MBA 3rd SEMESTER 1st MID IMPORTANT QUESTIONS

INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

1. Define investment. Explain the investment decision process.

2. What are the features and types debt Instruments?
3. Write a short note on analysis and valuation of common stocks.

1. Define investment. Explain the investment decision process?

Investment can be defined allocating money to assets with the hope that in the future it would
provide some benefit such as generation of income. Property and gold are some common
examples of the traditional type of investment. The value of property, gold, mutual funds and
shares bought today may see a significant increase in the future. In the financial industry,
investments can be bifurcated into two broad categories, namely traditional and alternative.
Investment Decision Process:-
Investment Decision Process
Some Definitions • Investment: An investment is the current commitment of money or other
resources in the expectation of reaping future benefits. (Kane, Bodie and Marcus 2005)
Definitions Generally, “investments” refers to financial assets and in particular to marketable
securities. Financial assets are paper or electronic claims on some issuer, such as the government or
a company. Marketable securities financial assets that are easily and cheaply tradable in organized
markets Real assets are tangible assets such as gold, silver, diamonds, real estate.
Speculation: Act of trading in an asset, or conducting transaction, that has significant risk of losing
most or all of initial outlay, in expectation of substantial gain. Definitions
Investment • Long term planning (at least one year) • Low or moderate risk. • Low or moderate rate
of return. • Investment decisions are based on fundamentals. • Investors leveraged its own funds.
Speculation • Short term Planning (few days or months) • High Risk. • High rate of return. •
Decisions are based on hearsay and market psychology. • Resort to borrowed funds.
Why to invest? Investment increases future consumption possibilities ◦ By foregoing consumption
today and investing the savings, investors expect to increase their future consumption possibilities by
increasing their wealth
If we do not invest, then? If we have savings and we do not invest, we can’t earn anything on our
savings. Second, the purchasing power of cash diminishes in inflation This means that if savers
do not invest their savings, they will not only lose possible return on their savings, but will also
lose value of their money due to inflation If we do not invest, then?
But investment has problems • Investment has the following three problems: • A. Sacrifice • While
investing, investor delay their current consumption (delaying consumption is kind of sacrifice) • B.
Inflation - Investment loses value in periods of inflation • C. Risk - giving your money to someone
else involves risk
Compensation to investors • Due to the three problems, investors will not invest until they are
compensated for these problems • Required rate of return = compensation for (sacrifice , inflation,
risk) • RRR= opportunity cost + risk premium
Understanding the investment decision process • The basis of all investment decisions is to earn
return and assume risk • By investing, investors expect to earn a return (expected return)
Expected return and risk Realized returns(actual return) might be more or less than the expected
return The chance that the actual return on an investment will be different from the expected return
is called risk This way t-bills has no risk as the expected return and actual return are the same But
actual returns on common stock have greater chances of deviating from expected return and hence
have high risk
The expected risk-return trade-off
The expected risk-return trade-off The expected risk-return is depicted in the graph The line from
RFR shows risk-return relationship of different investment alternatives. It shows that at zero level
of risk, investor can earn risk free rate (RFR) which is equal to the rate on t-bills To earn a little
higher return than the risk free rate, investors can invest in corporate bonds, but the investors will
have to take some risk as well
Ex-ante and ex-post risk-return • To earn even higher return than on corporate bonds, investor can
invest in common stocks, but the risk is also high • The risk return trade-off depicted in the graph in
ex-ante i.e. before the fact or before the investment is made • Ex post (after fact or actual) trade-off
may be positive, flat or even negative
• Fundamental Approach: Believed that there is an intrinsic value of a security that can be company,
industry and economy. • Psychological Approach: This approach based on the premises that stock
prices are guided by the emotions. It is more important to analyse that how investor tend to behave
as the market is swept by the waves of optimism and pessimism. Different approaches to investment
decision making
• Academic Approach: Suggest that: -Stock market is efficient in reacting quickly and rationally
hence it reflects intrinsic value fairly well. -Stock price behavior correspond to the random walk,
hence past price behavior can not be used to predict the future price. - There is positive relationship
between risk and return. Different approaches to investment decision making
• Electric Approach: This approach draws on all the three approaches. -Fundamental analysis is
helpful in establishing basic standard benchmarks. - Technical analysis is useful in broadly gauging
the mood of the investor. –
2. What are the features and types debt Instruments?
ANS:- A debt instrument is a contract between a lender, a party loaning money, and a borrower,
a party borrowing money. The debt instrument enables the lender to loan funds to the borrower,
who promises to repay the loan. Common types of debt instruments include mortgages, loans,
bonds, leases and notes.
Types Debt Instruments:-
Bond:- A bond, also sometimes called a fixed-income security, is a type of debt instrument that
memorializes a loan made by an investor to a corporate or government entity. The loan is to be
paid back over a period of time with a fixed interest rate and is often secured to fund projects.
Loan:- A loan is a debt instrument where one party, the lender, gives another party, the
borrower, money, property, assets or materials goods on the basis of a promise by the borrower
that the loan will be repaid with interest and finance charges. Loans may be an open-ended credit
line with a limit, such as with credit cards, or they may be a specific one-time loan, such as a
loan to buy a car. For larger loans, lenders may require that the loan be secured by collateral
property.
Mortgage:- A mortgage is a secured lien or loan on residential property. The loan is secured by
the associated property. More specifically, if the borrower fails to pay, the lender can take the
property to fulfill the outstanding debt.
Lease:- A lease is an agreement between an owner of property and a tenant or renter. A lease is a
type of loan instrument because it secures a regular rent payment from the tenant to the owner,
thereby creating a secured long-term debt
Features Debt Instruments:- To build the investment part of your portfolio, you need to first
create its ‘safe’ part. This is the core that earns less but is more stable than the risky part. And to
create this ‘safe’ part, you need to invest in debt instruments. These can shield your portfolio
from the volatilities of the equity market and have the capacity to reduce the overall risk of an
investment portfolio. Debt instruments also help in de-risking a portfolio. What this means is that
as your goals approach, you should move from equity to debt to protect your capital gains.
For most middle-class Indians, a fixed deposit (FD) is often the only financial investment other
than an Employees’ Provident Fund (EPF) and physical assets such as gold and real estate. But
over the past few years, diehard FD investors have begun to realize that there is life beyond this
inflation and tax-unfriendly product. Tax-free bonds and debt funds now rank high on the safety
seeking investor’s list.
“Even though PPF or EPF are good debt instruments, with tax benefits and tax-free returns, the
choice of debt instruments should be dependent on the time horizon of your goal,” said Pankaaj
Maalde, a certified financial planner. For instance, short-term needs (up to five years) will need a
low-risk product like an FD. However, you can also use short-term debt funds instead to get
better returns and more flexibility. Balanced funds with a small allocation to equity, of less than
20%, are also useful for nearer-term goals.
Longer-term investment options include contributions made to EPF, Public Provident Fund
(PPF) and tax-free bonds.
So, do not park your short-term money in long duration products. Typically, conservative
investors make the mistake of dipping into their PPF and EPF and not linking these to their
goals. These two products form the core of long-term investment money. Maximize your PF
contribution and PPF investment and don’t dip into it during the accumulation years.
While debt instruments serve an important purpose in an investor’s portfolio, avoid over-
allocating to them as returns after inflation and tax are less. Allocating enough for short-term
goals and building the long-term core in low-risk products allows you to take more risks with the
rest of your money at the next stage on the investment road.
3. Write a short note on analysis and valuation of common stocks.
ANS:- Valuation methods typically fall into two main categories: absolute and relative.
Two Categories of Valuation Models:- Absolute valuation models attempt to find the intrinsic
or "true" value of an investment based only on fundamentals. Looking at fundamentals simply
means you would only focus on such things as dividends, cash flow and growth rate for a single
company, and you wouldn't worry about any other companies. Valuation models that fall into
this category include the dividend discount model, discounted cash flow model, residual income
models and asset-based models.

In contrast to absolute valuation models, relative valuation models operate by comparing the
company in question to other similar companies. These methods generally involve calculating
multiples or ratios, such as the price-to-earnings multiple, and comparing them to the multiples
of other comparable firms. For instance, if the P/E of the firm you are trying to value is lower
than the P/E multiple of a comparable firm, that company may be said to be relatively
undervalued. Generally, this type of valuation is a lot easier and quicker to do than the absolute
valuation methods, which is why many investors and analysts start their analysis with this
method.

Let's take a look at some of the more popular valuation methods available to investors, and see
when it is appropriate to use each model. (For related reading, see Top Things To Know For An
Investment Banking Interview.)
1.Dividend Discount Model (DDM):- The dividend discount model (DDM) is one of the most
basic absolute valuation models. The dividend model calculates the "true" value of a firm based
on the dividends the company pays its shareholders. The justification for using dividends to
value a company is that dividends represent the actual cash flows going to the shareholder, thus
valuing the present value of these cash flows should give you a value for how much the shares
should be worth. So, the first thing you should check if you want to use this method is if the
company actually pays a dividend.

Secondly, it is not enough for the company to just a pay dividend; the dividend should also be
stable and predictable. The companies that pay stable and predictable dividends are typically
mature blue-chip companies in mature and well-developed industries. These type of companies
are often best suited for this type of valuation method. For instance, take a look at the dividends
and earnings of company XYZ below and see if you think the DDM model would be appropriate
for this company:
2005 2006 2007 2008 2009 2010
Dividends Per
Share $0.50 $0.53 $0.55 $0.58 $0.61 $0.64
Earnings Per Share $4.00 $4.20 $4.41 $4.63 $4.86 $5.11
In this example, the earnings per share are consistently growing at an average rate of 5%, and the
dividends are also growing at the same rate. This means the firm's dividend is consistent with its
earnings trend which would make it easy to predict for future periods. In addition, you should
check the payout ratio to make sure the ratio is consistent. In this case the ratio is 0.125 for all six
years, which is good, and makes this company an ideal candidate for the dividend model. (For
more on the DDM, see Digging Into the Dividend Discount Model.)

2. Discounted Cash Flow Model (DCF):-

What if the company doesn't pay a dividend or its dividend pattern is irregular? In this case,
move on to check if the company fits the criteria to use the discounted cash flow model. Instead
of looking at dividends, the DCF model uses a firm's discounted future cash flows to value the
business. The big advantage of this approach is that it can be used with a wide variety of firms
that don't pay dividends, and even for companies that do pay dividends, such as company XYZ
in the previous example.
The DCF model has several variations, but the most commonly used form is the Two-Stage DCF
model. In this variation, the free cash flows are generally forecasted for five to ten years, and
then a terminal value is calculated to account for all of the cash flows beyond the forecast period.
So, the first requirement for using this model is for the company to have predictable free cash
flows, and for the free cash flows to be positive. Based on this requirement alone, you will
quickly find that many small high-growth firms and non-mature firms will be excluded due to
the large capital expenditures these companies generally face.
For example, take a look at the simplified cash flows of the following firm:
In this snapshot, the firm has produced increasingly positive operating cash flow, which is good.
But you can see by the high level of capital expenditures that the company is still investing a lot
of its cash back into the business in order to grow. This results in negative free cash flows for
four of the six years, making it extremely difficult (nearly impossible) to predict the cash flows
for the next five to ten years. So, in order to use the DCF model most effectively, the target
company should generally have stable, positive and predictable free cash flows. Companies that
have the ideal cash flows suited for the DCF model are typically the mature firms that are past
the growth stages. (To learn more about this method, see Taking Stock of Discounted Cash
Flow.)
3. Comparables Method:-
The last method we'll look at is sort of a catch-all method that can be used if you are unable to
value the company using any of the other models, or if you simply don't want to spend the time
crunching the numbers. The method doesn't attempt to find an intrinsic value for the stock like
the previous two valuation methods do; it simply compares the stock's price multiples to a
benchmark to determine if the stock is relatively undervalued or overvalued. The rationale for
this is based off of the Law of One Price, which states that two similar assets should sell for
similar prices. The intuitive nature of this method is one of the reasons it is so popular.
This method can be used in almost all circumstances because of the vast number of multiples that
can be applied, such as the price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S),
price-to-cash flow (P/CF) and many others. Of these ratios, the P/E ratio is the most commonly
used one because it focuses on the earnings of the company, which is one of the primary drivers
of an investment's value. (For more on this subject, see 6 Basic Financial Ratios And What They
Reveal.)
When can you use the P/E multiple for a comparison? You can generally use it if the company is
publicly traded because you need the price of the stock, and you need to know the earnings of the
company. Secondly, the company should be generating positive earnings because a comparison
using a negative P/E multiple would be meaningless. And lastly, the earnings quality should be
strong; earnings should not be too volatile and the accounting practices used by management
should not drastically distort the reported earnings. (Companies can manipulate their numbers, so
you need to learn how to determine the accuracy of EPS. Read How To Evaluate The Quality Of
EPS.)