BFN721

NATIONAL OPEN UNIVERSITY OF NIGERIA
FACULTY OF MANAGEMENT SCIENCES
COURSE DEVELOPMENT
Course Code BFN721
Course Title Investment and Portfolio Management
Writer Dr. Okoh, Johnson Ifeanyi

Department of Financial Studies
Faculty of Management Sciences
Course Editor Assoc. Prof. Uwaleke, U. Joseph, ACIB, FCA

Department of Banking and Finance
Faculty of Administration
Programme Coordinator DR. OKOH JOHNSON IFEANYI

Head of Department Dr. Ofe. Inua

CONTENTS PAGE
Introduction…………………………………………………………
What you will Learn in this Course ……………………………….
Course Aims………………………………………………………
Course Objectives………………………………………………
Working Through this Course ………………………….................
Course Materials ……………….. …………………………………
Study Units…………………………………………………………
Set Text Books …………………………………………...................
Assignment File………………………………………………………
Presentation Schedule………………………………………………
Assessment………………………………………………………
Final Examination and Grading ……………………………
How to get the most from this Course……………………………
Tutors and Tutorials………………………………………………
Summary…………
INTRODUCTION
BFN 721: Investment and Portfolio Management is a first semester course,

two credit unit, 700 level core courses. It will be available for all students
offering postgraduate diploma programme in Banking and Finance in the
Faculty of Management Sciences. The study covers portfolio selection as a
problem of constrained utility maximization under conditions of uncertainty;
Discussion of the different markets, along empirical evidence for validity
theory; activities involved in making selection among alternative financial
assets from the viewpoints of individuals and institutional investors;
implications of the efficient market theory for the profitability of alternative
investment; valuation of financial statements and analysis. The empirical
evidence for various mean variance models of assets for evaluating portfolio
performance were also emphasized.
.
COURSE GUIDE
The course guide tells students briefly what the course is about, what course
material will be used, and how you can work your way through the study
material. It suggest some general guidelines for the amount of time you are
likely to spend on each unit of the course in order to complete it successfully.
The guide also gives you some guidance on your tutor-marked assignments,
which will be made available to you in the Study Centre. There are regular
tutorial classes that are linked to the course. You are advised to attend these
sessions.
WHAT YOU WILL LEARN IN THIS COURSE
The BFN 721 course consists of 5 Modules and 20 units. Specifically, the
course discusses the following:
 Risk and uncertainty in portfolio management
 Portfolio theory
 Portfolio selection
 Regulatory institutions in the Nigeria financial
market – CBN
 Regulatory institutions in the Nigeria financial market –NDIC
 Regulatory institutions in the Nigeria financial market – SEC
 Money market operations
 Capital market operations
 Capital market investment as aid to Economic
Development
 Current State of empirical evidence of models for
evaluating portfolio performance
 Capital Asset Pricing Model (CAPM)
 Activities involved in making selection among alternative
Financial Assets Investments
 Implication of Efficient Market theory for investors’
profitability
 Valuation of financial statements and selection of alternative Financial
Assets- analysis of Quoted equities
 Valuation of unquoted equities contents
 Payback Period (Non- Discounting Technique)
 Accounting Rate of Return (Non- Discounting Technique)
 The Net Present Value (NPV) (Discounting Technique)
 The Internal Rate of Return I (Discounting Technique)
 The Profitability Index (Discounting Technique)
COURSE AIMS
The aim of this course can be summarized as follows:

The study covers portfolio selection as a problem of constrained utility
maximization under conditions of uncertainty; Discussion of the different
markets, along empirical evidence for validity theory; activities involved in
making selection among alternative financial assets from the viewpoints of
individuals and institutional investors.
COURSE OBJECTIVES
To achieve the aims set out, the course sets overall objectives. Each unit also
has specific objectives. The unit objectives are always specified at the
beginning of a unit, you should read them before you start working through
the unit. You may want to refer to them during your study of the unit to check
your progress.
You should always look at the unit objectives after completing a unit. When
you do that, you will ensure that you have followed the instructions in the unit.
Below are the overall objectives of the course. By meeting these objectives,
you should have achieved the aims of the course as a whole. On successful
completion of the course, you should be able to:
 State the different types of Risk

 Discuss the risk Management Strategies
 Discuss the different methods of measuring Risk and Uncertainty
 Understand how to select the best Portfolio
 What Risk free investments are all about
 The main categories of investment
 What Portfolio management means
 How to measure the risk and return on portfolio
WORKING THROUGH THIS COURSE
To complete this course, you are required to read the study units, read set
books and read other materials provided by the National Open University of
Nigeria (NOUN). Each unit contains assignments which you are required to
attempt and submit for assessment purposes. At the end of the course, there
will be a final examination. The course should take you a total of 16 - 17
weeks to complete.
Below, you will find listed all the components of the course. What you have to
do and how you should allocate your time to each unit in order to complete the
course successfully on time. The list of all the components of the course is as
presented.
COURSE MATERIALS
Major components of the course are:
 Course Guide
 Study Units
 Textbooks
 Assignment
 Presentation Schedule
Study units
The study units in this course are as follows:
MODULE 1
Unit 1 Risk and uncertainty in portfolio management

Unit 2 Portfolio theory
Unit 3 Portfolio selection
MODULE 2
UNIT 1: Regulatory institutions in the Nigeria financial market – CBN
Unit 2 Regulatory institutions in the Nigeria financial market –NDIC
Unit 3 Regulatory institutions in the Nigeria financial market – SEC
MODULE 3:
Unit 1 Money market operations
Unit 2:Capital market operations
Unit 3 Capital market investment as aid to Economic
Development
Unit 4 Current State of empirical evidence of models for
evaluating portfolio performance
Unit 5 Capital Asset Pricing Model (CAPM)
MODULE 4
Unit 1 Activities involved in making selection among

alternative Financial Assets Investments
Unit 2 Implication of Efficient Market theory for investors’
profitability
Unit 3 Valuation of financial statements and selection of alternative
Financial Assets- analysis of Quoted equities
Unit 4: Valuation of unquoted equities contents
MODULE 5
Unit1 Payback Period (Non- Discounting Technique)
Unit2 Accounting Rate of Return (Non- Discounting Technique)
Unit 3 The Net Present Value (NPV) (Discounting Technique)
Unit 4 The Internal Rate of Return I (Discounting Technique)
Unit 5 The Profitability Index (Discounting Technique)
Textbooks
At the end of each unit of the course, there are reference materials to which
you can refer in order to increase the depth of your knowledge on the course.
Please take this seriously.
Assignment Files
A number of assignments have been prepared to help you succeed in this
course. They will guide you to have understanding and good grasp of the
course.
Presentation Schedule
The presentation schedule included in your course materials also have

important dates of the year for the completion of tutor-marked assignments
(TMAs) and your attending to tutorials.
Remember, you are to submit all your assignments by the due date. You
should guard against falling behind in your work.
Assessments
There are two aspects to the assessment of the course: first are the tutor-
marked assignments and a written examination.
In tackling the assignments, you are expected to apply information, knowledge

and techniques gathered during the course. The assignments must be
submitted to your tutor for formal assessment in accordance with the deadlines
stated in the Presentation Schedule and the Assignment File. The work you
submitted to your tutor will count for 30 percent of your total course mark.
At the end of the course, you will need to sit for a final written examination of
‘three hours’ duration. This examination will also count for 70 percent of your
total coursework.
TUTOR-MARKED ASSIGNMENTS (TMAs)
Each of the units in the course material has a tutor-marked assignment (TMA)
in this course. You only need to submit five of the eight assignments. You are
to answer all the TMAs and compare your answers with those of your course
mates. However, you should ensure that you collect four (TMAs) from the
Study Centre. It is compulsory for you to answer four (4) TMAs from the
Study Centre. Each TMA is allocated a total of 10 marks. However, the best
three (3) of the four marks shall be used as your continuous assessment score.
You will be able to complete your assignment from the information and
materials contained in your reading, references and study units. However, it is
desirable in all degree level education to demonstrate that you have read and
researched more widely than the required minimum. Using other references
will give you a broader viewpoint and may provide a deeper understanding of
the subject.
FINAL EXAMINATION AND GRADING

The final examination for BFN721 will not be more than three hours’ duration
and has a value of 70 percent of the total course grade. The examination will
consist of questions, which reflect the types of practice exercises and tutor-
marked problems you have previously encountered. All areas of the course
will be assessed.
Use the time between finishing the last unit and sitting for the examination to
revise the entire course. You may find it useful to review your tutor-marked
assignments and comments on them before the examination. The final
examination covers information from all parts of the course.
COURSE MARKING SCHEME

Table showing the total course marking scheme is shown below:
ASSESSMENT MARKS
Assignment 4 (TMAs) Best three marks of the 4 TMAs @
10 marks is 30 marks of the course =
40%
Final Examination 60% of overall course marks
Total 100% of course marks
COURSE OVERVIEW
This table brings together the units and the number of weeks you should
spread to complete them and the assignment that follow them are taken into
account.
Unit Title of Work Week Assessment
Activity (end of unit
Module 1
1 Risk and uncertainty in portfolio management 1 Assignment 1
2 Portfolio theory 1 Assignment 2
3 Portfolio selection 1 Assignment 3
Module 2
4 Regulatory institutions in the Nigeria financial market – CBN 1 Assignment 4
5 Regulatory institutions in the Nigeria financial market –NDIC
6 Regulatory institutions in the Nigeria financial market – SEC
Module 3
7 Money market operations 1 Assignment 5
8 Capital market operations 1 Assignment 6
9 Capital market investment as aid to Economic
Development
10 Current State of empirical evidence of models 1 Assignment 7
for evaluating portfolio performance
11 Capital Asset Pricing Model (CAPM)
Module 4
12 Activities involved in making selection among
13 Implication of Efficient Market theory for
investors’ profitability
14 Valuation of financial statements and selection of
alternative Financial Assets- analysis of Quoted
equities
15 Valuation of unquoted equities contents
Module 5:
16 Payback Period (Non- Discounting Technique) 1 Assignment 8
Accounting
1 Rate of Return (Non- Discounting
Technique)
7
The Net Present Value (NPV) (Discounting
Technique)
The Internal Rate of Return (Discounting Technique)
The Profitability Index (Discounting Technique)
Revision
Total 20
HOW TO GET THE MOST FROM THIS COURSE
In distance learning, the study units replace the university lecturer. This is one
of the great advantages of distance education. You can read and work through
the specially designed study materials at your own pace, and at a time and
place that suits you best. Think of it as you read the lecture notes and that a
lecturer might set you some readings to do.
The study unit will tell you when to read your other materials. Jut as a lecturer
might give you an in-class exercise, your study units also provide assignments
for you to do at appropriate points.
Each of the study units follows a common format. The first item is an
introduction to the subject matter of the unit, and how a particular unit is
related with the other units and the course as a whole.
Next is a set of learning objectives. These objectives let you know what you
should be able to do by the time you have completed the unit. You should use
these objectives to guide your study. When you have finished the unit, you
must go back and check whether you have achieved the objectives set. If you
make a habit of doing this, you will significantly improve your chances of
passing the course.
The main body of the unit guides you through the required reading from other
sources. This will usually be either from Reading Section or some other
sources.
Self-tests/assignments are interspersed throughout the end of units. Working

through these tests will help you to achieve the objectives of the unit and
prepare you for the examinations. You should do each of the assignments as
you come to it in the study unit. There will also be numerous examples given
in the study units, work through these when you come to them too.
The following is a practical strategy for working through the course. If you run
into any trouble, telephone your tutor. When you need help, don’t hesitate to
call and ask your tutor to provide it. In summary:
(1) Read this course guide.
(2) Organise a study schedule. Refer to the course overview for more
details. Note the time you are expected to spend on each unit and how
the assignments relate to the unit. Important information e.g. details of
your tutorials and the date of the first day of the semester is available.
You need to gather together all information in one place, such as your
diary or a wall calendar. Whatever method you choose to use, you
should decide on and write in your own dates for working on each unit.
(3) Once you have created your own study schedule, do everything you
can to stick to it. The major reason that students fail is that they get
behind with their coursework. If you get into difficulty with your
schedule, please let your facilitator know before it is too late for help.
(4) Turn to unit 1 and read the introduction and the objectives for the unit.
(5) Assemble the study materials. Information about what you need for a
unit is given in the ‘Overview’ at the beginning of each unit. You will
always need both the study unit you are working on and one of your set
books, on your desk at the same time.
(6) Work through the unit. The content of the unit itself has been arranged
to provide a sequence for you to follow. As you work through this unit,
you will be instructed to read sections from your set books or other
articles. Use the unit to guide your reading.
(7) Well before the relevant due dates (about 4 weeks before the dates)
access the Assignment file on the web and download your next
required assignment. Keep in mind that you will learn a lot by doing
the assignments carefully. They have been designed to help you meet
the objectives of the course and, therefore, will help you pass the
examination. Submit all assignments not later than the due dates.
(8) Review the objectives for each study unit to confirm that you have
achieved them. If you feel unsure about any of the objectives, review
the study material or consult your tutor.
(9) When you are confident that you have achieved a unit’s objectives, you
can then start on the next unit. Proceed unit by unit through the course
and try to pace your study so that you keep yourself on schedule.
(10) When you have submitted an assignment to your tutor for marking, do
not wait for its return before starting on the next unit. Keep to your
schedule. When the assignment is returned, pay particular attention to
your facilitator’s comments. Consult your tutor as soon as possible if
you have any questions or problems.
(11) After completing the last unit, review the course and prepare yourself
for the final examination. Check that you have achieved the unit
objectives and the course objectives.
TUTORS AND TUTORIALS
There are eight (8) hours of tutorials provided in support of this course. You
will be notified of the dates, times and location of these tutorials, together with
the names and phone number of your tutor, as soon as you are allocated a
tutorial group.
Your tutor will mark and comment on your assignments, keep a close watch
on your progress and on any difficulties you might encounter as they would
provide assistance to you during the course. You must mail your tutor-marked
assignments to your tutor well before the due date (at least two working days
are required). They will be marked by your tutor and returned to you as soon
as possible. Do not hesitate to contact your tutor by telephone, e-mail, or
discussion board if you need help. The following might be circumstances in
which you would find help necessary.
Contact your tutor if:
 you do not understand any part of the study units or the assigned readings;
 you have difficulty with the tutor-marked assignments;
 you have a question or problem with an assignment or with your tutor’s
comments on an assignment or with the grading of an assignment.
You should try your possible best to attend the tutorials. This is the only
chance to have face-to-face contact with your tutor and to ask questions which
are answered instantly. You can raise any problem encountered in the course
of your study during such contact. To gain the maximum benefit from course
tutorials, prepare a question list before attending them. You will learn a lot
from participating in discussions actively.
SUMMARY
As earlier stated, the course BFN 721, Investment Analysis and Portfolio
management is designed to cover portfolio selection as a problem of
constrained utility maximization under conditions of uncertainty.
We hope you enjoy your acquaintances with the National Open University of
Nigeria (NOUN) and wish you every success in the future.
STUDY UNITS (INVESTMENT AND PORTFOLIO MANAGEMENT)

There are 5 Modules and 20 units in this course. The units should be
studied carefully
MODULE 1

MODULE 2
MODULE 3:
Unit 2: Capital market operations
Development
Unit 4 Current State of empirical evidence of models
MODULE 4

Unit 2 Implication of Efficient Market theory for
Unit 3 Valuation of financial statements and selection of
equities
MODULE 5
MODULE 1
UNIT 1 RISK AND UNCERTAINTY IN PORTFOLIO

MANAGEMENT
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Different Types of Risk
3.2 Risk Management Strategies
3.3 Methods of Measuring Risk and Uncertainty
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings
1.0 INTRODUCTION
Any business venture contains an element of risk. Risk means the

possibility of an expected return not being realized. It is the possibility
that the actual return (cash flows) from holding on investment will
deviate from the expected return. This means that investors cannot
predict the future with 100% precision, because returns from investment
and the timing of those returns are not certain. The greater the
magnitude of deviation of actual from expected return, the greater the
risk of an investment. Investors always require a rate of return high
enough to compensate them for risk and uncertainty in an investment.
2.0 OBJECTIVES
At the end of this unit, you should be able to:
 State the different types of Risk

 Discuss the risk Management Strategies
 Discuss the different methods of measuring Risk and Uncertainty
3.0 MAIN CONTENT
3.1 Different Types of Risk
3.1.1 Risk versus Uncertainty
Uncertainty refers to situation in which one has no knowledge of the

future outcome of the investor's wealth maximization, whereas risk
refers to cases in which the investor has a probability knowledge of the
outcome of return on investment Since no one has perfect knowledge of
the future, investors attempt to capture uncertainties in the future
through risk specification.
Risk is created by a wide range of factors which include instability in the

economy, competition, technological changes, market condition, labor
condition and even some unexpected natural occurrences such as flood,
drought, earthquake. Others include war, political instability, burglary,
fire etc.
3.1.2 Systematic Versus unsystematic Risk
Generally, risk can be classified as either systematic or unsystematic
Systematic Risk
Systematic Risk, otherwise known as market risk or unavoidable risk are

risks arising from the overall market condition. These risks affect all
securities and consequently cannot be diversified away by any investor.
Examples are risk associated with:

1. Tax Reform
2. Changes in the economy
3. Exchange rate fluctuations
4. Interest Rate Fluctuations
5. Stock market crash
6. Earthquake
7. Changes in the world energy situation etc.
Unsystematic Risks
Unsystematic Risks otherwise known as avoidable risk are risk caused

by factors that are unique to a particular company. These risks do not
affect all securities and so can be reduced or even eliminated through
efficient diversification.
Examples are risk due to:

 Strikes in a company
 Changes in management
 Competition
 Shortage of raw materials
 Changes in technology etc
Total risk associated with an investment is the addition of the systematic

and unsystematic risk.
3.1.3 Other classifications of Risk
Risk associated with securities investment can be categorized as follows:
(i) Business Risk: This refers to the total risk associated with a
company's business operation. Business risk is given for all firms
operating in an economy
(ii) Financial Risk: This risk results from the capital structure of a
company. It results from the way a company's operation is
financed, and it arises when a company makes use of debt in its
capital structure. Debt financing involves a fixed cost (interest)
being paid from operating profits. Fall in profit as a result of
rising cost of production or a fall in turnover will result to fixed
interest charges taking a larger proportion of the profit leaving
little or nothing for equity investors. Financial risk depends on
the amount of debt financing the company uses, the more
(iii) Purchasing power: This is risk due to inflation and changes in

price levels. Rising prices reduces the real values of return
receivable from investment. In an inflationary environment, the
longer the maturity of an investment, the greater the decline in
the purchasing power of money and the higher the required
compensation risk premium desired by investors.
(iv) Liquidity Risk: This Risk arising from the inability of a stock
holder to dispose or divest his investment. This may be as a result
of prevailing economic circumstances, market conditions, or poor
performance of the investment.
(v) Interest Rate Risk: This refers to possibility of capital loss

arising from increase in interest rates. It affects all investors in
high-quality bonds regardless of whether the investor holds short-
term or long-term bonds. However, changes in interest rate have
the greatest impact on the market price of long-term bonds.
Though changes in interest rate may have less effect on market
price of short-term bonds, it nevertheless affects its interest
income, which may be observed to fluctuate from period to
period as interest rate changes.
(vi) Exchange Rate Risk: This refers to risk arising from change in
exchange rate. It is mostly applicable to investments with foreign
interest. Foreign partners are susceptible to loss of income arising
from devalued real income due for repatriation abroad as a result
of revaluation of foreign currencies.
(vii) Default Risk: This refers to risk of losing interest and principal
when investment matures.
Investors use higher discount rate to capitalize the expected cash
inflows from the investment to compensate for the risk of
possible loss.
(viii) Re-Investment Risk: Risk associated with the re-Investment of

income from investment (interest or dividend) to generate more
income.
(x) Call Risk: Risk arising from earlier call of a bond or earlier
liquidation of an investment.
(xi) Political Risk: Risk associated with the political environment in

a country as well as actions of government as it relates to
economic policies on dividend declaration and payment, taxation
on investment income etc The degree of political stability in a
country determines level of new investment as well as income
expectation from existing investment.
(xii) Legal Risk: Is the risk from changes in the laws with adverse
effect on income accruable to investors.
(xiii) Moral Risk: Refers to the risk of dishonesty. For example

insider's trading on shares in which management perpetuate fraud
on its shareholders.
3.2 Risk Management Strategies
While the risk of investment can never be completely eliminated, they

can be managed Risk Management is the process of identifying and
evaluating the trade-off between risk and expected return, and choosing
the appropriate course of action.
The process of risk management requires that:

(i) You identify the risk
(ii) You evaluate the risk
(iii) You manage the risk
Identifying Risk: An investor need to be quite sure of exactly what risk

he is taking. What risks are associated with each investment options.
Evaluating Risk: There are various ways in which the risk of

investment can be forecast and evaluated. The decision as to whether the
risk exposure should be reduced will depend or investor attitude to risk
(his degree of risk aversion) and the cost involved. Hedgers take
position to reduce exposure to risk. Speculators take position to increase
risk exposure.
Managing Risk: An Investor can manage risk exposure in four ways:

(i) Risk Retention
(ii) Risk Avoidance
(iii) Risk Reduction
(iv) Risk Transfer
Risk Retention
An investor can carry on many risks, once identified. The larger and
more diversified his investments, the more likely it is to be able to
sustain losses in some investments.
Risk Avoidance
Some investors prefer to keep away from risky investments. They prefer
investing all their funds in risk - free securities like Government bonds
and stocks. The problem here is that this category of investment has low
return.
Risk Reduction
Investors can reduce risk through diversification. They can invest in

companies in different industries or company of different sizes or
product lines. Diversification can only help reduce unsystematic risk i.e
risk associated with a particular company.
Risk Transfer
Where a risk cannot be avoided or reduced and is too big to be absorbed

by an investor, it can be turned into someone else's problem or
opportunity by "selling" or transferring it to a willing buyer. Most risks
are two-sided. There may be a speculator willing to acquire the very risk
that the hedger wishes to do away with.
Risk can be transferred through diversification, insurance or hedging.

Hedges can be created for risk in interest rate. (e.g interest rate option,
forward rate agreement etc) commodity prices (e.g commodity options,
commodity futures etc) and many more transaction.
Diversification as a Means of Risk Reduction
Individual Investments cannot be viewed simply in terms of their risk

and return. The relationship between investments can be of three main
types
(a) Positive correlation: When there is positive correlation between

investments, if one investment does well or badly, it is likely that
others will perform likewise. For example, if you buy shares from
a company selling umbrella and from another company selling
rain coat, you would expect both companies to do badly in dry
season.
(b) Negative correlation: If one investment does well, the other will
do badly and vice versa. Thus if you hold shares in one company
selling umbrella and in another company selling pure weather,
the weather will affect the companies differently.
(c) No Correlation: The performance of one investment will be

independent of how the other performs. If you hold share in Oil
Company and also in an entertainment company, it is likely that
there will be no relationship between the profit and returns from
each.
The relationship between the returns from different investment is
measured by the correlation coefficient (r) where:
r = +1 = high positive correlation
r = -1 = high negative correlation
r = 0 = No correlation
If investments show high negative correlation then by combining

them in a portfolio, overall risk will be reduced. Risk can also be
reduced by combining in portfolio, investments which have no
significant correlation.
Investors Attitude to Risk
The implication of systematic risk and unsystematic risk are that:

(i) if an investor wants to avoid risk altogether, he must invest in a
portfolio consisting entirely of risk-free securities.
(ii) If an investor holds shares in just a few companies, there will be

some unsystematic risk as well as systematic risk in his portfolio
because he would not have spread his risk enough to diversity
away the unsystematic risk. To eliminate unsystematic risk he
must build up a well-diversified portfolio of investments.
(iii) If an investor holds a balanced portfolio of all the stock and share
on the stock market, he will be incurring systematic risk, which is
exactly equal to the average systematic risk in the stock market as
a whole.
(iv) Share in individual companies will have systematic risk

characteristics, which are different to the market average. Some
share will be less risky and some more risky, than the stock
market average.
(v) By accepting systematic risk, an investor will expect to earn a

return, which is higher than the return on a risk free investment,
to compensate them for systematic risk.
(vi) Investors should not require a premium for unsystematic risk

because this can be diversified away by holding a well spread
portfolio.
3.3 Methods of Measuring Risk and Uncertainty
The following are some techniques of taking risk into consideration

when making investment decision.
(i) Risk-Adjusted Discount Rate

(ii) Certainty-Equivalents or conservative forecasts
(iii) Expected value
(iv) Standard Deviation of cash flows
(v) Co efficient of variation
(vi) State of the world model
(vii) Simulation
(viii) Finite Horizon
(i) Risk-Adjusted Discount Rate

Securities differ in their associated risk Investors expected return
(as indicated by the discount rate) is therefore a function of its
risk i.e the higher the risk, the higher the expected return and vice
versa. The rate of discount is that which covers both the basic
money cost element as well as risk premium i.e additional return
required to compensate for uncertainty (risk) associated with the
investment.
It is quite possible to synthesize all the securities available in the

market according to their risk and return combinations, by an
imaginary line referred to as the security market line. It shows the
rate of discount to be an increasing function of the risk-free rate
(RF) and the risk premium (RP) i.e. r = RF+RP
(ii) Certainty-Equivalents or conservative forecasts
This method accounts for risk by adjusting the future (forecast)
cash flows to the best estimate or certainty-equivalent. This is
done by multiplying future cash flow by a risk-adjustment
factor or certainty equivalent coefficient. The certainty equivalent
coefficient assumes a value of between 0 and 1 and varies
inversely with risk. These coefficient reflects the investors’
confidence in obtaining a particular cash flow in the future, which
may be subjectively or objectively determined certainty-
equivalent coefficient ((ct) simply define the relationship between
the certain cash flows and the risky cash flows
ie Ct =
Illustration 1
An investment which costs N50,000 and has cash flows of
N30,000 N20,000, N10,000, N7,500 and N5,000 years 1 to 5
respectively, with certainty equivalent (C t) of 1.0, 0.85,0.70,
0.65, 0.5 attached.
Required
Determine the certain cash flow useful in appraising the
investment.
Solution
The certain cash flows are obtained by multiplying the cash flow
forecasts (estimate) by the certain equivalent for each of the
period.
Is N30,000 (I), N20,000 (0.85), N10,000 (.70); N7.500 (0.65);
N5000 (0.5) = N30,000; N17,000 ; N7000 ;N4875 ; N2500.
These are the certain cash flows to be appraised.
(iii) Expected value method

Investment decision deals with making of capital outlay now in
respect of expected future cash flows, which is at best, an
estimate. It is not certain whether the estimates will be accurate.
In order to increase its level of precision, a forecaster might
decide to use a range of estimate rather than one estimate. Based
on past experience and analysis of events affecting each estimate.
It is possible to assess the likelihood of each estimate occurring
by assigning probabilities.
Expected value is obtained by multiplying the monetary value of
possible events by the associated probabilities.
Illustration 2
The cash flows and probability estimate of dividend for a year on
UAC Plc share are as shown below:
Event Cash flow Probability
1 N8.50k 0.65
2 N7.50k 0.25
3 N6.00k 0.10
Required
Calculate the expected value of cash flow
Solution
Event Cash flow Probability Expected value
1 N8.50 0.65 5.525
2 N7.50 0.25 1.875
3 N6.00 0.10 0.60
N8.00k
Expected Dividend from UAC plc is N8.
(iv) Standard Deviation of Cash flows

Standard deviation is a measure of dispersion; hence it is useful
in measuring the risk of an asset. It shows the deviation about the
expected cash flow of each of the possible cash flows. The
procedure for calculating standard deviation is as follows:
(a) Calculate the expected cash flows as shown above
(b) Subtract the expected cash flow from each possible cash flows to
obtain a set of deviation about the expected cash flow.
(c) Square each deviation. Multiply the squared deviation by the

probability of occurrence for its related cash flows, and sum these
products to obtain the variance of the probability distribution.
(d) The standard deviation is found by calculating the square root of

the variance.
Mathematically, the standard deviation is given as

S = S (X— X)2p
Where
S = standard deviation
X = Future Net cash flow
X = Expected value of net cash flow
P = probability attached to each cash flow
Illustration 3
Compute for the risk (Standard deviation) of returns for UAC Plc shares
Solution
(X1)
Event Cash flow Probability X2 X1-X2 (X1-X2)2 (X-X)2P
1 N8.50 0.65 5.525 0.50 0.25 0.1625
2 N7.50 0.25 1.875 -0.50 0.25 0.0625
3 N6.00 0.10 0.60 -0.20 4 0.4
0.625
b = = 0.79
From the estimation above UAC Plc has an expected value (return) of
N8 and standard deviation (risk) of 0.63 on its shares.
(v) Coefficient of variation

Coefficient of variation is a relative measure of risk and it is
measured. Coefficient of variation =
It is used to measure risk when comparing two alternative investments

with the same standard deviation but different expected value or the
same expected value but different standard deviation or when their
standard deviation and expected values are different. The higher the
coefficient of variation, the higher the risk of the project.
Illustration 4
Given the following two securities with the attached standard deviation
and expected value of cash flows
Security A Security B
Standard deviation N5. 60 N 8.60
Expected value N12.00 N15.5
Required
Estimate their coefficient of variation and decide on the riskier security.
Solution
Coefficient of variation = Standard deviation
Expected value
Security A Security B
Coy = N5.60 N8.60
N12.00 N15.50
= 0.47; 0.55
Security B is riskier, hence, a risk averse investor will choose security A
(vi) State of the World Model

This method suggests that instead of mean and variance that investor
think of the various possible state of the world than can occur and the
amount that is obtainable under different state. This theory distinguishes
between two types of asset namely pure and complex asset.
Pure or primitive assets are investment-generating return in one state but

not in other state of nature. On the other hand complex or composite
asset are those generating return in more than one state of nature such as
capital market securities.
This model helps to idealize about the price to be placed on an asset

based on future income expectation on it through the following process:
a. Investor idealize the various states of nature

b. Forecast of the amount realizable
c. The price (probability) to be attached to all cash flow that will
accrue under such state. This ranges from 0 to 1
Illustration 5
Assume two securities A and B with the flowing information
Current Market Price Good state Bad state
A N1.50 N1.90 N1.30
B N0.90 N1.20 N0.50
Required
Determine the price to offer for the securities under the state of nature
Solution
Let P1 = price of security under good state
P2 = price of security under bad state
PA = current price of security A
PB = current price of security B
Hence: PA = PA P1 + PA P2
PB = PB P1 + PB P2
i.e 1.50 = 1.90 P1 + 1.30 P2 equation (1)
0.90 = 1.20P, + 0.50 P2 equation (2)
To solve simultaneously multiply equation (2) by 2.6 to give
2.34 = 3.12p + 1.30P2 equation (3)
Subtracting equation (1) from (3) we have

1. 22P1 = 0.84
P, = 0.84
1.22 = 0.69
Substitute value of P1 (0.69) into equation (1), we have

1.50 = 1.90 (0.69) + 1.30P2
1.50 = 1.311 + 1.30P2
1.50 = 1.311 = 1.30P2
P2 = = 0.15
An investor will be willing to pay N0.69 for every N1 in good state and
N0.15 for N1 to be received in a bad state.
Note:
Matrix Algebra can be used to solve three variable equations.
(vii) Simulation
This is a modeling process of experimentation on a mathematical
structure of a real-life system in order to describe and evaluate the
system Behavior. There are two types of simulation.
(i) Deterministic simulation
(ii) Probabilistic simulation
Deterministic simulation: otherwise called Sensitivity Analysis

involves conducting sensitively analysis on financial projections with a
view to testing the impact of alternatives assumptions on project
viability and thus the level of risk. It analysis the "what if" sensitivity
margin. It determines the tolerable extent the NPV of the project will be
able to accommodate unfavorable changes/errors of estimation in its
variables.
Probabilistic simulation
This is also known as morte-carlo simulation. It deals with the selection
of random numbers for the calculation of decision criterion. It works in a
random situation. The random numbers are derived from the cumulative
probabilities assigned for the possibilities.
Most investment projects depend on so many probabilistic variables
such that analytical solutions are unobtainable. The use of simulation
method in such cases could be very useful
(viii) Finite Horizon
If the life of an asset is very long, the Finite Horizon method
(FHM) is used. The finite Horizon method calculate present
values of cash flows over a significant time period, perhaps 15 or
20 years and ignores the cash flows beyond the fixed horizon.
Present value of cash flow beyond this level are unlikely to affect
the relative cost of investment options.
4.0 CONCLUSION
We have seen in this unit that the greater the risk of an investment the
greater the returns. Investors always require a rate of return high enough
to compensate them for risk and uncertainty in an investment. We have
discussed the different types of Risk, the Risk Management Strategies
and the Methods of Measuring Risk and Uncertainty.
5.0 SUMMARY
In this unit you have learnt the different types of Risk, the Risk
Management Strategies and the Methods of Measuring Risk and
Uncertainty.
6.0 TUTOR-MARKED ASSIGNMENT
1. Write short notes on the following risk management strategies:

(i) Risk Avoidance
(ii) Risk Reduction
(iii) Risk Retention
(iv) Risk Transfer
2. Identify and explain five methods that can be used in measuring

risk in investment analysis.
3. The cash flows and probability estimate of return for a year on

Total Plc shares are given as follows:
Cash flow N6 N8 N5 N10 N9

Probability 0.3 0.20 0.3 0.10 0.10
Required
Calculate the expected value of cash flow.
7.0 REFERENCES/FURTHER READINGS
Akinsulire, O. (2008). Financial management (5th Edition), Lagos : El-

Toda Ventures Ltd
Dunmade, A.A (undated). Investment analysis and portfolio
management, Lagos: Elite trust Ltd
Igbinosa, S.O. (2012). Investment analysis and management , Lagos:
Elite Trust Ltd
Osaze, E.B. (2007). Capital markets, Lagos : The Bookhouse Company
Osuoha, J. (2010). Portfolio management, Lagos: Emmaeth Printing and
publishing
Osuoha, J. (2010). Equity valuation and analysis, Lagos: Emmaeth
Printing and publishing
UNIT 2 PORTFOLIO THEORY
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Selecting the best Portfolio
3.2 Risk free investments
3.3 The main categories of investment
3.4 Portfolio management
3.5 How to measure the risk of portfolio
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
Portfolio is the combination or collection of investments. That is, not

investing in a single security but in a handful of securities to eliminate
the unsystematic risks or at 1st be able to reduce the level of risk as more
and more securities are combined or added to the portfolio.
2.0 OBJECTIVES
 Understand how to select the best Portfolio

 What Risk free investments are all about
 The main categories of investment
 What is Portfolio management
 How to measure the risk of portfolio
3.0 MAIN CONTENT
3.1 Selecting the best Portfolio:

In choosing the best portfolio, the investor will make use of indifference
curves which will measure the investor’s attitude to risk and matching it
with the efficient portfolio.
On the indifference curve, the following relationships exist:
 Every point on each curve has a higher ENPV and a lower risk
level than other points on the curve.
 A rational investor will choose combinations of risk and expected
return on one curve with equal indifference, but he would prefer
combinations of return and risk on a higher for the same level of
risk.
3.2 Risk free investments

Risk free investments are investments in government securities like
Treasury bills, Treasury Certificates and Treasury bonds that promise a
fixed return with security of capital. The usual characteristic of this type
of investment is that the return is often very lower but with high
security.
3.3 The main categories of investment

1. Fixed Capital Investments
2. Fixed Income Investments
3. Variable Income and Capital Investments
Fixed Capital Investments

This is a situation where an investor deposits a sum of money normally
for a period of time and receives interest at an agreed fixed or variable
rate while the deposit last. It could be a direct loan to a company or bank
deposit. It carries a percentage (%) of interest.
Fixed Income Securities

This is usually investments in bonds and government securities that
carry a fixed interest rate. Some of these securities are often redeemable
at an agreed period and can also be traded on the exchange if listed.
The main investments in this category are;

 Preference Shares
 Corporate bonds or stocks
 Gilt edge securities (Treasury Bills and Treasury Certificates)
 Corporate debentures.
Variable Income and Capital Investments

These are instruments whose returns vary with the market condition and
their capital also appreciates overtime. The common investment in this
category is ordinary shares whose market value varies with the
performance of the company in which the investment was made.
3.4 Portfolio management

Portfolio involves investing in a handful of securities. This wide range
of investments would help diversify away the risk of the portfolio. That
is, the management of portfolio combination in such a way that would
maximize returns and minimize the associated risks.
Portfolio management therefore involves the following activities:
 Securities Analysis
 Portfolio Analysis
 Portfolio Selection
 Portfolio Revision
 Portfolio Evaluation.
(a) SECURITY ANALYSIS

This is the first stage of portfolio management. There are many
securities that are listed in the stock market which can be included in the
portfolio; so there are many securities available and can be selected for
the inclusion in the portfolio. For instance, there are companies equities,
preference shares, government bonds and many money market
instruments. Without properly analyzing them with respect to return vis-
A-vis the risk level and their possible liquidity, the securities selected
may not be optimal.
There are two approaches to security analysis which are fundamental

and technical analysis.
(b) PORTFOLIO ANALYSIS

Security analysis provides investors with a set of worthwhile and
derivable securities for inclusion in the portfolio.
A portfolio is a group of securities held together as investment. This is

investment in a handful of securities rather than single securities to
diversify away with unsystematic risks. Therefore portfolio of
investments is an attempt to spread risks by not putting all eggs in a
single basket and this is what is known as diversification. Since all the
stocks in the market will not be included in the securities in the
portfolio. Portfolio analysis is very important unless one is trading on
index.
(c) PORTFOLIO SELECTION

The goal of portfolio selection is to provide a doorway to a portfolio that
yields optimal returns within a minimal risk tolerance level. Any
portfolio that combines these characteristics is known as efficient
portfolio. It is therefore imperative to use the input of portfolio analysis
in this regard.
(d) PORTFOLIO REVISION

Having constructed a balanced portfolio, the investor or the investment
manager has to constantly monitor the portfolio to ensure that it continue
to be optimal. The reason being that the economy and financial markets
are dynamic and therefore subject to change on regular basis. Therefore
as time passes and the event and circumstances of market changes, the
portfolio combination need to follow suit so as to still be able to
maintain its optimality.
(e) PORTFOLIO EVALUATION

The sole objective of constructing a balanced portfolio and revising it
regularly is to earn maximum return with minimum level of risk.
Therefore regular portfolio evaluation is of utmost importance to find
out the performance of the portfolio relative to time.
Portfolio evaluation is therefore the process of assessing the

performance of the portfolio over a defined period of time in terms of
return and risk tolerance level. This process involves qualitative
measurement of actual return realized and risk borne by the portfolio
over the period of the investment. The major advantage of portfolio
evaluation is that it provides mechanism for identifying weaknesses in
the investment process and amending or improving the deficient areas
and this suggests that portfolio management is an ongoing type of thing.
How to measure the risk of portfolio

Risk is defined as variability in return and this level of variability is
often measured by the use of variance and or standard deviation of the
expected return.
Illustration 1
Suppose that a portfolio has the following returns with the associated
probabilities.
Return X Probability
7% 0.2
8% 0.3
12% 0.4
15% 0.1
Required:
Calculate the expected return and the risk of the portfolio.
Solution:
Calculation of the expected return
Return X Probability Expected Value

7% 0.2 1.4
8% 0.3 2.4
12% 0.4 4.8
15% 0.1 1.5
10.1%
The expected return based on the calculation made above is 10.1%. The
standard deviation of the expected return will be calculated as follows.
Return
X (X – )
(%) = (X – 10.1) Probability Pro. (X - )2
%
7 -3.1 0.2 1.922
8 -2.1 0.3 1.323
12 1.9 0.4 1.444
15 4.9 0.1 2.401
Variance (α2) 7.09
Standard Deviation =
= 2.663%
The Expected return is 10.1% with a standard deviation of 2.663%.
PORTFOLIO DIVERSIFICATION
Portfolio diversification is an attempt to reduce the level of risk

associated with the portfolio by investing in a handful of securities.
The relationship between investments can be classified into three;
1. Positive Correlation
2. Negative Correlation
3. No Correlation
Positive Correlation
When there is positive correlation between the behaviors of the
investments, the investments are likely to behave the same way. Thus, if
one performs badly, the other one will also perform badly since their
behavior is related. For instance, if you buy shares in a company selling
cowbell milk and another selling peak milk. If there is general decline in
the consumption of milk they are not likely to release good results to the
market and hence their share price would be affected in the same way
and vice versa. The correlation coefficient is (+1). It is noteworthy that
some investment can be perfectly positive like (+1) while scenarios of
strong positive less than (+1) may also exist.
Negative Correlation
This is a situation whereby if one investment is performing very well the
other will perform badly because their performance is not related as they
are independent of each other. The correlation coefficient is therefore
(-1).
No Correlation
The performance of one is independent of the performance of the other.
That is there is no relationship between them at all. The correlation
coefficient is (o).
The relationship between the returns from different investments is

measured by the correlation co-efficient. A figure close to (+1) indicates
strong correlation while the one close to (-1) indicate high negative
correlation. A figure of (0) indicates no correlation.
It can therefore be argued that if the investments show a high negative

correlation, then combining them in a portfolio would reduce the overall
risk of the portfolio. Risk can also be reduced by combining the
portfolio of securities which have no significant correlation at all.
Illustration 2
Security X and Y have the following expected returns and Probabilities.
Probability Security X Security Y

0.3 20% 18%
0.2 25% 27%
0.4 30% 35%
0.1 50% 40%
Required:
Calculate the Expected Return and Risks
Security X
Return Probability EV (%)
20% 0.3 6.0
25% 0.2 5.0
30% 0.4 12.0
50% 0.1 5.0
Expected Return 28.0%
Security Y
Return Probability EV (%)
18% 0.3 5.4
27% 0.2 5.4
35% 0.4 14.0
40% 0.1 4.0
Expected Return 28.8%
Calculation of the variances and standard deviation of:
Security X
Return (X – X) Prob. (X – X)2 Pro.
20 -8 0.3 19.2
25 -3 0.2 1.8
30 +2 0.4 1.6
50 +22 0.1 48.4
α2 71.00
Standard Deviation = 71.00

= 8.426%
Security Y
Return (X – X) Prob. (X – X)2Pr.
18 -10.8 0.3 34.992
27 -1.8 0.2 0.648
35 6.2 0.4 15.376
40 11.2 0.1 12.544
α2 63.56
= 7.972%
Security Y offered a higher return than X with a lower level of risk also.
It will therefore be preferred by rational investors.
Perfect Positive Correlation

The standard deviation of the portfolio may be calculated as follows
given the expected return as 28.4% and asset allocation of 50%X, 50%Y
Security X Security Y Sec. X&Y

50% 50% Combined Prob. (X - ) Prob.( (X - )2
10.0 9.0 19.0 0.3 -9.4 26.508
12.5 13.5 26.0 0.2 -.2.4 1.152
15.0 17.5 32.5 0.4 4.1 6.724
25.0 20.0 45.0 0.1 16.6 27.556
Variance α2 61.94
= 7.87
Perfect Negative Correlation
The standard deviation of the portfolio given an expected return of

28.4% is as follows:
= 2.1%
No Correlation
If there is no noticeable correlation between returns, the probability
distribution of returns would be:
X Multiplier Prob.
20 18 0.3 x 0.3 0.09
20 27 0.3 x 0.2 0.06
20 35 0.3 x 0.4 0.12
20 40 0.3 x 0.1 0.03
25 18 0.2 x 0.3 0.06
25 27 0.2 x 0.2 0.04
25 35 0.2 x 0.4 0.08
25 40 0.2 x 0.1 0.02
30 18 0.4 x 0.3 0.12
30 27 0.4 x 0.2 0.08
30 35 0.4 x 0.4 0.16
30 40 0.4 x 0.1 0.04
50 18 0.1 x 0.3 0.03
50 27 0.1 x 0.2 0.02
50 35 0.1 x 0.4 0.04
50 40 0.1 x 0.1 0.01
The Standard Deviation Given Expected Return:
Return Return Combined

50% X 50% Y Return (X - ) Prob. Pr( (X - )2
10.0 9.0 19.0 (9.4) 0.09 7.9524
10.0 13.5 23.5 (4.9) 0.06 1.4406
10.0 17.5 27.5 (0.9) 0.12 0.0972
10.0 20.0 30.0 1.6 0.03 0.0768
12.5 9.0 21.5 (6.9) 0.06 2.8566
12.5 13.5 26.0 (2.4) 0.04 0.2304
12.5 17.5 30.0 1.6 0.08 0.2048
12.5 20.0 32.5 4.1 0.02 0.3362
15.0 9.0 24.0 (4.4) 0.12 2.3232
15.0 13.5 28.5 0.1 0.08 0.0008
15.0 17.5 32.5 4.1 0.16 2.6896
15.0 20.0 35.5 7.1 0.04 2.0164
12.5 9.0 34.0 5.6 0.03 0.9408
12.5 13.5 38.5 10.1 0.02 2.0402
12.5 17.5 42.5 14.1 0.04 7.9556
12.5 20.0 45.0 16.6 0.01 2.7556
33.914
Standard deviation = 5.824
Given an expected return of 28.4%, we discovered the followings:

1. The risk is at the highest when there is perfect positive
correlation.
2. The Skis lower when there is no correlation
3. The risk is at the least when there is perfect negative correlation.
Another method of calculating the standard deviation of a portfolio:

A quicker method of calculating the standard deviation of the returns of
a portfolio of two securities is to use the following formula;
P =
Where:
P = Standard deviation of a portfolio of two securities
a = Standard deviation of return from security (A)
b = Standard deviation of return from security (B)
a 2
= Variance of return from security (A)
b 2
= Variance of return from security (B)
Wa = Resource allocation to Security A
Wb = Resource allocation to Security B
r = Correlation coefficient of return from securities A & B
=
Using our last example; let's consider the portfolio of 2 securities with
equal resource allocation (50% each)
Variance of X = 71
Standard deviation of X = 8.426
Variance of Y = 63.56
Standard deviation = 7.972
With perfect correlation = (1)
Formula
p =
The formula is considering a situation of perfect correlation hence, it is

using the correlation coefficient of = 1
2p = (0.5)271 + (0.5)2 63.56 + 2(0.5 (0.5) (1) (8.426) (7.972)

= (0.25) 71 + (0.25) 63.56 + 33.586
= 17.75 + 15.89 + 33.586
2p = 67.226
p =
= 8.2%
(b) Assume the two securities is negatively correlated (-) the

correlation coefficient = -1
Using the formula again
p =
= (0.5)2 71 + (0.05)2 63.56 + 2(0.5(0.5) (-1) (8.426) (7.972)
= 17.75 + 15.89 - 33.586
= 33.64 – 33.586
= 0.054
p =
= 0.232%
(c) In a situation where there is no relationship between the two

securities, the correlation coefficient will be zero = 0
p =
2p = (0.5)2 71 + (0.5)2 63.56 + 2(0.5(0.5) (0) (8.426) (7.972)
2p = 17.75 + 15.89 + 0
2p = 33.64
p =
= 5.8%
Illustration 3
An investor wishes to construct a portfolio of two securities A & B in
proportion of 60% to 40% respectively. The expected return from
Security A is 20% with standard deviation of 5%. The expected return
from security B is 30% with standard deviation of 8%.
(a) What is the expected return from the portfolio and the standard
deviation under the following scenarios?
(b) (i) Perfectly positive correlation = 1

(ii) r = 0.5
(iii) No correlation = 0
(iv) Negatively correlated = -1
(a) Expected return

= (0.6) (20)% + (0.4) (30)%
= 12% + 12% = 25%
(b) (i) The standard deviation if r = 1

2 p = (0.6)2 (0.05)2 + (0.08)2 + 2(0.6 (0.4) (1) (0.05) (0.08)
= (0.36) (0.0025) + (0.16) (0.0064) + 0.00192
= 0.0009 + 0.001024 + 0.00192
= 0.003844
p = = 0.062 = 6.2%
(ii) If r = 0.5
0.0009 + 0.001024 + 2(0.6) (0.4) (0.5) (0.05) (0.08)
= 0.001934 + 0.00096
= 0.002894
0.0009 + 0.001024 + 2(0.6) (0.4) (0.5) (0.05) (0.08)
= 0.001924 + 0.00096
= 0.002894
p =
= 0.0537 = 5.37%
(iii) If r = 0
0.0009 + 0.001024
=
= 0.0439 = 4.39%
(iv) If r = -1
2 p = (0.6)2 (0.05)2 + (0.4)2 + (0.08)2 + 2(0.6(0.4) (-1)
(0.05) (0.08)
= 0.0009 + 0.001024 – 0.00192
= 0.001924 – 0.00192
= +0.000004
p =
= 0.002 = 0.2%
Importance of Portfolio Theory to the Investor

Portfolio theory helps the investor to denote the combination of
investments which will reduce the overall risk of his portfolio. The
reason being that it will be wrong to appraise a new project in isolation;
the effect of the new security on overall risk and return of the portfolio
needs to be examined.
Portfolio theory therefore bases the portfolio selection on three major

criteria:
 The expected return of the security
 The risk (standard deviation or variance) of the security return.
 The correlation of the security returns with the returns from all
other securities of the investment portfolio.
The ultimate aim of the portfolio manager is to select an optimal set of

investment portfolio based on the above characteristic.
4.0 CONCLUSION
We have seen in this unit that Risk is defined as variability in return and
this level of variability is often measured by the use of variance and or
standard deviation of the expected return. Also, that the goal of portfolio
selection is to provide a doorway to a portfolio that yields optimal
returns within a minimal risk tolerance level. Any portfolio that
combines these characteristics is known as efficient portfolio.
5.0 SUMMARY
In this unit you have learnt how to select the best Portfolio, what Risk
free investments are all about, the main categories of investment, the
meaning of Portfolio management and how to measure the risk of
portfolio
1 Suppose that a portfolio has the following returns with the

probabilities attached to it;
Return Probabilities
10 0.4
12 0.3
15 0.2
20 0.1
(a) What is the expected return on the portfolio?

(b) Calculate the risk of the portfolio (hints Standard deviation of
returns).
2. Explain the following terms in relation to classification of
investment relationship
(a) Positive Correlation
(b) Negative Correlation

Toda Ventures Ltd
Elite Trust Ltd
publishing
UNIT 3 PORTFOLIO SELECTION
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Feasible Set of Portfolios
3.2 Efficient Set of Portfolios
3.3 Selection of Optimal Portfolio
3.4 Limitations of Markowitz Model
3.5 Measuring Portfolio Return and Risk under Single Index
model
3.6 Multi-Index Model
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
The objective of every rational investor is to maximize his returns and
minimize the risk. Diversification is the method adopted for reducing
risk It essentially results in the construction of portfolios.
The goal of portfolio construction would be to generate a portfolio that

provides the highest return and the lowest risk such a portfolio would be
known as the optimal portfolio. The process of finding the optimal
portfolio is described as portfolio selection.
The conceptual framework and analytical tools for determining the

optimal portfolio in disciplined and objective manner have been
provided by Harry Markowitz in his pioneering work on portfolio
analysis described in his 1952 journal of Finance article and subsequent
book in 1959. his method of portfolio selection has come to be known as
the Markowitz model. In fact, Markowitzs work marks the beginning of
what is known today as modern portfolio theory.
2.0 OBJECTIVES
 Feasible Set of Portfolios

 Efficient Set of Portfolios
 Selection of Optimal Portfolio
 Limitations of Markowitz Model
 Measuring Portfolio Return and Risk under Single Index model
 Multi-Index Model
3.1 Feasible Set of Portfolios

With a limited number of securities an investor can create a very large
number of portfolios by combining these securities in different
proportions. These constitute the feasible set of portfolios in which the
investor can possibly invest. This is also known as the portfolio
opportunity set.
Each portfolio in the opportunity set is characterized by an expected

return and a measure of risk, viz, variance or standard deviation of
returns. Not every portfolio in the portfolio opportunity set is of interest
to an investor. In the opportunity set some portfolios will obviously be
dominated by others. A portfolio will dominate another if it has either a
lower standard deviation and the same expected return as the other, or a
higher expected return and the same standard deviation as the other.
Portfolios that are dominated by other portfolios are known as
inefficient portfolios. An investor would not be interested in all the
portfolios in the opportunity set he would be interested only in the
efficient portfolios.
3.2 Efficient Set of Portfolios

Let us consider various combinations of securities and designate them as
portfolios 1 to n. the expected returns of these portfolios may be worked
out The risk of these portfolios may be estimated by measuring the
standard deviation of portfolio returns. The table below shows
illustrative figures for the expected returns and standard deviations of
some portfolios.
Portfolio no Expected return Standard

(percent) deviation (Risk)
1 5.6 4.5
2 7.8 5.8
3 9.2 7.6
4 10.5 8.1
5 11.7 8.1
6 12.4 9.3
7 13.5 9.5
8 13.5 11.3
9 15.7 12.7
10 16.8 12.9
If we compare portfolio nos. 4 and 5, for the same standard deviation

of 8.1 portfolio no 5 gives a higher expected return of 11.7 making it
more efficient than portfolio no 4 again, if we compare portfolio nos. 7
and 8, for the same expected return of 13.5 per cent, the standard
deviation is lower for portfolio no. 7, making it more efficient than
portfolio no.8. thus, the selection of portfolios by the investor will be
guided by two criteria
i. Given two portfolios with the same expected return, the investor
would prefer the one with the lower risk.
ii Given two portfolios with the same risk, the investor would
prefer the one with the higher expected return.
These criteria are based on the assumption that investors are rational
and also risk averse. As they are rational they would prefer more return
to less return. As they are risk averse, they would prefer less risk to
more risk.
The concept of efficient sets can be illustrated with the help of a graph.
The expected return and standard deviation of portfolios can be
depicted on an 3CY graph measuring the expected return on the Y axis
and the standard deviation on the X axis. The figure below depicts such
a graph.
As each possible portfolio in the opportunity set or feasible set of

portfolios has an expected return and standard deviation associated
with it, each portfolio would be represented
by a single point in the risk-return space
enclosed within the two axes of the graph.
The shaded area in the graph represents the
set of all possible portfolios that can be
constructed from a given set of
securities. This opportunity set of
portfolios takes a concave shape
because it consists of portfolios containing securities that are less than
perfectly correlated with each other.
Let us closely examine the diagram above. Consider portfolios F and E
both the portfolios have the same expected return but portfolio E has
less risk. Hence, portfolio E would be preferred to portfolio F. now
consider portfolios C and E both have the same risk, but portfolio B
offers more return for the same risk. Hence, portfolio E would be
preferred to portfolio C. Thus, for any point in the risk-return space, an
investor would like to move as far as possible in the direction of
decreasing risk. Effectively, he would be moving towards the left in
search of decreasing risk and upwards in search of increasing returns.
Let us consider portfolios C and A. Portfolio C would be preferred to

portfolio A because it offers less risk for the same level of return. In
the opportunity set of portfolios represented in the diagram, portfolio C
has the lowest risk compared to all other portfolios. Here portfolio C in
his diagram represents the global minimum variance portfolio.
Comparing portfolios A and B, we find that portfolio B is preferable to

portfolio A because it offers higher return for the same level of risk. In
this diagram, point B represents the portfolio with the highest expected
return among all the portfolios in the feasible set.
Thus, we find that portfolios lying in the north west boundary of the
shaded area are more efficient than all the portfolios in the interior of the
shaded area. This boundary of the shaded area is called the Efficient
Frontier because it contains all the efficient portfolios in the opportunity
set. The set of portfolios lying between the global portfolios in the
opportunity set. The set of portfolios lying between the global minimum
variance portfolio and the maximum return portfolio on the efficient
frontier represents the efficient set of portfolios. The efficient frontier is
shown separately in graph below.
rp B
C
X The efficient frontier
O p
The efficient frontier is a concave curve in the risk-return space that
extends from the minimum variance portfolio to the maximum return
portfolio.
3.3 Selection of Optimal Portfolio

The portfolio selection problem is really the process of delinearing the
efficient portfolios and then selecting the best portfolio from the set.
Rational investors will obviously prefer to invest in the efficient

portfolios. The particular portfolio that an individual investor will select
from the efficient frontier will depend on that investor's degree of
aversion to risk. A highly risk averse investor will hold a portfolio on
the lower left hand segment of the efficient frontier, while an investor
who is not too risk averse will hold one on the upper portion of the
efficient frontier.
The selection of the optimal portfolio thus depends on the investor's risk
aversion, or conversely on his risk tolerance. This can be graphically
represented through a series of risk return utility curves or indifference
curve represents different combinations of risk and return all of which
are equally satisfactory to the concerned investors. The investor is
indifferent between the successive pints in the curve. Each successive
curve moving upwards to the left represents a higher level of satisfaction
or utility. The investor's goal would be to maximise his utility by
moving upto the higher utility curve. The optimal portfolio for an
investor would be the one at the point of tangency between the efficient
frontier and his risk-return utility or indifference curve.
This is shown in graph below. The point 0 represents the optimal

portfolio. Markowitz used the technique of quadratic programming to
identify the efficient portfolios. Using the expected return and risk of
each security under consideration and the covariance estimates for each
pair of securities, he calculated risk and return for all possible portfolios.
Then, for any specific value of expected portfolio return, he determined
the least risk portfolio using quadratic programming. With another value
of expected portfolio return, a similar procedure again gives the
minimum value of expected portfolio return, a similar procedure again
gives the minimum risk portfolio. The process is repeated with different
values of expected return, the resulting minimum risk portfolios
constitute the set of efficient portfolios.
I1
Y
I2
I3
FP
3.4 Limitations of Markowitz Model
 One of the main problems with the Markowitz model is the large
number of input data required for calculations. An investor must
obtain estimates of return and variance of returns for all securities
as also covariances of returns for each pair of securities included
in the portfolio. If there are N securities in the portfolio, he would
N return estimates, N variance estimates and N(N-1)/2 covariance
estimates, resulting in a total of 2N+ [N(N-1)/2] estimates. For
example, analysing a set of 200 securities would require 200
return estimates, 200 variance estimates and 19,900 covariance
estimates, adding upto a total of 20,300 estimates. For a set of
500 securities, the estimates required would be 1,25,750. it may
be noted that the number of estimates required becomes large
because covariances between each pair of securities have to be
estimated.
 The second difficulty with the Markowitz model is the

complexity of computations required. The computations required
are numerous and complex in nature. With a given set of
securities infinite number of portfolios, can be constructed. The
expected returns and variances of returns for each possible
portfolio have to be computed. The identification of efficient
portfolios requires the use of quadratic programming which is a
complex procedure.
Because of the difficulties associated with the Markowitz model, it has

found little use in practical applications of portfolio analysis. Much
simplification is needed before the theory can be used for practical
applications. Simplifications are needed in the amount and type of input
data required to perform portfolio analysis; simplification is also needed
in the computational procedure used to select optimal portfolios.
The simplification is achieved through index models. There are

essentially two types of index models, single index model and multi-
index model. The single index model is the simplest and the most
widely used simplification and may be regarded as being at one extreme
point of a continuum, with the Markowitz model at the other extreme
point. Multi-index models may be placed at the mid region of this
continuum of portfolio analysis techniques.
Single Index Model

The basic notion underlying the single index model is that all stocks are
affected by movements in the stock market. Casual observation of share
prices reveals that when the market moves up (as measured by any of
the widely used stock market indices), prices of most share tend to
increase. When the market goes down, the prices of most shares tend to
decline. This suggests that one reason why security returns might be
correlated and there is co-movement between securities, is because of a
common response to market changes. This co-movement of stocks with
a market index may be studied with the help of a simple linear
regression analysis, taking the returns on an individual' security as the
dependent variable (Ri) and the returns on the market index (Rm) as the
independent variable.
The return of an individual security is assumed to depend on the return

on the market index. The return of an individual security may be
expressed as:
R1 = ai Bi Rm + ei
Where
ai = Component of security Ps return that is independent of the
market's performance.
Rm = Rate of return on the market index
Bi = Constant that measures the expected change in Ri given a
change in Rm
ei = Error term representing the random or residual return.
This equation breaks the return on a stock into two components, one part
due to the market and the other part independent of the market. The beta
parameter in the equation, Bi, measures how sensitive a stock's return is
to the return on the market index. It indicates how extensively the return
of a security will vary changes in the market return. For example, if the
Bi of a security is 2, then the return of the security is expected to
increase by 20 per cent when the market returns increase by 10 per cent
In this case, if the market return decreases by 10 per cent, the security
return is expected to decrease by 20 percent. For a security with Bi of
0.5, when the market return increases or decreases by 10 per cent, the
security return is expected to increase or decrease by 5 per cent (that is
10 x 0.5). a beta coefficient greater than one would suggest greater
responsiveness on the part of the stock in relation to the market greater
responsiveness.
The alpha parameter ai indicates what the return of the security would
be when the market return is • zero. For example, a security with an
alpha of +3 per cent would earn 3 per cent return even when the market
return is zero and it would earn an additional 3 per cent at all levels of
market return. Conversely, a security with an alpha of 4.5 percent would
lose 4,5 percent when the market return is zero, and would earn 4.5 per
cent less at all levels of market return. The positive alpha thus represents
a sort of bonus return and would be a highly desirable aspect of a
security, whereas a negative alpha represents a penalty to the investor
and is an undesirable aspect of a security.
The final term in the equation, ei, is the unexpected return resulting from
influences not identified by the model. It les referred to as the random or
residual return. It may take on any value, but over a large number of
observations it will average out to zero.
William Sharpe, who tried to simplify the data inputs and data tabulation
required for the Markowitz model of portfolio analysis, suggested that a
satisfactory simplification would be achieved by abandoning the
covariance of each security with each other security and substituting in
its place the relationship of each security with a market index as
measured by the single index model suggested above. 'This is known as
Sharpe index model.
In the place of [N(N-1)/2] covariances required for the Makowitz model,

Sharpe model would requires only N measures of beta coefficients.
Measurin' g Security Return and Risk under Sing e Index Model

Using the single index model, expected return of an individual security
may be expressed as:
Ri = ?i + βi Rm
The return of the security is a combination of two components:

a. A specific return component represented by the alpha of the
security; and (b) a market related return component represented
by the term βi Rm. The residual return disappears from the
expression because its average value is zero i,e. it has an expected
value of zero.
Correspondingly, the risk of a security oi becomes the sum of a market

related component and a component that is specific to the security. Thus,
Total risk = market related risk + specific risk
2i = β2i 2m + 2ei
Where
2i = variance of individual security
2m =variance of market index returns
2ei = variance of residual returns of individual security
βi = beta coefficient of individual security.
The market related components of risk is referred to as systematic risk

as it affects all securities. The specific risk component is the unique risk
or unsystematic risk which can be reduced through diversification. It is
also called diversification risk.
The estimates of ?i βi and 2ei of a security are often obtained from

regression analysis of historical data of returns of the security as well as
returns of a market index. For any given or expected "value of Rm the
expected return and risk of the security can be calculated. For example,
if the estimated values of ai βi and 2ei of a security are 2 percent, 1.5
and 300 respectively and if the market index is expected to provide a
return of 20 per cent, with variance of 120, the expected return and risk
of the security can be calculated as shown below.
Ri = ?i + βi Rm
= 2 + 1.5 (20) = 32 per cent
2i = β2i2m + 2ei
= (1.5)2 (120) + 300
= 570
3.5 Measuring Portfolio Return and Risk under Single Index Model
Portfolio analysis and selection require as inputs the expected portfolio
return and risk for all possible portfolio that can be constructed with a
given set of securities. The return and risk of portfolios can be calculated
using the single index model.
The expected return of a portfolio may be taken as portfolio alpha plus

portfolio beta times expected market return. Thus,
Rp = ?p + βp Rm
The portfolio alpha is the weighted average of the specific returns

(alphas) of the individual securities. Thus:
n
?p = ? wi ai
=1
Where
wi = proportion of investment in an individual security.
ai = specific return of an individual security
The portfolio beta is the weighted average of the beta coefficients of the
individual securities. Thus,
n
βp = ? wi βi
i=1
Where
wi = proportion of investment in an individual security.
ai = beta coefficient of an individual security
The expected return of the portfolio is the sum of the weighted average
of the specific returns and the weighted average of the market related
returns of individual securities.
The risk of a portfolio is measured as the variance of the portfolio

returns. The risk of a portfolio is simply a weighted average of the
market related risks of individual securities plus a weighted average of
the specific risks of individual securities in the portfolio. The portfolio
risk may be expressed as:
n
2p = β2p2m + ? w2i 2ei
i=1
The first term constitutes the variance of the market index multiplied by
the square of portfolio beta and represents the market related risk (or
systematic risk) of the portfolio. The second term is the weighted
average of the variances of residual returns of individual securities and
represents the specific risk or unsystematic risk of the portfolio.
As more and more securities are added to the portfolio, the unsystematic
risk of the portfolio becomes smaller and is negligible for a moderately
sized portfolio. Thus, for a large portfolio, the residual risk or
unsystematic risk approaches zero and the portfolio risk becomes equal
to B2po2m. Hence, the effective measure of portfolio risk is Bp.
Let us consider a hypothetical portfolio of four securities. The table

below shows the basic input data such as weightage, alphas, betas and
residual variance of the individual securities required for calculating
portfolio return and variance.
Input Data
Security Weightage Alpha Beta Residual variance
(wi) (ai) (βi) (2i)
NBC 0.2 2.0 1.7 370
PHB 0.1 3.5 0.5 240
TOTAL 0.4 13 0.7 410
FBN 0.3 0.75 1.3 285
Portfolio value 1.0 1.575 1.06 108.45
The values of portfolio alpha, portfolio beta, and portfolio residual

variance can be calculated as the first step.
αP =  wi βi
n
I=1
= (0.2) (2) + (0.1) (3.5) + (0.4) (1.5) + (0.3) (0.75)
= 1.575
βP =  wi βi
n
I=1
(0.2) (1.7) + (0.1) (0.5) + (0.4) (0.7) + (0.3) (1.3)
= 1.06
portfolio residual variance =  wi βi

n
I=1
= (0.2)2 (370) + (0.1) (240) + (0.4) (410) + (0.3) 2 (285)
2 2
= 108.45
These values are noted in the last row of the table. Using these values,
we can calculate the expected portfolio return for any value of projected
market return. For a market return of 15 per cent, the expected portfolio
return would be:
RP = α P + βP R m
= 1.575 + (1.06) (15)
= 17.475
For calculating the portfolio variance we need the variance of the market
returns. Assuming a market return variance of 320, the portfolio
variance can be calculated as:
α2p = β2p2m + w2i2

i=1
n
= (1.06)2 (320) n+ 108.45
= 468.002
The single index model provides a simplified method of representing the

covariance relationships among the securities. This simplification has
resulted in a substantial reduction in inputs required for portfolio
analysis. In the single index model only three estimates are needed for
each security in the portfolio, namely specific return ?i measure of
systematic risk B i and variance of the residual return ?2ei. In addition to
these, two estimates of the market index, namely the market return Rm
and the variance of the market return ?2m are also needed. Thus, for N
securities, the number of estimates required would be 3N+2. For
example, for a portfolio of 100 securities, the estimates required would
be 302. in contrast to this, for the Markowitz model, a portfolio with 100
securities would require 5150 estimates of input data (i.e. 2N + [N(N-
1)12] estimates).
Using the expected portfolio returns and portfolio variances calculated

with the single index model, the set of efficient portfolios is generated
by means of the same quadratic programming routine as used in the
Markowitz model.
3.6 Multi-Index Model

The single index model is in fact an oversimplification. It assumes that
stocks move together only because of a common co-movement with the
market. Many researchers have found that there are influences other than
the market that cause stocks to move together. Multi-index models
attempt to identify and incorporate these non-market or extra-market
factors that cause securities to move together also into the model. These
extra-market factors are a set of economic factors that account for
common movement in stock prices beyond that accounted for by the
market index itself. Fundamental economic variables such as inflation,
real economic growth, interest rates, exchange rates etc. would have a
significant impact in determining security returns and hence, their co-
movement.
A multi-index model augments the single index model by incorporating
these extra market factors as additional independent variables. For
example, a multi-index model incorporating the market effect and three
extra-market effects takes the following form:
Ri = αi + βm Rm + βiR2 + β3R3 + ei
The model says that the return of an individual security is a function of

four factors, the general market factor Rm and three extra-market factors
R1R2and R3 The beta coefficients attached to the four factors have the
same meaning as in the single index model. They measure the sensitivity
of the stock return to these factors. The alpha parameter ?i and the
residual term ei also have the same meaning as in the single index
model. These values can then be used as inputs for portfolio analysis and
selection.
A multi-index model is an alternative to the single index model.

However, it is more complex and requires more data estimates for its
application. Both the single index model and the multi-index model have
helped to make portfolio analysis more practical.
Illustration 1: An investor owns a portfolio whose market model is

estimated as:
Rp = 2.3 + 0.85 Rm+ep
If the expected return on the market index is 17.5 per cent, what is the
expected return on the investor's portfolio?
Solution: Assuming that ep = 0
Rp = 2.3 + 0.85(17.5)
= 2.3 + 14.875
= 17.175 per cent
Illustration 2: An investor owns a portfolio composed of five securities

with the following characteristics:
Security Beta Random error term Proportion

standard deviation (percent)
AP 1.35 5 0.10
GTB 1.05 9 0.20
BCC 0.80 4 0.15
UACN 1.50 12 0.30
IEI 1.12 8 0.25
If the-standard deviation of the market index is 20 per cent, what is the

total risk of the portfolio?
Solution: The total portfolio risk may be expressed as:
2p = β2p2m +
I=1
Where
β = portfolio beta
2m = variance of the market index
wi = proportion of investment in each security
2ei = residual variance (random error) of individual securities
βp or portion beta has to be calculated using the formula
βp =
i=1
= (0.1) (1.35) + (0.2) (1.05) + (0.15) (0.80) + (0.3) (1.5) + (0.25) (1.25)
(1.12) = 1.195
Portfolio residual variance can be calculated as
= (0.1)2 (5)2 + (0.2)2 (9)2 + (0.15)2 (4)2 + (0.30)2 (12)2 + (0.25)2 (8)2
= 20.81
portfolio total risk can now be calculated as:
2p = β2p2m +
I=1
= (1.195)2 (20)2 + 20.81
= 571.21 + 20.81 = 592.02
Illustration 3: Consider a portfolio composed of five securities. All the

securities have a beta of 1.0 and unique or specific risk (standard
deviation) of 25 per cent. The portfolio distributes weight equally
among its component securities. If the standard deviation of the market
index is 18 per cent, calculate the total risk of the portfolio.
Solution: The input data may be arranged in the form of the following
table.
Security Beta specific risk proportion

(standard deviation)
Unilever 1.0 25 0.2
IBTC 1.0 25 0.2
UBN 1.0 25 0.2
Cadbury 1.0 25 0.2
Oando 1.0 25 0.2
Standard deviation of market index is 18 percent

Βp = Wiβi
i=1
= (0.2 x 1.0) x 5 = 10
Portfolio residual variance =

i =1
(0.2)2 (25)2 x 5 = 125

portfolio total risk
2p = β2p2m + ?
I=1
= (1.0)2 (18)2 + 125

= 324 +125 = 449
Illustration 4: How many parameters must be estimated to analyse the

risk-return profile of a 50 stock portfolio using (a) the original
Markowitz model, and (b) the Sharpe single index model?
Solution: In Markowitz model we require the following estimates:

N return estimates
N variance estimates
N (N-1)/2 covariance estimates
Total estimates = 2N + [N-1)/2]
= (2x50) + [50 (50- 1) /2]
= 100 + 1225 = 1325
In Sharpe single index model we must have

N α estimates
N β estimates
N residual variance estimates
Market return, Rm
Variance of market return 2m
Total estimates = 3 N +2
= (3 x 50)+ 2 = 152
Illustration 5: Consider a portfolio of four securities with the following
characteristics:
Security Weighing ai Βi Residual variance

2
( ei)
UBA 0.2 2.0 12 320

IBN 0.3 1.7 0.8 450
PZ 0.1 -0.8 1.6 270
Nestle 0.4 1.2 1.3 180
Calculate the return and risk of the portfolio under single index model, if
the return on market index is 16.4 per cent and the standard deviation of
return on market index is 14 per cent.
Solution: 1 Portfolio return under single index model is calculated using

the formula:
Rp = αp + βpRm
For applying this formula up and Bp have to be calculated
αp =
i=1
= (0.2) (2.0) + (0.3) (1.7) + (0.1) (-0.8) + (0.4) (1.2)
= 1.31
βp =
i=1
= (0.2) (1.2) + (0.3) (0.8) + (0.1) (1.6) + (0.4) (1.3)
= 1.16
Rp = αp + βpRm
= 1.31 + )1.16) (16.4)
= 1.31 + 19.024
= 20.334
2. Portfolio risk under single index model is calculated as:
2p = β2p2m +
I=1
For applying this, portfolio residual variance needs to be calculated as:
Thus,
(0.2)2(320) + (0.3)2(450) + (0.1)2(270) + (0.4)2(180)
= 12.8 + 40.5 + 2.7 + 28.8
=84.8
Now,
2p = β2p2m +
I=1
= (1.16)2 (14)2 + 84.8
= 263.74 + 84.8 = 348.54
Hence,
p =
= 18.67
Example 6: The data for three stocks are given. The data are obtained
from correlating returns on these stocks with the returns on the market
index.
Stock α2 Βi Residual variance (in percent)

(2ei)
A -2.1 1.6 14
B 1.8 0.4 8
C 1.2 1.3 1.8
Which single stock would an investor prefer to own from a risk-return

view point if the market index were expected to have a return of 15 per
cent and a variance of return of 20 per cent?
Solution: Here we have to calculated the expected return and risk of
each security under the single index model.
Expected return
i= αi + βiRm
Security A = 2.1 + (1.6) (15) = -2.1 + 24 = 21.9

Security B = 1.8 + (0.4) (15) = 1.8 + 6 = 7.8
Security C = 1.2 + (1.3) (15) = 1.2+ 19.5 = 20.7
4.0 CONCLUSION
In this unit, we have seen that the conceptual framework and
analytical tools for determining the optimal portfolio in disciplined and
objective manner have been provided by Harry Markowitz in his
pioneering work on portfolio analysis described in his 1952 journal of
Finance article and subsequent book in 1959. His method of portfolio
selection has come to be known as the Markowitz model. In fact,
Markowitzs work marks the beginning of what is known today as
modern portfolio theory. A portfolio will dominate another if it has
either a lower standard deviation and the same expected return as the
other, or a higher expected return and the same standard deviation as the
other. Portfolios that are dominated by other portfolios are known as
inefficient portfolios. An investor would not be interested in all the
portfolios in the opportunity set he would be interested only in the
efficient portfolios.
5.0 SUMMARY
You have learnt in this unit the feasible Set of Portfolios, the efficient
Set of Portfolios, how to select the Optimal Portfolio, the various
limitations of Markowitz Model as well as how to measure Portfolio
Return and Risk under Single Index model and Multi-Index Model
 Differentiate between efficient and inefficient Portfolios

 Discuss the obvious limitations of Markowitz Model

Toda Ventures Ltd
Elite Trust Ltd
publishing
MODULE 2
UNIT 1: REGULATORY INSTITUTIONS IN THE NIGERIA

FINANCIAL MARKET – CBN
CONTENT
1.0Introduction
2.0Objectives
1.0 Main Content
3.1 Overview of the Background of the Central Bank of Nigeria
3.1.1 Authorizing legislation
3.1.2 The Origin of Central Bank of Nigeria
3.2 Functions of Central Bank of Nigeria
3.3 Policy Implementation and Criticism
4.0Conclusion
5.0Summary
6.0Tutor Marked Assignment
7.0References and Further Reading
1.0 INTRODUCTION
The Nigerian financial institutions and indeed, the financial markets are
not regulated by only one entity. Different institutions regulate different
players in the various sub-sets of the financial markets. The Central Bank of
Nigeria (CBN) is the apex regulatory authority in the Nigerian Banking
Sector.
2.0 OBJECTIVES
 Overview of the Historical background of the Central Bank of

Nigeria
The Origin of Central Bank of Nigeria
 State the functions of Central Bank of Nigeria
 Clearly discuss the Policy Implementation and Criticism of CBN
3.0 MAIN CONTENT
3.1 Overview of the Background of the Central Bank of Nigeria

CBN)
The history of Central Bank of Nigeria includes its authorizing

legislation and its origin which are discussed in the following
subsections.
3.1.1 Authorizing legislation
In 1948, an inquiry under the leadership of G.D. Paton was established

by the colonial administration to investigate banking practices in
Nigeria. Prior to the inquiry, the banking industry was largely
uncontrolled. The G.D Paton’s Report, an offshoot of the inquiry
became the cornerstone of the first banking legislation in the country:
the Banking Ordinance of 1952. The ordinance was designed to prevent
non-viable banks from mushrooming, and to ensure orderly commercial
banking. The banking ordinance triggered a rapid growth in the industry,
with growth also came disappointment. By 1958, a few numbers of
banks had failed. To curtail further failures and to prepare for
indigenous control, in 1958, a bill for the establishment of Central Bank
of Nigeria was presented to the House of Representatives of Nigeria.
The Act was fully implemented on July 1, 1959, when the Central Bank
of Nigeria came into full operation. In April 1960, the Bank issued its
first treasury bills. In May 1961 the Bank launched the Lagos Bankers
Clearing House, which provided licensed banks a framework in which to
exchange and clear checks rapidly. By July 1, 1961 the Bank had
completed issuing all denominations of new Nigerian notes and coins
and redeemed all of the West African Currency Board's previous money.
3.1.2 The Origin of Central Bank of Nigeria
In 1892, Nigeria's first bank, the African Banking Corporation, was

established. No banking legislation existed until 1952, at which point
Nigeria had three foreign banks (the Bank of British West Africa,
Barclays Bank, and the British and French Bank) and two indigenous
banks (the National Bank of Nigeria and the African Continental Bank)
with a collective total of forty branches. A 1952 ordinance set standards,
required reserve funds, established bank examinations, and provided for
assistance to indigenous banks. Yet for decades after 1952, the growth
of demand deposits was slowed by the Nigerian propensity to prefer
cash and to distrust checks for debt settlements.
British colonial officials established the West African Currency Board in

1912 to help finance the export trade of foreign firms in West Africa and
to issue a West African currency convertible to British pounds sterling.
But colonial policies barred local investment of reserves, discouraged
deposit expansion, precluded discretion for monetary management, and
did nothing to train Africans in developing indigenous financial
institutions. In 1952, several Nigerian members of the Federal House of
Assembly called for the establishment of a central bank to facilitate
economic development. Although the motion was defeated, the colonial
administration appointed a Bank of England official to study the issue.
He advised against a central bank, questioning such a bank's
effectiveness in an undeveloped capital market. In 1957, the Colonial
Office sponsored another study that resulted in the establishment of a
Nigerian central bank and the introduction of a Nigerian currency. The
Nigerian pound on a par with the pound sterling until the British
currency's devaluation in 1967, was converted in 1973 to a decimal
currency, the naira (N), equivalent to two old Nigerian pounds. The
smallest unit of the new currency was the kobo, 100 of which equaled 1
naira. The naira, which exchanged for US$1.52 in January 1973 and
again in March 1982 (or N0.67=US$1), despite the floating exchange
rate, depreciated relative to the United States dollar in the 1980s. The
average exchange rate in 1990 was N8.004=US$1. Depreciation
accelerated after the creation of a second-tier foreign exchange market
under World Bank structural adjustment in September 1986. As 2014,
the Naira further depreciated to N166 per $1.
The Central Bank of Nigeria, which was statutorily independent of the

Federal Government until 1968, began operations on July 1, 1959.
Following a decade of struggle over the relationship between the
government and the Central Bank, a 1968 military decree granted
authority over banking and monetary policy to the Federal Executive
Council. The role of the Central Bank, similar to that of central banks in
North America and Western Europe, was to establish the Nigerian
currency, control and regulate the banking system, serve as banker to
other banks in Nigeria, and carry out the government's economic policy
in the monetary field. This policy included control of bank credit
growth, credit distribution by sector, cash reserve requirements for
commercial banks, discount rates and interest rates the Central Bank
charged commercial and merchant banks and the ratio of banks' long-
term assets to deposits. Changes in Central Bank’s restrictions on credit
and monetary expansion affected total demand and income. For
example, in 1988, as inflation accelerated, the Central Bank tried to
restrain monetary growth. During the civil war, the government limited
and later suspended repatriation of dividends and profits, reduced
foreign travel allowances for Nigerian citizens, limited the size of
allowances to overseas public offices, required official permission for all
foreign payments, and, in January 1968, issued new currency notes to
replace those in circulation. Although in 1970, the Central Bank advised
against dismantling of import and financial constraints too soon after the
war, the oil boom soon permitted Nigeria to relax restrictions. The three
largest commercial banks held about one-third of total bank deposits. In
1973, the Federal Government undertook to acquire a 40-percent equity
ownership of the three largest foreign banks. In 1976, under the second
Nigerian Enterprises Promotion Decree requiring 60 percent indigenous
holdings, the Federal Government acquired an additional 20 percent
holding in the three largest foreign banks and 60 percent ownership in
the other foreign banks. Yet, indigenization did not change the
management, control, and lending orientation toward international trade,
particularly of foreign companies and their Nigerian subsidiaries of
foreign banks.
At the end of 1988, the banking system consisted of the Central Bank of
Nigeria, forty-two commercial banks, and twenty-four merchant banks,
a substantial increase since 1986. Merchant banks were allowed to open
checking accounts for corporations only and could not accept deposits
below N50, 000. Commercial and merchant banks together had 1,500
branches in 1988, up from 1,000 in 1984. In 1988, commercial banks
had assets of N52.2 billion compared to N12.6 billion for merchant
banks in early 1988. In 1990, the government put N503 million into
establishing community banks to encourage community development
associations, cooperative societies, farmers' groups, patriotic unions,
trade groups, and other local organizations, especially in rural areas.
Other financial institutions included government-owned specialized

development banks: the Nigerian Industrial Development Bank, the
Nigerian Bank for Commerce and Industry, and the Nigerian
Agricultural Bank, as well as the Federal Savings Banks and the Federal
Mortgage Bank. Also active in Nigeria were numerous insurance
companies, pension funds, and finance and leasing companies. Nigeria
also had a stock exchange (established in Lagos in 1961) and a number
of stockbrokerage firms. The Securities and Exchange Commission
(SEC) Decree of 1988 gave the Nigerian SEC powers to regulate and
supervise the capital market. These powers included the right to revoke
stockbroker registrations and approve or disapprove any new stock
exchange. Established in 1988, the Nigerian Deposit Insurance
Corporation increased confidence in the banks by protecting depositors
against bank failures in licensed banks up to N50,000 in return for an
annual bank premium of nearly 1 percent of total deposit liabilities.
Finance and insurance services represented more than 3 percent of
Nigeria's GDP in 1988. Economists agree that services, consisting
disproportionately of nonessential items, tend to expand as a share of
national income as a national economy grows. However, Nigeria lacked
comparable statistics over an extended period, preventing
generalizations about the service sector. Statistics indicate, nevertheless,
that services went from 28.9 percent of GDP in 1981 to 31.1 percent in
1988, a period of no economic growth. In 1988, services comprised the
following percentages of GDP: wholesale and retail trade, 17.1 percent;
hotels and restaurants, less than 1 percent; housing, 2.0 percent;
government services, 6. percent; real estate and business services, less
than 1 percent; and other services, less than 1 percent. (Jhingan, 2004)
3.2 Functions of Central Bank of Nigeria
The functions of CBN are;
a. Issuance of Legal Tender Currency Notes and coins: The

Central Bank of Nigeria engages in currency issue and
distribution within the economy. The Bank assumed these
important functions since 1959 when it replaced the West
African Currency Board (WACB) pound then in circulation
with the Nigerian pound. The decimal currency
denominations, Naira and Kobo, were introduced in 1973 in
order to move to the metric system, which simplifies
transactions. In 1976, a higher denomination note – N20
joined the currency profile. In 1984, a currency exchange was
carried out whereby, the colors of existing currencies were
swapped in order to discourage currency hoarding and
forestall counterfeiting. In 1991, a currency reform was
carried out which brought about the phasing out of 2kobo and
5kobo coins, while the 1k, 10k and 25k coins were
redesigned. In addition, the 50k and N1 notes were coined,
while the N50 note was put in circulation. In the quest to
enhance the payments system and substantially reduces the
volume and cost of production of “legal tender notes”, the
N100 and N200 notes were issued in December 1999 and
November 2000, respectively. Similarly, the N500 note was
issued in 2001;
b. Maintenance of Nigeria’s External Reserves: In order to
safeguard the international value of the legal tender currency,
the CBN is actively involved in the management of the
country’s debt and foreign exchange;
c. Debt Management: In addition to its function of mobilizing
funds for the Federal Government, the CBN in the past
managed its domestic debt and services external debt on the
advice of the Federal Ministry of Finance. On the domestic
front, the Bank advises the Federal Government as to the
timing and size of new debt instruments, advertises for public
subscription to new issues, redeems matured stocks, pays
interest and principal as and when due, collects proceeds of
issues for and on behalf of the Federal Government, and
sensitizes the Government on the implications of the size of
debt and budget deficit, among others. On external debt
service, the CBN also cooperates with other agencies to
manage the country’s debt. In 2001, the responsibility of debt
management was transferred to Debt Management Office
(DMO);
d. Foreign Exchange Management: Foreign Exchange
management involves the acquisition and deployment of
foreign exchange resources in order to reduce the
destabilizing effects of short-term capital flows in the
economy. The CBN monitors the use of scarce foreign
exchange resources to ensure that foreign exchange
disbursements and utilization are in line with economic
priorities and within the annual foreign exchange budget in
order to ensure available balance of payments position as well
as the stability of the Naira;
e. Promotion and Maintenance of Monetary Stability and a
Sound and Efficient Financial System: The effectiveness of
any central bank in executing its functions hinges crucially on
its ability to promote monetary stability. Price stability is
indispensable for money to perform its role of medium of
exchange, store of value, standard of deferred payments and
unit of account. Attainment of monetary stability rests on a
central bank’s ability to evolve effective monetary policy and
to implement it effectively. Since June 30, 1993 when the
CBN adopted the market-based mechanism for the conduct of
monetary policy, Open Market Operations (OMO) has
constituted the pound. The decimal currency denominations,
Naira and Kobo, were introduced in 1973 in order to move to
the metric system, which simplifies transactions. In 1976, a
higher denomination note – N20 joined the currency profile.
In 1984, a currency exchange was carried out whereby, the
colors of existing currencies were swapped in order to
discourage currency hoarding and forestall counterfeiting. In
1991, a currency reform was carried out which brought about
the phasing out of 2kobo and 5kobo coins, while the 1k, 10k
and 25k coins were redesigned. In addition, the 50k and N1
notes were coined, while the N50 note was put in circulation.
In the quest to enhance the payments system and substantially
reduces the volume and cost of production of “legal tender
notes”, the N100 and N200 notes were issued in December
1999 and November 2000, respectively. Similarly, the N500
note was issued in 2001;
f. Banker and Financial Adviser to the Federal Government:
The CBN as banker to the Federal government undertakes
most of Federal Government banking businesses within and
outside the country. The Bank also provides banking services
to the State and Local Governments and may act as banker to
institutions, funds or corporation set up by the Federal, State
and Local Governments. The CBN also finances government
in period of temporary budget shortfalls through Ways and
Means Advances subject to limits imposed by law. As
financial adviser to the Federal Government, the Bank advises
on the nature and size of government debt instruments to be
issued, while it acts as the issuing house on behalf of
government for the short, medium and long-term debt
instruments. The Bank coordinates the financial needs of
government in collaboration with the treasury to determine
appropriately the term, timing of issue and volume of
instruments to raise funds for government financing.
g. Banker and Lender of Last Resort to Banks: The CBN
maintains current account for deposit money banks. It also
provides clearing house facilities through which instruments
from the banks are processed and settled. Similarly, it
undertakes trade finance functions on behalf of banks’
customers. Finally, it provides temporary accommodation to
banks in the performance of its functions as lender of last
resort.
3.3 Policy Implementation and Criticism of the CBN
The CBN's early functions were mainly to act as the government's

agency for the control and supervision of the banking sector, to monitor
the balance of payments according to the demands of the Federal
Government and to tailor monetary policy along the demands of the
federal budget. The central bank's initial lack of financial competence
over the finance ministry led to deferment of major economic decisions
to the finance ministry. A key instrument of the bank was to initiate
credit limit legislation for bank lending. The initiative was geared to
make credit available to the neglected national areas such as agriculture
and manufacturing. By the end of 1979, most of the banks did not
adhere to their credit limits and favoured a loose interpretation of CBN's
guidelines. The central bank did not effectively curtail the prevalence of
short-term loan maturities. Most loans given out by commercial banks
were usually set within a year. The major policy to balance this
distortion in the credit market was to create a new Bank of Commerce
and Industry, a universal bank. However, the new bank did not fulfill its
mission.
Another policy of the bank in concert with the intentions of the

government was direct involvement in the affairs of the three major
expatriate commercial banks in order to forestall any bias against
indigenous borrowers and consumers. By 1976, the Federal Government
had acquired 40% of equity in the three largest commercial banks. The
bank's slow reaction to curtail inflation by financing huge deficits of the
Federal Government has been one of the sore points in the history of the
central bank. Coupled with its failure to control the burgeoning trade
arrears in 1983, the country was left with huge trade debts totaling $6
billion.
4.0CONCLUSION
The Central Bank of Nigeria (CBN) plays a prominent role in economic

growth and development. It plays a promotional, financial, operational,
regulatory and participatory role in the money market and the capital
market.
There is the need for close integration between the CBN’s policies and
those of the Federal Government in order to achieve macro-economic
stability. There is also the need to guarantee CBN autonomy and should
be insulated from interference by the government.
5.0SUMMARY
In this unit, you learnt the history of Central Bank of Nigeria, its
authorizing legislation and origin. You also learnt the functions of
Central Bank of Nigeria and its policy implementation and criticism.
6.0TUTOR MARKED ASSIGNMENT
1. Clearly state the functions of the Central Bank of Nigeria.
7.0 REFERENCES AND FURTHER READING

Elite Trust Ltd
Jhingan, M.L. (2004). Monetary Economics. Delhi: Vrinda publications
(P) Ltd
UNIT 2 REGULATORY INSTITUTIONS IN THE NIGERIA
FINANCIAL MARKET –NDIC
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning of NDIC
3.2 Historical development of the Nigerian Deposit Insurance
Corporation (NDIC)
3.3 The Role of NDIC in the Banking Industry
3.4 Functions of NDIC
3.5 Essentials of Banking Regulation
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignment
1.0 INTRODUCTION
In this unit, we shall discuss the meaning, the historical development of
the Nigerian Deposit Insurance Corporation (NDIC), its mandates of
establishment and functions.
2.0 OBJECTIVES
At the end of unit you should be able to:
• Trace the historical development of the NDIC
• Discuss the roles of NDIC in the banking industry
• Discuss the essentials of banking regulation,
2.0 MAIN CONTENT
3.1 MEANING OF NDIC

NDIC stands for Nigerian Deposit Insurance Corporation. The NDIC is
an autonomous body which acts as an Supervisory authority over
licensed banks. The corporation not only provides financial guarantee to
depositors but also ensures that banks comply with regulations and
practices that foster safety and soundness in the market place
3.2 HISTORICAL BACKGROUND OF THE NIGERIA DEPOSIT

INSURANCE CORPORATION ( NDIC)
The history of Nigeria Deposit Insurance Corporation (NDIC) has its
origin in the report of a committee set up in 1983 by the Board of
Central Bank of Nigeria (CBN), to examine the operations of the
banking system in Nigeria. The Committee in its Report recommended
the establishment of a Depositors Protection Fund. Consequently, the
Nigeria Deposit Insurance Corporation was established through the
promulgation of Decree No. 22 of 15 th June 1988.
This was part of the economic reform measures taken by the then
government, to strengthen the safety net for the banking sector following
its liberalization policy and the introduction of the 1986 Structural
Adjustment Programme (SAP) in Nigeria.
The phenomenal increase in the number of banks from 40 in 1986 to 120
in 1992 led to:
 Increased Competition amongst banks leading to sharp practices

 People of questionable integrity becoming bank owners and
managers
 Inadequate Manpower
 The coming together of strange bedfellows due to the licensing
requirement that banks maintain adequate geographical spread.
All these led to serious breakdown in Corporate Governance and

Boardroom squabbles. The unpredictable policy environment, downturn
in the economy and political upheavals at the time, also exacerbated the
difficult situation the Corporation found itself in. The banking industry
was therefore, already in distress by the time the Corporation
commenced operations in March 1989. NDIC operated under a difficult
terrain at the time and was immediately saddled with the management of
distress in the banking industry, to avert the impending systemic crises
and its resultant consequences. Some of the measures undertaken by the
Corporation at the time, to manage distress in the interest of the
depositors and the System included:
 Moral suasion; continuous interaction with bank

managers/owners
 Imposition of Holding Actions on distressed banks to restrict
operations and encourage self-restructuring – about 52 distressed
banks had Holding Actions imposed on them at that time.
 Rendering of Financial Assistance to banks; In 1989 alone, NDIC
in collaboration with the CBN granted facilities to the tune of N2.3
billion to ten banks with serious liquidity problems
 Takeover of Management and Control of 24 distressed banks
between 1991 and 1996.
 Acquisition and restructuring of seven (7) distressed banks which
were handed over to new investors in 1999 and 2000
 Implementation of Failed Banks Decree No. 18 of 1994. At the
end of 1995, about one out of every two banks in Nigeria was
distressed. The Decree was intended to assist distressed banks
recover their classified assets and punish the malpractices that
contributed to the distress. As at June 1996, the Corporation had
recovered about N3.3 billion.
3.3 Rationale for the establishment of Deposit Insurance Scheme in

Nigeria
 The deposit insurance scheme was established in Nigeria in 1989

with the promulgation of an enabling legislation, Decree No. 22 of
1988.
 There were at least five major reasons for establishing a formal
bank deposit insurance scheme in Nigeria. The first was the lesson of
history connected with the experience of prior bank failures in
Nigeria. In the 1950s, many small depositors suffered untold
hardship as twenty-one (21) out of the twenty-five (25) indigenous
banks operating in Nigeria closed doors.
 The establishment of the Corporation was also informed by the
approach which some other countries adopted to ensure banking
stability. For example, Czechoslovakia which was the first country to
establish a nation-wide deposit scheme in 1924, used the scheme to
revitalize the country’s banking system after ravages of the First
World War. In addition, the scheme served to encourage saving, by
increasing the safety of deposits and ensuring the best possible
development of banking practice in that country. Similarly, the
United States of America (USA) established the Federal Deposit
Insurance Corporation (FDIC) in 1933 in response to a banking
collapse and panic.
 Also, the Structural Adjustment Programme (SAP) embarked
upon by government in 1986 was aimed at deregulating the economy
in the direction of market-determined pricing. It was envisaged that
since deregulation would involve the liberalisation of the bank
licensing process, there would be a substantial increase in the
number of licensed banks to be supervised by the CBN. The
establishment of an explicit deposit insurance scheme with
supervisory powers over insured institutions was expected to
complement the supervisory efforts of the CBN. Indeed, since the
establishment of the Corporation in 1989, it has been possible for
both institutions (CBN and NDIC) to carry out routine and special
examinations of licensed banks more frequently than before, despite
the increase in the number of banks. The banks are now examined
more frequently prior to the establishment of the Corporation.
 Finally, prior to the establishment of the Corporation,
government had been unwilling to let any bank fail, no matter a
bank’s financial condition and/or quality of management.
Government feared the potential adverse effects on confidence in the
banking system and in the economy following a bank failure.
Consequently, government deliberately propped up a number of
inefficient banks over the years, especially those banks in which
state governments were the majority shareholders. Thus, government
established the Corporation to administer the deposit protection
scheme on its behalf and to serve as a vehicle for implementing
failure resolution options for badly managed insolvent banks.
3.4 NDIC’s mandates
Deposit Guarantee: This is the most significant and distinct mandate of

the Corporation. Deposit Guarantee ensures Depositors are protected
against loss of their insured deposits in the event of a bank unable to
meet its obligations to the depositors
Bank Supervision:
 The Corporation supervises banks in order to protect depositors
and to ensure safety and soundness of the banking system
 Ensures potential risk of failure is reduced
 Ensures the unsafe and unsound banking practices do not go
unchecked
Failure Resolution:
 One of the primary roles of the NDIC is to ensure that failing and
failed institutions are resolved in a timely and efficient manner
Bank Liquidation
 Liquidation process involves orderly and efficient closure of the
failed institutions with minimum disruption to the banking
system
 Cost-effective realization of assets
 Settlement of claims to Depositors, Creditors and where possible,
Shareholders
3.5 Functions of NDIC

Section 2 of the NDIC Act 2006 stipulates the functions for the
Corporation as follows:
 Insuring all deposit liabilities of licensed Banks and such Other
Financial Institutions operating in Nigeria to engender confidence
in the Nigerian banking system
 Giving Financial and Technical Assistance to eligible Insured
Institutions in the interest of Depositors
 Guaranteeing payments to Depositors, in case of imminent or
actual suspension of payments by Insured Institutions up to the
maximum provided for in section 20 of NDIC Act;
 Assisting monetary authorities in the formulation and
implementation of policies so as to ensure sound banking practice
and fair competition among insured institutions in the country;
 Pursuing any other measures necessary to achieve the functions
of the Corporation provided such measures and actions are not
repugnant to the objects of the Corporation.
4.0 CONCLUSION
We therefore conclude that the NDIC was established to prevent the
incidence of bank failure in Nigeria,
5.0 SUMMARY
We have learnt the meaning, historical development and functions of the
NDIC. In addition we have also learnt the essentials of banking
regulation.

Outline the functions of the NDIC in the banking sector.
Alhassan; H.A (2004): Banking Regulation as a Panacea for

Bank failure in Nigeria.-A Research Project submitted to the
Department of Business Administration, University of Abuja.
(un-published).
CBN /NDIC (1995): Distress in the Nigeria Financial Services Industry.
A Collaborative Study, October.
Nwankwo, G.O (1993): Prudential Regulation of Nigeria Banking.
University of Lagos Press.
Elite Trust Ltd
UNIT 3 REGULATORY INSTITUTIONS IN THE NIGERIA
FINANCIAL MARKET – SEC
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Historical development of the Securities and Exchange

Commission (SEC)
3.2 Objectives of the Securities and Exchange Commission
(SEC)
3.3 The Functions of the Commission
3.4 Composition of Membership of SEC
3.5 How Securities & Exchange Commission Protects the
investing Public
3.6 Prospectus
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignment
1.0 INTRODUCTION
The Securities and Exchange Commission (SEC) is the apex regulatory

institution of the Nigerian capital market. Since inception, the SEC has
been playing within the capital market a similar role to that played by
the Central Bank of Nigeria in the money market.
2.0 OBJECTIVES
 Understand the historical development of the Security and

Exchange Commission (SEC)
 State objectives of the Securities and Exchange Commission
(SEC)
 State the Functions of the Commission
 Understand the Composition of Membership of SEC
 Explain how Securities & Exchange Commission Protects the
investing Public
 Explain what Prospectus is all about
3.0 MAIN CONTENT
3.1 Historical development of the Security and Exchange
Commission (SEC)
The Securities and Exchange Commission (SEC) is a federal

government agency established by the Securities and Exchange
Commission act 71 of 1979 which was re-enacted as Decree number 29
of 1988. Before attaining its present status, the commission had
undergone a number of changes from the initial days of its progenitor,
the Capital Issues Committee that had ad-hoc powers 'to Capital Issues
Commission that was statutorily established by the Capital Issues
Decree of 1973. As would be expected, its role with each change
continued to vary over the years with the changing objective carved for
its evolving structure. The policy determination of the commission is the
responsibility of its board of directors, which includes the director-
general of the commission as a member. The director-general in turn
oversees the day-to-day administration of the commission on behalf of
the board.
Generally, members of the board are chosen in consideration of their

ability, experience, specialized knowledge and professional attainments
in securities business in particular and the national economy in general.
At inception, the staff of the commission was drawn from the Central
bank, (an inevitable fact of its history). But since attaining separate
existence, it has recruited more professionals in the accountancy,
economics, finance, statistics and law, in addition to administrative,
clerical and secretarial staff. Administratively, the commission is
divided into departments headed by departmental directors and divisions
under divisional heads, who must be at least of managerial status. In
broad terms, the main functions of the commission are to regulate and
develop the Nigerian capital market in order to achieve its wider
objectives of investor protection and capital market development toward
enhanced socio-economic development. The pursuit of these broad
objectives involves:
 Full disclosure requirements by operators and issuers in the

market.
 Regulation of trading in securities through market surveillance
activities. Registration of securities and institutions in the
market.
 Public enlightenment, research and general education about
securities industry.
 Creating the necessary atmosphere for the orderly growth and
development of the capital market.
 Investigation of complaints and suspected breaches of the
securities laws and,
 Making of rules to direct the market towards a desired course.
Apart from the Securities and Exchange Commission decree of 1988,

which the commission administers, it also operates within the provisions
of other statutory enactment's that relate to securities business, corporate
finance and investments in Nigeria. Significant among these are the
companies and allied matters decree, 1990 which vests the
administration of unit trust schemes in the SEC, the trustees investments
acts of 1957 and 1962, and the technical committee and privatization
and commercialization decree of 1988.
As a statutory corporation under the supervision of the federal finance

ministry, the commission submits reports of its activities annually to the
ministry. Despite its now familiar public enlightenment strategy for
broadening awareness, a certain level of ignorance still exists about the
commission, its functions, roles and place in the Nigerian socio-
economic set-up.
3.2 Objectives of the Security and Exchange Commission (SEC)
The basic objectives of the commission are:

 Investor protection, and
 Capital market development towards enhanced socio-economic
growth and development.
The need for investor protection emanates from the nature of financial
assets and financial services industry itself. The former, for instance,
cannot have their worth determined by ordinary physical examination,
like most other products do. Financial services on the other hand, are
perceived to be terse and intricate. It is therefore more difficult for
investors to evaluate with any degree of confidence, the quality of the
services and products that are offered. It is equally not easy for a single
investor to gain access to all the relevant information he may need in
order to make an informed and rational investment decision.
The objective of investor protection is to ensure that issuers of financial

instruments provide investors with relevant, timely and adequate
information about securities and institutions that are subject of public
issues. Secondly, such protection is pursued to prevent fraudulent prac-
tices such as false claims, deceit, price manipulation and unfair use of
undisclosed price sensitive information that could dent public
confidence in the securities business.
By and large, the rules and regulations of the commission have been
formulated to guide all market operations and operators with the aim of
offering far-reaching protection to all investors, whether local or foreign.
Capital market development on the other hand, involves creating general

awareness about the market as an important source of investment
finance and therefore, a catalyst for rapid socio-economic advancement.
Capital market development has involved research activities aimed at
improving market efficiency and competitiveness as well as introducing
new instruments and initiating policies with positive implications for the
market. The commission ensures that it balances regulation with
development and progressive ideas.
As the apex regulatory body for the capital market, the SEC is the
principal adviser to the Nigerian government on capital market issues
and is in this regard, called upon to give upon - from time to time to give
opinions on related subjects.
3.3 Composition of Membership of SEC

(a) A Chairman
(b) One person not below the rank of Director to represent the
Federal Ministry of Finance.
(c) One person not below the rank of Director to represent the
Central Bank of Nigeria.
(d) Two full time Commissioners who shall be persons with ability,
experience and specialized knowledge in capital market matters.
(e) The Director-General of the Commission; and
(f) Five other Commissioners who shall be persons with proven
ability and expertise in corporate matters generally.
3.4 Functions of Securities and Exchange Commission:

(a) Determining the price at which Securities are to be sold, the
amount to be sold as well as the appropriate time to issue the
securities either through offer for sale or offer for subscription.
(b) Registration of Securities proposed for offer for sale or offer for
subscription.
(c) Maintaining surveillance over the securities market to ensure
orderly, fair and equitable dealings in securities.
(d) Registering stock exchange or their branches, registrars,
securities dealers and other capital market operators with a view
to maintaining proper standards of and professionalism in the
securities business.
(e) Protect the integrity of the securities market against any abuse
arising from the practice of insider trading.
(f) Acting as regulatory apex organisation for the Nigerian Stock
exchange and its branches to which it would be at liberty to
delegate power.
(g) Reviewing, appointing and regulating of business combination.
(h) Creating the necessary atmosphere for the orderly growth and
development of the capital market.
3.5 How Does Securities & Exchange Commission Protect The

investing Public?
The Securities and Exchange Commission protects the investing public
by ensuring that companies make:-
(a) Full disclosure in prospectus.
(b) Adequate and timely financial reporting
(c) Fair and equitable issuance of securities
(d) Fair trading practice.
3.6 Prospectus
A company issuing securities either through offer for sale or offer for
Subscription is expected to submit a prospectus to Securities and
Exchange Commission (through its issuing house) detailing information
about the offer.
The prospectus often shows the following information:

(a) Summary of the offer:
- Name of the company
- Number of shares being offered
- Nominal price and offer price
- Market capitalization of the company (at offer price)
- Market capitalization of the offer (at offer price)
- Share capital (authorized issued)
- Forecast EPS, Earnings Yield, dividend and dividend yield.
(b) Parties to the offer:

- Names of directors, Company Secretary, issuing houses,
stockbrokers, Solicitors, reporting accountants, auditors and
registrar.
(c) Chairman's Letter:

- Purposes of the offer
- History and business of the company
- Company's management staff
- Staff training, industrial relations and welfare
- Staff pensions
- Future expansion programmes.
(d) The Profit Forecast:

- Forecast PBT, PAT, Reserves, Dividend and Retained profit.
- Assumptions on which the forecast is based
- Reporting Accountant's letter relating to the following.
(i) Review of accounting policies used for the forecast.
(ii) Review of the calculations of the forecast
(iii) Review of the reasonableness of the assumptions
(iv) Review of the consistency in the application of accounting
policies.
- Issuing House letter with respect to:
(i) Discussion with the Directors of the company and Reporting
Accountant with respect to assumptions, calculations and
accounting policies used for the forecast.
(ii) Acceptance of responsibility by the Directors for the forecast.
(e) Accountant's Report (content):

- A letter expressing opinion on the following:
(i) Examination of audited accounts for five years
(ii) Financial statements are prepared from audited accounts
after making necessary adjustments.
(iii) Whether the financial statements show true and fair view
and comply with CAMD and accounting standards.
(iv) Name of company auditor.
- Five-year financial summary of P & L, Balance sheet,
Statements of sources and applications of funds.
- Schedule of adjustments (e.g with respect to Extra-ordinary
items, prior year adjustments etc.).
(f) Statutory and General Information:

- Incorporations and capital history
- Extract from Memorandum and Articles of Association
- Company's borrowing power
- Material contracts.
- Claims and pending litigations.
4.0 CONCLUSION
We have seen in this unit the historical background of SEC, the
functions of SEC, how SEC protects the investors as well as what
Prospectus Document is all about.
5.0 SUMMARY
In this unit, you have learnt the historical development of the Security
and Exchange Commission (SEC), its objectives, the Functions of the
Commission and the Composition of Membership of SEC. We have also
explained how Securities & Exchange Commission Protects the
investing Public and what Prospectus is all about.
6.0 TUTOR MARKED ASSIGNMENT
 State five functions of SEC

 Explain how SEC protect the investing public

Elite Trust Ltd
(P) Ltd
MODULE 3:
Unit 2: Capital market operations
Development
Unit 4 Current state of empirical evidence of models
UNIT 1 MONEY MARKET OPERATIONS
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Instruments Traded in the Money Market
3.2 Reason for Establishing the Nigerian Money Market
3.3 Functions of Money Market
3.4 Operators in the Financial Market
3.5 Non-Banks Financial Institution
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
Money market is the market for sourcing short-term funds; the funds
having duration of one year and below. It is to meet the needs of
commercial activities and not for permanent investment as the
instruments traded are of short time duration.
2.0 OBJECTIVES
 Understand the Instruments Traded in the Money Market
 State the reasons for Establishing the Nigerian Money Market
 State the functions of Money Market
 Know the Operators in the Financial Market
 Know the non-Banks Financial Institution
3.0 MAIN CONTENT
3.1 Instruments Traded in the Money Market
The instruments traded in the money market are: Banker • acceptances,
Commercial papers, Treasury bills, Treasury certificates, Certificates of
Deposit.
Banker
Certificates of
acceptances
Deposit
Treasury Commercial
certificates papers
Treasury
Bills
Figure. Instruments Traded in the Money Market
(a) Banker Acceptances

The money market uses Banker Acceptances for the purpose of meeting
short term financial needs of corporate bodies. It is usually issued as a
bridging facility to finance either domestic or international trade. It is
often issued by the debtor company and accepted by its banker and
immediately it is endorsed it is a guarantee for payment by the bank.
However the success of that endorsement and the inherent risk in the
instruments is, more often than not, a function of the financial health of
the bank that endorsed it.
(b) Commercial Paper

This is another instrument for meeting short term need of corporate
bodies. It is often used as a bridging facility to meet the financial needs
of the company pending the time a more permanent source(s) of finance
is arranged. It is usually of 90 days tenure.
(c) Treasury Bills

Treasury bill is an instrument issued by Federal government to raise
money from the public through Central Bank. It is usually of short term
duration say 90 days and up to 180 days. They are often issued in
tranches and are redeemable; new ones can be issued to replace the old
ones being repaid.
(d) Treasury Certificates
Treasury Certificate is another short term instrument available to the
Federal Government to raise longer term fund. It is of a shorter duration
than the Treasury bills counterpart.
(e) Certificates of Deposit

This is the certificate, which the bankers issued to their customer that
deposit money with them for a specified period. It is usually within a
minimum time limit of 30 days with definite rate of interest attached to
it.
This affords the customers the opportunity to earn interest on their

money pending the time they would think of the use they want to put
them. It also affords the bank some level of flexibility in matching their
deposit obligation with risk assets.
3.2 Reason for Establishing the Nigerian Money Market

 To provide necessary short term financing requirements.
 To harness funds from small and big savers and channel such
towards productive purposes.
 To provide platform for the implementation of government
monetary policies.
 To provide credit base by providing local investment outlets for
the retention of funds in Nigeria and for investment of funds
repatriated from abroad following the laid down procedures.
 To provide basis for Nigeria monetary autonomy.
3.3 Functions of Money Market

 To harness funds from savers and channels them towards
productive use. It provides an orderly flow of short-term
funds.
 To ensure supply of necessary means of expanding and
contracting credit.
 To provide the basis for operating and executing effective
monetary policies.
 To provide mechanism for the injection of Central Bank
cash into the Economy.
 To maintain stable cash and liquidity ratios as a base for
the operation of the open market operation.
 To provide machinery needed for the government short-
term financial requirements.
 To provide the mechanism through which liquidity of
bank can be maintained at desired level.
 To provide effective management of financial instruments.
 To provide a central pool of liquid financial resources
upon which the banking system can draw when it needs
additional funds to make payments.
3.4 Operators in the Financial Market

(a) Commercial Banks
Commercial banks are at the center of money market operations.
They are able to carry out their duties effectively through their
numerous branch networks and instruments. According to Bank
and other Financial Institutions Act 1991, bank in Nigeria is
defined as an institution whose business includes the acceptance
of deposits and withdrawal is made by cheques. The universal
banking status granted to the banks has now widened their
operational scope to include other businesses like Insurance,
Capital market, Mortgage and any other businesses that can be
reasonably combined with their operations. The minimum share
capital of banks was therefore put at N25b to cope with the
millennium challenges.
(b) Functions of Commercial Banks

Apart from the above functions which are general to all
financial institutions; Bank in addition performs the
following functions:
 They accept deposits from customers on savings, current
and all forms of deposit accounts.
 They lend money to their customers.
 They provide standing order facilities.
 They finance viable projects.
 They are quite involved in the issue of traveler's cheques.
 They help government in the process of implementing its
monetary policies.
 They solve problems of foreign exchange for their
customers.
 They give business advice to their customers.
 They keep valuable assets for their customers
 They act as guarantors to their customers.
 They provide standing order facilities to their
 customers.
 They settle bills of exchange on behalf of their customers
 They offer employment opportunities to young graduates
and professionals.
(b) Development Banks

Development banks are Specialized Financial Institutions set up by
government to bridge the gap between short and long-term funding
created by the commercial banks that trades in short term instruments.
They are established to develop a particular sector of the economy,
hence they are specialized banks.
Nwankwo (1980) put it as 'gap and exigency thesis. According to him

they are to bridge the gap between short term funding of commercial
banks by the reason of their deposit structure and the long term finance
of projects with long gestation period. Another reason, according to him,
is the exigency of providing long term finance to priority areas of the
economy which commercial banks are reluctant to fund. This, he
referred to as 'gap and exigency thesis'
Presently, there are six development banks operating in the country with
each of them having their specific functions to perform:
(c) Nigerian Bank for Commerce and Industry (NBCI)

The Nigerian Bank for Commerce and Industry was set up in 1973
following the promulgation of the Nigerian Enterprises Promotion
Decree of 1972, known as indigenization Decree. The main function of
the bank is to provide much needed assistance to the Nigerian investors
in the areas of share underwriting, identification of viable projects,
writing of feasibility studies and offering of managerial and Technical
advice. It was also established to provide needed capital to meet the
needs of Enterprises promotion and to make money available to
Nigerians to set up their business or buy into foreign businesses as
provided for by the Act.
(d) Nigerian Agricultural and Cooperative Bank (NACB)

The Nigerian Agricultural and Cooperative Bank was established in
1973 to provide the needed finance for Agricultural development. This
is a step aimed at encouraging or improving the development of such
Industries as fisheries, snail rearing, poultry farming, animal husbandry,
timber production, forestry and any other type of farming.
The purpose is to promote Agricultural production by providing

facilities and financial support and assistance to interested individuals,
Cooperative societies, Companies and government agencies. It was also
to offer technical assistance in the area of giving advice including
preparation of feasibility report.
(e) Nigerian Industrial Development Bank (NIDB)

Nigerian Industrial Development Bank was established in 1964 to
foster growth and encourage the establishment of medium and
large scale industries in Nigeria. This it is to pursue by giving
medium and long term loans to the public and private enterprises.
It is also to provide technical, financial and managerial assistance
to indigenous enterprises. Initially the focus was on large scale
industries but recently it has amended its operations to cover
small and medium scale industries which are the mainstay of the
economy.
(f) Urban Development Bank

Urban Development Bank was established in 1992 to take care of
the provision of infrastructural supply like housing,
transportation, electricity and water supply that poses serious
social problems in most cities in Nigeria. Its main function is to
provide financial resources to both public and private sectors of
the economy to finance the aforementioned projects.
(g) Federal Mortgage Bank (FMB)

Federal Mortgage Bank of Nigeria was instituted by Decree 7 of
1977 of the Federal Military Government of Nigeria to take over
the activities of former Nigerian Building Society (NBS)
established in 1957. Its main function is to provide funds for
Nigerian who wants to invest in housing estate. The decree also
imposes the following additional responsibilities on the bank:
 To provide long term loans to mortgage institutions in

Nigeria at such rates and subject to such terms as may be
determined by the Federal Government being rates and
terms designed to enable the mortgage institutions to grant
comparable credit facilities to individual Nigerians that
want to acquire houses of their own.
 To encourage and promote, the development of mortgage
institution in the states and at National level.
 To supervise and control the activities of the primary

mortgage institutions in Nigeria based on federal
government directed principles.
 To provide credit facilities to Nigerians at such rates and

upon such terms as may be determined by the board in
accordance with the policy directed by the Federal
Government.
 T
o provide credit facilities with the approval of Government
at competitive commercial rates of interest to commercial
property developers, estate developers, developers of
offices and other specialized types of buildings.
 The enabling decree
also allows the bank to accept deposits and savings from
primary mortgage institutions, trust funds, the post office
and private individuals as board may determine to promote
the harnessing of savings from the public.
(h) Nigerian Export-Import Bank (NEXIM)

Nigerian Import and Export Bank was established in 1991 to encourage
Nigerians to develop other non oil export income generating areas, such
as agricultural produce to bail Nigeria out of mono-cultural economy.
This is the resultant product of the fall in oil revenue in the '70's as a
result of fall in prices. The bank is charged with the responsibility of
helping the nation to attain increases in export growth as well as
structured balance and diversification on the product composition and
destination of Nigerian products. The bank is also to provide export
credit guarantee and export credit insurance functions as well as
providing credit to support the establishment and management of export
funds art4 other ancillary services.
3.5 Non-Banks Financial Institution

(a) Insurance Companies
Insurance is a pool of risk or means of spreading risks or losses of
few people over a large number of people or companies. It is the
conversion of indeterminate risks into fixed costs by way of
consolidating or an economic device whereby risks of living and
of economic enterprises are spread over a reasonable number of
insured. In performing these functions, the insurance Companies
collect premium from several insured. The role they perform is
similar to that of banks because the premium they collect is in
form of deposit mobilization by banks.
Insurance business is classified into two categories:

(a) Life Insurance
Life insurance policy is a contract by which an insurer
undertakes to pay a sum of money on the death of the insured
person or attaining a particular age in the case of endowment.
The commonest types of policy are:

 Whole life policy
 Endowment policy
 Term assurance.
 Annuity.
(b) Non Life Insurance

This comprises every other type of insurance business aside from
life insurance.
Functions of Insurance Companies
o Insurance companies provide the most effective machinery for

handling individuals and corporate risks.
o It subrogates the risks of firms as well as that of the individuals.
o It underwrites some of the issues in the capital market using its

pool of funds.
o It executes performance bonds for its customers. It grants credit

facilities to estate developers.
o It facilitates the smooth running of international trade by insuring

imports and exports through marine insurance and reinsurance
facilities that spreads the risks among themselves.
o Before the advent of Pension Reform Act of 2004, it operated

pension scheme on behalf of companies.
o Insurance policies are also in some cases used as collateral

securities for bank loans.
o It improves the saving habits of people and even companies

through their premium policy.
o It harnesses huge long term funds which can be used for

investment.
o It also generates employment for the professionals and non

professionals.
Finance Companies
Finance Companies mobilize deposits from people and give them to
their customers to improve their business. They use money market
instruments like Commercial Paper (CP) and certificate of deposit and
other short time instruments. They make the funds mobilized available
to their customers for a short and medium term by making finance
available for such businesses like Local Purchase Orders (LPO), Debt
factoring and securities trading.
National Economic Reconstruction Fund (NERFUND)

National Economic Reconstruction Fund was established by Decree 25
of 1988 to provide soft medium and Long-term finance to small and
medium scale Enterprises that are wholly owned by Nigerians. The
primary purpose of its establishment is to act as financial intermediaries.
That is, the channel through which the government can fund the
aforementioned as they are financed by the Federal Government, Central
Bank of Nigeria and some International Development Financial
Institutions such as African Development Bank.
Primary Mortgage Institution

Every other institution involved in mortgage finance apart from Federal
Mortgage Bank is all referred to as primary mortgage institutions. The
reason for the name is that they deal directly with individuals and estate
firms; while the Federal Mortgage Bank remained the supervisory body.
They are also involved in the intermediation process as they accept
deposits from small savers and borrowing from other institutions W
finance the development of housing sector. They offer long term credit
facilities to encourage people to build or buy their own houses.
Functions of Mortgage Banks

They accept deposits from members of public.
They encourage members- of public to cultivate saving habits.
They build and provide houses for low income earners.
They finance estate developers.
They give loans to individuals and thereby encourage them to have their
own houses.
Traditional Financial Institutions

These are traditional financial groups like Credit and thrift societies
(Esusu) which encourage savings and also grant credit facilities to their
members. It is a sort of cooperative society in which people agree to
contribute certain sum of money regularly and the money so contributed
is handed over to the next member on the row each time contribution is
made.
Benefits of Traditional Financial Institutions

 They encourage savings among their members.
 They lend money to their members.
 They encourage their members to invest by the reasonable sum of
money their members contribute in form of thrift. ‘Ajo’.
 They save their members the rigorous procedures of getting loans
from banks.
 They reduce unnecessary spending of their members.
 They eliminate their members’ financial planning and queue
theory.
Discount Houses
These are the institutions that specialize in the provision of discounting
facilities; that is, buying and selling of securities; that is, buying and
selling of securities especially government securities. They also
discount bills for banks and save them the rigor of going to the Central
Bank. They also issue their own securities to the bank as a means of
raising funds.
Thrift and Credit Cooperative Society

The purpose of this type of society is to mobilize savings from the
members so that the needy members can borrow at minimum interest
rate. They meet regularly say monthly and contribute an agreed amount
of money to the purse of the association. This type of society is like
savings cub and usually found among traders, artisans and peasant
farmers.
Advantages
 Members obtain loans easily without collateral to boost their
trade.
 It is a means of encouraging savings among members.
 It is a means of mobilizing capital for members.
 They offer free advice to their members during their monthly
meetings.
 They often make it easy for their members to own real properties
by buying land with the cooperative money at lower prices and
distribute it to them.
Micro-Finance Bank
Micro-Finance Bank was formed to cater for the finance of small
businesses. They are to take over the activities of the former community
banks hence their operational scope is similar to that of former
community bank The bank is divided into two categories; the one that is
restricted to only one local Government area is having a minimum share
capital of N20 million; while that of state is N1 billion.
Unit Micro Finance Bank

Unit Microfinance banks are licensed to operate within a particular local
government area and grow organically until their operational scope
covers 2/3 of the local government. Thereafter they can spread to the
next local government within the state. Their require minimum paid up
share capital to register as operator is N20 million.
State Microfinance Bank

State Microfinance banks are however required to have a minimum
paid up capital of N1 billion to operate. They can maintain operational
base within 2/3 of the Local Government areas in the state before
moving to the next state until they cover the entire country.
Functions of Micro-Finance Banks
 To accept various types of deposits from their customers.
 To clear
negotiable instruments for their customers.
 To maintain bank accounts with commercial banks in Nigeria.
 To give micro-credit to their customers.
 To invest their surplus funds in income yielding instruments.
 To render advisory services to their customers to boost their
business.
Peoples Bank of Nigeria

 Peoples Bank of Nigeria is a non conventional bank established
by Decree 22 of 1990 to provide specialized services to urban and
rural poor masses. According to the establishing Decree, the bank
was established to:
 Provide basic requirements for under-privileged people who

engage in legitimate businesses in both urban and rural areas and
who cannot normally benefit from the services of the orthodox
banking system because of their inability to provide usual
collateral security.
 To accept savings from the same group of customers and making

repayment of such savings together with any interest thereon after
investing the money in bulk in short term instruments.
Objectives of Peoples Bank

 To bridge the
gap between the rich and the poor.
 To reduce rural-urban migration.
 To increase investment and savings among rural dwellers.
 To increase usefulness and productivity among poor people.
 To raise per capita income of the people.
 To provide credit facilities to the disadvantaged classes who
could not have ordinarily benefited from credit facilities in
conventional banks.
Federal Savings Bank

Federal savings bank is a post office linked savings bank established in
1889. The Bank went through series of reorganization until another Act
which renamed it Federal Savings Bank (FSB) came up in 1974.
According to Post Office Savings Act of 1958; the bank is to:
 Provide a ready means of savings especially among the rural

dwellers.
 E
ncourage thrift and mobilize savings in the rural areas.
 Mobilize funds for National Development.
The bank uses an instrument called postal order as a means of transfer of

payment.
Units and Mutual Trusts

Investment and Units Trust is an arrangement whereby funds are pooled
together from both small and big time investors for investment purposes.
It is a form of collective investment which provides investors with a
simple doorway to the stock market and also enjoys the services of
professional managers. Investors in this context pooled their money in a
fund which is managed by professional managers who invest the money
in a wide range of securities. The proportion of individual holding is
denoted by the number of units they hold as they are denominated in
units in the case of Unit Trust.
4.0 CONCLUSION
We have seen in this unit that money market instruments are used to
meet the needs of commercial activities and not for permanent
investment as the instruments traded are of short time duration.
5.0 SUMMARY
In this unit you have learnt the various Instruments Traded in the Money
Market, the reasons for establishing the Nigerian Money Market, the
functions of Money Market, the operators in the Financial Market as
well as the non-Banks Financial Institution.

 What are the reasons for establishing the Nigerian money
market?
 What are the benefits of traditional financial institutions?
 Write short note on Unit/Mutual Trust.

Elite Trust Ltd
(P) Ltd
UNIT 2: CAPITAL MARKET OPERATIONS
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Development of Capital Market in Nigeria
3.2 Instruments Traded in the Capital Market
3.3 Shareholding
3.4 Operators in the Capital Market
3.5 Importance of Nigerian Capital Market
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
Capital market is the market for medium and long-term funds. It is

created to meet the inadequacies created by the money market that
trades in instruments of short-term duration. The capital market
therefore deals with instruments of medium and long term to meet the
requirements of projects of long time gestation period.
2.0 OBJECTIVES
 At the end of this unit, you should be able to:
 Trace the development of Capital Market in Nigeria
 State the instruments traded in the Capital Market
 Understand what Shareholding is all about
 Know the Operators in the Capital Market
 Give the importance of Nigerian Capital Market
3.0 MAIN CONTENT
3.1 Development of Capital Market in Nigeria
The initial attempt to establish a Nigerian Capital Market was dated

back to 1959 with the issue of the first Nigerian Development Loan
stocks by the Central Bank of Nigeria. This was followed by the
inauguration of the Lagos Stock Exchange now Nigerian Stock
Exchange in the latter part of 1960 and its commencement of operation
in June, 1961.
The enactment of the Companies act of 1968 also catalyzed the growth
of the market. In 1972 the promulgation of Nigerian Enterprises
promotion act called indigenization program gave further impetus to the
market development and accounted for more than 120% growth in the
number of listed companies' equities on the Exchange. It is also
important to mention that the development of the market was greatly
influenced by the flow of government securities and the implementation
of the two indigenization programmes (1972 and 1977) and the statutory
requirements relating to investment in certain public sector institutions
like the pension and provident funds and the development banks.
3.2 Instruments Traded in the Capital Market
Instruments traded in the capital market include:
Equities
 Ordinary Shares
 Preference Shares
Debt Instruments
Long-term/Syndicated Loans
Debentures Stocks
Government Bonds/Stocks
3.3 Shareholding
A share is a unit of ownership interest in a company translated into

financial commitment. That is, the investors interest in the activities of a
company demonstrated by the units of shares they hold in the company.
These shares are denominated in units, with their price determined by
day to day activities on the stock exchange for quoted companies.
Equity trading is the most active sector on the floor of the Nigerian
Stock Exchange with large volume of shares changing hands on daily
basis with high degree of price volatility. The need to spread risk among
diverse investors formed one of the major characteristics of publicly
quoted companies. It is also a means of harnessing funds to finance blue
chip companies. It is also important to say that shareholding has now
becomes popular means of determining ownership and also voting
powers of quoted companies. Two types of shares emerged from this
ordinary shares and preference shares.
Ordinary Shares
Ordinary shares are usually referred to as equity shares. They are the
ultimate risk bearer of the company. They carry the residue in terms of
dividends and assets in the event of liquidation, after all other categories
of creditors have been settled including preference shareholders. That is
why they are referred to as the ultimate risk bearer. More often than not
part of their profits is passed to them in terms of bonus or script issues.
Equity can be acquired through the primary market where the company
issues new shares for subscription to the investing public. The investors
in this context obtain the form and prospectus, complete and return it to
the Issuing House or Registrar of the company along with the cheque
through the receiving agents. After allotment, the Registrar will send to
the investor, their share certificate.
Equity share holding can also be acquired through the secondary market.
This takes place at the stock-exchange trading session through the
stockbroker. The existing shareholder wanting to divest; forwards his
certificate to his stockbroker and signs appropriate columns of the
transfer form. The new investor also signs the appropriate column of the
similar transfer form and stockbroker effect the sale/purchase on the
floor of the exchange. After the transfer has been effected, the new
investor's account with the Central Securities Clearing Systems Limited
is credited with the units acquired, while the same quantity is removed
from the account of the seller. This entitles the new owner to all the
subsequent privileges accruing to the shareholders in the company.
Rights of Ordinary Shareholders
 Shareholders are entitled to dividend on the number of units they

hold if declared and approved at the AGM.
 They are entitle to vote at Annual General Meeting except the

class of share they hold does not carry voting right.
 To receive notice of general meetings
 To receive the appropriate portion of residual asset distribution in

the event of liquidation.
 To receive the copy of the financial statement before the AGM
 To appoint proxy to attend meeting on their behalf

 To inspect freely the various records maintained by the company.
 To petition for winding up in case of illegality or oppression/

denial of rights.
 To transfer their shares freely except in the case of private

companies.
 To inspect the copies of any of the directors contract with the

company etc.
Preference Shares
Preference shareholders are entitled to first consideration in terms of

dividends and residual assets in the event of the liquidation of the
company. Preference shares could be cumulative, non-cumulative and
participative. In all, they carry fixed rates of dividends while still
carrying the tag of ownership in the company. Depending on how it was
packaged, they may have or may not have voting right.
Rights/Features of Preference Shares
This is hybrid securities that have both nature of Equity shares and
Debt. That is, it is in form of equity capital which in addition has the
features of debt instruments. This is because they are always attached
with fixed or variable interest rate. Another important benefit of this
class of shares is that they are paid before paying the Equity holders in
the event of liquidation. Their other features/privileges include the
following:
(a) Cumulative and Non-Cumulative Preference Shares:

Preference shares are cumulative when interest/ dividend not paid
in the year they are earned is carried forward to the other year(s)
and it is non-cumulative when interest not paid in one year is lost
forever.
(b) Redeemable and Irredeemable:

Preference shares are redeemable when the issue instrument
contains provision for the repayment of capital at a predetermined
future dates and they are irredeemable when there is no provision
for the repayment (callable) in the issued document.
(c) Convertible and N on-Convertible Preference Shares:

Preference shares are convertible when the issued document
contains provision of their convertibility into ordinary shares of
the company at a specific future dates at fixed ratio and price.
This is inform of a call option contract and it is not mandatory for
any debentures holder. Non-convertible preference shareholder
does not have such option of conversion.
Long Term/Syndicated Loans
This is usually a medium term or long term bank loan device through
which projects of long-term gestation are financed. One or more banks
may fund such loans depending on the magnitude. Sometimes
consortium of banks as creditors would package such loan requirement
for a project; with one of the banks serving as the lead bank. This is
usually referred to as syndicated loan or consortium lending. The
packaging of this type of loan, involves the borrower signing a loan
agreement with the lead bank, spelling out in the loan agreement
documents, the terms and conditions of the loan, on one hand, and the
lead bank also signing an agreement with the participating banks. The
latter will state each banks commitment, fees and commission etc.
Companies considered this system as more convenient for a larger loan
commitment, especially when they have not exhausted their capacity to
borrow. Comparatively it is a more costly medium of financing, in the
short-run. In the long run the issue of dividend bonus or script issues
makes equity more expensive.
Government Bonds/Stocks
These are long-term debt instruments evidencing that government has

borrowed a certain amount from the holder. This could be Federal
Government, State or Local government stocks issued to raise funds for
government to finance development projects. If it is state or local
government stock, it is usually secured with revenue allocation from the
federal government, which often than not, is deducted at source. Federal
government stocks can come in form of bonds or development stocks
and of various tenor or maturity(ies)/ periods. They carry fixed amount
of interest but usually of low interest yielding but as good as the Naira
and usually redeemable.
Debentures
These are long-term instrument evidencing the borrowing of money by a

Company from the holder. It is usually denominated in units with value
attached to it. They often carry fixed interest rate and the holders are
often treated as creditors to the Company and therefore given preference
upon liquidation over all classes of shareholders.
There are Redeemable Debentures, Irredeemable Debentures; while

some Debentures are convertible to ordinary stocks of the borrowing
company at a definite time and at a predetermined rate.
Equity Attraction
Before the recent demise, investments in capital market have proved to

be highest yielding investment with low level of risk for a well
constructed and diversified portfolio. The following sectors has by
market indices proved to be the toast of the investors and speculators
over the years as a result of returns they enjoyed which is well
commensurate and or meet their investment objectives.
 Oil Sector
 Banking Sector
 Conglomerates
 Food and Beverages
Insurance sectors have not been so attractive because of poor dividend

payout policy which always falls below the investors' expectation or
comparable with return from other sectors/investments. Hence, the price
has been on the low side.
However, hope exists for the sector with the reforms going on in the
industry and the fact that their prices are very low compared with
other sector and occasional declaration of bonuses which temporarily at
times trigger price increases and for those buying for price sake.
3.4 Operators in the Capital Market
The following are the operators in the Nigerian Stock Market:
Regulators
1. Securities and Exchange Commission

2. Nigerian Stock Exchange
3. Central Securities Clearing System
4. Chartered Institute of Stockbrokers
Operators
1. Issuing House
2. Stockbroker to the Issue
3. Auditors to the company
4. Reporting Accountants
5. Solicitors to the company
6. Solicitors to an issue
7. Registrars
8. Receiving bank
9. Receiving Agents
10. Trustees (in case of debt instruments)
Securities and Exchange Commission (SEC)

Securities and Exchange Commission is the apex regulatory authority in
the Capital market. It registers the shares to be issued and registers all
other operators in the market and also monitors the operations on the
trading floor of the exchange
Nigerian Stock Exchange

Nigerian Stock Exchange is a self-regulatory authority in the capital
market. It provides trading floors and equipment for trading on every
trading day. It also trains the new members of the exchange in the use of
Automated Trading System (ATS).
Chartered Institute of Stockbrokers

The Chartered Institute of Stockbrokers trains all the securities dealers
and equips them to meet the millennium challenges.
Stockbrokers
Stockbrokers are the dealing members of the Nigerian Stock Exchange.
Their activities in the market spanned through participation in the
primary issue as a financial adviser or issuing house or as Stockbroker to
the issue, thus presenting the issue for listing and continuous trading on
the floor of the exchange.
The stockbrokers play active role in the capital market in both primary
and secondary but more in the secondary aspect of the market than the
primary side. They also participate actively in the primary aspect of the
market by making all necessary efforts to see that the shares are listed on
the daily official list of the exchange as the member of the family of the
exchange.
They also market the issue, on behalf of the issuer through their wide
range of clientele.
Issuing House
Issuing House is more often than not an investment barter and plays a
dominant role in the primary side of the market, by coordinating other
consultants to see that the public issue succeeds; by acting as financial
consultant to the issue.
The issuing house and the issuer co-joined in the appointment of other
professionals to the issue. They can also give bridging loans to the issuer
pending the time the issue will be completed and also underwrite the
issue to certain extent.
Auditors to the Company

The auditors to the company also perform an important role in the public
issue by supplying all the information required by the reporting
accountants to do their job efficiently. They attend all meetings and
answer any questions on the financial statements.
Reporting Accountants
This is a firm(s) of Chartered Accountants acting as reporting
accountants to a public issue. Their job is so enormous; they vet all the
financial statements that are to be presented to the public for fairness
and reasonableness. They also vet all the projections made by the issuer
and ascertain their reasonableness. In practice, their job is so enormous
to the extent that they are often assisted by the issuing house(s).
Solicitors to the Company

The solicitors to the company also assist in the public issue by assisting
the solicitors to the issue in providing information regarding the legal
form and all other related documents. They also assist in the area of
increase of share capital to accommodate the new issue and sees to the
fact that all the necessary documents are filed appropriately.
Solicitors to the Issue

This is also a firm of legal practitioners that act as consultant in public
issues. They are usually registered by the Securities and Exchange
Commission as Capital Market consultant.
Their major duties are to be a watchdog in the process of public issue.

First of all, they see to the fact that all the necessary documents are filed
with the relevant bodies and also that all the other consultants that
participate in the issue are qualified to do so and that they are formally
registered by SEC. They see to the orderliness of the whole
arrangement.
Registrar
As the name implies they are the company that act as registrar to
publicly quoted companies. Their job is so enormous and continuous. As
a matter of fact their major activities are post issue activities. They keep
the register of the members after allotment and maintain it on daily
basis. They are the one that distribute dividend to shareholders and
interest in case of debt instruments. They also issue certificates on both
public and bonus issues and send circulars and annual report and
accounts before AGM can hold.
Receiving Bank/Agent's
This is a bank that receives all the return monies on application and
surrenders it to the issuer after allotment.
Trustees
In the case of Debt Instrument, trustees have to be appointed to take care
of the interest of the bond-holders/creditors. Their work is similar to that
of the Registrar in that they see to the day to day management of the
debt until They are fully redeemed. They see to the regular payment of
interest and capital and if there is any unclaimed interest they are
transferred to them for management. They see to the fact that the
company follows the terms of the debentures instrument strictly.
Another important thing to note is that aside from stockbrokers whose

constituency is capital market all these other professionals are also
formerly registered with the Securities and Exchange Commission
(SEC.) as Capital market consultants.
3.5 Importance of Nigerian Capital Market
 It helps to harness the savings of individuals and channel them

towards productive means.
 It provides opportunities for Nigerians to participate in the

ownership structure of multinational Companies.
 It provides local opportunities for Long term borrowing and

lending.
 It provides opportunities for government to mobilize Long term

funds for economic development of the country.
 It provides opportunities for inflow of capital from the Diaspora.
 It provides employment opportunities for Nigerians especially the

market operators
 It provides a barometer for measuring the economic performance

of the country.
4.0 CONCLUSION
We have seen in this unit that Capital market is created to meet the
inadequacies created by the money market that trades in instruments of
short-term duration. Capital market is a market for long term funds.
5.0 SUMMARY
In this unit you have learnt the development of Capital Market in
Nigeria; the Instruments traded in the Capital Market, the Shareholding;
the various Operators in the Capital Market and the Importance of
Nigerian Capital Market.
1. Explain the word 'Capital Market'.

2. Who are the operators in the Nigerian Capital Market?
3. Who are the regulators in the Nigerian Capital Market?

Elite Trust Ltd
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UNIT 3 CAPITAL MARKET INVESTMENT AS AID TO
ECONOMIC DEVELOPMENT
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Functions of the Capital Market Investment
3.2 Roles of the Capital Market in Economic Development
3.3 How the Capital Market Currently Aids the Economy
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
From a global perspective, the state of the capital market investment

gives an idea of the state of health of the national economy. It also
measures the stability of the economy with regards to the extent to
which economic activities can rely on it. "Essentially, the level of
national economic development and the extent to which most economic
activities can effectively rely on the safety of the capital market are
major indicators of a healthy balance between a sound financial system
and macro-economic stability" (NEEDS, 2003). It is in the light of these
assumptions that the capital market performs several roles and functions.
2.0 OBJECTIVES

 Understand the functions of the Capital Market Investment
 State the roles of the Capital Market in Economic Development
 Understand how the Capital Market Currently Aids the Economy
3.0 MAIN CONTENT
3.1 Functions of the Capital Market investment
The capital market performs several functions in any economy. These

include:
(a) Financial intermediation from funds surplus to funds deficit
institutions.
(b) Offering enterprises new and wider opportunities for obtaining
funds.
(c) Acting as a means of exchanging securities at mutually beneficial
proves thereby creating liquidity through its pricing mechanism.
(d) Acting as means of ascertaining security prices.
(e) Acting as an easily accessible means of efficiently trading in
securities
(f) Allocating and rationing funds among competing demand and
uses.
3.2 Roles of the Capital Market in Economic Development
The capital market plays the following important roles in the economic
development process:
 Providing a means of raising long-term finance to assist
companies to expand and modernize;
 Providing a means of allocating the nation’s real and financial
resources between various industries and companies;
 Providing liquidity for investment funds from the standpoint of
the individual and the economy;
 Serving as a measure of confidence in the economy and as an
important economic barometer;
 Providing industrial management with some idea of the current cost
of capital through its pricing mechanism, an important issue in
determining the level and rate of investment;
 Acting as a reliable medium for broadening the ownership base of
erstwhile family dominated firms (NSE, 1990);
 Providing an avenue for marketing of securities in order to raise
fresh funds for expansion;
 Encouraging inflow of foreign capital when foreign companies or
investors invest in domestic securities;
 Providing facilities for foreign businesses to offer their shares to
Nigerian investors thereby giving Nigerians ownership stake in
foreign companies;
 Providing the opportunities for government to finance economic
development-oriented projects;
 Creating an avenue for government to privatize its erstwhile state-
owned companies;
 Encouraging transparency and good accounting and management
practices through adequate disclosure of relevant and adequate
information for investors to make well-informed decisions;
 providing needed seed money for venture capital development
which often serves as a vehicle for industrial growth and
development (SEC, Abuja, 2006).
3.3 How the Capital Market Currently Aids the Economy
 Through the second-tier Securities Market by promoting small

and medium sized industries.
 Through the securitization of the domestic national debt, by

promoting a bonds market to specifically cater for domestic
national debts. This makes the debts negotiable via the Debt
Management Office of Nigeria; and helps to provide liquidity to
lenders who would wish to encash their bonds.
 Through funding the bank consolidation exercise by Initial Public

Offers, Public Offers and Private Placements.
 Through financing upstream and downstream activities in the oil

and gas industry-specifically hydrocarbons (petrochemicals and
liquefied natural
 gas).
 Through the privatization and commercialization of government

controlled enterprises by offer for sale or subscription in the
capital market.
 Through the promotion of commodities exchanges to facilitate

liquidity for agricultural products in an organized market
 Through the internationalization of the capital market by cross-

border listings, cross listings on other stock exchanges and
provision of investment information on all securities listed on the
Nigerian Stock Exchange to the international community. This
encourages foreign inflow of capital through enquiries.
In summary, the significance of the capital market lies in the fact that:
 it is where the value of a business can be accessed through the
price of its stock;
 it is where changes in the ownership of businesses take place
through the purchase and/or sale of stock;
 it is where a business or government raises new capital and tests
its support in the broader business community by selling stock at
a given price; and
 it is the only forum where speculation and gambling take place
legitimately (Kidron & Segal, 1987).
4.0 CONCLUSION
We have seen in this unit the capital market investment gives an idea of
the state of health of the national economy and that it measures the
stability of the economy with regards to the extent to which economic
activities can rely on it.
5.0 SUMMARY
In this unit, you have learnt the various functions of the Capital
Market Investment, the roles of the Capital Market in Economic
Development and how the Capital Market Currently Aids the Economy
6.0TUTOR-MARKED ASSIGNMENT
 Explain briefly five roles of Capital Market investment in the
economic development of Nigeria

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Unit 4 CURRENT STATE OF EMPIRICAL EVIDENCE OF
MODELS FOR EVALUATING PORTFOLIO
PERFORMANCE
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Empirical debates on the models for evaluating portfolio
performance
3.2 Procedures in estimating and evaluating asset pricing
models.
3.3 Pitfalls in the Current Practice and Suggestions for
Improving Empirical Work
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignments
1.0 INTRODUCTION
Prices in financial markets aggregate dispersed information from

millions of investors. A vast literature considers portfolio choice
problems under symmetric information, but ignores this fundamental
function of financial markets. It is no coincidence that the overwhelming
majority of empirically successful equilibrium asset pricing models that
embed portfolio problems assume that information is symmetric, or
equivalently, that a representative agent exists. Equilibrium asset pricing
models with dispersed information are complicated, informationally
demanding and suffer from testability issues that limit their usefulness.
However, a realistic though challenging portfolio problem must rec-
ognize that investors allocate capital across multiple assets without
much knowledge of other, investors, their tastes or the precision of their
information. Money managers and retail investors alike must therefore
ask themselves two questions: First, what do current prices tell them
about the private information of others? Second, is the information in
prices valuable given their private information?
To answer the second question, we quantify the improvement in
portfolio performance of a privately informed investor who updates his
beliefs using market prices with those of an equally informed
"dogmatic" investor who only uses his private information. We do this
by providing the investor with a noisy signal of next period's actual
returns, which we, the econometricians, can correctly observe. Our
simple approach allows us to overcome the fundamental problem of
testing a model in which agents have private information unobservable
to the econometrician.
To answer the first question, Black and Litterman (1992) extract market-
implied expected returns using a symmetric information equilibrium
model, the CAPM, as an elegant approximation.1 They combine this
information from prices with the private information of the investor in a
Bayesian fashion. The approach is popular among active money
managers who believe they hold information superior to that of other
market participants, but wish to update their beliefs using market prices.
However, the benefits of using a misspecified asset pricing model to
learn from market prices about other investors' views on expected
returns remains an empirical question.
2.0 OBJECTIVES
 Understand the empirical debates on the models for evaluating

portfolio performance
 Understand the Procedures in estimating and evaluating asset
pricing models.
 Understand the Pitfalls in the Current Practice and
Suggestions for Improving Empirical Work
3.0 MAIN CONTENT

3.1 Empirical debates on the models for evaluating portfolio
performance
The performance evaluation of investment portfolios has been widely
debated in the financial literature, and is still an evolving subject. Only
through measures of performance may investors and portfolio managers
know if the type of information used resulted in abnormal returns.
Furthermore, the issue of assessing whether fund managers add value is
a challenging one, since it is closely related to questions (not easily
answered) about market efficiency and information dissemination in
capital markets.
The traditional approaches to measure performance are unconditional in

the sense that it is assumed that no information about the state of the
economy is used to form returns expectations. So, expected returns and
risk are assumed to be constant over time. It is well recognized that
traditional measures are biased when portfolio managers use dynamic
strategies resulting in time-varying risk (Jensen [1972], Dybvig and
Ross [1985], Admati and Ross [1985] and Grinblatt and Titman [1989]).
Several studies have shown that predetermined information variables are
useful in predicting stock and bond returns (among others, Keim and
Stambaugh [1986], Fama and French [1989]. This evidence resulted in
important developments on asset pricing models but, with few
exceptions, little has been explored at the level of portfolio performance
evaluation.
Many asset pricing theories predict that the price of an asset should be
lower (its expected return higher) if the asset provides a poor hedge
against changes in future market conditions (Rubinstein, 1976, Breeden,
1979). The classic capital asset pricing model (CAPM) of Sharpe
(1984) and Lintner (1965) considers the case in which investment
opportunities are constant and investors hold efficient portfolios so as to
maximize tier expected return for a given level of variance. The CAPM
predicts that an asset’s risk premium will be proportional to its beta – the
measure of return sensitivity to the aggregate market portfolio return.
The considerable empirical evidence against the CAPM points to the
fact that variables other than the rate of return on a market portfolio
proxy command significant risk premia. The theory of the intertemporal
CAPM (ICAPM) (Merton, 1973, Long, 1974) suggests that these
additional variables should proxy for the position of the investment
opportunity set. Although the ICAPM does not identify the various state
variables, leading Fama (1991) to label the ICAPM as a “fishing
license”. Breeden (1979) shows the Merton’s ICAPM is actually
equivalent to a single-beta consumption model (CCAPM) since the
chosen level of consumption endogenously reflects the various hedging-
demand effects of the ICAPM.
Over the years, researchers have made many attempts to refine the
theoretical predictions and improve the empirical performance of the
CAPM and CCAPM. Popular extensions include internal and external
habit models (Abel, 1990; Constantinides, 1990; Ferson and
Constantinides, 1991; Campbell and Cochrane, 1999), models with non-
standard preferences and rich consumption dynamics (Epstein and Zin,
1989, 1991; Well, 1989; Bansal and Yaron, 2004), models that allow for
slow adjustment of consumption to the information driving asset returns
(Parker and Julliard, 2005), conditional models (Jagannathan and Wang,
1996; Lettau and Ludvigson, 2001), disaster risk models (Berkman,
Jacobsen, and Lee, 2011), and the well-known “three-factor model” of
Fama and French (1993). Although empirical observation primarily
motivated the Fama-French model, its size and book-to-market factors
are sometimes viewed as proxies for more fundamental economic
variables.
The asset pricing theories listed above, to be of practical interest, need to

be confronted with the data. Two main econometric methodologies
have emerged to estimate and test asset pricing models: (1) the
generalized method of moments (GMM) methodology for models
written in stochastic discount factor (SDF) form and (2) the two-pass
cross-sectional regression (CSR) methodology for models written in
beta form.
The SDF approach to asset pricing indicates that the price of a security
is obtained by "discounting" its future payoff by a valid SDF so that the
expected present value of the payoff is equal to the current price. In
practice, finding a valid SDF, i.e., an SDF that prices each asset
correctly, is impossible and researchers. have to rely on some candidate
SDFs to infer the price of an asset. Although testing whether a particular
asset pricing model is literally true is interesting, a more useful task for
empirical researchers is to determine how wrong a model is and to
compare the performance of competing asset pricing models. The latter
task requires a scalar measure of model misspecification. While many
reasonable measures can be used, the one introduced by Hansen and
Jagannathan (1997) has gained tremendous popularity in the empirical
asset pricing literature. Many researchers have used their proposed
measure, called the Hansen-Jagannathan distance (NJ-distance), both as
a model diagnostic and as a tool for model selection. Examples include
Jagannathan and Wang (1996), Li, Xu, and Zhang (2010), and
Gospodinov, Kan, and Robotti (2011a). Asset pricing models in SDF
form are generally estimated and tested using GMM methods.
Importantly, the SDF approach and the HJ-distance Metric are
applicable whether or not the pricing model is linear in a set of
systematic risk factors.
When a model specifies that asset expected returns are linear in the
betas (beta-pricing model), the CSR method proposed by Black,
Jensen, and Scholes (1972) and Fama and MacBeth (1973) has been
the preferred method in empirical finance given its simplicity and
intuitive appeal. Although there are many variations of the CSR
methodology, the basic approach always involves two steps or
passes. In the first pass, the betas of the test assets are estimated
using the usual ordinary least squares (OLS) time series regression
of returns on some common factors. In the second pass, the returns
on the test assets are regressed on the betas estimated from the first
pass. Running this second-pass CSR on a period-by-period basis
enables obtaining the time series of the intercept and the slope
coefficients. The average values of the intercept and the slope
coefficients are then used as estimates of the zero-beta rate
(expected return for risky assets with no systematic risk) and factor
risk premia, with standard errors computed from these time series as
well. given its simple intuitive appeal, the most popular measure of
model misspecification in the CSR framework has been the R2 for
the cross-sectional relation (Kandel and Stambaugh, 1995; Kan,
Robotti, and Shanken, 2010). This R2 indicates the extent to which
the model’s betas account for the cross-sectional variation in
average returns, typically for a set of asset portfolios.
After reviewing the SDF and beta approaches to asset pricing, this
chapter describes several pitfalls in the current econometric analyses
and provides suggestions for improving empirical tests. Particular
emphasis is given to the role played by model misspecification and
to the need for more reliable inference procedures in estimating and
evaluating asset pricing models.
3.2 Procedures in estimating and evaluating asset pricing

models.
Stockastic Discount Factor Representations

The SDF approach to asset pricing provides a unifying framework
for pricing stocks, bonds, and derivative products and is based on
the following fundamental pricing equation (Cochrane, 2005).
Pt = Et [mt + 1Xt+1] (3.2.1)
Where Pt is an N-Vector of asset prices at time t; xt+1 = Pt+1 + dt+1 is
an N-vector of asset payoffs with dt+1 denoting any asset’s dividend,
interest or other payment received at time t +1; mt+1 is an SDF,
which depends on data and parameters; and Et is a conditional
expectation given all publicly available information at time t.
Dividing both sides of the fundamental pricing equation by pt (assuming

non-zero prices) and rearranging yields
Et[mt+1(1+Rt+1) – 1N] = ON (3.2.2)
where Rt+1 = -1= - 1 is an N-vector of asset returns and

1N and 0N are N-vectors of ones and zeros, respectively.
Portfolios based on excess returns, = Rt+1 - 1N, where

denotes the risk-free rate at time t, are called zero-cost portfolios. Since
the risk-free rate is known ahead of time, it follows that Et[mt+1(1+ )]
= Et[mt+1](1+ ) = 1 and Et[mt+1] = . In this case, with zero prices
and payoffs the fundamental pricing equation is given by
Et[mt+1 +1] = 0N. (3.2.3)
As an example of the SDF approach, consider the problem of a
representative agent maximizing her lifetime expected utility
βt E0[u(ct)] (3.2.4)
subject to a budget constraint
at+1 = (at + yt – ct) (1 + Rt+1). (3.2.5)
where β, ct, at and yt denote the time preference parameter, consumption,

asset’s amount and income at time t, respectively. The first-order
condition for the optimal consumption and portfolio choice is given by
Et = 0N. (3.2.6)
where u'(c) denotes the first derivative of the utility function u(c) with
respect to c. This first-order condition takes the form of the fundamental
pricing equation with SDF given by the intertemporal marginal rate of
substitution
mt+1 = (3.2.7)
While the SDF in Equation 3.7 is positive by construction, an SDF

can possibly price assets correctly and, at the same time, take on
negative values, especially when the SDF is linear in a set of risk
factors. Although a negative SDF does not necessarily imply the
existence of arbitrage opportunities, dealing with positive SDF’s is
generally desirable, especially when interest lies in pricing
derivatives (positive payoffs should have positive prices).
Therefore, a common practice in the derivative pricing literature is
to consider Equation 3.1 with mt+1 > 0, which implies the absence of
arbitrage. In some situations, however, imposing this positivity
constraint can be problematic. For example, if one is interested in
comparing the performance of competing asset pricing models on a
given set of test assets using the distance metric proposed by Hansen
and Jagannathan (1997), constraining the admissible SDF to be
positive is not very meaningful. Gospodinoc, Kan, and Robotti
(2010a) provides a rigorous analysis of the merits and drawbacks of
the no-arbitrage HJ-distance metric.
Beta Representation
By the law of iterated expectations, the conditional form of the

fundamental pricing equation for gross-returns can be reduced to its
unconditional counterpart:
E[mt+1(1 + Rt+1)] = 1N. (3.2.8)
From the covariance decomposition (suppressing the time index for

simplicity), the pricing equation for asset I can be rewritten as
1 = E[m(1 + Ri)] = E[m]E[1 + Ri] + Cov[m,(1 + Ri)]. (3.2.9)
Then, dividing both sides by E[m] > 0 and

rearranging,
E[Ri] = = 0 + βi,mm. (3.2.10)
using that = 1 + Rf = 1 +0 from above. Note that βi,m =
is the regression coefficient of the return Ri on m and m = - <0

denotes the price of risk.
Recall that the SDF in is a function of the data and parameters. Suppose
now that in can be approximated by a linear function of K (risk) factors f
that serves as proxies for marginal utility growth:
m = ’e, (3.2.11)
where = (1,f’)’. Then, substituting for m into the fundamental pricing

equation and rearranging (see Cochrane, 2005, pp.107-108),
E[Ri] = 0 + ’1βi, (3.2.12)
where the βi’s are the multiple regression coefficients of Ri on f and a

constant, o is the zero-beta rate and y1 is the vector of risk premia on the
K factors. The beta representation of a factor pricing model can be
rewritten in compact form as
E[R] = B, (3.2.13)
where B = [1N,β], β = Cov[R, f]Var[f] -1 is an (N x K) matrix of factor

loadings and  = (o, ’1)’. Constant portfolio characteristics can easily
be accommodated in Equation 3.13 (Kan
et al., 2010). Jagannathan, Skoulakis, and Wang (2010) show how to
write the beta-pricing relation when characteristics are time-varying.
3.3 Pitfalls in the Current Practice and Suggestions for
Improving Empirical Work
One empirical finding that consistently emerges from the statistical tests
and comparisons of competing asset pricing models is that the data are
too noisy for a meaningful and conclusive differentiation among
alternative SDF specifications. Given the large noise component in
returns on risky assets, explaining the cross-sectional variability of asset
returns by using slowly changing financial and macroeconomic
variables appears to be a daunting task. Even if the asset pricing theory
provides guidance for the model specification, the properties of the data
and some limitations of the standard statistical methodology can create
further challenges in applied work. This section discusses several pitfalls
that accompany the estimation of risk premia and evaluation of
competing asset pricing models using actual data. Particular attention is
paid to the possibility of model misspecification presence of useless
factors, highly persistent conditioning variables, large number of test
assets, potential lack of invariance to data scaling, and interpretation of
the risk premia.
Misspecified Models
A widely-held belief is that asset pricing models are likely to be
misspecified and should be viewed only as approximations of the true
data generating process. Nevertheless, empirically evaluating the degree
of misspecification and the relative pricing performance of candidate
models using actual data is useful.
Two main problems with the econometric analyses are present when
performed in the existing asset pricing studies. First, even when a model
is strongly rejected by the data (using one of the model specification
tests previously described, for example), researchers still construct
standard errors of parameter estimates using the theory developed for
correctly specified models. This process could give rise to highly
misleading inference especially when the degree of misspecification is
large. Kan and Robotti (2009) and Gospodinov et al. (2011a) focus on
the HJ-distance metric and derive misspecification-robust standard
errors of the SDF parameter estimates for linear and nonlinear models.
In contrast, Kan et al. (2010) focus on the beta representation of an asset
pricing model and propose misspecification-robust standard errors of the
second-pass risk premia estimates. For example, for linear SDF
specifications, the misspecification adjustment term, associated with the
misspecification uncertainty surrounding the model, can be decomposed
into three components: (1) a pure misspecification component that
captures the degree of misspecification, (2) a spanning component that
measures the degree to which the factors are mimicked by returns, and
(3) a component that measures the usefulness of the factors in explaining
the variation in returns. The adjustment term is zero if the model is
correctly specified (component (1) is zero) and/or the factors are fully
mimicked by returns (component (2) is zero). If the factors are poorly
mimicked by the returns, the adjustment term could be very large. This
issue will be revisited in the discussion of the useless factors case.
Second, many researchers are still ranking competing models by simply

eyeballing the differences in sample HJ-distances or sample R2's without
any use of a formal statistical criterion that accounts for the sampling
and model misspecification uncertainty. Kan and Robotti (2009), Kan et
al. (2010), and Gospodinov et al. (2011a) develop a complete statistical
procedure for comparing alternative asset pricing models. These model
selection tests take into account the restrictions imposed by the structure
of the competing models (nested, non-nested or overlapping) as well as
the estimation and model misspecification uncertainty. Gospodinov et
al. (2011a) also propose chi-squared versions of these tests that are easy
to implement and enjoy excellent finite-sample properties.
One recommendation for empirical work that emerges from these

remarks is that the statistical inference in asset pricing models should be
conducted allowing for the possibility of potential misspecification. This
will ensure robust and valid inference in the presence of model
misspecification as well as when the models are correctly specified.
Useless Factors
Consistent estimation and valid inference in asset pricing models

crucially depends on the identification condition that the covariance
matrix of asset returns and risk factors is of full rank. Kan and Zhang
(1999a, 1999b) study the consequences of the violation of this
identification condition. In particular, they show that when the model is
misspecified and one of the included factors is useless (i.e., independent
of asset returns), the asymptotic properties of parameter and
specification tests in GMM and two-pass cross-sectional regressions are
severely affected.
The first serious implication of the presence of a useless factor is that the
asymptotic distribution of the Wald test (squared t-test) of statistical
significance of the useless factor's parameter (HJ-distance case) is chi-
squared distributed with N – K – 1 degrees of freedom instead of one
degree of freedom as in the standard case when all factors are useful.
The immediate consequence of this result is that the Wald test that uses
critical values from a chi-squared distribution with one degree of
freedom will reject the null hypothesis too frequently when the null
hypothesis is true. The false rejections are shown to become more severe
as the number of test assets N becomes large and as the length of the
sample increases. As a result, researchers may erroneously conclude that
the useless factor is priced when, in reality, it is pure noise uncorrelated
with the stock market.
Another important implication is that the true risk premium associated

with the useless factor is not identifiable and the estimate of this risk
premium diverges at rate . The standard errors of the risk-premium
estimates associated with the useful factors included in the model are
also affected by the presence of a useless factor and the standard
inference is distorted. Similar results also arise for optimal GMM
estimation (Kan and Zhang, 1999a) and two-pass cross-sectional
regressions (Kan and Zhang, 1999b).
The useless factor problem is particularly serious because the traditional
model specification tests previously described cannot reliably detect
misspecification in the presence of a useless factor. This manifests itself
in the failure of the specification tests to reject the null hypothesis of
correct specification when the model is indeed misspecified and contains
a useless factor.
More generally, similar types of problems are symptomatic of a
violation of the crucial identification condition that the covariance
matrix of asset returns and risk factors must be of full rank. Therefore, a
rank restriction test (see, for example, Gospodinov, Kan, and Robotti,
2010b) should serve as a useful pre-test for possible identification
problems in the model (see also Burnside, 2010). However, this test
cannot identify which factor contributes to the identification failure.
Kleibergen (2009) proposes test statistics that exhibit robustness to the -
degree of correlation between returns and factors in a two-pass cross-
sectional regression framework. In the SDF framework, Gospodinov,
Kan, and Robotti (2011b) develop a simple (asymptotically,
d-distributed) misspecification-robust test that signals the direction of
the identification failure. Only after the useless factor is detected and
removed from the analysis, the validity of the (misspecification-robust)
inference and the consistency of the parameter estimates can be restored.
4.0 CONCLUSION
The Sharpe (1964), Lintner (1965) and Black (1972) Capital Asset
Pricing Model (CAPM) is considered one of the foundational
contributions to the practice of finance. The Model postulates that the
equilibrium rates of return on all risky assets are linear function of their
covariance with the market portfolio. Recent work by Fama and French
(1996, 2006) introduce a Three Factor Model that questions the “real
world application” of the CAPM Theorem and its ability to explain
stock returns as well as value premium effects in the United States
market.
One of the fundamental tenants in financial theory is the CAPM as

developed by Sharpe (1964), Lintner (1965) and Black (1972). The
CAPM's impact over the decades on the financial community has led
several authors inclusive of Fama and French (2004) to suggest that the
development of the CAPM marks "the birth of Asset Pricing models".
The CAPM is an ex-ante, static (one period) model. The model's main
prediction is that a market portfolio of invested wealth is mean-variance
efficient resulting in a linear cross-sectional relationship between mean
excess returns and exposures to the market factor (Fama and French,
1992).
5.0 SUMMARY
An important but still partially unanswered question in the investment

field is why different assets earn substantially different returns on
average. Financial economists have typically addressed this question in
the context of theoretically or empirically motivated asset pricing
models. Since many of the proposed "risk" theories are plausible, a
common practice in the literature is to take the models to the data and
perform "horse races" among competing asset pricing specifications. A
"good" asset pricing model should produce small pricing (expected
return) errors on a set of test assets and should deliver reasonable
estimates of the underlying market and economic risk premia. This unit
provides an up-to-date review of the statistical methods that are typically
used to estimate, evaluate, and compare competing asset pricing models.
The analysis also highlights several pitfalls in the current econometric
practice and offers suggestions for improving empirical tests.
6.0 TUTOR MARKED ASSIGNMENTS
 For linear SDF specifications, the uncertainty surrounding the

misspecification model can be decomposed into three
components. Discuss.
 Two main econometric methodologies have emerged to estimate
and test asset pricing models. Discuss succinctly.
Igbinosa, S.O. (2012). Investment analysis and

management , Lagos: Elite Trust Ltd
Nikolay, G. & Cesare, R. (Undated), Asset Pricising Theories, models,
and Tests, Concordia University and
CIREQ
Okafor, F.O. (1983). Investment decisions : Evaluation of
projects and securities, London : Cassell
publishing
UNIT 5 CAPITAL ASSET PRICING MODEL (CAPM)
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Risk and Capital Asset Pricing Model (CAPM)
3.2 Assumptions of CAPM
3.3 Implications of CAPM
3.4 The Capital Market Line (CML)
3.5 Return under CAPM
3.6 Workings and Illustrations
3.7 Limitations of CAPM
3.8 Arbitrage Pricing Theory (APT)
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignments
1.0 INTRODUCTION
The CAPM was developed by Sharpe (1964). Lintner (1965) and

Mossin (1966). The model shows the relationship between the expected
return of a security and its unavoidable risk. It also promotes a
framework for the valuation of securities and can be used to find the cost
of a company's equity.
2.0 OBJECTIVES
 Understand the concept of Risk and Capital Asset Pricing Model

(CAPM)
 The Assumptions of CAPM
 The Implications of CAPM
 The Capital Market Line (CML)
 The Return under CAPM
 The Workings and Illustrations
 The Limitations of CAPM
 The Arbitrage Pricing Theory (APT)
3.0 MAIN CONTENT

3.1 Risk and Capital Asset Pricing Model (CAPM)
By risk we mean that the actual returns on the investment might turn out
better or worse than hoped. Risks that can on the whole be diversified
away are referred to as Unsystematic sold-risk. Investments have an
element of risk, which is inherited, or characteristic to the nature of
investment itself. This inherent risk characteristic cannot be diversified
away, and it is referred to as Systematic risk (or market risk). By
accepting systematic risk, investor will expect to earn a return, which is
higher than the return on a risk free investment. Investors should not
require a premium for unsystematic risk because this can be diversified
away by holding a well spread portfolio.
3.2 Assumptions of CAPM
1. Investors are risk averse individuals who would maximize the

expected utility of their end of period wealth. This implies that
the model is a one-period model.
2. Investors are price takers and have homogenous expectations
about securities or return that have a joint normal distribution
3. There exist a risk-free security such that investors may borrow or
lend unlimited amount at the risk-free rate.
5. All securities are marketable and perfectly divisible
6. Security markets are frictionless. This implies that information
are costless and simultaneously available to all investors.
7. There are no market imperfections such as taxes, regulations or

transaction costs. There is negligible restriction on investment
and no investor is large enough to affect the market price of the
stock.
8. The stock market is efficient; ie, security values reflect all known
information which is available to all investors at low cost.
3.3 Implications of CAPM
The CAPM has the following practical implications:
1. Investors should invest in a portfolio of securities in a way that

diversify or eliminate most of the unique unsystematic risk from
their portfolios.
2. The CAPM can be used in computing the discount rate for equity
valuation in the dividend valuation model.
3. Shares in individual companies will have systematic risk

characteristic, which are different to the market average. Some
shares will be less risky and some are more risky than the stock
market average.
4. If investor holds a balanced portfolio of all the stocks and shares

on the stock market, be will be incurring systematic risk, which is
exactly equal to the average systematic risk in the stock market as
a whole.
5. If an investor wants to avoid risk all together, he must invest in a

portfolio consisting entirely of risk-free securities.
3.4 The Capital Market Line (CML)
This is also referred to as the security marker line (SML). Given the
assumptions of CAPM the price of each financial asset would be
expected to fall on the SML. The SML is given as:
E(Ri) = Rf + (E(RM) – Rf) Bj

Where Bj =
Where:
E (Rj) = expected return on security
Rf = Risk free rate
E(Rm) = Expected rate of return on market portfolio
Cov(Rj,Rm) = Covariance of security; with the returns on the market

portfolio
D2m = variance of return on the market portfolio
B = beta factor of security
equal to the risk free rate plus a risk premium, the later being defined as
the price of risk multiplied by the quantity of risk.
Graphically, the SML can be shown as:
Expected
The security market line
Expected return
RM Risk Premium
B C
An investor is expected to purchase security along the SML to maintain
a balance between its expected return and the risk exposure of his/her
portfolio.
3.5 Return under CAPM
Under CAPM the required rate of return is made up of two parts namely:
i. The risk free rate
ii. Risk premium
The Risk Free Rate

The Risk Free rate is the basic rate, which all projects must earn to
compensate for the value of interest on borrowed fund.
Risk Premium
Risk premium is the additional return above the risk free rate to
compensate investors for systematic risk. It is estimated by multiplying
the security's beta factor by the difference between the market return and
risk free rate of return.
Therefore, the expected minimum required return is given as:

Expected Return = Risk free rate + Risk premium
That; E (r) = Rf 9E (rm) – Rf ) B,
That is, E ( r) = RF (E(RIM) – RF) Bj
This can simply be written as:
Where:
Rs = Expected return on the individual security
Rf = Risk free rate
Rm = Market rate of return (ie market portfolio return)
B = Beta factor of the individual security
The Beta Factor
The measure of the relationship between market returns and an

individual security's return can be developed into a beta factor for the
individual Security.
Beta factor is defined in the CIMA's official terminology as the

measures of shares volatility in terms of market risk",
The Beta factor measures the degree of responsiveness /sensitivity of the

returns of individual security to changes in the returns of the market
securities. For example if the average market return rises by say 2%, the
return from a share with a beta factor of 0.8 should rise by 1.6% in
response to the same conditions which have caused the market return to
change.
The Beta coefficient represents the systematic risk of the security i.e.
that part of the total risk of the security, which cannot be eliminated
through efficient diversification CAPM states that it is the systematic
risk that would attract extra returns (risk premium) under equilibrium.
This is to say that the only risk for which an investor is compensated is
the systematic risk (non-diversifiable risk). Every investor is assumed to
have efficiently diversified his or her portfolio.
The Beta Factor Measurement
Given a security j in a market of portfolio M, Beta is the Covariance

between return on security, and the market portfolio M divided by the
variance of the return on the market portfolio.
B=
All gilt-edge securities (government securities) have a beta of zero

because the sensitivity of its return to market movement is zero.
The market portfolio has a beta of 1 (Bm = 1). This is because its
covariance with itself should under normal circumstance be equal to 1.
i.e. it should be the same as the variance of the market portfolio.
The Beta factor determines the size of the risk premium. The higher the
beta, the higher will be the premium (Compensation for the risk
assumed by the investors).
(i) If Beta = 1: It means that the return on the company's security

will be the same or will move in the same direction as the returns
of the market securities.
(ii) If Beta > 1: This implies that the systematic risk is high or the
returns on the company's security will fluctuate substantially in
relation to the market returns.
(iii) If Beta < 1: This means the company's security has a low
systematic risk i.e. they are considered less risky because they
would experience lower fluctuations with the market returns.
(iv) If Beta > 1: This implies that the systematic risk is high i.e the
returns on the company’s
(v) If Beta = 0: This means the company's security has no

relationship with the market. Consequently, changes in the
market will not affect the returns of the company's security.
Example is Government securities generally referred to as risk-
free assets.
3.6 Workings and Illustrations
How to calculate Beta Factor
Beta factor coefficient can be calculated using any of the following

approaches:
i. Excess Return Approach

ii. Linear Regression Approach
iii. Probability Approach.
iv. Covariance Approach
v. Standard Deviation Approach
1. Excess Return Approach
Under this method, Beta factor is given as:

B = Excess return on investment
Excess return on market
B =
Where Rs = Expected return on security

Rf = risk-free rate
Rm = market return
Illustration 1
Given a security with an expected return of 9% and a market return of
12%. Also given that government security rate is 7%. Calculate the Beta
factor.
Solution
B =
Given Rs = 9%
Rm = 12%
Rf = 7%
B= = 2/5
B = 0.40
ii. Line Regression Approach

This approach measures Beta as the gradient of the line of best fit
when the return on a security and the market return are plotted in
a graph. Therefore Beta is given as:
B =
where
B = The Beta Coefficient
X = Return from the market
N = number of pairs of data from x and y
Example 2
Wisdom Plc wishes to determine its historic beta coefficient in order to
decide the cost of capital. Its financial manager has decided to use linear
regression using a sample of 6 months data about the return on Wisdom
PLC ordinary shares and the market as a whole.
The sample data for the first 6 months are given below:
Monthly Return On:

Month Market Index (%) Wisdom’s shares (%)
1 +7 +4
2 +5 +3
3 -2 -5
4 0 -3
5 +1 +2
6 +2 +4
A dividend of 15k per share was paid by Wisdom plc in six months. The
month-end price is shown ex-dix,
Required
a. use the data above to calculate a beta value for Wisdom Plc
b. If the risk free rate of return is 8% per annum, calculate the
required return on the shares of Wisdom Plc.
Solution
Wisdom Plc
x y x2 xy
7 4 49 28
5 3 25 15
-2 -5 4 10
0 -3 0 0
1 2 1 2
2 4 4 8
13 5 83 63
b. =
= = = 0.951
Beta = 0.951
B. Required Return is: Rs = Rf + (Rm – Rf) b

Rf for 6 months = 4% (Annual rate 8%
Rm for 6 months = 7% (Annual rate 14%)
Rs = 4 + (7-4) 0.951
Rs = 4 + 2.853
Rs = 6.853%
ii. Probability approach

This is given as
b=
where
p = Probability attached to each possibility.
R = Expected return on security
Rs = Forecast return on security
Rm = Expected return on market
Rm = Forecast return on market
The probability approach is an extension of the co-variance approach.
iv. Covariance Approach

Under this approach, Beta is given as:
b = Co-variance x & y
Variance of x
Coy. xy
Varx
Where: Cov xy = covariance of individual security return and market

return as a whole. Var. x = Variance of returns for the market as a whole
Illustration 3
Assume that:
a. the risk free rate of return is 6%
b. the market rate of return is 11%
c. the standard deviation of return on the market as a whole is 40%
d. the co-variance of return for the market with returns for the
shares of Endurance Ltd over the same period has been 19.2%.
Calculate:
i. The Beta
ii. The security expected return for Endurance Ltd
Solution
i) B=
Since the variance is the square of a standard deviation then
ii) Rs = Rf + (Rm – Rf ) B
6% + (11 – 6%) 1.20
= 6% + (5) 1.20
= 12%
v) Standard Deviation Approach

This approach determines Beta by using the formular
B = Standard deviation of security xr

Standard deviation of market
dsxr
dm
where r = co-efficient of correlation between the security and the
market.
Illustration 4
Given the following information:

The average stock market return on equity = 15%
The risk-free rate of return (pre-tax) = 8%
Company x: dividend yield = 4%
Company x: share price rise = 12%
Standard deviation of total stock market
On equity = 9%
Standard deviation of total return on
Equity of company X 10.8%
Correlation coefficient between company X
return on equity and average stock market
return on equity 0.75
Required
i. What is the beta factor for company X share
ii. What does this information imply for the actual returns and actual
value of company x shares?
Solution
(i) B = = = 0.9
(ii) The cost of company X equity should therefore be:

Rs = Rf + (Rm - Rf ) B
= 8% + (15 – 8) 0.9
= 14. 3%
The Implications:
The actual returns on company X equity are 4% +12% = 16%. This
implies either that the actual returns include extra returns due to factors
which can be categorized as unsystematic risk factors or if
lower than it should be.
Beta of a portfolio
The Beta factor of an investor's portfolio is the weighted average beta
factor of each security in the portfolio. The portfolio Beta is the weight
of individual security multiplied by its respective Beta.
ie Bp = Sn Wipi
(i = 1
Illustration 5
Justine is considering allocating his portfolio funds to the following
securities
Security Weight Beta

A 15% 0.85
B 10% 1.30
C 20% 1.181
D 25% 1.25
E 30% 0.70
If the risk free rate is 12% and the return on the market portfolio is 18%,
calculate:
i. Portfolio Beta
ii. Expected Return on Jude's portfolio
Solution
i. Portfolio Beta (Bp) = Sn Wipi
i=1
Bp = 0.15 (0.85) +0.10(1.30) + 0.20 (1.181) + 0.25 (1.25) + 0.30 (0.7)
= 1.016
ii. Expected portfolio return:

Rp = Rf (Rm – Rf ) Bp
= 0.12 + 1.016 (0.18- 0.12)
= 0.18096
=18.1%
Beta of a Geared company

The gearing of a company will affect the risk of its equity. It then
follows that if a company is geared; its financial risk will be higher than
the risk of an all equity company. Therefore, the B value of A geared
company's equity will be higher than the B value of a similar ungeared
company's equity.
There is a direct connection between M & M's views about gearing and
weighted average cost of capital and the CAPM M & M argued that as
gearing rises, the cost of equity rises to compensate shareholders for the
extra financial risk of investing in a geared company. This financial risk
is an aspect of systematic risk and ought to be reflected in a company's
Beta factor.
The connection between M&M theory and CAPM means that it is

possible to establish a mathematical relationship between the B value of
an ungeared company and the B value of a similar
We should expect the B value of a geared company to be higher;

because of the extra financial risk, and the formulae to learn are:
Bu = Bg
1 + D (1 –t)………………..(1)
veg
Where:
Bu = the beta factor of an ungeared company i.e. the ungeared beta
Bg = the beta factor of a similar, but geared company i.e. the geared beta
D = the market value of the debt capital in the geared company.
Veg = the market value of the equity capital in the geared company
t = the rate of company's income tax
Re-arranging this, we have

Bg = Bu (1+ D (1-+) .................... (2)
Veg
Which is also = Bu + Bu (D (1-t)

Veg
Notice especially in formular 2 that the geared beta is equal to the

ungeared beta plus a premium for financial risk which equals.
Bu {D(1 - 1 )}
Veg
This is the geared Company's gearing ratio, multiplied by a tax

adjustment factor (1-t) and also multiplied by the beta of an ungeared
company
Illustration 6
Suppose that two companies are identical in every respect except for
their capital structure. Their market values are in equilibrium, as
follows:
Geared Ungeared
Ltd. Ltd.
N’000 N’000
Annual profit b/f Int & Tax 1,000 1,000
Interest (4,000 x 8%) 320 -
680 1,000
Tax at 35% 238 350
Profit after Tax = dividends 442 650
N’000 N’000
Market value of equity 3,900 6,500
Market value of debt 4,000 -
The total value of geared Ltd is higher than the total value of ungeared ,
which is consistent with MM's proposition that:
Vg =Vu + Dt.
The beta value of ungeared Ltd has been calculated as 1.0.
The debt capital of Geared Ltd can be regarded as risk-free
Required:
Calculate
a. the cost of equity in Geared Ltd
b. the market Return Rm
c. the beta value of Geared Ltd
Solution
a. The cost of equity in Geared Ltd is
= = 11.33%
This can be checked using the MM formula
Kg = Ku = +
Since kg = = 10%, and kd = = 8%
kg = 10% + { (1-0.35) (10-8) 4000) %

3,900
= 11.33%
b. The beta value of ungeared Ltd is 1.0 which means that the
expected returns from ungeared Ltd are exactly the same as the
market returns and so Rm = 10%
This allows us to reverify cost of equity in Geared Ltd as:
Kg = Rf + Bu (Bu (Rm – Rf) {1 + (1-+) D
= 8%+ 10 (10-8)% (1+0.65x400 veg

3,900
= 11.33%
c. Bg = Bu {f 1+ (1-t) D}
veg
=1.67
Illustration 7
Musagift Ltd has an opportunity to invest in a project lasting one year.
The net cash flows and the beta factor for each of the projects are as
follows:
Musagift N’000 B
Ltd 500 1.20
Sure Success Ltd 200 1.25
100 0.80
200 1.35
The market returns is 12% and the risk free rate of interest is 7%.
Required:
a. Calculate the total present value of the project that can be
undertaken by
1. Musagift Ltd
2. Sure success Ltd
b. Calculate the overall beta factor for sure success Ltd; Project,
assuming that all three are undertaken.
c. Using the information, discuss which company is likely to be

valued more highly by investors and suggest how portfolio
diversification by a company can reduce the risk experienced by
an investor.
Solution
a. Project discount rates
Musagift Ltd 7% + 1.2 (12-7)% = 13%
Sure success Ltd
i. 7% + 1.25 (12 – 7)% = 13.25%
ii. 7% + 0.8 (12 – 7)% = 11%
iii. 7% + 1.35 (12 – 7)% = 13.75%
Project net present values, assuming the cash flows all occur at the end
of year 1, are
N’000
Musagift 500 = 442.48
1.13
Sure success Ltd. i. 200

1.1325 176.60
ii. 100
1.11 = 90.09
iii. 200
1.1375 = 442.51
Allowing for rounding errors, the PV of the three projects of sure

success Ltd added up to the same amount as the PV of the project of
Musagift
b. Sure Success’ overall beta factor is a weighted average of the

beta factor of the three projects
Project Value B Weighting

(i) 200 1.25 250
(ii) 100 0.80 80
(iii) 200 1.35 270
500 600
Overall beta factor = = 1.2

This is the same as Musagift Ltd's project Beta factor.
c. This information shows that for the projects under review both
companies have the same PV and the same systematic risk (ie
the same beta factors). It therefore follows that on the basis of
these projects alone, investors should value both companies
equally.
It might be tempting to assume that since sure success Ltd is

divesting into three separate projects, whereas Musagift is putting
all its eggs in one basket and investing in one project, that
investors should show a preference for the low risk sure success
Ltd because Musa gift's unsystematic risk will be higher. But
with CAPM theory, it is assumed that investor can eliminate
unsystematic risk by diversifying their own investment portfolio,
and do not have to rely on companies to do the diversifying on
their behalf.
Portfolio diversification reduces risk beta use the returns from

projects will not be perfectly positively correlated, and
diversification reduces risk more when project returns show little
or no positive correlation (or preferably a negatively correlation
when only this is achievable). However, diversification by a
company reduces the risk of bankruptcy for the company itself
As stated earlier, investors can diversify themselves without
having to rely on a company to do it for them, and provided that
bankruptcy brings, no added costs to the investor, CAPM theory
states that diversification by a company should have no effect on
the risk experienced by a well diversified investor.
The Alpha Factor
The alpha factor in CAPM theory is another term for abnormal return
due to the specific (unsystematic) risk of an individual security that can
be "eliminated" by diversifying. It is the return on a share that is not due
to movements in the general market. Alpha factors is the recorded
difference between the actual return and Rf+ B(Rm – Rf).
3.7 Limitations of CAPM
1. There may be difficulty in determining the risk free rate.

2. Beta is difficult to measure accurately for an individual
company future event.
3. In the real world, a perfect market does not exist.
4. The model only considers systematic risk. The model assumes

that investors always hold balanced portfolio, which eliminate
unsystematic risk.
5. Beta values may be unstable over time.
6. Beta estimated from historical data may not be appropriate

when considering future event.
7. CAPM is a one-period model and should be used with caution

especially when dealing with multi-period projects.
8. The model only examines investments from the shareholders

point of view and does not consider other interest.
9. CAPM assumes insolvency cost to be zero. It assures that all

assets can be sold at going concern prices and that there are no
selling, legal or other costs.
10. Result reached using CAPM may conflict with that reached
using
WACC.
3.8 Arbitrage Pricing Theory (APT)
APT was suggested by Ross (1976) because of the dissatisfaction with

the CAPM. Unlike the CAPM that is a one-factor model (i.e. single Beta
generating model), the APT is a multi-factor model (i.e. multi-beta
model). APT makes use of relevant factor structure that affects security
returns.
Three Main Assumptions

1. Competitive capital markets
2. Investors prefer wealth to less wealth with certainty
3. The stochastic process generating asset returns can be represented
as a factor model
The Model is given by:
Ri = E (Ri) + bifi + bi2f2 + ........ + binfn + ei ........

This can be simply restated as:
Ri = E (R1) + Sn bijfj + ei
i=1
Where:
Ri = return on asset 1 during a specified time period
E(Rr) = expected return for asset i
Bij = reaction in asset 1 is returns to movement in a
common
factor j;.
Fj = a set of common factors with a zero mean that influence
the returns on all assets
Such factors include:

1. Inflation
2. Interest supply
3. Money supply
4. Political disturbance
5. Growth in GNP etc
ei = the error term (which has unique effect on asset 1’s return, assumed
to be uncorrelated with the factor). By assumption, it is completely
diversifiable in large portfolio and has a mean of zero.
The APT suggests that there is a linear relationship between a security

return and some factors, and
E (R1) = Rf + libil + 12bi2 +……………. lnbirn

Where Rf = risk free rate
In = risk premium related to each of the common factors
4.0 CONCLUSION
CAPM was developed in an attempt to simplify the individual portfolio
theory as it relates to investment in securities. The model brings together
aspect of portfolio theory, share valuation, the cost of capital and
gearing. It can help to establish what the "correct" equilibrium market
value of a company’s share to be.
6.0 TUTOR MARKED ASSIGNMENTS
1a) State the assumptions underlying the use of the "Capital Asset
Pricing Model" and indicate with definition the linear
representation of the model for stock valuation.
b. Assume that you have invested in some stocks that have a Beta of
1.35. The risk free rate is 10 while the expected return on marked
portfolio is 17%. What return would you expect on the stocks
using the CAPM.
2. Discuss the limitations of CAPM. How has APT model proffered

solutions to some of these problems.
3. The returns from the market as a whole have been 20% for some
time, which compares with a risk free rate of return of 9%. Peace
ltd's shares have a measured beta factor of 1.25. What would the
expected returns be for Peace Ltd's share:
a. If the market returns went up to 21.5%

b. if market return slumped to 8%
4. Holy Hills Plc currently pays a divided of N150 per share and
investors expect it to grow at 12% per annum indefinitely. If the
risk free rate is 14% and Holy Hills Plc has a Beta of 1.4, Find the
current market price per share of Holy Hills Plc, using
6.0 SUMMARY
In this unit you have learnt the Risk and Capital Asset
Pricing Model (CAPM), the different Assumptions of CAPM, the
Implications of CAPM, the concept of Capital Market Line (CML),
what Return under CAPM is all about, the various Workings and
Illustrations, the Limitations of CAPM and why Arbitrage Pricing
Theory (APT) was evoked.

Igbinosa, S.O. (2012). Investment analysis and
management , Lagos: Elite Trust Ltd
Nikolay, G. & Cesare, R.(Undated), Asset Pricising Theories,
models, and Tests, Concordia University and CIREQ
Okafor, F.O. (1983). Investment decisions : Evaluation of
projects and securities, London : Cassell
publishing
MODULE 4

Unit 2 Implication of Efficient Market theory for
Unit 3 Valuation of financial statements and selection of
equities
UNIT 1 ACTIVITIES INVOLVED IN MAKING SELECTION

AMONG ALTERNATIVE FINANCIAL ASSETS
INVESTMENTS
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Factors to Consider in Portfolio Planning
3.2 Investment Timing
3.3 Stock Selection Strategies
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
The portfolio planner should be well informed of the securities/financial

instruments available in the financial market and their distinguishing
characteristics. He/She must possess a good working knowledge of the
different types of markets within the financial system, locally and
internationally. Viz the money market, capital market and foreign
exchange market.
2.0 OBJECTIVES
3.0 MAIN CONTENT
3.1 Factors to Consider in Portfolio Planning
The following factors should be considered when planning investment.

(i) Investor's Objective
(ii) Liquidity
(iii) Safety
(iv) Security
(v) Return
(vi) Growth
(vii) Tax Implication
(i) Investor's Objective

The objective of the investor is very important in portfolio planning. It is
essential that portfolio formed must be able to meet investor's peculiar
circumstance or preference.
Generally, the objective of holding portfolio of financial asset is to

generate income or capital appreciation or both. Investors desiring
immediate income for current consumption will go for securities with
propensity of high dividend rate. Investors having preference for capital
appreciation will go for securities, which pay little dividends, but with
high growth potentials. Companies in this category reinvest high
proportion of their profit with the hope of improving its share price as a
result of the profitable investment opportunities undertaken.
(ii) Liquidity
The Investor's liquidity need should be taken into consideration in
portfolio planning. His liquidity need for housing, family feeding,
medical and other unforeseen contingency need should be considered so
as to ascertain the level of excess funds that is available for investment.
(iii) Security
This refers to risk preference class of the investor. How much risk is he
ready to take? What level of risk can he absorb? To what degree will the
income and principal repayments be guaranteed?
(iv) Safety
The investor wants to be sure of the safety of his principal. He will not
want his initial capital investment to be lost.
(v) Return
This is the expected rate of return. The higher the expected return, the
higher the sacrifice of investors.
(vi) Growth
This is concerned with the possibility of capital appreciation. How much
capital gains is the investor targeting?
(vii) Tax Implication

Investors usually consider the tax implications of their investment
decisions. Some investors will prefer tax- exempted investment. For
instance, they may go for shares of companies enjoying pioneer status.
3.2 Investment Timing
Investment Timing refers to the possibility of profiting from buying and

selling activities on securities given that such actions are taken at the
right time. Investors, especially speculators fair better in dealing on their
securities when they can reasonably forecast the trend of the economy
and business activities, thus making predicting the trend of prices in the
securities market possible.
Investment Timing requires possession of foresight, ability to read the

signs and then initiate necessary actions in order to defend one's
investment or profit from the envisaged situation in the future.
Speculator's profit often results from predicting the difference that may
likely exist between the market index return and the return on security.
However loss occurs when there is an error of judgment.
There are three main schools of thought in Investment Timing strategies.

They are:
(i) Aggressive Policy
(ii) Defensive Policy
(iii) Naira-Cost Averaging
3.2.1 Aggressive Policy
This policy seeks to find a set of indicators that are reliable predictors of
market conditions. The holders of the policy employ business and
economic statistics and data as well as stock market statistics in their
analysis. The former include indicators of economic conditions such as
rate of employment, Interest rate, growth of industrial production and
the growth of money supply; stock market statistic at least give
information on share prices and volume of trading.
It is believed that an accurate forecast of business condition can result

into reasonable prediction of share prices, particularly at major turning
points in the rate of business activities. An expansion in business
activities result into increased turnover and profit leading to increase in
the prices of shares and vice-versa. Investors are therefore actively
involved in buy and sell strategy and sometimes buy and hold as an
active policy rather than a passive one.
3.2.2 Defensive Policy
This policy is built on the opinion that it is difficult if not impracticable

to forecast the direction of the economy and market, hence discovering
the turning point, market levels; etc may not yield any appreciable
benefits.
Therefore, investors should be primarily concerned with investing on

shares of companies with good long run prospects and care less about
the market and timing of investment. Investors use the strategies of buy
for the long pull or the long-haul or buy and hold.
3.2.3 Naira-Cost Averaging
This is a middle-of-the-road investment timing method. The objective of

the investor is to spread his purchase over time on blue chip so that the
average cost per unit of shares in his portfolio is below the average
market price at any point in time.
Naira-Cost averaging involves two basic steps:
1. Shares that are included in the portfolio are those with long-run
prospect. These shares are fairly volatile and thus provide
maximum benefit from Naira cost averaging.
2. It requires commitment to purchase a specified amount of shares

at regular interval regardless of the share price, the company's
prospects or the economic outlook.
3.3 Stock Selection Strategies
When selecting stocks for their portfolio, many investors employ certain
style strategies based on past performance and price changes of the
stock. These strategies include:
i. Value stocks
ii. Growth stocks Price momentum
iii. Price strength
iv. Bottom fishing
Many investors have a preference for a particular method, while others
change methods as their preferences and market conditions evolve.
i. Value stocks
Stock selection based on the search for undervalued companies offers
extremely favorable values in fundamental terms. Usually value stocks
have a low price to earnings ratio or alternatively a low price to sales
ratio. The classic rationale behind this strategy is buying stocks at a
fraction of what they are worth and waiting for the market to fully
recognize the hidden value.
This "look for cheap stocks" strategy is a popular theme among

defensive investors since the reasonable price multiples offer a good
hedge against future adversity. It is usually a sound, solid strategy that
might, however, require an extra dose of patience and fortitude. The
market may take months, quarters, if not years to discover and
appreciate pure value plays. On the other hand the ratio of upside and
potential versus downside risk is often very appealing
ii. Growth Stocks

Growth stocks usually belong to companies with superior track records
or prospects in terms of earnings growth and/or revenue growth. The
idea is to buy stock in companies that grow fast regardless of the price
one has to pay to acquire them. Classic examples of this investment
approach are high tech stocks or stocks of small but rapidly expanding
and well managed Banks.
This strategy is usually quite risky. Protection against negative company
surprises or stock market dips is minimal, leaving the investment
vulnerable to steep losses. On the other hand, if the expected growth
materializes in the future, the stock price appreciation is substantial.
Many of the best performing stocks over the last 5 years have been pure
growth plays, for large caps as well as small cap stocks.
iii. Price Momentum

Price Momentum is usually referred to as trend following This
investment strategy focuses on stocks whose price action is strong, often
outperforming the relevant stock index. Stocks with positive price
momentum tend to rise faster than the market, showing continuous price
appreciation for weeks or months. The philosophy behind momentum
investing is along the lines of the belief that "the trend is your friend". A
number of market forces can be behind the continuous price strength of
a momentum play, but what really matters is that when a strong price
trend is in action, it often carries through for a while-enough to make a
good profits riding the momentum.
Statistically speaking, this is a sound strategy, although a number of

things can go wrong such as unexpected negative company surprises,
abrupt price trend reversals, sharp price corrections, or a dramatic shift
in investors' psychology. The previously strong momentum may
disappear overnight.
iv. Price Strength

Price Strength is a variation of Price Momentum because it is calculated
against the appropriate market or sector index. It is referred to as a
"relative" measure of the same momentum. The idea is to buy only
stocks that are performing stronger than relevant competing companies.
v. Bottom Fishing
Bottom Fishing is an opportunistic investment approach focusing on
stocks that, after a dramatic plunge in price (usually across a few
quarters), seem to be poised for a rebound. These are usually out-of-
favor stocks, appropriate for contraries investors that have been
neglected from the investment community for some time. The basic idea
is to go against the crowd and buys stocks (usually at very discounted
multiples) in hopes of participating in the expected rebound.
The price rebound may take a long time to materialize, but usually when
it comes dramatic and sharp. The ensuing profits can be significant in
percentage terms. Distressed securities sometimes fall in the category or
stocks with troubles in fundamental terms. However, some of these
companies may never recover. For this reason, bottom fishing should be
always associated with careful fundamental review.
4.0CONCLUSION
We have seen from this unit that generally, the objective of holding
portfolio of financial asset is to generate income or capital appreciation
or both. Investors desiring immediate income for current consumption
will go for securities with propensity of high dividend rate. Investors
having preference for capital appreciation will go for securities, which
pay little dividends, but with high growth potentials.
5.0 SUMMARY
You have learnt in this unit the various factors to consider in Portfolio
Planning, Investment Timing and the different stock Selection Strategies
1. State the factors to Consider in Portfolio Planning
2. State the stock Selection Strategies

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UNIT 2 IMPLICATION OF EFFICIENT MARKET
THEORY FOR INVESTORS’ PROFITABILITY
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Tests of Weak Form Efficiency
3.2 Tests of Semi-Strong Form Efficiency
3.3 Tests of Strong Form Efficiency
4.0 Conclusion
5.0 Summary
7.0 References/Further Reading
1.0 INTRODUCTION
A financial market is informatively efficient when market prices reflect

all available information about value. What is “all available
information? All available information includes:
 Past prices – weak form.
 Public information (prices, news etc) – semi strong form.
 All information including inside information – strong form.
2.0 OBJECTIVES
 Understand the tests of Weak Form Efficiency

 Understand the tests of Semi-Strong Form Efficiency
 Understand the Tests of Strong Form Efficiency
3.0 MAIN CONTENT
3.1 Tests of Weak Form Efficiency
The weak form of the efficient market hypothesis (EMH) says that the
current prices of stocks already fully reflect all the information that is
contained in the historical sequence of prices. The new price movements
are completely random. They are produced by new pieces of information
and are not related or dependent on past price movements. Therefore,
there is no benefit in studying the historical sequence of prices to gain
abnormal returns from trading in securities. This implies that technical
analysis. Which relies on charts of price movements in the past, is not a
meaningful analysis for making abnormal trading profits.
The weak form of the efficient market hypothesis is thus a direct

repudiation of technical analysis.
Two approaches have been used to test the weak form of the efficient
market hypothesis. One approach looks for statistically significant
patterns in security price changes. The alternative approach searches for
profitable short-term trading rules.
i. Serial Correlation Test: Since the weak form EMH postulates

independence between successive price changes, such
independence or randomness in stock price movements can be
tested by calculating the correlation between price changes in one
period and changes for the same stock in another period. The
correlation coefficient can take on a value ranging from -1 to 1; a
positive number indicates. a direct relation, a negative value
implies an inverse relationship and a value close to zero implies
no relationship. Thus, if correlation coefficient is dose to zero, the
price changes can be considered to be serially independent.
ii. Run Test: The run test is another test used to test the randomness
in stock price movements. In this test, the absolute values of price
changes are ignored, only the direction of change is considered.
An increase in price is represented by + sign. The decrease is
represented by - sign. When there is no change in prices, it is
represented by '0'. A consecutive sequence of the same sign is
considered as a run. For example, the sequence +++--- has two
runs. In other words, a change of sign indicates a new run. The
sequence ---++0---++++has five runs; a run of three - 's, followed
by a run of two +'s, another run of one 0, a fourth run of three -'s
and a fifth run of four +'s. In a run rest, the actual number of runs
observed in a 'series of stock price movements is compared with
the number of runs in a randomly generated number series. If no
significant differences are found, then the security price changes
are considered to be random in nature.
iii. Filter Tests: If stock price changes are random in nature, it

would be extremely difficult to develop successful mechanical
trading systems. Filter tests have been developed as direct of
specific mechanical trading strategies to examine their validity
and usefulness. It is often believed that, as long as no new
information enters the market, the price fluctuates randomly
within two barriers -one lower, and the other higher-around the
fair price. When new information comes into the market, a new
equilibrium price will be determined. If the news is favourable,
then the price should move up to a new equilibrium above the old
price. Investors will know that this is occurring when the price
breaks through the old barrier. If investors purchase at this point,
they will benefit from the price increase to the new equilibrium
level. Likewise, if the news received is unfavourable, the price of
the stock will decline to a lower equilibrium level. If investors
sell the stock as it breaks the lower barrier, they will avoid much
of the decline. Technicians set up trading strategies based on such
patterns to earn excess returns. The strategy is called a filter rule.
The filter rule is usually stated in the following way; Purchase the
stock when it rises by x per cent from the previous low and sell it
when it declines by x percent from the subsequent high. The
filters may range from 1 per cent to 50 per cent or more. The
alternative to this active trading strategy is the passive 'buy and
hold' strategy.
The returns generated by trading according to the filter are

compared with the returns earned by an investor following the
buy and hold strategy. If trading with filters results in superior
returns that would suggest the existence of patterns in price
movements and negate the weak form EMH.
Distribution Pattern: It is a rule of statistic that the distribution of

random occurrence will conform to a normal distribution. Then, if price
changes are random their distribution should also be approximately
normal. Therefore, the distribution of price changes can be studied to
test the randomness or otherwise of stock price movements. In the 1960s
the efficient market theory was known as the random walk theory. The
empirical studies regarding share price movements were testing whether
prices followed a random walk.
Two articles by Robert and Osborne, both published in 1959, stimulated

a great deal of discussion of the new theory then called random walk
theory.
Roberts study compared the movements in the Dow Jones Industrial

Average (an American stock market index) with the movement of a
variable generated from a random walk process. He found that
the random walk process produced patterns which were very similar to
those of the Dow Jones index.
Osborne's study found a dose resemblance between share price changes

and the random movements of small particles suspended in a solution,
which is known in Physics as the Brownian motion. Both the studies
suggested that share price changes are random in nature and that past
prices had no predictive value.
During the 1960s there was an enormous growth in serial correlation

testing. None of these found any substantial linear dependence in price
changes. Studies by Moore, Fama and Hagerman and Richmond serial
correlation coefficient of (-) 0.06 for price changes measured over
weekly intervals. Fama's study tested the serial correlation for the thirty
stocks comprising the Dow Jones industrial average for the five years
prior to 1962. The average serial correlation coefficient was found to be
0.03. Both the coefficients were not statistically different from zero, thus
both the studies supported the random walk theory.
Fama also used run tests to measure dependency. The results again
supported the random walk theory. Many studies followed Moore's and
Fama's work each of which used different databases. The results of these
studies were much the same as those of Moore and Fama.
Hagerman and Richmond conducted similar studies on securities traded

in the over-the-counter market and found little serial correlation. Serial
correlation tests of dependence have also been carried out in various
other stock markets around the world. These have similarly revealed
little or no serial correlation.
Much research has also been directed towards testing whether

mechanical trading strategies are able to earn above average returns.
Many studies have tested the filter rules for its ability to earn superior
returns. Early American studies were those by Alexander, who
originally advocated the filter strategy, and by Farna and Blume. There
were similar studies in the United Kingdom by Dryden and in Australia
by Praetz. All these studies have found that filter strategies did not
achieve above average returns. Thus, the results of empirical studies
have been virtually unanimous in finding little or no statistical
dependence and price patterns and this has corroborated the weak form
efficient market hypothesis.
3.2 Tests of Semi-Strong Form Efficiency

The semi-strong form of the efficient market hypothesis says that
current prices of stocks not only reflect all informational content of
historical prices, but also reflect all publicly available information about
the company being studied. Examples of publicly available information
are corporate annual reports, company announcements, press release,
announcements of forthcoming dividends, stock splits, etc. The semi-
strong hypothesis maintains that as soon as the information becomes
public the stock prices change and absorb the full information. In other
words, stock prices instantaneously adjust to the information that is
received.
The implication of semi-strong hypothesis is that fundamental analysts

cannot make superior gains by undertaking fundamental analysis
because stock prices adjust to new pieces of information as soon as they
are received. There is no time gap in which a fundamental analyst can
trade for superior gains. Thus, the semi-strong hypothesis repudiates
fundamental analysis.
Semi-strong form tests deal with whether or not security prices fully
reflect all publicly available information. These tests attempt to establish
whether share prices react precisely and quickly to new items of
information. If prices do not react quickly and adequately, then an
opportunity exists for investors or analysts to earn excess returns by
using this information. Therefore, these tests also attempt to find if
analysts are able to earn superior returns by using publicly available
information.
There is an enormous amount and variety of public information. Semi-

strong form tests have been performed with respect to many different
types of information. Much of the methodology used in semi-strong
form tests has been introduced by Fama, Fisher, Jensen and Roll. Theirs
was the first of the studies that were directly concerned with the testing
of the semi-strong form of EMH. Subsequent to their study, a number of
refinements have been developed in the test procedure.
The general methodology followed in these studies has been to take an

economic event and measure its impact on the share price. The impact is
measured by taking the difference between the actual return and
expected return on a security. The expected return on a security is
generally estimated by using the market model (or single index model)
suggested by William Sharpe. The model used for estimating expected
returns is the following:
Ri = ai + bi Rm + ei
Where
Ri = Return on security i
Rm = Return on a market index
ai and bi = Constraints
ei = Random error
This analysis is known as 'Residual analysis. The positive difference

between the actual return and the expected return represents the excess
return earned on a security. If the excess return is close to
zero, it implies that the price reaction following the public
announcement of an information is immediate and the price adjusts to a
new level almost immediately. Thus, the lack of excess returns would
validate the semi -strong form EMH.
Major studies on the impact of capitalisation issues such as stock splits

and stock dividends have been conducted in the United States by Fama,
Fisher, Jensen and Roll and Johnson, in Canada by Finn, and in the
United Kingdom by Firth. All these studies found that the market
adjusted share prices instantaneously and accurately for the new
information. Both Pettit and Watts have investigated the market's
reaction to dividend announcements. They both found that all the price
adjustment was over immediately after the announcement and thus, the
market had acted quickly in evaluating the information.
Other items of information whose impact on share prices have been

tested include announcements of purchase and sale of large blocks of
shares of a company takeovers, annual earnings of companies, quarterly
earnings, accounting procedure changes, and earnings estimates made
by company officials. All these studies which made use of the Residual
analysis approach, showed the market to be relatively efficient.
Ball and Brown tested the stock market's ability to absorb the
informational content of reported annual earnings per share information.
They found that companies with good earnings report experienced price
increase in stock, while companies with bad earnings report experienced
decline in stock prices. But surprisingly, about 85 per cent of the
informational content of the earnings announcements was reflected in
stock price movements prior to the release of the actual earnings figure.
The market seems to adjust to new information rapidly with much of the
impact taking place in anticipation of the announcement.
Joy, Litzenberger and McEnally tested the impact of quarterly earnings

announcements on the stock price adjustment mechanism. Some of their
results, however, contradicted the semi-strong form of the efficient
market hypothesis. They found that the favourable information
contained in published quarterly earnings reports was not always
instantaneously adjusted in stock prices. Thus may suggest that the
market does not adjust share prices equally well for all types of
information.
By way of summary it may be stated that a great majority of the semi-

strong efficiency tests provide strong empirical support for the
hypothesis; however, there have been some contradictory results
too. Most of the reported results show that stock prices do adjust rapidly
to announcements of new information and that investors are typically
unable to utilise this information to earn consistently above average
results.
3.3 Tests of Strong Form Efficiency
The strong form hypothesis represents the extreme case of market
efficiency. The strong form of the efficient market hypothesis maintains
that the current security prices reflect all information both publicly
available information as well as private or inside information. This
implies that no information, whether public or inside, can be used to
earn superior returns consistently.
The directors of companies and other persons occupying senior

management positions within companies have access to much
information that is not available to the general public. This is known as
insider information. Mutual funds and other professional analysts who
have large research facilities may gather much private information
regarding different stocks on their own. These are private information
not available to the investing public at large.
The strong form efficiency tests involve two types of tests. The first type
of tests attempt to find whether those who have access to insider
information have been able to utilize profitably such inside information
to earn excess returns. The second type of tests examine the
performance of mutual funds and the recommendations of investment
analysts to see if these have succeeded in achieving superior returns with
the use of private information generated by them.
Jaffe, Lode and Niederhoffer studied the profitability of insider trading

(i.e. the investment activities of people who had inside information on
companies). They found that insiders earned returns in excess of
expected returns. Although there have been only a few empirical studies
on the profitability of using inside information, the results show, as
expected, that excess returns can be made. These results indicate that
markets are probably not efficient in the strong form.
Many studies have been carried out regarding the performance of

American mutual funds using fairly sophisticated evaluation models. All
the major studies have found that mutual funds did no better than
randomly constructed portfolios of similar risk. Firth studied the
performance of Unit Trusts in the United Kingdom during the period
1965-75. He also found that unit trusts did not outperform the market
index for their given levels of risk. A small research has been conducted
into the profitability of investment recommendations by investment
analysts. Such studies suggest that few analysts or firms of advisers can
claim above average success with their forecasts.
The results of research on strong form EMH may be summarized as

follows:
1. Inside information can be used to earn above average returns.
2. Mutual funds and investment analysts have not been able to earn
superior returns by using their private information.
In conclusion, it may be stated that the strong form hypothesis is invalid

as regards inside information, but valid as regards private information
other than inside information.
EMH, Fundamental, and Technical Analyses Compared
There are three broad theories concerning stock price movements. These
are the fundamental analysis, technical analysis and Efficient Market
Hypothesis. Fundamental analysts believe that by analyzing key
economic and financial variables they can estimate the intrinsic worth of
a security and then determine what investment action to take.
Fundamental seeks to identify underpriced securities and overpriced
securities. Their investment strategy consists in buying underpriced
securities and selling overpriced securities, thereby earning superior
returns.
A technical analyst maintains that fundamental analysis is unnecessary.

He believes that history repeats itself. Hence, he tries to predict future
movements in share prices by studying the historical patterns in share
price movements.
The Efficient Market Hypothesis (EMH) is expressed in three forms.

The weak form of the EMH directly contradicts technical analysis by
maintaining that past prices and past price changes cannot be used to
forecast future price changes because successive price changes are
independent of each other. The semi-strong form of the EMH
contradicts fundamental analysis to some extent by claiming that the
market is efficient in the dissemination and processing of information
and hence, publicly available information cannot be used consistently to
earn superior investment returns.
The strong form of the EMH maintains that not only is publicly
available information useless to the investor or analysts but all
information is useless.
Even though the EMH repudiates both fundamental analysis and

technical analysis, the market is efficient precisely because of the
organised and systematic efforts of thousands of analysts undertaking
fundamental and technical analysis. Thus, the paradox of efficient
market hypothesis is that both fundamental and technical analyses are
required to make the market efficient and thereby validate the
hypothesis.
Competitive Market Hypothesis (CMH)

An efficient market has been defined as one where share prices always
fully reflect available information on companies. In practice, no existing
stock market is perfectly efficient. There are evident shortcomings in the
pricing mechanism. Often, the complete body of knowledge about a
company's prospects is not publicly available to market participants.
Further, the available information would not be always interpreted in a
completely accurate fashion. The research studies on EMH have shown
that price changes are random or independent and hence unpredictable.
The prices are also seen to adjust quickly to new information. Whether
the price adjustments are correct and accurate, reflecting correctly and
accurately the meaning of publicly available information is difficult to
determine.
4.0CONCLUSION
We have seen in this unit that what can be validly concluded is that
prices are set in a very competitive market, but not necessarily in an
efficient market. Thus competitive market hypothesis provides scope for
earnings superior returns by undertaking security analysis and following
portfolio management strategies.
5.0SUMMARY
You have learnt from this unit the tests of Weak Form Efficiency, the
Tests of Semi-Strong Form Efficiency and the tests of Strong Form
Efficiency

 What do you understand by the Weak Form Efficiency?

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UNIT 3 VALUATION OF FINANCIAL STATEMENTS AND
SELECTION OF ALTERNATIVE FINANCIAL ASSETS-
ANALYSIS OF QUOTED EQUITIES
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Balance sheet valuation model
3.2. Dividend Discount Model
3.3. Other valuation Model
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
Equity has unlimited life with undefined cashflow stream. This is unlike
Fixed Income Securities that have a limited life and a well defined
cashflow stream. This makes the valuation of Equity a little bit more
difficult.
Although the basic principle of valuation are the same for Fixed Income
securities as well as equity shares, the factors of growth and risk create-
more complexity in Equity Valuation.
If the markets are efficient, the actual market price of a share of

common stocks is a direct function of the cashflow expected, the time
value of money the risk involved, and the returns required by Investors.
The return required by investors is usually the risk-free rate plus a risk
premium.
2.0OBJECTIVES
At the end of this unit, you should be able to understand :
i. Balance Sheet Valuation
ii. Dividend Discount Model
iii. Other Valuation Models
3.0 MAIN CONTENT
3.1. Balance sheet valuation model
Looking at the Balance Sheet of a firm, one can determine some share
values as follows:
(i) Book Value
(ii) Replacement Value
(iii) Liquidation Value
(i) Book Value per Share

Book Value per Share is determined by dividing the networth by the
number of equity shares in issue. The networth or net asset of a
company is equal to paid up equity capital plus all reserves and retained
profit of the firm. It is also equal to total assets less total liabilities.
Example:
Favour Plc with N50, 000,000 net worth has 10,000,000 shares in issue.
Calculate the book value per share.
BVP = = = N5
Advantage
1. It is easy to calculate
2. It represents an "Objective" measure of value
3. Derived directly from the firm’s financial statement.
Disadvantages
1. Based on accounting conventions and policies
2. Accounting policies is characterized by subjectivity and or
arbitrariness.
3. The Balance is historical in nature and does not reflect current
economic realities.
(ii) Replacement Value

Under this method, the share value is derived by considering the
replacement cost of the firm’s assets Less Liabilities. The justification of
this approach is that the market value of a firm cannot deviate too much
from its replacement cost. If any difference occurs between the two
value, competitive pressure will operate to align them. The ratio of
market price to replacement is called Tobinq.
Advantages
1. The idea is very popular among Economist.
2. In the long run Tobin's q will tend to 1, this justify the valuation
model.
Disadvantages
1. The Organizational capital is not reflected in the Balance Sheet.
2. Organizational capital is the value created by bringing together of
employees, customers, suppliers, managers and others in a
mutually beneficial and productive relationship. Organizational
capital cannot easily be separated from the firm as a going
concern.
(iii) Liquidation Value
The liquidation value per share is equal to
Value realized from Amt. payable to all creditors

liquidating all the assets - and preference shareholders
of the form
Number of equity shares in issue
Illustration
Sinnomore Plc would realize N100 Million from the liquidation of all
of its assets and pay N20 million to its creditors and preference
shareholders in full settlement of their claims. Sinnomore Plc has 4
million shares in issue. Calculate the liquidation value per share.
Solution:
Advantages
1. Easy to calculate
2. More realistic than book value per share.
3. Very suitable for a company about to close shop.
Disadvantages
1. Difficulty in estimating amount realizable from assets.
2. Does not reflect earning capacity of the company.
3. Not suitable for a going concern.
3.2. Dividend valuation model

To start, think of common stock valuation as being exactly like bond
valuation. The present current market price of a share of common stock
is theoretically equal to the value of the expected cash dividends and
future market price, where
Price, P0 = ---------------- (1)
Where
Dt = the amount of cash dividends expected to be received at
the end of the tth period (or year)
ks = the rate of return required by investors on the stock
n = the number of time periods, or years
Pt = the expected market price of the stock at the end of period
t
The current market price of a stock that is expected to pay cash

dividends of N1.00 at t = 1, N1.50 at t = 2, and N2.00 at t = 3, and have
an expected market value of N40.00 at t = 3, can be determined in a
straightforward manner. If the return demanded by investors is 14 per
cent, the price of this stock is
P0 =
= + + = N30.38
If an investor pays N30.38 for the stock, and the stream of dividends and
ending market price occurs as projected, the compound rate of return
realized on the stock will be 14 per cent.
What if we keep adding more years of dividends to Equation 1, so that

we can think of the cash dividends going on forever? In that case, we
have the fundamental common stock model - the dividend valuation
model - which states that the market price of a share of common stock is
equal to the present value of all future dividends:
Price, P0 =  ------ (2)
D1 and D2 in Equation 1 refer to cash dividends at time t = 1 and t = 2,

respectively. In Equation 1 the second term is Pn/(1 + k2)n, where Pn
represents the market price at time t = n. But what determines the market
price at time n? It is simply the present value of all cash dividends
expected to be received from period n + 1 to infinity, discounted at the
investor's required rate of return of ks. Equation 1 is simply a special
case of the more general Equation. This relationship will prove useful
when we consider valuing stocks that are expected to have non-constant
growth in future cash dividends. However, before doing that, we want to
consider the simpler cases of no growth in cash dividends and constant
growth in cash dividends.
No Growth in Cash Dividends

In the special case of no future expected growth in cash dividends,
assume that the stock will pay a constant dividend of, say, N2 per year
from now until infinity Although the no-growth model is often
unrealistic, it provides a convenient bench-mark. In such a case, the
dividend valuation equation (Equation2) is simply a perpetuity For a
common stock with a constant expected cash dividend from t = 1 to
infinity its current market price is given by
price with no growth, P0 =
If we have a no-growth stock that is expected to pay a cash dividend of

N2 per year from time t = 1 until infinity, and the investor's required rate
of return is 16 per cent (or 0.16), then its current price, PO, is N2/0.16 =
N12.50. A rational investor would pay no more than N12.50 for this
stock if his or her required rate of return is 16 per cent.
Constant Growth in Cash Dividends (Gordon Model)

In another special case, consider what happens if cash dividends are
expected to increase at a constant (percentage) rate each year. This
situation is just a growing perpetuity, so we can use our knowledge of
the constant-growth model (which is often called the Gordon model) is:
price with constant growth, P0 = --------- (4)
where g is the constant percentage growth rate in cash dividends. In

valuing a took with constantly growing cash dividends, we must use the
cash dividends expected 1 year hence, or Dl. If we have a stock whose
current cash dividend, D0, (at time t = D) is N2, the constant compound
growth rate in dividends is 10 percent per year, and the return demanded
by investors is 16 per cent, the value of this stock is
P0 = = = = = N36.67
Note that this price of N36.67 is substantially higher than the N12.50
computed using the no-growth model. This makes common sense
because, other things being equal, an investor would value a growing
cash flow stream at a higher rate than a non-growing stream.
Non-constant Growth in Cash Dividends

The next situation we consider is when a firm grows at a fast rate for a
few years as then and reverts to constant – or no-growth situation. This
might occur because a firm made previous positive net present value
investments that produced high cash flows and increases in value but
faces increasing competition that is expected to reduce the future growth
rate. For example, if the required rate of return demanded by investors
remains at 16 percent, consider how we would value this stock:
(1) Dividend at time t = 0 are N2; (2) followed by 10 percent growth
in dividends for each of years 1, 2 and 3; (3) followed by 3 percent
compound growth thereafter until infinity This set of cash flows is
graphed below.
We would use the following four-step procedure to solve this problem:
STEP 1: Determine the cash dividends until the series reverts to

either constant growth to infinity or no growth. Thus,
D1 = N2.00(1.10)1 = N2.20
D2 = N2.00(1.10)2 = N2.42
3
D3 = N2.00(1.10) = N2.66
STEP 2: Determine the first years dividend after the growth rate
changes to either constant growth to infinity or no grow:
D4 = D3(1.03) = N2.66(1.03) = N2.74
Dividends per
share ($)
3.00
2.50
3% growth
from here to infinity
2.00
Year
0 1 2 3 4 5 6 7
Because the growth rate changed to 3 per cent (from 10 per cent),
the new growth rate of 3 per cent must be used in this step.
STEP 3: Determine the market price of the stock as of time t = 3 for the
constant-growth period. Thus
P3 = = = = N21.08
Note that (1) the growth rate used is the constant one expected from time
t = 3 until infinity; and (2) the market price is as of time t = 3.
STEP 4: Using Equation 1 and the required rate of return of 16 per cent,
discount both the expected cash dividends from Step 1 and the expected
market price from Step 3 back to the present. As shown in Figure below,
the present value of this stream of expected cash flows is N18.91. Thus,
the current market value of the stock should be N18.91.
Timeline and solution for Non constant Dividend series.

0 2 3 4
$2.20 $2.42 $2.66 $2.74

$1.90
$1.80
$1.70
P3 = =
= $21.08
Note: The dividend in year 4 equals N2.66 (1.03)1. The market price
determined using D4 is the price at t = 3. This market price must be
brought back to time 1 = 0, as are the cash dividends for years 1,2 and 3,
by discounting at 16%.
Relationship between Expected Growth and Market Price

There is a direct relationship between the amount and length of expected
growth in cash dividends and a stock's market price.
Conditions* Resulting Market

Price (P0)
No future growth in expected cash dividends N12.50
10 percent compound growth in expected cash 16.05
dividends for times t = 1, t = 2, and t = 3, followed by
no future growth
dividends for times t = 1, t = 2, and t = 3, followed by 3
percent compound growth to infinity
dividends to infinity
* D0 = N2 and ks = 16 percent for all conditions.
* If there was no growth in cash dividends expected after year 3 P3 =

D4/Ks = N2.66/0.16 = N16.625. Discount back to time zero at 16 per
cent and adding it to the discounted value of the cash dividends to be
received for period and 3 produces a market price of N16.05.
To see the relationship between growth opportunities, the rate in

expected cash dividends, and the current market price of a stock,
consider Table 1, which summarizes our calculations. In the case of no
future growth, the market price is N12.50, whereas it is N36.67 at a 10
per cent compound rate to infinity Finally, growth at 10 per cent for 3
years followed by low or no growth thereafter produces market prices of
N18.91 and N16.05, respectively. Clearly, the rate and duration of
expected growth opportunities leading to growth in cash dividends have
a major impact on the market price of a common stock. Accurate
estimation of growth opportunities and expected growth rates is the most
important aspect of common stock valuation using the dividend
valuation approach. It is also one of the most difficult.
When investors require a higher rate of return on common stock, the

result is a lower stock price today. A lower stock price means a higher
cost of raising equity funds if the firm sells additional common stock.
Non-Dividend-Paying Stocks
We have discussed stock valuation when the firm pays cash dividends,
but not all firms pay dividends. How, then, should we value non-
dividend-paying stocks? There are three ways. The first is to estimate
when the firm will start paying dividends, their size, growth rate, and so
forth; then simply proceed as we have discussed. The second is a
variation of the first, except you must estimate some future market price
and then discount it back to the present, as we have done previously.
The final approach employs earnings and multiplies (or capitalizes)
them by some factor (based on perceived growth, risk, and/or estimates
derived by looking at "similar" firms) to arrive at an estimated value.
Often this approach relies on price/earnings (P/E) ratios.
4.0CONCLUSION
Most investors, amateurs or professionals, do not employ the dividend

valuation model exactly as we have described it. However, their
decision making does have characteristics in common with the model:
(1) They focus on cash flows and dividends, (2) they consider the
returns needed to compensate them for the risk incurred (given their
alternatives and economic conditions), and (3) they look for growth
opportunities. Thus, the intuition behind the dividend valuation model
underlies much of what drives decisions made by investors.
5.0 SUMMARY
You have learnt from this unit that Financial analyst usually adopt two
kinds of analysis i.e. fundamental analysis and technical analysis.
Fundamental analysts determine the fair value of equity by examining
the assets, earnings prospects/cash flow projective, dividend potential
and other economy-wide factors. Technical analysts rely on price and
volume trends, charts in determining share price.
i. Balance Sheet Valuation

ii. Dividend Discount Model
iii. Other Valuation Models
 State three advantages and disadvantages of the Book Value per
Share model of dividend Valuation.

Toda Ventures Ltd
Elite Trust Ltd
publishing
UNIT 4: VALUATION OF UNQUOTED EQUITIES
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Why value unquoted equities
3.2 Methods of valuation
3.3 Factors that influence P/E Ratio
3.4 Dividend Yield Method
3. 5 Super Profit Method
3.6 Dual Capitalization Approach
3.7 DCF Method
3.8.Dividend valuation Method
3.9Accounting Rate of Return (ARR)
3.10 When to use Net Asset Basis
3.11Data required for equity security analysis and
valuation
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
Equities are ordinary shares or common stocks. By unquoted equities,

we mean ordinary share of companies that are not listed on the stock
exchange. Unquoted equities are "prohibited dealings" ie they cannot be
traded on the stock Exchange unless they get quoted. For example the
ordinary shares of Global com., MTN etc are presently unquoted and
their price are not known in the stock market except they are specially
valued.
2.0OBJECTIVES
At the end of this unit, you should be able to understand the following:
 Why value unquoted equities
 Methods of valuation
 Factors that influence P/E Ratio
 Dividend Yield Method
 Super Profit Method
 Dual Capitalization Approach
 DCF Method
 Dividend valuation Method
 Accounting Rate of Return (ARR)
 When to use Net Asset Basis
 Data required for equity security analysis and valuation
3.0 MAIN CONTENT

3.1 Why value unquoted equities
It is necessary to value the common stock of a company under the
following circumstances
(i) When there is a scheme of merger and a need arises to assess the
worth or values of share of each company involved in the merger.
(ii) When the shares are being offered as a security for a loan.
(iii) When there is intention to acquire or dispose of majority

shareholdings.
(iv) When there is need to assess the value of shares for the purpose
of taxation.
(v) When a will bequest stipulates a holding of shares of a certain

value which must then be ascertained to determine the number of
shares passing to the legatee.
(vi) When trust funds or other investors buy significant holdings in

unquoted companies
(vii) When a company is planning to "go public" and therefore need to

know the price at which the shares will be sold to the public.
(viii) When shares are allotted in a capital restructuring.
(ix) When shares are sold to employees under shares option or

incentive schemes.
(x) When a right issue is made, the valuation will point out the value
of the right to assist the prospective purchaser make informed
decision.
(xi) In a corporate demerger, when a larger company may be broken

up into two or more parts to be run by separate management.
(xii) When institutional investors are financially backing an unquoted

company and take a minority stake of between 15% to 25%.
(xiii) When there is a takeover bid
(xiv) For the purpose of determining the purchase consideration in an

amalgamation or absorption scheme.
(xv) For the purpose of ascertaining the breakup value of a company

in liquidation
(xvi) For the purpose of determining the amount of capital to be

contributed by a new partner
(xvii) For the purpose of ascertaining the total amount of the Estate of a
deceased.
3.2 Methods of valuation

The most common methods of ascertaining the value of shares of
unquoted companies are
(i) P/E Ratio method / Earning Basis

(ii) Dividend yield method
(iii) Super profit method
(iv) Dual capitalization Approach
(v) DCF method
(vi) Dividend valuation method
(vii) Accounting Rate of Return
(viii) Net Asset Basis
(ix) Berliner method
1. P/E Ratio method (Earning Basis)

P/E Ratio measures the relationship between the company's share
price and earning per share (EPS )
P/E Ratio
Where MPS = market price per share

EPS = earnings per share
When future expected earning are given, these should be used as they
represent a more accurate earning than historical figures.
Illustration I
Endurance Plc is proposing to take over Quickwin Ltd. Presently
Quickwin Ltd is valued at PE ratio of 16. It has in issue 1,000.000 at
ordinary share and earned profit after tax of N200,000 per annum.
Required
How much will Endurance Plc pay for the share of Quickwin Ltd
using PE ratio approach.
Solution
EPS = =
P/E ratio
16 =
MPS = 16 x 0.2 = N3.10
Total value of Quickwin Ltd shares = N3.2 x 1,000,000
= N3,200,000
Endurance Plc will pay at least N3.2million to acquire Quickwin Ltd.
3.3 Factors that influence P/E Ratio

The choice of P/E ratio can be influenced by a number of factors, which
include:
(i) General economic and financial conditions

(ii) The type of industry and the prospect of that industry
(iii) The size of the undertaking and its status within its industry
(iv) Marketability - the market is always a restricted one for the
unquoted shares
(v) The diversity of shareholdings and the financial status of any
principal shareholder
(vi) The size of the holding to be valued
(vii) Reliability of profit estimates and the past profit record
(viii) Assets backing and liquidity
(ix) Gearing - a relatively high ratio will generally mean greater risk
and call for a higher rate of return
(x) The extent to which the business is dependent on the technical
skills of one or more individuals.
Implication of P/E Ratio

A high P/E ratio usually indicates that investors have a high regard for
company's prospects and the quality of its earnings. Well — established
and successful companies with sound growth prospects in a profitable
industry should expect to have a high P/E ratio. On the other hand, a low
P/E ratio indicates that investors regard the company's earning as "risky"
and of low quality.
Investors do not use a P/E ratio to value a quoted company's shares;

rather the P/E ratio is a measure of the relationship between the
'investors' valuation of share and its earnings. The P/E ratio is a means
of comparison but it has no inherent significance of its own right. It
would therefore be unusual to try to value a quoted company's shares
with a P/E ratio, because the market value will already have been
established by market transactions of buying and selling.
The P/E ratio method of valuation is suitable for estimating a value of

unquoted company shares. By this method an appropriate P/E ratio is
selected and used to derive a share value.
3.4 Dividend Yield Method

This measures the relationship between Dividend per share (DPS) and
market price per share (MPS). Under this method, the market value of a
company's share is determined by capitalizing the ordinary dividend
using the company's dividend yield. That is
DY =
i.e. MPS =
Where MPS = Market price share

DY = Dividend yield which is the rate of return
required by ordinary shareholders
DPS = Dividend per share.
Illustration 2
Shares of Good Life Ltd on yearly basis experience dividend yield of
15% and this is expected to continue into the nearest future. Good Life
earns N5m after tax and interest yearly. The company's policy is to
retain 80% of profit after Tax while 20% is paid out as dividend. Good
Life has in issue 1million ordinary shares.
Required
As a consultant to a predator company, that has interest in Good Life,
how much do you think Good Life is worth using dividend yield method
Solution
DPS = = 1.2
DY =
MPS = = 1.2 = N8
The total value of Better life share is N8 x 1,000.000 = N8,000,000
Note:
Dividend yield method of share valuation is most useful when valuing
minority shareholding since holders of such shares do not have any say
in the management of the company.
3. 5 Super Profit Method
This method, which is rather out of fashion at present, starts by applying

a "Fair return" to the net tangible assets and comparing the result with
the expected profits.
Any excess of profit (the super profits) is regarded as providing the basis
for a calculation of goodwill. The goodwill is normally taken as a fixed
number of years super profits. The excess profit generated by the
company above the industry average is calculated and capitalized by an
agreed number of years.
Illustration 3
Safe Ltd has net tangible asset of N180, 000. The company's profit for
the year amounted to N30,00. The industry in which Safe Ltd operates
has an expected return on net tangible asset of 10%. A predator
company value Safe Ltd goodwill at 4 years of super profit.
Required
Calculate how much Safe Ltd is worth.
Solution
Present Earnings = N30,000
Normal profit = N18,000 (10% of N180,000)
Super profit = N12,000
Goodwill =
Net worth of Sinkills Ltd = Goodwill + Net Total Assets

= N48,000 + N180,000
N228,000
Safe Ltd is worth N228,000
The Super profit method is therefore a combination of the an assets basis

valuation and a type of earning - based valuation for goodwill. The
principal demerits of this method are
The "normal" rate of return required is a subjective valuation The

number of years purchase of super — profits is arbitrary
3.6 Dual Capitalization Approach

Under this method return on intangible asset is recognized alongside
return from tangible assets. This is done by placing value on intangible
assets of the company. Hence the total value of the company is the
summation of both tangible and intangible asset and it is derived as
I.e. NTA + EP — (RTA x TA)

RITA
Illustration 4
Given that the Net Tangible Asset of a Repentance Ltd is N200,000,
expected profit N60,000, rate of return on Net Tangible Asset is 20%,
Return on intangible asset is 30%
Required
Value the company using dual capitalization approach
Solution
= N200,000 + N66,666.67
= N266,666.67
Illustration5
Given the following information relating to Mercy Ltd
Net tangible Assets = N100,000

Required rate of return on net tangible asset = 15%
Required rate of return on intangible asset = 20%
Expected profit = N20,000
Required
Determine the total market value of Mercy Ltd
Solution
Calculation of Intangible Assets

N
Expected profit 20,000
Less return on net tangible
Asset (ie 15% of N100,000) 15,000
Return on intangible assets 5,000
Value of intangible assets = N25,000
market value of the company = value of tangible Asset + intangible asset

= N100,000 + N25,000
= N125,000
3.7 . DCF Method

This is used when the investment is for a short period of time. The
methodology of this approach is that the buying company will evaluate
return that will accrue from the target company using the predator cost
of capital as discount factor.
Illustration 6
Express Ltd is negotiating a take-over bid with the Directors of Ways
Ltd. The projected profits of Ways Ltd for the next 5 years are as
follows:
Years Projected profit
1 N300,000
2 N250,000
3 N450,000
4 N500,000
5 N500,000
The objective of Express Ltd is to hold shares in Ways ltd for a short
period of 5 years after which Express Ltd hopes to sell the share for
N150,000. Furthermore, the company is thinking of buying 10% of
Ways Ltd equity
Required
How much is the maximum price Express Ltd should pay if the
predator cost of capital is 15%
Solution
Year (10% of profit) Discount factor Present value

Cash flow
N @15% N
1 30,000 0.8696 26,085
2 25,000 0.7561 18,902.5
3 45,000 0.6575 29,587.5
4 50,000 0.5718 28,590.0
5 50,000 0.4972 24,860
6 150,000 0.4972 74,580
N202,608
Express Ltd. will be willing to paid N202,608 for the

share of Ways Ltd.
3.8. Dividend valuation Method

This method of share valuation is based on the principle that the value of
a share is the present value of all future dividend payments, discounted
at a suitable (marginal) rate of shareholder's time preference.
Under this method, the value of the company's share is determined by:
Ke =
Where MPS = (This is used when there is no growth in dividend)
But where there is growth in dividend
MPS =
Where Ke = cost of equity

g = growth rate of dividend
3.9 Accounting Rate of Return (ARR)
Under this method, the future earning of the target company is divided
by the predator's return on capital employed (ROCE). It is important to
note that the future income will be adjusted to take care of expected
increase in administration and other costs notably the following:
(i) New level of Director's remuneration
(ii) New level of interest
(iii) Charge for notional interest
(iv) The effect of product rationalization, improved management etc.
This method considers the accounting rate of return, which will be

required from the shares to be valued. It is therefore distinct from the
WE ratio method, which is concerned with the 'market rate of return'
required.
The following formula is normally used

Valuation =
Illustration 7
Heaven Ltd is considering acquiring Earth Ltd. At present Earth Ltd
is earning an average of N480,000 after tax. The directors of Heaven Ltd
feels that after reorganization, this figure could be increased to N600,00.
All the companies in the Heaven group are expected to yield a post - 0
tax return of 15% on capital employed.
Required
What is the value of Earth Ltd
Solution
Valuation of Earth Ltd = N600,000 N4,000,000
15%
8 Net Asset Basis
In order to arrive at price per share, the net asset of the company is
determined and this is divided by the number of ordinary share in issue.
In determining net asset, we consider only tangible asset. Intangible
asset like trademarks, preliminary expenses etc are excluded.
Value per share = Tangible Assets - liabilities

No of ordinary shares in issue
Under this method the value of a share in a particular class (equity) is

equal to the net tangible assets attributable to that class, dividend by the
number of shares in it. Intangible assets which should be excluded are –
(i) Goodwill if shown in the account would also have a value, which
is related to future profits rather than to the worth of the
company's physical asset.
(ii) Development expenditure if shown in the accounts would also

have a value, which is related to future profit rather than to the
worth of the company's physical assets.
The difficulty in an asset valuation method is not the arithmetic

involved, but in the process of establishing the asset value to use. It must
be remembered that the figure attached to an individual assets may vary
considerably depending on whether it is valued on a going concern or
break-up basis.
The following list should give some idea of the factors that must be
considered.
1. Do the asset need professional revaluation, if so, how much will

this cost?
2. Haven the liabilities been accurately quantified, e.g, deferred

taxation?
Are there any contingent liabilities? Will any capital gain tax
arise on disposal?
3. If the assets have been previously revalued, was 'tax provided on

the excess over cost?
4. How have the current asset such as those given below been
evaluated?
(i) Debtors — are they all collectable?
(ii) Stocks — are they all realizable?
5. Can all assets be physically located and brought into a sellable

condition? This may be difficult in certain circumstances where
the assets are situated in different parts of the world.
6. Can the hidden liabilities be accurately assessed eg redundancy

payments and closure costs.
7. Is there an available market in which the asset can be realized?
8. Are there any period charges on the asset?
3.10 When to use Net Asset Basis

The net assets basis of valuation should be used
(i) When the company is about to go into liquidation. A break - up
valuation method should thereby be used
(ii) When unquoted shares are offered as collateral for a loan. A
break up valuation method should be used.
(iii) As a measure of the 'Security' in a share value, a share may be
valued using the earnings basis or dividend yield basis, and this
valuation may be:
(a) Higher than net asset value per share, if the company went into
liquidation, the investor could not expect to receive the full value
of his shares when the underlying asset are realized.
(b) Lower than the net assets value per share, in which case the share
would have a higher asset backing. If the company went into
liquidation, the investor might expect to receive the full value of
his shares (perhaps much more) when the underlying assets are
realized.
The asset backing for shares thus provides a measure of the

possible loss if the company fails to make the expected earnings
or dividend payment.
(iv) As a measure of comparison in a scheme of merger
9. Berliner Method
This is a simple average of

(i) The Net Asset Basis and
(ii) Any other Basis
It is a combination of Net asset basis plus any other method of

valuation dividend by two.
Illustration 9
Assuming the price derived using Net Asset basis and earnings
basis are given as:
N
Net Asset per share 1.15
Price using Earning 0.9
The share price using Berliner method will be:

= = N1.025
Other qualitative Factors to consider

The final price of the shares of a company depends on the
following qualitative factors:
1. The company fixture prospects

2. Composition of the Board of Directors of the company
3. The extent of foreign investment in the ownership and
management of the company
4. The company's expansion programme and capital commitment
5. The individual shareholders intention
6. The ability of the company to buy back its shares
7. The age of the company's fixed asset
8. The tax position of the company and the shareholders
9. The company's Dividend yield or cost of capital
10. Involvement of regulatory authorities in the activities
3.11 Data required for equity security analysis and valuation
In order to value any security, the following documents and information

are imminently important.
(i) Audited Annual Accounts for the five years immediately

preceding the valuation or actual number of years since
commencement of operation if less than five years.
(ii) Detailed manufacturing, trading profit and loss Accounts for the
period listed in (I) above.
(iii) Profit forecast and management accounts if the company has

operation for up to six months at time of valuation.
(iv) Full description of the nature of business and the operation of the
company
(v) Statement about the staff and management of the company and
staff requirement in case of new companies that have not
commenced operation.
(vi) Particulars of any litigation in which the enterprise is presently

engaged or likely to be involved.
(vii) A copy of the Memorandum and Articles of Association —

changes in the authorized capital if any should be supported with
relevant documents of authorized capital if any should be
supported with relevant documents of registration with the
Corporate Affairs Commission. Increase in paid up capital to be
supported with Board Resolutions.
(viii) A certified copy of the Certificate of incorporation.

(ix) Any other information which the issuing House may consider
necessary
Issuing Houses usually work on a five — year track record when

valuing shares. In case of enterprises having less than five years track
record, individual enterprises is then treated on its own merit.
In the case of new companies, since they may not have any supportive
audited accounts, the following documentation is required of them:
(i) A copy of the feasibility Report, if any

(ii) Operational and Cash flow projections for three to five years
(iii) Statement of find utilization.
Issuing houses work only on audited and signed accounts audited

accounts are not acceptable.
4.0 CONCLUSION
We have seen in this unit that by unquoted equities, we mean ordinary
share of companies that are not listed on the stock exchange. Unquoted
equities are "prohibited dealings" ie they cannot be traded on the stock
Exchange unless they get quoted. We have also seen the various
methods of valuation of unquoted stocks.
5.0 SUMMARY
In this unit you have learnt the various methods of valuation of
unquoted stocks as well as the data required for equity security analysis
and valuation
1. Egg Plc is proposing to take over Poop Ltd, an unquoted

company. Presently, Poop Ltd is valued at PE ratio of 18. It has
in issue 2,000,000 ordinary shares and earned Profit after tax of
N450,000 per annum.
Required
Advise Egg Plc on how much to offer Poop Ltd.
5. The management of Horn Plc, a medium size company playing

in the Telecom Sector, has just approached you. The company
wishes to approach the Nigeria Capital market to raise funds to
finance the roll out of its GSM lines, having been recently
licensed by Nigeria Communication Commission.
The company wants to do a preliminary valuation of its share and
wishes to get your advice.
Required
(i) What documents or information will you require from Horn Plc
before carrying out the valuation of its shares?
(ii) What other financing options will you recommend to the
Management of Horn Plc?

Toda Ventures Ltd
Elite Trust Ltd
publishing
MODULE 5
UNIT 1 PAYBACK PERIOD ((Non- Discounting Technique)

CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning of Payback Period
3.2 Workings on Payback period
3.3 Decision Rules
3.4 Advantages of Payback period
3.5 Disadvantages of Payback period
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
Capital budgeting is the appraisal of capital projects (Long-term assets)
so as to enable management take decision on what asset to invest on
most efficiently in anticipation of future earnings. Capital investment
decisions include decisions on expansion, acquisition, modernization or
replacement of producing fixed assts.
2.0 OBJECTIVES
1) To understand what payback period is all about and the formula
involved in calculating it.
2) To know how to make decisions after calculations especially
when there are mutually exclusive projects.
3) To understand the advantages and disadvantages of the technique.
3.0THE MAIN CONTENT

3.1 Meaning of Payback period: Appraising capital investment on the
basis of time that would be taken to get back your initial investment is
called as payback period.
Payback period is one of the easiest methods of capital investment
appraisal techniques. Projects with a shorter payback period are usually
preferred for investment when compared to one with longer payback
period.
However, there is the discounted Payback Period – Capital Investment
Appraisal using discounted payback period which is similar to payback
period but here, the time value of money or discounted value of cash
flow is considered for calculation of payback period.
3.2 Workings
The formula to calculate payback period of a project depends on
whether the cash flow per period from the project even or uneven. In
case they are even, the formula to calculate payback period is:
Payback Period =
N/B: When cash inflows are uneven, we need to calculate the
cumulative net cash flow for each period and then use the following
formula for PBP –
Payback period = A +
Where:
A = the last period with a negative cumulative cash flow
B = the absolute value of cumulative cash flow at the end of
the period A.
C = is the total cash flow during the period after A.
N/B: Payback period uses only cash flows not profit.
Example 1
Onyinye Company Ltd is planning to undertake a project requiring
initial investment of N200,000,000. The project is expected to generate
N45, 000,000 per year for 6 years, calculate the payback period of the
project.
Solution:
Payback Period =
Payback Period = = 4.44 years
Example 2
Lagos Limited is to undertake a project requiring N1, 000,000 outlay.
The project generates N200,000 annually.
Required: what is the payback period?
Solution:
Payback Period = i.e
= 5years
3.3 Decision Rules
A. Independent project
1. Accept if the project has a PBP that equal to or less than that set
by the management.
2. Reject if the project has a PB that is greater than the time set by
the management.
B. Mutually Exclusive Project
1. Select the project with the least PBP.
2. Ensure that the project selected has a PBP that is equal to or less
than that set by the management.
3.4 Advantages of Payback period
1. It is simple to calculate.
2. It can be a measure of risk inherent in a project since cash flows
that occurs later in a projects life are considered more uncertain,
payback period provides an indication of how certain the project
cash inflow are.
3. For companies facing liquidity problems it provides a good
ranking of projects that would return money early.
4. Unlike ARR, it uses cash flows instead of accounting profit, cash
profit or inflows is superior to accounting profit.
5. It serves as a first screening process i.e. as a simple initial
screening process for new projects.
3.5 Disadvantages of PBP
1. Unless discounted cash flows are used, it is ignored the time
value of money.
2. It does not take into account the cash flows that occur after the
payback period.
3. It may lead to excessive investment in short term projects.
4. It is unable to distinguish between projects with the same
payback period.
4.0 CONCLUSION
Payback period as one of the budgeting techniques is one of the best
traditional methods of assessing project and it has been going a long
way in selecting a good projects among bad ones.
5.0 SUMMARY
Payback period always serve as the first screening process for new
project. Based on the decision rule, one can easily determine which
projects to choose after calculation and it has a lot of advantages that
makes it outstanding among other budgeting techniques.
Flourish Plc is to undertake a project requiring an investment of
N200,000 on necessary plant and machinery. The project is to last for 5
years at the end of which the plant and machinery will have net book
value or scrap value of N40,000 – profit after depreciation are as
follows.
Yrs Cashflows
1 50,000
2 45,000
3 40,000
4 30,000
5 20,000
You are required to calculate the payback period.

Akinsulije, O (2003). Financial management (7th Edition), Lagos:
Ceemol Nigerian Ltd Publication
William, J. R. et al(2012) Financial And Managerial Accounting,
McGraw-Hill,
UNIT 2. ACCOUNTING RATE OF RETURN (ARR) (Non-

Discounting Technique)
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning of Accounting Rate of Returns
3.2 Workings on Accounting Rate of Returns
3.3 General Decision Rules
3.4 Advantages of Accounting Rate of Returns
3.5 Disadvantages of Accounting Rate of Returns
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
This Capital Investment Appraisal technique compares the profit that
can be earned by the concerned project to the amount of initial
investment capital that would be required for the project. Projects that
can earn a higher rate of return is naturally preferred over ones with low
rate of return. ARR is a non-discount capital investment appraisal
technique in that it does not take into consideration the time value of
money involved.
2.0 OBJECTIVES
1. Define and calculate the ARR technique.
2. Make decision regarding the answers and observation especially
when there are mutually exclusive projects.
3. Understand the advantages and disadvantages of ARR
3.0 THE MAIN CONTENT

3.1 Meaning of ARR: Accounting Rate of Returns (ARR) measures the
average annual net earnings throughout the estimated life of the project.
It is an investment’s average net income divided by its book value.
3.2 Workings
Accounting Rate of Return is calculated using the following formulas:
ARR = x
OR
ARR = x
N/B: The formula can be used depending on the question but if asked
to get the ARR without specifying the one to use, it is advisable to use
the first formula. ARR uses profit not cash flow, you have convert it to
profit by subtracting the depreciation.
3.3 General Decision Rule

Accept the project only if it’s ARR is equal or greater than the required
Accounting rate of return. In case of mutually exclusive project, accept
the one with highest ARR.
Example 1:
An initial investment of N130,000 is expected to generate annual cash
flow of N32,000 for 6 years. Depreciation is allowed on the straight
line basis. It is estimated that the project will generate scrap value of
N10,500 at the end of 6 years. Calculate its accounting rate of return
assuming that there are no other expenses on the project.
Solution:
Annual Depreciation =
= = N19,917
Accounting Income = N32,000 - 19,917 = N12,083
N/B: We were given cashflow instead of profit so we subtracted
depreciation to get profit.
Then Average Investment
= = N70, 250
ARR = x = 17.2%.
Example 2:
EdoDelta Plc is to undertake a project requiring an investment of
N100, 000 on necessary plant and machinery. The project is to last for
5 years at the rate of which the plant and machinery will have net book
value of N20, 000. Profit before depreciation are as follows:
Yrs Cashflows
1 40,000
2 44,000
3 48,000
4 52,000
5 58,000
You are required to calculate the ARR of the project.
Solution:
Annual Depreciation =
= N16, 000
Average Investment =
=
= 60,000
Average Profit
Yr Profit Depreciation Net Profit
1 40,000 16,000 240,000
2 44,000 16,000 28,000
3 48,000 16,000 32,000
4 52,000 16,000 36,000
5 58,000 16,000 42,000
162,000
Average Profit = = 32,400
ARR = = 54%
Example 3
If Nwata Ventures has a project with the Initial Outlay N20, 000,
annual profit of N5, 000 for 6 years what is the ARR
Solution:
Average Investment = = 10,000
Average Profit = 5,000
ARR = x = 5%.
Example 4
A project has a cost of N53, 500 and its expected cash inflows are N11,
500 per annum for 6 years. If the cost of capital is 5%, what is the
ARR?
Average Investment = = 26,750
Average Profit = N11,500
ARR = x = 43%
Example 5
Consider the following two projects
Project A Project B
Cost 150,000 150,000
Residual value 0 0
Estimated Profit after
Depreciation.
Yr 1 35,000 100,000
Yr 2 50,000 80,000
Yr 3 60,000 60,000
Yr 4 70,000 40,000
Yr 5 80,000 30,000
What project is ARR?
Solution:
Since we were given direct profit.
Average profit for Project A = = 59,000
Average profit for Project B = = 62,000
Average Investment for Project A = = 75,000
Average Investment for Project B = = 75,000
There ARR for profit A = x = 78.67%
The ARR for Profit B = x = 82.67%
Decision
Chose Project B because it has higher retarded using ARR
3.4 Advantages of ARR
 Like Payback Period, this method of investment appraisal is easy
to calculate.
 It recognizes the profitability factor of investment.
 Unlike the Payback Period, it considered the profit over the entire
life of the project.
 It uses readily available accounting data.
 It could be used to compare performance for many companies.
3.5 Disadvantages of ARR
 It ignores the time value of money.
 It can be calculated in different ways. Thus there is problem of
consistency.
 It uses accounting income instead of cash flow information.
 It ignores risk and management attitude towards risk
 There are no rules for setting the minimum acceptable ARR by
the management.
4.0 CONCLUSION
Having seen the way, ARR works based on the calculations and decision
using the answers and observation one can categorically say that the
objective of this unit has been achieved.
5.0 SUMMARY
Accounting Rate of Return as one of the basic method of budget
appraisal is very necessary because it gives a straight forward answer
and it makes use of the entire profit throughout the project life and the
decision using the technique is very easy to make.

From the example 5 given in the contest above, assume that the scrap
value is N10,000 for project A and N15,000 for project B and the profit
given was before depreciation.
Recalculate the ARR and choose between the two projects.
7.0 REFERENCES / FURTHER READING

1. S. Chen DCF Techniques and non-financial measures in capital
budgeting. A contingency Approach analysis. Behavioural
Research in Accounting. 20(1),13-29.
2. Ryan P. A & Ryan G. P (2002). Capital Budgeting practices of
the fortune 1000. How have things changed Journal of Business
and Management, 8(4), 1-16,
3. M. T. Stanley, S. A. Sungster (1993). Capital Investment
Appraisal Technique. A survey of current usage Journal of
Business 3, 307-353
4. Millles,(2012) Links between Net present value and shareholder
value from a Business Economics Perspective. Theory
Methodology Practice Club of economics in Miskole, 8(2), 31-36
UNIT 3 THE NET PRESENT VALUE (NPV) (Discounting
Technique)
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Assumptions Underlying the Basic Discounted Cash Flow
Appraisal
3.2 Net Present Value (NPV)
3.3 Illustration of Net Present Value (ANNUITY)
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
Discounted Cash Flow (DCF)
Against the backdrop that the traditional techniques ignore the timing of
cash flow, a new approach known as the discounted cash flow has been
developed. This approach uses cash flows rather than accounting
profits. According to Lucey, (1988), accounting profits are invariably
calculated for stewardship purposes and are period-oriented (usually
monthly, quarterly or annually) thus necessitating accrual accounting
with its attendant conventions and assumptions. Therefore, for
investment appraisal purposes, a project-oriented approach using cash
flow is to be preferred since it disallows depreciation as an expense and
also recognises the timing of cash flows.
2.0 OBJECTIVES
 define Net Present Value (NPV)

 apply the formula for simple NPV
 describe the investment criteria under NPV.
3.0 MAIN CONTENT
3.1 Assumptions Underlying the Basic Discounted Cash Flow

Appraisal
According to Lucey (1988), certain assumptions are made initially so

that the underlying principles can be more easily understood.
These are as follows:
 uncertainty does not exist

 inflation does not exist
 the appropriate discount rate to use is known
 a perfect capital market exists, that is unlimited funds can be
raised at the market rate of interest.
Later, each of the above assumptions will be isolated and handled

accordingly.
3.2 Advantages of NPV
 Net present value account for time value of money which makes
it a sounder approach than other investment appraisal techniques
which do not discount future cash flows such as Payback Period
and Accounting Rate of Return.
 Net Present Value is even better than some other discounted cash
flow techniques such as IRR, in situations where IRR and NPV
gives conflicting decision, NPV decision should be preferred.
 It gives a clear accept/reject recommendation.
 It makes use of all the cash flow over the project life span unlike
Payback Period.
 NPV gives absolute measures of profit ability which immediately
reflects in the shareholder’s wealth.
 NPV of projects is additive, it can be summed up.
3.3 Disadvantages of NPV
 It may be difficult to calculate.
 Net present Value does not take into account the size of the
project.
N/B: NPV uses cash flows in the calculation i.e. profit before
depreciation so if the net profit is given i.e profit after depreciation, we
must add back depreciation to make it cash flows.
3.2 Net Present Value (NPV)
Net Present Value (NPV) is defined as the difference between the

present value of cash inflows and those of the cash outflows all
discounted at the cost of capital.
According to Okafor (1983), the net present worth of a project is the

present value of the discounted net proceeds anticipated throughout the
economic life of the project. The cash outflows and inflows are
discounted using the same rate of discount. The algebraic sum of the
discounted stream of cash flows is the Net Present Value (NPV).
That is
n FC t
NPV 
 (1  K ) t
t=0
where
NPV = net present value
CFt = net cash flow at time t
K = discount rate
For most conventional investments, the net cash outflow would occur at
the initial period, that is, at t = 0. In such cases, the equation becomes:
n CFi
CF0
 (1  K ) i
NPV
t=0
The present value of one ratio today, is of course N1. Therefore, CF0,
would be equal to the initial cost of the project.
Decision Rule
The general criteria under the NPV appraisal techniques are the
followings.
 INVEST: if NPV > 0. That is, invest if the NPV is positive.

 DON’T INVEST: if NPV < 0. That is, do not invest if the NPV
is negative.
 Remain indifferent: if NPV = 0. That is, you may or may not
invest if the NPV = 0.
According to Okafor (1983), choosing among alternatives and mutually
exclusive projects, the decision rule is to rank them according to their
relative net present worth. The project with the highest NPV is
presumed to be the most preferable.
Illustration 1
NOUN Fresh LTD. is trying to decide which type of machine tool to

buy, of the two types available. Type A costs N10, 000,000 and the net
annual income from the first three years of its life will be
N3,000,000, N4,000,000 and N5,000,000 respectively. At the end of
this period, it will be worthless except for scrap value of N1,000,000.
To buy a type A tool, the company would need to borrow from a
Finance Group at 9%. Type B will last for three years too, but will give
a constant net annual cash flow of N3,000,000. It costs N6,000,000 but
credit can be obtained from its manufacturer at 6% interest. It has no
ultimate scrap value. Which investment would be the more profitable?
Give reason for your answer.
Solution
NOUN Fresh LTD

Type A Cash flow Discount Factor (9%) Net Present Value
Year N’000 N’000 N’000
0 (10,000) 1.000 (10,000)
1 3,000 0.917 2,751
2 4,000 0.842 3,368
3 6,000 0.772 4,632
NPV N751
N.B: 6,000 = 5,000 cash flow + 1,000 scrap value.
Type B Cash flow Discount Net Present

Factor (6%) Value
Year N’000 N’000 N’000
0 (6,000) 1.000 (6,000)
1 3,000 0.943 2,829
2 3,000 0.890 2,670
3 3,000 0.840 2,520
NPV N2,019
Alternatively, for project B, since the cash inflows form an annuity, we

then use annuity factor. For n = 3, r = 6%, the annuity factor is:
1 – (1.06)-3 = 2.673
0.06
The NPV = 3000 x 2.673 – 6000 = 2019.
Thus, we can see that type B has a far higher NPV and this will be the
better investment.
Illustration 2
Wisdom Plc is proposing to purchase a new machine for N20, 000,000

which will have a life span of 6 years. The cash inflows estimated to be
generated by the machine are as follows: Year 1 = N12,400,000; Year 2
= N6,000,000; Year 3 = N7,100,000; Year 4 = N2,203,000 and Year 5
= N2,774,000 and removed in year 6 an estimated net cash outflow of
N1,477,000.
The company’s cost of capital is 15%. Should investment be proceeded

with?
Solution
Wisdom Plc
Year Cash flow 15% Discount Net PV at 15%
N’000 N’000 N’000
0 (20,000) 1.000 (20,000)
1 12,400 0.870 10,788
2 6,000 0.756 4,536
3 7,100 0.658 4,672
4 2,203 0.572 1,260
5 2,774 0.497 1,379
6 -1,477 0.432 -638
Net Profit Value (NPV) = + 1,997
The NPV is positive, hence ‘go’ for the project.
3.3 Illustration of Net Present Value (Annuity)
Dangote Group of Companies leases land and erects building on it,

financing the construction from term loans. The buildings are rented out
by the company which can borrow and invest money at 15 percent per
annum.
As the company’s financial controller, you have been approached to

advise it on how best to use a site it leased 25 years ago for 80 years,
from Chibok North East Local Government for an initial premium of
N50, 000,000 and annual ground rent of N6, 000,000. When the lease
expires, the building will revert to the local government. The following
options are available to the company on the use of the site in question.
a. The site could be out-leased for the remaining years at an annual

rent of N40, 000,000.
b. A house could be constructed quickly on the site with the
following estimated costs and income.
Building and other capital expenditure N500, 000,000

Annual management and maintenance fee N150, 000,000
Annual rental income (till the lease expires) N250, 000,000
c. Blocks of flats could be constructed on the site. However, this

would entail a long development period and rents would not be
collected till after 5 years. The estimated costs and income for
this option are given as follows.
Building and other capital expenses = N250, 000,000 per year

(amounting to N1, 250,000.00) Annual management and
maintenance costs of N200, 000,000.00 and annual rental income
of N550, 000,000.00 (for the 50 years after completion)
Solution
This is an interesting question that brings out some cost/management

concepts clearly. The concepts are the followings.
a. The initial premium of N50, 000.00. This cost is already incurred

hence it is both sunk and irrelevant. Accordingly, we shall
disregard it in our analysis.
b. The annual ground rent of N6, 000.00. This cost is yet to be
incurred. Hence, it is a relevant cost. However, since it must
necessarily be incurred regardless of the option embarked upon, it
becomes a common cost. Accordingly, including or excluding it
in our analysis shall not affect our decision. We shall exclude it.
c. The net cash inflows in each case form an annuity. Hence, we
shall use annuity table (present value) instead of ordinary present
value table.
d. Relevant period.
The land was rented 25 years ago for 80 years. The relevant period
therefore is from today (the 25th year) to the 80th year. That is, 55 years.
Therefore, the annuity factor at 15 percent for 55 years is calculated

thus.
The formula is =
where n = the number of periods

r = the interest rate
Substituting
= 6.6636
Option C however takes the form of a deferred annuity since the

building would take 5 years to complete and cash inflows can only take
place as from the 6th year. This we can represent on a number line thus:
<----3.3522 -------------->5<-------3.3114------>55
 a5 0.15 = 3.3522 and

 a55 0.15 = 6.6636
 difference = 3.3114
Therefore, the annuity factor for the deferred annuity is 3.3114.

Anchored on foregoing comments, we then proffer our solution thus:
Option A: Out- lease the site for remaining years

Since the yearly income is N40, 000,000 for 55 years, the
present value is N40, 000,000 x 6.6636 = N266,
544,000.00.
Option B: Quick construction of a house at the site. This is purely

theoretical, as house cannot be so quickly built.
Assuming that it is possible to quickly construct a house, then the cost of

the house N500, 000,000 took place in year zero.
Also, since the annual management and maintenance fee is

N150,000,000 and the annual rental income is N250,000,000, the net
annual cash inflow is N100,000,000 (i.e. N250,000,000 –
N150,000,000). Therefore, the NPV is N100, 000,000 x 6.6636 – N500,
000,000 = N166, 360,000.
Option C: Construction of a block of flats.
Since the construction would last for 5 years @ N250,
000,000 per annum, the present value of the cost of the
block of flats is:
N250, 000,000 x 3.3522 = N838,050,000
Also, given that annual management and maintenance costs

N200,000,000 and annual rental income of N550,000,000 shall
commence after 5 years, the annual net cash inflows of N350,000,000
(N550,000,000 – N200,000,000) form a deferred annuity whose present
value is
N350, 000,000 x 3.3114 = N1,158,990,000
This leaves us with an NPV of N320, 940,000 (That is N1, 158,990,000

– N838, 050,000).
Summary
Option A: NPV = N266, 544,000

Option B: NPV = N166, 360,000
Option C: NPV = N320, 940,000
Therefore, since option C has the highest NPV, that option is the most
preferable and hence recommended.
N.B: We most logically assumed the 25th year as our focal date.
4.0 CONCLUSION
In this unit, you have learnt about the most fundamental methods for
appraisal capital projects – the Net Present Value (NPV). This approach
must be understood and applied most religiously.
5.0 SUMMARY
In this unit, you are acquainted with the Net Present Value (NPV)
method of capital investment approach. You are now familiar with the
basic definition, its advantages and disadvantages as well as the formula.
You have also learnt about the computational technique and the
investment criteria.
Flourish Plc is to start up a project worth N8m and having the

following cash flows:
Yrs Cashflows (N)
1 5,000,000
2 6,000,000
3 8,000,000
If the discount rate is 25% calculate the NPV if the scrap value at
the end of 3 years is N100,000.
Peculiar Nig. Ltd. invested N10m in a project that gives it N1m per
annum for 40 years. If the cost of capital is 10 per cent per annum,
compute the Net Present Value.
7.0 REFERENCES/FURTHER READING
Horngren, C.T., Datar, S. & Foster (1997). Cost Accounting: A

Managerial Emphasis. New Delhi: Prentice Hall.
Lucey, T. (1984). Costing: An Instructional Manual. Eastheigh Hanks:

DPP.
Lucey, T. (1985). Management Accounting. London: DPP.
Matz, A. & Usry, M. T. (1976). Cost Accounting: Planning and

Control. Cincinnati Ohio: Southern Western Pub. Co.
MAYO Association & B. P. Publications Ltd. (1988). Management

Accounting. Lagos/London: B. P. Publications Ltd.
Nweze, A. U. (2000). Profit Planning: A Quantitative Approach.

Enugu: M’Cal Communications.
Okafor, F. O. (1983). Investment Decisions: Evaluation of Projects and

Securities. London: Cassell.
UNIT 4 THE INTERNAL RATE OF RETURN
(Discounting Technique)
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Internal Rate of Return (IRR)
3.2 Investment Criteria under the IRR Approach
3.3 Advantages of IRR
3.4 Disadvantages of IRR
3.5 Short cut to IRR computation
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
In our previous sections, you are conversant with the various

investments appraisal techniques. While the payback period tried to
answer the question of how long it would take for the cost of the
investment to be recovered, the Net Present Value (NPV) on the other
hand centred on wealth maximization.
Yet, there is another method that sets a hurdle rate, internally, before
investment can take place. This is called the Internal Rate of Return
(IRR). This is the focus of this unit.
2.0 OBJECTIVES
 define Internal Rate of Return (IRR)

 state IRR formula and how to derive unknown values within a
range
 outline the investment criteria under the IRR
 state the merits and the demerits of IRR.
3.0 MAIN CONTENT
3.1 Internal Rate of Return (IRR)
According to Okafor (1983), the IRR criterion follows the basic

principles of the NPV method. Unlike the NPV method, the IRR does
not use an exogenously determined (exogenously to the project being
considered) discount rate. Rather, the principle is to find a rate of
discount that will match the discounted value of cash inflows and
outflows. The rate of discount, which achieves that equality, is the
internal rate of return.
Put differently, the internal rate of return is the rate at which NPV is
zero; the rate, at which the present value of the cash inflows is equal to
those of the outflows, and the hurdle rate or the break-even rate.
According to Lucey (1988), alternative names for the IRR include DCF
yield, marginal efficiency of capital, trial and error method, discounted
yield and the actuarial rate of return.
According to Okafor (1983) and Van Home (1986), the IRR is derived
mathematically by solving the following equation for r:
n
CFt
 (I  r) t
0
t 0
For conventional projects, the equation becomes:
n
CFt
 (I  r) t
 CF0
t 0
3.2 Investment Criteria under the IRR Approach
Under the IRR, the investment criteria are as follows.

 Invest if IRR > cost of capital. That is invest if the internal rate
of return is more than the cost of capital.
 Do not invest if the IRR < cost of capital. That is, do not invest if
the internal rate of return is less than the cost of capital.
 Remain indifferent if IRR = cost of capital.
3.3 Advantages of IRR

1. It shows the return on the original money invested.
2. IRR rates are presented in form of familiar figures that can easily
be interpreted by the user of the data.
3. IRR though peculiar to a given project avoids disputes that
characterize the choice of the appropriate cost of capital to use
when appraising project.
3.4 Disadvantages of IRR
1. It is difficult to compute and interpret.
2. It most times bring conflicting answers with NPV of which NPV
will be used for decision making therefore making IRR more
irrelevant.
3.
Workings
Illustration 1
Refer to illustration 2 under Module 2 unit 6. Compute the Internal Rate

of Return (IRR).
Solution
Trial and Error: Let us try 20% since 15% gives NPV of N1, 997,000
Year Cash flow 20% Discount Net Present

N’000 N’000 N’000
0 -20,000 1,000 -20,000
1 12,400 0.833 10,329
2 6,000 0.694 4.164
3 7,100 0.579 4,111
4 2,203 0.402 1,061
5 2,774 0.402 1,061
6 -1,477 .0335 -495
285
Let us try 22%
Year Cash flow 20% Discount Net Present

N’000 N’000 N’000
0 -20,000 1,000 -20,000
1 12,400 0.820 10,168
2 6,000 0.672 4.032
3 7,100 0.551 3,912
4 2,203 0.451 994
5 2,774 0.370 1,026
6 -1,477 0.303 -447
-315
Since IRR lies between positive and negative numbers, it should lie
between + 286 and –315.
Hence, using the formula to calculate the IRR, we have:
a
IRR  x  ( y  x)
ab
where x = the lower rate of interest used

 Y = the higher rate of interest used
 a = the absolute NPV at X%
 b = the absolute NPV at Y%
 II = modulus i.e. assume every figure to be positive.
 IRR = Internal Rate of Return
Using the above formula, we have:
20% + [285/ (285 + 315)] x (22 – 20)

= 20 + (285 x 2)/600
= 20 + 0.95
 IRR = 20.95%
This is the highest cost of capital, which could be used on the project.
As a check, calculate the NPV with 20.95% as your cost of capital.
Proof: Femi Nig. Ltd.
Year Cash flows N DF @ 20.95% PV N

0 (20,000) 1.000 (20,000)
1 12,400 0.827 10,255
2 6,000 0.684 4,104
3 7,100 0.565 4,012
4 2,203 0.467 1,029
5 2,774 0.386 1,071
6 (1,477) 0.319 (471)
0
Illustration 2
Haruna Nigeria Ltd.

An investment is being considered for which the net cash flows have
been estimated as follows:
Year 0 Year 1 Year 2 Year 3 Year 4

N N N N N
-9,500 3,000 4,700 4,800 3,200
What is the NPV if the discount rate is 20%? Is the project acceptable?
Calculate the IRR.
Solution
From the table, at r = 20%
The discount factors are 0.833, 0.694, 0.579 and 0.482
 NPV = -9500 + (0.833 x 3000) + (0.694 x 4700) + (0.597 x
4800) + (0.482 x 3,200) = + N582.
Since, the NPV is positive, the project is acceptable. To calculate the

IRR, we try higher rate say 25%. The NPV if r = 25% is calculated
thus:
Year Cashflow 20% Discount Net Present

N’000 N’000 N’000
0 -9500 1,000 -9,500
1 3,000 0.8000 2,400
2 4,700 0.6400 3,008
3 4,800 0.5120 2,458
4 3,200 0.4096 1,311
That gives NPV = -323.
The IRR can be calculated as follows:
IRR = 20% + 5% (582) = 23.22%

905
a b c d
where:
 is a discount rate, which gives a positive NPV? In this example,
20% gives N-582.
 is the difference between (a) and the rate, which gives a negative
NPV? In this example, 25% - 20% = 5%.
 is the positive NPV at the discount rate chosen in (a)? In this
example, it is 582?
 is the total range of NPV at the rates chosen? In this example, +
582 to – 323 = 905?
(Lucey, 1988)
Illustration 3
Justice Chukwuyem has been looking for a suitable investment which

will give a target internal rate of return of 17 to 20%. An investment
adviser has offered the company a project, the details of which are given
below.
Pineapple Squash Bottling Project
Initial investment involves purchase of machinery for N1, 800,000 and

installation expenses of N310, 000. The plant can produce N100,000
cartons of pineapple squash per annum, during the first two years, rising
to125,000 cartons per annum, for the next three years. Cost of
production of each carton, excluding depreciation costs is N21 and the
selling price will be N27. The plant will be scrapped at the end of the
5th year and is expected to have negligible scrap value.
You are required to calculate the actual internal rate of return of the
above project. You may ignore the effect of taxation.
Solution
Present Value factor = (1 + r) n
where r is the rate; and

n is the number of year.
Solution
i. Pineapple Squash Bottling Project
Year Cash PV Present PV Present

flow N Factor Value Factor Value
17% 20%
0 (211,000) 1.000 (211,000) 1.000 (211,000)
1 60,000 0.855 51,300 0.833 49,980
2 60,000 0.731 43,860 0.694 41,640
3 75,000 0.624 46,800 0.579 36,150
4 75,000 0.534 40,050 0.482 36,150
5 75,000 0.456 34,200 0.402 30,150
Net present value 5,210 (9,655)
Cash flow – years 1 and 2 (N27 – 21) x N10, 000 = N60, 000
Cash flow – years 3, 4, and 5 (N27 – 21) x N12, 5000 = N75,000
N/B: This is a neat way of determining the cash inflows.
Actual Rate of Return = a + (b – a)
Where a = the low discount rate

b = the high discount rate
c = the low rate of present value
d = the high rate of net present value
17 + (20 – 17)
= 17 + 5210 x 3
14865
= 17 + 1.05 = 18%
3.5 Short cut to IRR computation

You learnt that the computation of IRR involved a lot of trial and error
except when you are using computers. Therefore, any discussion that
could considerably reduce the quantum of trial and error shall be a
welcome development.
Accordingly, we shall be concern with developing short cuts to trial and

error approach.
Since the calculation of IRR is based on trial and error, any technique to
minimize the extent of the trial and error would be highly appreciated.
The following steps would be helpful.
Step 1: Sum up the cash inflows

Step 2: Find the average of the cash inflows. Let this be x
Step 3: Given that the cash outflow occurred in year zero and
taking year zero as the focal date, we then establish an
equation of values,
Thus x and i = CFO
Where x = the average of cash inflows
And i = annuity factor for a given value of n and i
CFO = cash outflow in year 0.
Step 4: From the annuity table (present value) read up the nearest
(most approximate) rate in which annuity factor at the
given value of n is very close to the quotient
Step 5: The rate obtained in Step 4 above becomes the base rate.
Step 6: Compute the NPV using the rate as the discount rate.
Step 7: If the NPV derived from above is positive, a higher rate of
discount is tried and if negative, a lower rate is tried.
Step 8: Upon arriving at two rates, one having a positive NPV and
the other a negative NPV, resort to interpolation viz:
a
IRR  x  ( y  x)
ab
where IRR = internal rate of return
x = the lower rate

a = NPV at x
y = the higher rate
b = NPV at y
II = modulus sign (meaning assume every figure to be positive).
Illustration
Anulika Nig. Ltd. is considering investing in a project which cash flows

were as follows:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

N’000 N’000 N’000 N’000 N’000 N’000
-144 +15 +25 +35 +45 + 60
Given that the cost of capital is at 10% per annum, should Anulika Nig.
Ltd. invest in it or not – using the IRR approach?
Solution
To minimize the extent of the trial and error, the above eight steps are
then sequentially followed in the following way.
Step 1: Sum up the cash inflows N (15,000 + 25,000 + 3,500 +

45,000 + 60,000) = N180, 000
Step 2: Find the average of the cash inflows: the average is N180,
000  5 = N36, 000
Step 3: Given that the outflow occurred in year zero and taking
year zero as the focal date, we then establish an equation
of values, thus:
X an i = CFO
Substituting
36,000 as 5 i = 144,000
a 5 i = 4.00
Step 4: From the annuity table (present value) read up the nearest
(most approximate) rate which annuity factor at the given
value of n is very close to the quotient, CFO: X
Substituting
144,000: 36,000 = 4.00
From the annuity table (present value) given that n = 5 and a5 i = 4.00
The nearest values of i are 7% (4.100) and 8% (3.993).
Step 5: The rate obtained in Step 4 above becomes the base rate.
In this case 8%
Step 6: Compute the NPV using the base rate at the discount rate.
Year Cash flow DCF @ 8% Present Value

N’000 N’000 N’000
0 -144 1,000 -144.00
1 15 0.926 13.89
2 25 0.857 21.43
3 35 0.794 27.79
4 45 0.735 33.08
5 60 0.681 40.86
NPV = -6.95
Step 7: If the NPV derived in Step 6 above is positive, a higher
rate of discount is tried and if negative, a lower rate is
tried.
Accordingly, let’s try lower rate say 6%
Year Cash flow DCF @ 8% Present Value

N’000 N’000 N’000
0 -144 1,000 -144.00
1 15 0.943 14.15
2 25 0.890 22.25
3 35 0.839 29.37
4 45 0.792 35.64
5 60 0.747 44.82
NPV = -2.23
Step 8: Upon arriving at the two rates, one having a positive NPV
and the other a negative NPV, resort to interpolation viz:
a
IRR  x  ( y  x)
ab
where IRR = internal rate of return

x = the lower rate
a = NPV at x
y = the higher rate
b = NPV at y
II = modulus
Substituting:
IRR = 6 + 2.23 (8 – 6)
2.23 + 6.95
= 6 + 2.23 x 2
9.18
= 6 + 0.4858
= 6.486
As a check, let’s now compute the NPV given that the discount rate =
6.486%.
Year Cash flow DCF @ 6.486% Present Value

N’000 N’000 N’000
0 -144 1,000 -144.00
1 15 0.9391 14.0865
2 25 0.8819 22.0475
3 35 0.8282 28.987
4 45 0.7777 34.999
5 60 0.7304 43.824
NPV = -0.056*
 For all practical purposes, the NPV at IRR should be zero.

However, occasionally, one could record a negligible negative or
positive NPV (-0.056 in this case) due to rounding up of error.
4.0 CONCLUSION
This method called Internal Rate of Return is also very important. Even
with the possibility of multiple rates, it is still very important.
5.0 SUMMARY
In this unit, you have learnt the various definitions of Internal Rate of
Return (IRR). You are now aware of computational techniques and the
investment criteria. You have also learnt the short cut approach to
solving IRR Problems.
1. Calculate the projects IRR if the initial outlay is N80,000 and the cash
flow are as follows:
Yrs CF (N)
Yr1 10,000
Yr2 12,000
Yr3 40,000
Yr4 25,000
Yr5 15,000
If the expected scrap value is 5,000 at the end of five years and the
discount factor is 15%.
Horngren, C. T., Datar, S. & Foster, (1997). Cost Accounting: A


DPP.

Accounting. Lagos/London:

UNIT 5 THE PROFITABILITY INDEX(Discounting Technique)
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Profitability Index or Excess Present Value Index (EPV I)
4.0 Conclusion
5.0 Summary
1.0 INTRODUCTION
As scientific as the Net Present Value (NPV) approach to investment

appraisal may appear to be, it has one major limitation– it fails to
consider the quantum of capital that generated the NPV. This is a major
weakness since ordinarily; a higher capital base will generate a higher
NPV. Logically, therefore, a relative NPV or better still, an NPV per
unit of capital base would give a better evaluation results. This is where
the Profitability Index (PI) comes from.
2.0 OBJECTIVES
 explain the meaning of profitability index (PI)

 state the formulae for PI
 apply the formulae for PI
 outline the merits and the demerits of PI
 compare the IRR method with the NPV method.
3.0 MAIN CONTENT
3.1 Profitability Index or Excess Present Value Index (EPV I)
There are two possible formulae to calculate this index.

a. According to Okafor (1983), the profitability index (PI) of a
project is the ratio of the sum of the present values of all its cash
inflows to the sum of the present values of its cash outflows, i.e.
PIi =
Where
PIi = profitability index of project I
Pvi = sum of present value of cash inflows from project I
Ci = sum of present value of cash outflows of project I.
b. According to Lucey (1988), the EPVI is merely a variant of the

basic NPV method and is the ratio of the NPV of a project to the
initial investment.
i.e. EPVI = NPV

Initial Investment
Thus, the index is a measure of relative and not absolute profitability.

Because of this, it suffers from the same general criticisms when used
for ranking purposes as the IRR.
Decision rule
The decision rules for the profitability index are as follows.
 Accept only projects that have profitability index of more than 1

(one)
 Reject projects that have profitability index of less than one
 Remain indifferent if the index is zero.
For the excess present value index, the decision rules are as follows.
 Accept only projects which EPVI is positive

 Reject projects which EPVI is negative
 Remain indifferent if the EPVI is zero.
ILLUSTRATION 1
Nwagod Company Ltd is considering five different investment

opportunities. The company’s cost of capital is 12 percent. Data on
these opportunities under consideration are given below.
Project Investment PV at NPV IRR Profitability
N’000 12% N’000 N’000 Index
N’000 N’000
a. 35,000 39,325 4,325 16 1.12
b. 20,000 22,930 2930 15 1.15
c. 25,000 27,453 2,453 14 1.10
d. 10,000 10,854 854 18 1.09
e. 9,000 8,749 (251) 11 0.97
i. Rank the five projects in descending order of preference,

according to:
 NPV (Net Present Value)

 IRR (Internal Rate of Return)
 Profitability Index.
Which ranking would you prefer?

Based on your answer in part 2, which projects would you select if N55,
000,000 is the limit to be spent?
Solution
i. Nwagod Company Ltd
Order of Preference NPV IRR Profitability Index

a. 1 2 2
b. 2 3 1
c. 3 4 3
d. 4 1 4
e. 5 5 5
ii. The profitability index approach is generally considered the most

dependable method of ranking projects competing for limited
funds. It is an index of relative attractiveness, measured in terms
of how much you get out for each naira invested.
i. Based on the answer in part 2, projects (a) should be selected,
where combine NPV would be N7, 255 (N2,930 + N4,325) with
the limited budget of N55,000,000.
4.0 CONCLUSION
In this unit, you have learnt that Net Present Value (NPV) has one major
weakness when one is faced with two or more projects – it fails to take
into consideration the quantum of capital outlay that generated the NPV.
This is a weakness because huge capital outlays are likely to have huge
NPV relative to small capital outlay. This is where the Profitability
Index (PI) comes in hence; PI is defined as NPV per unit of capital.
5.0 SUMMARY
In this unit, you have looked at the basic definition of profitability index.
You also looked at the computational techniques and the investment
criteria.
United Development Corporation has N2.5million naira available for

investment in projects. The following projects are under consideration.
Project No Initial Annual Life

N N
1. 800,000 230,000 6 years
2. 600,000 190,000 6 years
3. 700,000 210,000 6 years
4. 900,000 240,000 6 years
5. 300,000 92,000 6 years
6. 950,000 300,000 6 years
The corporation expects a minimum rate of return of 18%. Projects

Nos. 2 and 5 are complementary to each other. They have to be
accepted together or rejected together. Projects Nos. 2 and 5 are
mutually exclusive due to their nature.
You are required to:
i. calculate profitability of all the six projects (6 marks)

ii. advise the corporation on selection of projects to maximise
profitability, bearing in mind that only N2.5 million capital is
available (6 marks)
Note: Present value of annuity of N1 for the next 6 years at 18% is

N3.497 (ICAN, Nov. 1999, Q3).
Horngren, C. T., Datar, S. & Foster, (1997). Cost Accounting: A


DPP.

Accounting. Lagos/London: B. P. Publications Ltd.


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NATIONAL OPEN UNIVERSITY OF NIGERIA

FACULTY OF MANAGEMENT SCIENCES

Course Code BFN721

Course Title Investment and Portfolio Management

Writer Dr. Okoh, Johnson Ifeanyi

Course Editor Assoc. Prof. Uwaleke, U. Joseph, ACIB, FCA

Programme Coordinator DR. OKOH JOHNSON IFEANYI

Head of Department Dr. Ofe. Inua

Department of Financial Studies

BFN 721: Investment and Portfolio Management is a first semester course,

WHAT YOU WILL LEARN IN THIS COURSE

The aim of this course can be summarized as follows:

 State the different types of Risk

WORKING THROUGH THIS COURSE

Major components of the course are:

The study units in this course are as follows:

Unit 1 Risk and uncertainty in portfolio management

Unit 1 Activities involved in making selection among

The presentation schedule included in your course materials also have

In tackling the assignments, you are expected to apply information, knowledge

TUTOR-MARKED ASSIGNMENTS (TMAs)

FINAL EXAMINATION AND GRADING

COURSE MARKING SCHEME

2 Portfolio theory 1 Assignment 2

3 Portfolio selection 1 Assignment 3

HOW TO GET THE MOST FROM THIS COURSE

Self-tests/assignments are interspersed throughout the end of units. Working

(1) Read this course guide.

TUTORS AND TUTORIALS

STUDY UNITS (INVESTMENT AND PORTFOLIO MANAGEMENT)

Unit 1 Risk and uncertainty in portfolio management

Unit 1 Activities involved in making selection among

UNIT 1 RISK AND UNCERTAINTY IN PORTFOLIO

Any business venture contains an element of risk. Risk means the

 State the different types of Risk

3.1 Different Types of Risk

3.1.1 Risk versus Uncertainty

Uncertainty refers to situation in which one has no knowledge of the

Risk is created by a wide range of factors which include instability in the

3.1.2 Systematic Versus unsystematic Risk

Generally, risk can be classified as either systematic or unsystematic

Systematic Risk, otherwise known as market risk or unavoidable risk are

Examples are risk associated with:

Unsystematic Risks otherwise known as avoidable risk are risk caused

Examples are risk due to:

Total risk associated with an investment is the addition of the systematic

3.1.3 Other classifications of Risk

Risk associated with securities investment can be categorized as follows:

(iii) Purchasing power: This is risk due to inflation and changes in

(v) Interest Rate Risk: This refers to possibility of capital loss

(viii) Re-Investment Risk: Risk associated with the re-Investment of

(xi) Political Risk: Risk associated with the political environment in

(xiii) Moral Risk: Refers to the risk of dishonesty. For example

3.2 Risk Management Strategies

While the risk of investment can never be completely eliminated, they

The process of risk management requires that:

Identifying Risk: An investor need to be quite sure of exactly what risk

Evaluating Risk: There are various ways in which the risk of

Managing Risk: An Investor can manage risk exposure in four ways: