Risk of Investment

• Risk is defined in financial terms as the

chance that an outcome or
investment's actual gains will differ
from an expected outcome or return.
Risk includes the possibility of losing
some or all of an original investment.
• The possibility that an actual return will
deviate from our expected return.
 Classification of Risk
Risk
Systema company- unique
Unsystemat
Un expected risk
tic canicbe reduced
change in interest through
rates diversification
 unexpected a company’s top
changes tax rate management dies or
 political events become inefficient
 international  a huge oil tank
bursts and floods a
events company's
 Types of Risk
 Business Risk
 Market Risk
 Interest Rate Risk
 Exchange Rate Risk
 Liquidity risk
 Credit Risk
 Concentration Risk
 Inflation Risk
 Political and Legal Risk
 Types of Risk
 According to PWC report the top risk
for the year 2022 is:

Cyber Attack
Ethics of employees
Change in interest rate
 Types of Risk

Melisa virus caused severe destruction to

hundreds of companies, including Microsoft. It
is estimated that repairing the affected
 Types of Risk

have access to personal information of guests.

An estimated 339M guests have had their data
compromised. This led to fine the Marriott
 Types of Risk

Virus which attacked vulnerable Microsoft

Windows operating systems causing up to
$500 million in damage, its highest profile
victim was Delta, which was forced to cancel
 Measurement of Risk
• Analyzing asset’s risk takes two forms :
1.On a stand-alone basis (considering the
asset in isolation)
2.On a portfolio basis (holding an asset as
one in a group of assets)
• Note: Vitally important to understand
stand –alone risk so as to grasp the risk
in a portfolio context
• Stand-alone risk: the risk an investor
would face if he or she held only one
asset.
 Measurement of Risk
• Portfolio risk: the risk an investor
would face if he or she held more
than one assets, an investment
portfolio
• Measuring Stand-Alone Risk :
• The standard deviation: is a
measure of the dispersion of possible
outcomes
 a measure of the tightness of the
probability distribution
Therefore, at this point we
Questions on Risk and
Return
 Q1
• Assume ABC Company's last dividend was $1.25; how
much should you be willing to pay for the common
stock if you feel that the 7 percent growth rate can be
maintained indefinitely and you require a 16 percent
return?
A. $19.85
B. $11.15
C. $14.44
D. $14.86
E. $18.90
 Q2
• __________ is the variability of return on
stocks or portfolios not explained by general
market movements. It is avoidable through
diversification.
A. Systematic risk
B. Standard deviation
C. Unsystematic risk
D. Coefficient of variation.
 Q3
• The excess return required from an
investment in a risky asset over that required
from a risk free investment.
A. Risk premium
B. Risk free return
C. Return of inflation
D. Capital Gain
 Q4
• As the number of securities in a portfolio
increases, the amount of systematic risk
A. Remains constant.
B. Decreases.
C. Increases.
D. Changes in proportion
 Q5
• ______ is the ability of the investor to buy and
sell a company’s securities quickly and without
a significant loss of value.
A. Marketability risk
B. Default risk
C. Seniority risk
D. Maturity risk
 Q6
• A portfolio having two risky securities can be
turned risk less if

a) The securities are completely positively

correlated
b) If the correlation ranges between zero and one
c) The securities are completely negatively
correlated
d) None of the above.
 Q7
• A portfolio comprises two securities and the
expected return on them is 12% and 16%
respectively. Determine return of portfolio if
first security constitutes 40% of total portfolio.

a) 12.4%
b) 13.4%
c) 14.4%
d) 15.4%
Cost of Capital

By
Redwan Kelil
Understand the cost of capital, components and
its practice

1 marks (understanding)
 cost of capital
• The cost of capital for a firm may be defined as
the cost of obtaining funds.
• Cost of capital is the minimum rate of return
which a firm, must and, is expected to earn on its
investment so as to maintain the market value of
its shares.
• According to the definition of William and
Donaldson, “Cost of capital may be defined as
the rate that must be earned on the net proceeds
to provide the cost elements of the
• burden at the time they are due”.
 Question

What is the
relationship
between cost of
capital and market
share price of the
company
 Importance
• If management is to maximize the firm’s value,
the cost of all inputs, including capital, must be
minimized, and to minimize the cost managers
must be able to measure it.
• Capital budgeting decisions require an estimate of
the cost of capital. Correct capital budgeting helps
to boost the value of the firm.
• Financing policy decisions (mix of debt and
equity). In designing the proportion of debt and
equity the firm aims at minimizing the overall cost
of capital.
 COMPUTATION OF COST OF CAPITAL
• Computation of cost of capital consists of two
important parts:
1. Measurement of specific costs
2. Measurement of overall cost of capital
 Measurement of Cost of Capital

It refers to the cost of each specific sources of

finance like:
• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings
 cost of equity
• We begin with the most difficult question on
the subject of cost of capital: What is the
firm’s overall cost of equity?
• This section discusses two approaches to
determining the cost of equity: the dividend
growth model approach and the security
market line, SML, approach.
The Dividend Growth Model Approach
• under the assumption that the firm’s
dividend will grow at a constant rate
g, the price per share of the stock,
P0, can be written as:
Po= D1
RE – g
(The Gordon model)
The Dividend Growth Model Approach
• we can rearrange this to solve for RE as
follows:
• RE = (D1/P0) + g
• To estimate RE using the dividend growth
model approach, we obviously need three
pieces of information: P0, D0, and g.
• for a publicly traded, dividend-paying
company, the first two can be observed
directly, so they are easily obtained. Only the
third component, the expected growth rate
for dividends, must be estimated. Estimating g
The Dividend Growth Model Approach
• suppose Greater States Public Service, a large
public utility, paid a dividend of $4 per share
last year. The stock currently sells for $60 per
share. You estimate that the dividend will
grow steadily at a rate of 6 percent per year
into the indefinite future. What is the cost of
equity capital for Greater States?
The Dividend Growth Model Approach
• suppose Greater States Public Service, a large
public utility, paid a dividend of $4 per share
last year. The stock currently sells for $60 per
share. You estimate that the dividend will
grow steadily at a rate of 6 percent per year
into the indefinite future. What is the cost of
equity capital for Greater States?
13.07%
 Advantage and Dis-advantage
• It is both easy to understand and easy to use.
• the dividend growth model is obviously only
applicable to companies that pay dividends
• the key underlying assumption is that the
dividend grows at a constant rate.
• Finally, this approach really does not explicitly
consider risk.
 The SML Approach
• required or expected return on a risky
investment depends on three things:
• 1. The risk-free rate, Rf
• 2. The market risk premium, E(RM) Rf
• 3. The systematic risk of the asset relative to
average, which we called its beta coefficient,
• Ks = KRF + β(Km –KRF)
• (The CAPM approach)
 The SML Approach
•Rₑ = Expected return on the asset (or cost of
equity)
•Rₓ = Risk-free rate (usually the return on
government bills)
•β (Beta) = The asset's beta, a measure of its
volatility compared to the overall market
•Rₘ = Expected return of the market
•(Rₘ - Rₓ) = Market risk premium (the expected
return on the market above the risk-free rate)
 The SML Approach
• Example: Duchess Co. obtained the following
information from its investment advisors and
its own analyses. KRF = 7%, KM = 11%, and β of
its stock = 1.5. What is the cost of its common
stock equity?
 The SML Approach
• Example: Duchess Co. obtained the following
information from its investment advisors and
its own analyses. KRF = 7%, KM = 11%, and β of
its stock = 1.5. What is the cost of its common
stock equity?
• Ks = 7% + 1.5(11% - 7%) = 13%
 Advantage and Dis-advantage
• First, it explicitly adjusts for risk. Second, it is
applicable to companies other than just those
with steady dividend growth.
• There are drawbacks, of course. The SML
approach requires that two things be
estimated, the market risk premium and the
beta coefficient. To the extent that our
estimates are poor, the resulting cost of equity
will be inaccurate.
 The Cost of Debt
• The cost of debt is the return that the firm’s
creditors demand on new borrowing.
• Unlike a firm’s cost of equity, its cost of debt
can normally be observed either directly or
indirectly, because the cost of debt is simply
the interest rate the firm must pay on new
borrowing, and we can observe interest rates
in the financial markets.
 The Cost of Debt
• For example, if the firm already has bonds
outstanding, then the yield to maturity on
those bonds is the market-required rate on
the firm’s debt.
• Alternatively, if we know that the firm’s bonds
are rated, say, AA, then we can simply find out
what the interest rate on newly issued AA-
rated bonds is.
I
1000  N d

n
N d  1000
Kd= 2
 The Cost of Debt
• Duchess Company is contemplating selling $10
million worth of 20 year, 9% annual coupon
bonds, each with a par value of $1000. Since
similar-risk bonds earn returns greater than
9%, the firm must sell the bonds for $980 to
compensate for the lower coupon interest rate.
Floatation costs paid to the investment banker
are 2% of the par value of the bond (2% x
1000), or $20. Tax rate is 40%.
• Required: compute the after tax cost of the
bond.
 The Cost of Debt
1000  960
90 
Kd= 20 92 = 9.4%

960  1000 980
2

After tax cost of debt = 9.4% (1- 0.4) = 5.6%

• Here we are interested in the cost of new
financing. The coupon rate on existing debt is
not relevant, nor is any cost connected with
existing debt.
 The Cost of Preferred Stock
• Determining the cost of preferred
stock is quite straightforward.
• preferred stock has a fixed dividend
paid every period forever, so a share
of preferred stock is essentially a
perpetuity. The cost of preferred
stock, RP, is thus:
• RP = D/P0
 The Cost of Preferred Stock
• On September 4, 2001, Alabama Power Co.
Had issues of ordinary preferred stock that
traded on the NYSE. paid $1.30 annually per
share and sold for $21.25 per share.
• What is Alabama Power’s cost of preferred
stock?
 The Cost of Preferred Stock
• On September 4, 2001, Alabama Power Co.
Had issues of ordinary preferred stock that
traded on the NYSE. paid $1.30 annually per
share and sold for $21.25 per share.
• What is Alabama Power’s cost of preferred
stock?
$1.30/21.25= 6.12%
 Cost of Retained Earnings
• is the return on dividends foregone by equity
shareholders. It is the opportunity cost of
dividends used for investment purpose.
• Bondholders are compensated by interest
payments; preferred stockholders are
compensated by fixed dividend payments; and
the firm’s remaining income belongs to its
common stockholders.
 THE WEIGHTED AVERAGE COST OF
CAPITAL
• This is also called hurdle rate, opportunity
cost of capital, composite cost of capital. The
weighted average cost of capital is a weighted
average of the component cost of debt,
preferred stock and common equity.
 THE WEIGHTED AVERAGE COST OF
CAPITAL
Source of Amount Cost of
Financing Capital
Debt $30,000 6%
Preferred 20,000 10%
stock
Common 50,000 11%
Stock

Required:
Compute the weighted average cost of capital
(WACC)
 THE WEIGHTED AVERAGE COST OF
CAPITAL
Source of Amount Cost of
Financing Capital
Debt $30,000 6%
Preferred 20,000 10%
stock
Common 50,000 11%
Stock

WACC= 9.3%
Questions on Cost of
Capital
 Q1
• A company should arrange the capital
structure in such a way that there is
maximum flexibility in the capital and cost of
capital is
• A. Maximum
• B. Minimum
• C. Expensive
• D. All of the above
 Q2
• If the weighting of equity in total capital is 1/3,
that of debt is 2/3, the return on equity is 15%
that of debt is 10% and the corporate tax rate
is 32%, what is the Weighted Average Cost of
Capital (WACC)?
• A.10.533%
• B.7.533%
• C.9.533%
• D.11.350%
 Q3
• In case the firm is all-equity financed, WACC
would be equal to
• A. Cost of Debt
• B. Cost of Equity
• C. Neither (a) nor (b)
• D. Both (a) and (b)
 Q4
• Cost of Equity Share Capital is more than cost
of debt because:
• A. Face value of debentures is more than face
value of shares,
• B. Equity shares have higher risk than debt,
• C. Equity shares are easily saleable
• D. All of the three above
 Q5
• Equity shares of phonex Ltd are quoted in the
market at Rs17. The dividend expected a year
hence is Rs1.50. The expected rate of dividend
growth is 8%. The cost of equity capital to the
company is
• A.11.08%
• B.13.88%
• C.15.46%
• D.16.82%
 Q6
• Alpha Company has a Birr 1,000 par value,
10% coupon interest rate, and 15 years to
maturity. The bond is currently selling at Birr
1,090. Compute YTM.
A. 9%
B. 10%
C. 11%
D. 12%
CAPITAL BUDGETING

By
Redwan Kelil
Explain capital budgeting
decision and analyze
different CB decisions

1 mark (application)
 Capital Budgeting
• Capital Budgeting is the process of making
investment decisions in capital expenditures.
• It is the process of deciding whether or not to
commit resources to a particular long-term
project whose benefits are to be realized over
a period of time, longer than one year.
• There are many methods of evaluating
profitability of capital investment proposals.
Te various commonly used methods are as
follows:
 METHODS
I) TRADITIONS METHODS:
Pay Back Period Method
Discounted Pay Back Period Method
II) TIME ADJUSTED METHOD OR DISCOUNTED
METHODS:
1. Net present value method
2. Internal rate of return method
3. Profitability index method
 1. PAY- BACK PERIOD METHOD
• The 'pay back' sometimes called as pay out or
pay off period method represents the period
in which the total investment in permanent
assets pays back itself.
• It measures the period of time of the original
cost of a project to be recovered.
• The investment with a shorter payback period
is preferred.
 1. PAY- BACK PERIOD METHOD
Project A Project B
Year Cash flow $Year Cash flow $
0 -700 0 -700
1 100 1 400
2 200 2 300
3 300 3 200
4 400 4 100
5 500 5 0
 Limitation of PBP:
– It fails to consider the time value of money.
– It ignores cash flows beyond the PBP.
– It is a measure of project’s capital recovery, not
profitability.
 Discounted Payback Period
• A major shortcoming of the conventional PBP
is that it does not take into account the time
value of money.
• To overcome this limitation, the discounting
PBP has been suggested.
• In this modified method, cash flows are first
converted into their present values and then
added to ascertain the period of time required
to recover the initial outlay on the project.
 1. PAY- BACK PERIOD METHOD
Project A (10% rate) Project B
Year Cash flow $Year Cash flow $
0 -700 0 -700
1 100 1 400
2 200 2 300
3 300 3 200
4 400 4 100
5 500 5 0
 Accounting Rate of Return
• Average Rate of Return method: Under this
method average profit after tax and
depreciation is calculated and then it is
divided by the total capital outlay or total
investment in the project. In other words, it
establishes the relationship between average
annual profits to total investments.
 Average Rate of Return
• Example : A project requires an investment of
$ 500, 000 and has a scrap value of $ 20, 000
after five years. It is expected to yield profits
after depreciation and taxes during the five
years amounting to $ 40, 000, $60, 000, $ 70,
000, & 50, 000 and $ 20, 000. Calculate the
average rate of return on the investment.
 Average Rate of Return
Solution:
Total profit = $ 40, 000 + 60, 000 + 70, 000 + 50, 000 + 20, 000
= $ 2 40, 000
Average profit = $ 240, 000 = 48, 000
5
Net investment in the project = 500, 000 - 20, 000 ( Scrap Value)
= $ 480, 000
Average Rate of Return
= Average Annual profit X 100
Net investment in the project
= 48, 000 X 100 = 10%
480, 000
 NET PRESENT VALUE METHODS
• The net present values of all inflows of cash
occurring during the entire life of the project is
determined separately for each year by
discounting these flows by the firm's cost of
capital or pre-determined rate.
 NET PRESENT VALUE METHODS
• The net present value method is a modern method of
evaluating investment proposals.
• The NPV of a project is the sum of the present values
of all the cash flows – positive as well as negative –
that are expected to occur over the life of the project.
• Hence, the decision rule associated with the NPV
criterion is:
• Accept the project if the NPV is positive and
• Reject the project if the NPV is negative.
• If the NPV is zero, it is a matter of indifference.
 NET PRESENT VALUE METHODS
Illustration: From the following information
calculate the net present value of the two
projects and suggest which of the two projects
should be accepted assuming a discount rate
of 10%.
 NET PRESENT VALUE METHODS
Project X Project Y
Initial Investment $ 20, 000 $ 30, 000
Estimated Life 5 years 5 years
Scrap Value $ 1, 000 $ 2, 000

Year 1 Year 2 Year 3 Year 4 Year 5

Project X $ 5, 000 $ 10, 000 $ 10, 000 $ 3, 000 $ 2, 000

Project Y $ 20, 000 $ 10, 000 $ 5,000 $ 3,000 $ 2, 000

 = 24, 227

SOLUTION
P.V of $
@10%
P. V of
Year C.F $ (D.R)
Net C.F $ Present Value =24,227
Using Pv.
= (20, 000)
Tables
1. 5, 000 0.909 4,545 NPV =4,227
2. 10, 000 0.826 8,260
3. 10, 000 0.751 7, 510
4. 3, 000 0.683 2, 049
5. 2, 000 0.621 1, 242
5. (S.V) 1, 000 0.621 621
24,227
 INTERNAL RATE OF RETURN METHOD
• The IRR of a project is the discount rate which
makes its NPV equal to zero.
• It is the discount rate which equates the
present value of future cash flows with the
initial investment.
 INTERNAL RATE OF RETURN METHOD
To illustrate the calculation of IRR, consider the
cash flows of a project being considered by XYZ
company.
Year Cash flow
0 (100,000)
1 30,000
2 30,000
3 40,000
4 45,000
 INTERNAL RATE OF RETURN METHOD

Let us, to begin with, try r = 15 percent.

This makes the right-hand side equal to:
100,000 = 30000/(1.15)1 + 30000/(1.15)2 +
40000/(1.15)3 + 45000/(1.15)4
= 100,802
The right-hand side becomes:
100,000 = 30000/(1.16)1 + 30000/(1.16)2 +
40000/(1.16)3 + 45000/(1.16)4 = 98,641
 INTERNAL RATE OF RETURN METHOD
• Since this value is now less than 100,000, we
conclude that the value of r lies between 15
percent and 16 percent.
• Determine the NPV of the two closest rates of
return.
• (NPV/15 percent) = 802
• (NPV/16 percent) = (1,359)
 INTERNAL RATE OF RETURN METHOD

Find the sum of the absolute values of the NPV

obtained in step 1:
=802 + 1359 = 2,161
Calculate the ratio of the NPV of the smaller
discount rate, identified in step 1, to the sum
obtained in step 2:
=802/2161 = 0.37
 INTERNAL RATE OF RETURN METHOD

4. Add the number obtained in step 3 to the

smaller discount rate:
15 + 0.37 = 15.37 percent
The decision rule for IRR is as follows:
Accept : If the IRR is greater than the cost
of capital
Reject : If the IRR is less than the cost of
capital
Questions on Capital budgeting
 Q1
• Which of the following variable is not known
in IRR?
• A. discount rate
• B. terminal inflows
• C. life of the project
• D. intitial cash flows
 Q2
Under net present value criteria, a project is
approved if ……
• A.NPV is positive
• B. The funds are unlimited
• C. Both A & B
• D. None of these
 Q3
• The internal rate of return is:
A. the interest rate at which money is borrowed
for investment.
B. the interest that allows a profit
C. profit divided by investment amount.
D. the interest rate that equates the present
value of an investment with its cost
 Q4
• The internal Rate of Return (IRR) criterion for
project acceptance, under theoretically
infinite funds is: accept all projects which
have
• A.IRR equal to the cost of capital
• B.IRR greater than the cost of capital
• C.IRR less than the cost of capital
• D.None of the above
 Q5
• A project requires an investment of
Rs500000and has scrape value of Rs.20000
after five years. It is expected to yield profits
after depreciation and taxes during the five
years amounting to Rs.40000,Rs60000,
Rs.50000,Rs70000 and Rs20000.What is the
average rate of return on the investment?
• A.10%
• B.11%
• C.12%
• D.13%