(a) Explain 'Capital Asset Pricing Model'. 10 (b) Briefly explain any five risks faced by the financial institutions in India…

(a) Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model, developed by William Sharpe (1964), John Lintner (1965) and Jan Mossin (1966), establishes a linear relationship between the required rate of return of an asset and its systematic risk. The model is expressed as:

E(Rᵢ) = R_f + βᵢ [E(Rₘ) - R_f]

where E(Rᵢ) is the expected return, R_f is the risk-free rate (e.g., Indian 91-day Treasury Bills), E(Rₘ) is the expected market return, and [E(Rₘ) - R_f] is the equity risk premium.

CAPM bifurcates total risk into unsystematic (diversifiable/firm-specific) risk and systematic (non-diversifiable/market) risk. Because rational investors eliminate unsystematic risk through diversification, the market prices only systematic risk. Beta (βᵢ) quantifies this sensitivity relative to the market index. Graphically, this relationship forms the Security Market Line (SML).

While CAPM offers a clear benchmark for project appraisal and hurdle rates, it assumes frictionless markets, homogeneous expectations, and a single-period horizon, which often deviate from empirical market realities.

(b) Five Risks Faced by Financial Institutions in India

Financial institutions (FIs) in India navigate a complex operational and macroeconomic environment, exposing them to five key risks:

1. Credit Risk: The risk of loss arising from borrower default on interest or principal repayments. This manifests in elevated Non-Performing Assets (NPAs), necessitating higher provisioning under RBI guidelines and resolution via the Insolvency and Bankruptcy Code (IBC).
2. Liquidity Risk: Arises from an Asset-Liability Mismatch (ALM) when short-term liabilities (e.g., commercial papers) fund long-term illiquid assets, as observed during the IL&FS crisis.
3. Market Risk: Vulnerability of the trading book to adverse fluctuations in interest rates, equity prices, and foreign exchange rates, which affects the valuation of government securities and foreign currency exposures.
4. Operational Risk: Losses resulting from inadequate internal controls, technical disruptions, and cyber threats (e.g., payment gateway breaches or fraudulent issuance of Letters of Undertaking).
5. Regulatory and Compliance Risk: Financial and reputational penalties from non-compliance with evolving norms, such as Basel III capital adequacy ratios, Prompt Corrective Action (PCA) frameworks, and dynamic CRR/SLR mandates.

(c) Walter's Model of Dividend Decision

James E. Walter’s model posits that dividend policy directly influences firm valuation by linking the internal rate of return on investment (r) with the firm's cost of capital (kₑ). The valuation formula is:

P = [D + (r/kₑ)(E − D)] ÷ kₑ

where P is market price per share, D is dividend per share, and E is earnings per share.

The causal mechanism dictates three distinct strategic scenarios:

• Growth Firm (r > kₑ): The firm generates superior returns compared to what shareholders can earn externally. Maximum value is achieved by retaining all earnings (optimum payout ratio = 0%).
• Declining Firm (r < kₑ): External market opportunities yield higher returns than the firm's reinvestments. Value is maximized by distributing all earnings (optimum payout ratio = 100%).
• Normal Firm (r = kₑ): Internal returns match external expectations. The dividend payout is irrelevant, and P remains constant across all distribution ratios.

The model assumes 100% internal equity financing (no external debt or equity) and constant values of r and kₑ.

(d) Problem of Multiple Internal Rates of Return (IRR)

The Internal Rate of Return (IRR) is the discount rate that equates the Net Present Value (NPV) of a project to zero.

The problem of multiple IRRs arises in non-conventional (non-normal) cash flow streams, where the sequence of net cash inflows and outflows changes signs more than once across the project lifecycle (e.g., initial investment followed by inflows, and subsequent major decommissioning costs). By Descartes’ Rule of Signs, the number of positive real roots (IRRs) cannot exceed the number of sign reversals, so two reversals can give two IRRs, and some streams give no real IRR at all. Example: −1,600, +10,000, −10,000 gives IRRs of 25% and 400%.

Consequently, the project’s NPV profile intersects the horizontal discount-rate axis multiple times, so the decision rule (accept if IRR > cost of capital) becomes ambiguous, a project may have positive NPV only between the two IRRs. Furthermore, standard IRR unrealistically assumes reinvestment of interim cash inflows at the internal rate itself.

This structural defect is resolved by adopting the Net Present Value (NPV) criterion or computing the Modified Internal Rate of Return (MIRR), which assumes reinvestment at the firm's cost of capital.

(e) Objective of Maximising Shareholders' Wealth

Wealth maximisation represents the primary operational objective of modern financial management, operationalised as maximising the market value of the firm's equity shares. It is mathematically measured as maximizing the Net Present Value (NPV) of all corporate decisions:

W = Σₜ₌₁ⁿ (CFₜ)/((1+k)^t) - C₀

Wealth maximisation is conceptually superior to profit maximisation due to the following reasons:

• Time Value of Money: Profit maximisation focuses on accounting profit and ignores the timing of cash inflows, whereas wealth maximisation discounts expected future cash flows over time.
• Explicit Handling of Risk: Profit maximisation treats uncertain and certain earnings equally. Wealth maximisation incorporates business and financial risk through risk-adjusted discount rates (k).
• Ambiguity and Scale: "Profit" is subject to accounting interpretations (e.g., depreciation methods) and ignores the capital outlay required. Wealth maximisation relies on objective, verifiable cash flows.
• Agency and stakeholders: managers may pursue their own goals, so incentives, monitoring and governance align them with owners, and long-run value requires fair treatment of creditors, employees and customers.