Firm & Financial Management

Covers chp. 1
 The Firm
• Association of people for the provision of
goods and services with an intention of
making a profit.
• Legal forms are:-
– Sole Proprietorship
– Partnership
– corporations
 Corporate Structure
Sole Proprietorships
Unlimited Liability
Personal tax on profits
Partnerships

Limited Liability

Corporations Corporate tax on profits +

Personal tax on dividends
ENVIRONMENTAL FACTORS
What can go wrong ….
The counter reaction
 ENVIRONMENTAL FACTORS

• Important for Financial Manager to

understand the External Environment in
which he has to operate.
• Some of the dominant factors are :-
– Government/Financial Market Regulations
– Forms of Business organisation.
– Taxation etc.
 ENVIRONMENTAL FACTORS

• Regulatory Framework
– FERA/FEMA
– MRTP/COMPETION POLICY
– COMPANY’S ACT ( salient features)
 FERA/FEMA
• FERA(73) : for MNC operating in India.
• More than 40% share holding has to be
reported.
• Delay in implementation, (by 1979 only
50% of the companies diluted its equity
holdings below 40%).
• Liberalization put forth a new Industrial
and trade Policy (91) and in 1993
ordinance to amend FERA was passed.
 FEMA
• FEMA was introduced in 1998, with a
motive to “facilitate exchange market in
India”.
• There was a regime shift from “exchange
control to exchange
management”.
• 1993,exchange rate of rupee was made
market determined. 1994, accepted article
VIII of IMF.
Objective/ goal
Role of The Financial Manager
(2) (1)

Firm's Financial Financial

(4a)
operations manager markets

(3) (4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
 The Goal of Financial
Management

• What are firm decision-makers hired to do?

“General Motors is not in the business of making

automobiles. General Motors is in the business
of making money.”
--Alfred P. Sloan
 Goal Of Financial
Management
• What should be the goal of a corporation?
–Maximize profit?
–Minimize costs?
–Maximize market share?
–Maximize the current value of the company’s
stock?
 The Goal
• Maximize profit – Are we talking about long-run
or short-run profits? Do we mean accounting
profits or some measure of cash flow?
• Minimize costs – We can minimize costs today
by not purchasing new equipment or delaying
maintenance, but this may not be in the best
interest of the firm or its owners.
• Maximize market share – This has been a
strategy of many of the dotcom companies. They
issued stock and then used it primarily for
advertising to increase the number of “hits” to
their web sites. Even though many of the
companies have a huge market share (i.e.
Amazon) they still do not have positive earnings
and their owners are not happy (1996).
 Maximize the current value of the
company’s stock
• There is no short run vs. long run here. The stock
price should incorporate expectations about the
future of the company and consider the trade-off
between short-run profits and long-run profits.
• The purpose of a for-profit business should be to
make money for its owners. Maximizing the
current stock price increases the wealth of the
owners of the firm.
• This is analogous to maximizing owners’ equity
for firms that do not have publicly traded stock.
• Non-profits can also follow the same principle, but
their “owners” are the constituencies that they
were created to help.
Manager’s dilemma
 Indian Financial System
• Topics to be covered …
– Capital market
– Money Market
– Banking / developmental Institutions.
Capital Market

EQUITY MARKETS
 Common Stock

• Ownership in a Corporation
• One vote per share.
• Have a residual (last) claim on income
and assets in liquidation, thus a
riskier position than bonds and
preferred stockholders.
• Shareholders’ liability for the debts
of the corporation is limited to their
investment in the common stock.
 Common Stock (concluded)

• Shareholders’ return is derived from dividends

declared by the board of directors and from
market appreciation in the value of the stock.
• Common shareholders may vote their shares to
elect the members of the board of directors.
• Members of the board of directors can be
elected by cumulative voting or straight voting.
 Preferred Stock
• A Preferred or prior claim on earnings and
assets compared to common stock

• Dividends paid ahead of common if declared.

• Preferred stockholders are usually excluded

from voting for board of directors and
shareholder issues.

• Many corporations buy preferred stock.

 Convertible Securities
• Convertible preferred stock -- convertible to
common stock at specific common price or
number of shares (conversion ratio).
– Dividends received until conversion
– Investor may participate in growth of firm.
• Convertible bonds -- convertible to common
stock at specific common price or number of
shares (conversion ratio).
– Pays fixed bond rate until conversion.
– Provides potential for higher returns for investors.
 Primary Market for Equities
• The first time shares are sold in the market is an
unseasoned offering or an initial public offering
(IPO); additional shares may be sold later as a
seasoned offering.
• Equities may be:
– Sold directly to investors by the firm.
– Purchased and sold at a higher price (underwriter’s
spread) by investment bankers in an underwritten
offering.
– Sold to existing shareholders in a rights offering.
 Primary Market for Equities
(concluded)

• The size of the underwriter’s spread

depends on the underwriter’s level of
uncertainty concerning the shares’ market
price.
 The Secondary Market for
Equity Securities

• Subsequent Trading in Securities after

primary issue
• Stock may trade on:
– Exchanges.
– Over the counter
• Provides investor liquidity
 The Secondary Market for
Equity Securities (concluded)
• Stable prices are related to the extent of:
– Breadth of the market or the number of varied traders
of the stock.
– Depth of the market or the extent to which there are
conditional orders to buy and sell below and above
the current price, respectively.
– Resiliency of the market or the ability of the market to
attract buyer/sellers when the stock prices
decreases/increases, respectively.
 Secondary Markets
• Bring Buyers/ Sellers Together Four Ways:
– A buyer may incur search costs and find a seller
on their own, called a direct search.
– A broker may bring buyer and seller together,
charging a commission.
– A dealer may sell/buy (bid/ask) securities from an
inventory of securities, reducing search costs.
The dealer’s return is the bid/ask spread.
– An auction market allocates the selling shares to
the highest bidder, providing a buyer/seller.
 The Size of Dealer Bid/ask
Spreads:
• are proportionately higher for low priced
stocks due to fixed costs of operations.
• are higher for trades of a few shares.
• are higher for a large block trade; a liquidity
service is performed.
• are narrower with more frequent trading,
where the costs of providing liquidity are less.
• are wider with traders with insider information,
where the dealer may have to incur the cost
of price discovery, or buying high, selling low!
Inventory model
 Capital Market
• Defined as : the market of financial assets
that has long or indefinite maturity.
• Nerve centre of the industrial development
of any economy.
• SEBI regulates it.
 Composition/Structure of Capital
Market
HERE:
HERE
P&S
P & S : Primary/sec.
VC DFI markets
DFI:development
CM financial inst.
FIIs IFI IFI:Investment fin. Inst.
MF: Mutual Funds
CB: commercial Banks
CB MF
Transactions
 Challenges & SEBI
• SEBI was set up in 1988, but was given a
statutory recognition in 1992 on the
recommendation of the Narasimhan Committee
report.
• The ‘Strategic action plan’ has identified 4 key
spheres
• Investors – firms-market-regulations
• The Sebi Act(1992) was amended at oct 02.
• Sebi Appellate Tribunal (SAT).
• Penalty Max of 5 lacs.
• Board must comprise of : a chairman, 2 Min. of
Fin,1 from RBI,5 others (3 whole time Director)
 Hiccups
• Efficiency
• Insider trading / information efficiency
• Volatility
• Liquidity
• Reach
 Amount
Date Events (stock market crisis)
involved

Harshad Mehta : the market went up by 143% Rs. 54

1992 between Sept 91 & Apr 92 Billion
M.S.Shoes: (Pawan Sachdeva) manupulated the Rs. 170
1994 share prices before a Rights issue Million

Rs. 61.8
1995 Sesa Goa , Rupangi Impex & Magan Industries Ltd
Million

Rs. 7
1997 CRB Group : C.R. Bhansali
Billion

Rs. 0.77
1998 BPL, Videocon,Sterlite
Billion

Rs. 1
2001 Ketan Parekh (K10 stocks)
Billion
 Electronic Communication Networks

Gary Putnam South Western Sec Instinet Sal Smith Barney

Lehman
Reuters Heine
Strike
JP Morgan Herzog PaineWeber
E-Trade Archipelago
Townsend
Bear Stearns
CNBC
DLJ
Merrill Lynch SLK
Goldman Sachs Schwab

Knight Trinkmark REDIBook

BRUT Nasdaq Fidelity TD Waterhouse

ASC Sunguard
Attain All Tech
Morgan stanley Dean Witter

NextTrade PIM
Datek ISLAND

LVMH TradeBook Bloomberg

Platforms for Internalization
TA Associates
by Broker/Dealer and Banks
 Volatility
Daily Returns on BSE Sensex(1995-2004)

10

5
Daily Returns(%)

BSE

-5

-10
Volatility clustering

-15
3- 25- 21- 19- 12- 9- 2- 24- 17- 10- 7- 31- 26- 20- 17- 13- 8- 4- 29- 20- 5- 25-
Jun- Oct- Mar- Aug- Jan- Jun- Nov- Mar- Aug- Jan- Jun- Oct- Mar- Aug- Jan- Jun- Nov- Apr- Aug- Jan- Jul- Nov-
96 96 97 97 98 98 98 99 99 00 00 00 01 01 02 02 02 03 03 04 04 04

Date
 14th – 17th May’04
10:19 PM 17/05/2004

INDIAN STOCK MARKET CRASH (Times of India)

Indian stocks were in virtual free-fall on Monday, wiping out 40 billion dollars
in market value, amid frenzied selling on fears a new Congress-led
government will slow the pace of reform in Asia's fastest-growing economy.

The Bombay Stock Exchange and National Stock Exchange suspended

trading after their benchmark indices fell 15.5 percent and 17.5 percent,
respectively. Both racked up their biggest point drop ever and sank to their
lowest levels since the Big Bull crisis.
 To conclude…
• Financial management is more influence
by external factors than firm specific
problems
• CFOs/CEOs are expected to add value to
the investments trusted upon them rather
than just showing profits .
• Capital market in India is volatile and
shows seasonality.
Time Value of Money (contd.)

Session # 3
Financial Management - I
 Problem set #1 : solutions
1. Determine the future values utilizing a time preference
rate of 9 %:
(i) The future value of Rs. 15,000 invested now for a period
of 4 yrs.

(ii) The future value at the end of 5 yrs of an investment of

Rs 6000 now and of an investment of Rs. 6000 one
year from now.
(iii) The future value at the end of 8 years of an annual
deposit of Rs.18,000 each year.
(iv) The future value at the end of 8 years of an annual
deposit of Rs. 18000 at the beginning of each year.
(v) The future value at the end of 8 years of a deposit of Rs
18000 at the end of the first four years and withdrawal
of Rs.12, 000 per year at the end of year five through
seven.
 Solution # 1
• (i) time preference (discount rate) = 9%
investments = 15,000
time period = 4 yrs.
CVF(4,9%) = 1.4116 (appox.)
FV = 15,000*(1.09)4 = 15,000* 1.4116
= 21,173.72
(ii) Investments = 6000 (now) & 6000( 1 yr after)
period (eoy) = 5 yrs
compouning period = 5 & 4 yrs
CVF = 1.5386 & 1.4116
FV = 9231.74 & 8469.49
 Solution # 1
• (iii) Annual investments (eoy) = 18,000
time period = 8 yrs.
CVAF = 11.0285 (appox.)
FV = 18,000* 11.0285 = 198,513

(iv) Investments (b0y)= 18000

period = 8 yrs
CVAF (annuity due) = 12.0210
FV = 18000 * 12.0210 = 216378
 Solution # 1
withdrawal Balance
• (v)
annual investment for 4 yrs 18000

compounding value at the end of 4

yr 82316.32
compounding value at the end of 5
yr 89724.79 12000 77724.79
compounding value at the end of 6
yr 84720.02 12000 72720.0211

compounding value at the end of 7

yr 79264.82 12000 67264.823
compounding value at the end of 8
yr 73318.66 0 73318.65707
 Solution#2
• Rate of interest = 15 %
sum received now = 100
period = 10 yr
PVAF = 5.0188
therefore 1/ PVAF = 0.1993
100 = 5.0188A
Hence A = .1993*100= 19.93
For Annuity due , PVAF(1+.15) = 5.7716
Hence A = 100/5.7716 = 17.33
 Solution#3
• Needed future sum after 15 yr= 300,000
periods = 15 yrs
interest rate = 12%
CVAF = 37.28
Therefore , A*37.28 = 300000
A = 8047.22
 Solution#4

Price of the house = 500,000

Cash payment = 100,000
Balance = 400,000
Installment period = 20 yrs
Interest rate = 12%
PVAF = 7.4694
A*7.4694 = 400,000
A = 53551.51 (appox)
year Balance Installment interest Repayment
0 400000.00
1 394448.49 53,551.51 48000.00 5,551.51
2 388230.80 53,551.51 47333.82 6,217.69
3 381266.98 53,551.51 46587.70 6,963.81
4 373467.51 53,551.51 45752.04 7,799.47
5 364732.10 53,551.51 44816.10 8,735.41
6 354948.45 53,551.51 43767.85 9,783.66
7 343990.75 53,551.51 42593.81 10,957.70
8 331718.13 53,551.51 41278.89 12,272.62
9 317972.80 53,551.51 39806.18 13,745.33
10 302578.02 53,551.51 38156.74 15,394.77
11 285335.87 53,551.51 36309.36 17,242.15
12 266024.67 53,551.51 34240.30 19,311.21
13 244396.12 53,551.51 31922.96 21,628.55
14 220172.14 53,551.51 29327.53 24,223.98
15 193041.29 53,551.51 26420.66 27,130.85
16 162654.74 53,551.51 23164.95 30,386.56
17 128621.79 53,551.51 19518.57 34,032.94
18 90504.90 53,551.51 15434.62 38,116.89
19 47813.98 53,551.51 10860.59 42,690.92
20 0.15 53,551.51 5737.68 47,813.83
 Solution # 5
• Answer??
 Other forms of Annuity
• Perpetuity: it is an Annuity that occurs
indefinitely. (i.e. without a maturity)
P = A/I
E.g. , an investor expects a perpetual sum of
Rs 500 annually from his investments.
What is the present value of this perpetuity
if the interest rate is 10%.
soln : P = 500/0.10 = Rs 5000.
 Other forms of Annuity
Present value of a growing Annuity: the
periodic cash flows grow at a compounding
rate. E.g. Arun gets an annual salary of Rs
1,00,000 with the provision for an annual
increment of 10%.
P = A/(1+g)[ ( 1-(1+i*)-n) /i*]
Where, i* = (i-g)/(1+g)
 An Example…
• A dividend stream commencing one year
hence at Rs 66 is expected to grow at
10% annum for 15 Yrs and then ceases. If
the discount rate is 21%, what is the PV of
the expected series.
soln: P = A/(1+g)[ ( 1-(1+i*)-n) /i*]
Where, i* = (i-g)/(1+g)
i* =(0.21-0.10)/1.10 = 0.10
A/(1+g) = 66/1.10 = 60
 Example (contd.)
• Refer to table of PVAF (15,10%)= 7.606

P = 60 * 7.606 = Rs 456.36
 Some terms
• Capital Recovery: it is the annuity of an
investment for a specified time at a
given rate.
• If you make an investment today for a
given period of time at a specified rate
of interest you may like to know the
annual income generated from it.
• The reciprocal of PVAF is CRF ( capital
recovery factor).
 An Example…
• If you plan to invest Rs 10,000 today for a period
of 4 years. The interest rate is 10%. How mush
income per year should you receive to recover
your investment?
• Soln : PV = A (PVAFn,i)
A = PV (CRFn,i)
A = 10,000 (0.3155) = Rs 3155
 problems
• Suppose you have taken a 3 yr loan of Rs
10,000 @ 9% from your employer to buy a
motorcycle. If your employer requires
three equal end-of-year repayment ,then
what will be the annual installments?
 problems
• PV = A (PVAF n,i)
using the given values, we obtain..
10000 = A (2.531)
A = Rs 3951
i.e. paying Rs 3951 each year, for three yrs ,
you shall completely pay off your loan with
9% interest rate.
 problems
• Exactly ten yrs from now Sri Chand will
start receiving a pension of Rs 3000 a
year. The payment will continue for 16 yrs.
How much is the pension worth now, if Sri
Chand’s interest rate is 10%?
 problems
Soln: Sri Chand will receive the first payment at
the end of 10th Year and last payment at the end
of 25th year.
Assuming an Annuity for 25 yrs @ 10%, PVAF25
= 9.077 but we know that he will not receive
anything till the end of 9th yr. therefore we
subtract PVAF @ 10% for 9 yrs.
i.e. PVAF25 – PVAF9 = 9.077 – 5.759 =3.318
Therefore, the present value of the pension will be
= 3.318* 3000 = Rs 9954
 problems
• How long will it take to double your money
if it grows at 12% annually ?
• If a person deposits Rs 1000 on an
account that pays him 10% for the first 5
yrs and 13% for the following eight yrs,
what is the annual compound rate of
interest for the 13 yr period?
 problems
• Amount = 1000
interest rate for (1-5)yr = 10%
interest rate for (6-13) yrs = 13%
compound value for 13 yr period
= 1000 * (1.15)5 * (1.13)8 = 4281.45
the compound interest rate will be
= [ ( 4281.45/1000)1/13 – 1 ] = 11.84%
 problems
• A finance company makes an offer to
deposit a sum of Rs 1100 and then
receive a return of Rs 80 p.a. perpetually.
Should this offer be accepted if the rate of
interest is 8% ? Will the decision change if
the rate of interest is 5%?
 Problems
• The person should accept the offer if the
present value (PV) of the perpetuity is
more than the initial deposit of Rs 1100
If the rate of interest is 8%
PV = A/i = 80/.08 = RS 1000 ( reject)
If the rate of interest is 5 %
PV = 80/.05 = Rs 1600( accept)
 problems
• What is the minimum amount which a
person should be ready to accept today
from a debtor who otherwise has to pay a
sum of Rs 5000 today, Rs 6000, Rs 8000
and Rs 9000 and Rs 10000 at the end of
yr 1,2,3,4 respectively from today. The
rate of interest is 14%.
 problems

• Soln : the minimum amt. is the PV of the series of amt.

due ,discounted at 14% , as follows:

year Amt due PVF(n,14%) PV

0 5000 1 5000
1 6000 0.877 5262
2 8000 0.769 6152
3 9000 0.675 6075
4 10000 0.592 5920
28409
 problems
• A company is expected to declare a
dividend of Rs2 at the end of first year
from now and this dividend is expected to
grow 10% every year . What is the PV of
this stream of dividends if the rate of
interest is 15%?
 problems
• Soln : PV = A /(i - g)……………. Eqn #1
it is a perpetuity which is growing @ 10% p.a.
The formula
P = A/(1+g)[ ( 1-(1+i*)-n) /i*]
Here, n = ∞ , hence we get Eqn # 1
Solving for PV we obtain,
PV = 2/(0.15-0.10) = Rs 40
 WORKBOOK
• PART -1
– Page 25 onwards , questions-
109,120,123,134,133,131
• PART –II
– Page 109 onwards, questions -
9,12,18,21,33,43,50,85,103
 summary
• The concept of TVM refers to the fact that
the money received today is different in its
worth from the money receivable some
time in the future.
• Some business & personal decisions like
Capital recovery, Loan Amortization ,
returns from bonds etc can be effectively
determined using TVM.
Risk & Returns
 Topics

• Concept of Risk & Return

•Sources of risk
•Portfolio and risk
•CAPM ( Capital Asset Pricing Model)
 Concept of returns

•Required Returns (Ex post) are

statistically derived from historical
observations.

•Expected Returns (Ex ante) are

statistically derived expected values from
future estimates of observations.
 Probability & Returns

•In the world of uncertainty , the expected

returns may or may not materialize.
• The expected rate of return for any
asset is the weighted average rate of
return using the probability of each rate of
return as the weight.
 •E.g.:- consider the range of returns under the
possible states of economic conditions. What
rate of return can you expect ?

Economic Rate of Probability E(R)

conditions (1) Return(%) (3) (4)=(2)*(3)
(2)
Growth 18.5 0.25 4.63
Expansion 10.5 0.25 2.62
Stagnation 1.0 0.25 0.25
Decline -6.0 0.25 -1.50
6.00
 Risk & Returns

• Risk : the chance that the actual

outcome from an investment will differ
from the expected outcome.
•Investment decisions always involve a
trade off between risk & return.
 Sources of Risk

• Factors which make any financial

asset risky are:
1. Business Risk: industry/
environmental factors involved.
2. Market Risk: variability in returns due
to the fluctuations in the securities
market.
 Sources of Risk

3. Liquidity Risk: ease with which a

security can be bought or sold without
much transaction cost.

4. Financial Risk: influenced by the

degree of financial leverage
 Sources of Risk

5. Interest Rate Risk: changes in the

interest rates.

6. Inflation Risk: change in the inflation

influences the purchasing power of
the investors.
 Measuring Risk

•Risk of an asset can be measured in

terms of its variance.

•More the deviation from the expected

value , more riskier the asset.
 •E.g. :- Jenson & Nicholson, a paint company,
has the following dividend per share (DIV) and
the market price per share (AMP) for the period
87-92
Year DIV (Rs) AMP (Rs)
1987 1.53 31.25
1988 1.53 20.75
1989 1.53 30.88
1990 2.0 67.00
1991 2.0 100.00
1992 2.0 154.00

Calculate the annual returns(5yrs).how risky is the

share?
 solution
Div1 P1 − P0
Expected Return = r = +
P0 P0
R88 = [1.53 + 20.75-31.25]/ 31.25 = -0.287
Similarly,
R89 = 56.2%,R90 = 123.4%,R91 = 52.2%,R92 = 57%
Rm = 1/5 {-28.7+56.2+123.4+52.2+57} = 52%
To determine the riskness of the share, we calculate the
variation of the returns :
σ2 =1/5{ (-28.7-52)2 + (56.2-52)2 + (123.4 – 52)2 + (52.2-52)2 +
(57-52)2} = 2330.63 or S.D = 48.28
Probability distributions (Rev.)

• A listing of all possible outcomes, and the

probability of each occurrence.
• Can be shown graphically.

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return

 Investment alternatives

Economy Prob. GOI HLL HNC ACC MP

Recession 0.1 8.0% -22.0% 28.0% 10.0% -13.0%

Below avg 0.2 8.0% -2.0% 14.7% -10.0% 1.0%

Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0%

Above avg 0.2 8.0% 35.0% -10.0% 45.0% 29.0%

Boom 0.1 8.0% 50.0% -20.0% 30.0% 43.0%

Return: Calculating the expected return
for each alternative
^
k = expected rate of return
^ n
k = ∑ k i Pi
i=1

^
k HT = (-22.%) (0.1) + (-2%) (0.2)
+ (20%) (0.4) + (35%) (0.2)
+ (50%) (0.1) = 17.4%
Summary of expected returns for
all alternatives
Exp return
HLL 17.4%
Market 15.0%
ACC 13.8%
GOI 8.0%
HNC. 1.7%

HLL has the highest expected return, and appears

to be the best investment alternative, but is it
really? Have we failed to account for risk?
Risk: Calculating the standard deviation
for each alternative

σ = Standard deviation

σ = Variance = σ2
n
σ= ∑ (k
i=1
i
− k̂ ) Pi
2
Standard deviation calculation
σGOI = 0%
σHLL = 20%
σHNC = 13.4%
σACC = 18.8%
σM =15.3%
Comparing standard deviations

Prob.
GOI

ACC

HLL

0 8 13.8 17.4 Rate of Return (%)

 Comments on standard deviation
as a measure of risk
• Standard deviation (σi) measures total, or stand-
alone, risk.
• The larger σi is, the lower the probability that
actual returns will be closer to expected returns.
• Larger σi is associated with a wider probability
distribution of returns.
• Difficult to compare standard deviations, because
return has not been accounted for.
 Comparing risk and return
Security Expected return Risk, σ

GOIs 8.0% 0.0%

HLL 17.4% 20.0%
HNC* 1.7% 13.4%
ACC* 13.8% 18.8%
Market 15.0% 15.3%
 Coefficient of Variation (CV)
A standardized measure of dispersion about the
expected value, that shows the risk per unit of
return.

Std dev σ
CV = = ^
Mean k
 Risk rankings,
by coefficient of variation
CV
GOI 0.000
HLL 1.149
HNC. 7.882
ACC 1.362
Market 1.020

„ HNC has the highest degree of risk per unit of

return.
„ HLL, despite having the highest standard
deviation of returns, has a relatively average CV.
Illustrating the CV as a measure
of relative risk
Prob.

A B

0 Rate of Return (%)

σA = σB , but A is riskier because of a larger

probability of losses. In other words, the same
amount of risk (as measured by σ) for less returns.
 ACC Ltd courtesy: J P Morgan

ACC Ltd (250.800, 255.100, 248.300, 253.250, +3.20000) 300

250

200

150

40000
30000
20000
10000
x100
2002O N D 2003 M A M J J A S O N D 2004 M A M J J A
 Capital Market Theory

• Dominant principle
• Markowitz’s Portfolio theory
• Two asset portfolio
• Efficient frontier
• The CAPM
 The Dominance Principle
• States that among all investments with a
given return, the one with the least risk is
desirable; or given the same level of risk,
the one with the highest return is most
desirable.
 Dominance Principle Example
• Security E(Ri) σ
ATW 7% 3%
GAC 7% 4%
YTC 15% 15%
FTR 3% 3%
HTC 8% 12%
• ATW dominates GAC
• ATW dominates FTR
 Capital Market Theory
Markowitz Model
Markowitz model generates an efficient
frontier,which is a set of efficient portfolios.

• A portfolio is said to be efficient if it offers the

maximum expected return for a given level of
risk or minimum risk for a given level of expected
returns.
 Markowitz Diversification
• Although there are no securities with
perfectly negative correlation, almost all
assets are less than perfectly correlated.
Therefore, you can reduce total risk (σp)
through diversification. If we consider
many assets at various weights, we can
generate the efficient frontier.
 Risk revisited
• Unsystematic Risk
– ... is that portion of an asset’s total risk which
can be eliminated through diversification
• Systematic Risk
– ... is that risk which cannot be eliminated
– Inherent in the marketplace
 Diversification
Risk

75% of Co.
Total Risk
Unsystematic
Risk

25% of Co.
Systematic Risk Total Risk

1 5 10 20 30 No. of Assets
 Efficient Frontier
• The Efficient Frontier represents all the
dominant portfolios in risk/return space.
• There is one portfolio (M) which can be
considered the market portfolio if we
analyze all assets in the market. Hence,
M would be a portfolio made up of assets
that correspond to the real relative weights
of each asset in the market.
 Efficient Frontier (continued)
• Assume you have 20 assets.
• you can calculate all possible portfolio
combinations.
• The Efficient Frontier will consist of those
portfolios with the highest return given the
same level of risk or minimum risk given
the same return (Dominance Rule)
 Expected
Portfolio Efficient Set
Return, kp

Feasible Set

Risk, σp
Feasible and Efficient Portfolios
• The feasible set of portfolios represents all
portfolios that can be constructed from a
given set of stocks.
• An efficient portfolio is one that offers:
– the most return for a given amount of risk, or
– the least risk for a give amount of return.
• The collection of efficient portfolios is called
the efficient set or efficient frontier.
Expected
IB2 I
Return, kp B1

Optimal Portfolio
IA2 Investor B
IA1

Optimal Portfolio
Investor A

Risk σp
Optimal Portfolios
Selection of the O ptim al Portfolio
H ow w ill the investor go about selecting the
optim al portfolio?

Investors w ill have to consider their

indifference curves… .

Put the investor’s indifference curves and

the efficient frontier and go for the portfolio
on the farthest northw est indifference curve,
w here the indifference curve is tangent to the
efficient frontier.
• Indifference curves reflect an investor’s
attitude toward risk as reflected in his or her
risk/return tradeoff function. They differ
among investors because of differences in
risk aversion.
• An investor’s optimal portfolio is defined by
the tangency point between the efficient set
and the investor’s indifference curve.
Indifference Curves for a Risk-Averse Investor
E(R) I
4
I
Tangent Portfolio 3
I
2
I
1

σ
 Portfolio Selection for a Highly Risk-Averse
Investor
I
E(R) 4 I I
3 2
Tangent Portfolio I
1

σ
The optimal portfolios plotted along the curve have the
highest expected return possible for the given amount
of risk. (source:investopedia.com)
 What is the CAPM?

„ The CAPM is an equilibrium model that

specifies the relationship between risk and
required rate of return for assets held in well-
diversified portfolios.
„ Derived using principles of diversification with
simplified assumptions
„ Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development.
Slope and Market Risk Premium

M = Market portfolio
rf = Risk free rate
E(rM) - rf = Market risk premium

σM = Slope of the CAPM

E(r) = rf + (E (rM) – rf)ß

 What are the assumptions
of the CAPM?

• Investors all think in terms of

a single holding period.
• All investors have identical expectations.
• Investors can borrow or lend unlimited
amounts at the risk-free rate.

(More...)
 What are the assumptions
of the CAPM?
• There are no taxes and no
transactions costs.
• All investors are price takers, that is,
investors’ buying and selling won’t
influence stock prices.
• Quantities of all assets are given and
fixed.
 What impact does kRF have on
the efficient frontier?

• When a risk-free asset is added to the

feasible set, investors can create
portfolios that combine this asset with a
portfolio of risky assets.
• The straight line connecting kRF with M,
the tangency point between the line and
the old efficient set, becomes the new
efficient frontier.
 Efficient Set with a Risk-Free Asset

Expected Z
Return, kp
. B

^
k M
.
M

The Capital Market

kRF
A . Line (CML):
New Efficient Set

σM Risk, σp
 What is the Capital Market Line?

• The Capital Market Line (CML) is all

linear combinations of the risk-free asset
and Portfolio M.
• Portfolios below the CML are inferior.
– The CML defines the new efficient set.
– All investors will choose a portfolio on the
CML.
 The CML Equation

^
^ kM - kRF
kp = kRF + σ p.
σM

Intercept Slope
Risk
measure
 What does the CML tell us?

• The expected rate of return on any

efficient portfolio is equal to the risk-
free rate plus a risk premium.
• The optimal portfolio for any investor is
the point of tangency between the CML
and the investor’s indifference curves.
Expected
Return, kp
CML
I2
I1

^
k
^
kR
M

.
R
. M

R = Optimal
kRF Portfolio

σR σ M Risk, σp
What is the Security Market Line (SML)?

• The CML gives the risk/return

relationship for efficient portfolios.
• The Security Market Line (SML), also
part of the CAPM, gives the risk/return
relationship for individual stocks.
 The SML Equation

• The measure of risk used in the SML is

the beta coefficient of company i, ß.
• Where,
β = [COV(ri,rm)] / σm2
Slope, SML = E(rm) - rf
= market risk premium
SML = rf + β[E(rm) - rf]
 What are our conclusions
regarding the CAPM?

• Recent studies have questioned its

validity.
• Investors seem to be concerned with
both market risk and stand-alone risk.
Therefore, the SML may not produce a
correct estimate of ki.
(More...)
• CAPM/SML concepts are based on
expectations, yet betas are calculated
using historical data. A company’s
historical data may not reflect investors’
expectations about future riskiness.
• Other models are being developed that
will one day replace the CAPM, but it
still provides a good framework for
thinking about risk and return.
Cost of Capital
 Cost of capital
• Returns from the firms perspective
• Firm raises money from both equity investors
and lenders. Both group of investors make their
investments expecting to make a return .
• Firm’s average cost of funds, which is the
average return required by firm’s investors

• What must be paid to attract funds

What sources of long-term
capital do firms use?
Long-Term
Capital

Long-Term Preferred Stock Common Stock

Debt

Retained New Common

Earnings Stock
 Cost of equity/debt

• Expected returns for the equity investors,

would include a premium for the risk in the
investment….. Cost of equity

• Expected returns the lenders hope to

make on their investments, includes a
premium for default risk ….. Cost of debt.
 Weighted Average Cost of
Capital, WACC

• A weighted average of the component

costs of debt, preferred stock, and
common equity
⎡⎛ Proportion⎞ ⎛ After - tax ⎞⎤ ⎡⎛ Proportion ⎞ ⎛ Cost of ⎞⎤ ⎡⎛ Proportion ⎞ ⎛ Cost of ⎞⎤
= ⎢⎜ of ⎟ × ⎜ cost of ⎟⎥ + ⎢⎜ of preferred⎟ × ⎜ preferred⎟⎥ + ⎢⎜ of common⎟ × ⎜ common⎟⎥
⎢⎣⎜⎝ debt ⎟⎠ ⎜⎝ debt ⎟⎠⎥⎦ ⎢⎣⎜⎝ stock ⎟⎠ ⎜⎝ stock ⎟⎠⎥⎦ ⎢⎣⎜⎝ equity ⎟⎠ ⎜⎝ equity ⎟⎠⎥⎦

= wd k dT + w ps × k ps + ws × ks
 The Logic of the Weighted Average
Cost of Capital

•The use of debt impacts the ability to use

equity, and vice versa, so the weighted
average cost must be used to evaluate
projects, regardless of the specific financing
used to fund a particular project.
 Basic Definitions

• Capital Component
– Types of capital used by firms to raise
money
• kd = before tax interest cost
• kdT = kd(1-T) = after tax cost of debt
• kps = cost of preferred stock
• ks = cost of retained earnings
• ke = cost of external equity (new stock)
 After-Tax Cost of Debt

• The relevant cost of new debt

• The yield to maturity on outstanding LT debt
is often used as a measure
• Taking into account the tax deductibility of
interest
• Used to calculate the WACC
kdT = bondholders’ required rate of return
minus tax savings
kdT = kd - (kd x T) = kd(1-T)
 Cost of Preferred Stock

• Rate of return investors require on the

firm’s preferred stock
• The preferred dividend divided by the
net issuing price
D ps D ps D ps
k ps = = =
NP P0 − Flotation costs P0 (1 − F)
 Cost of Retained Earnings
• Rate of return investors require on the
firm’s common stock

D̂
k =k + RP = 1 + g = k̂
s RF P s
0
 Why is there a cost for retained
earnings?

• Earnings can be reinvested or paid out

as dividends.
• Investors could buy other securities,
earn a return.
• Thus, there is an opportunity cost if
earnings are retained.
Three ways to determine cost of
common equity, ks

1. CAPM: ks = kRF + (kM – kRF)b.

2. DCF: ks = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
Premium: ks = kd + RP.
What’s the cost of common
equity based on the CAPM?

kRF = 7%, RPM = 6%, b = 1.2.

ks = kRF + (kM – kRF )b.

= 7.0% + (6.0%)1.2 = 14.2%.

What’s the DCF cost of common
equity, ks? Given: D0 = Rs 4.19;
P0 = Rs 50; g = 5%.

D1 D0(1 + g)
ks = P + g = P +g
0 0

Rs 4.19(1.05)
= Rs 50 + 0.05

= 0.088 + 0.05
= 13.8%.
Suppose the company has
been earning 15% on equity
(ROE = 15%) and retaining
35% (dividend payout = 65%),
and this situation is expected
to continue.

What’s the expected future g?

 Retention growth rate:

g = (1 – Payout)(ROE) = 0.35(15%)
= 5.25%.

Here (1 – Payout) = Fraction retained.

Could DCF methodology be applied
if g is not constant?

• YES, nonconstant g stocks are

expected to have constant g at
some point, generally in 5 to 10
years.
• But calculations get complicated.
Find ks using the own-bond-yield-
plus-risk-premium method.
(kd = 10%, RP = 4%.)

ks = kd + RP

= 10.0% + 4.0% = 14.0%

• This RP ≠ CAPM RP.

• Produces ballpark estimate of ks.
What’s a reasonable final estimate
of ks?

Method Estimate
CAPM 14.2%
DCF 13.8%
kd + RP 14.0%
Average 14.0%
Industry survey reports…
Why is the cost of retained earnings
cheaper than the cost of issuing new
common stock?

1. When a company issues new

common stock they also have to pay
flotation costs to the underwriter.
2. Issuing new common stock may
send a negative signal to the capital
markets, which may depress stock
price.
Suppose new common stock had a
flotation cost of 15%. What is ke?

D0(1 + g)
ke = +g
P0(1 – F)

Rs 4.19(1.05)
= Rs 50(1 – 0.15) + 5.0%

Rs 4.40
= Rs 42.50
+ 5.0% = 15.4%.
 What’s the firm’s WACC
(ignoring flotation costs)?

WACC = wdkd(1 – T) + wpkp + wcks

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.
 What factors influence a company’s
composite WACC?

• Market conditions.
• Level of interest rates
• Tax rates
• The firm’s capital structure and dividend
policy.
• The firm’s investment policy. Firms with
riskier projects generally have a higher
WACC.
Should the company use the composite
WACC as the hurdle rate for each of its
projects?*
• NO! The composite WACC reflects the
risk of an average project undertaken by
the firm. Therefore, the WACC only
represents the “hurdle rate” for a typical
project with average risk.
• Different projects have different risks. The
project’s WACC should be adjusted to
reflect the project’s risk.
 Risk and the Cost of Capital

Rate of Return
(%) Acceptance Region

W ACC

12.0 H

10.5 A Rejection Region

10.0
9.5 B
8.0 L

Risk
0 Risk L Risk A Risk H
 Divisional Cost of Capital
Rate of Return
(%)
WACC
Division H’s WACC
13.0

Project H
11.0

10.0
Composite WACC
9.0 Project L
for Firm A

7.0 Division L’s WACC

Risk
0 RiskL Risk Average RiskH
 Take note
• Use of current cost of debt : the interest
rate the firm would pay if it issues the debt
today.
• when determining the market risk
premium, use current rate in both the
cases . i.e. current risk free rate & current
expected rate of return on the stock.
 Revision session

• Intro to FM
•Time value of Money
•Valuation of securities
•Risk & return
•Cost of capital
 Introduction to FM
• Three basic principles
1. Financing principle
2. Investment principle
3. Dividend principle.
 Introduction to FM
• What should be the goal of a
corporation?
– Maximize profit?
– Maximize the current value of the company’s
stock?
i.e PROFIT MAXIMISATION
OR
VALUE MAXIMISATION ??
THE FIRM
 Topics under TVM
• Introduction
• Future value of a single cash flow
• Present value of a single flow
• Multiple flows and Annuity
 Introduction
• The most important concept in finance
• Time preference for money
– Risk or uncertainty of future cash flows
– Preference for present consumption (PPP)
– Investment opportunities
• Time preference rate is generally
expressed by an interest rate.
What is the PV of Rs100 due in
3 years if k = 10%?

0 1 2 3
10%

PV = ? 100
Future Value of an Annuity

• Annuity: A series of payments of equal

amounts at fixed intervals for a specified
number of periods.
• Ordinary (deferred) Annuity: An annuity
whose payments occur at the end of each
period.
• Annuity Due: An annuity whose
payments occur at the beginning of each
period.
 Ordinary Annuity Versus
Annuity Due
Ordinary Annuity

0 1 2 3
k%

PMT PMT PMT

Annuity Due
0 1 2 3
k%

PMT PMT PMT

What’s the FV of a 3-year
Ordinary Annuity of Rs100 at
10%?

0 1 2 3
10%

100 100 100

110

121
FV = 331
What is the PV of this
Uneven Cash Flow Stream?

0 1 2 3 4
10%
100 300 300 -50
What is the PV of this
Uneven Cash Flow Stream?

0 1 2 3 4
10%
100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
Mathematical expressions: simplified
• Fn = P ( 1+i )n
the term ( 1+i )n is the CVF ( compound
value factor) .
We can make use of the tables for easy
reference. ( Formula Book – only for part-
B & C)
Eg: for i = 4% and n= 5 yrs , refer to 6th
column and the row corresponding to 5
years, the CVF/FVF is 1.217
Mathematical expressions: simplified
• Compound value of an annuity
Fn = A (FVAFn,i)
Present value of an annuity
PV = A ( PVAFn,i)
Compound value of an annuity due
Fn = A ( FVAFn,i)(1+i)
• Present value of an annuity due
PV = A ( PVAFn,i)(1+i)
 Problems
1. Mahesh deposits $5,000 in a savings
account earning 8% interest annually.

(a) How much will be in the account at the

end of the twelfth year?

(b) How many years would be required to

accumulate $20,000 under the same
assumptions?
 solution
(a) Future value
FV = PV(1 + i)n
FV = $5,000(1 + .08)12
FV = $5,000(2.518)
FV = $12,590

(b) $20,000 = $5,000(1 + .08)n

4 = (1.08)n
Read down the 8% column of the future value table until
the value 4 is found. The value 4 is not found exactly,
but it can be determined that N is approximately 18
years.
 Problem set #1 : solutions
1. Determine the future values utilizing a time preference
rate of 9 %:
(i) The future value of Rs. 15,000 invested now for a period
of 4 yrs.

(ii) The future value at the end of 5 yrs of an investment of

Rs 6000 now and of an investment of Rs. 6000 one
year from now.
(iii) The future value at the end of 8 years of an annual
deposit of Rs.18,000 each year.
(iv) The future value at the end of 8 years of an annual
deposit of Rs. 18000 at the beginning of each year.
(v) The future value at the end of 8 years of a deposit of Rs
18000 at the end of the first four years and withdrawal
of Rs.12, 000 per year at the end of year five through
seven.
 Solution # 1
• (i) time preference (discount rate) = 9%
investments = 15,000
time period = 4 yrs.
CVF(4,9%) = 1.4116 (appox.)
FV = 15,000*(1.09)4 = 15,000* 1.4116
= 21,173.72
(ii) Investments = 6000 (now) & 6000( 1 yr after)
period (eoy) = 5 yrs & 5yrs
compounding period = 5 & 4 yrs
CVF = 1.5386 & 1.4116
FV = 9231.74 & 8469.49
 Solution # 1
• (iii) Annual investments (eoy) = 18,000
time period = 8 yrs.
CVAF = 11.0285 (appox.)
FV = 18,000* 11.0285 = 198,513

(iv) Investments (b0y)= 18000

period = 8 yrs
CVAF (annuity due) = 12.0210
FV = 18000 * 12.0210 = 216378
 Solution # 1
withdrawal Balance
• (v)
annual investment for 4 yrs 18000

compounding value at the end of 4

yr 82316.32
compounding value at the end of 5
yr 89724.79 12000 77724.79
compounding value at the end of 6
yr 84720.02 12000 72720.0211

compounding value at the end of 7

yr 79264.82 12000 67264.823
compounding value at the end of 8
yr 73318.66 0 73318.65707
 problems
• A company is expected to declare a
dividend of Rs2 at the end of first year
from now and this dividend is expected to
grow 10% every year . What is the PV of
this stream of dividends if the rate of
interest is 15%?
 problems
• Soln : PV = A /(i - g)……………. Eqn #1
it is a perpetuity which is growing @ 10% p.a.
The formula
P = A/(1+g)[ ( 1-(1+i*)-n) /i*]
Here, n = ∞ , hence we get Eqn # 1
Solving for PV we obtain,
PV = 2/(0.15-0.10) = Rs 40
 Other forms of Annuity
• Perpetuity: it is an Annuity that occurs
indefinitely. (i.e. without a maturity)
P = A/I
E.g. , an investor expects a perpetual sum of
Rs 500 annually from his investments.
What is the present value of this perpetuity
if the interest rate is 10%.
soln : P = 500/0.10 = Rs 5000.
 Other forms of Annuity
Present value of a growing Annuity: the
periodic cash flows grow at a compounding
rate. E.g. Arun gets an annual salary of Rs
1,00,000 with the provision for an annual
increment of 10%.
P = A/(1+g)[ ( 1-(1+i*)-n) /i*]
Where, i* = (i-g)/(1+g)
 An Example…
• A dividend stream commencing one year
hence at Rs 66 is expected to grow at
10% annum for 15 Yrs and then ceases. If
the discount rate is 21%, what is the PV of
the expected series.
soln: P = A/(1+g)[ ( 1-(1+i*)-n) /i*]
Where, i* = (i-g)/(1+g)
i* =(0.21-0.10)/1.10 = 0.10
A/(1+g) = 66/1.10 = 60
 Valuation of Securities
• Bond valuation
• Equity valuation
 Concepts of valuation
• In general, the value of an asset is the
price that a willing and able buyer pays to
a willing and able seller
• Note that if either the buyer or seller is not
both willing and able, then an offer does
not establish the value of the asset
 Intrinsic Value
Intrinsic Value - The present value of the
expected future cash flows discounted at the
decision maker’s required rate of return

• The size and timing of the expected future

cash flows
• The individual’s required rate of return
• Note that the intrinsic value of an asset can be,
and often is, different for each individual (that’s
what makes markets work)
 Bond valuation : terminology
1. Par value : it is the value stated on the
face of the bond. It represents the
amount the firm borrows & promises to
repay at the time of maturity.
2. Coupon rate & Interest: a bond carries
a specific IR which is called the coupon
rate. The interest payable to the
bondholder is
= (par value of the bond * coupon rate)
3. Maturity Date - This is the date after
which the bond no longer exists
Calculating the Value of a Bond
The value of the bond can be expressed as :

INT INT M
VB = 1
+ ... + N
+ N
(1 + k d ) (1 + k d ) (1 + k d )
Where,
INT = annual coupon payment
Kd = req. rate of return/discount rate
N = time period.

VB = INT *PVAFn,i + M* PVFn,i

 Yield To Maturity
Yield to maturity (YTM) : rate of return earned on
bond held until maturity
The IR when:
Price of the bond = PV of all cash flow
receivables
Eg : par value : Rs 1000, CI = 9%,time to maturity
= 8and currently priced at Rs 800. what will be
the yield to maturity?
sol: An appox.
= INT + (M-P)/n
0.4M + 0.6 P
= 13.06%
 examples
#1: the govt. is proposing to sell a 5-year
bond of Rs 1000 @ 8% IR per annum. The
bond amount will be amortized equally
over its life. If an investor has a minimum
required rate of return of 7%, what is the
bonds present value for him?
 solution
Sol #1:the amt of interest will go on reducing
because of amortization. The amount of
interest for five years will be :
Rs 1000 * 0.08 = Rs 80
Rs (1000 – 200)*.08 = Rs 64
P = 280/(1+0.07) +264/(1+0.07)2
…+216/(1+0.07)5
= Rs 1025.66
 Valuing Common Stocks
Dividend Discount Model - Computation of today’s
stock price which states that share value equals
the present value of all expected future
dividends.

Div1 Div2 Div H + PH

P0 = + +...+
(1 + r ) (1 + r )
1 2
(1 + r ) H

H - Time horizon for your investment.

 Valuing Common Stocks
Example
Current forecasts are for XYZ Company to pay
dividends of Rs3, Rs3.24, and Rs3.50 over the
next three years, respectively. At the end of three
years you anticipate selling your stock at a market
price of Rs94.48. What is the price of the stock
given a 12% expected return?

3.00 3.24 3.50 + 94.48

PV = + +
(1+.12 ) (1+.12 )
1 2
(1+.12 ) 3

PV = Rs 75
 Valuing Common Stocks
Constant Growth DDM - A version of the dividend
growth model in which dividends grow at a
constant rate (Gordon Growth Model).

Div1
P0 =
r−g
Given any combination of variables in the
equation, you can solve for the unknown
variable.
 Concept of returns

•Mean Returns (Ex post) are statistically

derived from historical observations.

•Expected Returns (Ex ante) are

statistically derived expected values from
future estimates of observations.
 Sources of Risk

• Factors which make any financial

asset risky are:
1. Business Risk: industry/
environmental factors involved.
2. Market Risk: variability in returns due
to the fluctuations in the securities
market.
 Sources of Risk

3. Liquidity Risk: ease with which a

security can be bought or sold without
much transaction cost.

4. Financial Risk: influenced by the

degree of financial leverage
 Sources of Risk

5. Interest Rate Risk: changes in the

interest rates.

6. Inflation Risk: change in the inflation

influences the purchasing power of
the investors.
 Measuring Risk

•Risk of an asset can be measured in

terms of its variance.

•More the deviation from the expected

value , more riskier the asset.
 Capital Market Theory

• Dominant principle
• Markowitz’s Portfolio theory
• Two asset portfolio
• Efficient frontier
• The CAPM
 Diversification
Risk

75% of Co.
Total Risk
Unsystematic
Risk

25% of Co.
Systematic Risk Total Risk

1 5 10 20 30 No. of Assets
Probability distributions (Rev.)

• A listing of all possible outcomes, and the

probability of each occurrence.
• Can be shown graphically.

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return

The optimal portfolios plotted along the curve have the
highest expected return possible for the given amount
of risk.
 Efficient Set with a Risk-Free Asset

Expected Z
Return, kp
. B

^
k M
.
M

The Capital Market

kRF
A . Line (CML):
New Efficient Set

σM Risk, σp
 What is the Capital Market Line?

• The Capital Market Line (CML) is all

linear combinations of the risk-free asset
and Portfolio M.
• Portfolios below the CML are inferior.
– The CML defines the new efficient set.
– All investors will choose a portfolio on the
CML.
 The CML Equation

^
^ kM - kRF
kp = kRF + σ p.
σM

Intercept Slope
Risk
Measure
Expected
Return, kp
CML
I2
I1

^
k
^
kR
M

.
R
. M

R = Optimal
kRF Portfolio

σR σ M Risk, σp
What is the Security Market Line (SML)?

• The CML gives the risk/return

relationship for efficient portfolios.
• The Security Market Line (SML), also
part of the CAPM, gives the risk/return
relationship for individual stocks.
 The SML Equation

• The measure of risk used in the SML is

the beta coefficient of company i, ß.
• Where,
β = [COV(ri,rm)] / σm2
Slope, SML = E(rm) - rf
= market risk premium
SML = rf + β[E(rm) - rf]
 ABOUT BETA …..

• If beta = 1.0, stock is average risk.

• If beta > 1.0, stock is riskier than
average.
• If beta < 1.0, stock is less risky than
average.
• Most stocks have betas in the range of
0.5 to 1.5.
 BETA FOR Portfolios….(?)

• Betas of individual securities are not

good estimators of future risk.
• Betas of portfolios of 10 or more
randomly selected stocks are
reasonably stable.
• Past portfolio betas are good estimates
of future portfolio volatility.
 Question # 3
• The risk free rate is 8%. The expected
return on the market portfolio is 16%.
Calculate the expected return on the
following securities.
security beta
A 0.4
B 1.0
C 2.6
D 2.0
 Solution # 3
• Given, risk free rate security ß

8%. … R(f) R(f) + beta*(R(m) –R(f))

• The expected return A 0.4 11.20%
on the market B 1 16.00%
portfolio 16%... R(m) C 2.6
28.80%
D 2
24.00%
 Question # 4
• Calculate the beta Prob. Market Invest.
factor of the following
investments. Is 1/3 9% 6%
acceptance of the
investment worthwhile
1/3 12% 30%
based upon its level
of risk? The risk free
rate = 6%. 1/3 18% 18%
 Solution # 4
P(1)(2)
prob(P) Rm -Avg(Rm) Ri -Avg (Ri) P*(Rm-Avg(Rm))^2

(1) (2)

0.158
0.33 -4.00 -12.00% 5.28

-0.036
0.33 -1.00 12.00% 0.33

0.33 5.00 0.00% 8.25 0

13.86 0.12

Beta = Cov(i,m)/ σm2 = 0.12/.1386 = 0.86

Using CAPM, R(i) = R(f) +ß*(R(m) – R(f)) = 12%
∴ Expected return (18%) > req. return (12%),hence the
investment can be accepted.
 Question # 5
• The std. deviation of returns of the
security ‘s’ 20% & that of the market
portfolio is 15%.calculate beta . When,
1. Cor (s,m)=0.7
2. Cor (s,m)=0.4
3. Cor (s,m)= -0.25
 Solution # 5

Beta = Cov(s,m)/ σm2 = σsσm cor(s,m)/ σm2

Solving for the given values, we obtain …

1. 20*15*0.7/225 = 0.93
2. 0.53
3. -0.33
 Question # 6
• The expected return on the market portfolio & the
risk free rate of return are estimated to be 13% &
9% resp. ABC Ltd. Has Just paid a dividend of Rs.
2per share with annual growth rate of 7%. The
sensitivity index (beta) of ABC has been found to be
1.2
1. Find out the equilibrium price for the shares of ABC
Ltd.
2. Examine the change in the price if
(i) risk premium increases by 2%
(ii) expected growth rate of dividends increases to
10%
(iii) market sensitivity index becomes 1.3 for the
script.
 Solution # 6

• Using CAPM, R(i) = R(f) +ß*(R(m) – R(f))

the req. rate of return(R) = 9% +1.2*(13-9)=13.8%
Now , R = 13.8%
D = Rs. 2
g = 7%
1. The equilibrium price (P) = D(1+g)/ (R-g)…Annuity
due
or, P = 2.14/ .068 = Rs. 31.47
 Solution # 6
2. Effect on price :

(i) if the risk premium increases by 2%,

Then R = 13.8% +2%
Therefore the equilibrium price (P) = Rs. 24.32

(ii) g=10%
We obtain, P =Rs. 57.9

(iii) Beta = 1.3 then, R = 14.2%

Hence , P = Rs. 29.72
 Multiple choice
• If the market return is below the risk free
rate, then the stocks which possess high
systematic risk gives returns which
_________ as compared to the stocks
which have a low systematic risks.
1. Are lower
2. Are higher
3. Cannot be determined
4. None of the above
 Multiple choice
• Of the following, the systematic risk
encompasses:
1. Business risk
2. Financial risk
3. Interest rate risk
4. Inflation risk
 Multiple choice
• A stock will not have a finite Beta if
1. Its correlation with the market is –ve
2. The stock is highly volatile
3. The market index is stagnant
4. Both (2) & (3)
5. None of the above.
 Multiple choice
• The ratio of non-diversifiable risk to total
risk can be symbolically depicted by
1. The square of the correlation coefficient
2. The beta
3. The root of beta
4. The ratio of stock volatility to market
volatility
5. None of the above.
 Multiple choice
• An economic survey Asset Beta Correlation Residual
suggests that an with market variance
returns (%
economic boom is in squared)
offering. The following
data are available with
A 1.5 0.9 6
regards to asset A and B
B 0.1 0.1 2

1. Buy A
2. Sell A
3. Invest half of funds in A & other half in B
4. Buy B
 CAPM-Assumptions
• Individual investors are price takers.
• Single-period investment horizon.
• Investments are limited to traded financial
assets.
• No taxes and transaction costs.
 Assumptions (cont’d)
• Information is costless and available to all
investors.
• Investors are rational mean-variance
optimizers.
• There are homogeneous expectations.
 What are our conclusions
regarding the CAPM?

• Recent studies have questioned its

validity.
• Investors seem to be concerned with
both market risk and stand-alone risk.
Therefore, the SML may not produce a
correct estimate of ki.
(More...)
 Cost of capital
• Returns from the firms perspective
• Firm raises money from both equity investors
and lenders. Both group of investors make their
investments expecting to make a return .
• Firm’s average cost of funds, which is the
average return required by firm’s investors

• What must be paid to attract funds

What sources of long-term
capital do firms use?
Long-Term
Capital

Long-Term Preferred Stock Common Stock

Debt

Retained New Common

Earnings Stock
 Cost of equity

• Expected returns for the equity investors

would include a premium for the risk in the
investment….. Cost of equity

• Expected returns the lenders hope to

make on their investments includes a
premium for default risk ….. Cost of debt.
 The Logic of the Weighted Average
Cost of Capital

•The use of debt impacts the ability to use

equity, and vice versa, so the weighted
average cost must be used to evaluate
projects, regardless of the specific financing
used to fund a particular project.
 Basic Definitions

• Capital Component
– Types of capital used by firms to raise
money
• kd = before tax interest cost
• kdT = kd(1-T) = after tax cost of debt
• kps = cost of preferred stock
• ks = cost of retained earnings
• ke = cost of external equity (new stock)
 After-Tax Cost of Debt

• The relevant cost of new debt

• The yield to maturity on outstanding LT debt
is often used as a measure
• Taking into account the tax deductibility of
interest
• Used to calculate the WACC
kdT = bondholders’ required rate of return
minus tax savings
kdT = kd - (kd x T) = kd(1-T)
 Cost of Preferred Stock

• Rate of return investors require on the

firm’s preferred stock
• The preferred dividend divided by the
net issuing price
D ps D ps D ps
k ps = = =
NP P0 − Flotation costs P0 (1 − F)
 Cost of Retained Earnings
• Rate of return investors require on the
firm’s common stock

D̂
k =k + RP = 1 + g = k̂
s RF P s
0
 Weighted Average Cost of
Capital, WACC

• A weighted average of the component

costs of debt, preferred stock, and
common equity
⎡⎛ Proportion⎞ ⎛ After - tax ⎞⎤ ⎡⎛ Proportion ⎞ ⎛ Cost of ⎞⎤ ⎡⎛ Proportion ⎞ ⎛ Cost of ⎞⎤
= ⎢⎜ of ⎟ × ⎜ cost of ⎟⎥ + ⎢⎜ of preferred⎟ × ⎜ preferred⎟⎥ + ⎢⎜ of common⎟ × ⎜ common⎟⎥
⎢⎣⎜⎝ debt ⎟⎠ ⎜⎝ debt ⎟⎠⎥⎦ ⎢⎣⎜⎝ stock ⎟⎠ ⎜⎝ stock ⎟⎠⎥⎦ ⎢⎣⎜⎝ equity ⎟⎠ ⎜⎝ equity ⎟⎠⎥⎦

= wd k dT + w ps × k ps + ws × ks
Three ways to determine cost of
common equity, ks

1. CAPM: ks = kRF + (kM – kRF)b.

2. DCF: ks = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
Premium: ks = kd + RP.
Cost of Capital and Firm Value
A Pictorial View

WACC lowest
 What factors influence a company’s
composite WACC?

• Market conditions.
• Level of interest rates
• Tax rates
• The firm’s capital structure and dividend
policy.
• The firm’s investment policy. Firms with
riskier projects generally have a higher
WACC.
 mistakes to avoid
• Use of current cost of debt : the interest
rate the firm would pay if it issues the debt
today.
• when determining the market risk
premium, use current rate in both the
cases . i.e. current risk free rate & current
expected rate of return on the stock.
 Important !!!
• Group A – Money Market in India (**)
• Group B – Indian F/O Market ()
• Group C – Trading & Exchange (*)
• Group D – listing in foreign Exchanges ()
• Group E - FOREX Market (**)
• Group F – financial Institutions- developmental/NBFC
(***)
• Group G – Function of RBI (***)
• Group H – financial sector reforms (***)
• Group I – Indian Banking System (***)
 Important!!

• See problem number 64 and 71 of

workbook . (page # 583 and page# 585)