BA5012 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

UNIT – I

INVESTMENT SETTING

MEANING OF INVESTMENT

Investment involves employment of funds with the aim of achieving additional income or growth in
values .

DEFINITION

Investment may be defined as “ a commitment of funds made in the expectation of some positive rate of return
“.Every investment involves return and risk.

FINANCIAL MEANING OF INVESTMENT

Investment is the commitment of a person’s funds to derive future income in the form of
interest,dividend,premiums, pension benefits or appreciation in the value of their capital. Purchasing of
shares,debentures, post office savings certificates, insurance policies are all investments in the financial sense.
Such investments generate financial assets.

ECONOMIC MEANING OF INVESTMENT

Investment means the net additions to the economy’s capital stock which consists of goods and services that are
used in the production of other goods and services. New constructions, plant and machinery, inventories, etc.
physical assets.

CHARACTERISTICS OF INVESTMENT

RETURN

All investments are characterized by the expectation of a return .The return may be received in the form of yield
plus capital appreciation. The difference between the sales price and the purchase price is capital appreciation
.dividend or interest received from the investment is the yield . Return based on the nature of investment, maturity
period and other factors.

RISK

The risk may relate to loss of capital , delay in repayment of capital , non-payment of interest or variability of returns.
Government securities and bank deposits are riskless, others are more risky .

FACTORS

1. The longer the maturity period, the larger is the risk.

2. The lower the credit worthiness of the borrower , the higher is the risk.

3. The risk varies with nature of investment .

E.g., investment in ownership securities like equity shares carry higher risk compared to debentures and bonds .

SAFETY

The safety of an investment implies the certainty of return of capital without loss of money or time .
LIQUIDITY

An investment which is easily saleable or marketable without loss of money and without loss of time is said to
possess liquidity. Company deposits , P.O deposits , bank deposits, NSS,NSC are not marketable. Preference , debt ,
equity are easily marketable .

OBJECTIVES OF INVESTMENT

The objective of the investor is to minimize the risk involved in investment and maximizes the return from the
investment.

1.Maximisation of return

2.Minimisation of risk

3.Hedge against inflation

 Government securities would constitute the low risk category as they are practically risk free.
 Debentures and preference shares of companies may be classified as medium risk assets.
 Equity shares of companies would form the high risk category of financial assets.

There is a trade-off between risk and return .

 Savings are invested to provide a hedge or protection against inflation .

 Some investors are risk averse , some may have an affinity to risk.

 A person with higher income to have a higher risk bearing capacity.

 Each investor tries to maximize his welfare by choosing the optimum combination of risk and expected
return in accordance with his preference and capacity.
INVESTMENT VS SPECULATION

Factors INVEST SPE SPECULATION

INVESTMENT CULATION
MiiiiENT
1.RISK An investor commits his A speculator commits his funds to higher risk. Higher
funds to low risk risk-higher return.
2.CAPITAL GAIN Stable return and capital Buying low and selling high with the hope of making
appreciation over a large capital gains. Market actions and price
period of time movements
3.TIME PERIOD Long-term in nature Short-term
 INVESTMENT vs GAMBLING
Gambling E.g., horse races , card games , lotteries , etc.

factors INVESTMENT GAMBLING

1.RISK AND Moderate and continuous return High risk and high return
RETURN .Artificial and unnecessary
risks are created for increasing
the returns.
2.PLAN Planned and scientific one Unplanned and non-scientific

3.CERTAINTY More certain It involves uncertainty and is

based on tips and rumours.

TYPES OF INVESTMENT

 Financial Instruments
 Non-financial Instruments
Financial Instruments
 Equities
Equities are a type of security that represents the ownership in a company. Equities are traded (bought and sold)
in stock markets. Alternatively, they can be purchased via the Initial Public Offering (IPO) route, i.e. directly
from the company. Investing in equities is a good long-term investment option as the returns on equities over a
long time horizon are generally higher than most other investment avenues. However, along with the possibility
of greater returns comes greater risk.

Mutual funds
A mutual fund allows a group of people to pool their money together and have it professionally managed, in
keeping with a predetermined investment objective. This investment avenue is popular because of its cost-
efficiency, risk-diversification, professional management and sound regulation.

Bonds

Bonds are fixed income instruments which are issued for the purpose of raising capital.Both private entities, such
as companies, financial institutions, and the central or state government and other government institutions use this
instrument as a means of garnering funds. Bonds issued by the Government carry the lowest level of risk but
could deliver fair returns.

Fixed Deposits

Investing in bank or post-office deposits is a very common way of securing funds.These instruments are at the
low end of the risk-return spectrum.

Cash equivalents

These are relatively safe and highly liquid investment options. Treasury bills and money market funds are cash
equivalents.

Life Insurance
Life insurance is also one of the safest modes of investment, if you are looking for investing in the long term. If the
insured does not die before the maturity of the term, then money that you get on maturity is quite a good amount.

The best part of this type of investment is that you do not have to pay tax on the invested money. It is very good
option for those who are not market savvy and do not want to invest in schemes that are prone to risks. It is
encourages savings as you have to compulsorily keep aside a small amount of money for it.

E.g., It makes you less dependent financially when you need a large sum of money (for example child's education
or marriage) after you retire.

Money market account:

A type of savings account that offers a competitive rate of interest (real rate) in exchange for larger-than-normal
deposits.

Exchange-Traded Fund (ETF):

ETFs are funds – sometimes referred to as baskets or portfolios of securities – (ETFs) are open-ended investment
funds listed and traded on a stock exchange. Your money is pooled with money from other investors and invested
according to the ETF’s stated investment objective.

Unit Trusts

UTI is a public sector financial institution which mobilizes savings specially from the households sector and
reinvest the funds in to different investment outlets .

 Managed by board of trustees and Chairman appointed by the Central government .

 Safety and liquidity is the objective of UTI .

If you invest in a unit trust or fund, your money is pooled with money from other investors and invested in a
portfolio of assets according to the fund’s stated investment objective and investment approach.

Contract for Differences

A CFD allows you to speculate on future market movements of the underlying asset, without actually owning or
taking physical delivery of the underlying asset.

Investment-Linked Insurance Policies

Investment-linked insurance policies (ILPs) have both life insurance and investment components. Your premiums
are used to pay for units in investment–linked fund(s) of your choice. Some of the units you buy are then sold to
pay for insurance and other charges, while the rest remain invested

Non-financial Instruments

Real estate

With the ever-increasing cost of land, real estate has come up as a profitable investment proposition.

Gold

The 'yellow metal' is a preferred investment option, particularly when markets are volatile.Today, beyond physical
gold, a number of products which derive their value from the price of gold are available for investment. These
include gold futures and gold exchange traded funds.
 INVESTMENT ALTERNATIVES

NEGOTIABLE INSTRUMENTS

1.VARIABLE INCOME SECURITIES

Equity shares or common stock or ordinary shares.

2.FIXED INCOME SECURITIES

 Preference shares

 Debentures

 Bonds

 KVPs and IVPs

 Government securities

 Money market instruments – Treasury Bills , Commercial Paper , Certificate of Deposits .

NON NEGOTIABLE INSTRUMENTS

1.DEPOSITS

 Banks

 Post office

 NBFC

2.TAX SHELTERED

 NSS

 NSC

 PPF

3.LIFE INSURANCE

4.MUTUAL FUNDS

5.REAL ASSETS

 Real Estate

 Gold and Silver

 Art

 Antiques

EQUITY SHARES(VARIABLE INCOME)

  Equity shareholders has a pre-emptive rights at the time of company rising its capital.They have a voting rights
in the company.

 Sweat equity – it means retaining the employee in the company by issuing shares to them with a discount rate .

 It involves high risk and high return .

 Real owners of the company and the ownership is determined by the no of shares a person owns divided by the
total no of shares outstanding .

PREFERENCE SHARES(FIXED INCOME)

P.S are those shares which during the life time of the company are entitled to a priority in the payment of dividends at a
fixed rate, and the return of capital in the event of winding up of the company .

TYPES OF PREFERENCE SHARES

1.Cumulative preference shares

2.Non-cumulative

3.Participating

4.Non-participating

5.Redeemable

6.Irredeemable

7.Convertible

8.Non-convertible

DEBENTURES

A debenture is a document issued by the company as an acknowledgement of debt .Fixed rate of interestDebenture
holder is a creditor of the company .

TYPES OF DEBENTURES

 Simple or naked or unsecured debentures – are not given any security on debt.

 Secured or mortgage debentures – given security on assets of the company .

 Bearer debentures – easily transferable.

 Registered debentures – which are registered with the company ,proper procedure should be followed to transfer.
Both transferor and transferee are expected to sign the transfer deed.

 Redeemable debentures – are to be redeemed on the expiry of a certain period , interest periodically , principal
after a fixed period.

 Irredeemable / perpetual debentures – which can be repaid at the time of winding up .

 Convertible debentures – which can be converted into shares or other category of debentures.

 Non-convertible debentures – cannot be converted.

 Partly convertible – part convert into shares and the remaining part non-convertible portion.

 Zero interest debentures – usually convertible debentures which yields no interest. The investor is compensated
for the loss of interest through conversion into equity shares at a specified future date.

BOND

 Public sector companies issue the bonds.

 KVP AND IVP

 KVP – KISAN VIKAS PATRA - Minimum Investment Rs. 500/- No maximum limit.

 Rate of interest 8.40% compounded annually.

 Money doubles in 8 years and 7 months.

 Interest income taxable but no TDS

 Deposits are exempt from Wealth tax.

 IVP – INDIRA VIKAS PATRA –

 (IVP-Get fixed amount on maturity on the initial deposit after few years with interest)amount around Rs.1000
and Rs.5000. the amount paid in the post office, comparatively the interest rate will be more .

GOVERNMENT SECURITIES

Issued by the government. The amount is fixed one and interest rate is low.

TREASURY BILLS

are short term Government securities. They have Liquidity. They do not have the default risk . issued less
than one year typically three months.

NBFC – Registered with the Reserve Bank of India. It provides more interest to the depositors . Risk is more

 COMMERCIAL PAPER – are short term un-secured securities issued by the highly credit worthy large
companies. They are marketable securities, issued with a maturity of 3 months to one year.

 CERTIFICATE OF DEPOSITS – A CD is a negotiable instrument evidencing a deposit with a bank. amount

restricted to Rs.10,00,000. interest rate is vary and it is one type of short term instrument. Maximum one year .

DEPOSITS

BANKS – 3 TYPES

Current account – no interest

Saving account- less interest

Fixed deposit a/c – high interest.

POST OFFICE

Interest rates are higher than the banks.

2 TYPES:
 Monthly installment, Fixed deposit.

TAX SHELTERED

NSS – NATIONAL SAVING SCHEME

Considered the tax deduction .

NSC – NATIONAL SAVING CERTIFICATE – Designed for govt. employees ,business man ,and other salaried class
who are income tax assesses.no maximum limit for investment , no tax deduction at source. Investment up to
Rs.1,00,000 per annum.Theamount returned only after the maturity period . Income is fully taxable.

PPF – PUBLIC PROVIDENT FUND

A minimum yearly deposit of Rs. 500 is required to open and maintain a PPF account, and a maximum deposit of
Rs.100000/ can be made in a PPF account in any given financial year. Save a fraction of salary of the employees.

LIFE INSURANCE – Fully exempted from taxation.

MUTUAL FUNDS – Invest different avenues.

2TYPES: OPEN ENDED , CLOSE ENDED.

REAL ASSETS

REAL ESTATE – Purchase land and sell in the future to earn profit .

GOLD AND SILVER – Invest in gold it gives appreciation in value .

ART – purchase some paintings and its value will increase in future .

ANTIQUES – Collecting coins , protecting historical items , new statues or sculptures

CHOICE AND EVALUATION OF INVESTMENT

INVESTMENT EVALUATION

Three steps are involved in the evaluation of an investment.

 Estimation of cash flows

 Estimation of the required rate of return (the opportunity cost of capital)
 Application of a decision rule for making the choice .

Investment decision rule

The following other characteristics should also be possessed by a sound investment evaluation criterion.
 It should consider all cash flows to determine the true profitability of the project.
 It should provide for an objective and unambiguous way of separating good projects form bad projects.
 It should help ranking of projects according to their true profitability.
 It should recognize the fact that bigger cash flows true profitability.
 It should recognize the fact that bigger cash flows are preferable to smaller once and early cash flows are
preferable to later ones.
 It should help top choose among mutually exclusive projects that project which maximizes the
shareholders’ wealth.
 It should be a criterion which is applicable to any conceivable investment project independent of other.

VALUATION OF INVESTMENT
 The valuation helps the investor to determine the return and risk expected from an investment in the common
stock. The intrinsic value of the share is measured through the book value of the share and price earningratio.
Simple discounting models also adopted to value the shares.The real worth of the share is compared with the
market values and then the investment decisions are made.

FUTURE VALUE

Future value of the securities are estimated by using a simple statistical technique like trend analysis . The analysis
of the historical behavior of the price enables the investor to predict the future value.

EVALUATION

The portfolio has to be managed efficiently . The efficient management calls for evaluation of the portfolio. The process
consists of portfolio appraisal and revision.

APPRAISAL

The return and risk performance of the security vary from time to time.The variability in returns of the securities is
measured and compared.The developments in the economy , industry and relevant companies from which the stocks
are bought have to be appraised. The appraisal warns the loss and steps can be taken to avoid such losses.

REVISION

Revision depends upon the results of the appraisal .The low yielding securities with high risk are replaced with high
yielding securities with low risk factor.The investor revise the components of the portfolio periodically.

EVALUATION CRITERIA
A number of investments criteria (or capital budgeting techniques) are in use in proactive. They may be grouped in the
following two categories:

1. Discounted cash flow (DCF) criteria

• Net present value (NPV)
• Internal rate of return (IRR)
• Profitability index (PI)

2. Non-discounted cash flow criteria

• Payback period (PB)
• Discounted payback period
• Accounting rate of return (ARR).

NPV – NPV is the sum of all cash flows adjusted by the discount rate.

ROA – Return on assets

ROI – Return on Investment

ROFE – Return on funds employed

ROCE – Return on capital employed

Earnings

Investment
 Net Income

ROE =

Shareholder’s Equity Book value.

IRR – Is the discount rate that sets the NPV to zero .

IRR > Opportunity cost of capital = accept .

PROFITABILITY INDEX – preference against large-scale project.

PAY BACK – How long does it take for the project to pay back.

RISK AND RETURN CONCEPTS

MEANING OF RISK

The expected return is the uncertain future return that an investor expects to get from his investment . The
realized return is the certain return that an investor has actually obtained from his investment at the end of the
holding period . The possibility of variation of the actual return from the expected return is termed risk .

DEFINITION OF RISK

Risk can be defined in terms of variability of returns. “ Risk is the potential for variability in returns .”
elements of risk may be broadly classified into two groups .

SYSTEMATIC RISK

The risk comprises factors that are external to a company and affect a large number of securities simultaneously.
These are mostly uncontrollable in nature.

UNSYSTEMATIC RISK

This risk includes those factors which are internal to companies and affect only those particular companies. These
are controllable to a greater extent. total variability in returns of a security represents the total risk of that security
.

Total Risk = Systematic Risk + Unsystematic Risk .

SYSTEMATIC RISK

As the society is dynamic, changes occur in the economic, political and social systems constantly. These changes
have an influence on the performance of companies and there by on their stock prices.

For Example: economic and political instability adversely affects all industries and companies. Recession etc.

Systematic risk is subdivided into:

1. Interest rate risk

 2. Market risk

3. Purchasing power risk .

INTEREST RATE RISK

It is a type of systematic risk that particularly affects debt securities like bonds and debentures . A bond or
debenture has a fixed rate coupon rate of interest .

E.g., face value Rs.100. Coupon rate 10%, market interest rate 10% - may be market interest rate moves up to
12.5%. The price of the bond should reduced as Rs.80.

The variation in bond prices caused due to the variation in interest rate is known as interest rate risk.

MARKET RISK

It affects shares. Market price of shares move up or down consistently for some time periods.A general rise in
share prices is referred to as a bullish trend , whereas a general fall in prices is referred to as a bearish trend .

Index, NSE Index etc..

The stock market is seen to be volatile. This volatility leads to variations in the returns of investors in shares. The
variation in returns caused by the volatility of the stock market is referred to as the Market risk.

PURCHASING POWER RISK

It refers to the variation in investor returns caused by inflation. Inflation results in lowering of the purchasing power of
money. The two important sources of inflation are raising costs of production and excess demand for goods and
services in relation to their supply. They are known as cosMovement can be easily seen in the movement of share
price indices such as the BSE Sensitive Index, BSE National t-push and demand-pull inflation.

DEMAND-PULL INFLATION

When demand is increasing but supply cannot be increased, price of the goods increases thereby forcing out some
of the excess demand and bringing the demand and supply into equilibrium. This phenomenon is known as
Demand –Pull Inflation.

COST-PUSH INFLATION

It occurs when the cost of production increases and this increase in cost is passed on to the consumers by the
producers through higher prices of goods.

UNSYSTEMATIC RISK

When variability of returns occurs because of such firm-specific factors, it is known as Unsystematic risk.

E.g., raw material scarcity, labor strike, management inefficiency.

The Unsystematic or Unique risk affecting specific securities arises from two sources.

A. Operating environment of the company

B. The financing pattern adopted by the company.

These two types referred to as Business risk and Financial risk.

BUSINESS RISK
 Business risk is thus a function of the operating conditions faced by a company and is the variability in operating
income caused by the operating conditions of the company.

Internal and external environment

Operating costs

Fixed cost is higher than variable cost it will affect the operating profit.

FINANCIAL RISK

The variability in EPS due to the presence of debt in the capital structure of a company is referred to as financial
risk. It’s an avoidable risk.

Fixed payment of interest to debt compulsory if the company earn profit or loss., operating profit low it affect
EPS .

MEASUREMENT OF RISK

Every investor tries to measure or quantify the risk of each investment that he considers before making the final
selection.

The quantification of risk is necessary for investment analysis. Risk in investment is associated with return.

Forecasted dividend + forecasted end of the period stock price

Return = -1

Initial Investment

RETURN

The income from investment.

ELEMENTS IN RETURN

It consists of two components.

1. The basic component is the periodic cash receipts (or income) on the investment , either in the form of interest
or dividends.

2. The change in the price of the asset –commonly called the capital gain or a loss .

Yield refers to the income component in relation to some price for a security.

Total return = Income + Price change (+ / - ) .

RETURN APPLICATIONS

 ARITHMETIC AND GEOMETRIC RETURN

 ARITHMETIC AVERAGE

The sum of each values being considered divided by the total number of values.

∑x

X =
 n

GEOMETRIC AVERAGE – is defined as the n th root of the product resulting from multiplying a series of
returns together, 1/n

G = [ (1+R1)(1+R2)….(1+Rn)] - 1

Where: R = Total return

n = Number of periods.