I Unit Assignment Amritraj 5 Batch

8/2/2019 I Unit Assignment Amritraj 5 Batch

http://slidepdf.com/reader/full/i-unit-assignment-amritraj-5-batch 1/51

FINANCIAL MANAGEMENT

UNIT-I

1. AN OVERVIEW OF FINANCIAL MANAGEMENT

2. TIME VALUE OF MONEY

3. RISK & RETURN

4. VALUATION OF BONDS & SHARES

5. OPTION VALUATION

1. AN OVERVIEW OF FINANCIAL MANAGEMENT



1. INTRODUCTION TO FM2. EVOLUTION OF FM3. SCOPE OF FM4. OBJECTIVES OF FM5. GOALS OF FM6. FINANCE FUNCTIONS7. INTER-RELATION AMONG FINANCIAL DECISIONS8. INTEFACE OF FM WITH OTHER DISCIPLINES9. DIMENSIONS OF FM10. ACTIVITIES, ROLE & FUNCTIONS OF FINANCIAL MANAGER

11. ORGANIZATION OF FINANCE FUNCTION12. RESPONSIBILITIES OF FINANCIAL MANAGEMENT13. CORPORATE MANAGEMENT14. AGENCY PROBLEM15. APPENDIX

An overview of Financial Management

Financial

Maximization of

Financial DecisionInvestm

entLiquidi

tyFinancing

DividendReturn Risk



Trade -off

1. INTRODUCTION TO FINANCIAL MANAGEMENT

Financial Management is the part of management which is concerned mainly withraising funds in the most economic and suitable manner

Financial management provides the best guideship for present and future resourceallocation of Firm



Financial management is dynamic in the making of day-to-day financial decisions ina business of any size

Financial management is concerned with three activities

Definitions

“Financial Management is the operational activity of business that is responsible for obtaining and effectively utilizing the funds for efficient operations” -Joseph & Massie

“Financial Management is an area of financial decision-making, harmonizing individualmotives and enterprise goals”

-Weston & Brigham

“Financial management is the application of the planning & control functions to thefinance functions”

-Archer & Ambrosia

2. EVOLUTION OF FINANCIAL MANAGEMENT

Financial Management has emerged as a distinct field of study only in the early part of this century as a result of consolidation movement & formation of large enterprises

Its evolution may be divided into three phases

Activities

Anticipating financial

needs

Acquiring FinancialResources

Allocating Funds

in

Evolution



The Traditional Phase

This phase has lasted about four decades In this phase the focus on FM was on four selected aspects

➢ It treats entire aspects of finance from outsider’s point of view➢ It place much importance on corporation finance➢ The sequence of treatment was on certain episodic events➢ It placed heavy emphasis on long-term financing institutions

The Transition Phase

It has been around early 1940’s and continued through the early 1950’s The nature of FM in this phase is almost similar to that of earlier phase but more

emphasis was given to the day-to-day problems Capital budgeting techniques were developed in this phase

The Modern Phase

It has begun in the mid 1950’s The Main issue of this phase is rational matching of funds to their uses, which leads to

the maximization of shareholder’s wealth This phase witnessed significant development

3. SCOPE OF FINANCIAL MAGEMENT

The scope of Financial Management is included in the following two approaches

Traditional Phase

Transition Phase

ModernPhase

TraditionalApproach

ModernApproach



The Traditional Approach

The scope of FM in traditional approach was in the narrow sense The field of FM was interrelated with the following aspects

➢ Raising of funds from financial institutions➢ Raising of funds through financial instruments shares/bonds➢ The legal & Accounting relationships between an enterprise & its sources of

funds The following criticism argued against traditional approach

➢ Ignored day-to-day problem➢ Outsider-looking-in approach➢ Ignored working capital Financing➢ Ignored allocation of capital

The Modern Approach

Modern approach scope is wider, since it covers conceptual and analytical framework for financial decision making

The main contends of this new approach are➢ What is the total volume of funds an enterprise should commit?➢ What specific assets should an enterprise acquire?➢ How should the funds required be financed?

The above three questions related to the three decisions of Financial Management➢ Financing Decision➢ Investment Decision➢ Dividend Decision

4. OBJECTIVES OF FM

Aim of FM concerned with acquisitions, financing and management of assets withsome overall goal in mind.

Anticipation of

Acquire the

Allocation of funds

Increase Profitability

Maximizing Firm’s



Anticipation of Necessary Funds

In the series of financial decisions, investment decision takes first place, but beforegoing to identify the investment assets or projects there is a need to evaluate theavailable investment or projects

Acquire the anticipated funds

The main aim or finance function is to assess the required needs of affirm and thenarrange the funds needed to raising sources of finance

Allocation of funds

Efficient allocation o utilization of funds is the objective of modern finance function Efficient allocation means investing funds on profitable projects

Increase Profitability

Proper planning & control of finance function aims at increasing profitability of thefirm

Control of operations like cash receipts & payments helps to increase profits

Maximizing Firm’s value

The primary objective of any function in any organization is to maximize firm’s value by taking right decisions so as to finance function.

5. Goals of Financial Management

There are two widely accepted goals of Financial Management

Profit Maximization

Goals



Profit is primary motivating force for any economic activity Profit maximization means maximizing rupee (or any other currency) income of

firms Profit ensures maximum welfare to the shareholders, employees and prompts

payment to creditors of a company Profit maximization increases the confidence of management in expansion and

diversification programmes of a company

It suffers the following limitations

➢ It is vague➢ It ignores Time value of Money➢ It ignores quality of benefits

It is Vague

The term profit is value and it does not clarifies what exactly does it mean It has different interpretations such as short-term or long-term, total profit or net

profit, profit before tax or profit after tax.

Ignores Time value of Money

The profit maximization goal does not help in distinguishing between the returnsreceivable in different periods

It gives equal importance to all earnings though the receivable is different periods

Ignores quality of benefits

Quality refers to the degree of certainty with which benefits can be expected The more certain expected benefits, the higher are the quality of benefits and vice

versa.

Shareholder’s Wealth Maximization

The goals of financial management may be such that they should be beneficial toowners, management, employees & customers

These goals may be achieved only by maximizing the value of firm The elements involved in the maximization of the wealth of the firm is given below

Elements



The wealth maximization guides the management in framing consistent strong dividend policy, to earn minimum returns to the equity holders

Shareholders wealth maximization means maximizing Net Present Value (NPV) of acourse of action to shareholders.

The shareholders wealth can be derived more explicitly by using the formula

W= C1F1 C1F2 …….. C1Fn ICo

(1+r)1 (1+r)2 (1+r)n

➢ W-Net present Worth➢ C1F1, C1F2…-Cash inflows➢ ICo-Initial Cash outflow to buy the assets➢ r=Expected Rate of Return

Criticisms of Wealth maximization

The objective of wealth maximization is not descriptive The concept of increasing the wealth of the shareholders differs from one business to

another. It also leads to confusion and misinterpretation of financial policy.

Alternative goals

There are several alternative goals which will help to maximize value of the firm or market price per share.

➢ Maximization of return on Equity (ROE)➢ Maximization of Earnings per Share (EPS)➢ Management of reserves for growth & Expansion

6. FINANCE FUNCTION

Finance function or decisions include➢ Investment or long-term asset-mix decision➢ Financing or capital-mix decision➢ Dividend or profit allocation decision➢ Liquidity or short-term asset-mix decision

Increase in

profits

Reduction incost

Judicious

choice

Minimized risk

Long-run

Value

Investment

Financing Decision

DividendDecision

FinanceFunction



Investment Decision

Investment decision or capital budgeting involves the decision of allocation of capitalor commitment of funds or long term assets

Two important aspects of investment are➢ The evaluation of the prospective profitability of new investments➢ The measurement of a cut-off rate against the prospective return of new

investment

Financing Decision

Financing decision is the second important function to be performed by the financialmanager

The financial manager must strive to obtain the best financing mix or the optimumcapital structure

Dividend decision

Dividend decision is the third major decision. The financial manager must decidewhether the firm should distribute all profits or retain them or distribute a portion andretain the balance

The optimum dividend policy is one that maximizes the market value of the firms’shares

Liquidity Decision

Current assets management that affects a firms’ liquidity is yet another importancefinance decision

Current assets should be managed efficiently for safeguarding the firm against thedangers of illiquidity and insolvency.

7. INTER-RELATION AMONG FINANCIAL DECISIONS

The three financial decisions are different kinds of financial management decisions, but these decisions are inter-related due to that the underlying objective of all thethree decisions is maximization of shareholder’s wealth.

The financial decisions are not independent, they are inter-related to each other.

Liquidity Decision

Investment Decision

Financing Decision

Dividend

Decision



1. Inter-relation between Investment decision & Financing Decision

Under the investment decision financial manager will decide what type of asset or project should be selected.

There is a interrelation between investment decision and financing decision;without knowing the amount of funds required & types of funds it is not possibleto raise funds

Investment decision & financing decision cannot be independent. They aredependent on each other.

1. Interrelation between Financing decision & Dividend Decision

Financing decision influences and is influenced by dividend assets or projectsreduces the profit available to ordinary shareholder’s there by reducing dividend payout ratio.

Hence, there is an interrelation between financing decision & dividend decision

1. Inter-relation between Investment decision & dividend decision

Dividend decision & investment decision are interrelated because retention of profits for financing the selected asset depends on the rate of return on proposedinvestment & the opportunity cost of retained profits.

Profits are retained when return on investment is higher than the opportunity costof retained profits & vice versa.

8. INTER-FACE OF FINANCIAL MANAGEMENT WITH OTHER DISCIPLINES

Financial Management has relationship with almost all functional departments But it has close relationship with Economics & Accounting

HR

Marketing



Relationship to Economics

The relation between finance & economics can be studied under two prime areas of economics such as macroeconomics & microeconomics

It is important for financial manager to understand changes in macroeconomics &their impacts on the firm’s operating performance

Financial manager uses microeconomics theories as guidelines for efficient businessoperations

Relationship to Accounting

Financial accounting is concerned with developing & reporting data for measuring performance of the firm

Finance accounting prepares records on the accrual basis whereas financial mangerstakes decisions on the basis of cash flows

Relationship to HR

The activities of HR department include recruitment, training, development, fixingcompensation, incentives, promotion & providing other benefits

Finance Manager takes decision after studying the impact of HR activity inorganization

Relationship to Production

Production department is another functional department area that involves hugeinvestment on fixed assets (machines & tools)

The production manager & finance manager need to work closely for effectiveinvestment on plant & machinery

Relationship to Marketing

Marketing involves selection of distribution channel & promotion policies Finance & marketing managers need to work with coordination for maximize value of

the firm

Relationship to R&D

Innovation of products & process is the only way to survive in the competitive market Innovation needs to invest funds on R&D

9. DIMENSIONS OF FINANCIAL MANAGEMENT



The different dimensions of Financial management also known as 6A’s of FinancialManagement

1) Anticipating Financial Needs

The Financial Manager has to forecast expected events in business & note their financial implications.

1) Acquiring Financial Resources

This implies knowing when, where & how to obtain the funds which a businessneeds

Funds should be acquired well before the need for them actually felt

1) Allocating funds in business

Allocating funds in a business means investing them in the best of plans of assets

Assets are balanced by weighing their profitability against their liquidity

1) Administering the allocation of funds

Once the funds are allocated to various investment opportunities it is the basicresponsibility of the financial manager to watch performance of each rupee thathas been invested

1) Analyzing the performance of finance

Once the funds are administered, it is necessary for the finance manager to takedecisions

Through the budgeting, he will be able to compare the actual with standards

1) Accounting & Reporting to management The financial manger has to advice & supply information about the performance

of finance to top management. He is also responsible for maintaining upto date records of the performance of

financial decisions.

6A

Allocation

Administeri

Analysis

Accounting

Anticipation

Acquiring



10. ACTIVITIES, ROLE & FUNCTIONS OF FINANCIAL MANAGER

A financial manager is a person who is responsible in a significant way to carry out the financefunction

Roles of Manager

Functions of Manager

Key Activities

Roles

Financial Structure

Foreign Exchange

Treasury operations

Investor communication

Management Control

Functions

ExecutiveFunctions

RoutineFinance

Functions

Episodicor

Incidental



Executive Functions

➢ Finance forecasting➢ Allocation of funds➢ Raising financial resources➢ Establishing assets-management policies➢ Dividend policies➢ Financial Planning & control

Routine Finance Functions

➢ Receipt & disbursement of cash➢ Maintenance of financial records➢ Preparation of financial statements

➢ Negotiations with banks and financing corporate➢ Development of financial data for decision making

Episodic or Incidental functions

➢ Preparation of financial plan➢ Financial readjustment at the time of financial crisis➢ Valuation of firm at the time of merger ➢ All other Incidental functions

11. ORGANIZATION OF FINANCE FUNCTION

Finance function is very essential for any business undertaking It is necessary to set up a sound & efficient department for the purpose of achieving its

objectives The structure of Financial Management varies from Firm to Firm depending on the

factors like the size of the firm. The designation of Financial Officers also differs from one organization to another

organization. The different designations are Financial Manager, Chief Financial Officer (CFO), or the

Director of Finance or Vice-President Finance & Financial Controller The Financial Vice President’s key subordinates are the Treasurer & the Controller

Board of

Managing

Production Personnel FinancialDirector MarketingTreasurAuditing

Retirement Benefits

CreditManagem

Costcontrol Planning&

Performance InventoryAccountiControlle



Treas

Treasurer

The main concern of the treasurer is with the financing activities of the firm.Also includes➢ Obtaining finance➢ Banking relationship➢ Investor relationship➢ Short-term financing➢ Cash management➢ Credit administration➢ Investment➢ Insurance

Controller

The functions of controller are related mainly to accounting & control. Also includes➢ Financial Accounting➢ Internal Audit➢ Taxation➢ Management Accounting & control➢ Budgeting, planning & control➢ Economic appraisal etc.,

12. RESPONSIBILITY OF FINANCIAL MANAGEMENT



The responsibilities of financial management or financial manager vary widely fromone business entity to another depending upon the size & nature of the business

The responsibilities of financial managements are segregated into the following twotypes➢ Main responsibilities➢ Other responsibilities

Other Responsibilities

13. AGENCY PROBLEM

Agency problem is the likelyhood that managers may place personal goals ahead of corporate goals.

The agency problem can be prevented\Minimized by acts of ➢ Market forces➢ Agency costs

MainRes onsibilities

Final Plan

Raio

Nece

Conng theof fu

Dispon

prof

Other

Responsibility to

Legal Obligations

Responsibilities of Employees

Responsibility tocustomers

Wealth



i) Market Forces

Market forces act to prevent\minimize agency problems in two ways➢ Behavior of security market participants➢ Hostile Takeovers

a) Behavior of security market participants

The security market participants/shareholders in general & large institutionalinvestors like mutual funds, insurance organizations, financial institutions, and so onwhich hold large blocks of shares of corporate

To ensure competent management & minimize agency problem they have in recentyears actively exercised their voting right to replace more competent management in place of under-performing management.

b) Hostile takeovers

Hostile takeovers is the acquisition of the firm by another firm that is not supported by the management

ii) Agency costs

Agency costs are cost borne by shareholders to prevent\minimize agency problems as tocontribute to maximize owner’s wealth

The shareholders have to incur four types of cost

AgencyProblemPrevention

Market ForcesAgency costs

AGENCY

COSTS



➢ Monitoring➢ Bonding➢ Opportunity➢ Structuring

a) Monitoring Expenditure

Such expenditures relate to monitoring the activities of the management to prevent a satisfyingin contrast to share price maximizing behavior of them

b) Bonding Expenditure

They protect the owners against the potential consequences of dishonest acts bymanagement\managers.

The firm pays to obtain a fidelity bond

c) Opportunity cots

Such costs result from the inability of large corporate from responding to newopportunities

d) Structuring Expenditure

The structuring expenditures are the most popular, powerful & expensive agency costsincurred by corporate.

They relate to structuring managerial compensation to correspond with share pricemaximization.

14. CORPORATE MANAGEMENT

Traditionally, the corporate industrial sector in India was dominated by group of companieswith close links with the promoter groups

The major objective of Corporate Finance by Indian corporate are summarized as follows

➢ Maximization of earnings before interest & tax (EBIT) and Earnings per share (EPS)➢ Maximization of the spread between return on assets (ROA) & Weighted Average

cost of Capital (WACC) that is Economic Value Added (EVA)➢ There is no significant difference in the EVA as a corporate finance objective

followed by the firms in public & private sectors➢ The spread between Cash Flow Return On Investment (CFROI) & the WACC, that is

Cash Value Added (CVA), is the third most important objective➢ Another important objective is the maximization of market capitalization➢ The MVA (Market Value Added) objective is more likely to be followed by public

sector units than Private sector firms.



APPENDIX

1) 7M’s of Management

2) Economic Value Added

Economic Value Added (EVA) is equal to after-tax operating profits of a firm less the cost of funds used to finance investments.

The merits of EVA are,

➢ Its relative simplicity➢ Its strong link with the wealth maximization of the owners

3) Stakeholders

7M

Money

Material

Machines

Management

Methods

Minutes



The stakeholders include employees, customers, suppliers, creditors and owners and otherswho have a direct link to the firm. The implication of the focus on stakeholders is that a firmshould avoid actions detrimental to them through the transfer of their wealth to the firm

4) Risk-Return trade off

The financial decisions of the firm are interrelated & jointly affect the market value of itsshares by influencing return & risk of the firm

The relationship between return & risk can be simply expressed as

Return=Risk-free-trade + Risk Premium

Risk-free trade is a compensation for time & risk-premium for risk.

A proper balance between return & risk should be maintained to maximize the market valueof a firm’s shares. Such balance is called risk-return-trade off.

5) Financial services

Financial services concerned with the design & delivery of advice and financial products toindividuals, businesses & governments

6) Fidelity bond

Fidelity bond is a contract which a bonding company agrees to re-imburse a firm upto astated amount for financial losses caused by dishonest acts of managers

7) Capital budgeting

Capital budgeting (investment decision) is the most crucial financial decision of a firm

It related to the selection of an asset or investment proposal or course of action whose benefits are likely to be available in future over the lifetime of the project.




1. TIME VALUE OF MONEY2. REASONS FOR TIME PREFERENCE FOR MONEY3. TECHNIQUES OF TIME VALUE OF MONEY4. COMPOUDING OR FUTURE VALUE

➢ COMPOUND VALUE OF LUMPSUM➢ MULTIPLE COMPOUNDING PERIOD➢ EFFECTIVE RATE OF INTEREST➢ DOUBLING PERIOD➢ COMPOUND VALUE OF A SERIES OF PAYMENTS➢ COMPOUND VALUE OF AN ANNUITY➢ COMPOUND VALUE OF AN ANNUITY DUE

5 .DISCOUNTING OR PRESENT VALUE

➢ PRESENT VALUE OF LUMPSUM➢ PRESENT VALUE OF A SERIES OF PAYMENTS

➢ PRESENT VALUE OF ANNUITY➢ PRESENT VALUE OF ANNITY DUE➢ PRESENT VALUE OF PERPETUITY➢ SINKING FUND FACTOR ➢ LOAN AMORTISATION➢ PRESENT VALUE OF GROWING ANNUITY➢ SHORTER DISCOUNTING PERIODS



6. APPENDIX


A rupee that is receivable today is more valuable than a rupee receivable in future An individual’s preference for possession of a given amount of cash flow, rather than

the same amount at some future time is called time value of money Time value of money means that the value of a unit of money is different in different

time periods The present worth of a rupee received after some time will be less than a rupee

received today The time value of money also be called as time preference for money The main reasons for the time preference for money are to be found in the

reinvestment opportunities for funds which are received early. The fundamental principle behind the concept of time value for money is that a sum

of money received today is worth more than if the same is received after sometime. Time value of money or time preference for money is one of the central ideas in

finance Individuals as well as business organizations frequently encounter the situations

involving cash receipts or disbursements over several periods of time When this happens time value of money becomes important and some time vital

consideration in decision making.

TIME PREFERENCE RATE

The time preference for money is generally expressed interest rate This rate will be positive even in the absence of any risk It may be therefore called as the risk-free trade

Required Rate of Interest

The required rate of interest may also be called as the opportunity cost of capital of comparable risk



It is called so because the investor could invest his money in assets or securities of equivalent risk.

2. REASONS FOR TIME VALUE OF MONEY

I. Uncertainty Future is uncertain. There is a chance of not getting the money at all Hence people like to receive the money today itself rather than waiting for the

futureii. Preference for consumption The money may be needed to meet urgent current needs Therefore, people prefer to receive money as early as possible

iii. Investment opportunities Money has time value The reason why individuals prefer present money is due to the possibility of

investment opportunity through which they can earn additional cash

3. TECHNIQUES OF TIME VALUE FOR MONEY

4. Compounding or Future value

Interest is compounded when the amount earned main initial deposit (the initialdeposit) becomes part of the principal at the end of the first compounding period.

The compounding techniques has the following methods to find the future value of money

TECHNIQUES

REASONS

UNCERTAINTY

PREFERNCEFOR

INVESTMENT

Lump sum



i) Compound value of lumpsum

The compound value can be computed for any lump sum amount at i rate of interestfor n years. The formula,

FV=P(1+i)n

➢ FV-Future value➢ P-Principal➢ i-Rate of Interest➢ n-No of years.

ii) Multiple Compounding periods

Compounding of interest may be done half-yearly, quarterly, or even monthly. Thecompounding of multiple periods can be calculated using the following formula

FV=p(1+im)m*n

m-Frequency of compounding in a year

iii) Effective Rate of interest

When interest is compounded annually, the nominal rate of interest is the Effective Rate of Interest (ERI).

ERI= (1+im)m -1

iv) Doubling period

Often investors and financial decision makes are interested in knowing the doubling period thatis the time taken for doubling of an investment. There are two formulas used,

➢ Rule 72➢ Rule 69

Compounding

Multiple periods

Effective Rate of

Doubling Period

Series of

Annuity

Annuity Due



Rule 72

Doubling period=72rate of interest

Rule 69

Doubling period=0.35+ 69interest rate

V) Compounding value of series of payments

Payments may be made at different points of time, such as at the end of the first years, secondyear and so on. This can be calculated by using the following formula,

FV=P1(1+i)n-1

+P2(1+i)n-2

+……+Pvi)Compounding value of an Annuity

Annuity refers to a series of equal annual payments made at the end of each year for a particular period

FV=A(1+i)n-1+A(1+i)n-2+……+A

vii) Compounding value of Annuity Due

Annuity due refers to equal, annual payments made at the beginning of each year.

FV=A(1+i)n+A(1+i)n-1+…..+A(1+i)

5. DISCOUNTING OR PRESENT VALUE

The concept of the present value is the exact opposite of that of compound value Discounting is determining the present value of a future amount Discounting technique is quite important in making financial decisions. The following are the methods of discounting

Lumpsum

Series of payments

Annuity

AnnuityDue

Perpetuity

Sinking Fund

LoanAmortization

ShorterDiscounting

GrowingAnnuity



i) Present value of LumpsumPresent value of a lumpsum is calculated by the following formula,

PV=FV1+inii) Present value of a series of payments

When payments are made in a series over a period of time, each payment or cash flow isdiscounted with reference to the period.

PV=F1(1+i)1+F2(1+i)2+…..+Fn(1+i)n

iii) Present value of an AnnuityAnnuity refers to a series of equal annual payments for a particular

period of time

PV=A(1+i)1+A(1+i)2+……+A(1+i)n

iv) Present value of an Annuity DueAnnuity due refers to equal annual payments made at the beginning of every

year.

PV=A+A(1+i)1+A(1+i)2+……..+A(1+i)n

v) Present value of perpetuityAn annuity with an infinite duration providing continual annual cash flow

PV=Ai

vi) Sinking Fund FactorEstimation of annual payments o as to receive an accumulate pre-determined amount

after a future date



vii) Loan Amortization

Payment of loan over a specified period in the equal or unequal period installments.Payment of loan is called amortization.

viii)Present value of growing Annuity Growing annuity means the cash flows that grows at a constant rate for a specified

periods of time. The following steps explains the calculation of present value of growing annuity

➢ Calculate the series of cash flows➢ Convert series of cash flows into present values at a given discount factor ➢ Add all the present values of series of cash flows to get total PV of a

growing annuity

ix) Shorter Discounting periodThe Shorter Discounting period can be calculated by using the formula,

PV=CIFN11+imm*n

6. APPENDIX

1) Compound InterestIt is the interest earned on a given deposit\principal that has become a part of the

principal at the end of a specified period

2) PrincipalIt refers to the amount of money on which interest is received

3 ) Mixed StreamIt is the stream of cash flows that reflects on particular patterns

4) Deferred AnnuityThe cash flows happen at the end of the period

5) Flat Rate of InterestWhen the rate of interest is applied to the original amount of the loan to determine the

interest component, the interest rate is called as the flat rate.



3. RISK AND RETURN

1. RISK AND RETURN2. NATUE OF RISK & RETURN3. RISK PREFERENCE BEHAVIOUR 4. RISK & RETURN OF A SINGLE ASSET5. RISK & RETURN OF A PORTFOLIO6. CAPM7. EXTENDED CAPM8. ARBITRAGE PRICING THEORY



1. Risk and return

Risk

Risk is present in every decision whether it is corporate decision or personal decision Risk is the variability of actual return from the expected return associated with a

given assets The greater the variability the riskier the security (e.g shares) is said to be. Risk refers to the dispersion of a probability distribution The risk of an asset is divided into two parts

Diversifiable Risk

Diversifiable risk (also referred to as unsystematic risk or non-market risk) stem fromfirm factors like

➢ Workers declare strike in a company➢ The R & D expert on the company leaves➢ A formidable competitor enters the market➢ The company loses a big contract in a bid➢ The company makes a breakthrough in process innovation

Non-diversifiable Risk

Non-diversifiable risk (also referred to as systematic risk or market security risk)stems from the influence of certain economy wide factors like

➢ Money inflation➢ Level of government spending➢ Industrial policy➢ The corporate tax is increased➢ The government charge the interest rate policy

Return

Risk

Diversifiable Non-



Return is the actual income received plus any change in market price of anasset\investment

Return expressed in terms of percentage The return from an investment is the realizable cash flow earned by its owner during

a given period of time

Return=D1+(p1-p0)p0

➢ D1=Dividend at the end of the time period➢ P1=price at the end of the year ➢ P0=price at the beginning of the year

2. Nature of risk & return

Nature is the chance of financial loss, or the variability of returns associated with a givenasset.

Assets that are having higher chances of loss are viewed as more risky, than those with

lesser chances of loss. There are different source of risk that affects financial managers and shareholders. Financial managers shows greater interest on business and financial risk because they are

firm specific Interest rate, liquidity and market risk and more shareholders specific and therefore are of

greatest interest to shareholders Event exchange rate, purchasing power and tax risk directly affects both company and

shareholders Moral risk also affects both company and shareholders.

Firm Specific

Market

Activities that affect only one firm Activities that affect allinvestment

Affect few firms Affect many firms

Projectsmay dobetter orworse thanexpected

Competitionmay bestronger orweaker thananticipated

Entiresector may beaffected byaction

Exchangerate andpolitical risk

Interestrateinflation &new aboueconom



3. Risk preference behavior

Risk is a financial loss There exist differences among managers to accept risk

i. Risk Indifferent

Managers with this type of behavior does not expect the change in required rate of return, with a given change in risk

ii. Risk-Averse

Require rate of return for an increased risk. Managers with this types of risk preference behavior expects higher return to compensate the higher risk

iii. Risk-seeking

Risk seeking behavior type of managers enjoys the risk by not expecting an extra returnfor extra risk assumed.

Instead they give up some return & accept more risk

4. Risk and return of a single Asset

Return on investment for a given period, is the income received over the period plus changein trade of investment (assets)

Rate of return=Income+(selling price-purchase price)purchase price

Risk Measurement

The risk associated with a single asset is assessed from both a behavioral and aquantitative/statistical point of view. The behavioral view of risk can be obtained

using➢ Sensitivity analysis➢ Probability

Risk BehaviorRisk Averse

Risk

Risk

Risk Measurement

Behavior QuantitativeSensitivity Analysis

Probability StandardDeviation

Co-

efficient of variation



a. Sensitivity Analysis

Sensitivity analysis takes into account a number of possible outcomes & returns estimateswhile evaluating an asset assessing risk

In order to have a sense of the variability among return estimates, a possible approach isto estimate the worst (pessimistic), the expected (most likely), the best (optimistic) returnassociated with the asset.

Range=Optimistic-pessimistic

b. Probability

Probability distribution is a model than relates probabilities to the associated outcome Probability is the chance that a given outcome will occur

E(R)=(R*P)

c. Standard deviation

Standard deviation measures the dispersion around the expected value It represents the square root of the averse squared deviations of the individual returns

from the expected returns.s.d=E(d*d)n

d. Coefficient of variation

Coefficient of variation is a measure of relative dispersion used in comparing the risk of assetswith differing expected returns.

CV=σER

5. Risk & return of a portfolio

A portfolio means a combination of two or more securities (assets) A large number of portfolios can be formed from a given set of assets



Portfolio theory, originally developed by Harry Markowitz, shows that portfolio risk,unlike portfolio returns, is more than simple aggregation of the risks of individual assets

The expected rate of return on portfolio is the weighted average of the expected rates of return in assets comprising the portfolio

Total risk is measured in terms of co-variance The co-variance in turn depends on the correlation between returns on assets in the

portfolio Correlation coefficient is a measure of correlation between two series The following are the types of correlation

6. CAPM (Capital Asset Pricing Model)

CAPM is an equilibrium model of the trade-off between expected portfolio return andunavailable risk, the basic theory that links together risk and return of all assets

The Capital Asset Pricing Model consists of two elements➢ The Capital Market Line (CML)➢ The Security Market Line (SML)

CML (Capital Market Line)

The capital market line is a capital allocation line (CAL) provided by one month T bills with a broad index of common stocks

It serves two functions. First it depicts the risk-return relationship for efficient portfolio available to investors. Second, it shows that the appropriate measure of risk for an efficient portfolio.

The CML indicates,➢ The locus of all efficient portfolios➢ Risk-return relationship & measure of risk for efficient portfolios➢ The appropriate measure of risk for the portfolio is a standard deviation on

portfolios

Correlation

Perfect Positive

Perfect Negative

Zero-Correlation

CAPMCML SML



➢ The relationship between risk & expected return for efficient portfolios islinear.

SML (Security Market Line)

Security market line is a graphic depiction of CAPM and describes the market price of risk in capital markets

The total risk consists of two components i) Systematic risk & ii) Unsystematic risk According to capital market theory, the market compensates or rewards for systematic

risk only For a given amount of systematic risk (b), SML shows the required rate of return

Assumptions of CAPM



All investors are price takers. Their number is so large that no single investor can affect prices.

Assets / securities are perfectly divisible. All investors plan for one identical holding period. Homogeneity of expectation for all investors results in identical efficient frontier and

optimal portfolio. Investors can lend or borrow at an identical risk – free rate. There are no transaction costs and income taxes. The capital market efficiency implies that share prices reflect all available information

7. Extended CAPM

Extended CAPM adds variables additional to beta to the model The major factors included in the extended CAPM are

8. ARBITRAGE PRICING THEORY (APT)

The APT is an alternative model of asset/security pricing which has considerableattention in the financial literature in recent years

Arbitrage has markets equilibrating across securities through arbitrage driving outmispricing

The APT model was developed in the 1970’s by Ross In the context of pricing of securities, arbitrage implies finding of two securities which

are essentially the same

Arbitrage will ensure that riskless assets provide the same expected return in competencefinancial markets.

4. VALUATION OF BONDS & SHARES

Factors

Taxes

Inflation

Liquidity

Market-capitalization

Price Earnings



1. NATURE OF VALUE2. VALUATION OF ASSETS3. THE BASIC VALUATION MODEL4. BOND VALUATION5. BOND VALUE BEHAVIOUR 6. BOND YIELDS7. PREFERENCE SHARE VALUATION8. VALUATION OF EQUITY SHARES9. VALUATION OF WARRANTS

1. NATUE OF VALUE

The term value is used in different senses The following are the types of values



i. Book value

It is an accounting concept It is equal to cost of an asset minus accumulated depreciation

ii. Market value

Market value of an asset is the price at which the asset (security) is bought or sold inthe market.

Equity stock is sold or purchased in the stock exchange.

iii. Liquidation value

Liquidation refers to sale of business or a part of business. Liquidation value is the actual amount that can be realized when an asset is sold.

iv. Going concern value

It is the value that a firm can be realized if it sold its business as a continuingoperating business.

This value would be higher than the liquidation and book value

v. Intrinsic value

Investors invest on equity stock with an expectation of intrinsic cash inflow stream. The present value of cash inflows expected from a asset over its holding period is

called intrinsic value.

2. VALUATION OF ASSETS

Valuation is the process that links risk & return to determine the worth of an asset(bonds, stock, investment projects and so on.)

Value

Book Value MarketValue Liquidation Value GoingConcernValue

Intrinsic Value



It can be applied to expected benefits from real\physical as well as financialsecurities\assets to determine their worth at a given point of time

There are three key inputs required for valuing an asset.

1. Cash flows

An investors invests on a asset with an expected flow of returns over the ownership

period Value of asset is decided based on the expected cash inflows (return)

2. Timing

Timing of return is another input that is required to value an asset It is the period over which returns are expected

3. Required Return

It is one another & very important input needed for valuation of an asset Expected rate of return depends on the level of risk associated with the given

investment.

3. THE BASIC VALUATION MODEL

Value of any asset (bond, equity & preference share, a lease, machinery, equipment & building) is simply the present value of the future cash inflows (return) expected to provide over the relevant time period

The time period can be any length or even infinity The expected return over the time period are discounted, using the required rate of return,

that commensurate with the asset’s risk as the appropriate discounting rate to get givenvalue of an asset.

V=A1(1+k)

1+A2(1+k)

2+…...+An(1+k)

n

v-value of the asset; A1-Cash flow streams; K-Required rate of return;

4. BOND (DEBENTURE) VALUATION

A bond is a legal document issued by the issuing company under its common sealacknowledging a debt & setting forth the terms under which they are issued and are to be paid

Valuation



A bond is a long term contract under which a borrower promises to pay interest & principal amount, on specific dates, to the holder of the bond

Bond is also known as debenture Bonds are issued by different types of organizations. In India the issuers of bonds are Government (Central & state), Financial institutions,

Public sector undertaking & private sector organizations We need to understand few terms used in bond valuation. They are par value, coupon rate

& Maturity period.

1. Par value

The par value (face value) is the stated on the face of the bond It is the amount at which a bond is issued to public, and promises to pay either at the

end of maturity period or pre-determined installments.

2. Coupon Rate

Coupon rate is the interest rate with which a bond is issued

3. Maturity Period

It is the number of years for which a bond is issued.

a. Bonds with the Maturity Period

The valuation of bonds with the maturity period can be computed using thefollowing formula,

Vd=I1(1+kd)1+I2(1+kd)2+…..+In(1+kd)n+MV(1+kd)n

I1,I2-Annual Interest rate; MV-maturity value; Kd-Required rate of return

b. Bonds Redeemable in installments

The valuation of this type can be accomplished using the following formula,

Vd=CF1(1+kd)1+CF2(1+kd)2+…..+CFn(1+kd)n

CF1, CF2..-Cash inflows; kd-Required rate of interest

Bond

Par Value

Coupon

MaturityPeriod



5. BOND VALUE BEHAVIOR

The market value of bond generally does not equal to its par value, because forces inthe economy & number of years to maturity

Bond value behavior includes,➢ Required rate of return & bond values➢ Time to maturity & bond values➢ Relationship between bond value & Time to maturity period

1. Required Rate of return & bond values

As stated in the inputs of bond valuation equation required rate of return is the primeinput

Whenever there is change in the required rate of return bond value shows fluctuationsfrom its par value

It is important to understand the relationship between required rate of return & the

interest rate.➢ Value of bond when interest rate equals to required rate of return – In this case

value of bond is equals to par value➢ Value of bond when required rate of return is higher than the interest rate- In

this case the value of bond would be less than par value➢ Value of bond when required rate of return is less than the interest rate-In this

case the value of bond would be above par value.

2. Time to Maturity & bond Values

As stated in the inputs of bond valuation time maturity is the one of inputs of valuation.

When the required rate of return is different from the interest rate the length of time tomaturity affects bond value.➢ When the interest rate is equals to the required rate of return, the value of

bond is equals to the par value, whatever may be the maturity period➢ When the interest rate is less than the required rate of return, the value of bond

decreases when time period to maturity increases and vice versa.➢ When the Interest rate is greater than the required rate of return, the value of ➢ bond increases when the time period to maturity increases.

3. Relationship between Bond value & Time to maturity Period

When required rate of return equals to coupon rate, a bond will sell at face value. When required rate of return increases above coupon rate than the bond vale falls

below par value When required rate of return falls below interest rate, then the bond values goes

above par value Increase in required rate of return affects bond values



Market value of bond will always reaches its face value by the end of it maturity period, provided the firm does not go bankrupt.

6. BOND YIELDS

Investors not only interested in knowing the bond value but also show interest in

knowing yield on bonds There are three yields of bond.

1. Yield to Maturity

It is the rate of return that an investor earns if they buy a bond at a specific price andhold it until maturity

i) Redeemable bonds

YTM=I+(MV-PP)/n(MV+PP)/2

YTM can be found by trial & error method

ii) YTM on Perpetual bonds

Perpetual bonds have no maturity value The YTM of perpetual bonds is simple to calculate

YTM=Annaul InterestCurrent Market Price

2) Yield to Call

YTC is exactly similar to YTM. But here yield is found till the call of the bond

YTC is computed with following formula,

YTC=tnI(1+kd)t+CP(1+kd)n

CP-call price of bond

3) Current Yield

It is the yield related to the annual interest to the current market price

Yield toCall

Yield toMaturity

Current Yield



Current yield=I÷CMP

CMP-Current Market Price

7) PREFERENCE STOCK VALUATION

Preference stock is called as preference share; it gives some preferential rights to preference shareholders

The preferential rights are payment of fixed rate of dividend & payment of principalamount at the time of liquidation before paying to equity shareholders.

i) Valuation of redeemable shares

v p=PD1(1+kp)1+PD2(1+kp)2+…..+PDn(1+kp)n+MV(1+kp)n

V p-Value of preference share; PD-Preference Dividend; MV-Maturity Value;

ii) Valuation of Perpetual preference Shares

v p=PDk

PD-Preference Dividend

8) VALUATION OF EQUITY SHARES

Equity shareholders are the owners of the firm. They are called as equity, because they share profit or loss equally among equity

shareholders They are also known as residual owners; because they receive residual income that is

left out after paying all other claims. The following are the methods of valuation of equity shares

1. Dividend Capitalization Approach

The general principle of valuation applied to the share valuation This approach consists of the following types

➢ Single period valuation➢ Multiple period valuations➢ Dividend valuation model

i) Single Period Valuation

Equity SharesDividend Earnings



The Single period valuation uses the following formula to compute the value of equityshares.

P0=D1+p11+ke

P0-Current price or value of equity shares;

P1-sales price

D1-Dividend price

ii) Multiple Period Valuation

The multiple period uses the following formula

P0=D1(1+ke)1+D2(1+ke)2+…..+Dn(1+ke)n+Pn(1+ke)n

iii) Dividend valuation model

➢ Dividends do not remain constant➢ Earnings & dividends of most companies grow over time, at least, because of their

retention policies

a) When there is no growth in dividends

P0=DKe

b) When there is growth in dividends

P0=D0(1+g)(ke-g)

c) When there is super normal growth

I. Estimate the dividend expected during the period of super normal profitsII. Find out the present value of expected dividend arrive at step1. Let this value be A.III. Find out the value of share at the end of the super normal growth period. For this

valuation apply the normal growth rate & required rate of returnIV. The value arrived at the step3, is the future value. Hence, find out its present value by

discounting. Let this value be BV. Value of the share=(A+B)

2. Earnings Capitalization Method

This method uses the following formula to calculate the value of equity shares

P0=EPSKe

Return on equity shares

E(R)=D1+(P1-P0)P0



9) VALUATION OF WARRANTS

Warrant is a financial instrument issued by companies It gives the holder to buy the fixed number of shares at fixed price at the fixed period of

time Warrants are issued along with issue of shares, debentures & preference shares

When issue warrant has no value Value of warrants can be computed using the following formula,

Value=(market price-Offer price)*No.of shares

5. OPTION VALUATION

➢ OPTIONS➢ CALL OPTION

➢ PUT OPTION➢ OPTIONS TRADING IN INDIA➢ INDEX OPTIONS➢ COMBINATIONS PUT, CALL, SHARE➢ MODEL FOR OPTION VALUATION➢ OPTION’S DELTA



1. OPTIONS

An option is a contract that gives the holder a right, without any obligation, to buy or sell an asset at an agreed price on or before a specified period of time.

The option to buy an asset is known as a call option. The option to sell an asset is called a put option. The price at which option can be exercised is called an exercise price or a strike price. The asset on which the put or call option is created is referred to as the underlying asset. The option premium is price that the holder of an option has to pay for obtaining a call

or a put option.

When an Option can be Exercised

European option -When an option is allowed to be exercised only on the maturity date, itis called a European option.

American option -When the option can be exercised any time before its maturity, it iscalled an American option

Possibilities at Expiration



In-the-money A put or a call option is said to in-the-money when it is advantageous for the investor to exercise it.

Out-of-the-money A put or a call option is out-of-the-money if it is not advantageous for the investor to exercise it.

At-the-money When the holder of a put or a call option does not lose or gain whether or not he exercises his option

2. CALL OPTION

Buy a call option

You should exercise call option when: Share price at expiration > Exercise price. Do not exercise call option when: Share price at expiration < Exercise price. The value of the call option at expiration is: Value of call option at expiration = Maximum [Share price – Exercise price, 0].

The expression above indicates that the value of a call option at expiration is themaximum of the share price minus the exercise price or zero.

The call buyer’s gain is call seller’s loss

3. PUT OPTION

Buy a put option

Exercise the put option when: Exercise price > Share price at expiration. Do not exercise the put option when: Exercise price < Share price at expiration. The value or payoff of a put option at expiration will be: Value of put option at expiration = Maximum [Exercise price – Share price at

expiration, 0].

The put option buyer’s gain is the seller’s loss.

4. OPTIONS TRADING IN INDIA

The Security Exchange Board of India (SEBI) has announced a list of 31 shares for thestock-based option trading from July 2002. SEBI selected these shares for option tradingon the basis of the following criteria:

Shares must be among the top 200 in terms of market capitalisation and trading volume.



Shares must be traded in at least 90 per cent of the trading days. The non-promoter holding should be at least 30 per cent and the market capitalisation of

free-float shares should be Rs 750 crore. The six-month average trading volume in the share in the underlying cash market should

be a minimum of Rs 5 crore. The ratio of daily volatility of the share vis-à-vis the daily volatility of the index should

not be more than four times at any time during the previous six months The minimum size of the contract is Rs 2 lakh. For the first six months, there would be

cash settlement in options contracts and afterwards, there would be physical settlement.The option sellers will have to pay the margin, but the buyers will have to only pay the premium in advance. The stock exchanges can set limits on exercise price

5. INDEX OPTIONS

Index options are call or put options on the stock market indices. In India, there areoptions on the Bombay Stock Exchange (BSE)—Sensex and the National Stock Exchange (NSE)—Nifty.

The Sensex options are European-type options and expire on the last Thursday of thecontract month. The put and call index option contracts with 1-month, 2-month and 3-month maturity are available. The settlement is done in cash on a T + 1 basis and the prices are based on expiration price as may be decided by the Exchange. Optioncontracts will have a multiplier of 100.

The multiplier for the NSE Nifty Options is 200 with a minimum price change of Rs 10(200 × 0.05).

6. COMBINATIONS OF PUT, CALL AND SHARE

Protective Put: Combination of a Share and a Put Protective Put vs. Call Put-Call Parity Covered Calls: Buying a Share and Selling a Call Straddle: Combining Call and Put at Same Exercise Price Strips and Straps Strangle: Combining Call and Put at Different Exercise Prices Spread: Combining Put and Call at Different Exercise Prices Spread: Combining the Long and Short Options Collars

Factors Determining Option Value

1. Exercise price and the share (underlying asset) price

2. Volatility of returns on share

3. Time to expiration

4. Interest rates



7. Model for Option Valuation

➢ Simple binomial tree approach to option valuation.

➢ Black-Scholes option valuation model.

Simple Binomial Tree Approach

Sell a call option on the share. We can create a portfolio of certain number of shares (letus call it delta, D) and one call option by going long on shares and short on options thatthere is no uncertainty of the value of portfolio at the end of one year.

Formula for determining the option delta, represented by symbol D, can be written asfollows:

Option Delta = Difference in option Values /

Difference in Share Prices

The value of portfolio at the end of one year remains same irrespective of the increase or decrease in the share price. Since it is a risk-less portfolio, we can use the risk-free rate as the discount rate: PV of Portfolio = Value of Portfolio at end of year /

Discount rate Since the current price of share is S , the value of the call option can be found out as

follows: Value of a call option = No. of Shares ( D) Spot Price – PV of Portfolio The value of the call option will remain the same irrespective of any probabilities of

increase or decrease in the share price. This is so because the option is valued in terms of the price of the underlying share, and the share price already includes the probabilities of its rise or fall.

Black and Scholes Model for Option Valuation

The B–S model is based on the following assumptions: The rates of return on a share are log normally distributed. The value of the share (the underlying asset) and the risk-free rate are constant during

the life of the option. The market is efficient and there are no transaction costs and taxes. There is no dividend to be paid on the share during the life of the option. The B–S model is as follows:

where

➢ C 0 = the current value of call option➢ S 0 = the current market value of the share



➢ E = the exercise price➢ e = 2.7183, the exponential constant➢ r f = the risk-free rate of interest➢ t = the time to expiration (in years)➢ N (d 1) = the cumulative normal probability density

function

where

ln = the natural logarithm;

σ = the standard deviation; σ 2 = variance of the continuously compounded annual return on the share

Features of B–S Model

Black–Scholes model has two features-➢ The parameters of the model, except the share price volatility, are contained in the

agreement between the option buyer and seller.➢ In spite of its unrealistic assumptions, the model is able to predict the true price of

option reasonably well. The model is applicable to both European and American options with a few

adjustments

8. OPTION’S DELTA OR HEDGE RATIO

The hedge ratio is a tool that enables us to summarize the overall exposure of portfoliosof options with various exercise prices and maturity periods.

An option’s hedge ratio is the change in the option price for a Re 1 increase in the share price.

A call option has a positive hedge ratio and a put option has a negative hedge ratio. Under the Black–Scholes option valuation formula, the hedge ratio of a call option is

N (d 1 ) and the hedge ratio for a put is N (d 1 ) – 1.

Ordinary Share as an Option



The limited liability feature provides an opportunity to the shareholders to default on adebt.

The debt-holders are the sellers of call option to the shareholders. The amount of debt to be repaid is the exercise price and the maturity of debt is the time to expiration.

The shareholders’ option can be interpreted as a put option. The shareholders can sell(hand-over) the firm to the debt-holders at zero exercise price if they do not want tomake the payment that is due.

Documents

I Unit Assignment Amritraj 5 Batch