Financial

Management
FIBA601
Introductory Session

2
Session Flow
✓ General Introduction
✓ Introduction to the Course Objectives
✓ Syllabus Content
▪ Course Delivery Approach
❖Quadrant 1: Video Lecture
❖Quadrant 2: Reference Material
❖Quadrant 3: Class Discussion
❖Quadrant 4: Assessment
▪ Student Learning Outcome
▪ Text & Reference Book
▪ Important Sites for Reference
▪ Assessment Plan
❖Mid Term [15 Marks]
❖Integrated Project [20 Marks]
❖Home Assignment [10 Marks]
 Course Objectives

Imbibing To equip the

knowledge about Developing the Developing skills students with the
Familiarizing the
the decisions and analytical skills for interpretation essential skills
students with the
decision by associating business and knowledge
financial
variables the tools and information and necessary to
environment of
involved in techniques for application of make sound
business,
building the evaluating capital financial theory financial
especially the
liability side of projects in financing decisions in
financial markets
balance sheet of related decisions dynamic
the firm environment
 Syllabus Content
A Framework for Financial Decision-Making- Financial Environment, Introduction to
Module I : Introduction Financial Markets and Financial Instruments Changing Role of Finance Managers,
Objectives of the firm, Time Value of Money, and Risk- Return Analysis [20%]

Leverage Analysis (EBIT-EPS analysis) and Computation of Cost of Capital (WACC

Module II : Financing &WMCC), Capital Structure Theories- Net Income Approach, Net operating Income
Decision Approach, Traditional approach & Modigliani Miller Model, Trade off Models, pecking
order theory. Factors determining the optimum capital Structure. [30%]

Module III: Investment Capital Budgeting – Estimation of Cash Flows, Criteria for Capital Budgeting
Decisions- Capital Budgeting Decisions Pay back, ARR, Discounted. Payback NPV, IRR, PI, Issues Involved in
Capital Budgeting, Risk analysis in Capital Budgeting – An Introduction Working
and Working Capital Capital Management – Factors Influencing Working Capital Policy, Operating Cycle
Decision Analysis, Management of Inventory, Management of Receivables, Management of Cash
and Marketable Securities, Financing of Working Capital. [25%]
Introduction, Factors determining dividend policy, and types of dividends. Theories of
Module IV : Dividend Dividend Decisions- MM Hypothesis, Walter Model, Gordon Model. Forms of
Decision Dividends- cash dividend, Bonus shares, stock split. Dividend policies in practice.
[15%]
Module V : Valuation ROI, Economic Value Added, Market Value Added, Shareholders Value Creation and
Concept latest development [10%]
Teaching Learning Strategy

Quadrant 1 Quadrant 2
[Video [Reference
Lectures] Material]

Quadrant 3
[Class Quadrant 4
Interaction & [Assessment]
Discussion]
 Student Learning Outcome

Students will be
Student will be
able to identify Students will be
able to
the variable able to analyze
remember the
associated with the various
various
the Financial sources of
Creating
financial or
Environment, finance and their
decisions taken
for wealth
Financial System optimum Integration
and Financial allocation
creation
Decisions
Students will Analyzing
Students will be
be able to
able to create
and Evaluating
apply their Students will be different Applying
understanding able integrate scenarios while
in assessing different financial evaluating the
the rationale decisions in value Capital
Concept
behind the creation process. Remembering and
Budgeting
Retention and Understanding
projects
payout
Text Reading:
• Van Horne, J.C., Financial Management and Policy, 12th Ed., Prentice Hall of
India
• Pandey, I.M., Financial Management, 10th Ed., Vikas Publishing House
• Khan & Jain. , Financial Management: Text, Problems and Cases, 8th Ed., McGraw
Hill Education

References:
• Damodaran, A. 2012, Corporate Finance: Theory and Practice, 2nd Ed., Wiley &
Sons..
• Brearly, R. A. and Myers, S. C., Principles of Corporate Finance, 8th Ed., Tata
McGraw Hill
• Rustagi, R.P., Financial Management: Theory, Concepts and Problems, Galgotia
Publishing Company.
Additional Reading:

• Mint Newspaper
• Musings on Markets, Prof. Aswath Damodaran's blog
• "Onward" by Howard Schultz
• Finance Sense, by Prasanna Chandra, McGraw Hill Education
 Sites

https://www.businesstoday.in/
https://forum.valuepickr.com/
https://ajuniorvc.com/
https://www.non-engineer.com/post/best-finance-business-books-mba
Yahoo finance.com
Google Finance.com
Finshort - https://finshots.in/

9
 Assessment Plan

50:50

Internal External

✓ Home Assignment 10
End term Semester
✓ Mid Term 15 Examination
✓ Integrated Project 20
✓ Attendance 5
 Module I
Weightage : 20 Percent

11
 Topics
❑Meaning of Financial Management
❑A Framework for Financial Decision-Making
❑Financial Environment
❑Introduction to Financial Markets and Financial Instruments
❑Changing Role of Finance Managers,
❑Objectives of the firm,
❑Agency Problem
❑Time Value of Money
❑ Risk- Return Analysis

12
 Financial Management

Deals with the planning Procurement Utilization

and controlling of the firm’s
financial resources.

It encompasses the
procurement of the funds
and Utilization of these Source Long Term
funds in the most optimum
way to maximize the
returns of the Shareholder.

Cost Short Term

 Financial Management Decisions

❖ Capital Budgeting Decision

Investing ❖ Working Capital Management

Financing Dividend

❖ Capital Structure
❖ Leveraging Decisions ❖ Policy & Factor Determining
❖ Cost of Capital ❖ Retention
❖ Payout
❖ Share Re-purchase
 Financial Management

Financing Investment Dividend

Decision Decision Decision

Market Price of the Share

Value Creation [Wealth Maximization]

Financial Environment
 The Financial
System

Financial
Financial Financial Financial Institutions
Regulatory Bodies

Regulatory
Market Services Instruments Regulatory Bodies

Bodies
Banking Non-
Money Fund Fee Base Term Types Banking
Capital
Market Market Base SEBI
Commercial Cooperative
Primary RBI
Call Merchant Long
Leasing Secondary IRDA
Primary Money Banking Medium Public
Hire Innovative PFRDA
Secondary T-Bills Credit Short Private
Purchase
Derivatives
Commerc Rating RRBs
Factoring
ial Papers Foreign

17
Class Discussion on

Changing Role of
Finance Manager

18
 Goal of the Firm or Financial Management

Wealth
Maximization Profit
Maximization
 Profit Maximization
✓ Business earns profits (Accounting profits) to cover its costs
and provide funds for growth.
✓ Profit earnings is the main aim of every economic activity.
✓ Profit is a measure of efficiency of a business enterprise.
✓ The accumulated profits enables a business to face risks
like fall in prices, competition or change in government
policies etc.

Ambiguity in term
Profit
Ignore Risk and
Time Value of 20

Money
 Wealth Maximization
This objective is generally expressed in terms of
maximization of the value of a share of a firm.

Wealth maximization is the concept of increasing the

value of a business in order to increase the value of
the shares held by its stockholders.

Maximization of shareholder’s wealth as an objective

of Financial Management implies that the financial
decisions will be taken in such a way that the
shareholders receive highest combination of
dividends and the increase in market price of share.
21
Agency Theory was developed by Jensen and Meckling. According to them the principals
(Stockholder) can assure themselves that the management (Agent) will make optimal decisions
only if appropriate incentives are given.

Owners/ Shareholders [Principal] Managers/Director [Agent]

Agency Theory

Agency
Problem
Agency
Cost
Time Value of
Money
 “Money has time value”
A rupee earned today is more valuable than a rupee a
year hence.
WHY?
•Future uncertainties
•Preference for present consumption
•Reinvestment opportunities
Therefore, TVM is the Rate of Return which an investor
can earn by reinvesting its present money.

This Rate of Return can also be expressed as required rate of

return to make equal the worth of money of two different
time period
How amounts in different time periods can compare?

One can adjust values from different time periods using an interest
rate.

Remember, one CANNOT compare numbers in different time periods

without first adjusting them using an interest rate
 TVM Techniques
Compounding

Present Interest Future

Discounting 27
 Compounding

Today Future Future Value

Discounting
Present Future
Value Today Period
28
 Time Value of Money Technique

Compounding
Discounting [Present Value]
[Future Value]

Series of
Single Cash Series of Cash Single Cash
Cash Flow
Flow Flow [Annuity] Flow
[Annuity]

Ordinary Ordinary
Annuity Due Annuity Due
Annuity Annuity
29
 Compounding [Future Value]
Single Cash Flow
If you deposited ₹ 55,650 in a bank, which was paying a 15 per cent rate of interest on a ten-
year time deposit, how much would the deposit grow at the end of ten years?

FV = PV[1+r]n

or

FV = PV x CVF r,n

= ₹55,650 [1+.15]10 = ₹55,650 x 4.0455577357 = 225135

or

₹ 55,650 x 4.046 = 225159.9

30
 Non-Annual Compounding
Compounding is not always annually it may be half-
yearly, quarterly, monthly. So, in this case compounding
can be done be using the following formula.
FV = PV(1+r/m)mxn
m is the number of time compounding is done in a year
n is the time period.
Compounding Period No of period (m)
Annually 1
Half- Yearly 2
Quarterly 4
Monthly 12
Note: More frequently the compounding is made, the
faster is the growth in the FV
Effective Rate of Interest
Effective rate of interest is a rate at which money held at
present actually increases in a year.

Sometimes it often happens that interest is compounded

more than once in a year. In such circumstances effective
rate of interest is different from given rate of interest.
Formula for Effective Rate of Interest is:

re = (1+r/m)m -1
Question

X wanted to make some deposit in

Bank for a period of one year and
he has approached a bank.
The Bank offers two options
(i) To receive interest at 12% p.a.
compounded monthly.
(ii) To receive interest at 12.25% p.a.
compounded half yearly.
Which option should be accepted
Solution
option (i) option (ii)
Rate of interest =12% p.a. Rate of interest = 12.25%p.a.

Time 1yr (compounded

monthly) Time 1yr
(compounded Half- yearly)
re = (1+r/m)m -1 re = (1+r/m)m -1
re = (1+.12/12)12 = (1+ .1225/2)2 -1
= 1.1268-1 = 1.1263 -1
= .1268 = .1263
= 12.68% = 12.63%
 Annuity (Series of cash flow)
An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods
Types of Annuities
• Ordinary Annuity: Payments or receipts
occur at the end of each period.
• Annuity Due: Payments or receipts
occur at the beginning of each period
Examples of Annuities
✓ Student Loan Payments
✓ Car Loan Payments
✓ Insurance Premiums
✓ Mortgage Payments 35

✓ Retirement Savings
 PARTS OF ANNUITY

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

₹100 ₹100 ₹100

Today Equal Cash Flows

 PARTS OF ANNUITY DUE

(Annuity Due)
Today Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

₹1000 ₹1000 ₹1000

Equal Cash Flows

 Time Value of Money Technique

Compounding
[Future Value]

FVn = PV[1+i]n Single Cash Series of Cash

Flow [Lump Flow [Annuity]
Sum]
OR
FVn = PV x CVFr,n
Ordinary
Annuity Due
Annuity

 (1 + i ) n − 1 
Fn = A    (1 + i ) n − 1 
 i  Fn = A   (1+i)
 i 
38

FV = A x CVAFi,n FV = A x CVAFi,n x (1+i)

 Example of ordinary Annuity
Cash flows occur at the end of the period
Annuity = 1000
0 n= 3
7% 1 2 3 4
r= 7%
FV = Annuity x CVAFr,n
₹1,000 ₹1,000 ₹1,000
₹1,070
₹1,145 FV = 1000 x 3.215
FVA3 = ₹1,000(1.07)2 + ₹3,215 = FVA3 FV = 3215
₹1,000(1.07)1 + ₹1,000(1.07)0 OR
= ₹1,145 + ₹1,070 + ₹1,000
= ₹3,215
 Example of Annuity Due

Cash flows occur at the Beginning of the period

0 1 2 3 4
7%
₹1,000 ₹1,000 ₹1,000
₹1,070
₹1,145
₹1,225

FVAD3 = ₹1,000(1.07)3 + ₹3,440 = FVAD3

₹1,000(1.07)2 + ₹1,000(1.07)1 OR
= ₹1,225 + ₹1,145 + ₹1,070 FV = Annuity x CVAFrn x (1+r)
= ₹3,440 FV = ₹ 1000 x 3.215 x1.07 = ₹3440
 Time Value of Money Technique

Discounting [Present Value]

PVn = FV/(1+i)n Single Cash Series of Cash

Flow [Lump Flow [Annuity]
sum]
OR
PVn = FV/ PVFi,n
Ordinary
Annuity Due
Annuity
1 1 
P = A − 
i (1 + i ) 
n
 i 1 
1
P = A − (1+i)
i (1 + i )
n


i 

PV = A x PVAF i,n
PV = A x PVAF i,n x (1+i)
 PRESENT VALUE OF ORDINARY ANNUITY

Cash flows occur at the end of the period

0 1 2 3 4
7%

₹ 1,000 ₹ 1,000 ₹ 1,000

₹ 934.58
₹ 873.44
₹ 816.30

₹ 2,624.32 = PVA3 PVA3 = ₹ 1,000/(1.07)1 +

₹ 1,000/(1.07)2 +
₹ 1,000/(1.07)3
= ₹ 934.58 + ₹ 873.44 + ₹ 816.30
= ₹ 2,624.32
 Example of an Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
₹ 1,000 ₹ 1,000 ₹ 1,000

₹934.58
₹873.44

₹ 2,808.02 = PVADn

PVADn = ₹ 1,000/(1.07)0 + ₹ 1,000/(1.07)1 +

₹ 1,000/(1.07)2 = ₹ 2,808.02
The Rule of 72 is a formula that estimates the amount of time it takes for an investment to
double in value, earning a fixed annual rate of return.
The Rule of 72 gives an estimation of the doubling time for an investment.

72
Doubling period =
𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒

You are the owner of a coffee machine manufacturing company. Due to the large capital needed to
establish a factory and warehouse for coffee machines, you have turned to private investors to fund the
expenditure. You meet with John, who is a high net-worth individual willing to contribute Rs 50,00,000
to your company.
However, John is only willing to contribute the said amount on the presumption that he will get a 12%
annual rate of return on his investment, compounded yearly. He wants to know how long it will take for
his investment in your company to double in value.
 Numerical Questions

Q1. At the time of retirement, Mr. John is given a choice between two alternatives:
a. An annual pension of ₹120,000 as long as he lives or
b. a lump Sum amount of ₹ 10,00000.
If Mr. John expects to live for 20 years and the Interest rate is expected to be 10% p.a.
throughout, which option appears more attractive.

Q2. Find out the present value of an investment which is expected to give a return of ₹2500
p.a. indefinitely and the rate of interest is 12%.p.a.

Q3. An investment company makes an offer to deposit a sum of ₹1100 and then receive a
return of ₹80p.a. perpetually.
(a) Should this offer be accepted if the rate of interest is 8%.
(b) Will the decision change if the rate of interest is 5%.
45
Sinking Fund Question
Q4. A machine is costing ₹ 95000 and its effective life is estimated at 12yrs. What should be
retained out of profit at the end of each year to accumulated at compound interest rate at
5%p.a. so that a new machine can be purchased after 12yrs.

Q5. A machine costs Rs.98000 has an effective life of 12 years is purchased today. The
estimated scrap Value is Rs.3000. What amount should be retained each Year to accumulate at
compound interest rate at 5% p.a. so that new machine can be purchased.

Q6. Well Limited has ₹50 Crore bonds outstanding. Bank deposits earn 10% per annum. The
bonds will be redeemed after 30 years for which purpose Well Limited wishes to create a
sinking fund.
(a) How much Amount should be deposited to the sinking fund each year so that AXE Limited
would have in the sinking fund ₹50 crores to retire its entire issue of bonds?
46
(b) What shall be the deposit amount each year if the rate of interest earn on deposit is 12%.
Loan Amortization Question

Q7. Zee ltd is borrowing Rs.50 Lakhs for a period of 4 Years at interest of15% repayable in
equal installment at the end of each year. Find out the installment amount, interest paid each
year and principal repayment each year .

Q8. Peter is borrowing a 3 years’ loan of ₹1,00,000 at 9% from a commercial bank to buy a
new racing cycle for his younger brother. He is required to pay the amount in three equal
yearly instalments. Prepare the loan amortization schedule for 3 years.

47
Miscellaneous Questions
Q9. A finance company offers a scheme called “Lakhpatti in 10 Years” It has promised to pay Rs.100000
after 10 years for every Rs.20,000 deposit made today.
The advertisement states that a firm pays Rs. 80,000 as interest at Rs.8000 every year. And there fore
40% annual returns.
Question:
(a) Do you agree with the claim made in the scheme?
(b) Explain what would be the maturity value if the company really had to offer 40% returns annually

Q10. Suppose you have ₹1,20,000 today and need to preserve it for nest 8 years. When you are required
to pay fees for your sibling which is estimated to be ₹4,00,000.
Question:
(a) At what rate should you invest this money to have required sum at the end of 8 years.
(b) If you need ₹4,00,000 after 8 years and the prevailing rate of interest is 12% then what amount
should be invested today? 48
Q11A finance company advertises that it will pay a lump sum of ₹1,00,000 at the end of 15
years to every investor who deposits an annual amount of ₹12,000 to the company. What is
the implicit rate of interest in this offer?

Q12. You can save ₹5,000 a year for 3 years and ₹7000 a year for 7 years thereafter. What
will these savings accumulate at the end of 10 years if the rate of interest is 8 percent

49
Q13. What is the present value of an income stream which provides ₹30,000 at the end of
year one, ₹50,000 at the end of year three and ₹ 1,00,000 at the end of year four if the cut off
rate is 9%.?

Q14.Your Father is planning to have a corpus for his retirement and is interested in
accumulating ₹50,00,000 in a bank account that offers a rate of interest of 10%. Today he is
40 years of age and is planning to retire at the age of 60. How much should he start saving
every year so that he can accumulate the required corpus. Also calculate the amount of
Annuity he can receive for next 20 years after his retirement from this corpus money

Q15. What is the minimum amount which a person should be ready to accept today from a
debtor who otherwise has to pay a sum of Rs 5,000 to day Rs 6,000, Rs 8,000, Rs 9,000 and
Rs 10,000 at the end of year 1, 2, 3, 4 respectively from today. The rate of interest may be
taken at 14%. 50
Mini Case
Allen needs your help in his retirement planning. He is 30 years old and would like to retire at
the age of 55 years. He estimated that post retirement he would need an annuity of $12,000
per annum for next 30 years to meet his living expenses. The rate of return on his investment
portfolio is expected to be 8 per cent per annum. You are required to:
(a) Determine the retirement corpus needed to provide him an annuity of $12,000 per annum
for 30 years so that at the end of the annuity period his corpus is completely exhausted,
assume that annuity is needed in the beginning of the year.
(b) Also calculate how much Mr Allen should invest each year to reach the target retirement
corpus. Assume that the investment are made at the end of the period.

51
52
 Risk –Return Analysis
Risk – Variability of Returns; Return – Outcome or reward from an investment

Return Risk
Investments are made to primarily to derive It is potential for variability in returns. Risk
returns. Return may be received in the form of: may be related to :

• Yield [Interest or Dividend] • Loss of Capital

• Capital appreciation [Difference between the • Delay in repayment of capital
sales Price and Purchase price • Non-payment of Interest
• Variability of returns

Objective of any Investment

✓ Maximization of Returns
✓ Minimization of Risk
✓ Hedge against Inflation
53
 Elements of Risk
The essence of Risk in an investment is the variation in its returns. This
variations in returns is caused by number of factors. These factors which
produces the variation in the returns are referred to as element of risk and it is
classified into two broad category:
▪ Systematic Risk
▪ Unsystematic Risk

The total Variability in returns of a security represents the total risk of that security:
Total Risk = Systematic Risk + Unsystematic Risk

54
Systematic Risk: It is external to the company and affects many securities
simultaneously. Mostly uncontrollable.
▪ Market Risk
▪ Interest Rate Risk
▪ Purchase Power Risk

Un-Systematic Risk: These are internal to companies and affect only particular
companies or securities.
• Business Risk
• Financial Risk

55
 BASIS FOR
SYSTEMATIC RISK UNSYSTEMATIC RISK
COMPARISON
Meaning Systematic risk refers to the hazard Unsystematic risk refers to the
which is associated with the market or risk associated with a
market segment as a whole. particular security, company or
industry.
Nature Uncontrollable Controllable
Factors External factors Internal factors
Affects Large number of securities in the Only particular company.
market.
Types Interest risk, market risk and Business risk and financial risk
purchasing power risk.
Protection Asset allocation Portfolio diversification
56
 Measurement of Risk
➢ Risk in investment is associated with returns.
➢ The risk of an investment cannot be measured without reference to returns
➢ Returns in turn depends on the cash inflows to be received from the investment in the
future.
➢ The future is uncertain, so the investor expects the returns (expected returns) based on past
data.

Let's understand with an example

X Share limited is currently selling at ₹120. you are interested in buying this share.
Further studying the past trend you anticipates that the company will declare a Dividend
of ₹5 in the next year and you expects to sell off this share after one year at ₹175.

Step 1: With the given information, expected Returns may be calculated as follows:
𝐹𝑜𝑟𝑐𝑎𝑠𝑡𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑+𝐹𝑜𝑟𝑐𝑎𝑠𝑡𝑒𝑑 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟
Return = -1
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 57
 Returns = ₹5+₹175
-1 = .50
₹120

Based on the calculation your expected Returns is 50 percent.

Bust as the future is uncertain, the dividend declared by the company may be turn out to be
either more or less than the anticipated price.
Similarly, the ending Price (selling Price) may be more or less than the anticipated price.
Thus, there is a possibility that the future returns may be more or less than 50 percent.

58
Step 2:
As the future is uncertain, so the Investor (you) may consider the probability of several other
possible returns. The expected returns may be 30 percent, may be 40 percent, may be 50
percent, may be 60 percent or 70 percent. The investor must assign the probability of occurrence
of these possible alternate returns, continuing with the same example:
Possible Returns (in Percentage) Xi Probability of occurrence p(Xi)
30 0.10
40 0.30
50 0.40
60 0.10
70 0.10
The expected returns of the investment is the probability weighted average of the all the
possible returns. If the possible returns are denoted by X, and the related probabilities are
p(Xi), the expected returns may be represented as x̄ and can be calculated as:
x̄ = σ𝑛𝑖=1 𝑋𝑖𝑝(𝑋𝑖)
 Calculation of Expected Returns
Possible Returns (in Probability of occurrence 𝑋𝑖 𝑝(𝑋𝑖)
Percentage) Xi p(Xi)
30 0.10 3.0
40 0.30 12.0
50 0.40 20.0
60 0.10 6.0
70 0.10 7.0

x ̄ = σ𝑛𝑖=1 𝑋𝑖𝑝 𝑋𝑖 = 48.0

Here, the expected return is 48 percent

Expected Returns are insufficient for decision making, the risk aspect should also be
considered.
The most popular measure of risk is the variance or standard deviation of probability
distribution of possible returns.
60
 Step 3 Calculation of Variance and Standard Deviation
𝑛

σ2 = ෍[ 𝑋𝑖 − x̄ 2 𝑝(𝑋𝑖)
𝑖=1
Possible Returns 𝑋𝑖 Probability P(Xi) Deviation (Xi -x̄) Deviation Squared Product
(Xi -x̄)2 ((Xi -x̄)2 𝑝(𝑋𝑖)
30 0.10 -18 324 32.4
40 0.30 -8 64 19.2
50 0.40 2 4 1.6
60 0.10 12 144 14.4
70 0.10 22 484 48.4

σ2 = 116.0
Variance = 116 percent
Standard Deviation = 116 = 10.77 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
The variance and standard Deviation measures the extent of variability of possible returns
from the expected returns.
This measure used for assessing risk is known as mean variance approach.
The mean gives the expected value, and the variance or standard Deviation gives the
variability

The Standard Deviation or Variance however provides measure of the total risk associated with
the security.
Total Risk = Systematic Risk + Unsystematic Risk

The Risk that is significant and measurable is Systematic Risk, Unsystematic Risk is company
specific Risk or unique risk that can be diversified.

In Investment, the Risk that can be measured or quantified for Decision making is Systematic
Risk 62
 Measurement of Systematic Risk
✓ Systematic Risk is the variability in security returns caused by changes in the economy or
the market.
✓ All Securities are affected by such changes to some extent, but some securities exhibit
greater variability in response to market changes. Such securities are said to have higher
Systematic Risk.
✓ The average affect of a change in the economy can be represented by the change in the
stock market Index.
✓ The Systematic risk of a security can be measured by relating that security’s variability
with the variability in the stock market Index.

The systematic Risk of a security can be measured by using historical data through
calculation of Beta.
Beta can be calculated using statistical measure:
(a) Regression
(b) Correlation
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Beta measures the variability of the security with relative to the variability of the market as
a whole. As Beta measures the volatility of a security’s return relative to the market, the
larger the Beta, the more volatile the security is.

Beta =1 Average Risk

Beta >1 High Risk

Beta <1 Low Risk

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 Miscellaneous Question
The Returns on Security A & Security B is given below. Analyse the securities and select based
on Risk and Return
Probability Security A Security B
0.5 4 0
0.4 2 3
0.1 3 3
Solution

Security A Security B
Expected Return E(r) = R1P1 +R2P2 + R3P3 Expected Return E(r) = R1P1 +R2P2 + R3P3
= [4 x 0.5] + [2 x 0.4] + [3 x 0.1] = [0 x 0.5] + [3 x 0.4] + [3 x 0.1]
= 2.8 = 1.5
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 Risk Security A Risk Security B
Returns (r) Probability [r- E(r)] 2 P1 [r- E(r)] 2 Returns (r) Probability [r- E(r)] 2 P1 [r- E(r)] 2
(Pi) (Pi)
4 0.5 1.44 0.720 0 0.5 2.25 1.125
2 0.4 0.64 0.256 3 0.4 2.25 0.9
0 0.1 7.84 0.784 3 0.1 2.25 0.225
σ2= 1.76 σ2= 2.25
Variance = 1.76 Security A Variance = 2.25 Security B
Standard Deviation = 1.76 Return = 2.8 Standard Deviation = 2.25 Return = 1.5
= 1.33 Risk = 1.33 = 1.5 Risk = 1.5

As the Return of Security A is High with low Risk so Security A will be selected
Risk Return Trade-off
Maximize the Returns at the given level of Risk
Minimize the Risk at the given level of Returns 66
Complete the Followings from Quadrant 4
in LMS

i. Numerical Question
ii. Theory Question
iii.MCQ for concept check

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Thank You
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