CMA Inter – P11 – Financial Management – Unit 1

❖ Return and risk are the two critical factors in investment decisions. They are closely linked.
❖ If high risk is involved, the required return on the project should also be high.

❖ So, the level of risk is measured first and then the level of return.

❖ Meaning & types of Return:

 Return on a typical investment consists of two
components. The basic component is the periodic cash
receipts and (or income) on the investment, either in
the form of interest or dividends.
The second component is the change in the price of the
– commonly known as capital gain or loss.
 Realised return is after the fact return -return that
was earned or could have been earned. Realised return is called historical return.
 Expected return is the return from an asset that investors anticipate they will earn over future
period. It may or may not occur.
 The term yield is often used in connection this component of return. Yield refers to the income
component in relation to some price for a security.
 Some investors may measure return by using financial ratios- Return on Investment (ROI), Return
on Equity (ROE) etc. Further, investors may assign more values to cash flows rather than to
distant returns such as Internal Rate of Return (IRR).
 Ex-ante Return: Ex-ante refers to future events. Ex-ante return is the prediction of returns
that investor can get from a security or a portfolio.

(i) It helps investor to predict future return and to take right decision from investment.

(ii) Ex-ante predictions help companies to attract investors and raise capital.

(iii) It helps company to effectively plan inflation, deflation, or serious situations like a recession
 Ex-post Return Ex-post means after the event. Ex-post returns are the returns that investor has
already got from investment, i.e., historical return.

(i) It is useful for prediction of future trend, price.

(ii) It helps in predicting returns from a security based on actual returns from it over years.

(iii) Companies can use historical data to predict future earnings

(iv) Government and other agencies can use actual results from the past data.

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 CMA Inter – P11 – Financial Management – Unit 1

❖ Meaning & Types of Risk

 Risk is the variability of returns from those that
are expected. The greater the variability, the
riskier the security is said to be.

Systematic Risk:
It represents that portion of total risk which is attributable to factors that affect the
market as a whole. It arises out of external and uncontrollable factors, which are not specific
to a security or industry to which such security belongs. It is that part of risk caused by
factors that affect the price of all the securities. Beta is a measure of Systematic Risk. It
cannot be eliminated by diversification.
Market Risk Interest Rate Risk Purchasing Power Risk
These are risks that are triggered due Uncertainty of future market Purchasing Power Risk
to social, political and economic events. values and extent of income in is the erosion in the
For example, when CBDT issued a the future, due to fluctuations in value of money due
draft circular on how to treat income the general level of interest, is to the effects of
from trading in shares, whether as known as Interest Rate Risk. inflation.
Capital Receipts or Business Receipts, These are risks arising due to
the stock prices fell down sharply, fluctuating rates of interest and
across all sectors. These risks arise due cost of corporate debt. The cost
to changes in demand and supply, of corporate debt depends on the
expectations of the investors, interest rates prevailing, maturity
information flow, investor’s risk periods, credit worthiness of the
perception, etc. consequent to the borrowers, monetary and credit
social, political or economic events. policy of RBI, etc.

UnSystematic Risk:
These are risks that emanate from known and controllable factors, which are unique and / or
related to a particular security or industry. These risks can be eliminated by diversification of
portfolio.
Business Risk Financial Risk Default Risk
It is the volatility in revenues and These are risks that are associated These arise due to
profits of particular Company due with the Capital Structure of a default in meeting
to its market conditions, product Company. A Company with no Debt the financial
mix, competition, etc. It may arise Financing, has no financial risk. Higher obligations on time.
due to external reasons or the Financial Leverage, higher the Non-payment of
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 CMA Inter – P11 – Financial Management – Unit 1
(Government policies specific to Financial Risk. These may also arise financial dues on time
that kind of industry) internal due to short term liquidity problems, increases the
reasons (labour efficiency, shortage in working capital due to insolvency and
management, etc.) funds tied in working capital and bankruptcy costs.
receivables, etc.

❖ Calculation of Return:

Total Return The total return of a security for a given holding period relates all the cash flows

received by an investor during any designated time period to the amount of money

invested.

The total return is used to measure of return for a specified period of time.

Further, this return can be split in two components: dividend and capital gains. The

percentage (%) of return can be expressed in mathematical terms.

Average Annual There are two commonly methods used in calculating average annual returns:

Return (a) Arithmetic Mean and

(b) Geometric Mean.

▪ When an investor wants to know the central tendency of a series of returns, the
arithmetic mean is the appro- priate measure. It represents the typical
performance for a single period.

▪ If you want to calculate the average compound rate of growth that has actually
occurred over multiple periods, the arithmetic mean is not appropriate. Then
geometric mean is used.

Expected Rate The expected return is simply a weighted average of the possible returns, with the

of Return weights being the probabilities of occurrence. The expected rate of return can be
calculated by using the formula given below:

E(R) = R1 × P1+ R2 × P2+ R3 × P3+ R4 × P4+__________ + Rn × Pn

❖ R is the rate of returns and

❖ P is the probability

Expected The expected return on a portfolio is the weighted average of the expected returns

Return on on the assets comprising the portfolio.

Portfolio

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 CMA Inter – P11 – Financial Management – Unit 1
❖ Calculation of Risk:

 Risk may be defined as the variability of returns from an investment.

 Since it indicates variation in expected return, therefore statistical techniques may be used to
measure risks. Generally, the following methods are used to measure risk of an investment

▪ Subjective Estimates:

Risk analysis is ‘generic’ and may be applied to any situation and any form of decision-making,
from determining policy and strategy, through all levels of planning to tactical decision- making. In
different situations, risk may be expressed as low, moderate and high. When variations of returns
will not be wide, it may be called low level of risk; when forecast returns are likely to vary widely,
it may state as high-risk level and variability of returns is likely to moderate in nature then it
may represent as moderate level of risk. This method of risk assessment has its own limitations.

▪ Standard Deviation and Variance:

The standard deviation is a measure of how each possible outcome deviates from the expected
value. It measures the risk in absolute terms. The higher the value of dispersion, the higher is the
risk associated with the Portfolio and vice-versa. Generally, Standard Deviation of a specified
security or portfolio is considered to be the Total Risk associated with that security or portfolio.
Standard Deviation is generally considered as the total risk of a particular security. It can be
measured as follows:
Where,
 Variance = x = Expected rate of return = E(R)
xi = ith rate of return from an investment proposal
pi = Probability of occurrence of the ith rate of return
n = Number of outcomes

Coefficient of Variation:
Variance or standard deviation are the absolute measure of risk. Standard devia- tion can sometimes
be misleading in comparing the risk. The standard deviation when compared with the expected
returns is known as the coefficient of variation
𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐃𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧
Coefficient of Variation (CV) =
𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐕𝐚𝐥𝐮𝐞
Thus, the coefficient of variation is a measure of relative dispersion (risk) – a measure of risk “per
unit of expect- ed return.” The larger the CV, the larger the relative risk of the investment.
Beta
 The sensitivity of a security to market movements is called beta (β). When an investor wants to
invest his money in a portfolio of securities, beta is the proper measure of risk. Beta measures
systematic risk i.e., that which affects the market as a whole and hence cannot be eliminated
through diversification.

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 CMA Inter – P11 – Financial Management – Unit 1
 Beta depends on the following factor:
❖ Standard Deviation (Risk) of the Security or Portfolio.
❖ Standard Deviation (Risk) of the Market.
❖ Correlation between the Security and Market.
 According to the Capital Asset Pricing Model, the required rate of return is equivalent to the risk-
free return plus risk premium. E(RP) = RF + { βP × (RM -RF)}

 Beta is measured as follows:

❖ Cov(A,M) = Covariance of returns on an individual company’s security (A) with returns for
market as a whole (M).
❖ σ M2 = Variance of market returns

 If the value of changes in different ranges, accordingly, risk of the security would be changes.
Inferences are shown below

Beta Value is Security is

Less than 1 Less risky than the market portfolio.

Equal to 1 As risky as the market portfolio. Normal Beta security. When security beta =
1 then if market move up by 10% security will move up by 10%. If market fell
by 10% security also tend to fall by 10%.

More than 1 More risk than the market portfolio. Termed as Aggressive Security/High beta
Security. A Security beta 2 will tend to move twice as much as the market.
If market went up by 10% security tends to rise by 20%. If market fall by
10% Security tends to fall by 20%.

Less than 0 Negative Beta. It indicates negative (inverse) relationship between security
return and market return. If market goes up security will fall and vice versa.
Normally gold is supposed to have negative beta.

Equal to 0 Means there is no systematic risk and share price has no relationship with
market. Risk free security is assumed to be zero.

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 CMA Inter – P11 – Financial Management – Unit 1
❖ Capital Asset Pricing Model – by William F. Sharpe and John Linter

 The model emphasises the risk factor in portfolio theory which is a combination of two risks,
systematic risk and unsystematic risk. The model suggests that a security’s return is directly
related to its systematic risk which cannot be neutralized through diversification.
 CAPM explains the behavior of security prices and provides a mechanism whereby investors could
assess the impact of a proposed securities are determined in such a way that the risk premium
or excess return are proportion- al to systematic risk, which is indicated by the beta coefficient.
 Features of CAPM:
▪ CAPM explains the relationship between the Expected Return, Non-Diversifiable Risk (Systematic
Risk) and the valuation of securities.
▪ CAPM is based on the premise that the diversifiable risk of a security is eliminated when more and
more securities are added to the Portfolio.
▪ All securities do not have same level of systematic risk and therefore, the required rate of return
goes with the level of systematic risk. It considers the required rate of return of a security on the
basis of its (Systematic Risk) contribution to the total risk.
▪ Systematic Risk can be measured by Beta, which is a function of the following:
(a) Total Risk Associated with the Market Return,

(b) Total Risk Associated with the Individual Securities Return,

(c) Correlation between the two.

 Assumptions:
▪ With reference to Investors:
1 Investment goals of investors are rational. They desire higher return for any acceptable level
of risk and lower risk for any desired level of return.
2 Their objective is to maximize the utility of terminal wealth.
3 Their choice is based on the risk and return of a security.
4 They have homogenous expectations of risk and return over an identical time horizon.
▪ With reference to Market:
1 Information is freely and simultaneously available to all investors.
2 Capital Market is not dominated by any individual investors.
3 Investors can borrow and lend unlimited amount at the risk-free rate.
4 No taxes, transaction costs, restrictions on short-term rates or other market imperfections.
5 Total asset quantity is fixed, and all assets are marketable and divisible.

E(RS) = RF + { βS × (RM -RF)}

Where,
E(RS) = Expected Return on the Security or Investment
RF = Risk Free Rate of Interest/ Return
βS = Security Beta or Risk Premium
RM = Expected Return on all securities or Market Return
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 CMA Inter – P11 – Financial Management – Unit 1

Que 1.
The current market price of a share is ₹600. An investor buys 100 shares. After one year he sells these shares at
a price of ₹720 and also receives the dividend of ₹30 per share. Find the total return (%) of the investor?

Que 2.
X Ltd. has forecasted returns on its share with the following probability distribution:
Return (%) Probability
-20 0.05
-10 0.05
-5 0.10
5 0.10
10 0.15
18 0.25
20 0.25
30 0.05
Find out the following: (a) Expected Rate of Return (b) Variance (c) Standard Deviation

Que 3.
Consider, two securities, A and B, whose normal probability distributions of one-year returns have the
following characteristics:

Security A Security B
Expected return, [E(R)] 0.08 0.24
Standard deviation, (σ) 0.06 0.08
Coefficient of variation, (CV) 0.75 0.33

Comment on the above information

Que 4.
From the following data, compute the beta of Security X. Given: σX = 12%; σM = 9%; r(X,M)= + 0.72

Que 5.
The stock price and dividend history of X Ltd. are given below:

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 CMA Inter – P11 – Financial Management – Unit 1

Year Closing Share Price (₹) Dividend per Share (₹)

2015 312 5.50
2016 389 6.75
2017 234 4.60
2018 345 5.90
2019 367 3.78
2020 389 4.10
2021 412 5.98
Using the above data, compute the following:
1. Annual rates of return
2. Expected average rate of return
3. Variance
4. Standard deviation

Que 6.
The following information is given:
• Security Beta: 1.2
• Risk-free rate: 4%
• Expected market return: 12%
Calculate expected rate of return on the security

Que 7.
Compute the future values of (1) an initial ₹100 compounded annually for 10 years at 10% and (2) an annuity
of ₹100 for 10 years at 10%.

Que 8.
A note (secured premium note) is available for ₹1,400. It offer, including one immediate payment, 10 annual
payments of ₹210. Compute the rate of return (yield) on the note

Que 9.
The shares of ABC Ltd. are currently selling for ₹100 on which the expected dividend is ₹4. Compute the
total return on the shares if the earnings or dividends are likely to grow at (a) 5 % (b) 10 % and (c) 0 (zero)
% (no growth).

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 CMA Inter – P11 – Financial Management – Unit 1

Que 10.
ABC Ltd. is considering a proposal to buy a machine for ₹30,000. The expected cash flows after taxes from the
machine for a period of 3 consecutive years are ₹20,000 each. After the expiry of the useful life of the
machine, the seller has guaranteed its repurchase at ₹ 2,000. The firm’s cost of capital is 10% and the risk
adjusted discount rate is 18%. Should the company accept the proposal of purchasing the machine?

Que 11.
The Hypothetical Ltd is examining two mutually exclusive proposals. The management of the company uses
certainty equivalents (CE) approach to evaluate new investment proposals. From the following information
per- taining to these projects, advise the company as to which project should be taken up by it.
Year Proposal A Proposal B
CFAT (Rs ) CE CFAT (Rs) CE
0 (25,000) 1.0 (25,000) 1.0
1 15,000 0.8 9,000 0.9
2 15,000 0.7 18,000 0.8
3 15,000 0.6 12,000 0.7
4 15,000 0.5 16,000 0.4
The firm’s cost of capital is 12%, and risk-free borrowing rate is 6%.

Que 12.
A life insurance company offers a 10-year single premium plan. According to the policy conditions, the
investor has to pay Rs. 1,00,000 at the beginning of first year and he will receive a pension of Rs. 16,000 at
the beginning of the second year onwards. What will be the yield generated by the investor?

Que 13.
Share of a company is traded at Rs. 60. An investor expects the company to pay dividend of Rs. 3 per share,
form one year now. The expected price one year now is Rs.78.50.
(a) What is the expected dividend yield, rate of price change and holding period yield?
(b) If the beta of the share is 1.5, risk free rate is 6 % and the market risk premium is 10%, then calculate
the required rate of return.

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