Time Value of Money

Practical Application
of
Compounding & Discounting
 When FV is known
• Company is establishing a fund to retire
for Rs 5,00,000 at 6% for 10 years.
The company plans to put a fixed amount
into the fund for 10 years.
 Solution
• This problem is related to the process of
finding the compounded sum of an
annuity.
• And we know Table A-2 will solve this
purpose.
• So, finding the value in the table which
comes to 13.181
• =500000/ 13.181=37933.39 amount of
Rs. To be deposited each year @6%
for 10 years.
 When PV is known
• Taken a loan of Rs.10,00,000 at 12% for 5
years.
• Calculate EMI.
 Solution
• This problem relates to Loan amortization.
• The loan process involves finding the
future payments to be made.
• Under table A-4 THE value comes 3.605
• So, 1000000/ 3.605=277393
Thus 277393 is to be paid for 5 years to
repay the principal & interest on 1000000
@12% for 5 years.
 A small example
• How the TOTAL Component is broken into:
1. Principal
2. Interest
3. Total payment (EMI)
4. Principal balance at end.
Loan amount:10000
Tenure:3 yrs.
Interest:10%
 Have a look 
• First see in table A-4
Which comes:2.487
• 10000 / 2.487=4020.9
EMI
Yr. Loan Interest. Princip EMI Principal
O/S al at end.
1 10000 1000 3021 4020 6978.8

2 6978.8 697.8 3323.3 4020 3655.48

3 3655.48 365.5 3655.4 4020 0

 Risk & Return
• Know what is rate of return
• Determine risk and return of a portfolio
• Diversification and Portfolio risk
• Calculation of Beta
• Relationship between risk and return
 INTRODUCTION
• Risk is present in virtually every decision. When
a production manager selects on equipment, or
a marketing manager make an advertising
campaign, or a finance manager make a
portfolio of securities all of them face uncertain
cash flows. Assessing risks and incorporating
the same in the final decision is an integral part
of financial analysis.
• The objective in decision making is not to
eliminate or avoid risk - often it may be neither
feasible nor necessary to do so - but to properly
assess it and determine whether it is worth
bearing.
RISK AND RETURN OF A SINGLE ASSET
• Risk and return may be defined for a single asset
or a portfolio of assets. We will first look at risk
and return for a single asset and then for a
portfolio of assets.

• Rate of Return:-The rate of return on an asset for

a given period (usually a period of one year) is
defined as follows:

• Rate of return =Annual income/ dividend

+
Ending price - Beginning price
Beginning price
• To illustrate, consider the following
information about a certain equity stock.
• Price at the beginning of the year: Rs. 60.00
• Dividend paid at the end of the year: Rs. 2.40
• Price at the end of the year: Rs. 69.00
• The rate of return on this stock is
calculated as follows:

• 2.40 + (69.00 - 60.00)

60.00

= 0.19 or 19 %
• It is sometimes helpful to split the rate of return
into two components, viz., current yield and
capital gains/loss yield as follows:

Annual income + Ending price - Beging price

Beginning Price Beginning price
• Current yield Capital gains/loss yield
• The rate of return of 19 per cent in our
example may be broken down as follows:

• 2.4 + 69-60
60 60
=4% + 15% =19%
current capital gain
yield yield
 Probability Distribution
• When we invest in a stock we know that the return
from it can take various possible values. For
example, it may be - 5 per cent, or 15 per cent, or
35 per cent. Further, the likelihood of these
possible returns can vary. Hence, you should
think in terms of a probability distribution.
• The probability of an event represents the
likelihood of its occurrence. Suppose we say that
there is a 4 to 1 chance that the market price of a
stock A will rise during the next fortnight. This
implies that there is an 80 per cent chance that
the price of stock A will increase and 20 per cent
chance that it will not increase during the next
fortnight.
• Your judgment can be represented in the
form of a probability distribution as follows:
• Outcome Probability
• Stock price will rise 0.80
• Stock price will not rise 0.20
 When we define the probability distribution of
rate of return (or for that matter any other
variable) remember that:

• The probability assigned to an outcome

may vary between 0 and 1. (An impossible
event is assigned a probability of 0, a
certain event a probability of 1, and an
uncertain event a probability somewhere
between 0 and 1).

• The sum of the probabilities assigned to

various possible outcomes is 1.
• Example1:Probability Distributions of the
Rate of Return on Essar Stocks and
GESCO Stock
• State of Prob. Of RoR on RoR on
Economy occurrence Essar GESCO
BOOM .30 25 40
NORMAL .50 20 10
RECESSION .20 15 -20
• Based on the probability distribution of the rate of
return, you can compute two key parameters, the
expected rate of return and the standard deviation
of rate of return.

• Expected Rate of Return

• The expected rate of return is the

weighted average of all possible returns
multiplied by their respective probabilities.
• The expected rate of return on Essar stock is:
• RE = (0.30) (25%) + (0.50) (20%) + (0.20) (15%)
• = 20.5%

• Similarly, the expected rate of return on GESCO

stock is:
• RG = (0.30) (40%) + (0.50) (10%) + (0.20) (-
20%)
• = 13.0%
Standard Deviation of Return
• Risk refers to the dispersion of a variable.
It is commonly measured by the variance
or the standard deviation. The variance of
a probability distribution is the sum of the
squares of the deviations of actual returns
from the expected return, weighted by the
associated probabilities.
 RISK AND RETURNS OF A
PORTFOLIO
• Most investors invest in a portfolio of assets,
as they do not want to put all their all eggs in
one basket. Hence, what really matters to
them is not the risk and return of stocks in
isolation, but the risk and return of the
portfolio as a whole.
 Expected Return on a Portfolio
• The expected return on a portfolio is simply the weighted
average of the expected returns on the assets comprising the
portfolio. For example, when a portfolio consists of two
securities, its expected return is:

• Rp = x1R1 + (1 - x1)R2

• where Rp = expected return on a portfolio

• x1 = proportion of portfolio invested in security 1
• R1 = expected return on security 1
• (1 - x1) = proportion of portfolio invested in security 2
• R2 = expected return on security 2.
• To illustrate
• Consider a portfolio consisting of two
securities A and B.
• The expected return on these two securities
are 10 per cent and 18 per cent respectively
• The expected return on the portfolio, when
the proportions invested in A and B are 0.4
and 0.6
• It is simply; 0.4 x10 + 0.6 x 18 = 14.8%.
• In general, when a portfolio consists of n
securities, the expected return on the
portfolio is:
• Rp = xi Ri
• Where Rp = expected return on portfolio
• xi = proportion of portfolio invested in
security i.
• Ri = expected return on security i.
• To illustrate consider a portfolio consisting of five
securities with the following expected returns R1
= 10 per cent, R2 = 12 per cent, R3 = 15 per
cent, R4 = 18 per cent and R5 = - 20 per cent.
The portfolio proportions invested in these
securities are: x1 = 0.1, x2 = 0.2, x3 = 0.3, x4 =
0.2, and x5 = 0.2. The expected portfolio return
is
• Rp = x1R1 + x2R2 + x3R3 + x4R4 + x5R5
• = 0.1 x 10 + 0.2 x 12 + 0.3 x 15 + 0.2 x 18 + 0.2
x 20 = 15.5 per cent
 Types of Risk (s)
Total risk = Unique risk + Market risk
• The unique risk of a security represents that
portion of its total risk which stems from firm
specific factors like the development of a new
product, a labor strike, or the emergence of a new
competitor. Events of this nature primarily affect
the specific firm and not all firms in general.
• Hence, the unique risk of a stock can be washed
away by combining it with other stocks. In a
diversified portfolio, unique risks of different stocks
tend to cancel each other a favorable development
in one firm may offset an adverse happening in
another and vice versa. Hence, unique risk is also
referred to as diversifiable risk or unsystematic
risk.
• The market risk of a stock represents that portion
of its risk which is attributable to economy wide
factors like growth rate of GNP, the level of
government spending, money supply, interest rate
structure, and inflation rate.
• Since these factors affect all firms to a greater or
lesser degree, investors cannot avoid the risk
arising from them, however diversified their
portfolios may be. Hence, it is also referred to as
systematic risk (as it affects all securities) or non-
diversifiable risk. In other words this type of risk
cannot be eliminated.
 Mutual fund schemes may be classified on the basis of its
structure and its investment objective.
• 1. By Structure:
• a. Open-ended Funds: An open-end fund is one that is
available for subscription all through the year. These do not
have a fixed maturity. Investors can conveniently buy and sell
units at Net Asset Value ("NAV") related prices. The key
feature of open ended funds is liquidity and they can be
redeemed any time the investors wants.

• b. Closed-ended Funds: A closed-end fund has a stipulated

maturity period which generally ranging from 3 to 15 years.
The fund is open for subscription only during a specified
period. Investors can invest in the scheme at the time of the
initial public issue and thereafter they can buy or sell the units
of the scheme on the stock exchanges where they are listed.
In order to provide an exit route to the investors, some close-
ended funds give an option of selling back the units to the
Mutual Fund through periodic repurchase at NAV related
prices. SEBI Regulations stipulate that at least one of the two
exit routes is provided to the investor.
 Banking sector reforms

• Since 1991, major changes have been made in

respect of the working of banks in India. These
were necessary because the operational
efficiency of the banking system had become
unsatisfactory, characterized by low profitability,
high and growing non-performing assets (NPA),
and relatively low capital base. The reforms
have had general and specific objectives . The
introduction of prudential regulation for ensuring
the safety and soundness of banks
 Required Rate of Return
• The concept of required rate of return plays an
important role in the valuation of assets and in
both financial and real investment decisions.
• The RRR for a security is defined as the
minimum expected rate of return needed to
induce or persuade an investors to purchase the
security at a given level of risk.
• The RRR has two components, first the risk –
free rate of return or the real rate of return . The
second component of RRR is risk premium.
 Contd…
• The rational risk-averse investor purchasing an asset expect to
be compensated for the risk. The premium for risk must reflect
all the uncertainty involved in investing in the securities. Thus ,
• Required rate of return => The pure time value of money +
inflation premium + Risk premium.
OR
• Required rate of return => Risk free rate of return
+
Risk premium ( For taking the
risk )
It must be noted that rate of return may change over a period of
time and the required rate of return and interest rates are
positively related . This is different from expected rate of return
and required rate of return it is important to note the distinction
between the two terms and the objective of maximizing the
return can be pursued only at the cost of incurring higher risk.
The financial market offers a wide range of assets from safe to
very risky bu