This document discusses various measures for evaluating portfolio performance, including Sharp's measure, Treynor's measure, and Jensen's measure. Sharp's measure evaluates return relative to total risk. Treynor's measure evaluates return relative to systematic risk or beta. Jensen's measure expresses the relationship between risk and return based on the Capital Asset Pricing Model. Examples are provided to demonstrate calculating these measures for sample portfolios. The document also provides instructions for ranking portfolios according to Sharp's, Treynor's, and Jensen's measures.
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Everything you ever wanted to know about trustees: What does it mean to be a trustee? What are your responsibilities and liabilities? What makes a good trustee?
For more information, please visit us at www.givnerkaye.com
Slide 1
12-1
Cost of Capital
Slide 2
12-2
Key Concepts and Skills
• Know how to determine:
– A firm’s cost of equity capital
– A firm’s cost of debt
– A firm’s overall cost of capital
• Understand pitfalls of overall cost of
capital and how to manage them
From our modules on capital budgeting, we learn that the discount rate, or required return, on an investment
is a critical input. However, we haven’t discussed how to come up with that particular number. This module
brings together many of our earlier discussions dealing with stocks and bonds, capital budgeting, and risk
and return. Our goal is to illustrate how firms go about determining the required return on a proposed
investment. Understanding required returns is important to everyone because all proposed projects must
offer returns in excess of their required returns to be acceptable.
In this module, we learn how to compute a firm’s cost of capital and find out what it means to the firm and
its investors. We will also learn when to use the firm’s cost of capital and, perhaps more important, when
not to use it.
Why is it important? A good estimate is required for:
• good capital budgeting decisions—neither the NPV rule nor the IRR rule can be implemented without
knowledge of the appropriate discount rate
• financing decisions—the optimal/target capital structure minimizes the cost of capital
• operating decisions—cost of capital is used by regulatory agencies in order to determine the “fair”
return in some regulated industries (e.g. utilities)
Slide 3
12-3
Chapter Outline
• The Cost of Capital: Some Preliminaries
• The Cost of Equity (RE)
• The Costs of Debt (RD) and Preferred Stock (RP)
• The Weighted Average Cost of Capital (WACC)
• Divisional and Project Costs of Capital
Slide 4
12-4
Cost of Capital Basics
• The cost to a firm for capital funding = the
return to the providers of those funds
– The return earned on assets depends on the
risk of those assets
– A firm’s cost of capital indicates how the
market views the risk of the firm’s assets
– A firm must earn at least the required return to
compensate investors for the financing they
have provided
– The required return is the same as the
appropriate discount rate
Cost of capital, required return, and appropriate discount rate are different phrases that all refer to the
opportunity cost of using capital in one way as opposed to alternative financial market investments of the
same systematic risk.
• Required return is from an investor’s point of view.
• Cost of capital is the same return from the firm’s point of view.
• Appropriate discount rate is the same return used in a PV calculation.
Slide 5
12-5
Cost of Equity
• The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm
• Two major methods for determining the
cost of equity
▪Dividend growth model
▪SML .
MMS students have many opportunities in finance sector to do carrier but they have to decide the path in the beginning itself on which they have to walk for lifetime.
Slide 1
12-1
Cost of Capital
Slide 2
12-2
Key Concepts and Skills
• Know how to determine:
– A firm’s cost of equity capital
– A firm’s cost of debt
– A firm’s overall cost of capital
• Understand pitfalls of overall cost of
capital and how to manage them
From our modules on capital budgeting, we learn that the discount rate, or required return, on an investment
is a critical input. However, we haven’t discussed how to come up with that particular number. This module
brings together many of our earlier discussions dealing with stocks and bonds, capital budgeting, and risk
and return. Our goal is to illustrate how firms go about determining the required return on a proposed
investment. Understanding required returns is important to everyone because all proposed projects must
offer returns in excess of their required returns to be acceptable.
In this module, we learn how to compute a firm’s cost of capital and find out what it means to the firm and
its investors. We will also learn when to use the firm’s cost of capital and, perhaps more important, when
not to use it.
Why is it important? A good estimate is required for:
• good capital budgeting decisions—neither the NPV rule nor the IRR rule can be implemented without
knowledge of the appropriate discount rate
• financing decisions—the optimal/target capital structure minimizes the cost of capital
• operating decisions—cost of capital is used by regulatory agencies in order to determine the “fair”
return in some regulated industries (e.g. utilities)
Slide 3
12-3
Chapter Outline
• The Cost of Capital: Some Preliminaries
• The Cost of Equity (RE)
• The Costs of Debt (RD) and Preferred Stock (RP)
• The Weighted Average Cost of Capital (WACC)
• Divisional and Project Costs of Capital
Slide 4
12-4
Cost of Capital Basics
• The cost to a firm for capital funding = the
return to the providers of those funds
– The return earned on assets depends on the
risk of those assets
– A firm’s cost of capital indicates how the
market views the risk of the firm’s assets
– A firm must earn at least the required return to
compensate investors for the financing they
have provided
– The required return is the same as the
appropriate discount rate
Cost of capital, required return, and appropriate discount rate are different phrases that all refer to the
opportunity cost of using capital in one way as opposed to alternative financial market investments of the
same systematic risk.
• Required return is from an investor’s point of view.
• Cost of capital is the same return from the firm’s point of view.
• Appropriate discount rate is the same return used in a PV calculation.
Slide 5
12-5
Cost of Equity
• The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm
• Two major methods for determining the
cost of equity
▪Dividend growth model
▪SML .
MMS students have many opportunities in finance sector to do carrier but they have to decide the path in the beginning itself on which they have to walk for lifetime.
Reserve Bank of India (RBI)
Functions of RBI, credit control measures,
qualitative credit control and quantitative
credit control, regulatory measures taken
by RBI to facilitate financial inclusion.
Objectives and definitions under FEMA,
1999,current account transactions and
capital account transactions, establishment
of branch, office etc. in India, realization
and repatriation of foreign exchange,
authorized person, penalties and
enforcement, foreign contribution
(Regulation)Act, 2010.
IRDA Act, Salient features of the IRDA
Act, 1999, IRDA (protection of policy
holder interests) Regulations 2002, its
duties, power and functions of authority.
3. Objectives of portfolio
• Maximum return with minimum risk
• Allocation of fund
• Transfer of risk
• Combination of securities
• Professional service
• Expert advice
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4. Portfolio evaluation
• To identify sources of strength or weakness
• As Control mechanism
• For comparison
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6. Sharp’e Measure
• It measures return relative to total risk
• Risk is predominately from systematic risk
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7. =( 𝑅 - Rf ) / σ
• 𝑅 = Average return
• Rf = Risk free return
• σ = standard deviation of return
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8. • Birla SL Frontline Equity (G) and SBI Blue Chip Fund
(G) are two portfolios. Birla SL Frontline Equity (G)
has a sample mean of success 12% and SBI Blue
Chip Fund (G) has a sample mean of success 16%.
The respective standard deviation are 15% and
18%. The mean return for the market index is 12
and standard deviation is 8% while the risk free rate
of return is 8%.
• Compute the sharpe index for the portfolios and
market and comment
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9. Birla Sun Life Top 100 (G) Kotak Select Focus Fund -
Regular (G)
Average Return 17 15
Standard deviation 16 12
Risk free rate 9.5 9.5
Compute the sharp’e index for the
portfolios and market and comment
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12. Portfolio Average Return Beta Standard Deviation
L&T India Value
Fund (G)
18 2 3
Principal Emerging
Bluechip(G)
12 1.5 2
The risk free rate of return is 9%. The rate of
return on market portfolio is 15%. The standard
deviation on market is 6%.
Compute Treynor’s and sharpe index for
portfolio and evaluate portfolio’s performance.ingleyogeshh@gmail.com
13. Jensen’s Measure
• It is based on CAPM
• It express relationship between risk and return
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14. Ki=Rf +β (Km – Rf)
• Ki= Required or Expected rate of return on
security
• Rf= Risk free rate of return
• β= Beta of security
• Km= Expected rate of return on market
portfolio
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15. • You are required to rank these portfolios
according to Jensen’s measure of Portfolio
evaluation.
Portfolio Return on portfolio Portfolio beta Risk free interest
rate
Franklin Build India
Fund (G)
15 1.2 8
Kotak Infras. & Eco
Reform -Standard
(G)
12 0.8 8
Tata India Tax
Savings Fund - Reg
(D)
16 1.5 8
Market Index 13 1.0 8
ingleyogeshh@gmail.com
16. You are required to rank these portfolios
according to Sharpe, Treynor and Jensen’s
measure. Risk free rate of return is 8%
Portfolio Return on portfolio Portfolio beta Standard deviation
Franklin Build India
Fund (G)
15 1.25 0.25
Kotak Infras. & Eco
Reform -Standard
(G)
12 0.75 0.75
Tata India Tax
Savings Fund - Reg
(D)
10 1.10 1.10
Market Index 12 1.20 1.20
ingleyogeshh@gmail.com