RISK AND RETURN ANALYSIS OF EQUITY SHARES WITH SPECIAL REFERENCE TO SELECT MUTUAL FUND COMPANIES (USING CAPITAL ASSET PRICING MODEL)

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RISK AND RETURN ANALYSIS OF EQUITY SHARES WITH SPECIAL REFERENCE TO SELECT MUTUAL FUND COMPANIES (USING CAPITAL ASSET PRICING MODEL) DR.S.NIRMALA 1 K.

1 RISK AND RETURN ANALYSIS OF EQUITY SHARES WITH SPECIAL REFERENCE TO SELECT MUTUAL FUND COMPANIES (USING CAPITAL ASSET PRICING MODEL) DR.S.NIRMALA 1 K.DEVENDRAN 2 1 Rathnavel Subramanian College of Arts and Science (Autonomous), Sulur, Coimbatore, Tamilnadu. 2 II M.Com, PG, Rathnavel Subramaniam College of Arts and Science (Autonomous), Sulur, Coimbatore, Tamilnadu. ABSTRACT Financial markets are not free from the risk of imperfections, which make results inconsistent with the expectations. The concept of risk management assumes greater importance in the modern day financial management.investing always involves a certain amount of risk, ie, there is a chance that an investment will yield not only profit but also loss. This study aims to study the risk and return of select five mutual fund companies listed at NSE.As the main object of the study is to test the relation between risk and return on equity shares of mutual fund companies in India, the sample were randomly selected from NSE 500 index.the risk and return analysis done by using Capital Asset Pricing Model and Performance analysis done by using Jenson s Alpha.It can be concluded from the study that the investors can choose SBI and ICICI to invest their fund because their cost of capital and risk is less and they are performing too good. This could be understand from the Jenson s Alpha that these two companies earned more than 7% excess return than the expected return. Long term investors were able to take advantage of the market as it less volatile. As there is less fluctuation in the shares when compared to market as well as its prices, the long term investors able to predict about when the share will raise. Key words: Beta, Cost of Equity, Cost of Debt, Cost of Capital, CAPM, Risk free Rate, Risk Premium, Jenson s Alpha. Introduction The Indian stock market has gained a new dimension of life in the post-liberalization era. The present competitive globalized business scenario evidenced that risk is attached with every business process. Financial markets are not free from the risk of imperfections, which make results inconsistent with the expectations. The concept of risk management assumes greater importance in the modern day financial management. The objective of financial investing is to earn the largest possible profit or return on investment.investing always involves a certain amount of risk, ie, there is a chance that an investment will yield not only profit but also loss. Thus investing aims at profit maximization and risk minimization. This study aims to study the risk and return of select five mutual fund companies listed at NSE. Statement of the Problem The research on stock market is essential to good financial and investment decision making. To evaluate and choose the right security or portfolio to an investor requires a detailed research on the level of risk that the stock carries. An estimation of the riskreturn profile of a security or portfolio is an important aspect in investment management. The stock market research will allow one to assess the possible risk of a stock against the possible rewardsthe stock may offer. The present study in this 25 editor@researchscripts.org

2 context is relevant in explaining the parity between risk and return in the Indian equity market. It will definitely help the stakeholders to take appropriate decision regarding the time of investment, horizon of investment, quantum of investment and even portfolioselection. Objectives of the Study To study the Capital Asset Pricing Model. To measure the risk and return of select mutual fund companies listed NSE by using CAPM. To analyse the performance of stock of select companies by using Jenson s Alpha. Methodology As the main object of the study is to test the relation between risk and return on equity shares of mutual fund companies in India, the sample were randomly selected from NSE 500 index. The period covered is from April 2011 to March The risk and return analysis done by using Capital Asset Pricing Model and Performance analysis done by using Jenson s Alpha. Limitations of the study The generality of this research is restricted due to certain limitations. Most of these limitations are offshoots of the self-imposed restrictions during the process of research, for keeping research within manageable limits. It may be recalled that the study is based on secondary data collected from Annual reports of the companies concerned. The limitations of the secondary data if any will also influence the study. Review of Literature Sangeetha and Dheeraj (2007) studied the risk return relation using market and accounting based information and found that risk computed on the basis of accounting information was not significantly captured by the market but financial risk had significant influence. Madhu and Tamimi (2010) in their study revealed that CAPM held good in Indian stock market in explaining the systematic risk and establishing the tradeoff between risk and return. In order to establish the positive risk-return relationship between equity returns and different distributional and financial risk variables. Risk and Return Analysis of Select Mutual Fund Companies Risk and return analysis plays a key role in most individual decision making process. Every investorwants to avoid risk and maximize return. In general, risk and return go hand. If an investor wishes to earn higher returnsthan the investor must appreciate that this will only be achieved by accepting a commensurate increase in risk. Based on risk and return analysis, high risk gives high returns with low risk gives to low return. The top five mutual fund companies selected for this study are Kotak Mahindra, HDFC, ICICI, SBI and IDFC. The Capital Asset Pricing Model One tool that finance professionals use to calculate the return that an investment should bring is the Capital Asset Pricing Model which we will refer to as CAPM. The capital asset pricing model (CAPM) is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for the pricing of risky securities, generating expected returns for assets given the risk of those assets and calculating costs of capital. The formula for calculating the expected return of an asset given its risk is as follows: 26 editor@researchscripts.org

3 Measurement of Risk Beta is a statistical measure of the variability of a company s stock price in relation to the stock market overall. Every stock is exposed to two types of risks Non-Systematic Risks include risks that are specific to a company or industry. This kind of risk can be eliminated through diversification across sectors and companies.. The effect of diversification is that the diversifiable risks of various equities can offset each other. Systematic Risks are those risks that affect the overall stock markets. Systematic risks can t be mitigated through diversification but can be well understood via an important risk measure called as BETA Beta measures the stock risks in relation to the overall market. If Beta = 1: If Beta of the stock is one, then it has the same level of risk as the stock market. Hence, if stock market rises up by 1%, the stock price will also move up by 1%. If the stock market moves down by 1%, the stock price will also move down by 1%. If Beta > 1: If the Beta of the stock is greater than one, then it implies higher level of risk and volatility as compared to the stock market. Though the direction of the stock price change will be same, however, the stock price movements will be rather extremes. If Beta >0 and Beta<1: If the Beta of the stock is less than one and greater than zero, it implies the stock prices will move with the overall market, however, the stock prices will remain less risky and volatile. Calculation of Beta for the select Companies The risk of selected stocks can be identified by using either of the three methods to calculate Beta 1) Variance/Covariance Method 2) SLOPE Function 3) Data Regression. The present study adopted the third method i.e data regression to measure the risk. Table 1 - Measurement of risk of Select Companies Risk (Beta β) Kotak HDFD ICICI SBI IDFC It is inferred from the above table in all the select mutual fund companies, the 1 % change in the market return causes less than a percent in the stocks concerned. This shows that the returns of these stocks are less volatile compare with the market. 1% changes in the market leads to 0.65% changes in the stock return of HDFC which is highest among the select stocks. The stocks of SBI mutual funds and ICICI mutual funds are almost risk free since it has too less number of beta. It leads to conclude that these stocks are less volatile and yields constant return editor@researchscripts.org

4 Cost of Equity The cost of equity is the return that stockholders require for their investment in a company. The cost of equity can be a bit tricky to calculate as share capital carries no "explicit" cost. Unlike debt, which the company must pay in the form of predetermined interest, equity does not have a concrete price that the company must pay, but that doesn't mean no cost of equity exists. Common shareholders expect to obtain a certain return on their equity investment in a company. The equity holders' required rate of return is a cost from the company's perspective because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop. The cost of equity is basically what it costs the company to maintain a share price thatis theoretically satisfactory to investors. On this basis, the most commonly accepted method for calculating cost of equity comes from the Nobel Prize-winning capital asset pricing model (CAPM): The cost of equity is expressed below: Cost of Equity = Risk Free Rate + Beta x Risk Premium Table 2 - Cost of Equity of select companies COMPANY RISK FREE BETA RISK PRIMIUM COE=RISKFREERATE RATE +(BETA *RISK PRIMUM) KOTAK 5.03% % 8.83% HDFC 5.03% % 9.84% ICICI 5.03% % 5.04% SBI 5.03% % 5.06% IDFC 5.03% % 7.00% The above table reveals the cost of equity i.e the minimum expected rate of return from the select companies. The minimum expected rate of return from HDFC is highest among the select companies because the rate risk in this company is high compare with other companies. The hurdle rate i.e minimum expected rate of return from SBI and ICICI is low since the risk of these companies related to the market is very low. Cost of Debt The cost of debt represents the cost to a company of its debt finance. A distinction must be made between the required return of debt holders / lenders (K d ) and the company's cost of debt (K d (1-T)). Although in the context of equity the company's cost is equal to the investor's required return, the same is not true of debt. This is because of the impact of tax relief. The cost of debt needs to be determined as part of calculating a weighted average cost of capital for use as a discount rate for investment appraisal. Table 3 - Cost of Debt of Select Companies Debt Interest Cost of Debt Kotak 314,148,793 10,187, % HDFC 530,184,746 3,616, % SBI % ICICI 1,748,073,779 1,582, % IDFC 0 0 0% 28 editor@researchscripts.org

5 From the table 3, it is clear that the IDFC has no debt and the whole part of its capital employed is financed through the insider s fund. Cost of Debt to Kotak is higher compare with other companies. The cost of debt is very cheap at ICICI. This definitely help them improving their profitability. The value of this company may also be increased due to the higher return to the shareholders since interest is too low. Cost of Capital The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Generally speaking, a company's assets are financed by debt and equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. Table Debt Equity Composition Debt % Owners Capital % Kotak 314,148,793 59% 221,533,150 41% HDFC 530,184,746 42% 726,777,647 58% SBI % % ICICI 1,748,073,779 66% 897,288,813 34% IDFC 0 0% 87,845,577, % The above table presents the debt equity composition of the select companies. IDFC has financed their project only through share capital. No debt is claimed by them. This shows that they have enough chance to rise debt capital for their future projects. They have enough capacity to raise debt financing with cheaper rate. Among the companies selected, ICICI and SBI has more than 60 percent of their capital with borrowings and only less than 40 percent is financed through equity. The reason behind this may be due to the tax advantage of debt finance. Table 5 - Weighted Average Cost of Capital Debt % Owners Capital % Cost of Debt Cost of equity WACC Kotak 314,148,793 59% 221,533,150 41% 3.24% 8.83% 5.55% HDFC 530,184,746 42% 726,777,647 58% 0.68% 9.84% 5.98% SBI % % 0.28% 5.04% 2.14% ICICI 1,748,073,779 66% 897,288,813 34% 0.09% 5.06% 1.78% IDFC 0 0% 87,845,577, % 0% 7.00% 7.00% The table 5 shows that the weighted average cost of capital under CAPM. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors.wacc serves as a useful reality check for investors. To be blunt, the average investor probably wouldn't go to the trouble of 29 editor@researchscripts.org

6 calculating WACC because it is a complicated measure that requires a lot of detailed company information. Nonetheless, it helps investors to know the meaning of WACC when they see it in brokerage analysts' reports. It can be concluded that the cost of capital i.e the minimum expected rate of return for the select companies are minimum and the actual return from the market is high. So the investor can choose these companies to invest their fund for good returns. These companies have less risk and give more returns to the investors. Performance measure of Stocks of select companies The Jensen's measure is a risk-adjusted performance measure that represents the average return on a portfolio or investment above or below that predicted by the capital asset pricing model (CAPM) given the portfolio's or investment's beta and the average market return. This metric is also commonly referred to as Jensen's alpha, or simply alpha. Jensen's Alpha is important to investors because they need to look not only at the total return of a security or portfolio, but also at the amount of risk involved in achieving that return. Calculation of Jenson s Alpha Assuming the CAPM is correct, Jensen's alpha is calculated using the following four variables: R(i) = the realized return of the portfolio or investment R(m) = the realized return of the appropriate market index R(f) = the risk-free rate of return for the time period B = the beta of the portfolio of investment with respect to the chosen market index Using these variables, the formula for Jensen's alpha is: JENSEN'S ALPHA = PORTFOLIO RETURN [RISK FREE RATE + PORTFOLIO BETA * (MARKET RETURN RISK FREE RATE)] Alpha = R(i) - (R(f) + B x (R(m) - R(f))) Table 6 - Performance measure based on Jenson s Alpha Company Monthly risk R(1-ß) Excess return KOTAK % IDFC % SBI % ICICI % HDFC % From the above table, it is clear that SBI and ICICI managers did well because they have given 7.22 % and 7.30% excess returns than the expected minimum return. So the investors can choose these two companies to invest their money to get higher returns. IDFC register negative return which means that this company did not do well and they have not even earned the minimum rate of return expected. Kotak and HDFC also did well since they have excess returns editor@researchscripts.org

7 Summary of Findings and Conclusion Most businesses have assets financed by capital providers. The cost of capital is a measure of the returns required by those capital providers. Its main use is to set a target for the profits, which must be achieved on the firm's assets in order to satisfy equity and bond holders. The following paragraphs present the summary of findings from the application of CAPM on the five select mutual fund companies. Beta: The stocks of SBI mutual funds and ICICI mutual funds are almost risk free since it has too less number of beta. It leads to conclude that these stocks are less volatile and yields constant return. Cost of Equity: The cost of equity of the select companies reflected the risk involved. The cost of capital is too high for HDFC and it is low for SBI and ICICI. Cost of Debt: It is clear from this analysis that IDFC has no debt in its capital structure and the highest cost of debt is rested with Kodak. Cost of Capital: The cost of capital i.e. the minimum expected rate of return from SBI and ICICI is too low since there is less risk involved in these companies related to the market volatility. Performance Measure: The excess return from Jenson s Alpha calculation reveals that SBI and ICICI earned more than 7 % excess return compare with their expected return. IDFC s performance is not good because it has earned less than the minimum expected return. Conclusion Risk and return analysis plays a key role in most individual decision making process. Every investorwants to avoid risk and maximize return. In general, risk and return go hand. If an investor wishes to earn higher returns than the investor must appreciate that this will only be achieved by accepting a commensurate increase in risk. Based on risk and return analysis, high risk gives high returns with low risk gives to low return. It can be concluded from the study that the investors can choose SBI and ICICI to invest their fund because their cost of capital and risk is less and they are performing too good. This could be understood from the Jenson s Alpha that these two companies earned more than 7% excess return than the expected return. Long term investors were able to take advantage of the market as it less volatile. As there is less fluctuation in the shares when compared to market as well as its prices, the long term investors able to predict about when the share will raise. References: 1) Bartov, E., Bodnar, G. M., &Kaul, A. (1996). Exchange rate variability and the riskiness of US multinational firms: evidence from the breakdown of the Bretton Woods system. Journal of Financial Economics, 42(1), ) Bodnar, G. M., & Wong, M. F. (2003). Estimating exchange rate exposures: issues in model structure. Financial Management, editor@researchscripts.org

8 3) Chang, Y. (2002). The pricing of foreign exchange risk around the Asian financial crisis: evidence from Taiwan's stock market. Journal of Multinational Financial Management, 12(3), ) Chen, N. F., Roll, R., & Ross, S. A. (1986). Economic forces and the stock market. Journal of business, 59(3), ) Choi, J. J., & Prasad, A. M. (1995). Exchange risk sensitivity and its determinants: a firm and industry analysis of US multinationals. Financial Management, 24(3), ) Choi, J. J., Elyasiani, E., &Kopecky, K. J. (1992). The sensitivity of bank stock returns to market, interest and exchange rate risks. Journal of banking & finance, 16(5), ) Chow, E. H., & Chen, H. L. (1998). The determinants of foreign exchange rate exposure: evidence on Japanese firms. Pacific-Basin Finance Journal, 6(1), editor@researchscripts.org

RISK-RETURN RELATIONSHIP ON EQUITY SHARES IN INDIA

RISK-RETURN RELATIONSHIP ON EQUITY SHARES IN INDIA 1. Introduction The Indian stock market has gained a new life in the post-liberalization era. It has experienced a structural change with the setting