CORPORATE FINANCE

Unit-I
Define corporate finance. Corporate Finance is the specific area of finance dealing with the financial decisions corporations make, and the tools and analysis used to make the decisions. The discipline as a whole may be divided between long term, capital investment decisions, and short term, working capital management. Corporate finance has two basic functions:Acquisition of Resources Acquisition of resource means fund generation at lowest possible cost. Resource generation can be done through:Equity --- It includes proceeds obtained from stock selling, retained earnings, and investment returns. Liability --- It includes bank loans, warranties of products and payable account.

Allocation of Resources Investment of funds for profit maximization motive is known as allocation of resources. Investment can be categorized into two groups:

Fixed Asset --- Land, Machinery, buildings, etc. Current Asset --- Inventory, cash, receivable accounts, etc.

Corporate or business finance is all about raising and allocation of funds for increasing profit. Senior management chalks out long-term plan for fulfilling future objectives. Value of the company's stock is a very important issue for the management because it is directly related to the wealth of the share-holders of the company. Functions of Corporate Finance are:

Raising of Capital or Financing Budgeting of Capital Corporate Governance Financial management Risk Management

All the above functions are interrelated and interdependent. For example, in order to materialize a project a company needs to raise capital. So, budgeting of capital and financing are interdependent.

Decisions making of the corporate finance are basically of two types based on the time period for the same, namely, Long term and Short term. i . Long term decisions:It is basically concerned with the capital investment decisions such as viability assessment of the project, financing it through equity or debt, pay dividend or reinvest out of the profit. Long term corporate finance which is generally related to fixed assets and capital structure are called Capital Investment Decisions. Senior managements always target to maximize the value of the firm by investing in positive NPV (Net Present Value) projects. If such opportunities don't arise then reinvestment of profits should be stalled and the excess cash should be returned to the shareholders in the form of dividends. Hence, Capital Investment Decisions constitute three decisions:You might get confused to know how to get the best Car Financing Option. However, you are able to

Decision on Investment Decision on Financing Decision on Dividend

ii. Short term decisions:These are also known as working capital management which tries to strike a balance between current assets (cash, inventories, etc.) and current liabilities (a company's debts or obligations impending for less than one year).

Principle of Corporate Finance

Principles of Corporate Finance constitute the theories and their implementations by the managers of the companies in the practical field for maximization of profit. Corporate Finance deals with a company's financial or monetary activity (promotion, financing, investment, organization, capital budgeting etc.). All these activities are accomplished with the sole objective of profit maximization. For meeting the fund requirements for any project of a corporation, a company can get it from various sources such as internal, external or equities at the lowest cost possible. This fund is then used for investment purposes for the production of the desirable asset. Principle of Corporate Finance shows how the different corporate financial theories help to formulate the policies for the growth of a company.

Finance is a science of managing money and other assets. It is the process of canalizations of funds in the form of invested capital, credits, or loans to those economic agents who are in need of funds for productive investments or otherwise. Eg. On one hand, the consumers, business firms, and governments need funds for making their expenditures, pay their debts, or complete other transactions. On the other hand, savers accumulate funds in the form of savings deposits, pensions, insurance claims, savings or loan shares, etc which becomes a source of investment funds. Here, finance comes to the fore by channeling these savings into proper channels of investment. Broadly, finance can be classified into three fields:Public Sector Finance: Financing in the government or public level is known as public sector finance. Government meets its expenditures mainly through taxes. Government budget generally don't balance, hence it has to borrow for these deficits which in turn gives rise to public debt. Corporate or Business Finance: It tries to optimize the goals (profit, sales, etc.) of a corporation or other business organization by estimating future asset requirements and then allocating funds in accordance to the availability of funds. Personal Finance :

It basically deals with the optimization of finances in the individual (single consumer, family, personal savings, etc.) level subjected to the budget constraint. Eg. A consumer can finance his/her purchase of a car by taking a loan from any bank or financial institutions. Corporate or business finance is all about raising and allocation of funds for increasing profit. Senior management chalks out long-term plan for fulfilling future objectives. Value of the company's stock is a very important issue for the management because it is directly related to the wealth of the share-holders of the company. Some of the terms important in principle of Corporate finance are:Net Present Value (NPV) Net Present Value = (Present Value of Inflow of Cash) (Present Value of Outflow of Cash) NPV helps to measure the value of a currency today with that of the future, after taking into consideration returns and inflation. Positive Net Present Value for a project means that the project is viable because cash flows will be positive for the same. Senior managements always target to maximize the value of the firm by investing in positive NPV (Net Present Value) projects. If such opportunities don't arise then

reinvestment of profits should be stalled and the excess cash should be returned to the shareholders in the form of dividends. Financial Risk management According to Financial Economics, that project which increases the value of the shareholders wealth should be taken on. Financial Risk Management is the creation of value of the shareholders of a firm by managing the exposure to risk by the use of financial instruments (loans, deposits, bonds, equity stocks, future and options, etc.). Financial risk management involves:

Identification of the source of risk Risk measurement Chalking out of plans to manage the risks

Financial Risk Management always tries to find out viable opportunity to hedge the costly risk exposures by using financial instruments. Indian capital market A market in which individuals and institutions trade financial securities. Organizations/institutions in the public and private sectors also often sell securities on the capital markets in order to raise funds. Thus, this type of market is composed of both the primary and secondary markets. Indian financial system: Financial system is the system which consists of variety of institutions, markets and instruments. It provides means by which savings are transferred in to investments. Financial Institution and Intermediaries.

Surplus Units

Deficit Units

Financial Market

Functions of financial system 1. Payment system 2. Pooling of funds 3. Transfer of resources 4. Risk management 5. Price information Objectives of financial system 1. Speeding up economic growth 2. Rapid industrialization 3. Support to agriculture 4. Support to trade 5. Rural / Backward development 6. Project finance 7. Entrepreneurship development 8. Housing education and health 9. Infrastructure 10. Liquidity 11. Price control 12. Human development. Financial market 1. Capital market 2. Money market 3. Forex market Capital market: Capital market compresses various channels which make the individuals and community savings available for public trade, business and industry. Capital market is defined as a market which constitutes all long term lending by banks and financial institutions, ling term borrowings from foreign markets and rising of capital by new issue markets. Therefore capital market is the mechanism which provides long term finance like shares, debentures and ling term borrowings and not the short term finance. Elements of capital Market: Equity share: Equity share is a share which is not a preference share i.e., no priority given to share holders. All the share holders are treated alike. Types 1. 2. 3. 4. Growth Share Income Share defensive share Cyclic Share.

Preference Shares: Preference share is a share, where the holder of the share will be given preference in paying dividends and settlement during liquidation. Types 1. Cumulative preference share 2. Non cumulative preference share 3. Participating preference share 4. Non participating preference share 5. Convertible preference share 6. Non convertible share 7. Redeemable preference share 8. Irredeemable preference share 9. Cumulative convertible preference share Debenture and Bonds; Both the instruments are documents acknowledging the debt of the company. The difference between bond and debenture is bond unsecured where as debenture secured Types 1. Registered debenture / Bond 2. Bearer/ unregistered debenture /Bond 3. Fully convertible debenture 4. Partly convertible debenture 5. Non convertible debenture 6. Redeemable debenture 7. Sinking fund bondsInstallment 8. Serial bonds serial 3 to 4 times in a year 9. Collateral bonds floating charge 10. Secured debenture /bond fixed charge 11. Non secured debenture/ bond 12. Guaranteed bonds 13. Joint bonds 14. Income bondspayment of the rest will be made only when there is a profit Mutual fund: Mutual fund is collection of funds from small investors and investing large amounts out of collections in equalities and other securities. Types By structure 1. Open ended 2. closed ended 3. Interval schemes. By investment objective 1. Growth schemes 2. Income schemes 3. Balanced schemes 4. Money market schemes Other schemes

1. Tax saving schemes (ELSS) 2. Industry specific / sector specific 3. Index schemes 4. Load funds 5. No load fund 6. Theme fund 7. Children fund Non Tradable Securities 1. Post office / Govt securities 2. term loan from bank and financial institution 3. Feed capture by financial institutions Capital MarketTypes 1. Primary market 2. Secondary market Primary Market: It is also called as new issue market. It deals with securities issued for the first time in the market. Corporate organizations are willing to raise the funds through primary market only. They raise funds through the issue equity and preference shares and debentures. There are two methods of raising funds in primary market they are. 1. Public issue: In this method the company will to the general public and raises the funds by issue of securities. It involves advertising in newspapers etc and equity subscription. 2. Rights issue: In this method the funds are raised by the money contributed by the equity share holders of the company. Secondary Market: Secondary Market is a market for trading existing securities of the companies. Stock market is an organized market through which the securities are bought and sold in an orderly manner. Since the securities market is called as secondary market it is also been known as stock exchange. Money Market: Money Market is the market deals with short term securities. It is a marker to provide short term finance for the organizations. 1. Call money market: Amount borrowed or lent on demand for a very shout period of 1 to 14 days. Interring holidays and Sundays are excluded for the purpose. 2. Bill market: The documents of bill of exchange will be issued by the passes which can be negotiable and will mature in a shout period of time. 3. Certificate deposits: A certificate of deposits is a marketable receipt of fund which is having a maturity period of up to one year. It is issued by bands in the form of promissory notes.

4. Commercial paper: Commercial paper is a short term negotiable instrument issued by the companies. The maturity period range from 30 to 364 days. Compulsory credit is also required. 5. Treasury bills: The lowest risk category instrument is Treasury bill which is issued by RBI. The maturity period ranges from 14 to 364 days. 6. Money market Mutual fund: Money market Mutual fund is introduced here to provide additional short term avenue through which the small investor could actually take part in the money market. Forex Market: Forex market is the market deals with the trading of foreign currencies. It is also considered as one of the important avenue of investment. Advantages, Disadvantages of various instruments Equity shares: Advantages: 1. Command and control 2. No fixed cost 3. No charge over assets 4. Permanent capital 5. Public issue Disadvantages: 1. Control /management by equity share holders 2. Market price- If it is low further raising can be possible 3. High dividend 4. Excessive capitalization of equity shares will affect the companys profit. Preference share: Advantages: 1. Assured return 2. Fixed return 3. Maturity period 4. Chance of convertibility 5. Preference right Disadvantages: 1. Not a permanent capital 2. Rigid capital structure Not able to alter the returns 3. Cost of capital higher than debenture 4. No tax benefits Debenture: Advantages: 1. Assured return

2. Less risky and secured 3. Tax benefit 4. Flexibility/ convertibility Disadvantages: 1. Charge on assets 2. Not a permanent capital 3. More of debenture will affect the profit of the organization. Problems of Industrial finance: 1. High cost 2. Difficulty in information transfer 3. Less response from house hold (10%of investment) 4. Prevalence of unorganized market 5. Inability of the poor to approach organized market 6. No integration between various segments of financial market 7. Pricing and allocation of resources is not efficient 8. Participation is not uniform 9. More amount of brokerage and underwriting exchanges 10. difficulty in attaining minimum subscription 11. Problem of repaying the amount of the minimum subscription is not attained 12. Gap between functional and institutional setup. Merchant banking is absent. 13. Due to risk aversion of investor they prefer less risky securities 14. the cost of flotation is very high 15. the Existing companies with sound track record can raise funds very easily but the new organization cant do it very easily. Problems other View: 1. Applicant submitting window dressed annual report 2. Unrealizable accounting creates non performing assets 3. Difficulty in assessing capital finance 4. Diluting the loan other than original purpose 5. Relevant norms not framed so it leads to failure 6. Poor projects appraisal 7. Double or multiple financing 8. Improper monitoring of borrower by lender 9. Undue delay in sanctioning loans. "Debt Financing vs. Equity Financing Financing your new business can be categorized into two different types: debt financing and equity financing. Debt Financing: In basic terms, this is a loan. Money that you borrow from another source with the understanding that you will pay it back in a fixed amount of time. As the name suggests, this type of financing means that you have "debt" -- money that you owe to someone. The person who lends you money does not have any liberties or ownership over your business. Your relationship continues as long as you owe the money and once it is paid

back, your relationship with the lender ends. Debt financing can be short-term (one year or less for repayment) or long-term (repayment over more than one year). This type of financing occurs with banks and the SBA (Small Business Administration). Advantages to Debt Financing:

You retain maximum control over your business The interest on debt financing is tax deductible

Disadvantages to Debt Financing:

Too much debt can cause problems if you begin to rely on it and do not have the revenue to pay it back. Too much debt will make you unattractive to investors who will view you as "high risk."

Equity Financing: This type of financing is an exchange of money (from a lender) for a piece of ownership in the business. This appears to be "easy money" because it involves no debt. This type of financing normally occurs with venture capitalists and angel investors. Advantages to Equity Financing:

You don't have to worry about repayment in the traditional way. As long as your business makes a profit, the lenders will be repaid. With the help of investors, your business becomes more credible and may win new attention from the lenders' networks.

Disadvantages to Equity Financing:

As the business owner, you lose your complete control and autonomy. Now, investors have a say in the decisions that are made. Too much may indicate to potential funders that you are willing to take the necessary personal risks, which could signify a lack of belief in your own business venture.

When a banker, venture capitalist, or angel investor is considering giving you money, they will look at your debt to equity ratio. This is the amount of debt you have compared to the amount of equity you have. To lenders, this ratio is important because it tells the amount of money available for repayment in the case of default. It also shows if your business is being run in a sensible way, without too much dependence on any one source. When considering what type of financing you want or need, take some time to think about your business motives. How much control do you want? What are your long-term goals? With equity financing, you and your investors may come to disagree on important business decisions. When this happens, it is often best for you to "cash in" and let your

investors take the business into the future without you. To some entrepreneurs who believe in their business idea and want to see it through, selling is not an option. If this describes you, equity financing is not for you. Instead, you should explore debt financing and retain control over the direction of your business venture. SEBI Guide Lines Equity 1. Price band is free for existing companies but at par for fresh issue 2. The prospectus must contain the net asset value. 3. Proper justification of price should be given. 4. Promoters contribution 20 to 25 % on the issue. 5. Minimum No of share application and application money For at par 200 shares face value of 10 each For premium minimum application money is not less than Rs.2000 25% on face value of shares and not less than 5% on face value 6. Securities issued should be fully paid up with in 12 months. 7. 12 months elapsed between two issues. 8. Period of subscription 10 working days at least for 3 working says. Rights issue- 30 days not mare than 60 days. 9. Retention of oversubscription: 10% of the net offer for rounding off to the nearest multiple of 100 10. Underwriting optional but the underwriter has to give commit money for 5% of issue amount or 25 lakh which ever is less. 11. Merchant banker are also responsible for prospectus. 12. Promoters lock in period 5 years 13. For premium 3 years track record is needed and promoters contribution 25%. If not promoters contribution is 50%. 14. If the issue amount goes beyond Rs 500 crores the issuer has to arrange for monitoring by financial institution. SEBI Guide lines for debenture: 1. Conversion period not more than 36 months. 2. Compulsory credit rating 3. No restriction on fixing interest 4. Creation of Redemption reserves. 5. Premium can be collected for the company which has 3 years sound track record. 6. Disclose of loan certificate 7. If interest rate is less than bank rate, proper disclosure has to be made about it. 8. After interest dividend has to be paid. 9. Redemption can be made after 5 years. 10. Protection of interest of debenture holder. Monitor the progress financial institution Adjust certificate for utilization of fund Appointing trustees for debentures

Filing of encumbrance certificate with SEBI and NOC from banks. Supervising by trustees.

Commercial banks

An institution which accepts deposits, makes business loans, and offers related services. Commercial banks also allow for a variety of deposit accounts, such as checking, savings, and time deposit. These institutions are run to make a profit and owned by a group of individuals, yet some may be members of the Federal Reserve System. While commercial banks offer services to individuals, they are primarily concerned with receiving deposits and lending to businesses. Functions of Commercial Banks The functions of commercial banks are divided into two categories: i) Primary functions, and ii) Secondary functions including agency functions. i) Primary functions: The primary functions of a commercial bank include: a) Accepting deposits; and b) Granting loans and advances; a) Accepting deposits The most important activity of a commercial bank is to mobilize deposits from the public. People who have surplus income and savings find it convenient to deposit the amounts with banks. Depending upon the nature of deposits, funds deposited with bank also earn interest. Thus, deposits with the bank grow along with the interest earned. If the rate of interest is higher, public are motivated to deposit more funds with the bank. There is also safety of funds deposited with the bank. b) Grant of loans and advances The second important function of a commercial bank is to grant loans and advances. Such loans and advances are given to members of the public and to the business community at a higher rate of interest than allowed by banks on various deposit accounts. The rate of interest charged on loans and advances varies depending upon the purpose, period and the mode of repayment. The difference between the rate of interest allowed on deposits and the rate charged on the Loans is the main source of a banks income. i) Loans A loan is granted for a specific time period. Generally, commercial banks grant shortterm loans. But term loans, that is, loan for more than a year, may also be granted. The borrower may withdraw the entire amount in lump sum or in installments. However, interest is charged on the full amount of loan. Loans are generally granted against the security of certain assets. A loan may be repaid either in lump sum or in installments. ii) Advances An advance is a credit facility provided by the bank to its customers. It differs from loan in the sense that loans may be granted for longer period, but advances are normally granted for a short period of time. Further the purpose of granting advances is to meet the day to day requirements of business. The rate of interest charged on advances varies from bank to bank. Interest is charged only on the amount withdrawn and not on the sanctioned amount.

Modes of short-term financial assistance Banks grant short-term financial assistance by way of cash credit, overdraft and bill discounting. a) Cash Credit Cash credit is an arrangement whereby the bank allows the borrower to draw amounts up to a specified limit. The amount is credited to the account of the customer. The customer can withdraw this amount as and when he requires. Interest is charged on the amount actually withdrawn. Cash Credit is granted as per agreed terms and conditions with the customers. b) Overdraft Overdraft is also a credit facility granted by bank. A customer who has a current account with the bank is allowed to withdraw more than the amount of credit balance in his account. It is a temporary arrangement. Overdraft facility with a specified limit is allowed either on the security of assets, or on personal security, or both. c) Discounting of Bills Banks provide short-term finance by discounting bills that is, making payment of the amount before the due date of the bills after deducting a certain rate of discount. The party gets the funds without waiting for the date of maturity of the bills. In case any bill is dishonored on the due date, the bank can recover the amount from the customer. ii) Secondary functions Besides the primary functions of accepting deposits and lending money, banks perform a number of other functions which are called secondary functions. These are as follows:a) Issuing letters of credit, travellers cheques, circular notes etc. b) Undertaking safe custody of valuables, important documents, and Securities by providing safe deposit vaults or lockers; c) Providing customers with facilities of foreign exchange. d) Transferring money from one place to another; and from one branch to another branch of the bank. e) Standing guarantee on behalf of its customers, for making payments for purchase of goods, machinery, vehicles etc. f) Collecting and supplying business information; g) Issuing demand drafts and pay orders; and, h) Providing reports on the credit worthiness of customers. Difference between Primary and Secondary Functions of Commercial Banks Primary Functions Secondary Functions 1. These are the main activities of the bank. 1. These are the secondary activities of the bank. 2.These are the main sources of 2. These are not the main sources of Income of the bank. income of the banks. 3. These are obligatory on the part of bank 3. These are not obligatory on the part of to perform. bank to perform. But generally all commercial banks perform these activities.

Different modes of Acceptance of Deposits Banks receive money from the public by way of deposits. The following types of deposits are usually received by banks: i) Current deposit ii) Saving deposit iii) Fixed deposit iv) Recurring deposit v) Miscellaneous deposits i) Current Deposit Also called demand deposit, current deposit can be withdrawn by the depositor at any time by cheques. Businessmen generally open current accounts with banks. Current accounts do not carry any interest as the amount deposited in these accounts is repayable on demand without any restriction. The Reserve bank of India prohibits payment of interest on current accounts or on deposits up to 14 Days or less except where prior sanction has been obtained. Banks usually charge a small amount known as incidental charges on current deposit accounts depending on the number of transaction. ii) Savings deposit/Savings Bank Accounts Savings deposit account is meant for individuals who wish to deposit small amounts out of their current income. It helps in safe guarding their future and also earning interest on the savings. A saving account can be opened with or without cheque book facility. There are restrictions on the withdrawals from this account. Savings account holders are also allowed to deposit cheques, drafts, dividend warrants, etc. drawn in their favour for collection by the bank. To open a savings account, it is necessary for the depositor to be introduced by a person having a current or savings account with the same bank. iii) Fixed deposit The term Fixed deposit means deposit repayable after the expiry of a specified period. Since it is repayable only after a fixed period of time, which is to be determined at the time of opening of the account, it is also known as time deposit. Fixed deposits are most useful for a commercial bank. Since they are repayable only after a fixed period, the bank may invest these funds more profitably by lending at higher rates of interest and for relatively longer periods. The rate of interest on fixed deposits depends upon the period of deposits. The longer the period, the higher is the rate of interest offered. The rate of interest to be allowed on fixed deposits is governed by rules laid down by the Reserve Bank of India. iv).Recurring Deposits Recurring Deposits are gaining wide popularity these days. Under this type of deposit, the depositor is required to deposit a fixed amount of money every month for a specific period of time. Each installment may vary from Rs.5/- to Rs.500/- or more per month and the period of account may vary from 12 months to 10 years. After the completion of the specified period, the customer gets back all his deposits along with the cumulative interest accrued on the deposits. v).Miscellaneous Deposits Banks have introduced several deposit schemes to attract deposits from different types of people, like Home Construction deposit scheme, sickness Benefit deposit scheme, Children Gift plan, Old age pension scheme, Mini deposit scheme, etc.

Different methods of Granting Loans by Bank The basic function of a commercial bank is to make loans and advances out of the money which is received from the public by way of deposits. The loans are particularly granted to businessmen and members of the public against personal security, gold and silver and other movable and immovable assets. Commercial bank generally lends money in the following form: i) Cash credit ii) Loans iii) Bank overdraft, and iv) Discounting of Bills i) Cash Credit: A cash credit is an arrangement whereby the bank agrees to lend money to the borrower up to a certain limit. The bank puts this amount of money to the credit of the borrower. The borrower draws the money as and when he needs. Interest is charged only on the amount actually drawn and not on the amount placed to the credit of borrowers account. Cash credit is generally granted on a bond of credit or certain other securities. This very popular method of lending in our country. ii) Loans: A specified amount sanctioned by a bank to the customer is called a loan. It is granted for a fixed period, say six months, or a year. The specified amount is put on the credit of the borrowers account. He can withdraw this amount in lump sum or can draw cheques against this sum for any amount. Interest is charged on the full amount even if the borrower does not utilize it. The rate of interest is lower on loans in comparison to cash credit. A loan is generally granted against the security of property or personal security. The loan may be repaid in lump sum or in installments. Every bank has its own procedure of granting loans. Hence a bank is at liberty to grant loan depending on its own resources. The loan can be granted as: a) Demand loan, or b) Term loan a) Demand loan Demand loan is repayable on demand. In other words it is repayable at short notice. The entire amount of demand loan is disbursed at one time and the borrower has to pay interest on it. The borrower can repay the loan either in lump sum (one time) or as agreed with the bank. Loans are normally granted by the bank against tangible securities including securities like N.S.C., Kisan Vikas Patra, Life Insurance policies and U.T.I. certificates. b) Term loans Medium and long term loans are called Term loans. Term loans are granted for more than one year and repayment of such loans is spread over a longer period. The repayment is generally made in suitable installments of fixed amount. These loans are repayable over a period of 5 years and maximum up to 15 years. Term loan is required for the purpose of setting up of new business activity, renovation, modernization, expansion/extension of existing units, purchase of plant and machinery, vehicles, land for setting up a factory, construction of factory building or purchase of other immovable assets. These loans are generally secured against the mortgage of land,

plant and machinery, building and other securities. The normal rate of interest charged for such loans is generally quite high. iii) Bank Overdraft Overdraft facility is more or less similar to cash credit facility. Overdraft facility is the result of an agreement with the bank by which a current account holder is allowed to withdraw a specified amount over and above the credit balance in his/her account. It is a short term facility. This facility is made available to current account holders who operate their account through cheques. The customer is permitted to withdraw the amount as and when he/she needs it and to repay it through deposits in his account as and when it is convenient to him/her. Overdraft facility is generally granted by bank on the basis of a written request by the customer. Some times, banks also insist on either a promissory note from the borrower or personal security to ensure safety of funds. Interest is charged on actual amount withdrawn by the customer. The interest rate on overdraft is higher than that of the rate on loan. iv) Discounting of Bills Apart from granting cash credit, loans and overdraft, banks also grant financial assistance to customers by discounting bills of exchange. Banks purchase the bills at face value minus interest at current rate of interest for the period of the bill. This is known as discounting of bills. Bills of exchange are negotiable instruments and enable the debtors to discharge their obligations towards their creditors. Such bills of exchange arise out of commercial transactions both in internal trade and external trade. By discounting these bills before they are due for a nominal amount, the banks help the business community. Of course, the banks recover the full amount of these bills from the persons liable to make payment.

Agency and General Utility Services provided by Modern Commercial Banks:You have already learnt that the primary activities of commercial banks include acceptance of deposits from the public and lending money to businessmen and other members of society. Besides these two main activities, commercial banks also render a number of ancillary services. These services supplement the main activities of the banks. They are essentially nonbanking in nature and broadly fall under two categories: i) Agency services, and ii) General utility services. i) Agency Services Agency services are those services which are rendered by commercial banks as agents of their customers. They include: a) Collection and payment of cheques and bills on behalf of the customers; b) Collection of dividends, interest and rent, etc. on behalf of customers, if so instructed by them; c) Purchase and sale of shares and securities on behalf of customers; d) Payment of rent, interest, insurance premium, subscriptions etc. on behalf of customers, if so instructed; e) Acting as a trustee or executor; f) Acting as agents or correspondents on behalf of customers for other banks and financial institutions at home and abroad.

ii) General utility services General utility services are those services which are rendered by Commercial banks not only to the customers but also to the general public. These are available to the public on payment of a fee or charge. They include: a) Issuing letters of credit and travellers cheques; b) Underwriting of shares, debentures, etc.; c) Safe-keeping of valuables in safe deposit locker; d) Underwriting loans floated by government and public bodies. e) Supplying trade information and statistical data useful to customers; f) Acting as a referee regarding the financial status of customers; g) Undertaking foreign exchange business.

Various sources of finances

A company needs finance to meet its various types of requirements. Some funds are required for a fairly long time for the purpose of acquiring fixed assets and some others are required for day to day working. Sources of long term finance The main sources of long term finance are as follows: 1. Shares: These are issued to the general public. These may be of two types: (i) Equity and (ii) Preference. The holders of shares are the owners of the business. 2. Debentures: These are also issued to the general public. The holders of debentures are the creditors of the company. 3. Public Deposits: General public also like to deposit their savings with a popular and well established company which can pay interest periodically and pay-back the deposit when due. 4. Retained earnings: The company may not distribute the whole of its profits among its Shareholders. It may retain a part of the profits and utilize it as capital. 5. Term loans from banks: Many industrial development banks, cooperative banks and commercial banks grant medium term loans for a period of three to five years. 6. Loan from financial institutions: There are many specialized financial institutions established by the Central and State governments which give long term loans at reasonable rate of interest. Some of these institutions are: Industrial Finance Corporation of India (IFCI), Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), Unit Trust of India (UTI), and State Finance Corporations etc. These sources of long term finance will be discussed in the next lesson..

The short-term sources are: 1. Trade credit,

Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, components, etc. Usually business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered but payments are not made until the expiry of period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment. This is quite a popular source of finance. 2. Bank Credit Commercial banks grant short-term finance to business firms which are known as bank credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or in installments as and when needed. Bank credit may be granted by way of loans, cash credit, overdraft and discounted bills. (i) Loans When a certain amount is advanced by a bank repayable after a specified period, it is known as bank loan. Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan irrespective of the amount of loan actually drawn. Usually loans are granted against security of assets. (ii) Cash Credit It is an arrangement whereby banks allow the borrower to withdraw money up to a specified limit. This limit is known as cash credit limit. Initially this limit is granted for one year. This limit can be extended after review for another year. However, if the borrower still desires to continue the limit, it must be renewed after three years. Rate of interest varies depending upon the amount of limit. Banks ask for collateral security for the grant of cash credit. In this arrangement, the borrower can draw, repay and again draw the amount within the sanctioned limit. Interest is charged only on the amount actually withdrawn and not on the amount of entire limit. (iii) Overdraft When a bank allows its depositors or account holders to withdraw money in excess of the balance in his account up to a specified limit, it is known as overdraft facility. This limit is granted purely on the basis of credit-worthiness of the borrower. Banks generally give the limit up to Rs.20,000. In this system, the borrower has to show a positive balance in his account on the last Friday of every month. Interest is charged only on the overdrawn money. Rate of interest in case of overdraft is less than the rate charged under cash credit. (iv) Discounting of Bill Banks also advance money by discounting bills of exchange, promissory notes and undies. When these documents are presented before the bank for discounting, banks credit the amount to customers account after deducting discount. The amount of discount is equal to the amount of interest for the period of bill. 3. Customers Advances Sometimes businessmen insist on their customers to make some advance payment. It is generally asked when the value of order is quite large or things ordered are very costly. Customers advance represents a part of the payment towards price on the product (s) which will be delivered at a later date. Customers generally agree to make advances when such goods are not easily available in the market or there is an urgent need of goods. A firm can meet its short-term requirements with the help of customers advances. 4. Installment credit

Installment credit is now-a-days a popular source of finance for consumer goods like television, refrigerators as well as for industrial goods. You might be aware of this system. Only a small amount of money is paid at the time of delivery of such articles. The balance is paid in a number of installments. The supplier charges interest for extending credit. The amount of interest is included while deciding on the amount of installment. Another comparable system is the hire purchase system under which the purchaser becomes owner of the goods after the payment of last installment. Sometimes commercial banks also grant installment credit if they have suitable arrangements with the suppliers. 5. Loans from Co-operative Banks Co-operative banks are a good source to procure short-term finance. Such banks have been established at local, district and state levels. District Cooperative Banks are the federation of primary credit societies. The State Cooperative Bank finances and controls the District Cooperative Banks in the state. They are also governed by Reserve Bank of India regulations. Some of these banks like the Vaish Co-operative Bank was initially established as a co-operative society and later converted into a bank. These banks grant loans for personal as well as business purposes. Membership is the primary condition for securing loan. The functions of these banks are largely comparable to the functions of commercial banks. Merits of short-term finance a) Economical : Finance for short-term purposes can be arranged at a short notice and does not involve any cost of raising. The amount of interest payable is also affordable. It is, thus, relatively more economical to raise short-term finance. b) Flexibility: Loans to meet short-term financial need can be raised as and when required. These can be paid back if not required. This provides flexibility. c) No interference in management: The lenders of short-term finance cannot interfere with the management of the borrowing concern. The management retains their freedom in decision making. d) May also serve long-term purposes : Generally business firms keep on renewing short-term credit, e.g., cash credit is granted for one year but it can be extended upto 3 years with annual review. After three years it can be renewed. Thus, sources of shortterm finance may sometimes provide funds for long-term purposes. Demerits of short-term finance Short-term finance suffers from a few demerits which are listed below: a) Fixed Burden: Like all borrowings interest has to be paid on short-term loans irrespective of profit or loss earned by the organization. That is why business firms use short-term finance only for temporary purposes. b) Charge on assets: Generally short-term finance is raised on the concern cannot raise further loans against the security of these assets nor can these be sold until the loan is cleared (repaid). c) Difficulty of raising finance: When business firms suffer intermittent losses of huge amount or market demand is declining or industry is in recession, it loses its creditworthiness. In such circumstances they find it difficult to borrow from banks or other sources of short-term financed) Uncertainty: In cases of crisis business firms always face the uncertainty of securing funds from sources of short-term finance. If the amount of finance required is large, it is also more uncertain to get the finance.

e) Legal formalities: Sometimes certain legal formalities are to be complied with for raising finance from short-term sources. If shares are to be deposited as security, then transfer deed must be prepared. Such formalities take lot of time and create lot of complications.

Export import bank (EXIM bank)

Meaning of EXIM bank Government or semi-government agency which commonly provides insurance cover to exporters against losses from non-payment by the importers, as a means to promote the country's foreign trade. Other services offered by EXIM banks may include (1) marine insurance, (2) post-shipment discounting of invoices, (3) pre-shipment advances against confirmed orders, and (4) help in finding new markets. Objectives: The objectives and functions of the Exim Bank include the following: 1. Grant of loans and advances in India solely or jointly with commercial banks to persons exporting or intending to export India goods which may include the export of turnkey projects and civil consultancy services. 2. Grant of lines credit to Governments, financial institutions and other suitable organizations in foreign countries to enable person outside India to import from India, goods including turnkey projects, civil construction contracts and other services including consultancy services. 3. Handling transaction where a mix of government credit and commercial credit for exports is involved. 4. Purchasing, discounting and negotiating export bills. 5. Selling or discounting export bills in international markets. 6. Discounting of export bills negotiated or purchased by a scheduled bank or financial institution notified by government, or granting loans and advances against such bills. 7. Providing refinance facilities to specified financial institutions against credits extended by them for specified exports or imports. 8. Granting loans and advances or issuing guarantees solely or jointly with a commercial bank for the import of goods and services from abroad. 9. Issuing confirmation/endorsing letters of credit on behalf of exporters in India, negotiating, collecting bills under letters of credit, opening letters of credit on behalf of importers of goods is services and negotiating documents received there under. 10. Buying and selling foreign exchange and performing such other functions of an authorized dealer as may necessary for the functions of an export- import bank. 11. Undertaking and financing research, surveys and techno-economic studies bearing on the promotion and development of international trade. 12. Providing technical, administrative and financial assistance to any exporter in India or any other person who intends to export goods from India for the promotion, management or expansion of any industry with a view to developing international trade. Functions Planning, promoting, developing and financing export oriented units. Underwriting the issue of shares for the export oriented companies Financing export or import of machinery or lease basis. Granting loans and advances for joint ventures.

Accepting, discounting bills of exchange relating to export or import. Subscribing the shares / securities of EXIM Bank of other countries. Providing technical, administrative, financial assistance for the export / import units. Creating data base about exporters. Providing re-finance facilities to the commercial banks. Providing agency services like Advice on exchange control practices in other countries. Advice and design financial packages for export oriented industries in India. Exposing Indian exporting companies to Euro Financing Guarding Indian companies on contracts abroad.

EXPORT FINANCING
Import LC Applicant/importer --->Issuing Bank---> Advising Bank--->Beneficiary/exporter. Payment Applicant--->Issuing Bank--->Negotiating bank--->Beneficiary. Modes 1. letter of credit 2. Payment in advance 3. Documentary collection Payment in Advance. Exporter risk is low Importer risk is high Exporter may dispatch goods not in accordance with specification Exporter may not dispatch goods or dispatch late. Loss of profit Documentary collection The collectin by banks of a sum of money ofn behalf of an exporters (the principal) due from an importer (the Drawee). Letters of credit: A conditional undertaking given by a bank (issuing bank) at the request of the customer (applicant) to pay a seller (beneficiary) against stipulated documents, provided all terms of conditions are compiled. Parties to a letter of Credit. Applicant Buyer importer Beneficiary seller / exporter Issuing Bank Applicant Bank Advising Bank Issuing banks agent in Beneficiarys country Reimbursing Bank Bank authorized by issuing bank to reimburse in bank making payment.

International sources of finance

Following are the international sources of finance: 1. Foreign Direct Investment Foreign direct investment is one of the most important sources of foreign investment in developing countries like India. It is seen as a means to supplement domestic investment

for achieving a higher level of growth and development. FDI is permitted under the forms of investments. 1. Through financial collaborations / capital / equity participation; 2. Through Joint ventures and technical collaborations; 3. Through capital markets (Euro Issues); 4. Through private placements or preferential allotment. 2. GDR/ADR Depository Receipts (DRs): A DR means any instrument in the form of depository receipt or certificate created by the overseas depository bank outside India and issued to non-resident investors against the issue of ordinary shares. In depository receipt, negotiable instrument evidencing a fixed number of equity shares of the issuing company generally denominated in U.S. $. DRs are commonly used by the company which sells their securities in international market and expanding their share holdings abroad. These securities are listed and traded in international stock exchanges. These can be either American depository receipt (ADR) or global depositary receipt (GDR). ADRs are issued in case the funds are raised through retail market in United States. In case of GDR issue, the invitation to participate in the issue cannot be extended to retail US investors. 3. FII Institutional investors are organizations which pool large sums of money and invest those sums in securities, real property and other investment assets. They can also include operating companies which decide to invest its profits to some degree in these types of assets. Types of typical investors include banks, insurance companies, retirement or pension funds, hedge funds, investment advisors and mutual funds. Their role in the economy is to act as highly specialized investors on behalf of others. For instance, an ordinary person will have a pension from his employer. The employer gives that person's pension contributions to a fund. The fund will buy shares in a company, or some other financial product. Funds are useful because they will hold a broad portfolio of investments in many companies. This spreads risk, so if one company fails, it will be only a small part of the whole fund's investment. 4. International Monetary fund The International Monetary Fund (IMF) is an intergovernmental organization that oversees the global financial system by taking part in the macroeconomic policies of its established members, in particular those with an impact on exchange rate and the balance of payments. The objectives are to stabilize international exchange rates and facilitate development through the influence of neoliberal economic policies in other countries as a condition of loans, debt relief, and aid. It also offers loans with varying levels of conditionality, mainly to poorer countries. Its headquarters is in Washington, D.C. The IMFs relatively high influence in world affairs and development has drawn heavy criticism from some sources. Functions: Helping in international trade, that is, business between countries Looking after exchange rates Looking after balance of payments Helping member countries in economic development

DEFINITION OF SICKNESS

Symptoms of sick units 1. Financial symptoms 1. irregularity in bank accounts unable to provide security 2. Non payment of interest on borrowings 3. Non payment of installments dues on loans. 4. inability to pay the creditors on tine 5. adverse reaction in the stock exchange to the shares of the company 2. Non-financial symptoms 1. 2. 3. 4. Incapacity to produce according to schedule in ability to market the goods produced Fast turnover of labor. Generally poor reputation in the market

Causes Internal causes 1. Low productivity of labour. 2. High cost of labour. 3. Obsolete plant and machinery 4. Obsolete technology 5. A weak marketing department 6. Inefficient and dishonest management. 7. Poor financial panning. External causes 1. Non availability of raw material 2. High cost of raw material. 3. Non availabity of infrastructure facilities 4. Marketing difficulties because of government interference. 5. Non availability of finance due to governmental measures. General and personnel administration: The problem areas are summarized as under: Dispute/difference of opinion among the promoters/directors. Poor industrial relations leading to labour unrest. Lack of motivation and co-ordination. Lack of manpower planning. Lack of assigning equal importance to all areas of business. It is generally observed that the main promoter takes more interest in the area of his specialization and ignores other aspects of The business. For example, technocrat entrepreneurs, by their nature are more inclined to improving the technical aspects of the product. The result may be that

the product will not be a commercial success though it may have technical excellence. Projects that solely depend upon the skills of a key promoter may find it difficult to sail Through in the event of death or ill-health of the key person. BOARD OF INDUSTRIAL AND FINANCIAL RECONSTRUCTION (BIFR) Board of industrial and Financial Reconstruction (BIFR) was established by the Central Government, under section 3 of the Sick Industrial Companies (Special provisions) Act, 1985 and it became fully operational in May, 1987. BIFR deals with issues like revival and rehabilitation on sick companies, winding up of sick companies, institutional finance to sick companies, amalgamation of companies etc. BIFR is a quasi judicial body. The role of BIFR as envisaged in the SICA (Sick Industrial Companies Act) is: (a) Securing the timely detection of sick and potentially sick companies (b) Speedy determination by a group of experts of the various measures to be taken in respect of the sick company (c) Expeditious enforcement of such measures BIFR has a chairman and may have a maximum of 14 members, drawn from various fields including banking, labour, accountancy, economics etc. It functions like a court and has constituted four benches. Course of Action by BIFR 1. Allowing the company time on its own to make its net worth positive with in a reasonable period. 2. Having a scheme through the operating agency in respect of the company. 3. Deciding of the winding up of the company. The scheme may be of the following 1. Financial assistance. 2. Merger. 3. Sale or lease of a part of the company. 4. Suspension of existing contracts Course of Action by BIFR 4. Allowing the company time on its own to make its net worth positive with in a reasonable period. 5. Having a scheme through the operating agency in respect of the company. 6. Deciding of the winding up of the company. The scheme may be of the following 5. Financial assistance. 6. Merger. 7. Sale or lease of a part of the company. 8. Suspension of existing contracts IRCI (Industrial Reconstruction Corporation of India ) The central Government in the year 1971 has established IRCI with the specific objective of dealing with the problem of industrial sickness.

IRBI 1. The IRCI ceased to exist when the industrial Reconstruction Bank of India was established in 1985. 2. The assets and liabilities were taken over by IRBI. 3. The IRBI identifies the sick units in the initial stage and corrects the imbalances of the long term and shout term funds, replacement of balancing equipment and modernization of obsolete plant and machinery. 4. IRBI also provides finance for expansion, diversification, Modernization etc. Reporting to the BIFR The Board of Directors of a sick industrial company is required, by law, to report the sickness to the BIFR within 60 days of finalization of audited accounts, for the financial year at the end of which the company has become sick. BIFR has prescribed a format for this report. While reporting by a company of its sickness to the BIFR is mandatory as per the provisions of law, any other interested person/party can also report the fact of sickness of a company to the BIFR. Such interested parties may be the financial institution/bank that has lent loan to the company, the RBI, the Central/State Governments. The BIFR has prescribed a different format for the report to be submitted by such interested parties. When a company has been financed by a consortium of banks, it is the Lead Bank that should report to the BIFR about the sickness under advice to other participating banks in the consortium. Viability study for rehabilitation proposal: Once bitten, twice shy! - Before attempting to rehabilitate a sick unit, a detailed and thorough viability study is to be undertaken to ensure that the revival programme will really bear fruits. It is not advisable to venture upon any revival programme if there are gray areas that need further study. The viability study shall enquire into the technical, commercial, managerial and financial aspects. Technical Appraisal (a) Study the manufacturing process used by the unit. Ascertain if any new process has since been developed. Explore the necessity of switching over to the latest manufacturing process and study the cost, benefit aspects of such switchover. (b) Study the production capacity of different production sections and checkup if the production capacities of different sections are perfectly balanced. If there is any production section, which has a lower capacity than that required for perfect balancing, the overall capacity of the plant can be significantly increased without huge investments, by adding the required balancing machinery. (c) Explore the possibilities of adding additional/special features to the products that will add competitive edge to the product. Also examine the need for changing the product-mix that is in tune with the market requirement. (d) Find out if any plant/equipment need major repair/overhauling to improve its operating efficiency. (e) If the locational disadvantages outweigh all other factors, the scope for shifting the location to an advantageous place may be examined and the consequent cost-benefit analysis studied. This may be possible if the firm is functioning in a leased premise and owns only the plant and machinery. If the unit is located in own building, the proposal for shifting the plant and machinery to a leased building in an advantages location may also be studied. The building owned by the firm can be leased out to some other firms. The

long-term cost benefit analysis will give lead to the acceptability or otherwise of such a proposal. (f) Study the modifications required, if any in the plant layout so that the material handling output. (g) Examine if any of the manufacturing operations that are done in house can be entrusted to outside agencies, which may result in cost reduction. Commercial Appraisal (a) Commercial failure of a project will be mainly due to problems relating to the product itself viz., defects/imperfections in product design which may lead to consumer resistance. Such situations indicate that the products offered by competitors have better features that attract consumers. Hence, the scope for product improvement and the cost involved are to be studied. (b) In spite of consumer acceptance of the product, if the project has gone sick, it is likely that the profit margins might be low. Minor modifications in designing and packing the product with upward revision in price may be accepted by the market which may bring better returns to the company. This aspect may be studied by carrying out test marketing for the improved product. (c) Every product follows a life cycle which passes through four stages viz., -Introduction. -Rapid expansion. -Maturity. - Decline. Profit margins shrink and signs of sickness appear when the product is in its decline stage. Product innovation can only sustain the product at this stage. The decline once started can not be contained for long in spite of product innovations. Product diversification may prove to be a feasible solution. Hence for rehabilitating a unit whose product has already reached its decline stage, the feasibility of witching over to diversify products making use of the existing production facilities is to be studied. The cost-benefit analyses of additional investments needed for product diversification and additional benefits that may accrue are to be analyzed. Management Appraisal: A good project in the hands of an ineffective management turns the project bad. Similarly a good management is capable making a not-so-good project, a success. Hence the first thing under management appraisal is to study whether the sickness is due to reasons beyond the control of the present management or due to ineffective management. If the sickness is due to reasons beyond the control of the management, for any revival package to come out successful, it should be first ascertained if the management is still committed to the project and is serious about reviving the unit. The managements commitment and seriousness may be indicated by, Its readiness to inject additional funds to revive the unit. Its readiness to strengthen the existing management by agreeing to induct professionals as directors at various functional areas like technical/finance/marketing/research and development etc. The managerial appraisal shall suggest the required changes in the existing organisational set up of the unit and also shall study the possible reduction in the man power that can be

achieved without affecting the organisiational efficiency, the likely compensation payable for retrenchment etc. Financial appraisal: Since appraisal of all other areas have a financial commitment in one form or the other, financial appraisal assumes greater importance. All aspects of financial reconstruction need to be considered and analysed. When a project that has long term debt component in its capital structure becomes sick, it becomes necessary to ease the burden of debt to enable the sick unit to recover from its sickness. This necessitates restructuring of the debts. In general, banks and financial institutions offer the following concessions in their package of rehabilitation assistance. (a) Reduction in interest rate of existing loans. (b) Conversion of short-term loans in to long-term loans. (This gives the unit under revival the much-needed leeway to repay short term borrowings.) (c) Conversion of part of long term loans into equity. (d) Funding of the overdue interest (un-paid interest) and making it repayable in easy installments. The funded interest component may carry concessional rate of interest or even at times bears no interest. (e) Offering a revised schedule of repayment for the principal components of term loan. (f) Sanction of additional loan to meet the additional capital expenditure. (g) Enhancement of working capital limits and regularizing the irregular portion of working capital finance already availed. If any asset is found not useful, the wise choice would be to dispose off the asset and use the amount realized to support the rehabilitation programme.

WORKING CAPITAL MANAGEMENT

INTRODUCTION The term working capital is commonly used for the capital required for day-to-day working in a business concern, such as for purchasing raw material, for meeting day-today expenditure on salaries, wages, rents rates, advertising etc. But there are much disagreement among various financial authorities (Financiers, accountants, businessmen and economists) as to the exact meaning of the term working capital. Working capital refers to the capital required for day-to-day operations of a business enterprise. There are two concepts of Working Capital Gross Working capital and Net Working capital. 1. Gross Working Capital Gross Working capital refers to the firms investment in current assets (Cash, Short Term Securities, Debtors, Bills Receivable and Inventory). Current assets are those assets, which can be converted into cash within a period of one year. 2. Net Working Capital Net Working capital refers to the difference between current assets and current liabilities. It may be positive or negative. TYPES OF WORKING CAPITAL Working capital can be divided into two categories on the basis of time. They are Permanent Working Capital and Temporary or Variable Working capital. Permanent Working Capital refers to that minimum amount of investment in current assets, which is required at all times to carry on minimum level of business activities. It represents the current assets required on a continuing basis over the entire year, and hence should be financed out of long term funds. Temporary Working capital represents the additional current assets required at different times during the operating year. Need for Working Capital Working capital is needed till a firm gets cash on sale of finished products. It depends on two factors: i. Manufacturing cycle i.e. time required for converting the raw material into finished product; and ii. Credit policy i.e. credit period given to Customers and credit period allowed by creditors. Thus, the sum total of these times is called an Operating cycle and it consists of the following six steps: i. Conversion of cash into raw materials. ii. Conversion of raw materials into work-in-process. iii. Conversion of work-in-process into finished products. iv. Time for sale of finished goodscash sales and credit sales. v. Time for realization from debtors and Bills receivables into cash. vi. Credit period allowed by creditors for credit purchase of raw materials, inventory and creditors for wages and overheads. Importance or Advantages of Adequate Working Capital Working capital is the life blood and nerve centre of a business. Just as circulation of blood is essential in the human body for maintaining life, working capital is very essential to maintain the smooth running of a business. No business can run successfully

without an adequate amount of working capital. The main advantages of maintaining adequate amount of working capital are as follows: 1. Solvency of the business: Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production. 2. Goodwill: Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. 3. Easy loans: A concern having adequate working capital, high solvency and good credit standing can arrange loans from banks and other on easy and favourable terms. 4. Cash Discounts: Adequate working capital also enables a concern to avail cash discounts on the purchases and hence it reduces costs. 5. Regular supply of raw materials: Sufficient working capital ensures regular supply of raw materials and continuous production. 6. Regular payment of salaries, wages and other day-to-day commitments: A company which has ample working capital can make regular payment of salaries, wages and other day-to-day commitments which raises the morale of its employees, increases their efficiency, reduces wastages and costs and enhances production and profits. 7. Exploitation of favourable market conditions: Only concerns with adequate working capital can exploit favourable market conditions such as purchasing its requirements in bulk when the prices are lower and by holding its inventories for higher prices. 8. Ability to face Crisis: Adequate working capital enables a concern to face business crisis in emergencies such as depression because during such periods, generally, there is much pressure on working capital. 9. Quick and Regular return on Investments: Every Investor wants a quick and regular return on his investments. Sufficiency of working capital enables a concern to pay quick and regular dividends to its investors as there may not be much pressure to plough back profits. This gains the confidence of its investors and creates a favourable market to raise additional funds i.e., the future. 10. High morale: Adequacy of working capital creates an environment of security, confidence, and high morale and creates overall efficiency in a business. Excess or Inadequate Working Capital Every business concern should have adequate working capital to run its business operations. It should have either redundant or excess working neither capital nor inadequate or shortage of working capital. Both excess as well as short working capital positions are bad for any business. However, out of the two, it is the inadequacy of working capital which is more dangerous from the point of view of the firm. Disadvantages of Redundant or Excessive Working Capital 1. Excessive Working Capital means ideal funds which earn no profits for the business and hence the business cannot earn a proper rate of return on its investments. 2. When there is a redundant working capital, it may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses. 3. Excessive working capital implies excessive debtors and defective credit policy which may cause higher incidence of bad debts. 4. It may result into overall inefficiency in the organization. 5. When there is excessive working capital, relations with banks and other financial institutions may not be maintained.

6. Due to low rate of return on investments, the value of shares may also fall.
7. The redundant working capital gives rise to speculative transactions.

FACTORS EFFECTING WORKING CAPITAL NEEDS OF FIRMS 1. Nature of business: In the case of public utility concern like railways, electricity etc most of the transactions are on cash basis. Further they do not require large inventories. Hence working capital requirements are low. On the hand, manufacturing and trading concerns require more working capital since they have to invest heavily in inventories and debtors. Example cotton or sugar mil 2. Size of business Generally large business concerns are required to maintain huge inventories are required. Hence bigger the size, the large will be the working capital requirements. 3. Time consumed in manufacture To run a long production process more inventories is required. Hence the longer the period of manufacture, the higher will the requirements of working capital and viceversa. 4. Seasonal fluctuations A number of industries manufacture and sell goods only during certain seasons. For example the sugar industry produces practically all sugar between December and April. Their working capital requirements will be higher during this session. It is reduced as the sales are made and cash is realized. 5. Fluctuations in supply If the supply of raw materials is irregular companies, are forced to maintain huge stocks to avoid stoppage of production. In such case, working capital requirement will be high. 6. Speed of turnover A concern say hotel which effects sales quickly needs comparatively low working capital. This is because of the quick conversion of stock into cash. But if the sales are slow, more working capital will be required. 7. Terms of sales Liberal credit sales will result in locking up of funds in sundry debtors. Hence a company, which allows liberal credit, will need more working capital than companies, which observe strict credit norms. 8. Terms of purchase Working capital requirements are also affected by the credit facilities enjoyed by the company. A company enjoying liberal credit facilities from its suppliers will need lower amount working capital. (For example book shops). But a company that has to purchase only for cash will need more working capital. 9. Labour intensive Vs. Capital intensive industries In labour intensive industries, large working capital is required because of heavy wage bill and more time taken for production. But the capital intensive industries require lesser amount of working capital because of have investment in fixed assets and shorter time taken for production.

10. Growth and expansion of business A growing concern needs more working capital to finance its increasing activities and expansion. But working capital requirements are low in the case static concerns. 11. Price level changes Changes in price level also affect the working capital requirements. Generally the rising prices will require the firm to maintain large amount of working capital. This is because more funds will be required to maintain the same amount of working capital to maintain the same level of activity.

Working capital advance by commercial banks

Working capital advance by commercial banks represents the most important source for financing current assets. Forms of Bank Finance: Working capital advance is provided by commercial banks in three primary ways: (i) cash credits / overdrafts, (ii) loans, and (iii) purchase / discount of bills. In addition to these forms of direct finance, commercials banks help their customers in obtaining credit from other sources through the letter of credit arrangement. i. Cash Credit / Overdrafts: Under a cash credit or overdraft arrangement, a predetermined limit for borrowing is specified by the bank. The borrower can draw as often as required provided the out standings do not exceed the cash credit / overdraft limit. ii. Loans: These are advances of fixed amounts which are credited to the current account of the borrower or released to him in cash. The borrower is charged with interest on the entire loan amount, irrespective of how much he draws. iii. Purchase / Discount of Bills: A bill arises out of a trade transaction. The seller of goods draws the bill on the purchaser. The bill may be either clean or documentary (a documentary bill is supported by a document of title to goods like a railway receipt or a bill of lading) and may be payable on demand or after a usual period which does not exceed 90 days. On acceptance of the bill by the purchaser, the seller offers it to the bank for discount / purchase. When the bank discounts / purchases the bill it releases the funds to the seller. The bank presents the bill to the purchaser (the acceptor of the bill) on the due date and gets its payment. iv. Letter of Credit: A letter of credit is an arrangement whereby a bank helps its customer to obtain credit from its (customers) suppliers. When a bank opens a letter of credit in favour of its customer for some specific purchases, the bank undertakes the responsibility to honour the obligation of its customer, should the customer fail to do so.

Commercial Paper
Commercial paper can be defined as a short term, unsecured promissory notes which are issued at discount to face value by well known companies that are financially strong and enjoy a high credit rating. Here are some of the features of commercial paper 1. They are negotiable by endorsement and delivery and hence they are flexible as well as liquid instruments. Commercial paper can be issued with varying maturities as required by the issuing company.

2. They are unsecured instruments as they are not backed by any assets of the company which is issuing the commercial paper. 3. They can be sold either directly by the issuing company to the investors or else issuer can sell it to the dealer who in turn will sell it into the market. 4. It helps the highly rated company in the sense they can get cheaper funds from commercial paper rather than borrowing from the banks. However use of commercial paper is limited to only blue chip companies and from the point of view of investors though commercial paper provides higher returns for him they are unsecured and hence investor should invest in commercial paper according to his risk -return profile. Eligibility for issuance of CP Presently, companies, which satisfy the following requirements, shall be eligible to issue commercial paper: The tangible net worth of the company is not less than Rupees four crore Working capital (fund-based) limit of the company is not less than four crore The minimum credit rating of the company shall be P-2 from CRISIL or equivalent from other Rating agencies The borrowed account of the company is classified as a Standard Asset. Besides companies, Primary Dealers (PDs) and Satellite Dealers are also permitted to issue CP.

Public Deposits
Public Deposits Many firms, large and small, have solicited unsecured deposits from the public in recent years, mainly to finance their working capital requirements. Inter-corporate Deposits A deposit made by one company with another, normally for a period up to six months, is referred to as an inter-corporate deposit. Such deposits are usually of three types. a. Call Deposits: In theory, a call deposit is withdrawal by the lender on giving a days notice. In practice, however, the lender has to wait for at least three days. The interest rate on such deposits may be around 10 percent per annum. b. Three-months Deposits: More popular in practice, these deposits are taken by borrowers to tide over a short-term cash inadequacy that may be caused by one or more of the following factors: disruption in production, excessive imports of raw material, tax payment, and delay in collection, dividend payment, and unplanned capital expenditure. The interest rate on such deposits is around 12 percent per annum. c. Six-months Deposits: Normally, lending companies do not extend deposits beyond this time frame. Such deposits usually made with first-class borrowers, carry and interest rate of around 15 percent per annum.

The various advantages of public deposits enjoyed by the companies are:

1. 2. 3. 4.

There is no involvement of restrictive agreement The process involved in gaining public deposit is simple and easy The cost incurred after tax is reasonable Since there is no need to pledge security for public deposits, the assets of firm that can be mortgaged can be preserved

The disadvantages of public deposits from the company's point of view are:
1. 2.

The maturity period is short enough Limited fund can be obtained from the public deposits

Who accepts public Deposits? 1. Public and private limited non banking non financial companies of varying sizes. 2. Public and private limited non banking financial companies 3. Government companies since 1980. 4. Branches of foreign companies. 5. Partnership terms. 6. Proprietary concerns.

Inter corporate investments

Inter corporate investment occurs when one corporation purchases the shares of another. There are four types of long term inter corporate investments: portfolio, significant influence, controlling and joint controlling. Portfolio investments Portfolio investments are long-term investments whereby the investor is unable to exercise significant influence or control over the invitees strategic, operating, financing and investing policies. This is presumed to be the case when the investor owns less than 20% share ownership. However, this presumption may be overturned by evidence to the contrary. Portfolio investments are accounted for using the cost method. Significant influence investments Significant influence investments are long-term investments whereby the investor is able to exercise significant influence over the invitees strategic, operating, financing and investing policies, but does not unilaterally control the investee. Significant influence is presumed to be the case when the investor owns between 20% 49% of the shares of the investee. Again, this presumption may be overturned by evidence to the contrary. For example, the presence of a controlling investor with a large equity interest might preclude any other investors from exercising significant influence. Evidence that an investor exercises significant influence includes representation on the board of directors, dictating the terms of related party transactions, interchange of management personnel, etc. Significant influence investments are accounted for using the equity method. Difference between cost and equity method

The cost and equity method differ in terms of how they record the change in the value of the investment over time. Because investors with significant influence are able to determine the investee's policies, the income earned by the investee is treated as if it was earned by the investor itself. As a result, in the equity method, the investor accrues the income earned by the investee. Inter company profits are eliminated because the investor and investee are considered to be part of the same economic entity. Also, significant influence investors control the dividend policy of the investee, so dividends are treated as a liquidation of the investment rather than income. In terms of a portfolio investment, the investor cannot impact the management policies of the investee and so, does not accrue income. Also, the investor does determine the dividend policy, so dividends are recognized as income. Inter company profits are recognized because the investor and investee are considered separate economic entities. The change in the value of the investee is recognized when the investor sells the investment.

CORPORATE FINANCE Unit-III

Risk Analysis in Capital Budgeting Introduction In discussing the capital budgeting techniques, we have so far assumed that the proposed investment projects do not involve any risk. This assumption was made simply to facilitate the understanding of the capital budgeting techniques. In real world situation, however, the firm in general and its investment projects in particular are exposed to different of risk. What is risk? How can risk be measured and analyzed in the investment decisions? Nature of risk Risk exists because of the inability of the decision maker to make perfect forecasts. Forecasts cannot be made with perfection or certainty since the future events on which they depend are uncertain. An investment is not risky if, we can specify a unique sequence of cash flows for it. But whole trouble is that cash flows cannot be forecast accurately, and alternative sequences of cash flows can occur depending on the future events. Thus, risk arises in investment evaluation because we cannot anticipate the occurrence of the possible future events with certainty and consequently, cannot, make are correct prediction about the cash flow sequence. To illustrate, let us suppose that a firm is considering a proposal to commit its funds in a machine, which will help to produce a new product. The demand for this product may be very sensitive to the general economic conditions. It may be very high under favorable economic conditions and very low under unfavorable economic conditions. Thus, the investment would be profitable in the former situation and unprofitable in the later case. But, it is quite difficult to predict the future state of economic conditions, uncertainty about the cash flows associated with the investment derives A large number of events influence forecasts. These events can be grouped in different ways. However, no particular grouping of events will be useful for all purposes. We may, for example, consider three broad categories of the events influencing the investment forecasts. General economic conditions This category includes events which influence general level of business activity. The level of business activity might be affected by such events as internal and external economic and political situations, monetary and fiscal policies, social conditions etc. Industry factors This category of events may affect all companies in an industry. For example, companies in an industry would be affected by the industrial relations in the industry, by innovations, by change in material cost etc. Company factors

This category of events may affect only a company. The change in management, strike in the company, a natural disaster such as flood or fire may affect directly a particular company. Investment Decisions under Capital Rationing Firms may have to choose among profitable investment opportunities because of the limited financial resources. In this article we shall discuss the methods of solving the capital budgeting problems under capital rationing. We shall show that the net present value (NPV) is the most valid section rule even under the capital rationing situations. A firm should accept all investment projects with positive net present value (NPV) in order to maximize the wealth of shareholders. The net present value (NPV) rule tells us to spend funds in the projects until the net present value (NPV) of the last project is zero. Capital rationing refers to a situation where the firm is constrained for external, or self imposed, reasons to obtain necessary funds to invest in all investment projects with positive net present value (NPV). Under capital rationing, the management has not simply to determine the profitable investment opportunities, but it has also to decide to obtain that combination of the profitable projects which yields highest net present value (NPV) within the available funds. Why capital rationing? Capital rationing may rise due to external factors or internal constraints imposed by the management. Thus there are two types of capital rationing.

External capital rationing Internal capital rationing

External capital rationing External capital rationing mainly occurs on account of the imperfections in capital markets. Imperfections may be caused by deficiencies in market information, or by rigidities of attitude that hamper the free flow of capital. The net present value (NPV) rule will not work if shareholders do not have access to the capital markets. Imperfections in capital markets alone do not invalidate use of the net present value (NPV) rule. In reality, we will have very few situations where capital markets do not exist for shareholders. Internal capital rationing Internal capital rationing is caused by self imposed restrictions by the management. Various types of constraints may be imposed. For example, it may be decide not to obtain additional funds by incurring debt. This may be a part of the firms conservative financial policy. Management may fix an arbitrary limit to the amount of funds to be invested by the divisional managers. Sometimes management may resort to capital rationing by requiring a minimum rate of return higher than the cost of capital. Whatever, may be the type of restrictions, the implication is that some of the profitable projects will have to be forgone

because of the lack of funds. However, the net present value (NPV) rule will work since shareholders can borrow or lend in the capital markets. It is quite difficult sometimes justify the internal capital rationing. But generally it is used as a means of financial controls. In a divisional set up, the divisional managers may overstate their investment requirements. One way of forcing them to carefully assess their investment opportunities and set priorities is to put upper limits to their capital expenditures. Similarly, a company may put investment limits if it finds itself incapable of coping with the strains and organizational problems of a fast growth. Risk analysis Risk exists because of the inability of the decision maker to make perfect forecasts. Forecasts can be made perfectly since the future events are uncertain. An investment is not risky if he can specify a unique sequence of cash flow. But the trouble is that cash flows can not be forecasted accurately. Thus risk arises in investment decisions. Factors causing/ influencing investment forecasts: 1. General economic conditions 2. Industry factors 3. Company factors Risk associated with an investment may be defines as variability that is likely to accrue in the future returns from the investment. The greater the variability of the expected returns higher the risk. The common measures of risks are standard deviation and co-efficient of variation. Eg. Investment in Govt securities Standard rate of return less risk. Investment in share Variable rate of return, high risk. It is quite obvious that one of the limitations of DCF techniques is the difficulty in estimating cash flows with certain degree of certainty. Certain projects when taken up by the firm will change the business risk complexion of the firm. This business risk complexion of the firm influences the required rate of return of the investors. Suppliers of capital to the firm tend to be risk averse and the acceptance of a project that changes the risk profile of the firm may change their perception of required rates of return for investing in firms project. Generally the projects that generate high returns are risky. This will naturally alter the business risk of the firm. Because of this high risk perception associated with the new project a firm is forced to asses the impact of the risk on the firms cash flows and the discount factor to be employed in the process of evaluation. Definition of Risk: Risk may be defined as the variation of actual cash flows from the expected cash flows. The term risk in capital budgeting decisions may be defined as the variability that is likely to occur in future between the estimated and the actual returns. Risk exists on account of the inability of the firm to make perfect forecasts of cash flows. Risk arises in project evaluation because the firm cannot predict the occurrence of possible future events with certainty and hence, cannot make any correct forecast about

the cash flows. The uncertain economic conditions are the sources of uncertainty in the cash flows. For example, a company wants to produce and market a new product to their prospective customers. The demand is affected by the general economic conditions. Demand may be very high if the country experiences higher economic growth. On the other hand economic events like weakening of US dollar, sub prime crises may trigger economic slow down. This may create a pessimistic demand drastically bringing down the estimate of cash flows. Risk is associated with the variability of future returns of a project. The greater the variability of the expected returns, the riskier the project. Every business decision involves risk. Risk arises out of the uncertain conditions under which a firm has to operate its activities. Because of the inability of firms to forecast accurately cash flows of future operations the firms face the risks of operations. The capital budgeting proposals are not based on perfect forecast of costs and revenues because the assumptions about the future behaviour of costs and revenue may change. Decisions have to be made in advance assuming certain future economic conditions. There are many factors that affect forecasts of investment, cost and revenue. 1) The business is affected by changes in political situations, monetary policies, taxation, interest rates, policies of the central bank of the country on lending by banks etc. 2) Industry specific factors influence the demand for the products of the industry to which the firm belongs. 3) Company specific factors like change in management, wage negotiations with the workers, strikes or lockouts affect companys cost and revenue positions. Therefore, risk analysis in capital budgeting is part and parcel of enterprise risk management. The best business decisions may not yield the desired results because the uncertain conditions likely to emerge in future can materially alter the fortunes of the company. Every change gives birth to new challenges. New challenges are the source of new opportunities. A proactive firm will convert every problem into successful enterprise opportunities. A firm which avoids new opportunities for the inherent risk associated with it, will stagnate and degenerate. Successful firms have empirical history of successful management of risks. Therefore, analyzing the risks of the project to reduce the element of uncertainty in execution has become an essential aspect of todays corporate project management. Types and sources of Risk in capital Budgeting Risks in a project are many. It is possible to identify three separate and distinct types of risk in any project. 1) Stand alone risk: it is measured by the variability of expected returns of the project. 2) Portfolio risk: A firm can be viewed as portfolio of projects having as certain degree of risk. When new project added to the existing portfolio of project the risk profile the firm will alter. The degrees of the change in the risk depend on the covariance of return from the new project and the return from the existing portfolio of the projects. If the return from the new project is negatively correlated with the return from portfolio, the risk of the firm will be further diversified away. 3) Market or beta risk: It is measured by the effect of the project on the beta of the firm. The market risk for a project is difficult to estimate.

Stand alone risk is the risk of a project when the project is considered in isolation. Corporate risk is the projects risks to the risk of the firm. Market risk is systematic risk. The market risk is the most important risk because of the direct influence it has on stock prices. Sources of risk: The sources of risks are 1. Project specific risk 2. Competitive or Competition risk 3. Industry specific risk 4. International risk 5. Market risk 1. Project specific risk: The sources of this risk could be traced to something quite specific to the project. Managerial deficiencies or error in estimation of cash flows or discount rate may lead to a situation of actual cash flows realized being less than that projected. 2. Competitive risk or Competition risk: unanticipated actions of a firms competitors will materially affect the cash flows expected from a project. Because of this the actual cash flows from a project will be less than that of the forecast. 3. Industry specific: industry specific risks are those that affect all the firms in the industry. It could be again grouped into technological risk, commodity risk and legal risk. All these risks will affect the earnings and cash flows of the project. The changes in technology affect all the firms not capable of adapting themselves to emerging new technology. The best example is the case of firms manufacturing motor cycles with two strokes engines. When technological innovations replaced the two stroke engines by the four stroke engines those firms which could not adapt to new technology had to shut down their operations. Commodity risk is the risk arising from the effect of price changes on goods produced and marketed. Legal risk arises from changes in laws and regulations applicable to the industry to which the firm belongs. The best example is the imposition of service tax on apartments by the Government of India when the total number of apartments built by a firm engaged in that industry exceeds a prescribed limit. Similarly changes in Import Export policy of the Government of India have led to the closure of some firms or sickness of some firms. 4. International Risk: these types of risks are faced by firms whose business consists mainly of exports or those who procure their main raw material from international markets. For example, rupee dollar crisis affected the software and BPOs because it drastically reduced their profitability. Another best example is that of the textile units in Tirupur in Tamilnadu, exporting their major part of the garments produced. Rupee gaining and dollar Weakening reduced their competitiveness in the global markets. The surging Crude oil prices coupled with the governments delay in taking decision on pricing of petrol products eroded the profitability of oil marketing Companies in public sector like Hindustan Petroleum Corporation Limited. Another example is the impact of US sub prime crisis on certain segments of Indian economy. The changes in international political scenario also affect the operations of certain firms. 5. Market Risk: Factors like inflation, changes in interest rates, and changing general economic conditions affect all firms and all industries. Firms cannot diversify this risk in the normal course of business. Techniques used for incorporation of risk factor in capital

budgeting decisions there are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology so far as incorporation of risk in the evaluation process is concerned. Statistical tools for Risk analysis Statistical techniques are analytical tools for handling risky investments. These techniques, drawing from the fields of mathematics, logic, economics and psychology, enable the decision-maker to make decisions under risk or uncertainty. The concept of probability is fundamental to the use of the risk analysis techniques. How is probability defined? How are probabilities estimated? How are they used in the risk analysis techniques? How do statistical techniques help in resolving the complex problem of analyzing risk in capital budgeting? We attempt to answer these questions in our posts 1. Probability: The most crucial information for the capital budgeting decision is a forecast of future cash flows. A typical forecast is single figure for a period. This referred to as best estimate or most likely forecast. But the questions are: To what extent can one rely this single figure? How is this figure arrived at? Does it reflect risk? In fact, the decision analysis is limited in two ways by this single figure forecast. Firstly, we do not know the changes of this figure actually occurring, i.e. the uncertainty surrounding this figure. In other words, we do not know the range of the forecast and the chance or the probability estimates associated with figures within the range. Secondly, the meaning of best estimates or most likely is not very clear. It is not known whether it is mean, median or mode. For these reasons, a forecaster should not give just one estimate, but a range of associate probabilitya probability distribution. Probability may be described as a measure of someones option about the likelihood that an event will occur. If an event is certain to occur, we say that it has a probability of one of occurring. If an event is certain not to occur, we say that its probability of occurring is zero. Thus, probability of all events to occur lies between zero and one. A probability distribution may consist of a number of estimates. But in the simple form it may consist of only a few estimates. One commonly used form employs only the high, low and best guess estimates, or the optimistic, most likely and pessimistic estimates. Assigning probability The classical probability theory assumes that no statement whatsoever can be made about the probability of any single event. In fact, the classical view holds that one can talk about probability in a very long run sense, given that the occurrence or non-occurrence of the event can be repeatedly observed over a very large number of times under independent identical situations. Thus, the probability estimate, which is based on a very large number of observations, is known as an objective probability. The classical concept of objective probability is of little use in analyzing investment decision because these decisions are non-respective and hardly made under independent

identical conditions over time. As a result, some people opine that it is not very useful to express the forecasters estimates in terms of probability. However, in recent years another view of probability has revived, that is, the personal view, which holds that it makes a great deal of sense to talk about the probability of a single event, without reference to the repeatability, long run frequency concept. Such probability assignments that reflect the state of belief of a person rather than the objective evidence of a large number of trials are called personal or subjective probabilities. Risk: Risk is referred to a situation where the probability distribution of the cash flow of an investment proposal is known on the other hand if the probability distribution proposal is not the cash flow of an investment proposal is not known then it is uncertainty. Expected Net Present Values: Once the probability assignments are made the expected net present value can be found out of multiplying the monetary values of possible cash flows b their probabilities. n ENPV = ENCFt ---------t=0 ( 1+K ) t ENCFt = NCFjt X Pjt NCF = Net cash flow Pjt = Probability of net cash flow J = Event T = Period K = Discount rate. Possible event A B C D E Solution Possible event A B C D E cash flow 4000 5000 6000 7000 8000 probability ENCF 0.10 400 0.20 1000 0.40 2400 0.20 1400 0.10 800 -----------6000 cash flow 4000 5000 6000 7000 8000 probability 0.10 0.20 0.40 0.20 0.10

------------6000 ENCF = ---------- - Co (1 + 0.1)1 = 5454.5 5000 = 454.5 This project can be accepted, since the value is positive. 2. Variance or standard deviation Dispersion is the right measure of calculating risk. Dispersion of cash flow means difference between the possible cash Flows that can occur and their expected value. It indicates the degree of risk. A commonly used measure of risk is standard deviation or variance. Variance measure the deviation about expected cash flow of each of the possible cash flows. Standard deviation is the square root of variance. 3. Risk Adjusted Discount Rate (RADR) The basis of this approach is that there should be adequate reward in the form of return to firms which decide to execute risky business projects. Man by nature is risk averse and tries to avoid risk. To motivate firms to take up risky projects returns expected from the project shall have to be adequate, keeping in view the expectations of the investors. Therefore risk premium need to be incorporated in discount rate in the evaluation of risky project proposals. Therefore the discount rate for appraisal of projects has two components. Those components are 1. Risk free rate and risk premium Risk Adjusted Discount rate = Risk free rate + Risk premium Risk free rate is computed based on the return on government securities. Risk premium is the additional return that investors require as compensation for assuming the additional risk associated with the project to be taken up for execution. The more uncertain the returns of the project the higher the risk. Higher the risk greater the premium. Therefore, risk adjusted Discount rate is a composite rate of risk free rate and risk premium of the project. Advantages: 1. It is simple and easy to understand. 2. Risk premium takes care of the risk element in future cash flows. 3. It satisfies the businessmen who are risk averse. Limitations: 1. There are no objective bases of arriving at the risk premium. In this process the premium rates computed become arbitrary. 2. The assumption that investors are risk averse may not be true in respect of certain investors who are willing to take risks. To such investors, as the level of risk increases, the discount rate would be reduced. 3. Cash flows are not adapted to incorporate the risk adjustment for net cash in flows. Under this method the risking uncertain, expected future cash flows are converted into cash flows with certainty. Here we multiply uncertain future cash flows by the certainty equivalent coefficient to convert uncertain cash flows into certain cash flows. The certainty equivalent coefficient is also known as the risk adjustment factor. Risk

adjustment factor is normally denoted by at (Alpha). It is the ratio of certain net cash flow to risky net cash flow = Certainty Equivalent = Certain Cash flow / Risky Cash flow The discount factor to be used is the risk free rate of interest. Certainty equivalent coefficient is between 0 and 1. This risk adjustment factor varies inversely with risk. If risk is high a lower value is used for risk adjustment. If risk is low a higher coefficient of certainty equivalent is used. In formal way, the certainty equivalent approach may be expressed as: Net present value = (the risk adjusted factor X the forecasts of net cash flow) / (1 + Risk free rate) The certainty equivalent coefficient, the risk adjustment factor assumes a value between zero and one, and varies inversely with risk. A lower risk adjustment rate will be used if lower risk is anticipated. The decision maker subjectively or objectively establishes the coefficients. These coefficients reflect the decision makers confidence in obtaining a particular cash flow in period. For example, a cash flow of 20000$ may be estimated in the next year, but if the investor feels that only 80% of it is a certain amount, then the certainty-equivalent coefficient will be 0.8. That is, he consider only 16000$ as the certain cash flow. Thus, to obtain certain cash flows, we will multiply estimated cash flows by the certainty-equivalent coefficients. The certainty-equivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows. That is: Risk adjustment factor = certain net cash flow / Risky net cash flow For example, if one expected a risky cash flow of 80000$ in period and certain cash flow of 60000$ equally desirable, then risk adjustment factor will be 0.75 = 60000/80000. If the internal rate of return method is used, we will calculate that rate of discount, which equates the present value of certainty equivalent cash outflows. The rate so found will be compared with the minimum required risk free rate. Project will be accepted if the internal rate is higher than the minimum rate; otherwise it will be unacceptable. Evaluation of certainty equivalent The certainty equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit and is likely to be inconsistent from one investment to another. Further, this method suffers from many dangers in a large enterprise. First, the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation. This will no longer give forecasts according to best estimate. Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecast or to make it ultra conservative. Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some good investments. 4. Sensitivity Analysis: In the methods discussed so far we have considered only one figure of cash lows for each year. However, there are chances of making some estimation errors. The sensitivity analysis approach takes care of this aspect by providing more than one estimate of future return of a project. It is superior to one figure forecast since it gives a more precise idea about the variability of the return.

Usually sensitivity analysis provides information about cash flows under three assumptions. i. Pessimistic ii. Most likely iii. Optimistic. Outcomes associated with the project. It explains how sensitive the cash flows are under these three difference between the pessimistic and optimistic cash flows the more risky is the project and vice versa. 5. Variance or standard deviation Dispersion is the right measure of calculating risk. Dispersion of cash flow means difference between the possible cash lows that can occur and their expected value. It indicates the degree of risk. A commonly used measure of risk is standard deviation or variance. Variance measure the deviation about expected cash flow of each of the possible cash flows. Standard deviation is the square root of variance. 6. Decision tree analysis Decision tree analysis is another technique which is helpful in tracking risky capital investment. Decision tree is a graphic display of relationship between a present decision and possible future events, future events and their consequences. The sequence of event is mapped out time in format resembling branches of a tree. In other words it is practical representation in tree from which indicates the magnititude, probability and inter relationship of all possible outcomes. An out standing feature of decision tree analysis is that it links events chronologically with forecasted probabilities and thus gives a systematic appearance of decisions and their forecasted events. Constructing a decision tree 1. Defining the proposal: We have to define what is exactly required under the proposal E.g. New product 2. Identifying of alternative: Every proposal will have two alternatives i.e, accept or reject. However there may be more than two alternative for the projects 3. Graphing to decision tree: The decision tree is than laid down showing decision point( cash outlay), decision branches (alternative) 4. Forecasting cash flows: The forecast regarding each decision branch are also shown along with the branch. Probabilities are also designed to each cash flow. Expected values for future return are calculated and the total expected value for the decision is determined. 5. Evaluating results: Having determined the expected value for each decision, the results are analyzed. Some alternatives may look to be acceptable while others may be weak or unacceptable. The firm may proceed with the profitable alternative.

FINANCING DECISION Simulation and financing decision: Simulation is a quantitative technique developed for studying alternative courses of action by building a model of that system and then conducting a series of repeated trial and error experiments to forecast the behavior of the system over a period of time. It is a technique for decision making under uncertainty. This is known as Monte Carlo simulation. There are two types of simulation 1. Process/ system simulation (Small scale model of sign or buildings) 2. Digital simulation (special case is Montecarlo) Simulation can be defined as replacement of unknown actual environment by its theoretical counterpart using an assumed probability distribution and the samples are drawn from the theoretical population using random number table. Reasons for applying simulation techniques 1. it is not possible to develop a mathematical model and solution without some basic assumptions. 2. It may be too costly to actually observe a system. 3. Sufficient time may not be available to allow the system for a very long time. 4. Actual operation and observation of a real system may be too disruptive. Methodology of simulation: 1. Clearly define the problem. 2. Construct an appropriate mathematical model of the problem (ie flow carts, formulae etc.) 3. Ensure that the model represents the real situation involving probabilistic elements. 4. Supply values for input parameters and observe the output values. 5. Analyze the results of simulation activity. 6. Make changes in the model or parameters and repeat the process. Simulation in financing: 1. Many business organizations invest large amount of investment for expanding their capacity, reducing production cost. 2. They often go for investment in new product development. 3. There is enough risk associated with each investment plan and this risk can be reduced if they have the knowledge about the effects of the various factors by evaluation the alternative courses of action. 4. The profitability of the investment will depend upon pricing policy, market share. 5. If the alternative involve many parameters and interrelation with large may be very difficult for human minds. 6. Monte Carlo simulation used for risk analysis which uses the probability estimates for each uncertain factor.

7. The simulation method enables the evaluation without actual investment and waiting for a long time. 8. It also gives the decision maker and ides regarding the important of one or more parameters over others on the rate of return. 9. Simulation makes approximately 1000 iterations. 10. Flexible budgets, profit planning are the areas of application of simulation. Cash inadequacy: Meaning: shortage of cash / non availability of cash to meet out immediate cash payment due to improper cash reserve or cash management though the firm having lot of assets, stocks etc., Circumstances that create cash inadequacy: 1. Improper payment schedule. 2. Making cash disbursement on non priority basis. 3. Miscalculation in holding cash. 4. More credit sales or more credit period. 5. Purchasing goods for cash but selling for credit. 6. Not preparing cash budget. 7. Not forecasting the cash requirement. 8. Poor debt collections. 9. Hasty decision to invest. 10. Lesser control of inflow of cash. Cash insolvency: It is a situation where no prevailing / availability of cash for a small period or a longer period that leads to financial crisis in spite of having considerable value of fixed assets. Circumstances lead to cash insolvency: 1. Unable to pay wages, salary for the current month lag. 2. Accumulation of non performing assets 3. Cash invested in long term securities. 4. Cash locked in non moving items. 5. No centralized system of cash disbursement. 6. Payments not made from single controlled account. 7. Poor cash collection process. 8. More difference of time between cheque receiving and collection/ realization. 9. Bank process time is more. 10. Time interval between billing and dispatch of goods is more. 11. Not following lock box system. 12. Failure to meet obligation, hence creditor may file a case, reputation cost. 13. Poor management of working capital (estimation). 14. Improper investment policy. 15. Poor control of cash in flows /out flows. 16. No provision for unpredicted expenses. 17. Conflict between finance manager and sales manager. 18. Non availability of other sources of cash. Motives of holdings:

1. 2. 3. 4.

Transportation motive. Precautionary motive. Speculative motive. Compensation (wages) motive.

Cash Management techniques: 1. Playing on the float. 2. Lock box system. 3. Concentration Banking. 4. Internet Banking. Objectives of cash Management: 1. Planning and managing cash flows. 2. Maintenance of optimum cash flows. 3. Productive utilization of excess funds. Options Definition An option is type of contract between two parties wherein one person grants the other person the right to buy a specific asset at a specific price within the specific time period. In other words, an option is contract between two parities to buy or sell a specified number of shares at a later date for an agreed price. An option is a contract conveying the right but not the obligation to buy or sell specified financial instruments. Types of option: As the option provides a right to buy or sell there are two types of options: (i)Call option A call option provides to the holder a right to buy specified assets at specified price on or before a specified data. In case of call option he has a right to call from the market the specified assets. (ii)Put option A put option provides to the holder a right to sell specified assets at specified price on or before a specified date. In case of put option he has a right to put the specified assets in the market. For example an investor A enters into a contract with B whereby A has the right to buy 100 shares of XYZ Ltd @ Rs.95 each on or before a specified date. This is a call option. In the same case if A has the right to sell instead of buying it is called put option. Further A may or may not exercise his right. If he does not exercise his right it will lapse after the specified date. In order to acquire this right A has to pay a price to B. (iii) American options In the American option, the option holder can exercise the right to buy or sell, at any time before the expiration or on the expiration date. (iv)European option This option can be exercised only on the expiration date by the holder of the option. The expiry and the exercise date coincide with each other.

For example the price of PQR Ltd, share is Rs.80 and one month put option is available at Rs.76.Midway during the month the rate comes down to Rs.74 and on the last date the rate is Rs.77. in case of American option the investor can exercise his right and can gain Rs.2 per share. But in case of European option he will have to wait till the end and he will incur a loss of Re.1 per share. (v)Naked options and covered options A call option is called a covered option if it is covered / written against the assets owned by the option writer. In case of exercise of the call option by the option holder the option writer can deliver the asset or the price differential. On other hand if the option is not covered by the physical asset it is known as naked option. In India all option at the BSE and NSE are cash settled and delivery of shares is not allowed even in stock options. (vi) Stock, interest and index options Options may also be classified with reference to the underlying asset. Options on the individual shares are known as stock options or equity options. In India, SEBI has allowed stock options at NSE as well as on BSE in selected shares. An index option is the option on the index of securities. In India SEBI has allowed options on NIFTY and Senex. Besides there may be interest rate options and currency options. In India these options are not popular. It may be noted that the stock options and index options are exchange traded options whereas the interest rate and currency options are over the counter. Features of options 1. Only the buyer or the owner has the right to exercise the option. 2. The buyer has limited liability 3. An option is created only when two parties i.e. a buyer and a writer/ seller, strike a deal. 4. Option holders do not carry any voting right and are not entitled to receive any dividend or interest payment. 5. Options have high degree of risk to the option writers / sellers. 6. Options involve buying counter positions by the option writers. 7. Options allow the buyer to earn profit from favorable market conditions. Thats why options have gained popularity. 8. Options provide flexibility to the investors (buyers) who have every right to either purchase or sell before or at a certain future date. 9. No certificates are issued by the company. Players in the options Market -Development institutions -Mutual funds -Domestic and foreign institutional investors -Brokers -Retail investors Factors affecting option prices The value of a put or call depends on the market behavior of the equity. Investors and option traders are very much interested in the expected future value of a put or call. So it becomes necessary for them to know the various factors that affect the option value. 1. Stock volatility

Buyers of option view volatile stocks favorably because their chances of getting profit are more. If at all there is a loss it can be limited to the amount of premium. On the other hand the seller (the owner of stock) dislikes volatility as it can work against him. The probability of rise and fall in prices affects the owner of the stock to great extent. As a result option sellers demand higher prices for writing options on volatile stocks. Thus volatility of stocks prices reflects a combined effect of the reluctance of the option sellers to write them and the willingness of the buyers to pay a higher premium on volatile stocks. Thus the value of the call option is high in case of volatile stocks. 2. Expiration date or option period The expiration date of the option considerably affects the premium. If the period of option is longer the buyer will have better chances of making a profit. Buyers benefit from extended periods of time which sellers suffer. So buyers are prepared to pay high premiums for options lasting longer. In other words longer the option period higher will be the option price. 3. Striking prices The price at which the stock may be put or called is the contract price. It is also referred to as the strike price. During the life of the contract the strike price remains fixed. As an exception to this general rule the amount of any dividend paid during the option period will reduce the strike price. When the strike price is nearer to the market price of the stock under option the buyer has the greater chances of making money on the option. 4. Dividends Dividends are one of the important factors which affect option value. Generally stocks paying higher dividends do not increase very much in price. So the prudent stock buyers avoid options on these stocks. Naturally options writers prefer to write options on high dividend stocks as they collect dividends in addition to their premium income. So buyers and sellers agree to lower premiums for high dividend paying stocks. 5. Interest rates When the interest rates are higher the value of the striking price would be lower and at the same time the call price would be higher. At higher interest rates holding bonds would fetch higher income in the form of interest. Options writers sacrifice considerable income by holding stocks instead of bonds when the rates interests are higher. As a result an option writer demands a higher premium for writing at a time when interest rates are higher. Option Pricing Model: While making a decision regarding finance of a project we may have general options. Option pricing is a technique which values the option at present and future level. Purpose of option pricing: 1. To value the option at present and future level. 2. To draw a condition that is required to have significant value. 3. To apply and embed with investment including expansion, delay and abandoning of a project. 4. To examine the option in firms valuation. 5. To consider option in financing dividend decisions.

6. To use option in the design and customize securities to reduce cost and risk. 7. It gives insights about financial flexibility. 8. Holding of large amount of cash is also option method. Data required for option pricing: 1. Current value of underlying assets S 2. Strike price of the option K 3. Life of the option t 4. Risk less interest rate corresponding life of the option r 5. Variance in the value of underlying asset 6. Dividend payment d Types of pricing Model 1. Binomial Model. 2. Black scholes Model. 3. Jump process option pricing Model. Binomial Model: It is base on a simple formulation for the assets price process in which the asset, in any time period moves to one of possible prices. In the figure S is the current stock price the price process up to Su with probability P and moves down to Sd probability 1-P in any time period. Value form value of call Stock price at Su Su - $B (1+r) Cu Sd Sd - $B (1+R) Cd is change in the price of security. Value of call = current value of underlying asset x option Borrowing needed to replace the option. Black Scholes Model: It is named after the creation of the model, Fischer Black and Myron Scholes. This model allows estimating the value of any option using a smaller number of inputs and it has been used value to many listed options. The value of the call option of this model is given below. S- Current value of underlying asset. K- Strictly price of the option. t Life to experience of the option r Risk less interest to the corresponding period. - Variance. Value of a call = SN (d1) ke-nt N (d2) Nd1- Probability of option 1 Nd2 Probability of option 2 ert - Present value of the option. The black scholes model was designed to value options that can be exercised only at maturity and on underlying assets that do not pay dividends. In addition options are

valued bases on the assumption that option exercise does not affect the value of the underlying asset. Jump process option pricing model: If the price changes remain large as the time periods in the binomial are shortened. Cox and Ross (1976) valued options where prices follow a pure jump process, where the jumps can only positive. Thus in the next interval the stock will have a large positive jump with a probability. The rate at which jump owns is The average jump size is k. as a percentage of stock prices. This model is known as jump diffusion model. Agency Cost: The core problem is that stock holders, managers, bond holders and society have less different increases and incentives. Hence conflict may arise amongst the groups which results in agency costs. Categories of Agency cost: 1. Managers act as agents for shareholders. 2. Differing incentives between stock holders and money lender. 3. Revealing of information about financial markets. Dividends A dividend refers to that part of the earnings (profit) of a company, which is distributed to shareholders. Shareholders would like to receive a higher dividend as it increases their current wealth. Forms of Dividend 1. Cash dividend The dividend is paid to shareholders in cash. Cash dividend is the usual method of paying dividends. It results in outflow of cash. Hence the company should arrange adequate cash resources for payment of dividend. 2. Bond dividend If the company does not have sufficient cash resources, it may issue bonds in lieu of dividend. The shareholders get bonds instead of dividends. The company generally pays interest on theses bonds and repays the bonds on maturity. Bond dividend enables the company to postpone payment of dividend. But it is not popular. 3. Property dividend It refers to the payment in the form of some assets other than cash. This type of dividend is also not popular. 4. Stock dividend Stock dividend refers to the issue of bonus shares to shareholders. Bonus shares are issued free of cost to shareholders out of accumulated profits. Usually they are issued when a company has substantial reserves but needs to retain cash for expansion /diversification. Determination for dividend policy

1. Expectations of shareholders Shareholders are the owners of the company. So the company should consider the dividend expectations of shareholders. They may be interested in dividend or capital gains. The preference for dividend or capital gains depends on the economic status or attitude of an individual. For example a retired person who wants a regular income may prefer to receive dividends. 2. New investments Availability of investment opportunities (such as expansion and diversification) is an important factor, which influence the dividend decision. If the company has profitable investment opportunities it may retain a substantial part of the earnings and pay out a small dividend. It the company does not have good investment opportunities; it is better to distribute the earnings as dividends. In other words a high payout is desirable for such companies. 3. Taxation Taxation policy also affects the dividend policy of a firm. In India dividends are tax free in the hands of the shareholders. Long term capital gain on listed shares sold on or after 1st October 2004 is also not taxable if securities transitions tax has been paid. But shortterm capital gain is taxable. The shareholders may prefer dividends or capital gains depending on the effect of tax on their incomes. 4. Liquidity The liquidity position is an important factor which influences the dividend decision. Some times a company, which has good earnings, may not have sufficient liquidity. In such case it is advisable to restrict the dividend to the available liquid resources. 5. Access to capital markets A company which is confident of raising resources from the capital market (for expansion and diversification) may pay higher dividends. On the hand if the company is unable to raise resources due to its poor image or the depressed state of the capital markets, it has to content with a low payout. 6. Restrictions by lenders The lenders particularly financial institutions impose restrictions on the payment of dividends to safeguard their own interests. For example, a lender may stipulate that only up to 30 percent of the profits may be paid as dividends. Because of these restrictions, a company may be forced to retain earnings and have a low payout. 7. Control The objective of maintains control by the present mang3ement may also affect the dividend policy. Suppose a companys is quite liberal in paying dividends, it may have to raise funds for expansion or diversification by the issue of new shares, its control will be diluted. Hence the management may opt for a low payout and retain earnings to maintain control over the company. 8. Legal Restrictions The provisions of the companies act are to be adhered in the formulation of dividends policy. According to these provisions, dividends can be paid only out of current profits or past profits, only after providing for depreciation. There are also stipulations regarding

transfer of profits to reserve before declarations of dividends. Further dividends cannot be paid out of capital. Stability of Dividends Stability of dividends is the consistency in the stream of dividend payments. It is the payment of certain amount of minimum dividend to the shareholders. The steadiness is a sign of good health of the firm and may take any of the following forms (a) constant dividend per share, (b) constant DP ratio and (c) constant dividend per share plus extra dividend. Constant dividend per share: As per this form of dividend policy, a firm pays a fixed amount of dividend per share year after year. For example, a firm may have a policy of paying 25% dividend per share on its paidup capital of Rs. 10 per share. It implies that Rs. 2.50 is paid out every year irrespective of its earnings. Generally, a firm following such a policy will continue payments even if it incurs losses. In such years when there is a loss, the amount accumulated in the dividend equalization reserve is utilized. As and when the firm starts earning a higher amount of revenue it will consider payment of higher dividends and in future it is expected to maintain the higher level. Constant DP ratio: With this type of DP policy, the firm pays a constant percentage of net earnings to the shareholders. For example, if the firm fixes its DP ratio as 25% of its earnings, it implies that shareholders get 25% of earnings as dividend year after year. In such years where profits are high, they get higher amount. Constant dividend per share plus extra dividend: Under this policy, a firm usually pays a fixed dividend ordinarily and in years of good profits, additional or extra dividend is paid over and above the regular dividend. The stability of dividends is desirable because of the following advantages: Build confidence amongst investors: A stable dividend policy helps to build confidence and remove uncertainty in the minds of investors. A constant dividend policy will not have any fluctuations suggesting to the investors that the firms future is bright. In contrast, shareholders of a firm having an unstable DP will not be certain about their future in such a firm. Investors desire for current income: A firm has different categories of investors old and retired persons, pensioners, youngsters, salaried class, housewives, etc. Of these, people like retired persons prefer current income. Their living expenses are fairly stable from one period to another. Sharp changes in current income, that is, dividends, may necessitate sale of shares. Stable dividend policy avoids sale of securities and inconvenience to investors. Information about firms profitability: Investors use dividend policy as a measure of evaluating the firms profitability. Dividend decision is a sign of firms prosperity and hence firm should have a stable DP. Institutional investors requirements: Institutional investors like LIC, GIC and MF prefer to invest in companies which have a record of stable DP. A company having erratic DP is not preferred by these institutions. Thus to attract these organizations having large quantities of investible funds, firms follow a stable DP. Raise additional finance: Shares of a company with stable and regular dividend payments appear as quality investment rather than a speculation. Investors of such companies are known for their loyalty and whenever the firm comes with new issues, they are more responsive and receptive. Thus raising additional funds becomes easy.

Stability in market price of shares: The market price of shares varies with the stability in dividend rates. Such shares will not have wide fluctuations in the market prices which is good for investors. Corporate Governance Corporate governance is the set of processes, customs, policies, laws, and institutions affecting the way a corporation (or company) is directed, administered or controlled. An important theme of corporate governance is the nature and extent of accountability of particular individuals in the organization, and mechanisms that try to reduce or eliminate the principal-agent problem. Corporate governance also includes the relationships among the many stakeholders involved and the goals for which the corporation is governed.[4][5] In contemporary business corporations, the main external stakeholder groups are shareholders, debt holders, trade creditors, suppliers, customers and communities affected by the corporation's activities. Internal stakeholders are the board of directors, executives, and other employees. Principles of corporate governance Rights and equitable treatment of shareholders: Organizations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by openly and effectively communicating information and by encouraging shareholders to participate in general meetings. Interests of other stakeholders]Organizations should recognize that they have legal, contractual, social, and market driven obligations to non-shareholder stakeholders, including employees, investors, creditors, suppliers, local communities, customers, and policy makers. Role and responsibilities of the board he board needs sufficient relevant skills and understanding to review and challenge management performance. It also needs adequate size and appropriate levels of independence and commitment to fulfill its responsibilities and duties. Integrity and ethical behavior Integrity should be a fundamental requirement in choosing corporate officers and board members. Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making. Disclosure and transparency: Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide stakeholders with a level of accountability. They should also implement procedures to independently verify and safeguard the integrity of the company's financial reporting. Disclosure of material matters concerning the organization should be timely and balanced to ensure that all investors have access to clear, factual information. Corporate governance controls Internal corporate governance controls monitor activities and then take corrective action to accomplish organizational goals. Examples include:

Monitoring by the board of directors: The board of directors, with its legal authority to hire, fire and compensate top management, safeguards invested capital. Regular board meetings allow potential problems to be identified, discussed and avoided. Whilst nonexecutive directors are thought to be more independent, they may not always result in more effective corporate governance and may not increase performance.[30] Different board structures are optimal for different firms. Moreover, the ability of the board to monitor the firm's executives is a function of its access to information. Executive directors possess superior knowledge of the decision-making process and therefore evaluate top management on the basis of the quality of its decisions that lead to financial performance outcomes, ex ante. It could be argued, therefore, that executive directors look beyond the financial criteria. Internal control procedures and internal auditors: Internal control procedures are policies implemented by an entity's board of directors, audit committee, management, and other personnel to provide reasonable assurance of the entity achieving its objectives related to reliable financial reporting, operating efficiency, and compliance with laws and regulations. Internal auditors are personnel within an organization who test the design and implementation of the entity's internal control procedures and the reliability of its financial reporting Balance of power: The simplest balance of power is very common; require that the President be a different person from the Treasurer. This application of separation of power is further developed in companies where separate divisions check and balance each other's actions. One group may propose company-wide administrative changes, another group review and can veto the changes, and a third group check that the interests of people (customers, shareholders, employees) outside the three groups are being met. Remuneration: Performance-based remuneration is designed to relate some proportion of salary to individual performance. It may be in the form of cash or non-cash payments such as shares and share options, superannuation or other benefits. Such incentive schemes, however, are reactive in the sense that they provide no mechanism for preventing mistakes or opportunistic behavior, and can elicit myopic behavior. External corporate governance controls External corporate governance controls encompass the controls external stakeholders exercise over the organization. Examples include: Competition Debt covenants Demand for and assessment of performance information (especially financial statements) Government regulations Managerial labour market Media pressure Takeovers Different Reform of Corporate Governance Corporate finance view The suppliers of finance to the company i.e. Debt holders and equity holders exercise control and ensure accountability of company management to assure themselves of getting the best possible return of their investment. Law point of view

It refers to protection of shareholders interest by implementing an inter related mechanism relating to Board of Directors ownership structure, institutional and individual investors and Government and Shareholders that influence the decision of the organization. Elements / Scope of Corporate Governance 1. Serving shareholders and protection of their interest. 2. Extending Corporate Governance for non investing stake holders like employees, customers, suppliers, society. 3. Corporate Governance is not only protecting share holders interest but also to promote social interest. 4. Secure employment. SEBI Guidelines on Corporate Governance Clause 49 (Listed Companies) 1. Submitting quarterly compliance report to Stock Exchange Signed by CEO. 2. Company must setup board and constitute a committee for investors grievances. 3. Setting up of monitoring cell. 4. Committee / Cell shall meet 4 times in a year with a gap of 3 months. 5. Provisions regarding constitution of board, remuneration, nature of directorship has to be followed. 6. An executive earlier of the company cannot become a director of the company. 7. Disclosure of non-executives directors compensation has to be made. 8. Directors cant borrow loan from the companies. 9. Disclosure Clause. - Details of material contracts. - Disclosure of Accounting treatment - Proceeds from public, rights issue - Management discussion and analysis - Auditors report or certificate Corporate Governance. Corporate Disaster When the company not complying various clauses of SEBI time to time, it may face disaster in future by insolvency or ultra virus activities where will finally resulting in winding up of the organization. Whistle blower policy may protect the organization from the problem of corporate disaster. Whistle blower policy is establishing a mechanism for employees to report the top management on unethical behavior, suspected and fraud behavior. Circumstances causes corporate disaster 1. 2. 3. 4. Non compliance of various SEBI Guidelines on CG. Mismanagement and ultra virus activities. Non-adhering the institution of company law board. Unethical / Unlawful activity of BODs.

5. Not able to control employee strike and no interest in protecting the interest of share holders, employees, general public. 6. Cheating the Govt. by white collar criminal activities like tax evasion, adulteration, pollution, etc. 7. Not performing the activities of directors. - Trustee, loyalty, supervision, etc. 8. No coordination between people like CEO, BODs, etc. 9. Not addressing the social responsibility. 10. Not conducting periodical meetings of BODs. What is corporate social responsibility? Corporate social responsibility (CSR) is also known by a number of other names: corporate responsibility, corporate accountability, corporate ethics, corporate citizenship, sustainability, stewardship, triple bottom line and responsible business, to name just a few. CSR is an evolving concept that currently does not have a universally accepted definition. Generally, CSR is understood to be the way firms integrate social, environmental and economic concerns into their values, culture, decision making, strategy and operations in a transparent and accountable manner and thereby establish better practices within the firm, create wealth and improve society. The World Business Council for Sustainable Development has described CSR as the business contribution to sustainable economic development. Building on a base of compliance with legislation and regulations, CSR typically includes "beyond law" commitments and activities pertaining to: Corporate governance and ethics Health and safety Environmental stewardship Human rights (including core labour rights) Human resource management Community involvement, development and investment Involvement of and respect for Aboriginal peoples Corporate philanthropy and employee volunteering Customer satisfaction and adherence to principles of fair competition Anti-bribery and anti-corruption measures Accountability, transparency and performance reporting Supplier relations, for both domestic and international supply chains. There are four dimensions of corporate responsibility

Economic - responsibility to earn profit for owners Legal - responsibility to comply with the law (societys codification of right and wrong) Ethical - not acting just for profit but doing what is right, just and fair Voluntary and philanthropic - promoting human welfare and goodwill Being a good corporate citizen contributing to the community and the quality of life.

Why has CSR become important? Many factors and influences, including the following, have led to increasing attention being devoted to CSR:

Globalization -- with its attendant focus on cross-border trade, multinational enterprises and global supply chains -- is increasingly raising CSR concerns related to human resource management practices, environmental protection, and health and safety, among other things. Governments and intergovernmental bodies, such as the United Nations, the Organization for Economic Co-operation and Development and the International Labour Organization have developed compacts, declarations, guidelines, principles and other instruments that outline social norms for acceptable conduct. Advances in communications technology, such as the Internet, cellular phones and personal digital assistants, are making it easier to track corporate activities and disseminate information about them. Non-governmental organizations now regularly draw attention through their websites to business practices they view as problematic. Consumers and investors are showing increasing interest in supporting responsible business practices and are demanding more information on how companies are addressing risks and opportunities related to social and environmental issues. Numerous serious and high-profile breaches of corporate ethics have contributed to elevated public mistrust of corporations and highlighted the need for improved corporate governance, transparency, accountability and ethical standards. Citizens in many countries are making it clear that corporations should meet standards of social and environmental care, no matter where they operate. There is increasing awareness of the limits of government legislative and regulatory initiatives to effectively capture all the issues that corporate social responsibility addresses. Businesses are recognizing that adopting an effective approach to CSR can reduce risk of business disruptions, open up new opportunities, and enhance brand and company reputation.

Potential benefits of implementing a CSR approach Key potential benefits for firms implementing CSR include:

Better anticipation and management of an ever-expanding spectrum of risk. Effectively managing social, environmental, legal, economic and other risks in an increasingly complex market environment, with greater oversight and stakeholder scrutiny of corporate activities, can improve the security of supply and overall market stability. Considering the interests of parties concerned about a firm's impact is one way of anticipating and managing risk. Improved reputation management. Organizations that perform well with regard to CSR can build reputation, while those that perform poorly can damage brand and company value when exposed. This is particularly important for organizations

with high-value retail brands, which are often the focus of media, activist and consumer pressure. Reputation, or brand equity, is founded on values such as trust, credibility, reliability, quality and consistency. Even for companies that do not have direct retail exposure through brands, their reputation as a supply chain partner -- both good and bad -- for addressing CSR issues can make the difference between a business opportunity positively realized and an uphill climb to respectability. Enhanced ability to recruit, develop and retain staff. This can be the direct result of pride in the company's products and practices, or of introducing improved human resources practices, such as family-friendly policies. It can also be the indirect result of programs and activities that improve employee morale and loyalty. Employees become champions of a company for which they are proud to work. Improved competitiveness and market positioning. This can result from organizational, process and product differentiation and innovation. Good CSR practices can also lead to better access to new markets. For example, a firm may become certified to environmental and social standards so it can become a supplier to particular retailers. Enhanced operational efficiencies and cost savings. These flow in particular from improved efficiencies identified through a systematic approach to management that includes continuous improvement. For example, assessing the environmental and energy aspects of an operation can reveal opportunities for turning waste streams into revenue streams (wood chips into particle board, for example) and for system-wide reductions in energy use.

Corporate Social Responsibility Socially responsible practices of the organization such as protection of investor interest, social commitment and giving more importance for ethical and social responsible business is known as CSR. CSR to Share Holders. 1. Dissemination of information. 2. Declaration of dividend, bonus shares and rights issue. 3. Wealth maximization. 4. Conduct of AGM notice. 5. Confidence building among shareholders. 6. Following legal rules relating to CSR. 7. Redressal of problems/Grievances of stake holders - Redemption of shares - Allotment letter/Transfer letter - Non receipt of dividend - Adopting corporate Governance. - Disclosure of information. - Setup of grievance committee.

CSR to employees: 1. Payment of wages/ salary 2. Conducting appraisal. 3. Payment of allowances. 4. Providing welfare benefits. 5. Providing insurance. 6. Financial assistance. CSR to society: 1. Avoiding pollution. 2. Backward development. 3. Organizing health and awareness camps. 4. Disclosure of information. CSR to Government: 1. Paying tax. 2. Pollution control. 3. Backward area development. Managerial Ethics Ethics: Ethos is a Greek word which means customs and traditions. Ethical decision - making When making a decision in management the following criteria of ethical decision making should be considered: Legality - will the decision somehow affect the legal status? Fairness - how will the decision affect those involved in it? Self - respect - does the decision - maker feel good about the decision and its consequences? Long - term effects" - how do the predicted long - term effects relate to the above parameters? "Ethics in Management" Management ethics are the ethical treatment of employees, stockholders, owners, and the public by a company. A company, while needing to make a profit, should have good ethics. Employees should be treated well, whether they are employed here or overseas. By being respectful of the environment in the community a company shows good ethics, and good, honest records also show respect to stockholders and owners. Managerial corporate Ethics: This subject deals with a specialized part of ethical and moral values that engage the corporate people in their day to day work. It is not enough when the managers are legally correct but also morally correct. Ethics for Managers:

The following figure shows that managerial ethics is the intersection of technical and administrative aspect and purely moral and ethical values of individual and society.

It includes a set of beliefs attitudes and habit that an engineer or manager is required to adopt and display in his work. Variety of Ethical issues: 1. Organization related 2. Environment related. 3. society related 4. Product related 5. Finance / cost related. 6. Customer related. 7. Supplier related. 8. Employee related. 9. Competitor related 10. Government related. Moral aspect of Ethics: 1. Not offending customs and sentiments. 2. Not to violate intellectual property rights. 3. Not to deplete environmental resources. 4. Running unsafe plants. 5. Pollution / Effluents. Various types of ethics for corporate Authority: 1. Sentiment centered ethics respecting others. 2. Bio centric ethics Respect living organisms, saving biological life. 3. Eco-centric ethics Environment / pollution control. 4. Human centered ethics for well being of the population. 5. Accounting ethics following accounting standards.

Frequently Asked questions (FAQs)

BA 9260 - CORPORATE FINANCE
UNIT- I
1. Explain the structure and functioning of Indian capital market. November/December 2006, April/May 2010, 2. Explain the role of SEBI in regulating Indian capital market. November/December2009, April/May 2010 3. Disuses the functions of BIFR in the rehabilitation of sick units. November/December2009, April/May 2010, November/December 2010 4. Explain the various sources of finance to large scale industries. November/December 2006, November/December2009 5. What are the various problems based by the industrial finance?

UNIT- II
1. Explain the provisions relating to inter corporate investments. May/June2012 2. Commercial paper as a source of financing working capital requirement of a firm Discuss. May/June 2012 3. Explain the various sources of finance, which is provided by EXIM Banks to Exporters in India. November/December 2006, November/December2008, November/December 2010, May/June 2012 4. What are factors affecting working capital requirements explain in detail? November/December 2010 5. Discuss the role of commercial banks as financial intermediaries. November/December 2006, November/December2008, November/December2009, UNIT-III 1. Explain the merits and demerits of decision tree approach in investment decisions. November/December2009, April/May 2010, November/December 2010 2. Discuss the various risk associated with the investment of funds. November/December2008, 3. Explain the nature of business risk, interest rate risk and market risk. November/December 2006, November/December2009, November/December 2010 4. Evaluate sensitivity analysis as method of for assessing risk. November/December 2006, November/December2008, April/May 2010,

UNIT-IV
1. Define dividend. Explain various forms of dividend. 2. What are the various factors influencing dividend policy? November/December 2006, November/December2008, 3. Explain the factors that determine the option pricing. November/December 2006 4. Discuss the relationship between the financing decision and dividend decision in a firm. November/December2009, April/May 2010

UNIT-V
1. Discuss the importance of social responsibility of present day business. November/December 2006, November/December2008, November/December2009, April/May 2010, November/December 2010, May/June 2012 2. Explain the guidelines issued by the SEBI towards corporate governance. November/December2009, April/May 2010, 3. Explain the key elements of organizational design and corporate governance. November/December 2006, 4. Explain ethics in business and explain points to be kept in mind by a businessman. November/December 2010, May/June 2012 5. Briefly mention the arguments against the social responsibility of business. November/December2008