Uevlao aden stration 2 A had purchased a bond at a ) what is his rate of re yymoent, then what will b Price of © 1,000 with a coupon payment of © 200 and sold it for © 1,250; turn, and (i) if the bond is sold for © 1,000 after receiving & 200 as coupon be his rate of return ? lution Capital Gain + Coupon Payment Rate of Ret = 100 Purchase Price 2500(1,2500- 1,000) +2 = 2500(1,250 1,000) +200 99 1,000 = 150 100 = 45% D0 If bond is sold for & 1,000, then Rate of Retum = 22°0-(1,000 1,000) + 200 199 1,000 si eaten = 20% 1,000 lustration 3 The following information is available in respect of the return from security X under different momic conditions : Economic Conditions Return Probability Good 20% 1 Average 15% 5 Bad 10% 4 Poor 5% 3 Find out the expected rate of return of the security and the risk associated with it. lution ‘The expected return from the security can be measured in terms of the weighted average return and risk can be measured in terms of the standard deviation (0) of the returns on follows : la 20 12.020 100 5.15 -.15)* = 00000 4(.10-.15)? =,00100 13.05 ~.15)* =.00300 ‘Therefore, ‘The Average Expected Return = .150 or 15% And Standard Deviation = v.00425 = 0.065 or a = 6.5%210 Mustration + ‘ following information is available Toe teak ay Share is & 100. Fol f nN dividends, market ne axl the expected market condition after one year 1g pee 7 a rket Condition Probability [Market Price Dividend >| gf z | z Good 20 110 8 Normal 40 | 105 4 Bad 20, L 98. 2 Find out the expected return and variability of returns of the equity shares Solution ~ Calculation of Expected REturn of Equity Shares Market Condition Probal Total Return Cost Net Return > z z Good 20 110+8=118 100 Normal 40 105 +4 =109 100 9 Bad 20 98+2=100 100 0 Expected Return = Indvidiaul Probability x Net Return 18 x.20) +(9 x 40) + (0.20) 6+3.6+0=7.2% Calculation of Variability of Return . =.20(18- 7.2) +.40(9- 7.2)? .20@- 7.2) 13.328 + 1.296 + 10.368 34.992 o® = 34.992 S 0 =5.92 Illustration 5 Mr. Mohan has a portfolio of five securities, whose expected return and amount inve follows ee Securities I i rit Amount @) 1,20,000 2,20,0002,80,000 804 Expected Return 10% 8% 12% Find out the expected rate of return of the portfolios. Solution Calculation of Expected Return (%)‘Therefore, ‘The expected return of the Portfolio is 10.95% 1,20,000 8,60,000 =.14 (approx.) and so on. justration 6 Ina portfolio of the company & 2,20,000 h 8, X which has an expected return 2.20,000 have been invested, in asset X which has an expe 10% € 3,00,000 in asset Y which has an expected return of 12% and & 3,50,000 in asset Z. which has an spected return of 15%. What is expected return for the portfolio ? lution Calculation of Expected Return on Portfolio and Investment Amount Ss | Return (R) | Ave. Return eel Neer (Retum +100) | (WR) _ Be 2,20,000 (000 8,70,000)=.253 | «10 0253 % 3,00,000 (3,00,000 8,70,000 2 0414 Z — |__3,50,000__|_(3,50,000 V 8,70,000) = .402 15 ___.0603 | 8,70,000 127 pete | 0 ee Therefore, Average Return on Investment = .127 x 100 =12.7% ~ lustration 7 Following information is available in respect of the rate of return of two securities A and B in lifferent economic conditions Rate of Return Economic Condition Probability r aa Security A Security B Recession | pone z = 15 is 20 Normal 50 20 30 Boom | 30 60 40 Find out the expected return and the Standard Deviation for these two securities. Suppose, an investor % 1,00,000 to invest. He invests & 75,000 in security A and the balance in security B. What will be the xpected return of the Portfolio ? lution Ry =(.20) x (-.15) +(.50 x.20) + (.30 x.60) = (-.03) + (.10) + (.18) 25 or 25 x 100 = 25% oy 31)? +.50(. 0049 = 7% In case, the investors invests 15,000 in A and ® 5,000 in B, the expected return and standard ation of the portfolio of the investor are : + Expected Return of the Portfolio (15 x.25) + (.25 x31) 265 or .265 x 100 = 26.5%SeMey, An investor is evaluation two investment options, Both have equal returns but the ecurrin ale are était Probabily Occurring these returns in two proposals are different. The returns and probabilities are sy Return Probability X Probability Y 12% rl a 15% az 3 20% 3 5 5 4 2 Find out the expected return from both proposals and also evaluate the risk of these returns The expected value of returns and risk can be analysed as follows : PROJECT X Return Probal Return x Probability | Prob. (Ret.- Exp. Ret.)? 12 1 012 |. a@2e20: lS 2 ~ .030 2(.15 -.202)? 20 3 060 3(.20-.202); 4 4(.25-.202)? Therefore, Expected Value of Return Now, Standard Deviation of Project Y (a) Rate of Return = .0462 or 4.62%" Now, Co-efficient of Variance of Proejct Y(CV,) = Standard Deviation _ Expt. Value of Return =:0402 _ 99 202 PROJECT Y Return | Return x Probabil P (Ret, - Exp. Ret. ? peel ral 012 112-207)? =,0007569 15 045 3 (15 - 207)? - 0009747 20 100 -5(.20-.207)? 25 | 050 .2(.25-.207)? | 2x 207i ea Therefore, Expected Value of Return =,207 or 207 x 100 = 20.7% -V.0021259or = .0461 0461x100 = 4.61% Now, Standard Deviation of Project Y (a, ) Now, Standard Deviation : roe = _Siandani Detjauons Co-efficiont of Variance of Project's (CV) aaa 0461 = ee 207tration 9 return and year-end prices are expected as follows : Condition Retur n Year-end Price ® @ Boom 3 50 Normal 2) 42 Recession 1 35 Find out the expected value of return for one year period. lution Calculation of Expected Value of Return An investment is currently available for % 40. The revenue return and the year end price of this tment depends upon economic conditions. These such conditions are likely with equal probabilities. | Probability a | Year-end Conditions | (Equal) | Return (%) ESS Total Return Boom | 1B | 3 50 | 3+(50-40)=13 Normal | = 13 2 42 2+(42- 40) =4 Recessic Ng) 1 35 el asmanleGse4 ey era 8 | Probability x Total Return Tee 33 fetes be i1i33 | Expected Return Therefore, Expected vAlue of Return = 4.33 + 40 = 0.10825 Or = 0.10825 x 100 = 10.83% (approx.) SS A SS aee 3 CAPT eT PRICING eh, (CAPM) “~~ Capita, Pl asset CAPTTAL ASSET PRICING MODEL > cost of equity share Aevelo CaPital ager NB Model (CAPM) can alao be used to est wt Lee Tt is further y Jon ect Pricing modal i od by William F. § p: s the Dear iby u ohn Lintner naan odel has been propounded by into two parts p . , ; divided , a 20 Jon Mossin, In CAPM the Cost of equity is sional risk Tot for ine gee arising on investing in Government bonds and an additional is Ups ; “Sng in a particular shares. ‘The risk of security investment ari ® Dive i. “sifiable or Unsystematic risk (ii) Non-diversifiable or systematic risk. More or mone able OF Unsystematic risk : It refer to those risk Which can be eliminated by Ga, diversification : Xe affect all gue ertifl25le or Systematio righ It refer to those riak: Which eannot be eliminated. Government port at @ Particular time, For example : risk of political uncertanities, risk of an investor is renies ct Hence, the non-diversifiable risk is the point where the attention Portfolio. It is eee Hon-diversifiable risk of security is measured in relation to market é yy the bet: According to CAPM, ‘€ coefficient B . following formula : the cost of equity share capital can be ascertain with the help of Ke =Rr+8 (Rm — Rr) Where, Ke= ost of Equity Capital Rr = Risk — free rate of return Rm = Market rate of return of the firm’s portfolio average rate of return on all assets. B = Beta Coefficient of the firm’s portfolio or the measure of non - diversifiable risk. ee = Followi pate fact of a firm. (i) Rigk-free rate of return 10% (ii) Beta-co-efficient of the firm's portfolio 1,20 Compute the cost of equity capital using Capital Assets Pricing Model (CAPM) assuming a market return of a diversified portfolio is 14%, What would be the cost of equity if B rises to 1.50. Solution Given : Risk-free rate of return (R,) = 10% Beta-Coefficient of the firm’s portfolio (8) = 1.20 Market return of a diversified portfolio (Rm) = 14% Ke = Rr + B(Rm— Ray Ke = 10% + 1.20 (14% ~ 10%) Ke = 10% + 1.20 x 4% Ke = 10% + 4.80% Ke = 14,80%—___ FINANCIAL MANAGEMENT If Beta Coefficient rises to 1.50 then Ke = 10% + 1.50(14% - 10%) Ke = 10% + 1.50 x 4% Ke = 10% + 6% Ke = 16% Mlustration 2 2 be Following is the information about the equity share of different five companies Name of the Company Market ce of Shares . 0.50 x 100,000 + Y 5,00,000 . z 4,00,000 : P 2,00,000 iD e —e {ied portfolio is 20%, then find out the If Risk-free rate of return is 12% and market return of a diversi following as per CAPM : 6) Cost of Equity share capital for each company Fz Gi) Weighted cost of equity share capital for all the companies Solution @ — Ke=RrB(Rm-Rr) 12% + 0.5 (20% ~ 12%) = 12% + 0.5 x 8% 12% + 4% = 16% 12% + 2.5 (20% ~ 12%) 12% + 20% = 32% 2% + 2(20% — 12%) = 12% +2 x 8% 2% + 16% = 28% 12% + 1(20% — 12%) = = 12% + 8% = 20% 12% + 1.5(20% — 12%) = 12% + 1.5 x 8% 2% + 12% = 24% (ii) Calculation of weighted beta Coefficient : Name of Company Market Value of z ao 1,00,000 12% + 2.5 x 8% 12% + 1x 8% inthe ‘market value 8 ree of Shares (w) 050 0.0335 Yy 5,00,000 25 0.8325, Z 4,00,000 2 0.534 = 2,00,000 a 3,00,000 15 038 16,00,000 aN, Ke=Rr+(Rm-Rr) 1 = 12% + 1.833(20% - 12%) i: = 12% + 1.833 x 8% 12% + 14.664= 26.664%RISK AND RETURN satan — stration 3 t rate (Rm) of Fie es following int natden| ig ests relating to risk free return rate (Rr) and marke rity during last five years : 2 Sea a 1 2 3 4 ee R, : 0.02 0.05 0.06 0.06 Bae Rinses 0.05 0.08 0.10 0.12 Compute the cost of equity using CAPM assuming that f is 0.5. Solution Tnorder to find out the cost of equity capital using CAPM, the average risk-free return and average market rate of the security are required. Average Rr = 0.02 + 0.05 + 0,06 + 0.06+ 0.08 _ 0.08 06 5 ‘Average R= 98.+008+0.10 +0.12+0.14 0.499, Now, the cost of equity capital can be determined as per CAPM as follows : Ke = Rr +B (Rm - Rr) QUESTIONS LongAnswerTypeQuecti,..