Finance

Portfolio Management

Definition: Portfolio management is the process of selecting, allocating, monitoring, and revising a group of financial assets (shares, bonds, debentures, deposits, real estate, etc.) in such a way that the investor achieves the maximum possible return for a given level of risk, or bears the minimum possible risk for a given level of return. In other words, it is the art and science of combining individual securities into a single investment basket so that the risk of the whole portfolio is lower than the average risk of its component securities, without a proportional sacrifice of return. The person or institution performing this task is called the portfolio manager, and the guiding principle is diversification.

Objectives: Maximize return, minimize risk, maintain liquidity, diversify to reduce unsystematic risk, and match the portfolio with the investor's age, income, tax position and time horizon.

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Relationship between Risk and Return

The central proposition of portfolio management is that risk and return are positively related — higher expected return can be earned only by accepting higher risk. This is called the risk–return trade-off.

1. Direct relationship: A treasury bill or fixed deposit carries almost no default risk and hence offers a low return. Ordinary shares of a company carry high variability of return and hence must offer a higher expected return to attract investors. The difference between the return on a risky security and the risk-free rate is the risk premium.

2. Compensation for uncertainty: Investors are generally risk-averse. They will hold a risky asset only if they are compensated for the extra uncertainty. Hence: $\text{Required return} = \text{Risk-free rate} + \text{Risk premium}$

3. Diversification changes the relationship: When securities are combined, total risk falls because the good performance of some securities offsets the poor performance of others. The risk that remains after full diversification is systematic (market) risk, which cannot be removed; the removable part is unsystematic (firm-specific) risk. Only systematic risk is rewarded in the market, as stated by the CAPM: $E(R_i) = R_f + \beta_i\,[E(R_m) - R_f]$

4. Efficient frontier: For every level of risk there is a portfolio offering the highest return; the locus of such portfolios is the efficient frontier. Rational investors choose a portfolio on this frontier according to their risk preference.

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Measuring Portfolio Return

Expected return of a single security (probability approach): $E(R) = \sum_{i=1}^{n} P_i R_i$

Expected return of a portfolio is the weighted average of the expected returns of the securities: $E(R_p) = \sum_{j=1}^{m} w_j E(R_j), \qquad \sum w_j = 1$

Example: An investor puts Rs 60,000 in Share A (expected return 16%) and Rs 40,000 in Share B (expected return 10%).

Weights: $w_A = 0.60$, $w_B = 0.40$

$E(R_p) = 0.60(16\%) + 0.40(10\%) = 9.6\% + 4.0\% = 13.6\%$

So the portfolio's expected return is 13.6%.

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Measuring Portfolio Risk

Variance and standard deviation measure total risk:

$\sigma^2 = \sum_{i=1}^{n} P_i\,[R_i - E(R)]^2, \qquad \sigma = \sqrt{\sigma^2}$

Portfolio standard deviation (two-asset case):

$\sigma_p = \sqrt{w_1^2\sigma_1^2 + w_2^2\sigma_2^2 + 2w_1w_2\,\rho_{12}\,\sigma_1\sigma_2}$

where $\rho_{12}$ is the correlation coefficient between the returns of the two securities.

Covariance: $\text{Cov}_{12} = \rho_{12}\sigma_1\sigma_2$

Coefficient of variation (risk per unit of return): $CV = \frac{\sigma}{E(R)}$

Beta measures systematic risk: $\beta_j = \frac{\text{Cov}(R_j, R_m)}{\sigma_m^2}$

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Numerical Example

Portfolio return: $E(R_p) = 0.60(16) + 0.40(10) = 13.6\%$

Portfolio risk: $\sigma_p = \sqrt{(0.60)^2(12)^2 + (0.40)^2(8)^2 + 2(0.60)(0.40)(0.30)(12)(8)}$

$= \sqrt{51.84 + 10.24 + 13.824} = \sqrt{75.904} = 8.71\%$

Interpretation: The weighted average risk of the two shares is $0.60(12) + 0.40(8) = 10.4\%$, but the portfolio risk is only 8.71%. The reduction from 10.4% to 8.71% is the diversification benefit, which arises because $\rho_{AB} = 0.30 < 1$. Had the correlation been $+1$, no benefit would arise; had it been $-1$, risk could be reduced to zero.

Coefficient of variation: $CV = \frac{8.71}{13.6} = 0.64$

This means the portfolio bears 0.64 units of risk for every unit of expected return — a better risk–return position than either share held alone (A: $12/16 = 0.75$; B: $8/10 = 0.80$).

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Conclusion

Portfolio management seeks an optimal combination of risk and return. Return is measured by the weighted average expected return, while risk is measured by standard deviation, variance, covariance, correlation, coefficient of variation and beta. Because returns of different securities are not perfectly positively correlated, combining them reduces unsystematic risk and pushes the investor toward the efficient frontier — the practical proof being the fall in risk from 10.4% to 8.71% in the example above, with the expected return remaining at 13.6%.

Financial Viability Evaluation of a Project and Appraisal Challenges of Nepali Banks in Infrastructure Projects

1. Introduction

Project appraisal is the systematic process by which a bank or financial institution assesses whether a proposed project is technically feasible, economically and financially viable, and bankable in terms of debt-servicing capacity. Financial viability means the project's cash inflows are sufficient to meet operating costs, debt service obligations and to yield an acceptable return to the promoters. In Nepal, infrastructure projects — hydropower, roads, bridges, airports, transmission lines, water supply — are typically large, long-gestation, capital-intensive and financed on a limited-recourse basis, which makes financial viability analysis both critical and difficult.

2. Methods Used to Evaluate Financial Viability

(a) Non-discounted (traditional) methods

• Payback Period (PBP): The time required to recover the initial investment from net cash inflows. $\text{PBP} = \frac{\text{Initial Investment}}{\text{Annual Net Cash Inflow}}$ A shorter period is preferred. It is simple but ignores cash flows after the payback period and the time value of money.

• Accounting Rate of Return (ARR): Based on accounting profit rather than cash flow. $\text{ARR} = \frac{\text{Average Annual Profit}}{\text{Average Investment}} \times 100$ A project is accepted if ARR exceeds the required rate. It ignores the time value of money.

(b) Discounted cash flow (DCF) methods

• Net Present Value (NPV): The present value of all future cash flows discounted at the cost of capital, minus the initial outlay. $\text{NPV} = \sum_{t=1}^{n}\frac{CF_t}{(1+k)^t} - I_0$ Rule: accept if NPV > 0; among mutually exclusive projects, choose the highest NPV. NPV is the most reliable criterion as it measures the absolute addition to shareholder wealth.

• Internal Rate of Return (IRR): The discount rate at which NPV equals zero. $\sum_{t=1}^{n}\frac{CF_t}{(1+r)^t} = I_0$ Rule: accept if IRR > cost of capital (or hurdle rate). It is popular because it is expressed as a percentage, but it may give multiple rates with non-conventional cash flows and can mislead in projects of unequal scale.

• Modified IRR (MIRR): Corrects the reinvestment-rate assumption of IRR by compounding inflows at the cost of capital and discounting outflows at the financing rate.

• Profitability Index (PI) / Benefit–Cost Ratio: The ratio of the present value of inflows to the initial investment. $\text{PI} = \frac{\text{PV of Cash Inflows}}{I_0}$ Rule: accept if PI > 1. It is useful when funds are rationed, as it ranks projects by return per rupee invested.

• Discounted Payback Period: The payback period computed on discounted cash flows, combining liquidity and time-value considerations.

(c) Debt-servicing and leverage measures

• Debt Service Coverage Ratio (DSCR): The core bankability test for infrastructure lending. $\text{DSCR} = \frac{\text{Net Operating Income (CFADS)}}{\text{Interest + Principal Repayment}}$ Lenders normally require an average DSCR of at least 1.2–1.5 and a minimum DSCR above 1.0 in every year, including stressed years. Related tests are the Interest Coverage Ratio and Loan Life Coverage Ratio.

• Break-even Analysis: Determines the level of output or revenue at which total cost equals total revenue, indicating the margin of safety.

(d) Risk and sensitivity analysis

• Sensitivity Analysis: Tests how NPV/IRR/DSCR change when one key variable (tariff, cost, exchange rate, load factor) is varied.
• Scenario Analysis: Examines best-case, base-case and worst-case combinations of variables.
• Monte Carlo Simulation: Assigns probability distributions to key variables and generates a distribution of outcomes, giving the probability of default or of NPV falling below zero.
• Real Options Analysis: Values managerial flexibility such as deferral, expansion or abandonment options, which is relevant for phased infrastructure projects.

(e) Economic vs financial analysis: Financial viability is judged at market prices from the project's (and lender's) viewpoint, while economic viability uses shadow prices and considers externalities. For infrastructure, both are examined, but the bank's lending decision rests primarily on financial viability and DSCR.

3. Major Challenges Faced by Nepali Banks in Appraising Infrastructure Projects

1. Weak and unreliable feasibility studies: Promoters often submit over-optimistic demand, tariff and cost projections; banks lack independent in-house capability to verify them.
2. Data scarcity: Absence of reliable historical data, benchmarks and credit histories for similar projects makes realistic cash-flow forecasting difficult.
3. Maturity mismatch and lack of long-term funds: Banks' liabilities are mostly short-term deposits while infrastructure loans require 10–20 year tenors, creating asset-liability management problems and liquidity risk.
4. Limited technical and appraisal expertise: Few banks have engineers, sector specialists and financial modellers competent to appraise complex hydropower or transport projects.
5. Political instability and policy inconsistency: Frequent changes in government, tariff policy, tax laws, land acquisition rules and licensing create regulatory risk that is hard to quantify.
6. Weak legal and enforcement framework: Slow courts, weak insolvency and foreclosure mechanisms, and difficulties in enforcing project security or invoking guarantees reduce lender confidence.
7. Collateral and security issues: Project assets are often immovable and illiquid; land acquisition and right-of-way problems delay financial closure.
8. Regulatory constraints: NRB directives on single obligor limits, sectoral exposure ceilings, capital adequacy (Basel III), loan classification and provisioning restrict large infrastructure exposures.
9. Currency and interest-rate risk: Foreign-currency debt for imported equipment exposes banks and borrowers to depreciation risk; absence of long-tenor fixed-rate funding and hedging instruments adds to uncertainty.
10. Cost and time overruns: Delays in approval, construction and transmission connection inflate project cost and postpone revenues, weakening DSCR.
11. Environmental and social compliance: Resettlement, compensation and IEE/EIA conditions add cost and time, and non-compliance can halt projects.
12. Lack of risk-mitigation instruments: Underdeveloped bond market, limited credit enhancement, inadequate insurance and few sovereign or partial guarantees.
13. Governance and integrity issues: Weak corporate governance of promoters, over-invoicing and rent-seeking reduce project transparency.
14. Natural disaster and climate risk: Nepal's seismic and flood-prone geography makes infrastructure assets highly vulnerable.
15. Coordination problems: Multiple agencies (ministries, NRB, local bodies, Nepal Electricity Authority) cause delays in approvals and power purchase agreements.

4. Conclusion

Nepali banks rely mainly on DCF techniques — NPV, IRR and especially DSCR — supplemented by sensitivity and scenario analysis to judge financial viability. However, weak feasibility studies, short-term deposit base, limited technical expertise, political and regulatory uncertainty, and weak legal enforcement make infrastructure appraisal unusually challenging. Strengthening in-house appraisal capacity, developing long-term debt instruments and a bond market, improving legal enforcement, and using credit guarantees and risk-sharing mechanisms would make infrastructure projects more bankable and help close Nepal's large infrastructure financing gap.