Financial Management -I (FM-I)

1. INTRODUCTION TO FINANCIAL MANAGEMENT

Forms of Business Organization

 Sole Proprietorship
One owner • Very simple • Unlimited liability • The firm has no separate status from a legal and tax
point of view
 Partnership
Two or more owners • Fairly simple • Unlimited liability • The firm has a separate status
 Private Limited Company
• Up to 50 owners • Not too complex • Limited liability • A distinct legal person
 Public limited company
• Many owners • Somewhat complex • Limited liability • Distinct legal person • Free transferability of
shares

Objectives of Financial Management- The primary objective of Financial management is wealth

maximization of shareholders.
Profit Maximization Vs Wealth Maximization
Profit maximization is the process by which a business arranges its prices and cost structure to achieve the
highest possible profit. The central goal of the organization is to increase its profits whereas Wealth
maximization is the concept of increasing the value of a business in order to enhance the value of the shares
held by its stockholders. This may involve additional investments in intellectual property and strategic
positioning, as well as attention to managing the risk profile of a business.
The essential difference between the maximization of profits and the maximization of wealth is that the profits
focus is on short-term earnings, while the wealth focus is on increasing the overall value of the business entity
over time.
 Effective mobilization is one of the most important objectives of financial function. It means that
managers need to make decisions regarding the allocation and utilization of various funds. Whether
it’s shares or debentures, finance managers need to estimate an organization’s requirements and make
financial decisions accordingly.
 Improved Efficiency - Proper utilization of finance also encourages proper distribution. From creating
inventories to investing in profitable businesses, mobilization and utilization of finances lead to better
business decisions.
 Balanced Structure - As financial managers prepare capital structure, it creates balance among
different sources of capital. This balance is essential for liquidity, flexibility and stability. This further
decides the ratio between owned capital and borrowed capital.
 Business Survival - The goal of financial management is ensuring an organization’s survival. As the
term suggests, businesses need to survive the competitive market and the best way to do so is to
manage their financial resources.
The fundamental principle of finance
A business proposal-regardless of whether it is a new investment or acquisition of another company or a
restructuring initiative –raises the value of the firm only if the present value of the future stream of net cash
benefits expected from the proposal is greater than the initial cash outlay required to implement the proposal.
Agency Problem: While there are compelling reasons for separation of ownership and management, a
separated structure leads to a possible conflict of interest between managers and shareholders. Managers may
place personal goals ahead of corporate goals.
Agency problem can be prevented by:
- Market forces
- Voting rights by institutional investors
- Hostile takeovers – firm acquiring by another Market forces
Agency Costs- costs borne by shareholders to minimize agency problems
- Monitoring costs – E.g., Auditing and control
- Bonding costs – Fidelity bond
Financial Management Decisions
1. Investment Decisions: These investment decisions are often referred to as capital budgeting or capital
expenditure (CAPEX) decisions, because most large corporations prepare an annual capital budget
listing the major projects approved for investment.
2. Financing Decisions: A corporation can raise money (cash) from lenders or from shareholders. If it
borrows, the lenders contribute the cash, and the corporation promises to pay back the debt plus a fixed
rate of interest. If the shareholders put up the cash, they get no fixed return, but they hold shares of
stock and therefore get a fraction of future profits and cash flow. The shareholders are equity investors,
who contribute equity financing. The choice between debt and equity financing is called the capital
structure decision. Capital refers to the firm’s sources of long-term financing.
Mobilization of Funds -The Finance Manager has to plan for and mobilize the required funds from
various sources when they are required and at an acceptable cost. This decision is called the Financing
Decision.
3. Dividend decisions: Determines the division of earnings between payments to shareholders and
retained earnings. The Dividend Decision, in corporate finance, is a decision made by the directors of
a company about the amount and timing of any cash payments made to the company’s stockholders.
The dividend decision, which consider the amount of funds retained by the company and the amounts
to be distributed to the shareholders, is closely linked to both investment and financing decisions.

Relationship of finance to economics

• Macroeconomic environment defines the setting within which the firm operates. GDP growth rate,
savings rate, fiscal deficit, interest rates, inflation rate, exchange rates, tax rates, and so on have an
impact on the firm
• Microeconomic theory provides the conceptual underpinnings for the tools of financial decision
making. Finance, in essence, is applied microeconomic
Relationship of finance to accounting
• Accounting is concerned with score keeping, whereas finance is aimed at value maximising.
• The accountant prepares the accounting reports based on the accrual method. The focus of the
financial manager is on cash flows.
• Accounting deals primarily with the past. Finance is concerned mainly with the future.
Emerging role of the financial manager
The Key challenges for the financial manager appear to be in the following areas-
  Investment planning
 Financial Structure
 Mergers, acquisitions and restructuring
 Working capital management
 Performance management
 Risk management
 Investor relations
The job of the financial manager in India has become more important, complex and demanding due to the
following factors:
• Liberalisation • Globalisation • Technological developments • Volatile financial prices • Economic
uncertainty • Tax law changes • Ethical concerns over financial dealings • Shareholder activism

2. INTRODUCTION TO FINANCIAL MARKETS

The financial system
A Financial System is a set of complex and closely connected or interlinked institutions, agents, practices,
markets, transactions, claims, and liabilities in the economy. The financial system is concerned about money,
credit and finance in the economy.
It is a composition of various institutions, markets, regulations & laws, practices, transactions and claims &
liabilities. Such a system comprises of set of subsystems of financial institutions, financial markets, financial
instruments and services which helps in the formation and usage of capital. It provides a mechanism by which
savings are transformed into investments, by functioning as an intermediary between savers and investors.
Financial System facilitates the flow of funds from the areas of surplus to the areas of deficit. It operates
through a set of institutions, instruments, markets, and intermediaries
The role of the financial system can be broadly classified into the following:
• Savings Function: Mobilize savings in a way to provide a potentially profitable and low risk outlet
• Policy Function: Through the policy function, the government ensures a smooth flow of funds from
Savings into investments in order to stabilize the economy.
• Credit Function: After mobilizing, the savings and laying down the necessary policies for the transfer of
these funds, the credit function of the financial system, will then ensure that these savings will transform
into the necessary credit for investment and spending purposes.
Functions of the financial system
The financial system of a country performs certain valuable functions for the economic growth of that country.
The main functions of a financial system may be briefly discussed as below:
1. Mobilise Savings
An important function of a financial system is to mobilise savings and channelize them into productive
activities.
2. Provide Liquidity
A financial system also ensures that money and monetary assets are provided for the production of goods
& services. Monetary assets are those assets which can be converted into cash or money easily without
loss of value. All activities in a financial system should be geared to provide liquidity to savers and
investors.
3. Facilitate Payments
Provide a very convenient mode of payment for goods and services, which can include mechanisms like
cheques, credit cards, debit cards, digital money transfers etc. to reduce the cost and time of transactions.
4. Protection against Risk
Financial markets provide protection against life, health and income risks, through mechanisms like life
insurance, health insurance and property insurance policies.
5. Dissemination of Information
A financial system makes available price-related information, to help those who need to take economic
and financial decisions. Financial markets disseminate information, for enabling participants to develop
an informed opinion about investment, disinvestment or reinvestment in a particular asset.
6. Transfer of Resources
A financial system provides a mechanism for the transfer of the resources across geographic boundaries.
7. Bringing Reforms
To cater to the emerging needs of borrowers and investors, the financial system should develop and,
introduce innovative financial assets/instruments, services, practices etc.
Financial intermediaries like banks and venture capital organizations can solve the problem of informational
asymmetry by handling sensitive information discreetly and developing a reputation for profitable activity
Financial markets
The financial markets channelize the savings of the households and other surplus budget units to those
individuals and institutions that need funds. A financial market is a market for creation and exchange of
financial assets.
Functions of Financial Markets: The main functions of financial markets are:
 Facilitating creation and allocation of credit and liquidity
 Serving as intermediaries for mobilisation of savings
 Helping in the process of balanced economic growth
 Providing financial convenience
 Providing information and facilitate transactions at low cost.
 To cater to the various credits needs of the business organisations
Classification of Financial Markets-
1. Classification on the basis of the type of financial claim:
a) Debt market: This is the financial market for fixed claims like debt instruments.
b) Equity market: This is the financial market for residual claims, i.e., equity instruments.

2. Classification on the basis of length of maturity of claim:

a) Money Market:
Short term monetary assets with a maturity period of one year or less, are borrowed and lent in the
Money market. Liquid funds as well as highly liquid securities are traded in the money market,
such as Treasury bills, call money, commercial bills etc. The main participants in this market are
banks, financial institutions and government. Money markets enable redistribution of cash
balances, in accordance with the liquidity needs of the participants. They help in the management
of liquidity and money in the economy by monetary authorities. They provide reasonable access
to the users of short-term money for meeting their requirements at realistic prices.
 b) Capital market:
Capital market is the market for long term funds. This market deals in the long-term claims and
securities, with a maturity period of more than one year. The stock market, the government bond
market and derivatives market are examples of capital market.

3. Classification on the basis of participants:

a) Primary market:
Primary markets are those markets which deal in the new securities, and also known as new issue
markets, where securities are issued for the first time directly by the companies. The primary
markets mobilise savings and supply fresh or additional capital to business units, by raising fresh
capital in the form of shares and debentures.

b) Secondary market
Secondary markets are those markets which deal in existing securities. Existing securities are those
securities that have already been issued and are already outstanding. It consists of stock exchanges.
Stock exchanges are self-regulatory bodies under the overall regulatory purview of the Govt.
/SEBI.

4. Classification on the basis of timing of delivery:

a) Cash / Spot market
This is the market where the buying and selling of commodities happens or stocks are sold for cash
and delivered immediately after the purchase or sale of commodities or securities.
b) Forward/Future market
This is the market where participants buy and sell stocks/commodities, contracts and the delivery
of commodities or securities occurs at a pre-determined time in future.
Financial Assets
Financial assets/instruments represent the financial obligations that arise when the borrower raises funds in
the financial market.
In exchange for the funds lent, the supplier will have a claim on the income/wealth of the borrower which may
be a company, a government body or a household. This financial claim will be packaged in the form of a
certificate, receipt or any other legal document.
Financial assets play a key role in developing the financial markets in particular and the financial system.
Types of Financial Assets
Majority of financial assets used worldwide are in the form of deposits, stocks and debt.
 Deposits - Deposits can be made either with banking or non-banking firms. In return, the lender will
receive a certificate in case of a fixed deposit and a checking account in case of a savings/current
deposit. These serve as payment mechanism to the supplier of funds. Interest will be earned on such
deposits.
 Stocks- When financial assets are in the form of stock, they represent ownership of the issuing
company. Due to this right to ownership, the holder of the stocks will have a share in the firms’ profits.
 Debt- Unlike the stocks, financial assets in the form of debt raise an obligation on the borrower to
repay the amount borrowed. The debt instrument will be a contract entered into by the borrower of
funds with the lender of funds, to repay the amount borrowed after a predetermined period and at a
certain rate of interest. If there is an asset serving as a collateral to the borrowing, then the holder of
the debt instrument will have a priority claim on the asset.
Financial Intermediaries
Financial intermediaries are firms that provide services and products that customers may not be able to get
more efficiently by themselves in financial markets. Financial intermediaries seem to offer several advantages:
diversification, lower transaction cost, economies of scale, confidentiality, and signalling benefit.
The major financial intermediaries in India are –

 Banks
A bank is a financial institution licensed to receive deposits and make loans. Banks may also provide
financial services such as wealth management, currency exchange, and safe deposit boxes. There are
several different kinds of banks including retail banks, commercial or corporate banks, and investment
banks.
 Credit Unions
Credit unions are financial cooperatives that provide traditional banking services to their members.
Credit unions have fewer options than traditional banks.
Credit unions follow a basic business model: Members pool their money—technically, they are buying
shares in the cooperative—in order to be able to provide loans, demand deposit accounts, and other
financial products and services to each other. Any income generated is used to fund projects and
services that will benefit the community and the interests of its members.
 Pension Funds
Pension funds are financial tools that help you in accumulating funds for your post-retirement years.
By investing a certain amount regularly towards your pension fund, you will build up a considerable
sum in a phase-by-phase manner.
 Insurance Companies
Insurance corporations are financial intermediaries which offer direct insurance or reinsurance
services, providing financial protection from possible hazards in the future.
Under an insurance policy, the insurance corporation undertakes to compensate the policyholder for
losses caused by a pre-defined event against a fee, or “premium”.
 Stock Exchanges
A stock exchange is a centralised location where the shares of publicly traded companies are bought
and sold. Stock exchanges differ from other exchanges because the tradable assets are limited to stocks,
bonds and exchange traded products (ETPs).
Role of Financial Intermediaries in the financial system:

Intermediaries Markets Role

Secondary market to
Stock Exchange Capital Market
securities
Capital Market, Credit Corporate advisory services,
Investment Bankers
market Issue of securities.
Capital Market, Money Subscribe to unsubscribed
Underwriters
Market portion of securities
Issue securities to the
Registrars, Depositories, investors on behalf of the
Capital Market
Custodians company and handle share
transfer activity
Market making in
Primary Dealer Money Market
government securities
Ensure exchange in
Forex Dealer Forex Market
currencies
Money Market Instruments
The instruments traded in the Indian money market are:
1) Treasury Bills (T-bills)
T-Bills are short-term instruments used by the government to raise short - term funds.
Features of T-Bills are:
 They are negotiable securities.
 At present, there are 91-day, 182-day, and 364-day T-bills in vogue. The 91-day T-bills are
auctioned by the RBI every Friday and the 364- day T-bills every alternate Wednesday, i.e.,
the Wednesday preceding the reporting Friday.
 There is an absence of default risk.
 Treasury bills are available for a minimum amount of `25,000 and in multiples thereof.
 They have an assured yield, low transaction cost, and are eligible for inclusion in the securities
for SLR purposes.

2) Commercial Papers (CPs)

Commercial Papers (CPs) are short-term, unsecured promissory notes issued at a discount to face value
by well-known companies that are financially strong and carry a high credit rating.
They are sold directly by the issuers to investor, or else placed by borrowers through agents like
merchant banks and security houses. The flexible maturities at which they can be issued is one of the
main attractions for borrowers and investors since issues cater to the needs of both.

Features of CP
 They are negotiable by endorsement and delivery like pro-notes and hence are highly flexible
instruments.
 They are issued in multiples of Rs.5 lakh, but the amount should not be less than Rs.5 lakh by
any single investor.
 The maturity varies between 15 days to a year.
 They are purely unsecured as they are not backed by any assets of the issuing company. They
normally have a buy-back facility; the issuers or dealers can buy-back the CPs if needed. No
prior approval of RBI is needed for CP issues.

3) Certificates of Deposits (CDs)

Certificate of Deposits (CDs) are issued by banks in the form of usance promissory notes. These bank
deposits are negotiable, and are in marketable form bearing specific face value and maturity. They are
transferable from one party to the other unlike term deposits. Due to their negotiable nature, these are
also known as Negotiable Certificates of Deposit (NCDs).

Features of CDs
 CD is a document of title to a time deposit and is distinct from conventional time deposit with
respect to negotiability and marketability.
 CDs are considered as virtually riskless instruments as the default risk is almost nil, and
investors are sure of receiving the invested amount with interest.
 The liquidity and marketability features are considered as the hallmarks of CDs.  CDs are
issued at a discount to face value.
 4) Call Money Market
The call money market forms a part of the national money market, where day-to-day surplus funds,
mostly of banks, are traded. The call money loans are of very short-term in nature and the maturity
period of these loans varies from 1 to 15 days.
 The money that is lent for one day in this market is known as ‘call money’, and if it exceeds
one day (but less than 15 days), it is referred as ‘notice money’.
 In this market, any amount could be lent or borrowed at a convenient interest rate which is
acceptable to both the borrower and lender.
 These loans are considered as highly liquid, as they are repayable on demand at the option of
either the lender or borrower.
 Call Rate
The interest rate paid on call loans is known as the ‘call rate.’ It is a highly volatile rate. It
varies from day-to-day, hour-to-hour, and sometimes even minute-to-minute. It is very
sensitive to changes in the demand for and supply of call loans. Within one fortnight, rates are
known to have moved from 1–2 per cent to over 140 per cent per annum.

3. RISK AND RETURN

Return
The objective of any investor is to maximize expected returns from his investments, subject to various
constraints, primarily risk. Return is the motivating force, inspiring the investor in the form of rewards, for
undertaking the investment. The importance of returns in any investment decision can be traced to the
following factors:
 Measurement of historical returns also helps in estimation of future returns. This reveals that there
are two types of returns – Realized or Historical Return and Expected Return.
 Expected Return - This is the return from an asset that investors anticipate or expect to earn over some
future period. The expected return is subject to uncertainty, or risk, and may or may not occur.
 The investor compensates for the uncertainty in returns and the timing of those returns by requiring
an expected return that is sufficiently high to offset the risk or uncertainty.
Average Mean returns of a stock – The average return is the simple mathematical average of returns
generated over a specifies period of time. The average return can help measure the past performance of a
security or portfolio. The average return is not the same as an annualized return, as it ignores compounding.

Geometric Mean – The geometric average return formula is a way to calculate the average rate of return on
an investment that is compounded over multiple periods. The geometric average return takes into account the
compound interest over the number of periods.
1
𝐺𝑀𝑅 = [(1 + 𝑅1 )(1 + 𝑅2 )(1 + 𝑅3 ) … . . (1 + 𝑅𝑛 )]𝑛 − 1
Risk- Risk refers to the dispersion of a variable. It is commonly measured by the variance or the standard
deviation.
The market risk of a security represents that portion of its risk which is attributable to economy-wide factors.
It is also referred to as systematic risk (as it affects all securities) or non-diversifiable risk (as it cannot be
diversified away). The market risk of a security reflects its sensitivity to market movements. It is called beta.
Variance - The variance is a measure of variability. It is calculated by taking the average of squared deviations
from the mean. Variance tells you the degree of spread in your data set. The more spread the data, the larger
variance in relation to the mean.
𝑛
(𝑋 − 𝑋̅ )2
𝜎𝑋2 = ∑
𝑛−1
𝑖=1

Standard Deviation – A standard deviation is a square root of the variance. Low SD means data are clustered
around the mean, and high SD indicates data are more spread out.

𝜎𝑋 = √𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒
Coefficient of Variation – It is basically risk to reward ratio. It is used to compare, in terms of risk and return
between two investment options
Covariance – Covariance indicates the relationship of two variables whenever one variable changes. If an
increase in one variable results in an increase in other variable, both variables are said to have a positive
covariance. Decreases in one variable also cause a decrease in the other. Statistically, it is the mean value of
the product of the deviations of two variates from their respective means.
∑𝑛 ̅ ̅
𝑖=1(𝑋−𝑋 )(𝑌−𝑌 )
𝐶𝑜𝑣𝑋𝑌 = 𝑛−1

Coefficient of correlation – It is scaling of the covariance.

𝐶𝑜𝑣𝑋𝑌
𝜌𝑋𝑌 = 𝜎𝑋 ∗𝜎𝑌

Beta of a stock - Beta is a way of measuring a stocks volatility compared with the overall markets volatility.
The market as a whole has a beta of 1. Stocks with value greater than 1 are more volatile than the market
(meaning they will generally go up more than the market goes up, and go down more than the market goes
down)
𝐶𝑜𝑣𝑋𝑀
𝛽𝑋 = 2
𝜎𝑀
Security Characteristic line -

A characteristic line is a straight line formed using regression analysis that summarizes a particular security's
systematic risk and rate of return.
The characteristic line presents a visual representation of how a specific security or other asset performs when
compared to the performance of the market as a whole. The return, and correlated risk, of a specific asset,
relative to the market in general, are represented by both the slope of the characteristic line and its standard
deviation.
Efficient Frontier

An efficient frontier is a set of investment portfolios that are expected to provide the highest returns at a given
level of risk. A portfolio is said to be efficient if there is no other portfolio that offers higher returns for a lower
or equal amount of risk. Where portfolios are located on the efficient frontier depends on the investor’s degree
of risk tolerance.
Securities Market Line
The security market line is an investment evaluation tool derived from the CAPM—a model that describes
risk-return relationship for securities—and is based on the assumption that investors need to be compensated
for both the time value of money (TVM) and the corresponding level of risk associated with any investment,
referred to as the risk premium.
Alpha of a stock – It is a risk adjusted performance measure that represents the average return on a stock or
portfolio, above or below that is predicted by Capital Asset Pricing Model (CAPM) given the stocks/portfolios
beta and the average market return. This metric is also commonly referred to as the Jensen’s measure or
Jensen’s alpha.
Alpha = Actual rate of return – Expected rate of return.

Portfolio Returns - A portfolio return is a reference to how much an investment portfolio gains or losses in
a given period of time. There are many types of portfolios available to investors ranging from small-cap stock
funds to balanced funds consisting of a mix of stocks, bonds, and cash. Investors typically have one or more
types of portfolios among their investments and seek to achieve a balanced return on investment over time.
Portfolio Returns = (𝑅𝐴 ∗ 𝑊𝐴 ) + (𝑅𝐵 ∗ 𝑊𝐵 ) + (𝑅𝐶 ∗ 𝑊𝐶 )
Portfolio Variance - Portfolio variance is a measurement of risk, of how the aggregate actual returns of a set
of securities making up a portfolio fluctuate over time.
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒
= (𝜎𝐴2 ∗ 𝑊𝐴2 ) + (𝜎𝐵2 ∗ 𝑊𝐵2 ) + (𝜎𝐶2 ∗ 𝑊𝐶2 )
+ 2[(𝑊𝐴 ∗ 𝑊𝐵 ∗ 𝐶𝑜𝑣𝐴𝐵 ) + (𝑊𝐵 ∗ 𝑊𝐶 ∗ 𝐶𝑜𝑣𝐵𝐶 ) + (𝑊𝐴 ∗ 𝑊𝐶 ∗ 𝐶𝑜𝑣𝐴𝐶 )]

Standard Deviation of Portfolio – Standard deviation can show the consistency of an investment's return
over time. A fund with a high standard deviation shows price volatility. A fund with a low standard deviation
tends to be more predictable.

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = √𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒

Minimum Variance Portfolio – A minimum variance portfolio is a collection of securities that combine to
minimize the price volatility of the overall portfolio. Volatility is a measure of a security's price movement.
The greater the volatility (the wider the swings up and down in price), the higher the market risk.
A minimum variance portfolio might contain a number of high-risk stocks, for example, but each from
different sectors, or from differently sized companies, so that they do not correlate with one another.
 HISTORICAL RETURNS ANALYSIS
Q1) Below are the returns of 2 stocks X & Y during the period of 5 years.

Stock X Stock Y
Period
(in %) (in %)
1 -6 4
2 3 6
3 10 11
4 13 15
5 16 19

Calculate:

a) Historical mean/ Ex-post mean

b) Geometric mean of returns
c) Variance
d) Standard deviation
e) Co-variance
f) Correlation coefficient

A1.)

Period
(in %) (in %)
1 -6 4 -13.2 -7 174.24 49 92.4
2 3 6 -4.2 -5 17.64 25 21
3 10 11 2.8 0 7.84 0 0
4 13 15 5.8 4 33.64 16 23.2
5 16 19 8.8 8 77.44 64 70.4
Total 36 55 0 0 310.8 154 207

a) Historical mean
𝑛 𝑛
𝑋𝑖 36 𝑌𝑖 55
𝑋̅ = ∑ = = 7.2% 𝑌̅ = ∑ = = 11%
𝑛 5 𝑛 5
𝑖=1 𝑖=1
 b) Geometric mean of returns
1
𝐺𝑀𝑅 = [ 1 + 𝑅1 1 + 𝑅2 1 + 𝑅3 … . . 1 + 𝑅𝑛 ]𝑛 1
1
𝐺𝑀𝑅 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑋 = [0.94 ∗ 1.03 ∗ 1.1 ∗ 1.13 ∗ 1.16]5 1 = 0.0690027 = 6.9%
1
𝐺𝑀𝑅 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑌 = [1.04 ∗ 1.06 ∗ 1.11 ∗ 1.15 ∗ 1.19]5 1 = 0.1086167 = 10.86%

c) Variance
𝑛 𝑛
𝑋 𝑋̅ 2 310.8 𝑌 𝑌̅ 2 154
𝜎𝑋2 = ∑ = = 77.7 𝜎𝑌2 = ∑ = = 38.5
𝑛 1 4 𝑛 1 4
𝑖=1 𝑖=1

d) Standard Deviation
𝜎𝑋 = √𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = √77.7 = 8.81% 𝜎𝑌 = √𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = √38.5 = 6.21%

e) Co-variance
∑𝑛𝑖=1 𝑋 𝑋̅ 𝑌 𝑌̅ 207
𝐶𝑜𝑣𝑋𝑌 = = = +51.75
𝑛 1 4

f) Correlation Coefficient
𝐶𝑜𝑣𝑋𝑌 51.75
𝜌𝑋𝑌 = = = +0.946 𝑜𝑟 + 94.6%
𝜎𝑋 ∗ 𝜎𝑌 8.81 ∗ 6.21

EXPECTED RETURNS ANALYSIS

Q2) Stock analyst made following forecasts of the returns for stocks A, B, C during the four years. You are required to compute average mean return, variance, standard
deviation, co-variance and correlation coefficient among these stocks.
 Conditional returns (in %)
Period Probability
X Y Z
1 0.2 -13 -4 -9
2 0.15 16 -2 8
3 0.4 32 21 16
4 0.25 12 20 20

A2)

∗ ∗ ∗ [ ] [ ] [ ]
(in %) (in %) (in %)
0.2 -13 -4 -9 -2.6 -0.8 -1.8 -28.6 -16.3 -19.8 817.96 265.69 392.04
0.15 16 -2 8 2.4 -0.3 1.2 0.4 -14.3 -2.8 0.16 204.49 7.84
0.4 32 21 16 12.8 8.4 6.4 16.4 8.7 5.2 268.96 75.69 27.04
0.25 12 20 20 3 5 5 -3.6 7.7 9.2 12.96 59.29 84.64
15.6 12.3 10.8

∗[ ] ∗[ ] ∗[ ] ∗[ ]*[ ] ∗[ ]*[ ] ∗[ ]*[ ]

163.592 53.138 78.408 93.236 64.548 113.256

0.024 30.6735 1.176 -0.858 6.006 -0.168
107.584 30.276 10.816 57.072 18.096 34.112
3.24 14.8225 21.16 -6.93 17.71 -8.28
274.44 128.91 111.56 142.52 106.36 138.92
a) Expected returns
𝑛 𝑛 𝑛

𝐸 𝑅𝑋 = ∑ 𝑃𝑖 ∗ 𝑋 = 15.6% 𝐸 𝑅𝑌 = ∑ 𝑃𝑖 ∗ 𝑌 = 12.3% 𝐸 𝑅𝑍 = ∑ 𝑃𝑖 ∗ 𝑍 = 10.8%

𝑖=1 𝑖=1 𝑖=1
b) Expected Variance

𝐸 𝜎𝑋2 = ∑𝑛𝑖=1 𝑃𝑖 ∗ [𝑅𝑋 𝐸 𝑅𝑋 ]2 = 274.44 𝐸 𝜎𝑌2 = ∑𝑛𝑖=1 𝑃𝑖 ∗ [𝑅𝑌 𝐸 𝑅𝑌 ]2 = 128.91 𝐸 𝜎𝑍2 = ∑𝑛𝑖=1 𝑃𝑖 ∗ [𝑅𝑍 𝐸 𝑅𝑍 ]2 = 111.56

c) Expected Standard Deviation

 𝐸 𝜎𝑋 = √𝐸 𝜎𝑋2 = √274.44 = 16.57% 𝐸 𝜎𝑌 = √𝐸 𝜎𝑌2 = √128.91 = 11.35% 𝐸 𝜎𝑍 = √𝐸 𝜎𝑍2 = √111.56 = 10.56%

d) Co-variance
𝑛 𝑛

𝐶𝑜𝑣𝑋𝑌 = ∑[𝑃𝑖 ∗ [𝑅𝑋 𝐸 𝑅𝑋 ] ∗ [𝑅𝑌 𝐸 𝑅𝑌 ] = 142.52 𝐶𝑜𝑣𝑌𝑍 = ∑[𝑃𝑖 ∗ [𝑅𝑌 𝐸 𝑅𝑌 ] ∗ [𝑅𝑍 𝐸 𝑅𝑍 ] = 106.36
𝑖=1 𝑖=1
𝑛

𝐶𝑜𝑣𝑋𝑍 = ∑[𝑃𝑖 ∗ [𝑅𝑋 𝐸 𝑅𝑋 ] ∗ [𝑅𝑍 𝐸 𝑅𝑍 ] = 138.92

𝑖=1

e) Correlation Coefficient
𝐶𝑜𝑣𝑋𝑌 142.52 𝐶𝑜𝑣𝑌𝑍 106.36 𝐶𝑜𝑣𝑋𝑍 138.92
𝑃𝑋𝑌 = = = 0.76 𝑃𝑌𝑍 = = = 0.89 𝑃𝑋𝑍 = = = 0.79
𝜎𝑋 ∗ 𝜎𝑌 16.57 ∗ 11.35 𝜎𝑌 ∗ 𝜎𝑍 11.35 ∗ 10.56 𝜎𝑋 ∗ 𝜎𝑍 16.57 ∗ 10.56

BETA, ALPHA & CAPM

Q3.)

Conditional returns (in %)

Probability
Stock X Stock Y Market
0.2 -12 15 -15
0.15 30 35 20
0.3 40 20 30
0.1 20 -30 35
0.25 -15 -10 -10

The risk-free rate of return is 4%. Compute:

a) Beta for stock A & B

b) Required rate of return using CAPM Model
c) Alpha for stock A & B
d) If risk-free interest rate increases to 6%, which stock will you recommend and why?
A3.)
∗ ∗ ∗ ∗[ ] ∗[ ]*[ ] ∗[ ]*[ ]
(in %) (in %) (in %)
0.2 -12 15 -15 -2.4 3 -3 -24.35 6.25 -25 125 121.75 -31.25
0.15 30 35 20 4.5 5.25 3 17.65 26.25 10 15 26.475 39.375
0.3 40 20 30 12 6 9 27.65 11.25 20 120 165.9 67.5
0.1 20 -30 35 2 -3 3.5 7.65 -38.75 25 62.5 19.125 -96.875
0.25 -15 -10 -10 -3.75 -2.5 -2.5 -27.35 -18.75 -20 100 136.75 93.75
12.35 8.75 10 422.5 470 72.5
𝑛 𝑛 𝑛

𝐸 𝑅𝑋 = ∑ 𝑃𝑖 ∗ 𝑋 = 12.35% 𝐸 𝑅𝑌 = ∑ 𝑃𝑖 ∗ 𝑌 = 8.75% 𝐸 𝑅𝑀 = ∑ 𝑃𝑖 ∗ 𝑀 = 10%

𝑖=1 𝑖=1 𝑖=1
𝑛
2
𝐸 𝜎𝑀 = ∑ 𝑃𝑖 ∗ [𝑅𝑀 𝐸 𝑅𝑀 ]2 = 422.5
𝑖=1
𝑛 𝑛

𝐶𝑜𝑣𝑋𝑀 = ∑[𝑃𝑖 ∗ [𝑅𝑋 𝐸 𝑅𝑋 ] ∗ [𝑅𝑀 𝐸 𝑅𝑀 ] = 470 𝐶𝑜𝑣𝑌𝑀 = ∑[𝑃𝑖 ∗ [𝑅𝑌 𝐸 𝑅𝑌 ] ∗ [𝑅𝑀 𝐸 𝑅𝑀 ] = 72.5
𝑖=1 𝑖=1

a) Beta (β)
𝐶𝑜𝑣𝑋𝑀 470 𝐶𝑜𝑣𝑌𝑀 72.5
𝛽𝑋 = 2 = = 1.112 𝛽𝑌 = 2 = = 0.172
𝜎𝑀 422.5 𝜎𝑀 422.5
b) Required rate of return using Capital Asset Pricing Model (CAPM)
𝑅𝐴 = 𝑅𝑓 + 𝛽(𝑅𝑀 𝑅𝑓 )
𝑤ℎ𝑒𝑟𝑒, 𝑅𝐴 = 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑓𝑟𝑜𝑚 𝑆𝑡𝑜𝑐𝑘 𝐴 𝑅𝑓 = 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛
𝛽 = 𝐵𝑒𝑡𝑎 𝑜𝑓 𝑎𝑛 𝑎𝑠𝑠𝑒𝑡 𝑅𝑀 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛𝑠
𝑅𝑀 𝑅𝑓 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

𝑅𝑋 = 4% + 1.112 10% 4% = 10.672% 𝑅𝑌 = 4% + 0.172 10% 4% = 5.032%

c) Alpha (α)
𝐴𝑙𝑝ℎ𝑎 𝑜𝑓 𝑎 𝑠𝑡𝑜𝑐𝑘 𝛼𝐴 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑎 𝑠𝑡𝑜𝑐𝑘 [𝐸 𝑅𝐴 ] 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑎 𝑠𝑡𝑜𝑐𝑘 [𝑅𝐴 ]
𝛼𝑋 = 𝐸 𝑅𝑋 𝑅𝑋 = 12.35% 10.672% = 1.678% 𝛼𝑌 = 𝐸 𝑅𝑌 𝑅𝑌 = 8.75% 5.032% = 3.718%
d) If Risk-free interest rate 𝑅𝑓 = 6%
 𝑅𝑋 = 6% + 1.112 10% 6% = 10.448% 𝑅𝑌 = 6% + 0.172 10% 6% = 6.688%
So, if risk-free return rate increases to 6%, then an aggressive investor would invest in Stock X, while a conservative investor would invest in Stock Y.

PORTFOLIO VARIANCE

Q4.) A portfolio consists of 3 securities. Find portfolio returns and its standard deviation.

Particulars A B C
Proportion 0.5 0.3 0.2
Returns 12% 10% 15%
10% 15% 20% )=

𝜌𝐴𝐵 = 0.3 𝜌𝐵𝐶 = 0.6 𝜌𝐴𝐶 = 0.5

A4.)
 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 = 𝑅𝐴 ∗ 𝑊𝐴 + 𝑅𝐵 ∗ 𝑊𝐵 + 𝑅𝐶 ∗ 𝑊𝐶 = 12% ∗ 0.5 + 10% ∗ 0.3 + 15% ∗ 0.2 = 12%
 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝜎𝐴2 ∗ 𝑊𝐴2 + 𝜎𝐵2 ∗ 𝑊𝐵2 + 𝜎𝐶2 ∗ 𝑊𝐶2 + 2[ 𝑊𝐴 ∗ 𝑊𝐵 ∗ 𝐶𝑜𝑣𝐴𝐵 + 𝑊𝐵 ∗ 𝑊𝐶 ∗ 𝐶𝑜𝑣𝐵𝐶 + 𝑊𝐴 ∗ 𝑊𝐶 ∗ 𝐶𝑜𝑣𝐴𝐶 ]
= 10 ∗ 10 ∗ 0.5 ∗ 0.5 + 15 ∗ 15 ∗ 0.3 ∗ 0.3 + 20 ∗ 20 ∗ 0.2 ∗ 0.2 + 2[0.5 ∗ 0.3 ∗ 0.3 ∗ 10 ∗ 15 + 0.3 ∗ 0.2 ∗ 0.6 ∗ 15 ∗ 20 + 0.5 ∗ 0.2 ∗ 0.5 ∗ 10 ∗ 20 ]

= 25 + 20.25 + 16 + 2 6.75 + 10.8 + 10 = 116.35

 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = √𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = √116.35 = 10.79%

ZERO VARIANCE PORTFOLIO

Q5.) Find the weightage of given 2 stocks in a zero-risk portfolio.

Conditional returns (in %)

Probability
Stock X Stock Y
0.1 50 8
0.2 40 18
0.4 30 26
0.2 20 36
0.1 10 45
A5.)

∗ ∗ ∗[ ] ∗[ ] ∗[ ]*[ ]
(in %) (in %)
0.1 50 8 5 0.8 20 -18.5 40 34.225 -37
0.2 40 18 8 3.6 10 -8.5 20 14.45 -17
0.4 30 26 12 10.4 0 -0.5 0 0.1 0
0.2 20 36 4 7.2 -10 9.5 20 18.05 -19
0.1 10 45 1 4.5 -20 18.5 40 34.225 -37
30 26.5 120 101.05 -110
𝑛 𝑛

𝐸 𝑅𝑋 = ∑ 𝑃𝑖 ∗ 𝑋 = 30% 𝐸 𝑅𝑌 = ∑ 𝑃𝑖 ∗ 𝑌 = 26.5%
𝑖=1 𝑖=1

𝐸 𝜎𝑋2 = ∑𝑛𝑖=1 𝑃𝑖 ∗ [𝑅𝑋 𝐸 𝑅𝑋 ]2 = 120 𝐸 𝜎𝑌2 = ∑𝑛𝑖=1 𝑃𝑖 ∗ [𝑅𝑌 𝐸 𝑅𝑌 ]2 = 101.05

𝐸 𝜎𝑋 = √𝐸 𝜎𝑋2 = √120 = 10.95% 𝐸 𝜎𝑌 = √𝐸 𝜎𝑌2 = √101.05 = 10.05%

𝑛

𝐶𝑜𝑣𝑋𝑌 = ∑[𝑃𝑖 ∗ [𝑅𝑋 𝐸 𝑅𝑋 ] ∗ [𝑅𝑌 𝐸 𝑅𝑌 ] = 110

𝑖=1

𝐶𝑜𝑣𝑋𝑌 110
𝑃𝑋𝑌 = = = 1
𝜎𝑋 ∗ 𝜎𝑌 10.95 ∗ 10.05
For zero variance portfolio, the portfolio variance has to equal to be zero.

 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝜎𝑋2 ∗ 𝑊𝑋2 + 𝜎𝑌2 ∗ 𝑊𝑌2 + 2 𝑊𝑋 ∗ 𝑊𝑌 ∗ 𝜌𝑋𝑌 ∗ 𝜎𝑋 ∗ 𝜎𝑌

 0 = 𝜎𝑋 𝑊𝑋 2 + 𝜎𝑌 𝑊𝑌 2 2 𝑊𝑋 ∗ 𝑊𝑌 ∗ 𝜎𝑋 ∗ 𝜎𝑌
 0 = 𝜎𝑋 𝑊𝑋 𝜎𝑌 𝑊𝑌 2
 𝜎𝑋 𝑊𝑋 = 𝜎𝑌 𝑊𝑌
 10.95𝑊𝑋 = 10.05 1 𝑊𝑋
 10.95𝑊𝑋 = 10.05 10.05𝑊𝑋
 21𝑊𝑋 = 10.05
 𝑊𝑋 = 0.48

𝑊𝑌 = 1 𝑊𝑋 = 0.52
 MINIMUM VARIANCE PORTFOLIO (2 SECURITY PORTFOLIO)

Q6.) Find weight of individual securities in a portfolio and also calculate standard deviation of the portfolio.

𝜎𝐴 = 21% 𝜎𝐵 = 30% 𝑃𝐴𝐵 = 0.25

A6.)
𝜎2 − 𝑃 ∗𝜎𝐴 ∗𝜎𝐵 30∗30 − 0.25∗21∗30 742.5
 𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐴 𝑊𝐴 = 𝜎2 +𝜎𝐵2 − 2∗𝜌
𝐴𝐵
= = = 0.72
𝐴 𝐵 𝐴𝐵 ∗𝜎𝐴 ∗𝜎𝐵 21∗21 + 30∗30 − 2∗0.25∗21∗30 1026
 𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐵 𝑊𝐵 = 1 𝑊𝐴 = 1 0.72 = 0.28
 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝜎𝐴2 ∗ 𝑊𝐴2 + 𝜎𝐵2 ∗ 𝑊𝐵2 + 2[ 𝑊𝐴 ∗ 𝑊𝐵 ∗ 𝐶𝑜𝑣𝐴𝐵 ]
= 21 ∗ 21 ∗ 0.72 ∗ 0.72 + 30 ∗ 30 ∗ 0.28 ∗ 0.28 + 2 ∗ 0.72 ∗ 0.28 ∗ 0.25 ∗ 21 ∗ 30
= 228.6144 + 70.56 + 63.504 = 362.68

 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = √𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = √362.68 = 19.04%

Security Market Line

SML
Expected rate of return

𝛽 𝑅𝑚 𝑅𝑓

𝑅𝑓

𝑅𝑓

Defensive stock Aggressive stock

1
Beta
 TIME VALUE OF MONEY
Time Value of Money – “means that the value of a unit of money is different in different periods time
periods”.
Importance of TVM:
 In Investment Decisions
 In Capital budgeting Decisions
 Valuation
 Loan, Leases, etc.

Applications of Time Value of Money

Time Value of Money, or TVM, is a concept that is used in all aspects of finance including:
 Bond valuation
 Stock valuation
 Accept/reject decisions for project management
 Financial analysis of firms

Time Line
• A series of cash flows can be graphically represented using a cash flow timeline. A timeline depicts
the timing and amount of the cash flows.
• For example, the following timeline depicts cash inflows of $100 to be received at the end of each of
the next 5 years
Types of Interest
Simple Interest - Interest paid (earned) on only the original amount, or principal, borrowed (lent).
Compound Interest- Interest paid (earned) on any previous interest earned, as well as on the principal borrowed
(lent).
Simple Vs Compounded Interest
Suppose you has a sum of Rs.1,000 to be invested, and there are two schemes, one offering a rate of interest
of 10 percent, compounded annually, and other offering a simple rate of interest of 10 percent, which one
should he opt for assuming that he will withdraw the amount at the end of
(a) one year
(b) two years, and
(c) five years?
Ans- The compound interest scheme interest earns interest, whereas interest does not earn any additional
interest under the simple interest scheme.
Components of the TVM-
PV: present value
FV: future value
R: rate of growth or interest rate
N: number of periods (typically measured in years or months

Future value of present cash flows

𝐹𝑉(𝐾%,𝑛) = 𝑃𝑉0 (1 + 𝐾 )𝑛

𝑤ℎ𝑒𝑟𝑒; 𝑘, 𝑟, 𝑖 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

𝑃𝑉0 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑚𝑜𝑢𝑛𝑡
(1 + 𝐾 )𝑛 = 𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 (𝐹𝑉𝐼𝐹 ) = 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟

Present value of future cash flows

𝐹𝑉(𝐾%,𝑛)
𝑃𝑉0 =
(1 + 𝐾 )𝑛
1
𝑤ℎ𝑒𝑟𝑒, = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 (𝑃𝑉𝐼𝐹 ) = 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟
(1 + 𝐾)𝑛

Q1.) Person invests different amounts each year. Find the final future value at the end of the year. Interest
is 7% p.a.

Year 1st 2nd 3rd 4th 5th 6th

Amount (in Rs.) 100 250 275 3000 5000 6000
A1.) 𝐹𝑉(𝐾%,𝑛) = 100𝐹𝑉𝐼𝐹(7%,5) + 250𝐹𝑉𝐼𝐹(7%,4) + 275𝐹𝑉𝐼𝐹(7%,3) + 3000𝐹𝑉𝐼𝐹(7%,2) + 5000𝐹𝑉𝐼𝐹(7%,1) +
6000𝐹𝑉𝐼𝐹(7%,0)

= (100 ∗ 1.075 ) + (250 ∗ 1.074 ) + (275 ∗ 1.073 ) + (3000 ∗ 1.072 ) + (5000 ∗ 1.071 )
+ (6000 ∗ 1.070 )
= 140.25 + 327.7 + 336.9 + 3434.7 + 5350 + 6000
= 𝑅𝑠. 15,590
Q2.) You will get Rs. 10,000 at the end of 10th year. Interest is 10% p.a. What is its present value?
𝐹𝑉(𝐾%,𝑛) 10000 10000
A2.) 𝑃𝑉0 = (1+𝐾)𝑛
= = 2.59374 = 𝑅𝑠. 3,855
1.110

Q3.) the effective compounding rate of interest on an investment is currently 7% p.a., but in 2 years’ time,
it will be reduced to 6% p.a. Find the accumulated amount in 5 years for an investment of Rs.4,000?

A3.) 𝐹𝑉 = 4,000 ∗ (1.07)2 ∗ (1.06)3 = 𝑅𝑠. 5,454

Q4.) A person has to pay following amounts: Rs.1,000 on 01/01/2013; Rs.2,500 on 01/01/2014 and
Rs.3,000 on 01/07/2014. Assuming interest rate of 6% p.a., find the value of these payments on
01/03/2012.
1000 2500 3000 1000 2500 3000
A4.) 𝑃𝑉 = 1.060.833 + 1.061.833 + 1.062.333 = 1.0498 + 1.1127 + 1.1456 = 𝑅𝑠. 5818

Doubling Period

Rule 72 Rule 69
72 69
𝑇𝑖𝑚𝑒 = ℎℎℎℎℎℎℎℎℎℎℎℎℎℎℎℎℎℎℎℎℎℎℎℎ𝑇𝑖𝑚𝑒 = 0.35 +
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 (𝑖𝑛 %) 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 (𝑖𝑛 %)
Note: If nothing is specified, follow Rule 72.

A frequent question posed by the investor is, ‘‘How long will it take for the amount invested to be doubled
for a given rate of interest’’. This question can be answered by a rule known as ‘rule of 72’. this rule says that
the period within which the amount will be doubled is obtained by dividing 72 by the rate of interest.
Q3.) Interest rate is 12% p.a. Principal amount is Rs.100. calculate future value as per both rules, so that amount is
doubled.

A3.) As per Rule 72,

72
𝑇𝑖𝑚𝑒 = = 6 𝑦𝑒𝑎𝑟𝑠
12%
𝐹𝑉(12%,6) = 100(1 + 0.12)6 = 100 ∗ 1.9738 = 𝑅𝑠. 197.38

As per Rule 69,

69
𝑇𝑖𝑚𝑒 = 0.35 + = 6.1 𝑦𝑒𝑎𝑟𝑠
12%
𝐹𝑉(12%,6.1) = 100(1 + 0.12)6.1 = 100 ∗ 1.99631 = 𝑅𝑠. 199.63

Effective Rate of Interest

𝐾 𝑚
𝑟 = (1 + ) − 1
𝑚
𝑤ℎ𝑒𝑟𝑒, 𝑟 = 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑟𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐾 = 𝑁𝑜𝑟𝑚𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
𝑚 = 𝑁𝑜. 𝑜𝑓 𝑡𝑖𝑚𝑒𝑠 𝑡𝑜 𝑏𝑒 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑
Q4.) Interest is 13% p.a. compute effective rate of interest, if compounded

a) Semi-annually
b) Quarterly
c) Weekly
d) Daily
0.13 2
A4.) a) Effective rate of interest = (1 + 2
) − 1 = 0.1342 = 13.42%

0.13 4
b) Effective rate of interest = (1 + 4
) − 1 = 0.136475 = 13.65%

0.13 52
c) Effective rate of interest = (1 + 52
) − 1 = 0.13864 = 13.86%

0.13 365
d) Effective rate of interest = (1 + 365 ) − 1 = 0.1388 = 13.88%

Q5.) If effective rate of annual interest is 5.23% p.a., then find the effective rate of annual interest for the following
periods:

a) Semi-annually
b) Quarterly
c) Weekly
d) Daily
5.23 1 1
A5.) a) Effective rate of interest = (1 + 100 )2 − 1 = 1.05232 − 1 = 2.58%

5.23 1 1
b) Effective rate of interest = (1 + 100 )4 − 1 = 1.05234 − 1 = 1.28%

5.23 1 1
c) Effective rate of interest = (1 + 100 )52 − 1 = 1.0523 52 − 1 = 0.098%
1 1
5.23
d) Effective rate of interest = (1 + )365 − 1 = 1.0523365 − 1 = 0.01397%
100

Q6.) If you will receive Rs.10,500 per year forever and interest rate is 11.5% p.a. What would be the present value of
cash flows under perpetuity concept.
𝐴𝑛𝑛𝑢𝑎𝑙 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 10500
A6.) 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦(𝑃∞ ) = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
= 11.5% = 𝑅𝑠. 91,304
ANNUITY

1) Future value annuity

a) Due/advance
(1 + 𝐾)𝑛 − 1
𝐹𝑉𝐴 = 𝐴 ∗ [ ] ∗ (1 + 𝐾)
𝐾
b) Regular/arrears
(1 + 𝐾)𝑛 − 1
𝐹𝑉𝐴 = 𝐴 ∗ [ ]
𝐾

(1 + 𝐾)𝑛 − 1
[ ] = 𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 𝑜𝑓 𝑎𝑛𝑛𝑢𝑖𝑡𝑦(𝐹𝑉𝐼𝐹𝐴(𝐾%,𝑛) )
𝐾
2) Present value annuity
a) Due/advance
(1 + 𝐾)𝑛 − 1
𝑃𝑉𝐴 = 𝐴 ∗ [ ] ∗ (1 + 𝐾)
(1 + 𝐾)𝑛 ∗ 𝐾
b) Regular/arrears
(1 + 𝐾)𝑛 − 1
𝑃𝑉𝐴 = 𝐴 ∗ [ ]
(1 + 𝐾)𝑛 ∗ 𝐾

(1 + 𝐾)𝑛 − 1
[ ] = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 𝑜𝑓 𝑎𝑛𝑛𝑢𝑖𝑡𝑦(𝑃𝑉𝐼𝐹𝐴(𝐾%,𝑛) )
(1 + 𝐾)𝑛 ∗ 𝐾

Q7.) A loan of Rs.1,00,000 is to be repaid in 5 equal annual installments. If the loan carries 14%p.a. rate of interest,
what would be the amount of each installment?
(1+𝐾)𝑛 −1
A7.) 𝑃𝑉𝐴 = 𝐴 ∗ [(1+𝐾)𝑛∗𝐾 ]

1.145 − 1
→ 1,00,000 = 𝐴 [ ]
1.145 ∗ 0.14
0.9254
→ 1,00,000 = 𝐴 [ ]
0.269558
→ 𝐴 = 𝑅𝑠. 29,129 (𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑠𝑡𝑎𝑙𝑙𝑚𝑒𝑛𝑡)

Closing loan
At the end Equated annual Capital (Principal
Interest outstanding
of year installemnt amount)
balance
1 ₹ 29,129 ₹ 14,000 ₹ 15,129 ₹ 84,871
2 ₹ 29,129 ₹ 11,882 ₹ 17,247 ₹ 67,624
3 ₹ 29,129 ₹ 9,467 ₹ 19,662 ₹ 47,962
4 ₹ 29,129 ₹ 6,715 ₹ 22,414 ₹ 25,548
5 ₹ 29,129 ₹ 3,577 ₹ 25,548 ₹0

(Note: Just for explanation purpose, we have made the repayment schedule.)

Q8.) A loan of Rs.50,000 is to be repaid over 5 years. Interest rate is 3% p.a. Immediately after 3rd payment was
made, the borrower requests that he be able to pay off the loan with a single lumpsum amount. Calculate the value
of the lumpsum amount that is required to repay the loan at this time.
 (1+𝐾)𝑛−1
A8.) 𝑃𝑉𝐴 = 𝐴 ∗ [(1+𝐾)𝑛 ∗𝐾 ]

1.035 − 1
→ 50,000 = 𝐴 [ ]
1.035 ∗ 0.03
0.159274
→ 50,000 = 𝐴 [ ]
0.034778
→ 𝐴 = 𝑅𝑠. 10,918 (𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑠𝑡𝑎𝑙𝑙𝑚𝑒𝑛𝑡)

Closing loan
At the end Equated annual Capital (Principal
Interest outstanding
of year installemnt amount)
balance
1 ₹ 10,918 ₹ 1,500 ₹ 9,418 ₹ 40,582
2 ₹ 10,918 ₹ 1,217 ₹ 9,701 ₹ 30,881
3 ₹ 10,918 ₹ 926 ₹ 9,992 ₹ 20,890

Value of the lumpsum amount to pay at the end of 3rd installment for remaining next 2 installments is Rs.20,890.

OR
10918 10918
𝐿𝑢𝑚𝑝𝑠𝑢𝑚 𝑎𝑚𝑜𝑢𝑛𝑡 = + = 𝑅𝑠. 20,891 [𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕𝒊𝒏𝒈]
1.031 1.032
OR

1.032 − 1
𝐿𝑢𝑚𝑝𝑠𝑢𝑚 𝑎𝑚𝑜𝑢𝑛𝑡 = 10918 ∗ [ ] = 𝑅𝑠. 20,891 [𝑷𝑽𝑨]
1.032 ∗ 0.03

Q9.) The annuity deposit scheme of SBI provides for fixed monthly income for suitable period of the depositor’s
choice, where initial deposit has to be made at starting. After the first month of deposit, the depositor receives
monthly installments depending upon the number of months he has chosen as annuity period. Rate of interest is
11% p.a. which is compounded quarterly. If an annual deposit of Rs.4,610 is made for an annuity period of 60
months, what would be value of monthly annuity?
0.11 4
A9.) 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = (1 + 4
) − 1 = 0.11462 = 11.46% 𝑝. 𝑎.
1
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = (1 + 0.1146)12 − 1 = 0.0090786 = 0.908%
(1+𝐾)𝑛 −1
𝑃𝑉𝐴 = 𝐴 ∗ [(1+𝐾)𝑛∗𝐾 ]

1.0090860 − 1
→ 4,610 = 𝐴 [ ]
1.0090860 ∗ 0.00908
0.720029564
→ 4,610 = 𝐴 [ ]
0.00653786
→ 𝐴 = 𝑅𝑠. 100(𝑓𝑖𝑥𝑒𝑑 𝑚𝑜𝑛𝑡ℎ𝑙𝑦 𝑖𝑛𝑐𝑜𝑚𝑒)

Q10.) A loan of Rs.5,000 is to be repaid by 20 equal annual installments. Rate of interest is 10% p.a. Find the amount
of each annual repayment, assuming that payments are made in arrears and in advance.

A10.) a) Advance
(1 + 𝐾)𝑛 − 1
𝑃𝑉𝐴 = 𝐴 ∗ [ ] ∗ (1 + 𝐾)
(1 + 𝐾)𝑛 ∗ 𝐾
 1.120 − 1
→ 5000 = 𝐴 ∗ [ ] ∗ 1.1
1.120 ∗ 0.1
5.7274999
→ 5000 = 𝐴 ∗ 1.1 ∗ [ ]
0.6727499
→ 𝐴 = 𝑅𝑠. 533.91

c) Regular/arrears
(1 + 𝐾)𝑛 − 1
𝑃𝑉𝐴 = 𝐴 ∗ [ ]
(1 + 𝐾)𝑛 ∗ 𝐾
1.120 − 1
→ 5000 = 𝐴 ∗ [ 20 ]
1.1 ∗ 0.1
5.7274999
→ 5000 = 𝐴 ∗ [ ]
0.6727499
→ 𝐴 = 𝑅𝑠. 587.3d

Annuity
• Series of Payments Made at Regular Intervals
• Examples- Regular Deposit to a savings account, Monthly home Mortgage payments, Monthly
Insurance payments
Difference Between Annuity Due and Ordinary Annuity
Ordinary annuity, payments or receipts occur at the end of each period. Example: Salary received at the end
of each month or EMI paid at the end of each month.
In an annuity due, payments or receipts occur at the beginning of each
period. Example: Rent at the beginning of every month, Recurring Deposit payment
Perpetuity
• An annuity of an infinite duration is known as perpetuity. The present value of such perpetuity can be
expressed as follows:
P∞ = A × PVIFA (k, ∞)
Where, P∞ = Present value of a perpetuity
A = Constant annual payment
PVIFA (k, ∞) = Present value interest factor for a perpetuity
• For example: if your business has an investment that you expect to receive 20,000 forever, this
investment would be considered as perpetuity.
• If you receive an amount of 20,000 every year for opportunity cost of 10% then
• P∞ = 20,000/ 0.1 = 2,00,000.
Growing Perpetuity
• A growing perpetuity is a cash flow that is not only expected to be received for infinite time period,
but also grow at the same rate of growth forever.
 • For example: if your business has an investment that you expect to receive 20,000 forever, with a
constant annual growth rate of 8%, this investment would be considered as growing perpetuity.
• For example: if your business has an investment that you expect to receive 20,000 forever, this
investment would be considered a perpetuity.
If you receive an amount of 20,000 every year for opportunity cost of 10% and growth rate of 8%.
Then
PV = 20,000/(0.1-0.08)
=10,00,000
Nominal Rate V/S Real Rate
• Nominal interest rate refers to the interest rate before taking inflation into account. It is the
interest rate that is quoted when we buy bonds or when we borrow money from the bank.
• Real interest rate refers to the nominal interest rate which is inflation-adjusted.
What is Intra- Year Compounding?
• It is the frequency of compounding which takes place during a year.
• It calculates how many times the principal amount will compound during a year.