2014

Ques. 1

The most widely accepted goal of the firm is ‘to maximise shareholder wealth’ or ‘market value
of the firm’. This goal incorporates both the profitability and risk into one objective. The firm
can maximise shareholder wealth by investing in only those projects that generate positive net
present values (NPV). Net present value refers to the discounted sum of the expected net cash
flows. The discount rate takes into account the timing and risk of the future cash flows that are
available from an investment. The NPV represents the amount of wealth or value added to the
firm from the project. Thus, the selection of projects on the basis of NPV criterion directly
relates to the achievements of the firm’s goal. (4 Marks)

Goal of the Firm

In finance, the goal of the firm is always described as "maximization of shareholders' wealth".

Profit Maximization - is always used as a goal of the firm in microeconomics. Focus on short term goal
to be achieved within a year. It stresses on the efficient use of capital resources. In order to maximize
profit, the financial manager will implement actions that would result in maximum profits without
considering the consequence of his actions towards the company's future performance.

Drawbacks of Profit Maximization

- Profit maximization is a short-term concept.
- Profit maximization does not consider the timing of returns.
- Profit maximization ignores risk.

Maximization of Shareholders' Wealth

The goal is to maximize the shareholders' wealth for whom it is being operated. It is being measured by
the share price of the stock, which in turn is based on the timing of returns, the amount of the returns
and the risk or uncertainty of the returns.

It also means maximizing the total market value of the existing shareholders' common stock. All financial
decisions will affect the achievement of this goal. Shareholders' wealth maximization can be achieved by
considering the present and potential future earnings per share, timing of returns, dividend policy and
other factors that affect the market price of the company's stock.

Motivating Managers to Act in Shareholder's Best Interest

Four primary mechanisms are used to motivate managers to act in stockholders' best interests:
  Managerial compensation
 Direct intervention by stockholders
 Threat of firing
 Threat of takeovers

1. Managerial Compensation
Managerial compensation should be constructed not only to retain competent managers, but to align
managers' interests with those of stockholders as much as possible.

 This is typically done with an annual salary plus performance bonuses and company shares.
 Company shares are typically distributed to managers either as:
o Performance shares, where managers will receive a certain number shares based on the
company's performance.
o Executive stock options, which allow the manager to purchase shares at a future date
and price. With the use of stock options, managers are aligned closer to the interest of
the stockholders as they themselves will be stockholders.

2. Direct Intervention by Stockholders

Today, the majority of a company's stock is owned by large institutional investors, such as mutual funds
and pensions. As such, these large institutional stockholders have the ability to exert influence on
mangers and, as a result, the firm's operations.

3. Threat of Firing
If stockholders are unhappy with current management, they can encourage the existing board of
directors to change the existing management, or stockholders may even re-elect a new board of
directors that will accomplish the task.

4. Threat of Takeovers
If a stock price deteriorates because of management's inability to run the company effectively,
competitors or stockholders may take a controlling interest in the company and bring in their own
managers.

Profit vs. Wealth Maximization

Profit vs Wealth maximization is a very common but a very crucial dilemma. The financial management
has come a long way by shifting its focus from traditional approach to modern approach. The modern
approach focuses on maximization of wealth rather than profit. This gives a longer term horizon for
assessment, making way for sustainable performance by businesses.
A myopic person or business is mostly concerned about short term benefits. A short term horizon can
fulfill objective of earning profit but may not help in creating wealth. It is because wealth creation needs
a longer term horizon Therefore, financial management emphasizes on wealth maximization rather than
profit maximization. For a business, it is not necessary that profit should be the sole objective; it may
concentrate on various other aspects like increasing sales, capturing more market share etc, which will
take care of profitability. So, we can say that profit maximization is a subset of wealth. Being a subset, it
will facilitate wealth creation.

Managers are now giving priority to value creation. They have now shifted from traditional to modern
approach of financial management that focuses on wealth maximization.

This leads to better and true evaluation of the business. For e.g., under wealth maximization, cash flows
are more important than profitability. As we know, profit is a relative term, it can be a figure in some
currency, a percentage etc. For e.g. we cannot judge a profit of say $10,000 as good or bad for a
business, till we compare it with investment, sales etc. Similarly, duration of earning the profit is also
important i.e. whether it is earned in short term or long term.

In wealth maximization, major emphasizes is on cash flows rather than profit. So, to evaluate various
alternatives for decision making, cash flows are taken into consideration. For e.g. to measure the worth
of a project, criteria like: “present value of its cash inflow – present value of cash outflows” (net present
value) is taken. This approach considers cash flows rather than profits into consideration. It also use
discounting technique to find out the worth of a project. Thus, maximization of wealth approach
believes that money has time value.

An obvious question that arises at this point is that how can we measure wealth. Well, a basic principle
is that ultimately wealth maximization should be discovered in increased net worth or value of business.
So, to measure the same, value of business is a function of two factors. These are earnings per share and
capitalization rate. And it can be measured by adopting following relation:

Value of Business = EPS / Capitalization rate

Ques. 2

Independent Projects: If the projects are independent meaning that investment in one project has
nothing to do with investment in others, the results of the two evaluation criteria will necessarily be the
same. Both of them will lead to the same accept/ reject decision. This is because when NPV is positive,
IRR must be greater than the cost of capital. At zero NPV, the IRR will be equal to the cost of capital. And
when NPV is negative, IRR is less than the cost of capital.

Ques. 3
Difference between Systematic and Unsystematic Risk

Definition of Systematic Risk

By the term ‘systematic risk’, we mean the variation in the returns on securities, arising due to
macroeconomic factors of business such as social, political or economic factors. Such
fluctuations are related to the changes in the return of the entire market. Systematic risk is caused
by the changes in government policy, the act of nature such as natural disaster, changes in the
nation’s economy, international economic components, etc. The risk may result in the fall of the
value of investments over a period. It is divided into three categories, that are explained as under:

 Interest risk: Risk caused by the fluctuation in the rate or interest from time to time and affects
interest-bearing securities like bonds and debentures.
 Inflation risk: Alternatively known as purchasing power risk as it adversely affects the
purchasing power of an individual. Such risk arises due to a rise in the cost of production, the
rise in wages, etc.
 Market risk: The risk influences the prices of a share, i.e. the prices will rise or fall consistently
over a period along with other shares of the market.

Definition of Unsystematic Risk

The risk arising due to the fluctuations in returns of a company’s security due to the micro-
economic factors, i.e. factors existing in the organization, is known as unsystematic risk. The
factors that cause such risk relates to a particular security of a company or industry so influences
a particular organization only. The risk can be avoided by the organization if necessary actions
are taken in this regard. It has been divided into two category business risk and financial risk,
explained as under:

 Business risk: Risk inherent to the securities, is the company may or may not perform well. The
risk when a company performs below average is known as a business risk. There are some
factors that cause business risks like changes in government policies, the rise in competition,
change in consumer taste and preferences, development of substitute products, technological
changes, etc.
 Financial risk: Alternatively known as leveraged risk. When there is a change in the capital
structure of the company, it amounts to a financial risk. The debt – equity ratio is the expression
of such risk.

Comparison Chart

Basis for
Systematic Risk Unsystematic Risk
Comparison

Systematic risk refers to the hazard which is Unsystematic risk refers to the risk
Meaning associated with the market or market associated with a particular security,
segment as a whole. company or industry.

Nature Uncontrollable Controllable

 Basis for
Systematic Risk Unsystematic Risk
Comparison

Factors External factors Internal factors

Affects Large number of securities in the market. Only particular company.

Interest risk, market risk and purchasing

Types Business risk and financial risk
power risk.

Protection Asset allocation Portfolio diversification

Key Differences Between Systematic and Unsystematic Risk

The basic differences between systematic and unsystematic risk is provided in the following points:

1. Systematic risk means the possibility of loss associated with the whole market or market
segment. Unsystematic risk means risk associated with a particular industry or security.
2. Systematic risk is uncontrollable whereas the unsystematic risk is controllable.
3. Systematic risk arises due to macroeconomic factors. On the other hand, the unsystematic risk
arises due to the micro-economic factors.
4. Systematic risk affects a large number of securities in the market. Conversely, unsystematic risk
affects securities of a particular company.
5. Systematic risk can be eliminated through several ways like hedging, asset allocation, As
opposed to unsystematic risk that can be eliminated through portfolio diversification.
6. Systematic risk is divided into three categories, i.e. Interest risk, market risk and purchasing
power risk. Unlike unsystematic risk, which is divided into two broad category business risk and
financial risk.

Conclusion

The circumvention of systematic and unsystematic risk is also a big task. As external forces are involved
in causing systematic risk, so these are unavoidable as well as uncontrollable. Moreover, it affects the
entire market, but can be reduced through hedging and asset allocation. Since unsystematic risk is
caused by internal factors so that it can be easily controlled and avoided, up to a great extent through
portfolio diversification.

Ques. 4
Independent projects – if the cash flows of one are unaffected by the acceptance of the other – more
than one project may be accepted.
Mutually exclusive projects – if the cash flows of one project can be adversely impacted by the
acceptance of the other
– accept one or the other.
Independent Vs. Mutually Exclusive Projects

The projects being analyzed by a company may be completely independent

of each other or mutually exclusive. When two projects are independent, it means that there cash
flows are independent of each other, and so is their profitability. A company may decide to
undertake both the projects if they are both profitable.

When two projects are mutually exclusive, it means that the firm wants to undertake only one of
these two projects, not both. For example, while deciding between two delivery trucks that have
different costs and output, the firm will have to choose one truck between the two.

Or,

Difference between Mutually Exclusive and Independent Events

Probability is a mathematical concept, which has now become a full-fledged discipline and is a
vital part of statistics. Random experiment in probability is a performance that generates a
certain outcome, purely based on chance. The results of a random experiment are called event. In
probability, there are various types of events, as in simple, compound, mutually exclusive,
exhaustive, independent, dependent, equally likely, etc. When events cannot occur at the same
time, they are called mutually exclusive

On the other hand, if each event is unaffected by other events, they are called independent
events. Take a full read of the article presented below to have a better understanding of the
difference between mutually exclusive and independent events.

Content: Mutually Exclusive Event Vs Independent Event

1. Comparison Chart
2. Definition
3. Key Differences
4. Conclusion

Comparison Chart

Basis for
Mutually Exclusive Events Independent Events
Comparison

Two events are said to be mutually Two events are said to be independent, when
Meaning exclusive, when their occurrence is not the occurrence of one event cannot control
simultaneous. the occurrence of other.

Occurrence of one event will result in Occurrence of one event will have no influence
Influence
the non-occurrence of the other. on the occurrence of the other.
 Basis for
Mutually Exclusive Events Independent Events
Comparison

Mathematical
P(A and B) = 0 P(A and B) = P(A) P(B)
formula

Sets in Venn
Does not overlap Overlaps
diagram

Definition of Mutually Exclusive Event

Mutually exclusive events are those which cannot occur concurrently, i.e. where the occurrence
of one event results in non-occurrence of the other event. Such events cannot be true at the same
time. Therefore, the happening of one event makes the happening of another event impossible.
These are also known as disjoint events.

Let’s take an example of tossing of a coin, where the result would either be head or tail. Both
head and tail cannot occur simultaneously. Take another example, suppose if a company wants to
purchase machinery, for which it has two options Machine A and B. The machine which is cost
effective and productivity is better, will be selected. The acceptance of machine A will
automatically result in the rejection of machine B and vice versa.

Definition of Independent Event

As the name suggests, independent events are the events, in which the probability of one event
does not control the probability of the occurrence of the other event. The happening or non-
happening of such an event has absolutely no effect on the happening or non-happening of
another event. The product of their separate probabilities is equal to the probability that both
events will occur.

Let’s take an example, suppose if a coin is tossed twice, tail in the first chance and tail in the
second, the events are independent. Another example for this, Suppose if a dice is rolled twice, 5
in the first chance and 2 in the second, the events are independent.

Key Difference Between Mutually Exclusive and Independent Events

The significant differences between mutually exclusive and independent events are elaborated as
under:

1. Mutually exclusive events are those events when their occurrence is not simultaneous. When
the occurrence of one event cannot control the occurrence of other, such events are called
independent event.
 2. In mutually exclusive events, the occurrence of one event will result in the non-occurrence of
the other. Conversely, in independent events, occurrence of one event will have no influence on
the occurrence of the other.
3. Mutually exclusive events are represented mathematically as P(A and B) = 0 while independent
events are represented as P (A and B) = P(A) P(B).
4. In a Venn diagram, the sets do not overlap each other, in the case of mutually exclusive events
while if we talk about independent events the sets overlap.

Conclusion

So, with the above discussion, it is quite clear that both the events are not same. Moreover, there is a
point to remember, and that is if an event is mutually exclusive, then it cannot be independent and vice
versa. If two events A and B are mutually exclusive, then they can be expressed as P(AUB)=P(A)+P(B)
while if the same variables are independent then they can be expressed as P(A∩B) = P(A) P(B).

Ques. 5
Calculating Discounted payback period

Cumulative Discounted cash flows will start with a negative value due to the original cost of investment,
but as cash is generated each year after the original investment the discounted cash flows for those
years will be positive, and the cumulative discounted cash flows will progress in a positive direction
towards zero. When the negative cumulative discounted cash flows become positive, or recover, DPP
occurs.

Discounted payback period is calculated by the formula:

DPP = Year before DPP occurs + Cumulative Discounted Cash flow in year before
recovery ÷ Discounted cash flow in year after recovery [2]

Advantages

Discounted Payback Period helps businesses reject or accept projects by helping determine their
profitability while taking into account the time-value of money.[1] This is done via the decision rule: If the
DPP is less than its useful life, or any predetermined period, the project can be accepted. If the DPP is
greater than the specified period or the project's useful life, the project should be rejected. the DPP also
helps compare mutually exclusive projects, as the project with the shorter DPP should be accepted.

Disadvantages

The Discounted Payback method still does not offer concrete decision criteria to determine if an
investment increases a firms value. In order to calculate DPP, an estimate of the cost of capital is
required. Another disadvantage is that cash flows beyond the discounted payback period are ignored
entirely with this method.[3]

Alternative,
Advantages of Discounted Payback Period

Although not entirely satisfactory, the calculation of discounted payback period is comparatively
better than a calculation using an undiscounted payback period as a capital budgeting decision
criterion. That said, an even better calculation to use in many instances is the net present value
calculation.

Calculation of Discounted Payback Period

The calculation for discounted payback period is a bit different than the calculation for regular payback
period because the cash flows used in the calculation are discounted by the weighted average cost of
capital used as the interest rate and the year in which the cash flow is received. Here is an example of a
discounted cash flow:

Imagine that the first year's cash flow from a project is $400 and the weighted average cost of
capital is 8%. Here is the formula:

Discounted Cash Flow Year 1 = $400/(1+i)^1, where i = 8% and the year = 1

The calculation of discounted payback period using this example is the following. Imagine that a
company wants to invest in a project costing $10,000 and expects to generate cash flows of $5,000 in
year 1, $4,000 in year 2, and $3,000 in year 3. The weighted average cost of capital is 10%. Here are the
steps you use to calculate discounted payback period:

1. Discount the cash flows back to the present or to their present value:

Here are the calculations:

 Year 0: -$10,000/(1+.10)^0 = $10,000

 Year 1: $5000/(1+.10)^1= $4,545.45
 Year 2: $4000/(1+.10)^2= $3,305.79
 Year 3: $3000/(1+.10)^3= $2,253.94

2. Calculate the cumulative discounted cash flows:

 Year 0: - $10,000
 Year 1: - $5,454.55
 Year 2: - 4$2,148.76
 Year 3: $105.18

Discounted payback period (DPP) occurs when the negative cumulative discounted cash flows
turn into positive cash flows which, in this case, is between the second and third year.

The formula to find the exact discounted payback period follows:

DPP = Year Before DPP Occurs + Cumulative Cash Flow in Year Before Recovery ÷
Discounted Cash Flow in Year After Recovery

Using our example above, the precise discounted payback period (DPP) would equal 2 +
$2,148.76/$2,253.94 or 2.95 years. In the example, the investment recovers its outlays in a little under
three years.

Conclusion
Discounted payback period is an upgraded capital budgeting method in comparison to simple payback
period method. It helps to determine the time period required by a project to break even. Even though
it suffers from some flaws, yet it is a good method to determine the viability of a project as it considers
the time value of money. By incorporating this method along with other methods, the managers can
arrive at a right decision and know the exact risk involved in a project.

Ques-7

INCREMENTAL CASH FLOWS

The difference between the cash flows of the firm with the investment project and the cash flows of
the firm without the investment project — both over the same period of time — is referred to as the
project’s incremental cash flows.
To evaluate an investment, we’ll have to look at how it will change the future cash flows of
the firm. We will be examining how much the value of the firm changes as a result of the investment.
The change in a firm’s value as a result of a new investment is the difference between its
benefits and its costs:

Project’s change in the value of the firm= Project’s benefits − Project’s costs

A more useful way of evaluating the change in the value is the breakdown of the project’s cash flows
into two components:

1. The present value of the cash flows from the project’s operating activities (revenues minus
operating expenses), referred to as the project’s operating cash flows (OCF); and
2. The present value of the investment cash flows, which are the expenditures needed to acquire the
project’s assets and any cash flows from disposing the project’s assets.

Or,

Change in the value of the firm = Present value of the change in operating cash flows provided by the
project
+ Present value of investment cash flows

The present value of a project’s operating cash flows is typically positive (indicating
predominantly cash inflows) and the present value of the investment cash flows is typically negative
(indicating predominantly cash outflows).
2013
Ques: 1
The certainty equivalent (CE) method follows directly from the concept of utility theory. Under the CE
approach, the decision maker must first evaluate a cash flow’s risk and then specify how much money,
to be received with certainty, will make him or her indifferent between the riskless and the risky cash
flows.

What is 'Certainty Equivalent?'

The certainty equivalent is a guaranteed return that someone would accept rather than taking a chance
on a higher, but uncertain, return. To put it another way, the certainty equivalent is the guaranteed
amount of cash that would yield the same exact expected utility as a given risky asset with absolute
certainty.

CERTAINTY EQUIVALENTS VERSUS RISK-ADJUSTED DISCOUNT RATES

As noted above, investment risk can be handled by making adjustments either to the numerator of the
present value equation (the certainty equivalent, or CE, method) or to the denominator (the risk-
adjusted discount rate, or RADR, method). The RADR method dominates in practice because people find
it far easier to estimate suitable discount rates based on current market data than to derive certainty
equivalent cash flows. Some financial theorists have suggested that the certainty equivalent approach is
theoretically superior, but other theorists have shown that if risk increases with time, then using a risk-
adjusted discount rate is a valid procedure.
Risk-adjusted rates lump together the pure time value of money as represented by the risk-free rate
and a risk premium:
RADR = rRF RRP.
On the other hand, the CE approach keeps risk and the time value of money separate. This separation
gives a theoretical advantage to certainty equivalents, because lumping together the time value of
money and the risk premium compounds the risk premium over time. By compounding the risk
premium over time, the RADR method automatically assigns more risk to cash flows that occur in the
distant future, and the farther into the future, the greater the implied risk. Since the CE method assigns
risk to each cash flow individually, it does not impose any assumptions regarding the relationship
between risk and time.

Or,
‘The certainty equivalent approach is theoretically superior to the risk-adjusted discount rate.’ Do you
agree? Give reasons.
Ans.:
Yes, because certainty equivalent approach measures risk more accurately by adjusting estimated cash
flows and employs risk-free rate to discount the adjusted cash flows. On the other hand, the risk-
adjusted discount rate adjusts for risk by adjusting the discount rate. If the investor thinks that an
investment may be more risky during the gestation period, and once established, risk may reduce. In
such case, the use of a constant risk-adjusted discount rate is not valid. But the increased or decreased
risks over a period of time can easily be accounted for by changing the certainty equivalent factors,
when the certainty equivalent approach is used. Q.5. What are the limitations of payback method as a
risk handling technique? Can it be used as a supplement to more sophisticated techniques? A.5. The
payback period is the number of years required to recover the initial outlay of the investment. The
payback period method ignores the time value of money, ignores the cash flows occurring after the
payback period, and also does not measure the profitability of the project. The payback period method
can be used, only in case of project having special type of risk like civil wars, introduction of new product
by a competitor, and natural disasters such as flood or fire, which will suddenly cease the entire project
altogether and be worth nothing. This method makes an allowance for risk by focusing attention on the
short term project and thereby emphasizing the liquidity of the firm through early recovery of project.
Q.6. How can you conduct the DCF break even analysis? Why is the DCF analysis important in risk
analysis in capital budgeting? A.6. DCF break-even means a situation where NPV is zero. The NPV of a
project depends on cash outlay, volume, price, variable costs, fixed costs, depreciation rate, tax rate, life
of the project etc. For calculating DCF break-even point, one can take one variable and determine its
minimum value at which NPV is zero. DCF analysis is important in risk analysis since it indicates the
sensitivity of the project NPV to changes in variables. It helps to identify variables which are critical to
the project NPV. Q.7. What is sensitivity analysis? What are its advantages and limitations?

Ques.: 2
A portfolio is the total collection of all investments held by an individual or institution, including stocks,
bonds, real estate, options, futures, and alternative investments, such as gold or limited partnerships.

Most portfolios are diversified to protect against the risk of single securities or class of securities. Hence,
portfolio analysis consists of analyzing the portfolio as a whole rather than relying exclusively on security
analysis, which is the analysis of specific types of securities. While the risk-return profile of a security
depends mostly on the security itself, the risk-return profile of a portfolio depends not only on the
component securities, but also on their mixture or allocation, and on their degree of correlation.

As with securities, the objective of a portfolio may be for capital gains or for income, or a mixture of
both. A growth-oriented portfolio is a collection of investments selected for their price appreciation
potential, while an income-oriented portfolio consists of investments selected for their current income
of dividends or interest.

The selection of investments will depend on one's tax bracket, need for current income, and the ability
to bear risk, but regardless of the risk-return objectives of the investor, it is natural to want to minimize
risk for a given level of return. The efficient portfolio consists of investments that provide the greatest
return for the risk, or—alternatively stated—the least risk for a given return. To assemble an efficient
portfolio, one needs to know how to calculate the returns and risks of a portfolio, and how to minimize
risks through diversification.

Since the return of a portfolio is commensurate with the returns of its individual assets, the return
of a portfolio is the weighted average of the returns of its component assets.

Portfolio Return Formula

 Dollar Amount of Asset k
n
Portfolio Return = ∑ × Return on Asset k
k=1
Dollar Amount of Portfolio

n = number of assets

The dollar amount of an asset divided by the dollar amount of the portfolio is the weighted
average of the asset and the sum of all weighted averages must equal 100%.

Example: Calculating the Expected Return of a Portfolio of 2 Assets

Example Portfolio

Asset Weightings

Asset A 30%

Asset B 70%

Expected Returns
for each Asset

E(rA) 13.9%

E(rB) 9.7%

The expected return of this portfolio is calculated thus:

Portfolio Expected Return = .3 × .139 + .7 × .097 = .109 = 10.9%

Portfolio Risk—Diversification and Correlation Coefficients

Portfolio risks can be calculated, like calculating the risk of single investments, by taking the
standard deviation of the variance of actual returns of the portfolio over time. This variability of
returns is commensurate with the portfolio's risk, and this risk can be quantified by calculating
the standard deviation of this variability. Standard deviation, as applied to investment returns,
is a quantitative statistical measure of the variation of specific returns to the average of those
returns. One standard deviation is equal to the average deviation of the sample.

Standard Deviation Formula for Portfolio Returns

s = Standard Deviation
rk = Specific Return
rexpected = Expected Return
n = Number of Returns (sample size)
n – 1 = number of degrees of freedom, which, in statistics, is used for small sample sizes

Although the diversifiable risk of a portfolio obviously depends on the risks of the individual
assets, it is usually less than the risk of a single asset because the returns of different assets are up
or down at different times. Hence, portfolio risk can be reduced by diversification—choosing
individual investments that rise or fall at different times from the other investments in the
portfolio. For most portfolios, diversifiable risk declines, quickly at first, then more slowly,
reaching a minimum with about 20 - 25 securities. However, how rapidly risk declines depends
on the covariance of the assets composing the portfolio.
The basis for diversification is that different classes of assets respond differently to different
economic conditions, which causes investors to move assets from 1 class to another to reduce
risk and to profit from changing conditions. For instance, when interest rates rise, stocks tend to
go down as margin interest rises making it more expensive to borrow money to buy stocks,
which lowers their demand, and therefore their prices, while higher interest rates also causes
investors to move more money into less risky securities, such as bonds, that pay interest.

Covariance is a statistical measure of how 1 investment moves in relation to another. If 2

investments tend to be up or down during the same time periods, then they have positive
covariance. If the highs and lows of 1 investment move in perfect coincidence to that of another
investment, then the 2 investments have perfect positive covariance. If 1 investment tends to be
up while the other is down, then they have negative covariance. If the high of 1 investment
coincides with the low of the other, then the 2 investments have perfect negative covariance.
The risk of a portfolio composed of these assets can be reduced to zero. If there is no discernible
pattern to the up and down cycles of 1 investment compared to another, then the 2 investments
have no covariance.

Because covariance numbers cover a wide range, the covariance is normalized into the
correlation coefficient, which measures the degree of correlation, ranging from -1 for a
perfectly negative correlation to +1 for a perfectly positive correlation. An uncorrelated
investment pair would have a correlation coefficient close to zero. Note that since the correlation
coefficient is a statistical measure, a perfectly uncorrelated pair of investments will rarely, if
ever, have an exact correlation coefficient of zero.

The most diversified portfolio consists of securities with the greatest negative correlation. A
diversified portfolio can also be achieved by investing in uncorrelated assets, but there will be
times when the investments will be both up or down, and thus, a portfolio of uncorrelated assets
will have a greater degree of risk, but it is still significantly less than positively correlated
investments. However, even positively correlated investments will be less risky than single assets
or investments that are perfectly positively correlated. However, there is no reduction in risk by
combining assets that are perfectly correlated.

Correlations can change over time and in different economic conditions. For instance, during the
late 1990's, stock prices increased significantly, then crashed in 2000. Interest rates were lowered
to boost the economy, which caused real estate prices to increase significantly from 2001 - 2006.
Hence, real estate prices were increasing while stocks were either declining, or not increasing by
nearly the same rate. This reflects the general negative correlation between the stock market and
the real estate market. The real estate market was forming a bubble due to the extremely low
interest rates at the time. The bubble finally burst in 2007, and especially 2008, leading to the
2007– 2009 credit crisis. This caused money to move into commodities during the summer of
2008, which formed another bubble, with oil prices, for instance, reaching $147 per barrel. The
fast increase in prices was not due to demand, but due to the transfer of money from assets doing
poorly—stocks and real estate—to commodities and future contracts. In other words, it was
another bubble. However, as credit dried up, due to the prevalence of many defaults of subprime
mortgages, almost every investment came crashing down in September and October of 2008: real
estate, stocks, bonds, commodities. Only United States Treasuries, which are virtually free of
credit-default risk, rose significantly in price, driving their yields down proportionately, with the
yields of short-term T-bills reaching almost zero.

So the corollary of this story is that correlations can and do change, and that investments always
have some risk.

Calculating the Covariance and Coefficient of Correlation between 2 Assets

In this section, we will actually calculate the covariance and the coefficient of correlation
between 2 assets, which is the simplest case, based on the following table:

Example: Expected Returns in Different Economic Times

Economic State Probability of State Asset A Return (%) Asset B Return (%)

Boom 20% 22 6

Normal 55% 14 10

Recession 25% 7 12

The variance of an asset A is calculated thus:

Variance Formula for an Asset

S
2
σ = ∑ Ps{[rAs – E(rA)]2
s=1

 σ2 = Variance of Asset A
 S = Number of Different States
(i.e., Boom, Normal, Recession)
 Ps = Probability of Economic State s
 rAs = Return for Asset A for the sth period.
 E(rA) = Expected Return for Asset A

Risk is typically represented by the standard deviation of the expected returns of an asset, equal
to the square root of its variance:

Standard Deviation = √σ2

To calculate variances for the 2 assets, the probability of each state is multiplied by the return for
that state minus the expected return squared. The expected returns for these 2 assets were
calculated in the 1st example at the top of the page:

Expected Returns

E(rA) 13.9%

E(rB) 9.7%

Variance for Asset A

σ2A = .2 × (22 – 13.9)2 +

.55 × (14 – 13.9)2 +

.25 × (7 – 13.9)2

= -25.03

Variance of Asset B

σ2B = .2 × (6 – 9.7)2 +

.55 × (10 – 9.7)2 +

.25 × (12 – 9.7)2

= -4.11

Variances of Returns (%)

σ2A 25.03

σ2B 4.11

Covariance is measured over time, by comparing the expected returns of each asset for each time
period. The time periods are selected for the different states of the economy , comparing the
expected returns of each asset during boom times, recessions, and normal times. Although
returns can be selected according to other criteria, such as monthly returns, it makes sense to
sample the returns based upon different states of the economy, since this is more likely to reveal
their covariance.
 Covariance Formula for 2 Assets

S
σAB = ∑ Ps{[rAs – E(rA)][rBs – E(rB)]}
s=1

 σAB= Covariance of Asset A with Asset B

 S = Number of Different States
(i.e., Boom, Normal, Recession)
 Ps = Probability of Economic State s
 rAs = Return for Asset A for the sth period.
 rBs = Return for Asset B for the sth period.
 E(rA) = Expected Return for Asset A
 E(rB) = Expected Return for Asset B

The covariance of 2 assets is equal to the probability of each economic state multiplied by the
difference of the return for each asset for each economic state minus the expected return for that
asset. The covariance of these 2 assets, based on the table above, is:

σAB = .2 × (22 – 13.9) × (6 – 9.7) +

.55 × (14 – 13.9) × (10 – 9.7) +

.25 × (7 – 13.9) × (12 – 9.7)

= -9.95

The coefficient of correlation between Asset A and Asset B, designated as σAB, which can range
from -1 to +1:

Coefficient of Correlation Formula for 2 Assets

σAB

σAB =

σA σB

Therefore:

Correlation Coefficient for Assets A and B

 σAB -9.95

σAB = = = -0.98

σA σB √25.03 √4.11

As the number of assets increases, the computational complexity greatly increases, since
covariance must be measured between every 2 different assets in a portfolio, which leads to (n2 –
n) / 2 covariance calculations, where n = number of assets in the portfolio, in addition to the
calculations of the expected returns and variances for each asset . The number of covariance
calculations is divided by 2 because the covariance of Asset A to Asset B is the same as the
covariance of Asset B to Asset A. To avoid this complexity, simplifying models are used. The
simplest of these models is the single-index model, which can approximate the covariance of
assets in a portfolio by comparing the variance of each asset with the variance of the market.

Q-3
What is 'Beta'

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the
market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates the expected
return of an asset based on its beta and expected market returns. Beta is also known as the beta
coefficient.

Beta is a measure of the risk arising from exposure to general market movements as opposed to
idiosyncratic factors. The market portfolio of all investable assets has a beta of exactly 1. A beta below 1
can indicate either an investment with lower volatility than the market, or a volatile investment whose
price movements are not highly correlated with the market. An example of the first is a treasury bill: the
price does not go up or down a lot, so it has a low beta. An example of the second is gold. The price of
gold does go up and down a lot, but not in the same direction or at the same time as the market.[1]

Beta is important because it measures the risk of an investment that cannot be reduced by
diversification. It does not measure the risk of an investment held on a stand-alone basis, but the
amount of risk the investment adds to an already-diversified portfolio. In the capital asset pricing model,
beta risk is the only kind of risk for which investors should receive an expected return higher than the
risk-free rate of interest.[3]

How do you find the beta of a portfolio?

To do it, you'll need to know the percentage of your portfolio by individual stock and the beta for each
of those stocks. You can learn to calculate beta for individual stocks by clicking here. The first step is to
multiply the percentage of your portfolio and the beta for each individual stock.

The beta of a portfolio

The beta of a portfolio is the weighted sum of the individual asset betas, According to the proportions of
the investments in the portfolio. E.g., if 50% of the money is in stock A with a beta of 2.00, and 50% of
the money is in stock B with a beta of 1.00,the portfolio beta is 1.50. Portfolio beta describes relative
volatilityof an individual securities portfolio, taken as a whole, as measured by the individual stock betas
of the securities making it up. A beta of 1.05 relative to the S&P 500 implies that if the S&P's excess
return increases by 10% the portfolio is expected to increase by 10.5%.

Q-4
Calculating DPP

Cumulative Discounted cash flows will start with a negative value due to the original cost of
investment, but as cash is generated each year after the original investment the discounted
cash flows for those years will be positive, and the cumulative discounted cash flows will
progress in a positive direction towards zero. When the negative cumulative discounted cash
flows become positive, or recover, DPP occurs.

Discounted payback period is calculated by the formula:

DPP = Year before DPP occurs + Cumulative Discounted Cash flow in year before recovery ÷
Discounted cash flow in year after recovery

Advantages

Discounted Payback Period helps businesses reject or accept projects by helping determine
their profitability while taking into account the time-value of money.[1] This is done via the
decision rule: If the DPP is less than its useful life, or any predetermined period, the project can
be accepted. If the DPP is greater than the specified period or the project's useful life, the
project should be rejected. the DPP also helps compare mutually exclusive projects, as the
project with the shorter DPP should be accepted.

Disadvantages

The Discounted Payback method still does not offer concrete decision criteria to determine if
an investment increases a firms value. In order to calculate DPP, an estimate of the cost of
capital is required. Another disadvantage is that cash flows beyond the discounted payback
period are ignored entirely with this method.[3]

Shortcomings

Payback period doesn't take into consideration the time value of money and therefore may not present
the true picture when it comes to evaluating cash flows of a project. This issue is addressed by using
Discounted Payback Period, which uses discounted cash flows. Payback also ignores the cash flows
beyond the payback period. Most major capital expenditures have a long life span and continue to
provide cash flows even after the payback period. Since the payback period focuses on short term
profitability, a valuable project may be overlooked if the payback period is the only consideration.

Q-5

Difference Between IRR and MIRR

Internal Rate of Return (IRR) for an investment plan is the rate that corresponds the present value of
anticipated cash inflows with the initial cash outflows. On the other hand, Modified Internal Rate of
Return, or MIRR is the actual IRR, wherein the reinvestment rate does not correspond to the IRR.

Every business makes a long-term investment, on various projects with the aim of reaping benefits in
future years. Out of various plan, the business has to choose one that generates the best outcome, and
returns are also as per investors needs. In this way, capital budgeting is used which is a process of
estimating and selecting long-term investment projects which are in alignment with the basic objective
of investors, i.e. value maximization.

IRR and MIRR are two capital budgeting techniques that measure the investment attractiveness. These
are commonly confused, but there is a fine line of difference between them, which is presented in the
article below.

Content: IRR Vs MIRR

Comparison Chart

Basis for
IRR MIRR
Comparison

IRR is a method of computing the rate
of return considering internal factors,
Meaning
i.e. excluding cost of capital and
inflation.
MIRR is a capital budgeting technique, that
calculate rate of return using cost of capital and
is used to rank various investments of equal
size.

It is the rate at which NPV is equal to It is the rate at which NPV of terminal inflows is
What is it?
zero. equal to the outflow, i.e. investment.

Project cash flows are reinvested at the Project cash flows are reinvested at the cost of
Assumption
project's own IRR. capital.

Accuracy Low Comparatively high

Definition of IRR

The internal rate of return, or otherwise known as IRR, is the discount rate that brings about
equality between the present value of expected cash flows and initial capital outlay. It is based on
the assumption that interim cash flows are at a rate, similar to the project which generated it. At
IRR, the net present value of the cash flows is equal to zero and profitability index is equal to
one.

Under this method, discounted cash flow technique is followed, which considers the time value
of money. It is a tool used in capital budgeting that determines the cost and profitability of the
project. It is used to ascertain the viability of the project and is a primary guiding factor to
investors and financial institutions.

Trial and Error method is used to determine the internal rate of return. It is mainly used to
evaluate the investment proposal, wherein a comparison is made between IRR and cut off rate.
When IRR is greater than the cut-off rate, the proposal is accepted, whereas, when IRR is lower
than the cut-off rate, the proposal is rejected.

Definition of MIRR

MIRR expands to Modified Internal Rate of Return, is the rate that equalizes the present value of
final cash inflows to the initial (zeroth year) cash outflow. It is nothing but an improvement over
the conventional IRR and overcomes various deficiencies such as multiple IRR is eliminated and
addresses reinvestment rate issue and generates outcomes, which are in reconciliation with net
present value method.

In this technique, interim cash flows, i.e. all cash flows except the initial one, are brought to the
terminal value with the help of an appropriate rate of return (typically cost of capital). It amounts
to a specific stream of cash inflow in the last year.

In MIRR, the investment proposal is accepted, if the MIRR is greater than the required rate of
return, i.e. the cut-off rate and rejected if the rate is lower than the cut-off rate.

Key Differences Between IRR and MIRR

The points given below are substantial so far as the difference between IRR and MIRR is
concerned:

1. Internal Rate of Return or IRR implies a method of reckoning the discount rate considering
internal factors, i.e. excluding the cost of capital and inflation. On the other hand, MIRR alludes
to the method of capital budgeting, which calculates the rate of return taking into account cost
of capital. It is used to rank various investments of the same size.
2. The internal rate of return is an interest rate at which NPV is equal to zero. Conversely, MIRR is
the rate of return at which NPV of terminal inflows is equal to the outflow, i.e. investment.
3. IRR is based on the principle that interim cash flows are reinvested at the project’s IRR. Unlike,
under MIRR, cash flows apart from initial cash flows are reinvested at firm’s rate of return.
 4. The accuracy of MIRR is more than IRR, as MIRR measures the true rate of return.

Conclusion

The decision criterion of both the capital budgeting methods is same, but MIRR delineates better
profit as compared to the IRR, because of two major reasons, i.e. firstly, reinvestment of the cash
flows at the cost of capital is practically possible, and secondly, multiple rates of return don’t
exist in the case of MIRR. Therefore, MIRR is better regarding measurement of the true rate of
return.

Q-6

To run a successful business project, you have to understand your cash inflows and outflows. A cash
flow enables you to create a short-term forecast that enables you to determine how you are going to
get money for the project and how you are going to pay for your expenses. Cash inflows usually arise
from financing, operations and investing. While cash outflows mainly result from expenses. Estimating
the cash flow of a project is necessary and one of the most challenging parts of capital budgeting.
Initial Cash Outlay

When estimating the cash flow of a project, first consider the initial cash outlay. This refers to
the amount of all the cash inflows and outflows that occur when the project starts. When starting
a project, there are initial costs involved, such as purchasing equipments, labor costs and the
costs of other utilities necessary to kick start the project. Adding up all the costs involved to
create the project enables you to have a clear mind of the expenses.

Working Capital

When undertaking the project, consider the fact that the needs of the operating working capital
change over different phases of the project. For instance, when the current assets are more than
the current liabilities, the working capital increases and this represents a cash outflow. Similarly,
if the current liabilities are more than the current assets, the net working capital is likely to
become negative and this is a cash inflow. Therefore, when estimating a projects’ cash flow,
consider the working capital and discount it appropriately.

Overhead Costs

Overhead costs will be incurred in starting and running the project. Overhead costs include rent
payments, employee benefits, legal expenses and other administrative costs incurred. Always
determine whether the overhead expenses are incremental cash flows affiliated to your project.
To make your project remain viable, ensure that the cost you are paying for your overheads does
not exceed the cash inflow.

Depreciation Expenses

To start a project, you typically need to purchase assets that will enable you to run the project.
The purchase of assets results to negative cash outflow, but you should not record it at once. Do
it progressively as a depreciating expense throughout the life of the asset. Depreciation is not a
cash flow but it affects income, which has an impact on cash flow. Therefore, when calculating
the cash flows of a project, add the depreciation back.

Q-7

Mutually Exclusive Projects

Mutually exclusive projects are projects in which acceptance of one project excludes the others
from consideration. In such a scenario the best project is accepted. NPV and IRR conflict, which
can sometimes arise in case of mutually exclusive projects, becomes critical. The conflict either
arises due to the relative size of the project or due to the different cash flow distribution of the
projects.

Since NPV is an absolute measure, it will rank a project adding more dollar value higher
regardless of the original investment required. IRR is a relative measure, and it will rank projects
offering best investment return higher regardless of the total value added.

Q-8

Difference between NPV and IRR

NPV or otherwise known as Net Present Value method, reckons the present value of the flow of cash, of
an investment project, that uses the cost of capital as a discounting rate. On the other hand, IRR, i.e.
internal rate of return is a rate of interest which matches present value of future cash flows with the
initial capital outflow.

In the lifespan of every company, there comes a situation of a dilemma, where it has to make a choice
between different projects. NPV and IRR are the two most common parameters used by the companies
to decide, which investment proposal is best. However, in a certain project, both the two criterion give
contradictory results, i.e. one project is acceptable if we consider the NPV method, but at the same
time, IRR method favors another project.

The reasons of conflict amidst the two are due to the variance in the inflows, outflows, and life of the
project. Go through this article to understand the differences between NPV and IRR.

Comparison Chart

Basis for Comparison NPV IRR

The total of all the present values of cash

IRR is described as a rate at which
flows (both positive and negative) of a
Meaning the sum of discounted cash inflows
project is known as Net Present Value or
equates discounted cash outflows.
NPV.
Basis for Comparison NPV IRR

Expressed in Absolute terms Percentage terms

Point of no profit no loss (Break even

What it represents? Surplus from the project
point)

Decision Making It makes decision making easy. It does not help in decision making

Rate for reinvestment

of intermediate cash Cost of capital rate Internal rate of return
flows

Variation in the cash

Will not affect NPV Will show negative or multiple IRR
outflow timing

Definition of NPV

When the present value of the all the future cash flows generated from a project is added together
(whether they are positive or negative) the result obtained will be the Net Present Value or NPV.
The concept is having great importance in the field of finance and investment for taking
important decisions relating to cash flows generating over multiple years. NPV constitutes
shareholder’s wealth maximization which is the main purpose of the Financial Management.

NPV shows the actual benefit received over and above from the investment made in the
particular project for the time and risk. Here, one rule of thumb is followed, accept the project
with positive NPV and reject the project with negative NPV. However, if the NPV is zero, then
that will be a situation of indifference i.e. the total cost and profits of either option will be equal.
The calculation of NPV can be done in the following way:

NPV = Discounted Cash Inflows – Discounted Cash Outflows

Definition of IRR

IRR for a project is the discount rate at which the present value of expected net cash inflows
equates the cash outlays. To put simply, discounted cash inflows are equal to discounted cash
outflows. It can be explained with the following ratio, (Cash inflows / Cash outflows) = 1.

At IRR, NPV = 0 and PI (Profitability Index) = 1

In this method, the cash inflows and outflows are given. The calculation of the discount rate, i.e.
IRR, is to be made by trial and error method.

The decision rule related to the IRR criterion is: Accept the project in which the IRR is greater
than the required rate of return (cut off rate) because in that case, the project will reap the surplus
over and above the cut-off rate will be obtained. Reject the project in which the cut-off rate
is greater than IRR, as the project, will incur losses. Moreover, if the IRR and Cut off rate are
equal, then this will be a point of indifference for the company. So, it is at the discretion of the
company, to accept or reject the investment proposal.

Key Differences Between NPV and IRR

The basic differences between NPV and IRR are presented below:

1. The aggregate of all present value of the cash flows of an asset, immaterial of positive or
negative is known as Net Present Value. Internal Rate of Return is the discount rate at which
NPV = 0.
2. The calculation of NPV is made in absolute terms as compared to IRR which is computed in
percentage terms.
3. The purpose of calculation of NPV is to determine the surplus from the project, whereas IRR
represents the state of no profit no loss.
4. Decision making is easy in NPV but not in the IRR. An example can explain this, In the case of
positive NPV, the project is recommended. However, IRR = 15%, Cost of Capital < 15%, the
project can be accepted, but if the Cost of Capital is equal to 19%, which is higher than 15%, the
project will be subject to rejection.
5. Intermediate cash flows are reinvested at cut off rate in NPV whereas in IRR such an investment
is made at the rate of IRR.
6. When the timing of cash flows differs, the IRR will be negative, or it will show multiple IRR which
will cause confusion. This is not in the case of NPV.
7. When the amount of initial investment is high, the NPV will always show large cash inflows while
IRR will represent the profitability of the project irrespective of the initial invest. So, the IRR will
show better results.

Similarities

 Both uses Discounted Cash Flow Method.

 Both takes into consideration the cash flow throughout the life of the project.
 Both recognize time value of money.

Conclusion

Net Present Value and Internal Rate of Return both are the methods of discounted cash flows, in
this way we can say that both considers the time value of money. Similarly, the two methods,
considers all cash flows over the life of the project.

During the computation of Net Present Value, the discount rate is assumed to be known, and it
remains constant. But, while calculating IRR, the NPV fixed at ‘0’ and the rate which fulfills
such a condition is known as IRR.
2012
Q1
The Capital Budgeting Process

Step 1: Identify Investment Opportunities

- How are projects initiated?

- How much is available to spend?

Step 2: Project Development

- Preliminary project review

- Technically feasible?
- Compatible with corporate strategy?

Step 3: Evaluation and Selection

- What are the costs and benefits?

- What is the project’s return?
- What are the risks involved?

Step 4: Post Acquisition Control

- Is the project within budget?

- What lessons can be drawn?

Capital Budgeting Process

The capital budgeting process includes identifying and then evaluating capital projects for the
company. Capital projects are the ones where the cash flows are received by the company over
longer periods of time which exceeds a year. Almost all the corporate decisions that impact
future earnings of the company can be studied using this framework. This process can be used to
examine various decisions like buying a new machine, expanding operations at another
geographic location, moving the headquarters or even replacing the old asset. These decisions
have the power to impact the future success of the company. This is the reason the capital
budgeting process is an invaluable part of any company.

The capital budgeting process has the following four steps:

 Generation of Ideas: The generation of good quality project ideas is the most important capital
budgeting step. Ideas can be generated through a number of sources like senior management,
employees and functional divisions or even from outside the company.
 Analysis of Proposals: The basis of accepting or rejecting a capital project is the project’s
expected cash flows in the future. Hence, all the project proposals are analysed by forecasting
their cash flows to determine expected the profitability of each project.
  Creating the Corporate Capital Budget: Once the profitable projects are shortlisted, they are
prioritized according to the available company resources, a timing of the cash flows of the
project and the overall strategic plan of the company. Some projects may be attractive on their
own, but may not be a fit to the overall strategy.
 Monitoring and Post-Audit: A follow up on all decisions is equally important in the capital
budgeting process. The analysts compare the actual results of the projects to the projected ones
and the project managers are responsible if the projections match or do not match the actual
results. A post-audit to recognize systematic errors in the cash flow forecasting process is also
essential as the capital budgeting process is as good as the inputs’ estimates into the forecasting
model.

The 5 Steps to Capital Budgeting

Big businesses need big budgets. Here are the 5 most important steps.

Capital budgeting is a multi-step process businesses use to determine how worthwhile a project or
investment will be. A company might use capital budgeting to figure out if it should expand its
warehouse facilities, invest in new equipment, or spend money on specialized employee training.

The capital budgeting process consists of five steps:

1. Identify and evaluate potential opportunities

The process begins by exploring available opportunities. For any given initiative, a company will probably
have multiple options to consider. For example, if a company is seeking to expand its warehousing
facilities, it might choose between adding on to its current building or purchasing a larger space in a new
location. As such, each option must be evaluated to see what makes the most financial and logistical
sense. Once the most feasible opportunity is identified, a company should determine the right time to
pursue it, keeping in mind factors such as business need and upfront costs.

2. Estimate operating and implementation costs

The next step involves estimating how much it will cost to bring the project to fruition. This process may
require both internal and external research. If a company is looking to upgrade its computer equipment,
for instance, it might ask its IT department how much it would cost to buy new memory for its existing
machines while simultaneously pricing out the cost of new computers from an outside source. The
company should then attempt to further narrow down the cost of implementing whichever option it
chooses.

3. Estimate cash flow or benefit

Now we determine how much cash flow the project in question is expected to generate. One way to
arrive at this figure is to review data on similar projects that have proved successful in the past. If the
project won't directly generate cash flow, such as the upgrading of computer equipment for more
efficient operations, the company must do its best to assign an estimated cost savings or benefit to see
if the initiative makes sense financially.

4. Assess risk
This step involves estimating the risk associated with the project, including the amount of money the
company stands to lose if the project fails or can't produce its previously anticipated results. Once a
degree of risk is determined, the company can evaluate it against its estimated cash flow or benefit to
see if it makes sense to pursue implementation.

5. Implement
If a company chooses to move forward with a project, it will need an implementation plan. The plan
should include a means of paying for the project at hand, a method for tracking costs, and a process for
recording cash flows or benefits the project generates. The implementation plan should also include a
timeline with key project milestones, including an end date if applicable.

Q-2
Questions: # 1: How are the total risk, non-diversifiable risk, and diversifiable risk related?

Total risk is systematic risk and unsystematic risk of an investment. Systematic risk is the risk associated
with entire class of assets. However, unsystematic risk is unique to the particular investment.
Unsystematic risk is also called as diversifiable risk. Diversifiable risk is the risk of price change due to the
unique features of the particular security and it is not dependent on the overall market conditions.
Diversifiable risk can be eliminated by diversification in the portfolio.
Non-diversifiable risk is the risk common to the entire class of assets or liabilities. The value of
investment declined over the period due to the changes in the economic conditions of the country or
any changes which affect the major portion of the market. Non-diversifiable risk is also called as
systematic risk.

Q-3
Why is non-diversifiable risk regarded as the only relevant risk? Do you agree this is correct?

Non-diversifiable risk is also called market risk since the risk is associated with market conditions. Total
risk, diversifiable risk and non -diversifiable risk are related with each other as diversifiable and non-
diversifiable risks are part of total risk.
A systematic risk is beyond the control it is not relevant for decision making as anything uncontrollable is
not relevant for the decision making. Unsystematic risk is relevant for decision making. Therefore,
diversifiable risk is relevant for the decision making.
Therefore, it is incorrect to say that only non-diversifiable risk is relevant for the decision making.

Q-6
Coefficient of Variation - Relative Standard Deviation

Coefficient of Variation (CV) is a measure of the dispersion of points/prices around the mean (Dispersion
of a probability distribution).

In statistics, the coefficient of variation is also called variation coefficient, unitized risk or relative
standard deviation (%RSD). Because its value is normalized and it is a dimensionless number, it is very
helpful in analyzing and comparing volatility of different stocks.
CV is expressed in percentage and its value is always positive. It is calculated by taking the standard
deviation of N-past prices and then dividing them by the absolute value of the mean (of these N-past
prices).

One the main advantage of using the coefficient of variation over the standard deviation to measure
volatility is the fact that CV is normalized and can be used to directly compare different asset's volatility.
The standard deviation must be used in the context of the mean of the data.

The main disadvantage is that the coefficient becomes very sensitive to small variation of the mean
when the latter is close to zero. This means that this trading indicator is not suited to measure the
volatility of penny stocks.

As with the standard deviation, the coefficient of variation function has two arguments. The first one
gets a time-series (Example: Close price) and the second one gets a look back period (Number of past
bars to use when calculating the mean and the standard deviation).

Q-8
Capital budgeting (also known as investment appraisal) is the process by which a company determines
whether projects (such as investing in R&D, opening a new branch, replacing a machine) are worth
pursuing. A project is worth pursuing if it increases the value of the company.
What is 'Capital Budgeting?'
Capital budgeting is the process in which a business determines and evaluates potential expenses or
investments that are large in nature. These expenditures and investments include projects such as
building a new plant or investing in a long-term venture. Often times, a prospective project's lifetime
cash inflows and outflows are assessed in order to determine whether the potential returns generated
meet a sufficient target benchmark, also known as "investment appraisal."
Importance of Capital Budgeting Decisions
1. Long-term Implications of Capital Budgeting: A capital budgeting decision has its effect over a long
time span and inevitably affects the company’s future cost structure and growth. A wrong decision can
prove disastrous for the long-term survival of firm. On the other hand, lack of investment in asset would
influence the competitive position of the firm. So the capital budgeting decisions determine the future
destiny of the company.
2. Involvement of large amount of funds in Capital Budgeting: Capital budgeting decisions need
substantial amount of capital outlay. This underlines the need for thoughtful, wise and correct decisions
as an incorrect decision would not only result in losses but also prevent the firm from earning profit
from other investments which could not be undertaken.
3. Irreversible decisions in Capital Budgeting: Capital budgeting decisions in most of the cases are
irreversible because it is difficult to find a market for such assets. The only way out will be scrap the
capital assets so acquired and incur heavy losses.
4. Risk and uncertainty in Capital budgeting: Capital budgeting decision is surrounded by great number
of uncertainties. Investment is present and investment is future. The future is uncertain and full of risks.
Longer the period of project, greater may be the risk and uncertainty. The estimates about cost,
revenues and profits may not come true.
5. Difficult to make decision in Capital budgeting: Capital budgeting decision making is a difficult and
complicated exercise for the management. These decisions require an over all assessment of future
events which are uncertain. It is really a marathon job to estimate the future benefits and cost correctly
in quantitative terms subject to the uncertainties caused by economic-political social and technological
factors.
6. Large and Heavy Investment: The proper planning of investments is necessary since all the proposals
are requiring large and heavy investment. Most of the companies are taking decisions with great care
because of finance as key factor.
7. Permanent Commitments of Funds: The investment made in the project results in the permanent
commitment of funds. The greater risk is also involved because of permanent commitment of funds.
8. Long term Effect on Profitability: Capital expenditures have great impact on business profitability in
the long run. If the expenditures are incurred only after preparing capital budget properly, there is a
possibility of increasing profitability of the firm.
9. Complicacies of Investment Decisions: Generally, the long term investment proposals have more
complicated in nature. Moreover, purchase of fixed assets is a continuous process. Hence, the
management should understand the complexities connected with each projects.
10. Maximize the worth of Equity Shareholders: The value of equity shareholders is increased by the
acquisition of fixed assets through capital budgeting. A proper capital budget results in the optimum
investment instead of over investment and under investment in fixed assets. The management chooses
only most profitable capital project which can have much value. In this way, the capital budgeting
maximize the worth of equity shareholders.
11. Difficulties of Investment Decisions: The long term investments are difficult to be taken because
decision extends several years beyond the current account period, uncertainties of future and higher
degree of risk.
12. Irreversible Nature: Whenever a project is selected and made investments as in the form of fixed
assets, such investments is irreversible in nature. If the management wants to dispose of these assets,
there is a heavy monetary loss.
13. National Importance: The selection of any project results in the employment opportunity, economic
growth and increase per capita income. These are the ordinary positive impact of any project selection
made by any company.

Q-9

Cash flow analysis

Cash flows are often transformed into measures that give information e.g. on a company's value and
situation:

 to determine a project's rate of return or value. The time of cash flows into and out of projects
are used as inputs in financial models such as internal rate of return and net present value.
 to determine problems with a business's liquidity. Being profitable does not necessarily mean
being liquid. A company can fail because of a shortage of cash even while profitable.
 as an alternative measure of a business's profits when it is believed that accrual accounting
concepts do not represent economic realities. For instance, a company may be notionally
profitable but generating little operational cash (as may be the case for a company that barters
its products rather than selling for cash). In such a case, the company may be deriving additional
operating cash by issuing shares or raising additional debt finance.
  cash flow can be used to evaluate the 'quality' of income generated by accrual accounting.
When net income is composed of large non-cash items it is considered low quality.
 to evaluate the risks within a financial product, e.g., matching cash requirements, evaluating
default risk, re-investment requirements, etc.

Cash flow notion is based loosely on cash flow statement accounting standards. The term is flexible and
can refer to time intervals spanning over past-future. It can refer to the total of all flows involved or a
subset of those flows. Subset terms include net cash flow, operating cash flow and free cash flow.

Business' financials
The (total) net cash flow of a company over a period (typically a quarter, half year, or a full year) is equal
to the change in cash balance over this period: positive if the cash balance increases (more cash
becomes available), negative if the cash balance decreases. The total net cash flow for a project is the
sum of cash flows that are classified in three areas
Operational cash flows: Cash received or expended as a result of the company's internal business
activities.
so how to calculate operating cash flow of a project? OCF=incremental earnings +depreciation=
(earnings before interest and tax-tax)+depreciation=earnings before interest and tax*( 1-tax rate)+
depreciation= ( revenue - cost of goods sold- operating expense- depreciation)* (1-tax
rate)+depreciation= ( Revenue - cost of goods sold- operating expense)* (1-tax rate)+ depreciation* tax.
By the way, depreciation*tax which locates at the end of the formula is called depreciation shield
through which we can see that there is a negative relation between depreciation and cash flow.
changing in net working capital. It is the cost or revenue related to the company's short-term asset like
inventory.
capital spending. This is the cost or gain related to the company's fix asset such as the cash used to buy
new equipment or the cash which is gained from selling old equipment.
The sum of the three components above will be the cash flow for a project.
And the cash flow for a company also includes three parts:
Operating cash flow: It refers to the cash received or loss because of the internal activities of a company
such as the cash received from sales revenue or the cash paid to the workers.
investment cash flow: It refers to the cash flow which related to the company's fix asset such as
equipment building and so on such as the cash used to buy a new equipment or a building
Financing cash flow: cash flow from a company's financing activities like issuing stock or paying
dividends.

The sum of the three components above will be the total cash flow of a company.

Examples

Description Amount ($) totals ($)

Cash flow from operations +70

 Sales (paid in cash) +30

Incoming loan +50

Loan repayment -5

Taxes -5

Cash flow from investments -10

Purchased capital -10

Total 60

2011

Ques: 2
What is 'Beta'

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the
market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates the expected
return of an asset based on its beta and expected market returns. Beta is also known as the beta
coefficient.

Beta is a measure of the risk arising from exposure to general market movements as opposed to
idiosyncratic factors. The market portfolio of all investable assets has a beta of exactly 1. A beta below 1
can indicate either an investment with lower volatility than the market, or a volatile investment whose
price movements are not highly correlated with the market. An example of the first is a treasury bill: the
price does not go up or down a lot, so it has a low beta. An example of the second is gold. The price of
gold does go up and down a lot, but not in the same direction or at the same time as the market.[1]
Beta is important because it measures the risk of an investment that cannot be reduced by
diversification. It does not measure the risk of an investment held on a stand-alone basis, but the
amount of risk the investment adds to an already-diversified portfolio. In the capital asset pricing model,
beta risk is the only kind of risk for which investors should receive an expected return higher than the
risk-free rate of interest.[3]

How do you find the beta of a portfolio?

To do it, you'll need to know the percentage of your portfolio by individual stock and the beta for each
of those stocks. You can learn to calculate beta for individual stocks by clicking here. The first step is to
multiply the percentage of your portfolio and the beta for each individual stock.
The beta of a portfolio

The beta of a portfolio is the weighted sum of the individual asset betas, According to the proportions of
the investments in the portfolio. E.g., if 50% of the money is in stock A with a beta of 2.00, and 50% of
the money is in stock B with a beta of 1.00,the portfolio beta is 1.50. Portfolio beta describes relative
volatilityof an individual securities portfolio, taken as a whole, as measured by the individual stock betas
of the securities making it up. A beta of 1.05 relative to the S&P 500 implies that if the S&P's excess
return increases by 10% the portfolio is expected to increase by 10.5%.

Q-3

Definition: An investor's risk attitude, is its degree of risk aversion (or, conversely, risk acceptance /
Tolerance) when making decisions.
There is a gradation in this risk-taking attitude

1) Risk averse
2) Risk neutral (risk tolerant)
3) Risk seeker (risk taker).

Risk aversion / averse: In average, people are risk averse. Usually they are not too ready to take risks
unless given extra incentives, which range from carrot to stick.
Some people are not risk averse, but risk neutral / risk tolerant (or unconscious of risks / indifferent to
it).
Some others are even risk seekers / risk takers,
Either all the time, or in some "exuberant" circumstances,
And either because of optimism, overconfidence, or for the thrill, ...if not
for suicidal reasons.

In some market situations, in which greed is strong, most investors might become more risk tolerant /
risk seeker. Also, it seems that some firms, even financial firms, are unconsciously tolerant, as they
have no real risk policy that defines what are their risks and how far they are ready to accept them.

Q-4
Types of Capital Budgeting Decisions

Capital budgeting refers to the total process of generating, evaluating, selecting and following up on
capital expenditure alternatives. The firm allocates or budgets financial resources to new Investment
proposals. Basically, the firm may be confronted with three types of capital budgeting decisions: .
1. Accept-Reject Decision .
2. Mutually Exclusive Project Decision .
3. Capital Rationing Decision .
1. Accept-Reject Decision

This is a fundamental decision in capital budgeting. If the project is accepted, the firm would invest in it;
if the proposal is rejected, the firm does not invest in it. In general, all those proposals which yield a rate
of return greater than a certain required rate of return or cost of capital are accepted and the rest are
rejected. By applying this criterion, all independent projects are accepted. Independent projects are the
projects that do not compete with one another in such a way that the acceptance of one precludes the
possibility of acceptance of another. Under the accept-reject decision, all independent projects that
satisfy the minimum investment criterion should be implemented. .

2. Mutually Exclusive Project Decision

Mutually Exclusive Projects are those which compete with other projects in such a way that the
acceptance of one will exclude the acceptance of the other projects. The alternatives are mutually
exclusive and only one may be chosen. Suppose a company is intending to buy a new folding machine.
There are three competing brands, each with a different initial investment and operating costs. The
three machines represent mutually exclusive alternatives, as only one of these can be selected.
Moreover, the mutually exclusive project decisions are not independent of the accept-reject decisions.
The project should also be acceptable under the latter decision. Thus, mutually exclusive projects
acquire significance when more than one proposal is acceptable under the accept-reject decision. .

3. Capital Rationing Decision

In a situation where the firm has unlimited funds, all independent investment proposals yielding returns
greater than some pre-determined level are accepted. However, this situation does not prevail in most
of the business forms in actual practice. They have a fixed capital budget. A large number of investment
proposals compete for these limited funds. The firm must, therefore, ration them. The firm allocates
funds to projects in a manner that it maximises long-run returns. Thus, capital rationing refers to a
situation in which a firm has more acceptable investments than it can finance. It is concerned with the
selection of a group of Investment proposals out of many investment proposals acceptable under the
accept-reject decision. Capital rationing employs ranking of acceptable Investment projects. These
projects can be ranked on the basis of a pre-determined criterion such as the rate of return. The projects
are ranked in descending order of the rate of return.

Real options

Main article: Real options analysis

Real options analysis has become important since the 1970s as option pricing models have gotten more
sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds,
with the promised cash flows known. But managers will have many choices of how to increase future
cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects -
not simply accept or reject them. Real options analysis tries to value the choices - the option value - that
the managers will have in the future and adds these values to the NPV.

Ranked projects

The real value of capital budgeting is to rank projects. Most organizations have many projects that could
potentially be financially rewarding. Once it has been determined that a particular project has exceeded
its hurdle, then it should be ranked against peer projects (e.g. - highest Profitability index to lowest
Profitability index). The highest ranking projects should be implemented until the budgeted capital has
been expended.

Accept-Reject Decision
This is a fundamental decision in capital budgeting. If the project is accepted, the firm would invest in it;
if the proposal is rejected, the firm does not invest in it. In general, all those proposals which yield a rate
of return greater than a certain required rate of return or cost of capital are accepted and the rest are
rejected. By applying this criterion, all independent projects are accepted. Independent projects are the
projects that do not compete with one another in such a way that the acceptance of one precludes the
possibility of acceptance of another. Under the accept-reject decision, all independent projects that
satisfy the minimum investment criterion should be implemented.

Q-6

The future value (FV) measures the nominal future sum of money that a given sum of money is “worth”
at a specified time in the future assuming a certain interest rate, or more generally, rate of return. The
Future value is calculated by multiplying the present value by the accumulation function.

PV and FV vary jointly: when one increases, the other increases, assuming that the interest rate and
number of periods remain constant. As the interest rate (discount rate) and number of periods increase,
FV increases or PV decreases.

When a business chooses to invest money in a project -- such as an expansion, a strategic acquisition or
just the purchase of a new piece of equipment -- it may be years before that project begins producing a
positive cash flow. The business needs to know whether those future cash flows are worth the upfront
investment. That's why the time value of money is so important to capital budgeting.

Time Value

Simply put, the time value of money is the idea that a particular sum of money in your hand today is
worth more than the same sum at some future date. For example, given the choice between receiving
$1 today or $1 a year from now, you should take the money today. You could invest that $1, and even if
you only earned a 2 percent annual return on your investment, you still would have $1.02 a year from
now -- more than the $1 you'd have gotten if you waited. If you didn't invest that $1 at all but simply
spent it, you'd still be better off; because of inflation, the $1 usually will have more buying power today
than in the future.

2010

Q-1
Definition: An investor's risk attitude, is its degree of risk aversion (or, conversely, risk acceptance /
Tolerance) when making decisions.
There is a gradation in this risk-taking attitude

1) Risk averse
2) Risk neutral (risk tolerant)
3) Risk seeker (risk taker).

Risk aversion / averse: In average, people are risk averse. Usually they are not too ready to take risks
unless given extra incentives, which range from carrot to stick.
Some people are not risk averse, but risk neutral / risk tolerant (or unconscious of risks / indifferent to
it).
Some others are even risk seekers / risk takers,
Either all the time, or in some "exuberant" circumstances,
And either because of optimism, overconfidence, or for the thrill, ...if not
for suicidal reasons.

In some market situations, in which greed is strong, most investors might become more risk tolerant /
risk seeker. Also, it seems that some firms, even financial firms, are unconsciously tolerant, as they
have no real risk policy that defines what are their risks and how far they are ready to accept them.

Q-2
An independent project is one whose cash flows are not related to the cash flows of any other project.
Accepting or rejecting an independent project does not affect the acceptance or rejection of other
projects.

Projects are mutually exclusive if the acceptance of one precludes the acceptance of other projects.
For example, suppose a manufacturer is considering whether to replace its production facilities with
more modern equipment. The firm may solicit bids among the different manufacturers of this
equipment. The decision consists of comparing two choices, either keeping its existing production
facilities or replacing the facilities with the modern equipment of one manufacturer. Since the firm
cannot use more than one production facility, it must evaluate each bid and choose the most attractive
one. The alternative production facilities are mutually exclusive projects: the firm can accept only one
bid.
Contingent projects are dependent on the acceptance of another project. Suppose a greeting card
company develops a new character, Pippy, and is considering starting a line of Pippy cards. If Pippy
catches on, the firm will consider producing a line of Pippy T-shirts — but only if the Pippy character
becomes popular. The T-shirt project is a contingent project.

Complementary projects: Another form of dependence is found in complementary projects, where

the investment in one enhances the cash flows of one or more other projects. Consider a manufacturer
of personal computer equipment and software. If it develops new software that enhances the abilities
of a computer mouse, the introduction of this new software may enhance its mouse sales as well.

Refer to ‘Classification of Investment Projects’ section in the textbook for a discussion on

different types of investments. Examples of each type of investment are presented below.

a) Independent Projects: The acceptance or rejection of one does not directly eliminate other
projects from consideration or cause the likelihood of their selection. Examples would include:
(i) The introduction of a new product line (soap) and at the same time the replacement of a
machine, which is currently producing a different product (plastic bottles).
(ii) The installation of a new air conditioning system and the commissioning of a new
advertising campaign for a product currently sold by the firm.

b) Mutually Exclusive Projects: The acceptance of one prevents the acceptance of an alternative
proposal. That is, two or more projects cannot be pursued simultaneously. Examples would
include:
(ii) A firm may own a block of land, which is large enough to establish a shoe manufacturing
business or a steel fabrication plant. The selection of one will exclude the acceptance of
the other.
(iii) A car manufacturing company considering establishing one of its manufacturing
complexes can locate it in Sydney, Brisbane or Adelaide. If the company chooses Sydney,
the other two locations are ruled out.

c) Contingent Projects: The acceptance or rejection of one is dependent on the decision to accept or
reject one or more other projects. Contingent projects may be complementary or substitute.
Example of each would include:
(i) Complementary: The decision to start a pharmacy may be contingent upon a decision to
establish a doctors’ surgery in an adjacent building. The cash flows of the pharmacy will
be enhanced by the existence of a nearby surgery and vice versa.
(ii) Complementary: The introduction of a water recycling plant may increase the profitability
of several other projects.
(iii) Substitutes: customers visiting a shopping complex may treat Chinese and Thai food as
close substitutes. Consequently if the firm establishes both restaurants, none of the
restaurants may be profitable due to the distribution of a given number of customers
between the two restaurants. However, if only one restaurant is established, it may
 generate net present value. Therefore, the acceptance of one is contingent upon the non-
acceptance of the other project.
(iv) Substitutes: two different brands of butter as two different projects. The success of one
project may depend on the non-acceptance of the other project.

Q-3
Independent Projects: If the projects are independent meaning that investment in one project has
nothing to do with investment in others, the results of the two evaluation criteria will necessarily be the
same. Both of them will lead to the same accept/ reject decision. This is because when NPV is positive,
IRR must be greater than the cost of capital. At zero NPV, the IRR will be equal to the cost of capital. And
when NPV is negative, IRR is less than the cost of capital.

Q-4

The efficient frontier is the set of optimal portfolios that offers the highest expected return for a
defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the
efficient frontier are sub-optimal, because they do not provide enough return for the level of risk.
Portfolios that cluster to the right of the efficient frontier are also sub-optimal, because they have a
higher level of risk for the defined rate of return.

Efficient portfolios

Modern portfolio theory, fathered by Harry Markowitz[1][2] in the 1950s, assumes that an investor wants
to maximize a portfolio's expected return contingent on any given amount of risk, with risk measured by
the standard deviation of the portfolio's rate of return. For portfolios that meet this criterion, known as
efficient portfolios, achieving a higher expected return requires taking on more risk, so investors are
faced with a trade-off between risk and expected return. This risk-expected return relationship of
efficient portfolios is graphically represented by a curve known as the efficient frontier. All efficient
portfolios, each represented by a point on the efficient frontier, are well-diversified. For the specific
formulas for efficient portfolios,[3] see Portfolio separation in mean-variance analysis. While ignoring
higher moments can lead to significant over-investment in risky securities, especially when volatility is
high[4], the optimization of portfolios when return distributions are non-Gaussian is mathematically
challenging.

Because portfolios can consist of any number of assets with differing proportions of each asset, there is
a wide range of risk-return ratios. If the universe of these risk-return possibilities—the investment
opportunity set—were plotted as an area of a graph with the expected portfolio return on the vertical
axis and portfolio risk on the horizontal axis, the entire area would consist of all feasible portfolios—
those that are actually attainable. In this set of attainable portfolios, there would be some which have
the greatest return for each risk level, or, for each risk level, there would be portfolios that have the
greatest return. The efficient frontier consists of the set of all efficient portfolios that yield the highest
return for each level of risk. The efficient frontier can be combined with an investor's utility function to
find the investor's optimal portfolio, the portfolio with the greatest return for the risk that the investor
is willing to accept.

Q-6
Capital budgeting (also known as investment appraisal) is the process by which a company determines
whether projects (such as investing in R&D, opening a new branch, replacing a machine) are worth
pursuing. A project is worth pursuing if it increases the value of the company.

Capital budgeting is the planning process used to determine whether an organization's long term
investments such as new machinery, replacement of machinery, new plants, new products, and research
development projects are worth the funding of cash through the firm's capitalization structure (debt,
equity or retained earnings). It is the process of allocating resources for major capital, or investment,
expenditures.[1] One of the primary goals of capital budgeting investments is to increase the value of the
firm to the shareholders.

Q-7
What is 'Capital Rationing'

Capital rationing is the act of placing restrictions on the amount of new investments or projects
undertaken by a company. This is accomplished by imposing a higher cost of capital for investment
consideration or by setting a ceiling on specific portions of a budget. Companies may want to implement
capital rationing in situations where past returns of an investment were lower than expected.

BREAKING DOWN 'Capital Rationing'

Capital rationing is essentially a management approach to allocating available funds across multiple
investment opportunities, increasing a company's bottom line. The combination of projects with the
highest total net present value (NPV) is accepted by the company. The number one goal of capital
rationing is to ensure that a company does not over-invest in assets. Without adequate rationing, a
company might start realizing decreasingly low returns on investments, and may even face financial
insolvency.

Two Types of Capital Rationing

The first type of capital rationing is referred to as "hard capital rationing." This occurs when a company
has issues raising additional funds, either through equity or debt. The rationing arises from an external
need to reduce spending, and can lead to a shortage of capital to finance future projects.

The second type of rationing is called "soft capital rationing," or internal rationing. This type of rationing
comes about due to the internal policies of a company. A fiscally conservative company, for example,
may have a high required return on capital in order to accept a project, self-imposing its own capital
rationing.
2009

Q-4
Terminal Cash Flow

Terminal cash flow is the net cash flow that occurs at the end of a project and represents the after-tax
proceeds from disposal of the project assets and recoupment of working capital.
Terminal cash flow is an important input in the capital budgeting process. While uniform periodic net
cash flows are discounted using the present value for annuity formula, terminal cash flow is treated
separately from other cash flows and discounted using the present value of a single sum formula.
Formula

Terminal cash flow has two main components:

Proceeds from disposal of project equipment, etc. and
Cash flows associated with reversion of working capital to the level that prevailed before the start of the
project.
It is calculated using the following formula:
Terminal Cash Flow = After-tax Proceeds from Disposal ± Change in Working Capital
After-tax Proceeds from Disposal = Pre-tax Proceeds from Disposal − Tax on gain on Disposal
Tax on Gain on Disposal = (Pre-tax Proceeds from Disposal − Ending Book Value) × Tax Rate

Q-5

Mutually Exclusive Projects

In capital budgeting decisions, mutually exclusive projects refer to a sect of projects out of which
only one project can be selected for investment. A decision to undertake one project from
mutually exclusive projects excludes all other projects from consideration.

Unlike independent projects, in which a decision to invest in one project has no bearing on the
decision to make investment in another, investment decision in case of mutually exclusive
projects is dependent on the relative merit of the projects.

Decision Rule

Capital budgeting decisions are made on the basis of net present value, IRR, payback period and other
techniques.

In case of mutually exclusive projects, the project with highest net present value or the highest IRR or
the lowest payback period is preferred and a decision to invest in that winning project exclused all other
projects from consideration even if they individually have positive NPV or higher IRR than hurdle rate or
shorter payback period than the reference period.
On the other hand, there is no such dependence in case of independent projects. Independent (or non-
mutually exclusive project) is favorable if the net present value is positive and/or IRR is higher than the
hurdle rate and/or the payback period is shorter than a specific reference period.

Independent Projects: If the projects are independent meaning that investment in one project has
nothing to do with investment in others, the results of the two evaluation criteria will necessarily be the
same. Both of them will lead to the same accept/ reject decision. This is because when NPV is positive,
IRR must be greater than the cost of capital. At zero NPV, the IRR will be equal to the cost of capital. And
when NPV is negative, IRR is less than the cost of capital

Q-10
Required Rate of return is the minimum acceptable return on investment sought by individuals or
companies considering an investment opportunity.

What is a 'Required Rate Of Return - RRR'

The required rate of return (RRR) is the minimum annual percentage earned by an investment that will
induce individuals or companies to put money into a particular security or project. The RRR is used in
both equity valuation and in corporate finance. Investors use the RRR to decide where to put their
money, and corporations use the RRR to decide if they should pursue a new project or business
expansion.

Q-11
Effect of inflation on required rate of return:

Inflation has the power to erode a person's annual rate of return. When the annual inflation rate
exceeds the rate of return, the consumer loses money when they invest it because of the decline in
purchasing power. For instance, when hyperinflation ravaged countries such as Germany after WWI and
Brazil in the 1980s, people with money in low interest-bearing savings accounts lost significant amounts
of money. In cases of high inflation, people should spend money in the present to avoid having the
money be worth less in the future. On the other hand, people have an incentive to invest money when
their investment yields a greater return than the rate of inflation.

2008

Q-1
Agency Problem

At times, wealth maximization may create conflict, known as agency problem. This describes conflict
between the owners and managers of firm. Owners appoint managers as their agents to act on behalf of
them. A strategic investor or the owner of the firm would be majorly concerned about the longer term
performance of the business; that can lead to maximization of shareholder’s wealth. Whereas, a
manager might focus on taking such decisions that can bring quick result, so that he/she can get credit
for good performance. However, in course of fulfilling the same, a manager might opt for risky decisions
which can put the owner’s objectives at stake.

Hence, a manager should align his/her objective to broad objective of organization and achieve a trade-
off between risk and return while making a decision; keeping in mind the ultimate goal of financial
management i.e. to maximize the wealth of its current shareholders.

Q-5

Diversification

An investor can reduce portfolio risk simply by holding combinations of instruments that are not
perfectly positively correlated. In other words, investors can reduce their exposure to individual asset
risk by holding a diversified portfolio of assets. Diversification may allow for the same portfolio expected
return with reduced risk. These ideas have been started with Markowitz and then reinforced by other
economists and mathematicians such as Andrew Brennan who have expressed ideas in the limitation of
variance through portfolio theory.

If all the asset pairs have correlations of 0—they are perfectly uncorrelated—the portfolio's return
variance is the sum over all assets of the square of the fraction held in the asset times the asset's return
variance (and the portfolio standard deviation is the square root of this sum).

If all the asset pairs have correlations of 1—they are perfectly positively correlated—then the portfolio
return’s standard deviation is the sum of the asset returns’ standard deviations weighted by the
fractions held in the portfolio. For given portfolio weights and given standard deviations of asset returns,
the case of all correlations being 1 gives the highest possible standard deviation of portfolio return.

Diversification is a technique that reduces risk by allocating investments among various financial
instruments, industries, and other categories. It aims to maximize return by investing in different areas
that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is
the most important component of reaching long-range financial goals while minimizing risk.

By owning a variety of company stocks across different industries, as well as by owning other types of
securities in a variety of asset classes, such as Treasuries and municipal securities, investors will be less
affected by single events. For example, an investor, who owned nothing but airline stocks, would face a
high level of unsystematic risk. She would be vulnerable if airline industry employees decided to go on
strike, for example. This event could sink airline stock prices, even temporarily. Simply the anticipation
of this news could be disastrous for her portfolio.
With example:

Let's say you have a portfolio of only airline stocks. If it is publicly announced that airline pilots are going
on an indefinite strike, and that all flights are canceled, share prices of airline stocks will drop. Your
portfolio will experience a noticeable drop in value.

If, however, you counterbalanced the airline industry stocks with a couple of railway stocks, only part of
your portfolio would be affected. In fact, there is a good chance that the railway stock prices would
climb, as passengers turn to trains as an alternative form of transportation.

But, you could diversify even further because there are many risks that affect both rail and air because
each is involved in transportation. An event that reduces any form of travel hurts both types of
companies. Statisticians, for example, would say that rail and air stocks have a strong correlation.

Therefore, you would want to diversify across the board, not only different types of companies but also
different types of industries. The more uncorrelated your stocks are, the better.

Q-6
What is a 'Sensitivity Analysis'

A sensitivity analysis is a technique used to determine how different values of an independent variable
impact a particular dependent variable under a given set of assumptions. This technique is used within
specific boundaries that depend on one or more input variables, such as the effect that changes in
interest rates have on bond prices.

Calculation

Sensitivity analysis needs to be realized in a systematic manner. To meet the above purposes, the
following steps are recommended to be followed:

1. identify key variables to which the project decision may be sensitive

2. calculate the effect of likely changes in these variables on the base-case IRR or NPV, and calculate a
sensitivity indicator and/or switching value

3. consider possible combinations of variables that may change simultaneously in an adverse direction

4. analyze the direction and scale of likely changes for the key variables identified, involving
identification of the sources of change

Step 1: Identifying the key variables. The base case project economic analysis incorporates many
variables: quantities and their inter-relationships, prices or economic values and the timing of project
effects. Some of these variables will be predictable or relatively small in value in the project context.
Step 2 and 3: Calculation of effects of changing variables. The values of the basic indicators of project
viability (EIRR and ENPV) should be recalculated for different values of key variables. This is preferably
done by calculating sensitivity indicators and switching values.

Step 4: Analysis of effects of changes in key variables. In the case of an increase in investment costs of
20 percent, the sensitivity indicator is 13.34. This means that the change of 20 percent in the variable
(investment cost) results in a change of 266 percent in the ENPV. It follows that the higher the SI, the
more sensitive the NPV is th change in the concerned variable.

Q-9

Advantages of Capital Budgeting:

 Capital budgeting helps a company to understand various risks involved in an investment

opportunity and how these risks affect the returns of the company.
 It helps the company to estimate which investment option would yield the best possible return.
 A company can choose a technique/method from various techniques of capital budgeting to
estimate whether it is financially beneficial to take on a project or not.
 It helps the company to make long-term strategic investments.
 It helps to make an informed decision about an investment taking into consideration all possible
options.
 It helps a company in a competitive market to choose its investments wisely.
 All the techniques/methods of capital budgeting try to increase shareholders wealth and give
the company an edge in the market.
 Capital budgeting presents whether an investment would increase the company’s value or not.
 It offers adequate control on expenditure for projects.
 Also, it allows management to abstain from over investing and under investing.