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  • 1. NameRegistration / Roll No.Course Master of Business Administration (MBA)Subject Financial ManagementSemester Semester 2Subject Number MB0045___________________Sign of Center Head__________________Sign of Evaluator________________Sign of Coordinator
  • 2. Q.1 Write the short notes on 1. Financial management 2. Financial planning 3. Capital structure 4. Cost of capital 5. Trading on equity.1. Financial ManagementFinancial Management is planning, directing, monitoring, organizing, and controlling ofthe monetary resources of an organization. The management of the finances of abusiness / organization in order to achieve financial objectives. Financial Management isthe efficient and effective planning and controlling of financial resources so as tomaximize profitability and ensuring liquidity for an individual(called personal finance),government(called public finance) and for profit and non-profit organization/firm (calledcorporate or managerial finance). Generally, it involves balancing risks and profitability.The decision function of financial management can be divided into the following 3 majorareas:INVESTMENT DECISION 1. Determine the total amount of assets needed by a firm hence closely tied to the allocation of funds 2. Two type of investment decisions namely: • Capital Investment decisions re: large sums, non routine, longer term, critical to the business like purchase of plant and machinery or factory • Working Capital Investment decisions re: more routine in nature, short term but are also very critical decisions like how much and how long to invest in inventories or receivablesFINANCING DECISION 1. After deciding on the amount and type of assets to buy, the financial manager needs to decide on HOW TO FINANCE these assets with the sources of fund 2. Financing decisions for example: • Whether to use external borrowings/debts or share capital or retained earnings • Whether to borrow short, medium or long term
  • 3. • What sort of mix – all borrowings or part debts part share capital or 100% share capital • The needs to determine how much dividend to pay out as this will directly affects the financial decision.2. Financial PlanningFinancial Planning is an exercise aimed to ensure availability of right amount of money atthe right time to meet the individual’s financial goalsConcept of Financial PlanningFinancial Goals refer to the dreams of the investor articulated in financial terms. Eachdream implies a purpose, and a schedule of funds requirements for realising the purposeAsset Allocation refers to the distribution of the investor’s wealth between different assetclasses (gold, property, equity, debt etc.)Portfolio Re-balancing is the process of changing the investor’s asset allocationRisk Tolerance / Risk Preference refers to the appetite of the investor for investment riskviz. risk of lossFinancial Plan Is a road map, a blue print that lists the investors’ financial goals andoutlines a strategy for realising themQuality of the Financial Plan is a function of how much information the prospect shares,which in turn depends on comfort that the planner inspires3. Capital StructureCapital structure of a firm is a reflection of the overall investment and financing strategyof the firm.Capital structure can be of various kinds as described below: - Horizontal capital structure: the firm has zero debt component in the structure mix. Expansion of the firm takes through equity or retained earnings only. - Vertical capital structure: the base of the structure is formed by a small amount of equity share capital. This base serves as the foundation on which the super structure of preference share capital and debt is built.
  • 4. - Pyramid shaped capital structure: this has a large proportion consisting of equity capita; and retained earnings. - Inverted pyramid shaped capital structure: this has a small component of equity capital, reasonable level of retained earnings but an ever-increasing component of debt.SIGNIFICANCE OF CAPITAL STRUCTURE: - Reflects the firm’s strategy - Indicator of the risk profile of the firm - Acts as a tax management tool - Helps to brighten the image of the firm.FACTORS INFLUENCING CAPITAL STRUCTURE: - Corporate strategy - Nature of the industry - Current and past capital structure4. Cost of CapitalCost of capital is the rate of return the firm requires from investment in order to increasethe value of the firm in the market place. In economic sense, it is the costof raising funds required to finance the proposed project, the borrowing rate of the firm.Thus under economic terms, the cost of capital may be defined as the weighted averagecost of each type of capital.There are three basic aspects about the concept of cost1. It is not a cost as such: The cost of capital of a firm is the rate of return which itrequires on the projects. That is why; it is a ‘hurdle’ rate.2. It is the minimum rate of return: A firm’s cost of capital represents the minimum rateof return which is required to maintain at least the market value of equity shares.3. It consists of three components. A firm’s cost of capital includes three componentsa. Return at Zero Risk Level: It relates to the expected rate of return when a projectinvolves no financial or business risks.b. Business Risk Premium: Business risk relates to the variability in operating profit(earnings before interest and taxes) by virtue of changes in sales. Business risk premiumis determined by the capital budgeting decisions for investment proposals.
  • 5. c. Financial Risk Premium: Financial risk relates to the pattern of capital structure (i.e., debt-equity mix) of the firm, In general, a firm which has higher debt content in its capital structure should have more risk than a firm which has comparatively low debt content. This is because the former should have a greater operating profit with a view to covering the periodic interest payment and repayment of principal at the time of maturity than the latter. 5. Trading on Equity When a co. uses fixed interest bearing capital along with owned capital in raising finance, is said “Trading on Equity”. (Owned Capital = Equity Share Capital + Free Reserves ) Trading on equity represents an arrangement under which a company uses funds carrying fixed interest or dividend in such a way as to increase the rate of return on equity shares.It is possible to raise the rate of dividend on equity capital only when the rate of interest on fixed – interest – bearing – security is less than the rate of return earned in business. •Two other terms: •Trading on Thick Equity :- When borrowed capital is less than owned capital •Trading on Thin Equity :- When borrowed capital is more than owned capital, it is called Trading on thin Equity. Q.2 a. Write the features of interim divined and also write the factors influencing divined policy? b. What is reorder level? Ans.2 Interim Dividend and factors effecting it. Usually, board of directors of company declares dividend in annual general meeting after finding the real net profit position. If boards of directors give dividend for current year before closing of that year, then it is called interim dividend. This dividend is declared between two annual general meetings. Before declaring interim dividend, board of directors should estimate the net profit which will be in future. They should also estimate the amount of reserves which will deduct from net profit in profit and loss appropriation account. If they think that it is sufficient for operating of business after declaring such dividend. They can issue but after completing the year, if profits are less than estimates, then they have to pay the amount of
  • 6. declared dividend. For this, they will have to take loan. Therefore, it is the duty ofdirectors to deliberate with financial consultant before taking this decision.Accounting treatment of interim dividend in final accounts of company :-# First Case : Interim dividend is shown both in profit and loss appropriation accountand balance sheet , if it is outside the trial balance in given question.( a) It will go to debit side of profit and loss appropriation account(b) It will also go to current liabilities head in liabilities side.# Second Case: Interim dividend is shown only in profit and loss appropriation account,if it is shown in trial balance.( a) It will go only to debit side of profit and loss appropriation account.If in final declaration is given outside of trial balance and this will be proposed dividendand interim dividend in trial balance will be deducted for writing proposed dividend inprofit and loss appropriation account and balance sheet of company, because if we willnot deducted interim dividend, then it will be double deducted from net profit that iswrong and error shows when we will match balance sheets assets with liabilities.Factors affecting dividend policy.The dividend decision is difficult decision because of conflicting objectives and alsobecause of lack of specific decision-making techniques. It is not easy to lay down anoptimum dividend policy which would maximize the long-run wealth of the shareholders.The factors affecting dividend policy are grouped into two broad categories. 1. Ownership considerations 2. Firm-oriented considerationsOwnership considerations: Where ownership is concentrated in few people, there are noproblems in identifying ownership interests. However, if ownership is decentralized on awide spectrum, the identification of their interests becomes difficult.Various groups of shareholders may have different desires and objectives. Investorsgravitate to those companies which combine the mix of growth and desired dividends.Firm-oriented considerations: Ownership interests alone may not determine thedividend policy. A firm’s needs are also an important consideration, which include thefollowing: • Contractual and legal restrictions
  • 7. • Liquidity, credit-standing and working capital • Needs of funds for immediate or future expansion • Availability of external capital. • Risk of losing control of organization • Relative cost of external funds • Business cycles • Post dividend policies and stockholder relationships.The following factors affect the shaping of a dividend policy:Nature of Business: Companies with unstable earnings adopt dividend policies whichare different from those which have steady earnings.Composition of Shareholding: In the case of a closely held company, the personalobjectives of the directors and of a majority of shareholders may govern the decision. Tothe contrary, widely held companies may take a dividend decision with a greater sense ofresponsibility by adopting a more formal and scientific approach.Investment Opportunities: Many companies retain earnings to facilitate plannedexpansion. Companies with low credit ratings may feel that they may not be able to selltheir securities for raising necessary finance they would need for future expansion. So,they may adopt a policy for retaining larger portion of earnings.Similarly, is a company has lucrative opportunities for investing its funds and can earn arate which is higher than its cost of capital, it may adopt a conservative dividend policy.Liquidity: This is an important factor. There are companies, which are profitable butcannot generate sufficient cash, since profits are to be reinvested in fixed assets andworking capital to boost sales.Restrictions by Financial Institutions: Sometimes financial institutions which grantlong-term loans to a company put a clause restricting dividend payment till the loan or asubstantial part of it is repaid.Inflation: In period of inflation, funds generated from depreciation may not be adequateto replace worn out equipment. Under inflationary situation, the firm has to depend uponretained earnings as a source of funds to make up for the shortfall. Consequently, thedividend pay out ratio will tend to be low.Other factors: Age of the company has some effect on the dividend decision.The demand for capital expenditure, money supply, etc., undergoes great oscillationsduring the different stages of a business cycle. As a result, dividend policies mayfluctuate from time to time.
  • 8. b. What is reorder level?Ans2 b. Reorder LevelThis is that level of materials at which a new order for supply of materials is to be placed.In other words, at this level a purchase requisition is made out. This level is fixedsomewhere between maximum and minimum levels. Order points are based on usageduring time necessary to requisition order, and receive materials, plus an allowance forprotection against stock out.The order point is reached when inventory on hand and quantities due in are equal to thelead time usage quantity plus the safety stock quantity.Formula of Re-order Level or Ordering Point:The following two formulas are used for the calculation of reorder level or point.Ordering point or re-order level = Maximum daily or weekly or monthly usage ×Lead timeThe above formula is used when usage and lead time are known with certainty; therefore,no safety stock is provided. When safety stock is provided then the following formulawill be applicable:Ordering point or re-order level = Maximum daily or weekly or monthly usage ×Lead time + Safety stock Q.3 Sales Rs.400, 000 less returns Rs 10, 000, Cost of Goods Sold Rs 300,000,Administration and selling expenses Rs.20, 000, Interest on loans Rs.5000,Income tax Rs.10000, preference dividend Rs. 15,000, Equity Share CapitalRs.100, 000 @Rs. 10 per share. Find EPS.Ans 3. 400,00 Sales 0 390,00 Less Returns 10,000 0 Less COGS 30,000 S&A 20,000
  • 9. Int onLoan 5,000 325,00IT 10,000 0Div 15,000 100,00ESC 0 @ 10/-NPAT - Pref ShareDivNo of SharesNPAT 55,000less Pref Share Div 15,000 40,000EPS 40,000 =Rs.4/- 10,000Q.4 What are the techniques of evaluation of investment?Ans4. Techniques of Investment EvaluationThree steps are involved in the evaluation of an investment:•Estimation of cash flows•Estimation of the required rate of return (the opportunity cost of capital)•Application of a decision rule for making the choice.The first two steps, discussed in the subsequent chapters, are assumed as given. Thus, ourdiscussion in this chapter is confined to the third step.speifically, we focus on the meritsand demerits of various decision rules.Investment decision ruleThe investment decision rules may be referred to as capital budgeting techniques, orinvestment criteria. A sound appraisal technique should be used to measure the economicworth of an investment project. The essential property of a sound technique is that itshould maximize the shareholders’ wealth. The following other characteristics shouldalso be possessed by a sound investment evaluation criterion.• It should consider all cash flows to determine the true profitability of the project.• It should provide for an objective and unambiguous way of separating good projectsform bad projects.
  • 10. • It should help ranking of projects according to their true profitability.• It should recognize the fact that bigger cash flows true profitability.• It should recognize the fact that bigger cash flows are preferable to smaller once andearly cash flows are preferable to later ones.• It should help top choose among mutually exclusive projects that project whichmaximizes the shareholders’ wealth.• It should be a criterion which is applicable to any conceivable investment projectindependent of other.These conditions will be clarified as we discuss the features of various investment criteriain the following pages.Evaluation criteriaA number of investments criteria (or capital budgeting techniques) are in use in proactive.They may be grouped in the following two categories:1. Discounted cash flow (DCF) criteria• Net present value (NPV)• Internal rate of return (IIR)• Profitability index (PI)2. Non-discounted cash flow criteria• Payback period (PB)• Discounted payback period• Accounting rate of return (ARR).Discounted payback is a variation of the payback method. It involves discounted cashflows, but as we shall see later, it is not a true measure of investment profitability. Wewill show in the following pages that the net present value criterion is the most validtechnique of maximizing the shareholders wealth.Q.5 What are the problems associated with inadequate working capital?
  • 11. Ans5. Problems associated with inadequate working capitalWorking capital may be regarded as the life blood of business. Working capital is ofmajor importance to internal and external analysis because of its close relationship withthe current day-to-day operations of a business. Every business needs funds for twopurposes. • Long term funds are required to create production facilities through purchase of fixed assets such as plants, machineries, lands, buildings & etc • Short term funds are required for the purchase of raw materials, payment of wages, and other day-to-day expenses. . It is other wise known as revolving or circulating capital It is nothing but the difference between current assets and current liabilities. i.e. Working Capital = Current Asset – Current Liability.Businesses use capital for construction, renovation, furniture, software, equipment, ormachinery. It is also commonly used to purchase inventory, or to make payroll. Capital isalso used often by businesses to put a down payment down on a piece of commercial realestate. Working capital is essential for any business to succeed. It is becomingincreasingly important to have access to more working capital when we need it.Importance of Adequate Working CapitalA business firm must maintain an adequate level of working capital in order to run itsbusiness smoothly. It is worthy to note that both excessive and inadequate workingcapital positions are harmful. Working capital is just like the heart of business. If itbecomes weak, the business can hardly prosper and survive. No business can runsuccessfully without an adequate amount of working capital.Danger of inadequate working capitalWhen working capital is inadequate, a firm faces the following problems.Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficientworking capital. Low liquidity position may lead to liquidation of firm. When a firm isunable to meets its debts at maturity, there is an unsound position. Credit worthiness ofthe firm may be damaged because of lack of liquidity. Thus it will lose its reputation.There by, a firm may not be able to get credit facilities. It may not be able to takeadvantages of cash discount.Disadvantages of Redundant or Excessive Working Capital1. Excessive Working Capital means ideal funds which earn no profits for the businessand hence the business cannot earn a proper rate of return on its investments.2. When there is a redundant working capital, it may lead to unnecessary purchasing and
  • 12. Accumulation of inventories causing more chances of theft, waste and losses.3. Excessive working capital implies excessive debtors and defective credit policy whichMay cause higher incidence of bad debts.4. It may result into overall inefficiency in the organization.5. When there is excessive working capital, relations with banks and other financialinstitutions may not be maintained.6. Due to low rate of return on investments, the value of shares may also fall.7. The redundant working capital gives rise to speculative transactions.Disadvantages or Dangers of Inadequate Working Capital1. A concern which has inadequate working capital cannot pay its short-term liabilitiesin time. Thus, it will lose its reputation and shall not be able to get good credit facilities.2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.3. It becomes difficult for the firm to exploit favorable market conditions and undertakeprofitable projects due to lack of working capital.4. The firm cannot pay day-to-day expenses of its operations and its createsinefficiencies, increases costs and reduces the profits of the business.5. It becomes impossible to utilize efficiently the fixed assets due to non-availability ofliquid funds.6. The rate of return on investments also falls with the shortage of working capital.Disadvantages or Dangers of Inadequate or Short Working Capital • Can’t pay off its short-term liabilities in time. • Economies of scale are not possible. • Difficult for the firm to exploit favorable market situations • Day-to-day liquidity worsens • Improper utilization the fixed assets and ROA/ROI falls sharply
  • 13. Q6. What is Leverage? Compare and contrast Financial and operating leverage.Ans6. ‘Leverage’ is the action of a lever or the mechanical advantage gained by it; it alsomeans ‘effectiveness’ or ‘power’. The common interpretation of leverage is derived fromthe use or manipulation of a tool or device termed as lever, which provides a substantiveclue to the meaning and nature of financial leverage.When an organization is planning to raise its capital requirements (funds), these may beraised either by issuing debentures and securing long term loan 0r by issuing share-capital. Normally, a company is raising fund from both sources. When funds are raisedfrom debts, the Co. investors will pay interest, which is a definite liability of thecompany. Whether the company is earning profits or not, it has to pay interest on debts.But one benefit of raising funds from debt is that interest paid on debts is allowed asdeduction for income tax. ‘When funds are raised by issue of shares (equity) , the investorare paid dividend on their investment. Dividends are paid only when the Company ishaving sufficient amount of profit. In case of loss, dividends are not paid. But dividend isnot allowed as deduction while computing tax on the income of the Company. In this wayboth way of raising funds are having some advantages and disadvantages. A Companyhas to decide that what will be its mix of Debt and Equity, considering the liability, costof funds and expected rate of return on investment of fund. A Company should take aproper decision about such mix, otherwise it will face many financial problems. For thepurpose of determination of mix of debt and equity, leverages are calculated andanalyzed.Concept of Financial LeverageLeverage may be defined as the employment of an asset or funds for which the firm paysa fixed cost or fixed return. The fixed cost or return may, therefore be thought of as thefull annum of a lever. Financial leverage implies the use of funds carrying fixedcommitment charge with the objective of increasing returns to equity shareholders.Financial leverage or leverage factor is defined, as the ratio of total value of debt to totalassets or the total value of the firm. For example, a firm having a total value of Rs.2,00,000 and a total debt of Rs. 1,00,000 would have a leverage factor of 50 percent.There are difficult measures of leverage such as. i. The ratio of debt to total capital ii. The ratio of debt to equity iii. The ratio of net operating income (earning before interest and taxes) to fixed’ charges) The first two measures of leverage can be expressed either in book v8lue or market value the debt of equity ratio as a measure of financial leverage is more popular in practice. “
  • 14. Risk & Financial Leverage:Effects of financial Leverage: The use of leverage results in two obvious effects: i. Increasing the shareholders earning under favorable economic conditions, and ii. Increasing the financial risk of the firm. Suppose there are two companies each having a Rs. 1,00,000 capital structure. One company has borrowed half of its investment while the other company has only equity capital: Both earn Rs. 2,00,000 profit. The ratio of interest on the borrowed capital is 10%and the rate of corporate tax 50%. Let us calculate the effect of financial leverage, both in the shareholders earnings and the Company’s financial risk in these two companies.(a) Effect of Leverage on Shareholders Earnings: Company Company A B Profit before Interest and Taxes Rs. Rs. Equity 2,00,000 2,00,000 Debt 10,00,000 5,00,000 Interest (10%) —- 5,00,000 Profit after interest but before —- 50,000 Tax 2,00,000 1,50,000 Taxes @ 50% 1,00,000 75,000Rate of return on Equity of Company A Rs. 1,00,000/Rs. 10,00,000 = 10%Rate of return on Equity of Company B Rs. 75,000/Rs. 5,00,000 = 15%The above illustration points to the favorable effect of the leverage factor on earnings ofshareholders. The concept of leverage is 5 if one can earn more on the borrowed moneythat it costs but detrimental to the man who fails to do so far there is such a thing as anegative leverage i.e. borrowing money at 10% to find that, it can earn 5%. Thedifference comes out of the shareholders equity so leverage can be a double-edged sword.(b) Effect of Leverage on the financial risk of the company: Financial risk broadlydefined includes both the risk of possible insolvency and the changes in the earningsavailable to equity shareholders. How the leverage factor leads to the risk possibleinsolvency does is self-explanatory. As defined earlier the inclusion of more and moredebt in capital structure leads to increased fixed commitment charges on the part of thefirm as the firm continues to lever itself, the changes of cash insolvency leading’ to legalbankruptcy increase because the financial ‘charges incurred, by the firm exceed theexpected earnings. Obviously this leads to fluctuations in earnings’ available to the equityshareholders. Relationship: Financial and Operating leverage:
  • 15. Relationship between financial and operating leverage: In business terminology,leverage is used in two senses: Financial leverage & Operating LeverageFinancial leverage: The effect which the use of debt funds produces on returns is calledfinancial leverage.Operating leverage: Operating leverage refers to the use of fixed costs in the operationof the firm. A firm has a high degree of operating leverage if it employs a greater amountof fixed costs. The degree of operating leverage may be defined as the percentage changein profit resulting from a percentage change in sales. This can be expressed as:= Percent Change in Profit/Percent Change in SalesThe degree of financial leverage is defined as the percent change in earnings available tocommon shareholders that is associated with a given percentage change in EBIT. Thus,operating leverage affects EBIT while financial leverage affects earnings after interestand taxes the earnings available to equity shareholders. For this reason operating leverageis sometimes referred to as first stage leverage and financial leverage as second stageleverage. Therefore, if a firm uses a considerable amount of both operating leverage andfinancial leverage even small changes in the level of sales will produce wide fluctuationsin earnings per share (EPS). The combined effect of both these types of leverages is aftercalled total leverage which, is closely tied to the firm’s total risk. Master of Business Administration- MBA Semester 2 MB0045 – Financial Management - Assignment Set- 2 Q. 1 Discuss the three broad areas of Financial Decision Making Q.2 What is the future value of an annuity and state the formulae for future value of an annuity The value of a group of payments at a specified date in the future. These payments are known as an annuity, or set of cash flows. The future value ofan annuity measures how much you would have in the future given a specified rate ofreturn or discount rate. The future cash flows of the annuity grow at the discount rate, andthe higher the discount rate, the higher the future value of the annuity.This calculation is useful for determining the actual cost of an annuity to the issuer:C = Cash flow per period
  • 16. i = Interest raten = Number of paymentsThis calculates the future value of an ordinary annuity. To calculate the future value of anannuity due, multiply the result by (1+i). (Payments start immediately instead of oneperiod into the future.) Example Example: What amount will accumulate if we deposit $5,000 at the end of eachyear for the next 5 years? Assume an interest of 6% compounded annually. PV = 5,000 i = .06 n=5 FVoa = 5,000 [ (1.3382255776 - 1) /.06 ] = 5,000 (5.637092) = 28,185.46 Year 1 2 3 4 5 Begi 5,000. 10,30 15,91 21,873 0n 00 0.00 8.00 .08 Inter 300.0 618.0 955.0 1,312. 0est 0 0 8 38 Dep 5,000 5,000. 5,000. 5,000. 5,000.osit .00 00 00 00 00 5,000 10,30 15,91 21,87 28,185 End .00 0.00 8.00 3.08 .46 Q.4 State the assumptions underlying the CAPM model and MM model Capital asset pricing model (CAPM) is used to determine a theoreticallyappropriate required rate of return of an asset, if that asset is to be added to an alreadywell-diversified portfolio, given that assets non-diversifiable risk. The model takes intoaccount the assets sensitivity to non-diversifiable risk (also known as systematic risk ormarket risk), often represented by the quantity beta (ß) in the financial industry, as well asthe expected return of the market and the expected return of a theoretical risk-free asset. Assumptions made are as below - 1. Aim to maximize economic utilities. 2. Are rational and risk-averse. 3. Are broadly diversified across a range of investments. 4. Are price takers, i.e., they cannot influence prices. 5. Can lend and borrow unlimited amounts under the risk free rate of interest. 6. Trade without transaction or taxation costs. 7. Deal with securities that are all highly divisible into small parcels. 8. Assume all information is available at the same time to all investors.
  • 17. The model assumes that either asset returns are (jointly) normally distributedrandom variables or that investors employ a quadratic form of utility. It is howeverfrequently observed that returns in equity and other markets are not normally distributed.As a result, large swings (3 to 6 standard deviations from the mean) occur in the marketmore frequently than the normal distribution assumption would expect The model assumes that the variance of returns is an adequate measurement ofrisk. This might be justified under the assumption of normally distributed returns, but forgeneral return distributions other risk measures (like coherent risk measures) will likelyreflect the investors preferences more adequately. Indeed risk in financial investments isnot variance in itself, rather it is the probability of losing: it is asymmetric in nature. The model assumes that all investors have access to the same information andagree about the risk and expected return of all assets (homogeneous expectationsassumption).[citation needed] The model assumes that the probability beliefs of investors match the truedistribution of returns. A different possibility is that investors expectations are biased,causing market prices to be informationally inefficient. This possibility is studied in thefield of behavioral finance, which uses psychological assumptions to provide alternativesto the CAPM such as the overconfidence-based asset pricing model of Kent Daniel,David Hirshleifer, and Avanidhar Subrahmanyam (2001) The model does not appear to adequately explain the variation in stock returns.Empirical studies show that low beta stocks may offer higher returns than the modelwould predict. Some data to this effect was presented as early as a 1969 conference inBuffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes.Either that fact is itself rational (which saves the efficient-market hypothesis but makesCAPM wrong), or it is irrational (which saves CAPM, but makes the EMH wrong –indeed, this possibility makes volatility arbitrage a strategy for reliably beating themarket).[citation needed] The model assumes that given a certain expected return investors will prefer lowerrisk (lower variance) to higher risk and conversely given a certain level of risk will preferhigher returns to lower ones. It does not allow for investors who will accept lower returnsfor higher risk. Casino gamblers clearly pay for risk, and it is possible that some stocktraders will pay for risk as well.[citation needed] The model assumes that there are no taxes or transaction costs, although thisassumption may be relaxed with more complicated versions of the model.[citationneeded] The market portfolio consists of all assets in all markets, where each asset isweighted by its market capitalization. This assumes no preference between markets andassets for individual investors, and that investors choose assets solely as a function oftheir risk-return profile. It also assumes that all assets are infinitely divisible as to theamount which may be held or transacted.[citation needed] The market portfolio should in theory include all types of assets that are held byanyone as an investment (including works of art, real estate, human capital...) In practice,such a market portfolio is unobservable and people usually substitute a stock index as aproxy for the true market portfolio. Unfortunately, it has been shown that this substitutionis not innocuous and can lead to false inferences as to the validity of the CAPM, and ithas been said that due to the inobservability of the true market portfolio, the CAPM might
  • 18. not be empirically testable. This was presented in greater depth in a paper by RichardRoll in 1977, and is generally referred to as Rolls critique The model assumes just two dates, so that there is no opportunity to consume andrebalance portfolios repeatedly over time. The basic insights of the model are extendedand generalized in the intertemporal CAPM (ICAPM) of Robert Merton, and theconsumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.[citationneeded] CAPM assumes that all investors will consider all of their assets and optimize oneportfolio. This is in sharp contradiction with portfolios that are held by individualinvestors: humans tend to have fragmented portfolios or, rather, multiple portfolios: foreach goal one portfolio — see behavioral portfolio theory and Maslowian PortfolioTheory MMs key assumptions and the role played by each are: Unlimited borrowing and lending is available to all market participants at one rateof interest. Role: makes the cost of personal and corporate borrowing and lending thesame. (2) Individual margin borrowing is secured by the shares purchased, theborrowers liability is limited to the value of these shares, there are no costs tobankruptcy. Role: makes the risk of personal and corporate borrowing and lending thesame. (3) All companies can be grouped into equivalent risk classes. Role: enablesinvestors to identify companies with identical business risk. (4) Capital markets are perfect. Role: permits investors to easily and costlesslyarbitrage between securities of companies which differ only in their financing mix. (5) There are no corporate income taxes. Role: prevents the tax code from makingdebt financing more valuable by allowing interest and not dividends as a tax deduction. (6) Shareholders are indifferent to the form of their returns, all returns are taxed atthe same rate. Role: prevents investors from seeing any difference in value betweeninterest, dividends, and capital gains. Q.5 Write the cash flow analysis? (1) Estimate your annual gross income as the first step in preparing a cash flow analysis. Allow for subtractions if your business is not operating at full potential. For instance, if you own an apartment complex, you add the amount of rent for each month, but subtract an estimated amount for unforeseen vacancies. The longer you are in business, the easier it will be to predict operating losses. (2) Add any other income you receive and you will arrive at your "effective gross income." This is a reliable business accounting figure that represents your entire annual projected gross income. Write this number down for future figuring. (3) Compile a list of the expenses you incur in order to operate your business. Separate this by category. Think about the purchases of big equipment you make. If you have a painting business, you would write down the expenses you pay annually for paint sprayers, rollers, brushes and drop cloths.
  • 19. (4) Write down all your office expenses, utility charges, advertising expenses and other fees you pay for equipment repairs and maintenance. Everything you need to purchase in the operation of your business counts. (5) Remember to include professional fees and taxes in your cash flow analysis. If you have an accountant, his fee goes here--so does insurance policy expense, workers compensation payments, unemployment insurance fees and taxes charged on your equipment or building. (6) Add your business accounting expense together and double check your chart of accounts to make sure you got them all. This number represents the total amount of expenses necessary to operate your business. Write it down beneath the effective income figure. (7) Figure out your debt service. Calculate the amount of payments you will make to the bank for loans, mortgages or other financing. Add these together and write the number down beneath the total expenses figure. (8) Subtract the total expenses and the total debt service figures from the effective annual income number. This is your cash flow analysis for the year. Q.6 The following two projects A and B requires an investment of Rs 2,00,000 each. The income returns after tax for these projects are as follows: Year Project A Project B 1 Rs. 80,000 Rs. 20,000 2 Rs. 80,000 Rs. 40,000 3 Rs. 40,000 Rs. 40,000 4 Rs. 20,000 Rs. 40,000 5 Rs. 60,000 6 Rs. 60,000 Using the following criteria determine which of the projects is preferable. ProjectA year Income PVIF@10% PVCI 1 80000 0.909 72720 2 80000 0.826 66080 3 40000 0.751 30040 4 20000 0.683 13660 PVCI 182500 PVCI - NPV 18250 20000 -0 0 = 17500 ProjectB year Income PVIF@10% PVCI
  • 20. 1 20000 0.909 18180 2 40000 0.826 33040 3 40000 0.751 30040 4 40000 0.683 27320 5 60000 0.621 37260 6 60000 0.564 33840 PVCI 179680 PVCI - NPV 17968 20000 -0 0 = 20320 As Project A is preferable option as it has minimal losses.