have also entered
the foreign exchange market and have become direct competitors to commercial
banks. These new institutions have emerged as important foreign exchange service
providers to a variety of customers in competition with the commercial banks. Hedge
funds have become more aggressive in currency speculation and are now became
capable of influencing foreign exchange rates.
Corporations and High Net-Worth Individuals:
Corporations and high-net worth individuals, domestic as well as multinational
corporations participate in the foreign exchange market to convert their foreign
currency denominated export receipts foreign borrowings and foreign remittances
into their home currency. They may buy foreign currency to make import payments,
interest payments and loan payments and to invest funds abroad. Some high-net
Dr. G V Kesava Rao, B.Sc., MBA, PGDFM, LL.M.-Research, FDP-IIM A, CS, LIP-
IBBI, Ph. D
Professor, Advocate and Qualified Limited Insolvency Professional Page 1 of 41
Adjunct Faculty, IBS Bangalore.
worth individuals also participate in the foreign exchange market to meet their
investment needs.
IBBI, Ph. D
Central Banks:
Central banks of different countries may also participate in the foreign exchange
market in order to control factors such as money supply, inflation and interest rates
by influencing exchange rate movements in a particular direction. In other words, the
intention of the central bank is warranted when the government wants to maintain
target exchange rates or avoid violent fluctuations in exchange rates. Central bank
may also use their foreign exchange reserves to intervene in the foreign exchange
market. Reserve Bank of India intervenes in the foreign exchange market especially
to arrest violent fluctuations in exchange rate due to demand supply mismatch in the
domestic foreign exchange market.
The Participants of International Financial Markets (Retail Markets):
The retail segment of the foreign exchange market consists of tourist, restaurants,
hotel, shops banks and other bodies and individuals. Travellers and other individuals
exchange one currency for another, in order to meet their specific requirements.
Currency notes, travellers’ cheques and bank drafts are the common instruments in
the retail market. Authorised restaurants, hotels, shops, banks and other entities buy
and sell foreign currencies, bank drafts and travellers’ cheques to provide easy access
to foreign exchange for individual customers and also to convert their foreign
currency into their home currency. Individuals who receive foreign remittances and
those who send foreign currencies abroad may also participate in the retail segment
of foreign exchange market
Euro-Dollar Market:
Though the emergence of Euro-dollar in the international financial system is of
recent origin, in the late sixties, it has caused a profound influence upon the money
and capital markets of the Western world. Effectively the euro dollar market began in
the 1950s, when the Soviet Union began moving its dollar denominated oil revenues
out of US banks in order to prevent US from freezing its assets. The Euro-dollar
Market has become a permanent integral part of the international monetary system.
Euro-dollar is meant all U.S. dollar deposits in banks outside the United States,
including the foreign branches of U.S. banks. A Euro-dollar is, however, not a
special type of dollar. It bears the same exchange rate as an ordinary U.S. dollar has
in terms of other currencies. In short, the term Euro-dollar is used as a common term
to include the external markets in all the major convertible currencies.
The Euro-dollar market is principally located in Europe and basically deals in U.S.
dollars. The euro dollar market is one of the world’s biggest capital markets and
consists of sophisticated financial instruments.
IBBI, Ph. D
Euro-dollar market performs 3 important functions:
 It acts as an international conduit for short and medium-term capital from surplus nations to
deficient nations.
 It enables cover operations in foreign exchange.
 Euro dollar market acts as financial intermediary within the border of a single country’s
currency.
The Euro-dollar market has two facts:
 It is a market which accepts dollar deposits from the non-banking public and gives credit in
dollars to the needy non-banking public.
 It is an inter-bank market in which the commercial banks can adjust their foreign currency
position through inter-bank lending and borrowing.
Following benefits seem to have accrued to the countries involved in the Euro-dollar market:
1. It has provided a truly international short-term capital market, owing to a high degree of
mobility of the Euro-dollars.
2. Euro-dollars are useful for the financing of foreign trade.
3. It has enabled the financial institutions to have greater flexibility in adjusting their cash and
liquidity positions.
4. It has enabled importers and exporters to borrow dollars for financing trade, at cheaper rates
than otherwise obtainable.
5. It has helped in reducing the profit margins between deposit rates and lending rates.
6. It has enhanced the quantum of funds available for arbitrage.
7. It has enabled monetary authorities with inadequate reserves to increase their reserves by
borrowing Euro-dollar deposits.
8. It has enlarged the facilities available for short-term investment.
9. It has caused the levels of national interest rates more akin to international influences.
The major drawbacks of the Euro-dollar market may be mentioned as under:
1. It may lead banks and business firms to overtrade.
2. It may weaken discipline within the banking communities.
3. It involves a grave danger of sudden large- scale withdrawal of credits to a country.
4. It has rendered official monetary policies less effective for the countries involved.
IBBI, Ph. D
International Capital Market Instruments:
American Depository Receipts:
A foreign company might make issue in U.S. by issuing securities through
appointment of Bank as depository. By keeping the securities issued by the foreign
company, the U.S. Bank will issue receipts called American Depository Receipts
(ADRs) to the investors.
It is a negotiable instrument recognizing a claim on foreign security. The holder of
the ADRs can transfer the instrument as in the case of domestic instrument and is
also entitled for dividends as and when declared.
The ADR holder can ask the bank for the original foreign security by exchanging the
ADR. The Bank will act as a custodian for the investors.
An ADR can be described as a negotiable instrument denominated in US dollars,
representing a non-US Company’s local currency equity shares or known as
depository receipts.
These are created when the local currency shares of an Indian Company are
delivered to an overseas depository bank’s domestic custodian bank, against which
depository receipts in US dollars are issued.
Each depository receipt may represent one or more underlying shares. These
depository receipts can be listed and traded as any other dollar denominated security.
The disclosures as required under the Securities Exchange Commission’s (SEC)
regulations are stringent and onerous. In order to protect the investor, the SEC places
the onus on the issuer company, its officers and directors to ensure that the
prospectus does not contain any misstatement or omissions which are material in
nature.
Benefits to Indian Company:
 Better corporate image both in India and abroad which is useful for strengthening the business
operations in the overseas market.
 Exposure to international markets and hence stock prices in line with international trends.
 Means of raising capital abroad in foreign exchange.
 Use of the foreign exchange proceeds for activities like overseas acquisitions, setting up
offices abroad and other capital expenditure.
 Increased recognition internationally by bankers, customers, suppliers etc.
 No risk of foreign exchange fluctuations as the company will be paying the interest and
dividends in Indian rupees to the domestic depository bank.
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Benefits to Overseas Investors:
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 Assured liquidity due to presence of market makers.
 Convenience to investors as ADRs are quoted and pay dividends in U.S. dollars, and they
trade exactly like other U.S. securities.
 Cost-effectiveness due to elimination of the need to customize underlying securities in India.
 Overseas investors will not be taxed in India in respect of capital gains on transfer of ADRs to
another non-resident outside India.
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Chapter 6: Session 12 – Raising Finance from International Markets
Global Depository Receipts:

Global Depository Receipt (GDR) is an instrument which allows Indian Corporate,
Banks, Non- banking Financial Companies etc. to raise funds through equity issues
abroad to augment their resources for domestic operations.
A GDR is a dollar denominated instrument of a company, traded in stock exchanges

outside the country of origin i.e. in European and South Asian Markets. It represents
a certain number of underlying equity shares.
Though the GDR is quoted and traded in dollar terms, the underlying equity shares
are denominated in rupees only. Instead of issuing in the names of individual
shareholders, the shares are issued by the company to an intermediary called the
‘depository’, usually an Overseas Depository Bank, in whose name the shares are
registered.
It is the depository, which subsequently issues the GDR to the subscribing public.
The physical possession of the equity shares will be with another intermediary called
the ‘custodian’, who is an agent of the depository. Though the GDR represents the
company’s shares, it has a distinct identity and does not figure in the books of the
company.
Foreign Currency Convertible Bonds:

Foreign Currency Convertible Bonds (FCCBs) are issued in accordance with the
scheme and subscribed by a non-resident in foreign currency and convertible into
ordinary share of the issuing company in any manner, either in whole or in part on
the basis of only equity related warrants attached to debt instrument. The FCCB is
almost like the convertible debentures issued in India.
The Bond has a fixed interest or coupon rate and is convertible into certain number
of shares at a prefixed price. The bonds are listed and traded on one or more stock
exchanges abroad. Till conversion the company has to pay interest on FCCBs in
dollars (or in some other foreign currency) and if the conversion option is not
exercised, the redemption also has to be done in foreign currency. These bonds are
generally unsecured.
External Commercial Borrowing:

External Commercial Borrowings (ECBs) is a borrowing of over 180 days. ECB is
the borrowing by corporate and financial institutions from international markets.
ECBs include commercial bank loans, buyers’ credit, suppliers’ credit, security
instruments such as floating rate notes and fixed rate bonds, credit from export-credit
agencies, borrowings from international financial institutions such as IFC etc.
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The incentive available for such loans is the relative lower financing cost. ECB’s can
be taken in any
major currency and for various maturities. ECBs are being permitted by the
Government for
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providing an additional source of funds to Indian corporate and PSU’s for financing
expansion of existing capacity as well as for fresh investment to augment the
resources available domestically.
ECBs are approved with an overall annual ceiling. Consistent with prudent debt-
management keeping in view the balance of payments position and level of foreign
exchange reserves.
Regulatory Aspects:
In theory, financial regulation around the world is governed by standards set by
three main groups of regulators. For banking, it is the Basel Committee, set up
under the auspices of the BIS. For securities firms and markets, it is the
International Organisation of Securities Commissions (IOSCO), and for insurance
companies it is the International Association of Insurance Supervisors (IAIS). All
three organisations have established principles of good regulatory practice, to which
most countries in the world are, at least nominally, signed up. These principles
describe the appropriate structures for regulation.
Once currencies came under pressure, and inadequate external liquidity became the
issue, the opacity of local accounting standards, the insecure basis of provisioning
policies, uncertainties in enforcing collateral, dubious corporate governance and the
inability of central banks and supervisory authorities to impose discipline were all
important factors undermining confidence and aggravating the collapse.
There is a need to enhance supervision, particularly in economies open to capital

flows, and to strengthen their compliance with internationally agreed best practices.
The groups of supervisors themselves do not have the basis on which to enforce
rules among their voluntary membership. The Basel Committee has tried hard, and
with some success, to reach out beyond its membership, but of course it has no firm
mandate to do so. Instead, the necessary expertise, resources and willingness to pass
judgement on compliance with these standards are being put together by the IMF
and the World Bank.
The IMF has a worldwide responsibility for economic surveillance, has only
recently been extended to cover financial systems in any depth. A desire by the
international financial community to consider more carefully the threats to financial
stability, to put in place better incentives for avoiding such crises, and to bring
together the key government officials, supervisors, central banks and the financial
institutions, through the new Financial Stability Forum is very important for the
regulation of International Financial Market.
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Some Important Regulators of International Financial Markets:
Organization for Economic Co-operation and Development (OECD):
The mission of the Organization for Economic Co-operation and Development

(OECD) is to promote policies that will improve the economic and social well-being
of people around the world. The OECD provides a forum in which governments can
work together to share experiences and seek solutions to common problems. While
the OECD does not engage in direct regulatory activities, they nevertheless influence
regulatory policy.
The World Bank (WB):
Established in 1944, the World Bank offers support to developing countries through
policy advice, research, analysis, and technical assistance. The World Bank’s
analytical work often underpins World Bank financing and helps inform developing
countries’ own investments. In addition, the organization supports capacity
development in the countries they serve. The World Bank also sponsors, hosts, or
participates in many conferences and forums on issues of development, often in
collaboration with partners. While they do not play a direct role in relation to
financial regulation, their work often informs the regulatory policies of various
nations across the world.
Bank of International Settlements (BIS):
Established on 17 May 1930, the Bank for International Settlements (BIS) is an

international financial organisation owned by 60 member central banks, representing
countries from around the world that together make up about 95% of world GDP. Its
head office is in Basel, Switzerland and it has two representative offices: in the Hong
Kong Special Administrative Region of the People’s Republic of China and in
Mexico City. The mission of the BIS is to serve central banks in their pursuit of
monetary and financial stability, to foster international cooperation in those areas and
to act as a bank for central banks.
International Organization of Securities Commissions (IOSCO):
The International Organization of Securities Commissions (IOSCO) is the

international body that brings together the world's securities regulators and is
recognized as the global standard setter for the securities sector. IOSCO develops,
implements and promotes adherence to internationally recognized standards for
IBBI, Ph. D
Professor, Advocate and Qualified Limited Insolvency Professional Page 10 of
Adjunct Faculty, IBS Bangalore. 41
securities regulation. It works intensively with the G20 and the Financial Stability
Board (FSB) on the global regulatory reform agenda. Established in 1983, IOSCO
members
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regulate more than 95% of the world's securities markets in more than 115
jurisdictions with securities regulators in emerging markets accounting for 75% of its
ordinary membership.
International Capital Market Association (ICMA):
ICMA is a membership association, committed to serving the needs of its wide range
of members representing both the buy side and sell side of the industry. Its
membership includes issuers, intermediaries, investors and capital market
infrastructure providers. ICMA currently has more than 500 members located in over
60 countries worldwide. Working actively with its members in all segments of the
wholesale market, ICMA focuses on a comprehensive range of regulatory, market
and other relevant issues, which impact market practices and the functioning of the
international debt capital markets.
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Chapter 7: Session 13 - Time Value for Money
Introduction:
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According to the concept of Time Value for money “a rupee which we have today has
a better
value than the rupee receivable sometime in future.”
Reasons for changes in the value of money with time may be attributed to:
 Rate of Return
It means that the money which we have today is capable of generating a return depending
on the kind of investment made.
(Rs. 1,00,000 today, the value after 1 year assuming 10% interest would be Rs. 1,10,000)
Which means if only rate of return is taken into account, Rs. 1,00,000 which we have today
is equal to Rs. 1,10,000 after one year when the rate of return is 10%.
In other words, Rs. 1,10,000 receivable after one year is equal to Rs. 1,00,000 today when
the rate of return is 10%.
 Inflation
(Rs. 1,00,000 today, after 1 year assuming 8% inflation, you need to spend Rs. 1,08,000 to
buy the same item)
If (Rs. 1,00,000 today, after 1 year assuming 9.9 inflation, you need to spend Rs. 1,09,900
to buy the same item)
 Risk and Uncertainty
P=1 - Certainty, P=0 – Uncertainty, P= Between 0 to 1 –
Risk Risk Premium, Future is not predictable
 Preference for Present Consumption (Bird in Hand Approach)
Most of the financial decisions involve cash flows occurring at different time
periods. Any decision on the arithmetic value of the same will not be appropriate.
Therefore, all of them should be brought in to one common reference point for
logical and reasonable comparison. Hence, we need to know how to bring them on to
a common platform. The concepts compounding and discounting would enable us to
do the same. Majority of our decisions in Both personal and professional life utilise
the concept of time value for money. before that we should understand the type of
cash flows that will occur.
Types of cash flows:

The cash flows may be divided in to
1. Single Cash Flow
2. Multiple Cash Flows (Stream of Cash Flows)
a. Uneven Cash Flow Stream
b. Even Cash Flow Stream - Annuity
Determination of Time Values is broadly divided in to two categories:
Future Value:
When we want to know the value of money known to us today, after some time in
future, then we will be applying the logic of future value calculations.
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In Future Value calculations, unless otherwise specified, it is assumed that
investments will be done at the beginning of the year and value will be determined at
the end of the year i.e. t0 = ‘X’ (Beg), tn =? (End)
Compounding Interest:
In compounding interest logic, interest is charged both on Principal and Interest after
a specified period, typically after every year if the period of compounding is not
specified.
A = P(1 + r)n
A = Amount, Future Value (FV), P = Principal, Present Value (PV), r = Rate of
Interest, n = Number of Years/Periods
Future Value of Single Cash Flow (Onetime Investment):

FV = PV(1 + r)n
Where (1 + r)n is nothing but the future value
interest factor. This is also known as compounding
factor.
The table gives us the value of one unit of currency invested today for different
combinations of the rate of interest and the time periods.
Once we know the value of one unit of currency, determination of the value for any
amount would be very simple.
FV= PV × (FVIF r%, n y)
Timeline of Future Value Determination
t=0 t=1 t=2 t=3 t=4 t=5
Rs. 5,00,000 X (FVIF r%, 5 years) FV=?

Illustration:
Determine the value of Rs. 10,00,000 after 5 years, when the rate of interest is a) 10%,
b) 15% and c) 20%
PV = 10L, n= 5 years, r= 10%, 15% and 20%
FV = PV × (FVIF r%, n y) = 10L × (FVIF 10%, 5 y) = 10L × 1.6105
= 16.105L FV = PV × (FVIF r%, n y) = 10L × (FVIF 15%, 5 y) =
10L × 2.0114 = 20.114L FV = PV × (FVIF r%, n y) = 10L × (FVIF
20%, 5 y) = 10L × 2.4883 = 24.883L
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Future Value calculations are directly proportionate to the rate of interest and/or the number
of years i.e. 𝐅𝐕 ∝ 𝐫% 𝐚𝐧𝐝 𝐧 𝐲
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Future Value of Uneven Cash Flow Stream (Multiple Cash Flows):
“Uneven cash flow stream means, some amount of money over some specified period
of time,
periodically”
In this case the 1st year amount will earn interest for ‘n’ years, 2 nd year amount will
earn interest for ‘n-1’ years and so on and finally the n th year amount will earn
interest for 1 year. Then it will be totalled to find out the total future value at the end
of the ‘n’ years.
Illustration:
Mr. Mahesh is planning invest the following amounts over a period of 5 years, what
will be the total value by the end of the period when the rate of interest is 20% per
annum?
Year1 – 4,00,000, Year2 – 12,00,000, Year3 – 40,00,000, Year4 – 8,00,000 and Year5
– 1,50,00,000
Year Amount FVIF FVIF FV
@20%
1 4 FVIF r%, 5 2.4883 99
0 y 53
0 20
0
0
0
2 1 FVIF r%, 4 2.0736 24
2 y 88
0 32
0 0
0
0
0
3 4 FVIF r%, 3 1.7280 69
0 y 12
0 00
0 0
0
0
0
4 8 FVIF r%, 2 1.4400 11
0 y 52
0 00
0 0
0
0
5 1 FVIF r%, 1 1.2000 18
5 y 00
0 00
0 00
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0
0
0
0
Total Future Value 29
54
76
40
In the above problem, if the investments are made at the end of each of the years then
the 1st year amount will earn interest for ‘n-1’ years, 2nd year amount will earn
interest for ‘n-2’ years and so on and finally the n th year amount will earn interest for
0 year. Then it will be totalled to find out the total future value at the end of the ‘n’
years.
Year Amount FVIF FVIF FV

@20%
1 4 FVIF r%, 4 2.0736 82
0 y 94
0 40
0
0
0
2 1 FVIF r%, 3 1.7280 20
2 y 73
0 60
0 0
0
0
0
3 4 FVIF r%, 2 1.4400 57
0 y 60
0 00
0 0
0
0
0
4 8 FVIF r%, 1 1.2000 96
0 y 00
0 00
0
0
0
5 1 FVIF r%, 0 1.0000 15
5 y 00
0 00
0 00
0
0
0
0
Total Future Value 24
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62
30
40
Future Value of Annuity (Even Cash Flow Stream)

An annuity is a stream of constant cash flows.
The 2 conditions that must be satisfied to call a cash flow as an annuity are,
1. The amount of money must be the same, and
2. the time gap between any 2 time periods must be the same.
When the cash flows occur at the end of each period the annuity is called ordinary
annuity and when the cash flows occur at the beginning of each period, the annuity is
called an annuity due.
Best examples for an annuity are life insurance premium payments, recurring deposit
payments.
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(1 + r)n − 1
FV
= r
(1+r)n−1
A
×
is also known as future value interest factor for an annuity.
r
The table gives the value of one unit of currency deposited for each of the period for
different combinations of the rate of interest and time.
FV = A × (FVIFA r%, n y)
Illustration:
Mr. Nadakarni, is planning to send his son to USA for higher studies after 5 years
and expects that it would cost him Rs. 100,00,000 by then. How much should he save
annually when the rate of interest is 10 percent per annum.
n = 5 Years, FV = 100L and r =10%; A=?
FV = A × (FVIFA
r%, n y), 100L =
A × (FVIFA 10%,
5 y)
100L
A= =Rs. 16,37,975
6.1051
Implied Rate of Interest in transactions:

Any time value calculation involves 4 parameters. When we know any 3, we will be
able to identify the other parameter. The next most important decision would be the
determination of rate of interest involved in the transactions.
Illustration:
In a deposit scheme of a finance company, you would be paid Rs. 20,00,000 after
7 years if you deposit with them Rs. 12,00,000 today. What interest rate is implicit
in this offer?
FV = 20L, n = 7 years, PV = 12L; r=?
FV = PV × (FVIF r%, n y)
20L = 12L × (FVIF r%, 7 y)
20L
F = 1.6667
VI 12L
Table: F
r
%
,
7
y
=
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FVIF 7%, 7 y = 1.6058, FVIF 8%, 7 y =
1.7138
Interpolation or Linear Approximation for FV
Req. Value − Min. ] × (HR − LR)}
Value
r = LR + {[
Max. Value − Min.
Value
1.6667 − 1.6058
r ] × (8 − 7)} ; r = 7.563%
=1.7138 − 1.6058
I 7
ll +
{[
u
s
t
r
a
ti
o
n
:
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A finance company promises to pay you Rs. 10,00,000 after 6 years if you deposit
with them Rs. 1,40,000 a year. What interest rate is being offered by the finance
company in this offer?
FV = 10L, n = 6 years, A = 1.4L; r=?
FV = A × (FVIFA r%, n y)
10L = 1.4L × (FVIFA r%, 6 y)
10L
FVI = 7.1428
FA 1.4 L
Table: r%,
6y
=
FVIF 6%, 6 y = 6.9753, FVIF 7%, 6 y =
7.1533
Interpolation or Linear Approximation for FV
Req. Value − Min. ] × (HR − LR)}
Value
r = LR + {[
Max. Value − Min.
Value
7.1428 − 6.9753
r = 6 + {[ ] × (7 − 6)} ; r = 6.941%
7.1533 − 6.9753
Present Value:
When we want to know the value of money as on today, which is receivable after
some time in future, then we will be applying the logic of present value calculations.
In Present Value calculations, unless otherwise specified, it is assumed that the
amounts are received at the end of the year and value will be determined at the
beginning of the year i.e. tn = ‘X’ (End), t0 =? (Beg)
Present Value of Single Cash Flow (Onetime Investment):

1
PV = FV × −𝑛
(1 + r)n = FV × (1 + r)
Where (1 + r)−n is nothing but the present value
interest factor. This is also known as discounting
factor.
The table gives us the value of one unit of currency receivable in future for different
combinations of the rate of interest and the time periods.
PV = FV × (PVIF r%, n y)
Timeline of Present Value Determination
t=0 t=1 t=2 t=3 t=4 t=5
PV=? (PVIF r%, 5 years) X Rs. 5,00,000
Illustration:
What is the present value of Rs. 200 lakhs receivable after 10 years from now,
when the rate of interest is 15% per annum?
FV = 200L, n = 10y,
r = 15%, PV =? PV
= FV × (PVIF r%, n
y)
PV = 200L × (PVIF 15%, 10 y)
= 200L X 0.2472 = Rs. 49,44,000
Future Value calculations are directly proportionate to the rate of interest and/or the number
𝟏
of years i.e. 𝐏𝐕 ∝ 𝐫% 𝐚𝐧𝐝 𝐧 𝐲
Present Value of Uneven Cash Flow Stream (Multiple Cash Flows):
In this case the amount receivable in the 1 st year will be discounted for ‘1’ year, the
amount receivable in the 2nd year will be discounted for ‘2’ years and so on and
finally the amount receivable in the nth year will be discounted for n years. Then it
will be totalled to find out the total present value at the beginning of the period i.e.
today.
Illustration:
ABC Ltd. is expecting the following benefits from an investment activity over a
period of 5 years, what will be the total value as on today, when the rate of interest is
20% per annum.
Year1 – 25,00,000, Year2 – 5,00,000, Year3 – 45,00,000, Year4 – 1,00,000 and Year5
– 1,00,00,000
Year Amount PVIF r%, n y PVIF@20 PV

%
1 2 PVIF r%, 1 y 0.8333 2
5 0
0 8
0 3
0 2
0 5
0 0
2 5 PVIF r%, 2 y 0.6944 3
0 4
0 7
0 2
0 0
0 0
3 4 PVIF r%, 3 y 0.5787 2
5 6
0 0
0 4
0 1
0 5
0 0
4 1 PVIF r%, 4 y 0.4823 4
0 8
0 2
0 3
0 0
0
5 1 PVIF r%, 5 y 0.4019 4
0 0
0 1
0 9
0 0
0 0
0 0
0
Total Present Value 9
1
0
1
8
3
0
In the above problem, if the amounts are received at the beginning of each of the
years then the amount receivable in the 1st year will be discounted for ‘0’ year, the
amount receivable in the 2nd year will be discounted for ‘1’ year and so on and finally
the amount receivable in the nth year will be discounted for ‘n-1’ years. Then it will
be totalled to find out the total present value at the beginning of the period i.e. today.
Year Amount PVIF PVIF@20 PV

r%, %
ny
1 2 PVIF 1.0000 25
5 r%, 00
0 0y 00
0 0
0
0
0
2 5 PVIF 0.8333 41
0 r%, 66
0 1y 50
0
0
0
3 4 PVIF 0.6944 31
5 r%, 24
0 2y 80
0 0
0
0
0
4 1 PVIF 0.5787 57
0 r%, 87
0 3y 0
0
0
0
5 1 PVIF 0.4823 48
0 r%, 23
0 4y 00
0 0
0
0
0
0
Total Present Value 10
92
23
20
Chapter 7: Session 16 – Time Value for Money
Present Value of Annuity (Even Cash Flow Stream):

An annuity is a stream of constant cash flows.
The 2 conditions that must be satisfied to call a cash flow as an annuity are,
1. The amount of money must be the same, and
2. the time gap between any 2 time periods must be the same.
(1+r)n−1
PV = A × r (1+r)n
(1+r)n−1
is also known as present value interest factor for an annuity.
r (1+r)n
The table gives the value of one unit of currency receivable for each of the period for
different combinations of the rate of interest and time.
PV = A × (PVIFA r%, n y)
Illustration:
At the time of his retirement Mr. Shyam has been given a choice between 2
alternatives. Alternative 1: Rs. 5 Crores immediately or Alternative 2: Rs. 1 Crore
every year as long as he is alive. He expects that he would be alive for the next 15
years. Which option should he choose when the rate of interest is 1) 15% 2) 20%?
Alternative 1: Rs. 5 Crores now and Alternative 2: 1 Crore every year as
long as he is alive n= 15 years and r = 15% or 20%
When the rate is 15%
PV of alternative 1 = 5 Cr.
PV of alternative 2 = A × (PVIFA r%, n y) = 1Cr × PVIFA 15%, 15y = 1Cr ×
5.8474 = 5.8474Cr.
Decision: Choose alternative 2.
When the rate is 20%
PV of alternative 1 = 5 Cr.
PV of alternative 2 = A × (PVIFA r%, n y) = 1 × PVIFA 20%, 15y = 1 × 4.6755 =
4.6755Cr.
Decision: Choose alternative 1.
Implied Rate of Interest in transactions:
Any time value calculation involves 4 parameters. When we know any 3, we will be
able to identify the other parameter. The next most important decision would be the
determination of rate of interest involved in the transactions.
Illustration:
In a deposit scheme of a finance company, you would be paid Rs. 20,00,000 after
7 years if you deposit with them Rs. 12,00,000 today. What interest rate is implicit
in this offer?
FV = 20L, n = 7 years, PV = 12L; r=?
PV = FV × (PVIF r%, n y)
12L = 20L × (PVIF r%, 7 y)
12L
P = 0.6
VI 20L
Table: F
r
%
,7
y
=
PVIF 7%, 7 y = 0.6227, PVIF 8%, 7 y =
0.5835
Interpolation or Linear Approximation for PV
Max. Value − Req. ] × (HR − LR)}
Value
r = LR + {[
Max. Value − Min. Value
0.6227 − 0.6
r = 7 + {[ ] × (8 − 7)} ; r = 7.5791%
0.6227 − 0.5835
Illustration:
If you have been promised to be paid Rs. 100 lakh a year for 7 years if you deposit Rs.
400 lakhs today, what interest rate is implied in this offer?
A = 100L, n = 7 y, PV = 400L, r =?
PV = A × (PVIFA r%, n y)
400L = 100L × (PVIFA r%, 7 y)
400L
PVI =4
FA 100L
Table: r%,
7y
=
PVIFA 16%, 7 y = 4.0386, PVIFA 20%, 7 y =
3.6046
Interpolation or Linear Approximation for PV
Max. Value − Req. ] × (HR − LR)}
Value
r = LR + {[
Max. Value − Min. Value
4.0386 − 4
r = 16 + {[ ] × (20 − 16)} = 16.36%
4.0386 − 3.6046
Illustration:
You are planning to invest Rs. 25,00,000 a year for the first 5 years, thereafter Rs.
10,00,000 a year for the next 10 years. What will be the value of all these amounts by
the end of that period when the rate of interest is 12% per annum?
1 – 5 Years; 25L
6 – 15 Years; 10L
r =12%
FV=? (At the end of 15 Years)
FV= {25L (FVIFA 12%, 5 y)} (FVIF 12%, 10 y) + 10L (FVIFA 12%, 10 y)
= (25L X 6.3528 X 3.1058) + 10L x 17.5490 = 49,32,63,156 + 1,75,49,000 = Rs.
51,08,12,156
Illustration:
What would be the total value of the benefits provided by a business, which provides
you an income of Rs. 100 lakhs in the first year, Rs. 200 lakhs in the second year and
320,00,000 for every year from 3 through 10 years, when the rate of interest is 14%
per annum?
1 Year; 100L
2 Year; 200L
3 - 10 Years; 320L
r =14%
PV=? (At the beginning of Year 1)
PV = 100L X (PVIF 14%, 1 y) + 200L X (PVIF 14%, 2 y) + {320L X (PVIFA
14%, 8 y)} X (PVIF 14%, 2 y) = 100L X 0.8772 + 200L X 0.7695 + {320L X
4.6389} X 0.7695 = 87.72 + 153.9 +
1142.283 = Rs. 1383.903 Lakhs
Effective Rate of Interest:

When we deposit Rs. 10,000 today, that will be Rs.11,000 by the end of one year,
when the rate of interest is 10% per annum i.e. 10,000, 10%, 1 Year = 11,000
Alternatively, when we deposit 10,000 today at the rate of 10% for the first half year
then the amount would be Rs. 10,500 along with the interest and when we deposit
this total amount for the remaining half year at the same rate of 10% then the final
amount by the end of the year would be Rs. 11,025. i.e. 10,000, 10%, 0.5 Year =
10,500; 10%, 0.5 Year = 11,025.
Though the starting amount is the same i.e. Rs. 10,000, the rate of interest i.e. 10%
and the period
i.e. 1 year are also the same, it effectively resulted in a higher amount.
This leads to the concept of effective rate of interest when there is higher frequency of
compounding than the annual compounding.
If one should get Rs. 11,025 on an investment of Rs. 10,000 for one year then the
rate of interest should have been 10.25% and this is called effective rate of interest
i.e. 11,025 after 1 Year on 10,000; Rate = 10.25%
Frequency of Compounding (m):
“Frequency of Compounding (m) is the number of times the interest is added to the
principal
amount”
If interest is added Frequency (m) Name

Once in 12 months 1 Annual/Yearly Compounding
Once in 6 months 2 Semi-annual/Half-yearly Compounding
Once in 3 months 4 Quarterly Compounding
Once in 1 month 12 Monthly Compounding
Once in 1 day 365/366 Daily Compounding
Once in Every Moment ∞ Continuous Compounding
Illustration:
What will be the effective rate of interest when the rate of interest is 10% and
compounding is done semi-annually?
r m 0.1 2
r= 10%,
m=2, , = (1 +
r
rme) = ) − 1 = 0.1025 = 10.25%
− 1(1 + e 2
I
ll
u
s
t
r
a
ti
o
n
:
You are planning to deposit an amount of Rs. 100 crores and approached the
various banks and their quotes are as follows:
SBI: 12.6% compounded annually, Canara Bank: 12.4% compounded semi-
annually, HDFC: 12.2% compounded quarterly and PNB: 12% compounded
monthly.
Which bank would
you choose?
Effective Rate:
SBI:
0.126 1
r = (1 + ) − 1 = (1 + 0.126)1 − 1 = 1.126 − 1 = 0.126 = 12.6%
e
1
Cana
ra:
0.124 2
r = (1 + ) − 1 = (1 + 0.062)2 − 1 = 1.127844 − 1 = 0.1278441 = 12.7844%
e
2
HDFC:
0.122 4
re = (1 + ) − 1 = (1 + 0.0305)4 − 1 = 1.127696 − 1 = 0.127696 = 12.7696%
PNB: 4
r 0.12 12
= (1 + ) − 1 = (1 + 0.01)12 − 1 = 1.126825 − 1 = 0.126825 = 12.6825%
e
12
Decision: Choose Canara Bank as the effective rate is the highest.
Very Important Note:

In the interest factors, wherever “r” is there, divide by ‘m’, and wherever “n” is there
multiply by ‘m’.
𝒓
XXIF ( %, 𝒏 × 𝒎 𝒚𝒆𝒂𝒓𝒔)
𝒎
Then the resultant factor will be equal to that of with the effective rate for the that period of
years.
Illustration:
What will be the value of Rs. 10 lakhs after 5 years when the rate of interest is 12%
compounded quarterly?
PV= 10 Lakhs, r = 12%, n= 5 years, compounded

quarterly (m=4) If effective rate of interest logic is
applied:
0.12
𝑟𝑒 = (1 + )4 − 1 = (1 + 0.03)4 = 1.12551 − 1 = 0.12551 = 12.55%
4
FV = 10L(1 + 0.1255)5 = 10L X 1.8060 = 18.06 Lakhs
If factor is adjusted, then
12
F %, 5 × 4 years) = 10L X FVIF 3%, 20 years = 10L X 1.8061 = 18.061 Lakhs
4
V
=
1
0
L
X
(F
V
IF
Annuity:
The 2 Conditions that must be satisfied to call them as annuity are;
1. Amount should be the same
2. Time Gap should also be same.
Present Value of a Growing Annuity:

Growing Annuity:
An amount that grows at a constant rate for a specified period is called
growing annuity. The present value of a growing annuity can be determined
by using the following formula.
n
1+g
PV = A1 1 − ( )
1+r
{
}
r−g
Illustration:
Your salary package is Rs. 10,00,000 now and it is expected to grow at a rate of
9% for 7 years. What is the value of all these amounts as on the date when the rate
of interest is 12%?
A0 = 10 Lakhs, g=0.09, n=7 years, r=0.12
1+g n 1+0.09 7
1−(1+0.12)
PV = A1 {1−(1+r) }= 10.9 { } = 62.89 Lakhs
r−g 0.12−0.09
A1 = A0(1 + g)1 = 10 (1 + 0.09) = 10.9 Lakhs
Present Value of Perpetuity:

A perpetuity is an annuity of infinite duration. Which means forever
from today. In simple Same Amount from Year 1 to Year ∞.
PV = ∑∞ A A
t
=
t=1 (1 + r) r
As per the will of your grandfather hey you are going to receive an amount of Rs.
7,50,000 per annum for ever. What is the present value, if the rate of interest is 1)
10%, 2) 15% and 3) 20%?
750000
1. r = 10%, PV = 75,00,000 - PV
0.1
= 750000
0.15
2. r = 15%, PV = 50,00,000 - PV 750000
= 0.2
3. r = 20%, PV = 37,50,000 - PV
=
Present Value of a Growing Perpetuity:
PV = A1
r−g
“Growing perpetuity is that amount which grooves at a constant rate forever that is
from year one to year Infinity. The growth rate may be constant, but the amount will
be variable i.e. increasing.”
In simple the amount grows at constant rate for ever.
The Dividends of ABC Ltd are expected to grow at 7% p.a. for ever. What is the value
of the share today, when required rate is 10% and the company has just declared a
dividend of Rs. 5.
g = 7%, r = 10%, A0 = 5
A1 = A0(1 + g)1 = 5 (1 + 0.07) = 5.35
A1 5.35
PV = = = 178.33
r−g 0.10−0.07
Doubling Period:
“Doubling period is the time period required to double
the amount.” There are 2 thumb rules to calculate the
doubling period.
72
According to Rule of 72; Doubling Period =
R
Therefore,
72
when r = = 6 years and when r = 18%, DP = = 4 years
12%, DP 72
=
12 18
69
According to Rule of 69; Doubling Period = 0.35 +
R
Therefore,
when r = 12%,
69 = 6.1 years and when r = 18%, DP = 0.35 + = 4.1833 years
DP = 0.35 + 69
12
18
Illustration:
Mr. Karthik is planning to invest Rs. 5 Lakhs today and expect that it should become
640 Lakhs. How long will it take for this transaction when the rate of interest is 12%
per annum? Note: Use rule of 72.
5 Lakhs – 640 Lakhs
72
R = 12%; when r = 6 years
= 12%, DP =
12
5- 10; 1DP, 10-20; 2DP, 20-40; 3DP, 40-80; 4 DP, 80-160; 5DP, 160-320; 6DP, 320-
640; 7DP.
In this transaction, there are 7 doubling periods of 6 years are involved and therefore
the total time period to make 5 Lakhs to 640 Lakhs is: 7DP = 7 X 6 = 42 years
Illustration:
A finance company promises to give you Rs 16,00,000 after 12 years if you deposit
with them Rs. 2,00,000 today. What interest rate is employed in this offer? Note: Use
rule of 69.
2L – 16L; 12 years; r=?
2-4; 1 DP, 4-8; 2 DP, 8-16; 3 DP
The time period involved in this transaction is 12 years.
Which means 3 doubling periods is equal to 12 years. 3
DP = 12 years Therefore, each doubling period is 4
years. DP = 4 years
69
Doubling Period = 0.35 +
R
69
4 = 0.35 + ;
69 = 4 − 0.35; R = 69/3.65 = 18.90%
R R
Analysis of Case study ABC Wealth Advisors
Chapter 9: Session 20 – Introduction to Risk and Return
Any rational human being will be considering 2 things when making decisions as
rational human beings i.e. the rate of return and risk.
Rate of Return:
When we are referring to the rate of return, It is always per annum and represented in
percentage. Unless otherwise specified it is assumed that it is compounded annually.
Historical return
This is also called realised return or ex-post return or the return which is already being
earned.
Expected return
This is the return from an asset that an investor anticipates or expects to earn over
some future period. These returns are subject to uncertainty or risk.
The total return for a period is given by
Cash payment received during the period + Price change over the period
Total Return =
Price of the investment at the beginning
C + (PE − PB)
R= PB
R = Rate of Return, C = Cash Benefit, PE = Price at the end of the period, PB = Price
at the beginning of the period
Illustration:
Mrs. Prathiksha has purchased shares of ABC limited at a price of Rs. 240 per share.
She has received a dividend of Rs. 24 per share during the year and by the end of the
year she could sell it for Rs. 276. What is the rate of return on this investment?
C + (PE − PB)
R= = 24 + (276 − 240) 24 + 36 60
PB = = = 25%
240 240 240
Components of the Rate of Return
The rate of return has two components i.e. current yield and capital gains yield.
Cash payment received Price change
Total Return = during the period over the period
+
Price of the investment Price of the investment
at the beginning at the beginning
Total Return = Current Yield + Capital Gains Yield
C
R= + (PE − PB)
PB
PB
Illustration:
Mrs. Prathiksha has purchased shares of ABC limited at a price of Rs. 240 per share.
She has received a dividend of Rs. 24 per share during the year and by the end of the
year she could sell it for Rs. 276. What is the current yield and capital gains yield?
24
Current Yield = = 10%
240
(276 − 240) 36
Capital Gains Yield = = = 15%
240 240
24
R= + (276 − 240) = 24 + 36 = 10 + 15 = 25%
240
240 240 240
Total Return = Current Yield + Capital Gains Yield = 10% + 15% = 25%
Average Annual Return:
It is nothing but the arithmetic mean of the historical or realised return for each year
during the years.
The mean return is given by
R1+ R2+ R3+⋯+ Rn n

R̅ = n
∑
t=1 t
R
= n
R̅ = Mean Return, Rt =Return of a particular year (t= 1 to n), n =

No. of years Illustration:
From the following rate of returns relating to the past 5 years, calculate the mean
return.
Year 1 2 3 4
Rate of Return 21 16 22 -10
R1 + R 2 + R 3 + ⋯ + R n 21 + 16 + 22 − 10 + 15 64
R̅ = n = = = 12.8%
5 5
Geometric Mean:
The average compound rate of growth for a period of time is called geometric mean.
n
Geometric Mean = √(1 + 1 )(1 + r2 ) … … … (1 + ) − 1
r rn
Where, ‘n’ is the number of years and ‘r’ is the rate of interest in decimal form.
The geometric mean reflects the compound rate of growth over time. The geometric
mean is always less than the arithmetic mean. The difference between the geometric
mean and arithmetic mean depends on the variability of the distribution. The greater
the variability, the greater would be the difference between the 2 means.
Illustration:
From the following rate of returns relating to the past 5 years, calculate the geometric
mean.
Year 1 2 3 4 5
Rate of Return 18 16 24 12 -9
5
GM = √(1 + 0.18)(1 + 0.16)(1 + 0.24)(1 + 0.12)(1 − 0.09) − 1
5
= √(1.18)(1.16)(1.24)(1.12)(0.91) − 1
5
= √1.7299 − 1 = 1.1158 − 1 = 0.1158 = 11.58%
Expected Return:
Expected returns are subjected to possibility of occurrences. As we know it very
well, it can take various possible values. When the possibilities can be expected in
the form of a probability distribution, the main return is calculated as expected
return.
n
R̅ = E(R) = p1 × R1 + p2 × R2 + p3 × R3 + ⋯ + pn × Rn = ∑ pi × Ri
i=1
R̅ = Expected Return or Mean Return, pi = Probability of occurance

of ith return Ri = Rate of Return of ith possibilty
Illustration:
From the following rate of returns and their associated probabilities of the past 5
years, calculate the expected (mean) return.
Year 1 2 3 4 5
Rate of Return 21 16 22 10 15
Probability 0.05 0.20 0.40 0.25 0.10
Year Probability Rate of Return Prob. X Rate

1 0.05 20 0.05x20 = 1.00
2 0.20 16 0.20x16 = 3.20
3 0.40 22 0.40x22 = 8.80
4 0.25 10 0.25x10 = 2.50
5 0.10 15 0.10x15 = 1.50
Expected Return E(R) = R̅ 17.05
Risk:
Risk may be defined as the chance that the actual outcome from an investment will
differ from the expected outcome. This means that the more variable the possible
outcomes that can occur
i.e. the broader the range of possible outcomes, the greater the risk.
The absolute value of risk is quantified by various measure such as range, quartile
deviation, mean absolute deviation, variance, standard deviation and Semi-variance.
Among all the measures quantifying risk, variance and standard deviation are the most
popular measures of quantifying the risk.
Some of the general sources of risk are interest rate risk, market risk, inflation risk,
business risk, financial risk and liquidity risk.
Measurement of Risk:
Risk is associated with the dispersion in the likely outcomes. If an asset has no
variability it has no risk.
The variance of an asset’s rate can be found as the sum of the squared deviations of
each possible rate of return from the expected rate of return multiplied by the
probability that the rate of return occurs.
Standard deviation denoted by ‘σ’ is simply the square root of the variance of the rates
of return.
∑n (Ri − R̅ )2
Variance = σ2 = { t=1
}
n−1
σ = √Variance = √σ2
I
ll
u
s
t
r
a
ti
o
n
:
From the following rate of returns relating to the past 5 years, calculate the mean
and standard deviation of the return.
Year 1 2 4
Rate of Return 21 16 10
Year Rate (Ri) (R i − R̅) (R i − R̅)2

1 23 23-18 = 5 25
2 16 16-18 = 2 4
3 22 22-18 = 4 16
4 14 14-18 = 4 16
5 15 15-18 = 3 9
∑ Ri = 90 ∑(R i − R̅ )2 =
70
∑ Ri 90
R̅ = = = 18
𝑁 5
∑n (R i − R̅ )2 70
Variance = σ2 = { t=1 }= = 17.5
n−1 4
σ = √Variance = √17.5 = 4.1833

Standard Deviation of a Return with Probability Distribution:

The variance of a probability distribution is the sum of the squares of the
deviations of actual returns from the expected returns weighted by the associated
probabilities.
Variancei=1 pi × (R i − R̅)2 and σ = √Variance = √σ2
= σ2 =
I ∑n
ll
u
s
t
r
a
ti
o
n
:
From the following rate of returns and their associated probabilities of the past 5
years, calculate the expected (mean) return.
Year 1 2 3 4 5
Rate of Return 20 16 22 10 15
Probability 0.05 0.20 0.40 0.25 0.10
Year Probability Rate of Prob. X Rate ( (𝑅 − 𝑝𝑖 × (𝑅 − R̅ )2

Return 𝑅 R̅ ) 2
−
R
)
1 0.05 20 0.05x20 = 1.00 2 9 0.45
0-
1
7
=
3
2 0.20 16 0.20x16 = 3.20 16 1 0.20
-
17
=
-1
3 0.40 22 0.40x22 = 8.80 2 25 10.00
2-
1
7
=
5
4 0.25 10 0.25x10 = 2.50 10 49 12.25
-
17
=
-7
5 0.10 15 0.10x15 = 1.50 15 4 0.40
-
17
=
-2
R̅ = 17.00 Variance = 23.30
σ = √Variance = √23.30 = 4.8270
Portfolio Return and Risk:

A portfolio is a combination of 2 or more assets that are owned by an investor. What
really matters is not the risk and return of stocks in isolation, but the risk and return
of the portfolio as a whole. This is based on a simple adage that an investor should
not put all his eggs in one basket.
Expected return of a portfolio:
The expected return on a portfolio is simply the weighted average of the expected
returns of the assets comprising the portfolio.
For example, when a portfolio consisted of two securities, its expected return is
E(RP) = W1 × E (R1) + ( 1 − W1) × E (R2)
Illustration:
Mr. Dharma is planning to invest 70% of his savings in the shares of company ‘A’
and the remainder in company ‘B’. He expects that the returns of company ‘A’ be
20% and that of ‘B’ be 30%. What is the expected return of the portfolio?
W1 = 0.7, R1 = 20%, R2 = 30%
E(RP) = 0.7 × 20 + ( 1 − 0.7) × 30 = 14 + 9 = 23
When a portfolio consists of ‘n’ securities, the expected return on the portfolio is
E(RP) = W1 × E (R1) + W1 × E (R2) + ⋯ + Wn × E (Rn)
i=1
E Wi × E (Ri)
I (
ll R
u p
s )
t
r =
a
ti ∑
n
o
n
:
An investor has a portfolio consisting of 5 securities. The details of the securities,
their expected returns and the amounts invested are as follows. Determine the
expected return of the portfolio.
Security A B C D E
Expected Return (%) 20 25 18 15 14
Amount (Rs.) 2,50,000 3,00,000 7,50,000 3,00,000 4,00,000
Security Expected Return (%) Amo Weightage (Wi) Weighted Return

unt
(Rs.)
A 20 2500 0.125 2.50
00
B 25 3000 0.150 3.75
00
C 18 7500 0.375 6.75
00
D 15 3000 0.150 2.25
00
E 14 4000 0.200 2.80
00
2000 1.000 E(Rp) = 18.05
000
Portfolio Risk:
If an investor is planning to invest his money in 2 securities either in A or in B or in
both with equal weightage (portfolio).
The details of the returns and their probability occurrence is as follows:
State of Economy A C D E
Probability (pi) 0.2 0.2 0.2 0.2
Return on Security A (%) 15 25 -5 35
Return on Security B (%) 25 -5 15 5
Return and Risk on Security A:
State of Economy Probability (pi) Return on Security A pi X RA pi X (RA –

(%) E(RA))2
A 0.2 15 3 0
B 0.2 5 1 20
C 0.2 25 5 20
D 0.2 -5 -1 80
E 0.2 35 7 80
E (RA) = Variance A =
15 200
σA = √Variance = √200 = 14.14
Return and Risk
on Security B:
State of Economy Probability (pi) Return on Security B pi X RB pi X (RB –

(%) E(RB))2
A 0.2 25 5 20
B 0.2 35 7 80
C 0.2 -5 -1 80
D 0.2 15 3 0
E 0.2 5 1 20
E (RB) = Variance B =
15 200
σB = √Variance = √200 = 14.14
Return and Risk on Portfolio A&B:
State Return on Return on Return on pi x

Prob.
of Security Security Portfolio pi X (RA&B –
(pi)
Economy A B A&B RA&B E(RA&B)
(%) (%) )2
A 0.2 15 25 20 4 5
B 0.2 5 35 20 4 5
C 0.2 25 -5 10 2 5
D 0.2 -5 15 5 1 20
E 0.2 35 5 20 4 5
E (RA&B) Variance A&B =
= 15 40
σA&B = √Variance = √40 = 6.3246
Diversification of Risk:
In the above example if we look at investment ‘A’ or ‘B’ has the same characteristic
features of the mean return of 15% and standard deviation of 14.14%.
When both the securities are combined in equal proportion, though the mean return
of the portfolio is still standing at 15%, but the standard deviation has decreased to
6.3246%.
From this we can understand that when we combine securities the total risk is
coming down. But this happens only when the securities are negatively correlated.
Higher the negativity better will be the possibility of diversification.
Total Risk
= Unique Risk + Market Risk
= Diversifiable Risk + Non-diversifiable Risk
= Unsystematic Risk + Systematic Risk
Unique risk:
Unique risk of a security represents that portion of its total risk which stems from the
specific factors of the business entity like development of a new product, labour
unrest, competitors etc. Events of this nature or specific to that business entity but
not to all in general. Therefore, the unique risk of business entity can be washed
away by combining it with other stocks or assets. The unique risks of different
businesses or stocks tend to cancel each other and thus this portion of the risk can be
brought down to some extent but of course cannot be removed in total. Therefore, it
is also referred to as diversifiable risk or unsystematic risk.
Market risk:
Market risk of a stock represents that portion of the risk which is attributable to the
economy as a whole. The facts like the growth rate of GDP, the government
spending, money supply, interest rates, inflation rates etc. contribute to the market
risk. The factors will affect all the firms in the
economy. Therefore, it cannot be diversified and hence it is also referred to as
systematic risk or non-diversifiable risk.
Measurement of Market Risk:
The market risk of security reflects its sensitivity to market movements. Different
securities display different sensitivities to market movements. The sensitivity of the
security to market movements is called beta (β). By definition the beta for the market
portfolio is one.
For example, if beta of a security is 2 it means the returns of the security will change
2 times as compared to the returns of the market. If the market return increases by
1% the returns of the security increase by 2% and in the same manner when the
market return falls by 1% the returns of the security will fall by 2%. Therefore,
higher the beta higher will be the systematic risk.
Calculation of beta (β):
The calculation of beta is based on the following equation.
𝑅𝑗𝑡 = 𝛼𝑗 + 𝛽𝑗𝑅𝑀𝑡 + 𝑒𝑗
Where,
𝑅𝑗𝑡 is the return of security j in period ‘t’
𝛼𝑗 is the intercept term, ‘alpha’
𝛽𝑗 is the regression co-efficient, ‘beta’

𝑅𝑀𝑡 is the return on market portfolio in period ‘t’
𝑒𝑗 is the random error term
Beta reflects the slope of the above relationship.
𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝑅𝑗,𝑅𝑚) 𝜌𝑖𝑀𝜎𝑗𝜎𝑀 𝜌𝑖𝑀𝜎𝑗
𝛽𝑗 = = 𝜎
2 = 𝜎
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑀𝑎𝑟𝑘𝑒𝑡 𝑀 𝑀
Wher
e
𝜎2 is the variance of returns on the market portfolio
𝑀
𝜌𝑖𝑀 is the correlation coefficient between the return jth security and the return on the
market portfolio
𝜎𝑗 is the standard deviation of return on the jth security
𝜎𝑗𝑀 is the standard deviation of return on the market

portfolio Illustration:
From the following information relating to the returns of ABC Ltd. and the market
portfolio for a 10-year period, determine the beta.
Year 1 2 4 5 6 8 9 10
Return of Security ABC Ltd. 6 -4 18 22 10 13 4 24
(%)
Return on Market Portfolio (%) 25 30 7 16 10 18 5 12
𝑅𝐴𝐵𝐶 − 𝑅𝑀 − (𝑅𝐴𝐵𝐶 − 𝑅̅𝐴𝐵𝐶 )
Year R ABC Ltd. R Market (%) (𝑅𝑀 − 𝑅̅𝑀 )2
×
(%) 𝑅̅𝐴𝐵𝐶 𝑅̅𝑀
(𝑅𝑀 − 𝑅̅𝑀 )
1 6 25 -6 12 144 -72
2 -4 30 -16 17 289 -272
3 14 15 2 2 4 4
4 18 7 6 -6 36 -36
5 22 16 10 3 9 30
6 10 10 -2 -3 9 6
7 13 -8 1 -21 441 -21
8 13 18 1 5 25 5
9 4 5 -8 -8 64 64
10 24 12 12 -1 1 -12
∑ = 120 ∑ = 130 ∑ = 1022 ∑ = −304
∑ 𝑅𝐴𝐵𝐶 120
𝑅̅ = = = 12 𝑅̅ ∑ 𝑅𝑀 130
= = = 13
𝐴𝐵𝐶 𝑀 𝑁 10
𝑁 10
2
∑(𝑅 − 𝑅̅ ) = 1022, ∑(𝑅
𝑀 𝑀 𝐴𝐵𝐶 − 𝑅̅ 𝐴𝐵𝐶 ) × (𝑅 𝑀 − 𝑅̅𝑀 ) = −304
∑(𝑅𝐴𝐵𝐶 − 𝑅̅𝐴𝐵𝐶 ) × (𝑅𝑀 − −304
𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝑅𝑗, 𝑅𝑚) = 𝑅̅𝑀 ) = − 33.77
= 9
𝑛−1
∑ (𝑅𝑀 − 1022
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝑅𝑚) = 𝑅̅𝑀 )2 = 113.55
= 9
𝑛−1
𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝑅𝑗, 𝑅𝑚) −33.77
𝛽𝑗 = = = −0.2974
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑀𝑎𝑟𝑘𝑒𝑡 113.55
𝛼𝑗 = 𝑅̅𝑗 − 𝛽𝑗 × 𝑅̅𝑀 = 12 − (−0.2974 × 13) = 12 − (−3.8662) = 15.8662
Relationship between Risk and return:

The following points are very important in understanding the relationship between
risk and return
 Securities are risky because their returns are variable, which means the investor is not
guaranteed of a fixed return.
 The most commonly used measure of risk is standard deviation.
 Total risk of security is the combination of unique risk and market risk.
 Unique risk emanates from the business specific factors whereas the market risk emanates
from economy related factors.
 By portfolio diversification the unique risk can be minimised, but market risk cannot be
avoided.
 When a portfolio is thoroughly diversified the total risk of the portfolio is equal to the
systematic risk and such portfolios are known as market portfolios.
 The beta of a security or a portfolio measures the sensitivity of its returns to the general
market movements.
Capital Asset Pricing Model (CAPM):

The CAPM establishes a linear relationship between the required rate of return of a
security and its systematic risk i.e. beta.
Assumptions of CAPM:
This model is based on the following assumptions
 Investors are risk-averse, that means they use the expected rate of return and standard
deviation of return as measures of risk and return. The greater the perceived risk of a portfolio,
the higher is the expected return a risk-averse investor expect to compensate the risk.
 Investors make their investment decisions based on a single period horizon.
 Transaction costs in financial markets are lower enough to be ignored.
 The securities are infinitely divisible, which means an investor is free to purchase any fraction
of securities.
 There are no taxes. (Removed later and replaced with) taxes do not affect the choice of
buying assets.
 All individuals assume that they can buy assets at the going market price and they all agree on
the nature of the return and risk associated with each investment, which means all the
investors will have the same subjective expectations about the market outcomes.
The concept of CAPM is explained in 2 categories
1. Capital Market Line (CML) and
2. Security Market Line (SML)
Capital market line explains the portfolio returns, whereas security market line
explains the expected returns of individual security.
Capital Market Line (CML):
The line used in the capital asset pricing model to present the rates of returns of
deficient portfolios is called capital market line. These rates will vary depending
upon the risk-free rate of return and the level of risk of a particular portfolio.
The capital market line shows a positive linear relationship between the returns and
portfolio lenders.
Capital market line (CML) is a graph that reflects the expected return of a portfolio
consisting of all possible proportions between the market portfolio and a risk-free
asset.
The market portfolio is completely diversified, carries only systematic risk, and its
expected return is equal to the expected market return as a whole.
𝐸 (𝑅𝑗) = 𝑅𝑓 + 𝜆 𝜎𝑗
𝜆 = 𝐸 (𝑅𝑀) − 𝑅𝑓
𝜎𝑀
𝐸 (𝑅𝑗) = Expected return on
portfolio ‘j’
𝑅𝑓 = Risk-free rate of interest

𝐸 (𝑅𝑀) = Expected return on market portfolio
𝜎𝑗 = Standard deviation of the returns of portfolio ‘j’
𝜎𝑀 = Standard deviation of the returns of market portfolio

𝜆 = the slope of the Corp capital market line which is regarded as price risk in the
market
Security Market Line (SML):

It shows the relationship between the expected return of a security and its risk
measured by its beta coefficient.
In other words, the SML displays the expected return for any given beta or reflects the
risk associated with any given expected return.
Required Rate of Return = Risk-free Rate of Return + Risk

Premium
Wher 𝑅𝑗 = 𝑅𝑓 + 𝛽𝑗 (𝑅𝑀 − 𝑅𝑓)

e
𝑅𝑗 = Expected rate of return on security ‘j’
𝑅𝑓 = Risk-free rate of return
𝑅𝑀= Return on market portfolio
𝛽𝑗 = Beta co-efficient of security ‘j’
Note:
Rate of interest applicable on Treasury bills or 10-year Government of India bonds is
taken as a proxy for risk-free rate of interest when it is not given
𝑅𝑀 − 𝑅𝑓, is called market risk premium
𝛽𝑗 (𝑅𝑀 − 𝑅𝑓), is called security risk premium
𝛽𝑗 = 𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝑅𝑗, 𝑅𝑚) 𝜌𝑖𝑀𝜎𝑗 𝜎𝑀 𝜌𝑖𝑀𝜎𝑗
= =
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑀𝑎𝑟𝑘𝑒𝑡 �𝑀2 𝜎𝑀
Dividend Capitalisation Model:
According to the dividend capitalisation model, the value of an equity share is equal
to the present value of dividends expected from its ownership plus the present value
of the sale price expected when the equity share is sold.
For applying the dividend discount model, we should make the following
assumptions:
(i) dividends are paid annually- this seems to be a common practice for business firms in India; and
(ii) the first dividend is received one year after the equity share is bought.
Zero Growth model
If we assume that the dividend per share remains constant year after year at a value of
D, the present value of the share is given by
𝐷1 𝐷∞
Po = 𝐷2 +⋯… + = ∑∞ 𝐷𝑡
(1+r)1
+ (1+r)2 (1+r)∞
𝑡=1 (1+r)t
On
D
simp Po =
lific r
ation
,
It is a straightforward application of the logic present value of perpetuity.
Illustration:
The share of a certain stock paid a dividend of Rs 4.00 last year. The dividend is
expected to be constant in the future for ever. The required rate of return on this
stock is 16 per cent. How much should be the value of the share?
D 4
Po = 25
=0.16
Constant Growth Model: =
r
One of the most popular dividend discount models assumes that the dividend per
share grows at a constant rate (g).
The value of a share, under this assumption is:
D1 D2 D∞ ∞ Dt
P0 = ( + + ⋯ … + =
1 + r )1 (1 + r )2 (1 + r)∞ t=0 (1 + r)t
∑
1 D0(1 + g)2 D0(1 + g)∞ ∞ D0(1 + g)∞

P0 = D(1
0(1 + g)
+ r)1 + (1 + r)2 + ⋯ … = ∑
(1 + r)∞ t=0 (1 + r)
∞
+
Applying the formula for the sum of a geometric progression, the above expression
can be simplified as:
D1
Po =
r−g
I
ll
u
s
t
r
a
ti
o
n
:
The share of a certain stock paid a dividend of Rs 2.00 last year (D 0=Rs 2.00) The
dividend is expected to grow at a constant rate of 6 per cent in the future. The
required rate of return on this stock is considered to be 12 per cent. How much
should this stock sell for now?
D0=Rs 2, r = 6%, g=12%, P0 =?
D1 = D0(1 + g)1 = 2(1 + 0.06)1 = 2.12

D1
Po = 2.12 = 35.33
r−g = 0.12−0.06
Chapter 10: Session 23 – Cases on Risk and
Return
Return
Return
Financial Management
Topics
1. Valuation of Bonds and Equity
2. Risk and Return
3. Cost of Capital
BOND VALUATION AND EQUITY
Valuation of Bonds
What is a bond?
Bond is a negotiable instrument which acknowledges the indebtedness of the issuer to the
investor. In this arrangement the investor extends credit to the issuer and in return the issuer
commits to repay the amount back at the end of the pre - determined tenure along with the
interest throughout the life of the bond.
Features
Par value: Face value of the bond which will be paid back at the time of maturity
Coupon rate: is the rate of interest the bond issuer will pay on the face value of the bond,
expressed as a percentage.
Maturity date: the date at which the bond holder will be paid back the principal (par value)
Redemption value: is the value paid to the bondholder, at the time of expiry of the term for which
bond is issued.
Types of bonds
Basis of classification Types
Issuer  Government
 Corporate
Coupon rate  Fixed rate

 Floating rate
 Zero coupon
Location  Domestic
 Foreign
 Euro
1
Bond rating  Investment grade
 High yield bonds
Embedded option  Callable

 Putable
 Covertible
Maturity  Short term

 Medium term
 Long term
 Perpetual
Risks in bond investment

Interest rate risk: there is an inverse relationship between interest rates and price of bonds. So
when interest rate in the economy rises, the prices of existing bonds fall to reflect the market
yield. This results in notional capital capital loss.
Reinvestment rate risk: a bond poses a reinvestment risk to investors if the proceeds from the
bond or future cash flows will need to be reinvested in a security with a lower yield than the
bond originally provided. For example, an investor buys a Rs 1,000 bond with an annual coupon
of 12%. Each year, the investor receives Rs 120 (12% x 1,000), which can be reinvested back
into another bond. But if, over time, the market rate falls to 10%. Suddenly, that Rs 120 received
from the bond can only be reinvested at 10%, instead of the 12% rate of the original bond.
Credit/Default risk: Default risk occurs when the bond's issuer is unable to pay the contractual
interest or principal on the bond in a timely manner or at all.
Liquidity risk: Liquidity risk is the risk that you will not be easily able to find a buyer for a bond
you need to sell.
Inflation risk: Inflation risk is the risk that the yield on a bond will not keep pace with
purchasing power. For instance, if you buy a five-year bond in which you can realize a coupon
rate of 5 percent, but the rate of inflation is 8 percent, the purchasing power of your bond interest
has declined.
Call risk: Callable bonds allow the issuer to pre mature the bonds. In this case, the investor
receives back the principal before the maturity and the interest income stops. Issuers usually do
so to retire their old high yield bonds and sell low rate bonds.
Bond yields
Concepts of return (yield) on bond investment
Current yield: Annual interest divided by the current market price of the bond.
Yield to maturity: Total return anticipated on the bond investment if the bond is held till maturity.
Includes interest income as well as capital gain/loss.
YTM of bond is similar to the internal rate of return of a capital expenditure. Mathematically, it
is the discount rate which equates the present value of all future cash flows receivable from the
bond to the current price of the bond.. Yield to maturity is considered a long-term bond yield but
is expressed as an annual rate. In other words, it is the internal rate of return of an investment in a
bond if the investor holds the bond until maturity and if all payments are made as scheduled.
Hence in the below equation Kd is the YTM and is calculated through trial and error
Market price =
 n
C

M
1  kd  1  kd 
t n
t 1
YTM (approximation formula)
C  (M  P) / n
YTM ~
0.4M  0.6P
Illustration : calculating current yield and YTM
A bond of Rs. 10000 bearing coupon rate 12% and redeemable in 8 years at par is trading at
Rs.10,600. Find out the current yield and YTM of the bond.
CY = Annual interest / Market price = (1200/10600)*100 = 11.32%
1200  (10000 10600) / 8

YTM =
0.4 *10000  0.6 *10600
= 1125/10360 = 10.86%
Observe that since the bond is trading at premium to its par value,
CY and YTM both are lower than the coupon rate.

Valuation :
Determining fair price (intrinsic value) of the bond. To be compared with the current market price
for buying decision.
Intrinsic value > Market price, Buy
Intrinsic value < Market price, Sell
Illustration : valuation of Straight bond
Aseem is considering buying Bond A currently quoting a price of Rs 800. Following are te
salient features of the bond. face value: Rs 1,000, maturity: 5 years, coupon rate: 6%, required
yield : 12%
Advise Aseem if he should invest in the bond.
Solution : First calculate the intrinsic value and then compare the same with the market price.
M
n
C
V=  1  k
t 1
t

1  kd
OR C(PVIFAkd,n) + M(PVIFkd,n)
d
 n
(1+0.12)5−1 1
V = 60* [ 0.12 ] + 1,000 ∗ [ ] = 216.29+567.44 = Rs 783.71
∗(1+0.12)5 (1+0.12)5
Since Intrinsic value (783) < Market price (800), Aseem is advised not to buy the bond. The
bond is overvalued.
Illustration : valuation of perpetual bond
Mr. A has a perpetual bond of the face value of Rs. 1,000. He receives an interest of Rs. 60
annually. What would be its value if the required rate of return is 10%?
Solution:
V = C/Kd
= 60/0.10
= Rs. 600
Illustration : Valuation of a Zero coupon bond
An investor is considering purchasing a 10-year zero-coupon bond of Rs 1,000 par value. Let’s
calculate the fair value of the bond if the current interest rate for equally risky bonds is 12.4%.
Solution: There is no interest payment received in a zero coupon bond, the only cash flow
received is the maturity price. Hence only that will be discounted at YTM to arrive at the fair
price.
Bond Price = M / (1+kd)n = 1,000 = Rs 310.70

(1 + 0.124)10
Bond Price- yield relationship
https://www.wisdomjobs.com/tutorials/price-yield-relationship.jpg
When interest rates rise, bond prices fall, and when interest rates go down, bond prices increase.
Bonds essentially compete against one another on the interest income they provide to investors.
When interest rates go up, new bonds that are issued come with a higher interest rate and provide
more income to investors. When rates go down, new bonds issued have a lower interest rate and
aren’t as attractive as older bonds.
Unfortunately, when rates go up, the older, lower-rate bonds can’t increase their interest rates to
the same level as the new, higher-interest bonds. The older bond rates are locked in, based on the
original terms.
5
As a result, the only way to increase competitiveness and value to new investors is to reduce the
price of the bond. But as a result, the original bondholder may be holding an investment that has
decreased in price—and doesn’t pay out as much as they could get for it right now on the market.
https://www.thebalance.com/why-do-bond-prices-go-down-when-interest-rates-rise-2388565
Valuation of Equity
The objective of financial management is to maximize the value of a firm. This makes the
valuation of equity and bonds an important concept to understood and applied by both the
investors and the companies who borrow funds by way of equity and bonds.
EQUITY VALUATION: DIVIDEND DISCOUNT MODEL
The Dividend Discount Model puts forth that the value of an equity share is the present value of
future expected dividends and the present value of the sale price of the share when sold.
The following assumptions are made while using the Dividend Discount Model:
1. Dividends are paid annually and
2. The first dividend is received one year after the purchase of the equity share.
Single Period Valuation Model
1. The first case is where the investor expects to hold the equity share for one year. The
price of the equity share is:
P0 = D1/(1+r) + P1/(1+r)
Where:
P0 - current price of equity share
D1 - dividend expected one year hence
P1 - price of equity share one year hence
r - rate of return required on equity share
Illustration 1:
6
Prestige’s equity share is expected to provide a dividend of Rs.2 and fetch a price of Rs.18 a year
hence. What price would it sell for now if investors’ required rate of return is 12 per cent?
The current price will be: 2.0/ (1.12) + 18.00/ (1.12) = Rs. 17.86.
2. What will be the price of the equity share in case it is expected to grow at a rate of g
percent annually? In case P0 is the current price, in year later the price of the equity share
becomes P0 (1+g).
P0 = D1/(1+r) + P0 (1+g)/(1+r)
P0 = D1/(r - g)
Illustration 2:
The expected dividend per share on the equity share of RK Company Ltd. is Rs.2. The dividend
per share has grown over the past five years at the rate of 5 per cent per year and the growth rate
will continue in future and the market price of the share is expected to grow at the same rate.
What is the fair estimate of the intrinsic value of the share when the required rate of return is 15
per cent?
The current price will be: 2.0/ (0.15 – 0.05) = Rs. 20.00.
3. What is the rate of return the investor expects given the current market price, and forecast
values of dividend and share price?
The expected rate of return is:

r = D1/ P0 + g
Illustration 3:
The expected dividend per share of Vaibhav Ltd. is Rs.5. The dividend is expected to grow at the
rate of 6 per cent per year. If the price of the share is now Rs.50, what is the expected return?
The expected rate of return = 5/50 + 0.06 = 16 per cent.
Multi - period Valuation Model
7
As equity shares have no maturity period, they may be expected to bring dividend steam for
indefinite period in the future. Hence the generalized multi-period valuation formula of an equity
share can be written as:
P0 = D1/(1+r) + D2/(1+r)2 + D3/(1+r)3 + … + D∞/(1+r)∞
P0 = ∑∞ 𝐷𝑡/(1 + 𝑟)^𝑡
𝑡=1
The assumptions regarding dividend patterns are as follows:
a. The dividend per share remains constant forever, implying that there is zero growth
known as the zero-growth model.
P0 = D /(1+r) + D /(1+r)2 + … + D /(1+r)n.............∞

P0 = D / r
Illustration 4:
If we assume that a company would pay Rs.100 as a dividend in the next period, and the required
rate of return is 10 per cent; then the price of the stock would be …...
The current price will be: 100.00 / 0.1 = Rs.1000.
8
b. The dividend per share grows at a constant rate per year forever known as the constant-
growth model.
P0 = D1/(1+r) + D1 (1+g)/(1+r)2 + …… + D1 (1+g)n+1/(1+r)n + …

P0 = D1/(r - g)
Illustration 5:
Ramesh Engineering is expected to grow at the rate of 6 per cent per annum. The dividend
expected a year hence is Rs.2. What is its expected price, if the required rate of return is 14 per
cent?
The price of Ramesh’s equity share would be: 2.00 / 0.14 – 0.06 = Rs. 25.00.
Two – stage Growth Model
Under this Model, it is assumed that there is constant growth in DPS per year for certain number
of years, thereafter; there is normal growth rate which remains constant forever.
Formula:
9
1 − 𝑔1
𝑃𝑜 = 𝐷1 [1 [ ]^𝑛 /𝑟 − 𝑔1] + [𝐷1(1 + 𝑔1)^𝑛 − 1
1+𝑟
(1 + 𝑔2)
] ∗ [1/(1 + 𝑟)^𝑛]
𝑟 − 𝑔2
Also,
𝐷1 = 𝐷𝑜 (1 + 𝑔1)
Where ,
Po = Current price of the share
g1 = Growth rate in the first period
g2 = Growth rate in the second period
r = Reqd. rate of return
D1 = Dividend expected in a year
10
n = number of years for the first period
Illustration 6:
The current dividend on an Equity Share of ABC Ltd. is Rs. 2.00.
The co. expects to have an above normal growth rate of 20% for coming 6 years. Thereafter, the
growth rate shall fall to a stable rate of 10%.
The investor’s expects a return of 15%.
Compute the Current Price of Share of ABC Ltd.

Solution :
Given:
D0 = Rs. 2.00,
g1 = 20%,
g2 = 10%,
n = 6 years
r = 15%
P0 = ???
D1= Do (1+g1)
= 2.00(1+0.2)
Hence ,
D1= 2.40
Formula:
1 − 𝑔1
𝑃𝑜 = 𝐷1 [1 [ ]^𝑛 /𝑟 − 𝑔1] + [𝐷1(1 + 𝑔1)^𝑛 − 1
1+𝑟
(1+𝑔2)
] ∗ [1/(1 + 𝑟)^𝑛]
𝑟−𝑔2
1 − 1.20
= 2.40 [1 [ ]^6/0.15 − 0.20] + [2.40(1.20)^5
1.15
(1.10)
] ∗ [1/(1.15)^6]
0.15 − 0.10
1−1.291
= 2.40 [1 [ ] + [2.40(2.488)(1.10)/0.05] [0.432]
−0.05
= 13.96 + 56.80
ANSWER : Po = Rs. 70.76.
Illustration 7:
X Ltd. currently pays dividend of Rs. 3.00 per share.
The company predicts a super normal growth of 40 % for next 5 years. Thereafter, the growth
rate is expected to stabilize at a lower level of 12 %.
The desired rate of return on X Ltd. stock is 15 %.
What is the Intrinsic Value of Equity of X Ltd.?
Solution :
Given:
D0 = Rs. 3.00,
g1 = 40%,
g2 = 12%,
n = 5 years
r = 15%
P0 = ???
D1= Do (1+g1)
= 3.00(1+0.4)
Hence ,
D1= 4.20
Under Two Stage Growth Rate Model :

1 − 𝑔1
𝑃𝑜 = 𝐷1 [1 [ ]^𝑛 /𝑟 − 𝑔1] + [𝐷1(1 + 𝑔1)^𝑛 − 1
1+𝑟
(1 + 𝑔2)
𝑟 − 𝑔2 ] ∗ [1/(1 + 𝑟)^𝑛
1 − 1.40
𝑃𝑜 = 4.20 [1 [ ]^5/0.15 − 0.40] + [4.20(1.40)^4 −
1.15
(1.12) 1
] ∗ [ ]
0.15−0.12 (1.15)5
ANSWER :Po = Rs. 327.60.
EQUITY VALUATION: THE P/E APPROACH
The P/E ratio or earnings multiplier approach is estimated as follows:
P0 = E1 X P0 / E1
Where
P0 is the estimated price
E1 is the estimated earnings per share
P0 / E1 is the justifies price to earnings ratio
The determinants of the P0 / E1 can be derived from the dividend discount model:
P0 = D1/(r - g)
In this model:
D1 = E1 (1 – b),
where
b is the retention ratio
g = ROE X b where ROE is Return on Equity
Hence substituting:
P0 = E1 (1 – b)/(r - ROE X b)
Dividing both sides by E1, we get:
P0 / E1 = (1-b) / (r - ROE X b)
Factors that determine P/E ratio are:
Dividend Payout Ratio: (1 – b)
Required rate of return: r
Expected growth rate: ROE X b
References
1. https://businessjargons.com/bonds.html#:~:text=Features%20of%20Bonds,interest%20pa
yable%20to%20the%20bondholder.
2. https://www.investopedia.com/terms/b/bond.asp#characteristics-of-bonds
3. https://www.finra.org/investors/learn-to-invest/types-investments/bonds/understanding-
bond-risk
4. https://www.thebalance.com/why-do-bond-prices-go-down-when-interest-rates-rise-
2388565
5. Text Book on: “Financial Management – Theory & Practice” by Prasanna Chandra – 9th
Edition. Chapter Nos. 7 on `Valuation of Bonds and Stocks.’
RISK AND RETURN
Concept of Risk and Return:

A person making an investment expects to get some returns from the investment in the future.
However, as future is uncertain, the future expected returns too are uncertain. It is the uncertainty
associated with the returns from an investment that introduces a risk into a project. The expected
return is the uncertain future return that a firm expects to get from its project. The realized return,
on the contrary, is the certain return that a firm has actually earned.
Return can be defined as the actual income from a project as well as appreciation in the value of
capital. Thus there are two components in return—the basic component or the periodic cash
flows from the investment, either in the form of interest or dividends; and the change in the price
of the asset, commonly called as the capital gain or loss.
RISK AND RETURN OF A SINGLE ASSET(HOLDING PERIOD RETURN)
Return = C + (PE – PB)

PB
Where,
R is the total return over the period, C is the cash payment received during the period, PE is the
ending price of the investment, and PB is the beginning price.
Example- Calculate the return if: Price at the beginning of the year: Rs. 60, Dividend paid at the
end of the year: Rs.2.40 and Price at the end of the year: Rs. 69
Solution:The total return on this stock is calculated as follows:
2.40 + (69.00 – 60.00) = 0.19 or 19 percent

60.00
HISTORICAL RISK AND RETURN CALCULATION
Average annual return of an investment during a given historical period is simply the arithmetic
mean of the realised returns for each year during that period. The arithmetic mean is defined as:
Where, R is the arithmetic mean, Ri is the ith value of the total return (i = 1, … n), and n is the
number of total returns.
STANDARD DEVIATION OF RETURN
Risk refers to the dispersion of a variable. It is commonly measured by the variance or the
standard deviation.
Example
PROBABILITY DISTRIBUTION AND EXPECTED RATE OF RETURN
Expected value is the benefit which an investor anticipates by investing his funds. It is the
weighted average or the mean of probability distribution of the possible future benefits that can
be derived out of a scheme of investment.
n
E(R) = ∑ pi Ri
i=1
E(R) is the expected return, Ri is the return for the ith possible outcome, pi is the probability
associated with Ri and n is the number of possible outcomes.
Portfolio Risk and Return
A portfolio is a bundle or a combination of individual assets or securities. The return of a

portfolio is equal to the weighted average of the returns of individual assets (or securities)
The following formula can be used to determine expected return of a portfolio:
Let’s say the returns from the two assets in the portfolio are R1 and R2. Also, assume the weights
of the two assets in the portfolio are w 1 and w2. Note that the sum of the weights of the assets in
the portfolio should be 1. The returns from the portfolio will simply be the weighted average of
the returns from the two assets, as shown below:
RP = w1R1 + w2R2
Let’s take a simple example. You invested Rs 60,000 in asset 1 that produced 20% returns and
Rs 40,000 in asset 2 that produced 12% returns. The weights of the two assets are 60% and 40%
respectively.
The portfolio returns in this case will be: RP = 0.60*20% + 0.40*12% = 16.8%
Portfolio Risk:
Let’s now look at how to calculate the risk of the portfolio. The risk of a portfolio is measured
using the standard deviation of the portfolio. However, the standard deviation of the portfolio
will
not be simply the weighted average of the standard deviation of the two assets. We also need to
consider the covariance/correlation between the assets.
If the standard deviation of the two assets are 10% and 16% and the weights of the two assets are
60% and 40% respectively., and the correlation between the two assets is -1. The standard
deviation of the portfolio will be calculated as follows:
σP = Sqrt(0.6^2*10^2 + 0.4^2*16^2 + 2*(-1)*0.6*0.4*10*16) = 0.4
Diversification:
Diversification means “Don’t put all your eggs in one basket”, spreading risk across a number of
securities.
MARKET RISK VS UNIQUE RISK
Total Risk = Unique risk + Market risk
Unique risk of a security represents that portion of its total risk which stems from company-
specific factors.
Market risk of security represents that portion of its risk which is attributable to economy –wide
factors.
MEASUREMENT OF MARKET RISK
The sensitivity of a security to market movements is called Beta (β). Beta for the market
portfolio is 1. Beta reflects the slope of a linear regression relationship between the return on the
security and the return on the portfolio.
CALCULATION OF BETA
For calculating the beta of a security, the following market model is employed:
Rjt = aj + bjRMt + ej
Where,
Rjt = return of security j in period t

aj = intercept term alpha
bj = regression coefficient, beta
RMt = return on market portfolio in period
t ej = random error term
Beta reflects the slope of the above regression relationship. It is equal to:
Betaj = Cov (Rj , RM)
σ2M
Where Covariance is equal to:
n _ _
∑ (Rjt – Rj)(RMt – RM)/(n-1) in case of historical data
i=1
The beta coefficient can be interpreted as follows:

β =1 exactly as volatile as the market
β >1 more volatile than the market
β <1>0 less volatile than the market
CALCULATION OF BETA
Year Return on security j (%) Return on market Portfolio (%)

1 10 12
2 6 5
3 13 18
4 -4 -8
5 13 10
6 14 16
7 4 7
8 18 15
9 24 30
10 22 25
Solution:
Year Rjt RMt Rjt-Rj RMt-R (Rjt - Rj)(RMt-RM) (RMt-RM)2
1 1 -2 - 2 1
0 1
2 6 -6 - 4 64
8 8
3 1 1 5 5 25
3
4 - -16 - 3 441
4 2 3
1 6
5 1 1 1 - 9
3 0 3
6 1 1 2 3 9
4 6
7 4 7 -8 - 36
6
8 1 1 6 2 4
8 5
9 2 3 12 1 289
4 0 7
1 2 2 10 1 144
0 2 5 2
_ _
Σ Rjt = 120 Σ RMt = 130 Σ (Rjt- Rj) (RMt - RM) = 778 Σ(RMt - RM)2
= 1022
_ _
Rj = 12 RM = 13 Cov (Rjt , RMt) = 778/9= 86.4 σM^2 =

1022/9=113.6
Cov (Rjt , RMt) 86.4

Beta : βj = σ2M = 113.6 = 0.76
Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between
the expected return and risk of investing in a security. It shows that the expected return on a
security is equal to the risk-free return plus a risk premium, which is based on the beta of that
security.8/
E(Ri) =Ke= Rf + βi * [E(Rm) – Rf] Where: E(Ri) = Expected return on asset i ,Rf = Risk-free
rate of return, βi = Beta of asset i, E(Rm) = Expected market return
The market risk premium represents the additional return over and above the risk-free rate,
which is required to compensate investors for investing in a riskier asset class.
Example- Let’s say the beta of Company M is 1 and risk-free return is 4%. The market rate of
return is 6%. We need to calculate the cost of equity using the CAPM model.
Company M has a beta of 1 that means the stock of Company M will increase or decrease
as per the tandem of the market.

Ke = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-free Rate of
Return)
Ke = 4 + 1 * (6 – 4) = 6%.
Security Market Line
1. All the assets which are correctly priced are represented on SML
2. The assets which are above the SML are undervalued as they give the higher
expected return for a given amount of risk.
3. The assets which are below the SML are overvalued as they have lower expected returns
for the same amount of risk.
4. A risk-averse investor’s investment is more often to lie close to y-axis or the beginning of
the line whereas risk-taker investor’s investment would lie higher on the SML.
Dividend Capitalization Model
The Dividend Capitalization Model only applies to companies that pay dividends, and it
also assumes that the dividends will grow at a constant rate.
Dividend Capitalization Formula:
Ke = (D1 / P0) + g
Where:Ke = Cost of Equity
D1 = Dividends/share next year
P0 = Current share price
g = Dividend growth rate
Example: XYZ Co. is currently being traded at $5 per share and just announced a
dividend of $0.50 per share, which will be paid out next year. Using historical
information, an analyst estimated the dividend growth rate of XYZ Co. to be 2%. What is
the cost of equity?
D1 = $0.50
P0 = $5
g = 2%
Ke = ($0.50/$5) + 2%
Ke = 12%
References
1. https://financetrain.com/how-to-calculate-portfolio-risk-and-return/ .
2. Financial Management by I.M Pandey( Eleventh Edition)

3. https://corporatefinanceinstitute.com
4. https://www.yourarticlelibrary.com/financial-management/risk-and-returns-concept-of-risk-and-
returns/43819
5. Financial Management by Prasanna Chandra(9TH Edition)
COST OF CAPITAL
Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders and
the debt-holders) to the business as a compensation for their contribution to the total capital.
Generally, the sources of finance for any business entity could be either internal (savings,
investments in current and non-current assets etc.) or external borrowings (loan from financial
institutions, local borrowings etc.). Cost of capital is also known as ‘cut-off’ rate, ‘hurdle rate’,
‘minimum rate of return’.
SIGNIFICANCE OF THE COST OF CAPITAL
The cost of capital is important to arrive at correct amount which is payable on the total funds
procured by the business entity and helps the management or an investor to take an appropriate
decision. The correct cost of capital helps in the following decision making:
(i) Evaluation of investment options: The estimated benefits (future cashflows) from the
selected investment (business or project) are converted into the present value of benefits by
discounting them with the relevant cost of capital. It is necessary to remember that every
investment option may or may not have same cost of capital, hence it is very important to use the
cost of capital which is relevant to the options available. Here Internal Rate of Return (IRR) is
that rate of discounting where NPV is nil which is used for evaluation of two options (projects).
(ii) Performance Appraisal: Cost of capital is used to appraise the performance of a
particulars project or business. The available earnings of the Company for different stakeholders
also depends on the cost of procuring the funds. Cost of capital gives the exact picture as to how
much minimum earnings an organisation should earn so as to mitigate the financial obligations.
(iii) Designing of optimum credit policy: The credit policy of the Company will decide the
credit period to be allowed to the customers. The cost of allowing credit period (Bad debts,
discount, opportunity cost of investment etc) is compared against the benefit/ profit earned by
providing credit to customer of segment of customers
Cost of capital : The cost of capital can either be explicit or implicit.

 Explicit cost of capital:
- The cash outflow of an entity towards the utilization of capital which is clear and obvious
is termed as explicit cost of capital.
- These outflows may be interest payment to debenture holders, repayment of principal
amount to financial institution or payment of dividend to shareholders etc.
 Implicit cost of capital:

- On the other side, implicit cost is the cost which is actually not a cash outflow but it is an
opportunity loss of foregoing a better investment opportunity by choosing an alternative
option.
The two factors which are considered to determine the cost of capital are:
i. Source of Finance
ii. Reciprocal payment of the using finance.
Debentures
Following are the different features of debentures/bonds:
i) Face Value: Debentures or Bonds are denominated with some value, called as the face value
of the debenture. The interest paid on debentures is always calculated on the face value of the
debentures.
E.g. If a company issue 8% Non- convertible debentures of ` 100 each, this means the face value
is `100 and the interest @ 8% will be calculated on this face value.
The payment of interest to the debenture holders is tax deductible expenses. Hence, interest paid
to the debenture holders save the tax liability of the company.
ii) Maturity period: Debentures or Bonds has a fixed maturity period for redemption.
However, in case of irredeemable debentures maturity period is not defined and it is taken as
infinite. I.e. it will continue till the time the Company is into operations.
iii) Redemption Value: It is the value at which the debentures of the Company will get
redeemed Redemption value may vary from the face value of the debenture.
Cost of Irredeemable Debentures

The cost of debentures which are not redeemed by the issuer of the debenture is known as
irredeemable debentures. Cost of debentures not redeemable during the life time of the company
is calculated as below:
Cost of Irredeemable Debenture ( Kd) = I (1-t) / NP
Kd = Cost of debt after tax
I Annual interest payment
Net proceeds of debentures or current market price (As

NP reduced by the flotation cost*)
t = Tax rate
* Flotation cost: The new issue of a security (debt or equity) involves some expenditure in the
form of underwriting or brokerage fees, legal and administrative charges, registration fees,
printing expenses etc.
Cost of Redeemable Debentures (using approximation method)

The cost of redeemable debentures will be calculated as below:
Cost of redeemable Debenture ( Kd) = I (1-t) + (RV-NP) / n
RV+NP
2
Where,
I = Interest payment
NP = Net proceeds from debentures in case of new issue of deb or Current
market price in case of existing debt.
(As reduced by the flotation cost)
RV Redemption value of debentures
t Tax rate applicable to the company
N Life of debentures.
Preference Share Capital

- The preference shareholders are paid dividend at a fixed rate on the face value of
preference shares.
- Payment of dividend to the preference shareholders is given priority over the equity
shareholder.
- The payment of dividend to the preference shareholders is considered as appropriation of

profit and thus it is not a tax-deductible expense.
- Like the debentures, Preference share capital can be categorized as redeemable and
irredeemable.
Cost of Redeemable Preference Shares

Preference shares issued by a company which are redeemed on its maturity is called redeemable
preference shares. Cost of redeemable preference share is similar to the cost of redeemable
debentures with the exception that the dividends paid to the preference shareholders are not tax
deductible. Cost of preference capital is calculated as follows:
PD (1+Dt)+ (RV-NP)
Cost of Reedemable Preference Share (Kp ) = N .

RV+NP
Where
PD = Annual preference dividend

RV = Redemption value of preference shares
Net proceeds on issue of preference shares

(As reduced by the flotation cost)
NP =
N = Life of preference shares
Cost of Irredeemable Preference Shares

The cost of irredeemable preference shares is similar to calculation of perpetuity. The cost is
calculated by dividing the preference dividend with the current market price or net proceeds from
the issue. The cost of irredeemable preference share is as below:
Cost of Irredeemable Preference Share (K ) = PD (1+Dt) / P0
Where,
PD = Annual preference dividend
P0 = Net proceeds in issue of preference shares
Equity Share Capital

- It is important source of Own funds, which once issued will be there till the buy-back or
dissolution of the Company.
- The dividend is not paid at a fixed rate but it is declared every year based on the earnings
of the Company.
- Equity shareholders are given the last priority while making Payment of dividend, The
Equity shareholders get dividend when all other parties are paid off.
- The payment of dividend to the equity shareholders is considered as appropriation of

profit and thus it is not a tax-deductible expense.
COST OF EQUITY SHARE CAPITAL
It may prima facie appear that equity capital does not carry any cost. But this is not true. The
market share price is a function of return that equity shareholders expect and get. If the company
does not meet their requirements, it will have an adverse effect on the market share price. Also,
it is relatively the highest cost of capital. Due to relative higher risk, equity shareholders expect
higher return hence, the cost of capital is also high.
In simple words, cost of equity capital is the rate of return which equates the present value of
expected dividends with the market share price. In theory, the management strives to maximize
the position of equity holders and the effort involves many decisions.
Different methods are employed to compute the cost of equity share capital.
i) Dividend OR Dividend Price Approach: In this approach dividend is constant, which
means there is no-growth or zero growth in dividend.
(Ke ) = D/ P
Where,
D= Annual dividend
P = Net proceeds in issue of equity shares
ii) Constant growth model (Gordan Model): Where earnings, dividends and equity share
price all grow at the same rate, the cost of equity capital may be computed as follows:
Ke = (D1/ P) + g
Where,
D1= Expected Annual dividend
G = Growth rate
iii) Earnings / Earnings Price Approach: This approach links the earnings of the company
with the market price of its share.Accordingly, the cost of equity share capital would be
based upon the expected rate of earnings of a company.
(Ke ) = EPS/ P
Where,
EPS= Earnings Per Share

iv) Realised Yield Approach : According to this approach, the average rate of return
realized in the past few years is historically regarded as ‘expected return’ in the future.
(Ke ) = 1 / PE ratio
Where, PE= Price Earnings Ratio
v) Capital Asset Pricing Model (CAPM): According to the CAPM approach, the expected
return of a security or a portfolio equals the rate on a risk-free security plus a risk
premium. The risk-free rate of return is the return from a Government security which has
no risk or
very low risk. Risk premium is calculated based on the Beta factor of the company which
measures the systematic risk.
Ke = Rf + β (Rm– Rf)
Where Ke = Cost of equity capital
Rf = Risk – free rate of return
Rm = Return on market portfolio
β = Beta of Security (Measure systematic risk)
Types of Risk: A security is exposed to different types of risks. These risks can be broadly
classified into two groups as below:
i. Unsystematic Risk:
- This is also called company specific risk as the risk is related with the company’s
performance.
- This type of risk can be reduced or eliminated by diversification of the securities
portfolio.
- This is also known as diversifiable risk.
ii. Systematic Risk:

- It is the macro-economic or market specific risk under which a company operates.
- This type of risk cannot be eliminated by the diversification hence, it is non-
diversifiable.
- The examples are inflation, Government policy, interest rate etc.
Weighted Average Cost of Capital:

It is the average of the costs of several of sources of financing. It is also known as composite
or overall or Average Cost of Capital. After computing the cost of individual sources of
finance, the Weighted Average Cost of Capital is calculated by putting weights in the
proportion of the various sources of funds to the total. Weighted average cost of capital is
computes by using either of the following two types of weights:
While using weights we have a choice between the book value & market value as explained
below:
1. Book Value (BV):

o These weights are operationally easy and convenient.
o While using BV, reserves such as share premium and retained profits are included
in the BV of equity, in addition to the nominal value of share capital.
o Here the value of equity will generally not reflect historic asset values, as well as
the future prospects of an organization.
2. Market Value (MV):

o Market value weights are more correct and represent a firm’s capital structure. It
is preferable to use MV weights for the equity.
o While using MV, reserves such as share premium and retained profits are ignored
as they are in effect incorporated into the value of equity.
o It represents existing conditions and also takes into consideration the impacts of
changing market conditions and the current prices of various securities.
o Similarly, in case of debt MV is better to be used rather than the BV of the debt,
though the difference may not be very significant.
Average cost of capital is computed as followings:

Kw = WeKe + WdKd + WpKp + Wr Kr
Where, Kw = Weighted Average Cost of Capital
Ke = Cost of Equity
Kr = Cost of Reserves
Kd = Cost of Debt
Kp = Cost of preference share capital
W = weights (proportions of specific sources of finance in the total)
The following steps are involved in the computation of Weighted Average Cost of Capital:
(i) Multiply the cost of each sources with the corresponding weight.
(ii) Add all these weighted costs so that weighted average cost of capital is obtained.
Marginal Cost of Capital:

The weighted average cost of capital can be worked out on the basis of marginal cost of
capital than the historical costs. The weighted average cost of new or incremental capital is
known as the marginal cost of capital. This concept is used in capital budgeting decisions.
The marginal cost of capital is derived, when we calculate the weighted average cost of
capital using the marginal weights. The marginal cost of capital would rise whenever any
component cost increases. The marginal cost of capital should be used as the cut off rate.
The average cost of
capital should be used to evaluate the impact of the acceptance or rejection of the entire
capital expenditure on the value of the firm.
Practical Questions:
Q.1.The Company issued 12% debentures of Rs. 200 each. Find the cost of the debt after tax if
the debentures are issued i) at par ii) at 10% premium and iii) at 5% discount.
(Consider tax rate as 30%. In all cases)
Ans: Calculation of cost of debt
I) when issued at par II) When issued at premium III) When issued at 5% Discount
𝐼(1−𝑡) 𝐼(1−𝑡) 𝐼(1−𝑡)
Kd = ∗ 100 Kd = ∗ 100 Kd = ∗ 100
𝑁𝑝 𝑁𝑝 𝑁𝑝
(200∗12%)(1−0.3) (200∗12%)(1−0.3) (200∗12%)(1−0.3)

Kd = 200 ∗ 100 Kd = 220 ∗ 100 Kd = 200 −10 ∗ 100
24(0.7) 24(0.7) 24(0.7)
Kd = ∗ 100 Kd = ∗ 100 Kd = ∗ 100
200 220 190
Kd= 8.4% Kd= 7.64% Kd= 8.84%
Q.2.Ravi Ltd. issued 1,000, 10% Debentures of Rs. 100 each redeemable after 10 years. The tax
rate is 35%. The floating cost is 4%. Determine pre tax and after tax cost of the debt if the
debt is issued i) At par ii) at 10% premium and iii) at 10% discount.
Note: Flotation cost is considered on issue price.
I) Issue at par II) Issue at 10% premium III: Issue at 10% Discount
𝑅𝑉−𝑁𝑃
( ) ( )
𝑅𝑉−𝑁𝑃
( )
𝑅𝑉−𝑁𝑃
𝐼 1−𝑡 +{
Kd = 𝑅𝑉+𝑁𝑃 𝑛
}
∗
𝐼 1−𝑡 +{
𝑅𝑉+𝑁𝑃 𝑛
}
∗
𝐼 1−𝑡 +{
𝑛
}
𝑅𝑉+𝑁𝑃 ∗ 100
2 2 2
100−96
( ) ( )
100−105.6
( )
100−86.4
10 1−0.35 +{ }
Kd = 100+96 10
} ∗ 10 1−0.35 +{
100+105.6 10
} ∗ 10 1−0.35 +{
100+86.4
10
∗
2 2 2
100
6.5+0.4 6.5−0.56 6.5−1.36

Kd = 98 ∗ 100 Kd = 102.8 ∗ 100 Kd = 93.2 ∗ 100
Kd = 7.04% Kd = 5.78% Kd = 8.43%
Q.3.The Company issued 14% Preference shares of Rs. 200 each. Find the cost of preference
shares if the shares are issued i) at par ii) at 10% premium and iii) at 5% discount.
(Income tax rate is 30% and Dividend Distribution tax rate is 15%)
I : Issued at Par II : Issued at 10% Premium III : Issued at 5% Discount
𝑃𝐷(1+𝐷𝐷𝑇) 𝑃𝐷(1+𝐷𝐷𝑇) 𝑃𝐷(1+𝐷𝐷𝑇)

Kp = ∗ 100 Kp = ∗ 100 Kp = ∗ 100
33
𝑁𝑝 𝑁𝑝 𝑁𝑝
28(1+0.15) 28(1.15) 28(1.15)

Kp = 200 ∗ 100 Kp = 220 ∗ 100 Kp = 190 ∗ 100
Kp = 28∗1.15 ∗ 100 Kp= 14.63% Kp= 16.9%

200
Kp = 16.1%
Q.4.Andrews Limited issued 10,000, 10% preference shares of Rs. 50 each redeemable after 20
years at par and the flotation cost is 5%. The tax rate is 35%. Determine the cost of the
preference shares if the shares are issued i) At par ii) at 10% premium and iii) at 10%
discount.
Ans:
Case – I : At par
𝑅𝑉−𝑁𝑃 } 5+{ 50−47.5}
𝑃𝐷+{
Kp =
𝑛
∗ 100 Kp = 20
∗ 100 Kp = 10.51%
𝑅𝑉+𝑁𝑃 50+47.5
2 2
Case – II :
At premium
𝑅𝑉−𝑁𝑃 } 5+{ 50−52.25}
𝑃𝐷+{
Kp =
𝑛
∗ 100 Kp = 20
∗ 100 Kp = 9.56%
𝑅𝑉+𝑁𝑃 50+52.25
2 2
Case – III :
At discount
𝑅𝑉−𝑁𝑃 } 5+{ 50−42.75}
𝑃𝐷+{
Kp =
𝑛
∗ 100 Kp = 20
∗ 100 Kp = 11.56%
𝑅𝑉+𝑁𝑃 50+42.75
2 2
34
Q.5.A Company has Equity shares of Rs. 20 each which is currently traded at Rs. 50. The
Company paid dividend @ 25%. Calculate the cost of equity.
Calculate the cost of equity if the growth rate is 10% for a finite period of time.
Ans: DPS/MPS*100
= 5/50*100
= 10%
Q.6.A Company has Equity shares of Rs. 10 each which is currently traded at Rs. 30. The
Company paid dividend @ 20% in the last year. The growth rate is 8%. Calculate the cost of
equity.
𝐷𝑃𝑆1
Ans: Ke= [ ∗ 100] + 𝑔
𝑀𝑃𝑆
DPS1= 2 + (2*8%) = 2.16

2.16
Ke = [ ∗ 100] + 8%
30
= 7.2%+8%
= 15.2%
Q.7.The Xavier Corporation, a dynamic growth firm which pays no dividends, anticipates a long
run level of future earnings of Rs 7 per shares. The current price of Xavier’s shares is Rs.
55.45, floatation costs for the sale of equity shares would average about 10% of the price of
the shares. What is the cost of new equity capital to Xavier Corporation?
𝐸𝑃𝑆
Ans: Ke = [ ∗ 100]
𝑀𝑃𝑆
7
=[
55.45 −(55.45∗10) ∗ 100]
7
=[
49.905 ∗ 100]
= 14.02%
Q.8. The government securities are currently offering interest @ 6% and the Nifty is giving
returns @ 14%. The beta factor for shares of ABC Ltd is 1.2. Then what is the cost of equity for
the Company considering CAPM approach.
Ans: Cost of Equity
Ke= 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓)
= 6%+1.2(14%-6%)
= 6%+1.2(8%)
= 6% + 9.6%
= 15.6%
Q.9. Following is the cost structure of a firm:
Rs. Cost
Equity Capital 4 14%
,
5
0
,
0
0
0
Retained Earnings 1 13%
,
5
0
,
0
0
0
Preference Share Capital 1 10%
,
0
0
,
0
0
0
Debts 3 4.5%
,
0
0
,
0
0
0
1
0
,
0
0
,
0
0
0
Calculate the new weighted average cost of capital of the firm.
Ans:
Particulars Amount Weight Cost (K) Weighted

(Rs.) (W) Cost (W*K)
Equity Capital 4,50,000 0.45 14% 6.30%
Retained Earnings 1,50,000 0.15 13% 1.95%
Pref Share Capital 1,00,000 0.10 10% 1.00%
Debt 3,00,000 0.30 4.5% 1.35%
Total 10,00,000 1.00 WACC = 10.60%

Q.10. From the following Capital Structure of Perfect Ltd. calculate overall cost of capital, using
(a) book value weights and (b) market value weights.
Source Book Value Market Value:

Equity Shares Rs. 10 each 4,50,000 9,00,000
Retained Earnings 1,50,000 --
Preference Share capital 1,00,000 1,00,000
Debentures 3,00,000 3,00,000
The after tax cost of different sources of finance are Equity Share Capital 14%, Retained Earnings
13%, Preference Shares 10% and Debentures 5%.
Ans: Calculation of WACC (based on book values)

Equity Capital 4,50,000 0.45 14% 6.30%
Debt 3,00,000 0.30 5% 1.50%
Total 10,00,000 1.00 WACC = 10.75%
Calculation of WACC (based on market values)

Equity Capital 9,00,000 0.6923 14% 9.6922%

Pref Share Capital 1,00,000 0 10% 0.7690%
.
0
7
6
9
Debt 3,00,000 0 5% 1.1540%
.
2
3
0
8
Total 13,00,000 1 WACC = 11.6152%
.
0
0
0
0
Q.11. Calculate the weighted average cost of capital from the following data.
Particulars Rs.
7%, 13,000 Debentures of Rs. 10 each 1,

3
9%, 700 Preference shares of Rs. 100 each 0,
0
Equity Shares (of Rs. 100 Face Value) 0
0
7
0,
0
0
0
6,
0
0,
0
0
0
Total 8,00,000
(There are no retained profits or securities premium)
A dividend of 10% a year has been paid on the equity shares in recent years and the market price
of the shares is Rs. 150. All of the company’s securities are quoted on the local stock exchange.
What is the weighted average cost of capital of the Company considering book value weights?
What will be weighted average cost of capital considering market value weights if the Market
price of the preference shares is Rs.105 and debentures is Rs. 10.5.
Ans: Cost of Equity Capital = ke = DPS/MPS * 100 = 10/150*100 = 6.67%
Calculation of WACC

Equity Capital 6,00,000 0 6.67% 5.0025%

.
7
5
0
0
Pref Share Capital 70,000 0 9% 0.7875%
.
0
8
7
5
Debentures 1,30, 0.1625 7% 1.1375%
000
Total 8,00, WACC = 6.9275%
000
Q.12. The Company has the following capital structure:
Particulars Rs.
Common Shares (4,00,000 Shares) 80,00,000
6% Preference shares 20,00,000
8% Debentures 60,00,000
Total 1,60,00,000
The shares of the company sells for Rs. 20. It is expected that company will pay next year a
dividend of Rs. 2 per share which will grow at 7 per cent for ever. Assume a 35 per cent tax rate.
(a) Compute the weighted average cost of capital based on existing capital structure.
(b) Compute the new weighted average cost of capital if the company raises an additional Rs.
40,00,000 debt by issuing 10 per cent debentures. This would result in increasing the
expected dividend to Rs. 3 and leave growth rate unchanged, but the price of share will
fall to Rs. 15 per share.
(c) Compute the cost of capital if in (b) above growth rate increases to 12 per cent.
Ans:
a) Kd= I (1 – Tax) =8% (1-035%)= 5.2%
Kp= 6%
Ke= Ke= [𝐷𝑃𝑆1/𝑀𝑃𝑆∗100]+𝑔 = Ke= [2/20∗100]+7% = 10%+7% =17%

Equity Capital 80,00,000 0.500 17% 8.50%
Debentures 60,00,000 0.375 5.2% 1.95%
Total 160,00,000 WACC 11.20%
(b) Kd (Old)= I (1 – Tax) =8% (1-035%)= 5.2%
Kd (New)= I (1 – Tax) =10% (1-035%) = 6.5%

Kp= 6%
𝐷𝑃𝑆1 3
Ke= Ke= [ ∗ 100] + 𝑔 = Ke= [ ∗ 100] + 7% = 20%+7% =27%
𝑀𝑃𝑆 15

Equity Capital 80,00,000 0.40 27% 10.80%
8% Debentures 60,00,000 0.30 5.2% 1.56%
10% Debentures 40,00,000 0.20 6.5% 1.30%
Total 2,00,00,000 WACC 14.26%
Case (c)
Kd (Old)= I (1 – Tax) =8% (1-035%)= 5.2%
Kd (New)= I (1 – Tax) =10% (1-035%) = 6.5%

Kp= 6%
𝐷𝑃𝑆1 3
Ke= Ke= [ ∗ 100] + 𝑔 = Ke= [ ∗ 100] + 12% = 20%+12% =32%
𝑀𝑃𝑆 15

Equity Capital 80,00,000 0.40 32% 12.80%
8% Debentures 60,00,000 0.30 5.2% 1.56%
10% Debentures 40,00,000 0.20 6.5% 1.30%
Total 2,00,00,000 WACC 16.26%
Q. 13. G. Ltd. has the following capital structure as on 31st March 2002.
Particulars Rs.
Equity Shares (2,00,000 Shares) 60,00,000
10% Preference shares 25,00,000
14% Bonds 15,00,000
The shares of the company are presently selling at Rs. 25 per share. It is expected that the
company will pay next year dividend of Rs. 2 per share which will grow @5% forever. Assume
tax rate of 40%. You are required to
(i) Compute the weighted average cost of capital based on existing capital structure.
(ii) If the company raises an additional Rs. 50 lakhs debt by issuing 15% debentures, the
expected dividend at year end will be Rs. 3, the market price per share will fall to Rs.
20 per share, the growth rate remaining unchanged. Calculate the new weighted
average cost of capital.
Ans: i) WACC = 11.56% ii) WACC = 13.51% (Working same as Q.12)

Q. 14. A company wants to raise additional funds of Rs. 10 lacs for meeting the investment
requirement. It has Rs. 2,10,000 as the retained earnings available for the investment.
Debt : Equity ratio = 30:70
Cost of Debt ; Upto Rs. 1.8 lacs = 10% (Before tax), Beyond Rs. 1.8 lacs = 16% (Before tax)
EPS = 4 DPS = 50% of earnings Growth rate = 10%
Current market price = Rs 44 and tax rate = 50%
You are required to determine the weighted average cost of capital.
Ans:
Total Funds = Debt + Equity
10 Lacs = 3 lacs + 7 Lacs
Equity = ESC + Res
7 Lacs = ESC + 2.1 lacs
ESC = 4.9 lacs
Cost of Debt
Kd (Upto 1.8 lacs) = 10% (1-0.5) = 5%
Kd (Additional 1.2 lacs) = 16% (1-0.5) = 8%
Cost of Equity =
Div paid= 4*50% = 2
Div expected = 2 + 2*10% = 2.2
Div Growth = Ke= [𝐷𝑃𝑆1/𝑀𝑃𝑆∗100]+𝑔
= [2.2/44∗100]+10%=15%
Equity Capital 4,90,000 0.49 15% 7.35%
10% Debt 1,80,000 0.18 5% 0.90%
16% Debt 1,20,000 0.12 8% 0.96%
Total 10,00,000 WACC 12.36%
Source: https://www.icai.org (CA Intermediate)

Financial Management 1 To 30

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Financial Management

Notes for 1-10 sessions

Introduction to Financial Management: Objectives - Functions and Scope - Evolution - Interface of

Year Inflow Cumulative Inflow

Particulars Machine A Machine B

Cost 56125 56125

Estimated life (in 5 5

Estimated salvage value 3000 3000

Determine ARR of both the machines.

Structures of Indian Banking Sector

Primary Markets and Secondary Markets: Procedural Aspects of Primary Issues –

Time Value of Money (TVM)

Based on Time Value of Money, two important concepts arise

The Present Value is calculated through the equation

FV= 1000 x (1+0.1)5

FV= 7200 x (1+0.08)11

FV= 102400x (1+0.12)9

10%? PV= 10000 {1/(1+0.1)6}

= 10000 x 0.5645 = 5645

Examples on Future and Present Values of Ordinary Annuities

# A company has borrowed a sum of Rs. 1000000 at an interest rate of 15%

Examples on Future and Present Values of Annuity Due

= 1,000 x 3.169 x (1 + 0.10)

End of Total Interest Principal Outstanding

1 3,951 900 3,051 6,949

2 3,951 625 3,326 3,623

3 3,951 326 3,625* 0

*Rounding off error

# A person has borrowed a sum of Rs.15,00,000 at an interest rate of 10%

Here, Capital Recovery Factor = 1/ 3.7908 = 0.2638

End of year Total payment Interest Principal repayment Outstanding

1 3,95,700 1,50,000 2,45,700 12,54,300

2 3,95,700 1,25,430 2,70,270 9,84,030

3 3,95,700 98,403 2,97,297 6,86,733

4 3,95,700 68,673 3,27,027 3,59,706

5 3,95,700 35,971 3,59,729* 0

*Rounding off error

FV = 1,000 x (1 + 0.12)1 = 1,000 x 1.12 = 1,120

FV = 1,000 x (1 + 0.12/2)2 = 1,000 x 1.1236 = 1,123.6

# When Rs.1,000 is invested for 1 year at an interest rate of 12% compounded

FV = 1,000 x (1 + 0.12/4)4 = 1,000 x 1.1255 = 1,125.5

FV = 1,000 x (1 + 0.12/12)12 = 1,000 x 1.1268 = 1,126.8

TIME VALUE OF MONEY – tables - FVIF

TIME VALUE OF MONEY – tables - PVIFA

International Financial Markets:

Global Depository Receipts:

A GDR is a dollar denominated instrument of a company, traded in stock exchanges

Foreign Currency Convertible Bonds:

External Commercial Borrowing:

There is a need to enhance supervision, particularly in economies open to capital

The mission of the Organization for Economic Co-operation and Development

The World Bank (WB):

Bank of International Settlements (BIS):

Established on 17 May 1930, the Bank for International Settlements (BIS) is an

International Organization of Securities Commissions (IOSCO):

The International Organization of Securities Commissions (IOSCO) is the

International Capital Market Association (ICMA):

Types of cash flows:

Future Value of Single Cash Flow (Onetime Investment):

Timeline of Future Value Determination

t=0 t=1 t=2 t=3 t=4 t=5

Rs. 5,00,000 X (FVIF r%, 5 years) FV=?