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Chapter 1:

What is corporate Finance? Corporate finance is the field of finance dealing with financial decisions business enterprises make and the tools and analysis used to make these decisions. The task of a finance manager mainly includes dealing with money i.e. how to raise the money required and how to use or allocate the money in such a way keeping in mind the maximisation of shareholder value as the goal. Corporate finance has three main areas of concern: a. Capital Budgeting: What long-term investments should the firm take? b. Capital Structure: Where will the firm get the long-term financing to pay for its investments? Also, what mixture of debt and equity should it use to fund operations? c. Working Capital Management: How should the firm manage its everyday financial activities to smoothly operate the business? The finance manager takes the decisions for the above areas of concerns keeping in mind the goal of financial management. The goal of financial management in a for-profit business is to make decisions that increase the value of the stock, or, more generally, increase the market value of the equity. There is the possibility of conflicts between stockholders and management in a large corporation. These conflicts are called agency problems. Financial Markets: The financial markets are composed of money markets and capital markets. Broadly, there are two sources of finance (external): debt and equity. Money markets are the markets for short term debt securities, while the capital markets are the markets for long term debt securities and for equity shares. Other classification of financial markets is that of primary markets and secondary markets. Primary markets are used for the initial issue of any type of securities that is debt or equity. A secondary market transaction involves one owner of the security selling the ownership to other person.

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Chapter 2
Relationship between profit and cash (Preparing Cash Flow Statement): In business, various transactions happen every day. All the transactions do not affect the profit or cash. The same way, the profit earned in a year need not be equal to cash generated from the business. To get the cash generated from the business, we prepare cash flow statement. Profit is the balance shown on income statement i.e. all the revenues minus all the expenses. Cash flow statement is divided into three parts: a. Cash flow from operating activities. b. Cash flow from investing activities. c. Cash flow from financing activities. To get the cash flow from operating activities, we deduct non-cash items of income and add the non-cash items of expenses to the profit shown in the income statement. Then, we adjust the change in working capital items. Apart from that we will add expenses of interest as that are considered under the financing activity and will be considered under the cash flow from financing activities. The result will be the cash flow from operating activities. To get the cash flow from investing activities, the cash paid for purchase of assets is deducted from the cash generated through the selling of assets. Most of the times, this figure will be negative. To get the cash from financing activities, the repayment of borrowings and interest are deducted from the cash generated through the issue of equity shares or any type of debt. The total of all the above head gives the cash flow generated throughout the year. The same is added to the opening cash balance to get the closing cash balance shown on the asset side of balance sheet.

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Chapter 3:
Financial Ratios and its implications:
Financial ratios are useful indicators of a firm's performance and financial situation. Financial ratios can be used to analyse trends and to compare the firm's financials to those of other firms.

Liquidity Ratios
Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. Various ratios under this head are: The current ratio is the ratio of current assets to current liabilities: Current Ratio = Current Assets / Current Liabilities Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm's assets are working to grow the business. The quick ratio is defined as follows: Quick Ratio = (Current Assets Inventory) / Current Liabilities The quick ratio often is referred to as the acid test. The cash ratio is the most conservative liquidity ratio. It excludes all current assets except the most liquid: cash and cash equivalents. The cash ratio is defined as follows: Cash Ratio = (Cash + Marketable Securities) / Current Liabilities The cash ratio is an indication of the firm's ability to pay off its current liabilities if for some reason immediate payment were demanded.

Asset Turnover Ratios


Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Various ratios under this head are:

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Receivables turnover is an indication of how quickly the firm collects its accounts receivables and is defined as follows: Receivables Turnover = Annual Credit Sales / Accounts Receivable The receivables turnover often is reported in terms of the number of days that credit sales remain in accounts receivable before they are collected. This number is known as the collection period. The collection period also can be written as: Average Collection Period = 365 / Receivables Turnover Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time period divided by the average inventory level during that period: Inventory Turnover = Cost of Goods Sold / Average Inventory The inventory turnover often is reported as the inventory period, which is the number of days worth of inventory on hand. Inventory Period = 365 / Inventory Turnover Total Assets Turnover = Net Income / Total ssets

Financial Leverage Ratios


Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt. Various ratios under this head are: The debt ratio is defined as total debt divided by total assets: Debt Ratio = Total Debt / Total Assets The debt-to-equity ratio is total debt divided by total equity: Debt-to-Equity Ratio = Total Debt / Total Equity The times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows: Interest Coverage = EBIT / Interest Charges
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Profitability Ratios
Profitability ratios offer several different measures of the success of the firm at generating profits. Various ratios under this head are: The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs. It is defined as follows: Gross Profit Margin = (Sales - Cost of Goods Sold) / Sales Net Profit Margin = Profit after Tax / Sales Return on assets is a measure of how effectively the firm's assets are being used to generate profits. It is defined as: Return on Assets = Net Income / Total Assets Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm's stock. Return on equity is defined as follows: Return on Equity = Net Income / Shareholder Equity

Dividend Policy Ratios


Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for future growth. Two commonly used ratios are the dividend yield and pay-out ratio. The dividend yield is defined as follows: Dividend Yield = Dividends per Share / Share Price A high dividend yield does not necessarily translate into a high future rate of return. It is important to consider the prospects for continuing and increasing the dividend in the future. The dividend pay-out ratio is helpful in this regard, and is defined as follows: Pay-out Ratio = Dividends per Share / Earnings per Share

Market Value Measure


Earnings per Share (EPS) = Net Income / total no. of Equity Shares Price-Earnings Ratio = Market Price per Share / EPS
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Chapter 4: Discounted Cash Flow


If r=10% then Rs. 100 will become 121 in 2 years. So, for a person cash inflow of 100 at year 0 (i.e. today) will be equivalent to cash inflow of 121 after 2 years. Here 100 is the Present value & 121 is the Future value Perpetuity: it is an annuity that has no definite end, or a stream of cash payments that continues forever. The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested in a different vehicle with similar risk 1. Two basic concepts, future value and present value, were introduced in the beginning of this chapter. With a 10 percent interest rate, an investor with $1 today can generate a future value of $1.10 in a year, $1.21 [= $1 x (1.10)2] in two years, and so on. Conversely, present value analysis places a current value on a future cash flow. With the same 10 percent interest rate, a dollar to be received in one year has a present value of $0.909 (= $1/1.10) in year 0. A dollar to be received in two years has a present value of $0.826 [= $1/(1.10)2]. 2. We commonly express an interest rate as, say, 12 percent per year. However, we can speak of the interest rate as 3 percent per quarter. Although the stated annual interest rate remains 12 percent (= 3 percent x 4), the effective annual interest rate is 12.55 percent [= (1.03)4 - 1]. In other words, the compounding process increases the future value of an investment. 3. A basic quantitative technique for financial decision making is net present value analysis. The net present value formula for an investment that generates cash flows (Ci) in future periods is:

The formula assumes that the cash flow at date 0 is the initial investment (a cash outflow).

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4. Frequently, the actual calculation of present value is long and tedious. So the following four simplifying formulas can be used:

Where: a. C is the cash flow to be received one full period hence. b. g is the Growth rate of cash flows c. t is the number of period

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Chapter 5
Zero Coupon Bond (ZCB): it is a bond on which no Interest (also called Coupon) is paid but only the face value is paid on maturity. Instead of paying interest these bonds are issued at discount. Eg. a ZCB with face value of Rs. 100, will mature after 5 years and if the required rate of return is 10% then this bond should be sold at 61.45%. 1. Pure discount bonds and perpetuities can be viewed as the polar cases of bonds. The value of a pure discount bond (also called a zero coupon bond, or simply a zero) is: = 38.55 i.e. at a discount of

The value of a perpetuity (also called a consol) is:

2. Level payment bonds can be viewed as an intermediate case. The coupon payments form an annuity, and the principal repayment is a lump sum. The value of this type of bond is simply the sum of the values of its two parts. 3. The yield to maturity on a bond is the single rate that discounts the payments on the bond to its purchase price. 4. A stock can be valued by discounting its dividends. Following are the three types of situations: i) The case of zero growth of dividends. ii) The case of constant growth of dividends. iii) The case of differential growth. 5. An estimate of the growth rate of a stock is needed for the formulas for situations 4(ii) or 4(iii). A useful estimate of the growth rate is Growth rate = Retention ratio x Return on retained earnings

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6. It is worthwhile to view a share of stock as the sum of its worth if the company behaves like a cash cow (the company does no investing) and the value per share of its growth opportunities. We write the value of a share as:

We showed that, in theory, share price must be the same whether the dividend growth model or the formula here is used. (If Growth rate =0 it means that dividend retention ratio=0 or in other words earning =dividend) 7. From accounting, we know that earnings are divided into two parts: dividends and retained earnings. Most firms continually retain earnings to create future dividends. One should not discount earnings to obtain price per share because part of earnings must be reinvested. Only dividends reach the stockholders, and only they should be discounted to obtain share price. Dividend=Earning * (1-Retention ratio)

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Chapter 6
Average Accounting Return: The average project earnings after taxes and depreciation divided by the average book value of the investment during its life. Basic IRR Rule: Accept the project if IRR is greater than the discount rate; reject the project if IRR is less than the discount rate. Capital Rationing: The case where funds are limited to a fixed dollar amount and must be allocated among competing projects. Incremental IRR: IRR on the incremental investment from choosing a large project instead of a smaller project. Independent Project: A project whose acceptance or rejection is independent of the acceptance or rejection of other projects. Internal Rate Of Return: A discount rate at which the NPV of an investment is zero. Mutually Exclusive Investments: Investment decisions in which the acceptance of a project precludes the acceptance of one or more alternative projects. NPV Rule: Invest in all positive NPV opportunities. Payback Period Rule: An investment decision rule which states that all investment projects that have payback periods equal to or less than a particular cutoff period are accepted, and all of those that pay off in more than the particular cutoff period are rejected. The payback period is the number of years required for a firm to recover its initial investment required by a project from the cash flow it generates. Value-Additivity: In an efficient market the value of the sum of two cash flows is the sum of the of the individual cash flows. A financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.

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Following are the Different investment decision rules: NPV Payback period Discounted payback period Accounting rate of return Internal rate of return Profitability index

Basic Steps of Capital Budgeting 1. Estimate the cash flows 2. Assess the riskiness of the cash flows. 3. Determine the appropriate discount rate. 4. Find the PV of the expected cash flows. 5. Accept the project if PV of inflows > costs or IRR > Hurdle Rate or payback < policy
Year 0 1 2 3 Expected Net Cash Flow Project L Project S ($100) ($100) 10 70 60 50 80 20

PAYBACK PERIOD Payback period = Expected number of years required to recover a projects cost. Payback for L = 2 + $30/$80 years

= 2.375 years. Payback for S = 1+30/50 1.6 years (so if Payback period is used, Project S will be preferred over L) Weaknesses of Payback: 1. Ignores cash flows occurring after the payback period. 2. Ignores the time value of money. This weakness is eliminated with the discounted payback method. In Discounted payback method, the PV of each cash flow is calculated and that that cash flow is used for computing payback period

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Net Present Value


Similarly the NPV of Project S will be NPVS = $19.98 If the projects are independent, accept both. (as both have +ve NPV) If the projects are mutually exclusive, accept Project S since NPVS > NPVL

Internal rate of return


IRRL = 18.1% IRRS = 23.6% If the projects are independent, accept both because IRR > k.

If the projects are mutually exclusive, accept Project S since IRRS > IRRL. Note: IRR is independent of the cost of capital. Profitability Index It is the ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment. =PV/Investment PI of Project L=118.79/100=1.1879 ( Select Project with Higher PI but PI should be always be >1) 1. Of the competitors to NPV, IRR must be ranked above both payback and accounting rate of return. In fact, IRR always reaches the same decision as NPV in the normal case where the initial outflows of an independent investment project are followed only by a series of inflows. Some projects have cash inflows followed by one or more outflows. The IRR rule is inverted here: One should accept when the IRR is below the discount rate. Some projects have a number of changes of sign in their cash flows. Here, there are likely to be multiple internal rates of return. The practitioner must use either NPV or modified internal rate of return here. Page | 12

2. 3.

Chapter 7
Erosion: Cash-flow amount transferred to a new project from customers and sales of other products of the firm. Net Working Capital: Current assets minus current liabilities. Nominal Cash Flow: A cash flow expressed in nominal terms if the actual dollars to be received (or paid out) are given. Nominal Interest Rate: Interest rate unadjusted for inflation. Opportunity Cost: Most valuable alternative that is given up. The rate of return used in NPV computation is an opportunity interest rate. Real Cash Flow: A cash flow is expressed in real terms if the current, or date 0, purchasing power of the cash flow is given. Real Interest Rate: Interest rate expressed in terms of real goods; that is, the nominal interest rate minus the expected inflation rate.

But for simplification it is also considered as Real=nominal-Inflation (Approximation Method) Sunk Cost: The cost that has already occurred and cannot be removed. Because sunk costs are in the past, such costs should be ignored when deciding whether to accept or reject a project. 1. Capital budgeting must be placed on an incremental basis. This means that sunk costs must be ignored, whereas both opportunity costs and side effects (Erosion/Synergy) must be considered. 2. Inflation must be handled consistently. One approach is to express both cash flows and the discount rate in nominal terms. The other approach is to express both cash flows and the discount rate in real terms. Because either approach yields the same NPV calculation, the simpler method should be used. The simpler method will generally depend on the type of capital budgeting problem. 3. Operating cash flow = EBIT + Depreciation - taxes (Note: this is not Free cash Flow) 4. A firm should use the equivalent annual cost approach (Annuty) when choosing between two machines of unequal lives.
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Chapter 8
Break-even analysis: Analysis of the level of sales at which a project would make zero profit. Number of units for BEP = Contribution margin: Amount that each additional product, such as a jet engine, contributes to after-tax profit of the whole project: (Sales price Variable cost) (1 Tc), where Tc is the corporate tax rate. At Break Even point Contribution=Fixed Cost + depreciation

1. Though NPV is the best capital budgeting approach conceptually, it has been criticized in practice for giving managers a false sense of security. Sensitivity analysis shows NPV under varying assumptions, giving managers a better feel for the project's risks. Unfortunately sensitivity analysis modifies only one variable at a time, but many variables are likely to vary together in the real world. Scenario analysis examines a project's performance under different scenarios (such as war breaking out or oil prices skyrocketing). Finally, managers want to know how bad forecasts must be before a project loses money. Break-even analysis calculates the sales figure at which the project breaks even. Though break-even analysis is frequently performed on an accounting profit basis, it is suggested that a net present value basis is more appropriate. Present value BEP: Where EAC is Equivalent Annual Cost 2. Monte Carlo simulation begins with a model of the firm's cash flows, based on both the interactions between different variables and the movement of each individual variable over time. Random sampling generates a distribution of these cash flows for each period, leading to a net present value calculation.

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Chapter 9: Risk and Return


Dollar Returns: The total dollar return on an investment is the sum of the dividend income and the capital gain or loss on the investment. Total Dollar Return = Dividend Income + Capital Gain (loss) A capital loss is equal to negative capital gain and thus whenever, there is loos on an investment, it will have a negative sign in the above equation. Percentage Return: The total dollar return expressed as a percentage of initial investment gives percentage return. Percentage Return = (Dividend income + Capital Gain)/ (Initial investment) Example: Suppose a stock begins with a price of Rs. 25 per share and ends with a price of Rs. 35 per share. During the year, it paid a Rs. 2 dividend per share. Find out its Total dollar return and Percentage return. Solution: Initial investment Value at the end of year Dividend during the year Dividend income Capital Gain (Loss) Total Dollar return Percentage return 25 35 2 2 10 12 0.48

Holding Period Returns: The total dollar return and percentage return are generally for a single period, i.e. one year. But, holding period return is the return over the period during which the security is held by an investor. This includes return on the original investment plus the return on the reinvestment of income generated during the period. Thus, it involves a compounding effect.
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For example, If a person has invested Re. 1 in a security in year 0 and returns during year 1,2,3 are 11 percent, -5 percent, and 9 percent respectively. Then , at the end of 3 years, Re. 1 will become (1+ r1)*(1+r2)*(1+r3) = (1+0.11)*(1-0.05)*(1+0.09) = 1.11*0.95*1.09 = 1.15 Thus, 0.15 or 15% here is three year holding period return which also include the return on reinvestment of income at the end of each year. Return Statistics: Returns on a security is also measure using statistical measures such as the mean. For example, suppose the returns on a common stock from 1926 to 1929 are 0.3580, 0.1370, 0.4514 and -0.0888. Then the average return will be Average return = (0.3580 + 0.1370 +0.4514 + -0.0888)/(4) = 0.2144 or 21.44% This is the mean return over this four year period. The mean return may or may not be same as Holding Period Return. Both do not have any relation. Arithmetic Average return and Geometric Average Return Suppose an investor buys a particular stock for Rs. 100. In the first year of its ownership, the stock falls to Rs. 50. During the second year, the stock rises back to Rs. 100. Now, in this case return during first year is (50-100)/100 = -0.5 i.e -50% and return during the second year is (100-50)/50 = 2 i.e. 100%. Thus, arithmetic average return during over two years is, (-50+100)/2 = 25 percent. But, if we observe, stock price is at the same level at the end of two years as it was at the time of investment i.e. the return is just 0 percent in absolute terms. So, which is correct, 0 percent or 25 percent? The answer is that both are correct. 25 percent is the arithmetic average , while 0 percent is geometric average, i.e (square root of (1-0.5)*(1+1))-1 which is equal to 0 percent.
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The geometric average return answers the question What was the average compound return per ear over a particular period? while the arithmetic return answers the question, What was the return on the investment during an average year over a particular period?. Geometric Return Formula = ((1+r1*(1+r2)*(1+r3)*.*(1+rT))^(1/T)-1 Where r1,r2,r3, .,rT are returns during Tth year and T is the total no. of years. Arithmetic average return is calculated in the same way as we calculate the normal average. To put it differently, the geometric average tells the investor what he/she actually earned per year on average, compounded annually. The arithmetic average is probably too high for longer periods and the geometric average is probably too low for shorter periods. Risk Free Returns: The government borrows money by issuing bonds, which the investing public holds. Because the government can raise taxes to pay for the debt it incurs, this debt is virtually free of the risk of default. Thus, return on such bonds is called as risk free return. Treasury bills, Treasury bonds, and treasury notes all give risk-free returns. The difference between returns on a risky security and risk free security is termed as excess return on that particular security. It is called excess because it is the additional return resulting from the riskiness of common stocks and is interpreted as an equity , risk premium. Risk Statistics: The variance and its square root, standard deviation, are the most common measures of variability or dispersion. For example, suppose the returns on common stocks from 1926 to 1929, are 0.137, 0.3580, 0.4514 and -0.0808, respectively. The variance of this sample is computed as follows:

Var = ((R1 Rmean)^2 + (R2 Rmean)^2 +(R3-Rmean)^3 + (R4- Rmean)^4++(Rt-Rmean)^T)/ (T-1) Standard Deviation = Square root of variance

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Chapter 10: Return and Risk: CAPM


Expected Return: This is the return that an individual expects a stock to earn over the next period. Of course, because this only an expectation, the actual return may be higher or lower. An individuals expectation may simply be the average return per period a security has earned in the past or it may be based on a detailed analysis of a firms prospects, on some computer based model or on special (or inside) information. Variance and Standard deviation : There are many ways to assess the volatility (risk) of a securitys return. One of the most common is variance, which is a measure of the squared deviations of a securitys return from its expected return. Standard deviation is the square root of variance. Covariance and Correlation: Returns on individual securities are related to one another. Covariance is a statistic measuring the interrelationship between two securities. Alternatively, this relationship can be restated in terms of the correlation between two securities. Covariance and correlation are building blocks to an understanding of the beta coefficient. To understand how to calculate the above mentioned parameters, please refer to page number 336-340 in the book Corporate Finance by Stephen Ross, Randolph Westerfield, Jeffrey Jaffe and Ram Kumar Kakani. This is our text book for FM I and FM II.

The return and risk for portfolios:


The expected return on a portfolio: The formula for expected return on a portfolio is very simple: The expected return on a portfolio is simply a weighted average of the expected returns on the individual securities. For example, consider that a portfolio has 40 percent of its total investment in security A, 35 percent in security B and 25 percent in security C. Now, also suppose that the expected return on security A,B,C is 15%, 20% and 25% respectively. Then, the expected return of the portfolio will be: Rportfolio = Wa*Ra + Wb*Rb + Wc*Rc = 0.4*0.15 + 0.35*0.2 +0.25*0.25 = 0.1925 = 19.25%
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The variance of a portfolio: Like the portfolio return, standard deviation of the portfolio is not the simple weighted average of variance of individual securities. The reason for this is that because of correlation between securities, there is a reduction in the variance of the portfolio. Suppose that a portfolio consists of two securities A and B. Let the weight of investment in A be Xa and that in B be Xb. Also, let the standard deviation in returns of A be Sa and that in B be Sb. Let the correlation between A and B be Pab. Then, first of all, form the following matrix: Correlation Matrix Security A Security B Security A Paa = 1 Pba Security B Pab Pbb=1

The correlation of a security with itself is always 1, i.e. Paa=1 and Pbb=1. Also, correlation of A with B is the same as correlation of B with A, i.e. Pab=Pba. Then Construct the following matrix and multiply the cell values with corresponding value in above matrix: Final Matrix Security A : XaSa Security B : XbSb Security A : XaSa Xa^2*Sa*2 XaXbSaSbPba Security B : XbSb XaXbSaSbPab Xb^2*Sb^2

Then, Variance of the portfolio will be the sum of values in the above cell: Variance = Xa^2*Sa*2 + 2XaXbSaSbPab + Xb^2*Sb^2 Similarly, for a portfolio of any number of securities, one can calculate portfolio variance using the above mentioned matrix method. As long as Pab<1, the standard deviation of a portfolio of two securities is less than the weighted average of the standard deviation of the individual securities. Diversification: Due to the correlation between different securities in a portfolio, the overall risk of a portfolio decreases. This is the impact of diversification. The total risk of a portfolio comprises of two parts: systematic and unsystematic. Systematic risk can not be done away with but unsystematic risk can be reduced or eliminated using diversification.
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The Formula for Beta: Beta(i) = Cov (Ri, Rm)/(Var (Rm) Where Cov(Ri,Rm) is the covariance between the return on Asset I and the return on the market portfolio and Var(Rm) is the variance of the market. Relationship between risk and expected return (CAPM) Rmean = Rf + Beta*(Rm-Rf) Where Rmean is the expected return on a security, Rf is the risk free rate, Beta is the Beta of that particular security and Rm is the Expected return on market. This formula, which is called the Capital Asset Pricing Model, implies that the expected return on a security is linearly related to its beta. The plot of expected return on a security against its Beta is called as the Security Market Line (page 367 in our textbook). The slope of this line is Rm-Rf and Rf is the intercept on the y-axis.

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Chapter 11: An alternative view of risk and return: Arbitrage Pricing Theory
The return on any stock traded in a financial market consists of two parts. First, the normal or expected return from the stock is the part of the return that shareholder in the market predict or expect. It depends on all of the information shareholders have that bears on the stock, and it uses all of their understanding on what will influence the stock next. The second part is the uncertain or risky return on the stock. This is the portion that comes from information that will be revealed within the month. A way to write return on the stock is as,

R = Rmean + U
Where R is the actual total return on the stock, Rmean is the expected part of the return and U stands for the unexpected part of the return. Risk: systematic and unsystematic A systematic risk is any risk that affects a larger number of assets, each to a greater or lesser degree. Systematic risk cannot be reduced or eliminated by diversification. An unsystematic risk is a risk that specifically affects a single asset or a small group of assets. Unsystematic risk can be reduced or eliminated by diversification. This permits us to break down the uncertainty or risk component U mentioned above into two components : the systematic risk and non-systematic risk. R = Rmean + U = Rmean + m + e where m stands for the systematic or market risk while e stands for unsystematic or firmspecific risk. Systematic Risk and Betas: We capture the influence of a systematic risk like inflation on a stock by using the beta coefficient. The Beta coefficient tells us the response of the stocks return to the factor (inflation) representing systematic risk.
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Suppose we have identified three systematic risks on which we want to focus. We may believe that these three are sufficient to describe the systematic risks that influence stock returns. Three likely candidates for this are inflation, GNP and interest rates. Thus, every stock will have a beta associated with each of these systematic risks: an inflation beta, a GNP beta and an interest rate beta. We can then write the return on stock as: R = Rmean + U = Rmean + m+ e = Rmean + Beta(inflation)*F(inflation) +e + Beta(GNP)*F(GNP) +

Beta(int.rate)*F(int.rate)

Where F in the equation stands for a deviation from expectation. Let us understand this with an example. Suppose the return is over the horizon of a year. Suppose that at the beginning of the year, the inflation is forecasted to be 5 percent, GNP is forecasted to be 2 percent and interest rates are expected not to change. Assume that Beta(inflation) = 2, Beta(GNP) = 1 and Beta(int.rate) = -1.8. Assume that e = 5 percent. And R mean = 4 percent. Then, during the year, it happens that inflation rises by 7 percent, GNP rises by 1 percent and interest rates fall by 2 percent. Then, putting the values in above equation, we get, R = Rmean + +e Beta(inflation)*F(inflation) + Beta(GNP)*F(GNP) +

Beta(int.rate)*F(int.rate)

=4% + 2*(7%-5%) + 1*(1%- 2%) -1.8 (-2% - 0) + 5% =4% + 4% -1% +3.6% +5% = 15.6% Likewise, we can generalize the formula as: R = Rmean + Beta1*F1 + Beta2*F2 ++BetaN*FN+ e

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If we construct a portfolio of different stocks with different percentage of total investment invested in each stock, the above equation can be used to find return on individual stocks and then these individual returns can be multiplied with their respective weights and summed up to find the return of a portfolio. Note, that as number of stocks in a portfolio increases, the unsystematic component of portfolio return will approach zero as unsystematic risk can be eliminated or reduced using diversification. The Capital Asset Pricing Model and the Arbitrage Pricing Theory One advantage of APT is that it can handle multiple factors while the CAPM ignores them. A multifactor model is always more reflective of reality. Style Portfolios: A portfolio that has a P/E ratio much in excess of the market might be characterized as a growth stock portfolio, while a portfolio made up of stocks with an average P/E less than that for a market index might be considered as a Value portfolios.

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Chapter 12: Risk, Cost of Capital and Capital Budgeting


The Cost of equity Capital Whenever a firm has extra cash, it can take one of two actions. It can pay out the cash to the shareholders as dividend. Alternatively, the firm can invest extra cash in a project, paying out the future cash flows of the project as dividends. Which procedure should the shareholders prefer? If a shareholder can reinvest the dividend in a financial asset with the same risk as that of the project, the shareholder would desire the alternative with the highest expected return. In other words, the project should be undertaken only if its expected return is greater than that of a financial asset of a comparable risk. Thus, we get a rule: The discount rate of a project should be the expected return on a financial asset of comparable risk. From the firms perspective, the expected return is the cost of equity capital. Under the CAPM, expected return on a stock can be given as: Rs = Rf + Beta * (Rm Rf) Where Rf is the risk free rate and Rm-Rf is the difference between expected return on market and risk free rate or it is also known as market risk premium. Example: Suppose the stock of S. Chand Company, a publisher of books , has a Beta of 1.3. The firm is 100 percent equity financed, and has no debt. The company is considering a number of capital budgeting projects that will double its size. Because these new projects are similar to the firms existing ones, the average beta on the new projects is assumed to be equal to S. Chands existing Beta. The risk free rate is 5 percent. Expected return on market is 13.4 percent. What is the appropriate discount for these new projects? As the risk of new projects is the same as the existing ones, the beta for new projects will also be the same as present Beta. Also, as the firm is all equity financed, Discount Rate = Cost of Equity = Rf + Beta * (Rm Rf) = 0.05 + 1.3 *(0.134-0.05) = 0.1592 = 15.92%
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Example: Suppose Alpha ir Freight is an all equity firm with a beta of 1.21. Further, suppose that the market risk premium is 9.5% and the risk free rate is 5 percent. We can determine the expected return on the common stock of Alpha Air Freight by using CAPM model and it is: Rs = 0.05 + 1.21*0.095 = 0.16495 =16.495% This is the return which Alpha Shareholders will expect from Alpha stock. Further, suppose that Alpha is evaluating all the following non-mutually exclusive projects. Project Project Beta Expected Cash Flows (next Year) 140 120 110 Projects Projects NPV when IRR cash flows are discounted at 0.16495 0.4 20.2 0.2 3 0.1 -5.6 Accept or Reject Accept Accept Reject

A B C

1.21 1.21 1.21

Determinants of Beta Because Beta is the standardized covariability of a stocks return with the market return. It is not surprising that highly cyclical stocks have higher beta. Operating Leverage: We know that fixed costs do not change as quantity changes. But, variable costs increase as the quantity of output rises. This difference between variable costs and fixed costs allows us to define operating leverage. Financial Leverage and Beta: Financial leverage is the extent to which a firm relies on debt, and a levered firm is a firm with some debt in its capital structure. Because the levered firm must make interest payments regardless of the sales of the firm, financial leverage refer s to the firms fixed costs of finance. Asset = Debt + Equity: Beta(asset) = Beta(debt)*(D/(D+E)*(1-t)) + Beta(equity) *(E/D+E) Assuming that the firm has a very good credit rating, there will be a time when the debt of the company is risk-less. Thus, in that case, Beta(debt) = 0 and the equation becomes: Beta (equity) = Beta (asset) * (1+D/E)
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The firm Versus the project: If a projects beta differs from that of the firm, the project should be discounted at the rate commensurate with its own beta. This is a very important point because firms frequently speak of a corporate discount rate. Calculating Beta when only the industry beta is known: Suppose that the Debt/Equity ratio of the firm is determined by D/E. Also, the Debt Equity ratio for the industry is Di/Ei. Also, Let Beta(asset) be the Beta of assets of the firm. Let the tax rate be t percent. Then, first we need to unlever industry beta, i.e. Beta(unlevered) = Beta(industry)/(1+Di *(1-t) /Ei) Beta(relevered) = Beta(unlevered)*(1 + (D *(1-t) /E)) Cost of Capital with debt: Let Rs be the cost of equity, and Rb be the cost of debt. Also, let the D/E ratio be the same D/E. Also, let the taxation rate be tc. Also, let the portion of debt in total investment be B and let the portion of equity be S. Then, Cost of Capital = Rs *(S/(S+B)) + Rb*(B/S+B)*(1-tc) It is usually referred to as weighted average cost of capital (R wacc) Please Refer to Example 12.7 on page 420 of FM I textbook to know how to calculate NPV.

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