Professional Documents
Culture Documents
What is finance?
Finance is the art and science of managing money. Finance is concerned with the
process, institutions, markets and instruments involved in the transfer of money among
individuals, organisations and governments.
Classification of finance
Finance
Financial management is referred to that part of management which is concerned with the
planning and controlling of firm’s financial resources. It deals with finding various
sources for raising funds for the firm and allocation of funds and thus aiming at
maximising the profit earning capacity of the organisation and also its wealth.
Finance Function
1
4. Liquidity or short-term asset-mix decision.
PROFIT MAXIMISATION
1. Actions that increase profits should be undertaken and those that decrease profits
are to be avoided.
2. The investment, finance, dividend and liquidity decisions of a firm should be
oriented to the maximisation of profits.
3. The term profit can be used in two senses.
i. As a owner-oriented concept it refers to the amount of share of national
income which is paid to the owners of business, that is who supply the
equity capital.
ii. As an operational concept, it signifies economic efficiency. In other
words it is a situation where output exceeds input.
The rationale
behind profitability maximisation
2
ii. It ignores the timing of the returns or benefits
iii. The quality of benefits are ignored i.e., the Risk is
ignored
WEALTH MAXIMISATION
This is also known as value maximisation or net present worth maximisation. The
following figure depicts the process of financial decision taking in terms of its impact on
the share price of the firm’s stock:
Financial Increase
Financial Decision Return? Share Accept
Alternative Risk? Price? Ye
Manager
Action s
No
Reject
3
Stock holder’s current wealth in a firm= Number of shares X Current stock price
Owned per share
Wo = NPo
W= Σ At - Co
t =1 (1+k)t
A A A A
W=
1 + 2 + 3 +……+ n - Co
(1+K) 2 3 n
(1+K) (1+K) (1+K)
Where
W = Wealth i.e., Net worth
A A A A
1, 2, 3,…., n = the stream of cash flows expected to occur from a course of action over
a period of time.
K = the appropriate discount rate to measure risk and timing; and
C = the initial outlay to acquire that asset or pursue that course of action.
Implications of
wealth maximisation
4
iii. There is some controversy whether the aim to maximise
the wealth of the firm or the shareholder
iv. It also faces some difficulties when ownership and
management are separated as in the case of large corporations. Because the managers
who act will act towards maximising the managerial utility but not always towards the
maximisation of stock holders utility.
A financial manager is one of the members of the top management team and his
role day-by-day is becoming more pervasive, intensive and significant in solving
complex management problems. In this present business context, a financial manager is
expected to perform the following functions:
5
The chief finance officer who may be designated as Director (Finance) or
Vice-President (Finance) supervises the work of the treasurer and the controller.
In turn, several specialist managers working under them assist these
officers.
The finance function in a large organisation may be organised as shown in
the following exhibit.
Stock Holders
Elect
Board of Directors
OWNERS
Hires
President MANAGERS
(CEO)
Treasurer Controller
Tax Cost
Capital Foreign Pension
Manager Accounting
Expenditure Exchange Financial Planning
Fund
Manager Manager Manager
Manager
and6 Corporate Financial
Credit Cash
fund raising Accounting Accounting
Manager Manager
Manager Manager Manager
Figure showing the Organisation of finance function
Treasurer Vs Controller
Treasurer Controller
Provision of capital (both long
1 1 Accounting
term and short term)
Liaison with banks and financial
2 2 Preparation of financial reports
institutions
3 Cash Management 3 Reporting and interpreting
4 Receivables Management 4 Planning and control
Protect funds and securities
5 5 Internal audit
(insurance)
6 Investor relations 6 Tax administration
Economic appraisal and reporting
7 Audit 7
to Government
7
Money refers to the
current medium of exchange or means of payment.
Credit or loan is a
sum of money to be returned, normally with interest; it refers to the debt of an
economic unit.
Finance is monetary
resources comprising debt and ownership funds of the state, company or person.
The following exhibit shows the components of Indian Financial system consisting
of financial institutions, financial markets, financial instruments and financial services:
Financial system
Regulatory Banking
Intermediaries Non-Banking
8
Others Organised Unorganised
Short term
Medium term
Funds Funds
Financial
Institutions
Deposits/Shares Loans
Funds
Funds
Suppliers of Private Demanders
funds Securities Placement of funds
9
Financial
Markets
Securities
Funds Funds
Securities Securities
COMPOUNDING TECHNIQUE
The technique of finding the future value of the present sum of money is called
compounding technique. In this technique the future sum is always more than the present value
of the same money.
Vn= Vo(1+I)n
OR
Vn = Vo (CFi,n)
Where
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Vn = Value after n number of years
Vo = original sum of money i.e., value of money at time 0
I= rate of interest
CF = compound factor for i interest rate and n number of years.
2. Doubling period
Doubling period = 72
Rule 72
Rate of interest
Doubling period = 0.35 + 69
Rule 69
Rate of interest
mxn
Vn= Vo 1+ i
Future value of money m
m
EIR= 1+ i -1
Effective Interest Rate m
Where
Vn = future value at a period n
R1 = Payment after period 1
R2 = Payment after period 2
Rn = Payment after period n
I = Rate of interest
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Compound Value of an annuity
An annuity is a series of equal payments lasting for some specified duration. The
premium payments of a life insurance company are examples.
When the cash flows occur at the end of each period, it is called regular annuity or
a deferred annuity.
When the cash flows occurs at the beginning of each period, it is called annuity
due.
Vn = R (1+i) n -1 (1+i)
Using Mathematical formula
i
This is the technique that is just opposite of the compounding technique. The present
value technique tries to know the present of a sum of money which is being received at a future
point of time. This is also called as discounting technique. In this the present sum of money is
always less than the future sum.
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Vo = Vn
Mathematically
(1+i)
Using Discount factor table Present Value (Vo)= Future Value(Vn) X DFi,n
n
Vo = Σ Rt where Rt is the payment at period t
t=1 (1+i)t
13
11. Present value of an infinite life annuity
The present value of an infinite (,α) life annuity can be calculated as under
Vo = (R ) (ADF i,α)
OR
Vo = R
I
When the cash flows grow at a constant rate, we will have to calculate the series of
cash flows and then the present value of the series of payments.
Vn = (R ) (ACF i,n) or R = Vn
(ACF i,n)
Vo = (R ) (ADF i,n) or R = Vn
(ADF i,n)
14
3. Compound growth rate problems
A finance manager can easily calculate such compound rate of growth by making use of
the use of compound factor tables as under
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2. They affect risk of the firm
3. They involve commitment of large funds
4. They have a long-term effect on profitability
5. They are irreversible in nature or reversible at substantial loss
6. They are among the complex decisions to make
7. They are of national importance
1
Identify
7 investment
proposals
Review of
performance 2
Screen Proposals
6 Capital
Implementation
of proposals
Budgetin
g Process 3
Evaluate the
proposals
5
Final Approval
4
Fix Priorities
Kinds of Investment Decisions
16
METHODS OF EVALUATION OF INVESTMENT PROPOSALS
A. TRADITIONAL METHODS
Pay-back period = Cash outlay of the project (or) original cost of the asset
3. Where the annual cash inflows ( profit before depreciation and after taxes) are
unequal, the pay-back period can be found by adding up the cash inflows until the total is
equal to the initial cash outlay of project or original cost of the asset.
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2. It saves cost, consumes les time and labour in capital budgeting
decisions
3. It reduces the loss through obsolescence as the project having lesser pay-
back period is preferred
4. It is suitable for a firm with limited cash resources and with a liquidity
position which is not very good
This method can be expressed in terms of percentage by multiplying the result by 100.
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c. According to this method, the project which gives the greatest post pay-back
period may be accepted.
19
OR
b. Return per unit of investment Method This method is an improvement over the average rate
of return method. In this method the total profit after tax and depreciation is divided by the total
investment.
OR
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2
21
iii. Compute the present value of total investment proceeds i.e., cash
inflows ( profit before depreciation and after tax) at the above discount rate
iv. Calculate the net present value of each project by calculating present
value of cash inflows from the present value of cash outflows for each project
v. If NPV is positive or Zero, the project may be accepted. But if it is
negative, the project should be rejected
vi. To choose between mutually exclusive projects, rank them in the
order of NPVs and choose the one with the maximum NPV.
If n is more then the calculation becomes difficult hence the present value factor tables
have to be used.
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2. Determine the rate of discount at which the value of cash inflows is equal to the
present value of cash outflows.
3. Accept the proposal if the internal rate of return is higher than or equal to the
minimum required rate of return i.e., cost of capital or cut off rate and reject the
proposal if the internal rate of return is lower than the cost of cut-off rate.
4. In case of alternative proposals select the proposal with the highest rate of return as
long as the rates are higher than the cost of capital or cut-off-rate.
Determination of IRR
a. When the annual net cash flows are equal over the life of the asset
Firstly find out the present value factor by dividing initial outlay (cost of investment) by
annual cash flow
Then consult present value annuity tables with the number of years equal to the life of the asset
and find out the rate at which the calculated present value factor is equal to the present value
given in the table.
b. When the annual net cash flows are unequal over the life of the asset
It is found through trial and error method. This process is summed as under:
i. Prepare the cash flow table using an arbitrary assumed discount rate
to discount the net cash flows to the present value.
ii. Find out the net present value by deducting from the present value of
total cash flows calculated in (i) above the initial cost of the investment
iii. If the net present value is positive, apply higher rate of discount.
iv. If the higher discount still gives a positive net present value, increase
the discount rate further until the NPV becomes negative.
v. If the NPV is negative at this higher rate, the internal rate of return
must be between these rates.
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3. Profitability Index method
It is also called as benefit cost ratio method. It is the relationship between the present
value of cash inflows and the present value of cash outflows. Hence
(OR)
Profitability index = Present value of cash inflows
Initial cash outlay
This cash flow is preferable over the accounting profit due to the following reasons:
1. The main objective of a firm is to maximise the wealth of the shareholders which
depends on the cash flow but not the profit.
2. The existence of certain accounting ambiguities in accounting makes cash flow
preferable than the accounting profit.
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3. The cash flow also takes into account the time value of money which is ignored by
accounting profit.
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Or
Net Earnings After Tax + Depreciation - Tax
Rs.
Cash Revenues ( Sales) Xxxxxx
(-) Cash Expenses (operating costs) Xxx
= EBDT xxxxx
(-) Depreciation Xxx
= EBT xxxxx
(-) Tax Xxx
= EAT xxxx
(+) Depreciation Xxx
= CFAT (Cash inflow after tax) Xxxx
Rs.
Cash flow from sale of the asset xxxxx
or Sale value of old asset in case of
Xxx
its replacement with a new asset
(+) Increase in the net working capital xxxxx
Total xxxxx
REPLACEMENT OF PROJECTS
o Replacement of like –for – like ------- due to physical wear and tear
o Replacement due to obsolescence----- due to the technological
advancements
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Depreciation is an allocation of the cost of fixed assets. Though it involves an accounting
entry as an expense, as it is not a cash expense and hence does not constitute part of the
computation of cash flow. And hence has no direct impact on the cash flow. But has an impact
on the cash flow in the form of reduction of tax liability. Hence it is considered for the
computation of after-tax cash flow in spite of the fact that it does not form a part of the cash
flow.
Rs.
Cash Revenues Xxxxxx
(-) Cash Expenses (operating costs)
Xxx
+ Depreciation
= Taxable Income xxxxx
(-) Taxes Xxx
= Net Income After Tax xxxx
(+) Depreciation Xxx
= NCFAT (Net Cash inflow after
Xxxx
tax)
Total xxxxx
In such circumstances, those projects which have higher NPV should be selected since such
projects maximise the share holders wealth. Thus NPV is more reliable than the IRR method.
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COST OF CAPITAL
A project’s cost of capital is the minimum acceptable rate of return on the funds
committed to the project. The minimum acceptable rate or the required rate of return is the
compensation for the time and risk in the use of the capital by the project. The firm’s cost of
capital will be the overall or average required rate of return on the aggregate of the investment
projects.
1. Investment evaluation
2. Designing debt policy
3. Performance appraisal
4. Dividend Decisions
5. Investment in working capital
6. As a basis for taking other financial decisions
Classification of Cost
28
t = Rate of tax
29
COST OF PREFERENCE SHARE CAPITAL
Preference capital is that capital raise through the issue of preference shares. Preference
shares are those shares which give to their share holders, a preference over equity share holders
during the distribution of dividend and also the redemption of capital during the winding up of
the company.
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COST OF EQUITY SHARE CAPITAL
Equity share capital is that capital which is raised through the equity shares. The equity
shareholders are the real owners of the company. The cost of equity capital is a function of the
expected return by its investors.
Ke = D or D
NP MP
When the dividend is being paid at a constant rate and there is a growth in the percentage
of dividend every year at a constant rate, then the cost of capital may be computed by
using this method. The following formula can be used:
Ke = D 1 + G
NP
Where D1 = Expected Dividend per share at the end of the year
Ke = Cost of Equity Capital
NP = Net Proceeds per share
G = Rate of Growth in dividend
b. The cost of existing equity share capital
Under this model, the cost of existing equity share capital when there is a constant growth
rate in the dividend, is computed by taking into consideration, the Market Price per share.
Ke = D 1 + G
MP
Where D1 = Expected Dividend per share at the end of the year
Ke = Cost of Equity Capital
MP = Net Proceeds per share
G = Rate of Growth in dividend
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3. Earnings-Price Ratio Method
According to this method, the cost of equity capital is the discount rate that equates the
present value of the expected future earnings per share with the net proceeds (or current
market price) of a share. It is represented by the following formula:
Ke = EPS or EPS
NP MP Cost of existing cost of
Capital
A company can also raise debt funds by taking term loans. These term loans can be
raised from Banks or Financial Institutions. Term loans are the loans that are taken for a fixed
period of time. Interest is paid annually on the loans taken from the institutions. The following
formula is used to find out the cost of term loans:
Kdb = I
P
Where Kdb = Before tax cost of debt
I = Interest
P = Principal
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CAPITAL ASSET PRICING MODEL
It s a model that describes the relationship/trade-off between risk and expected/required
return. The CAPM provides a frame work for basic risk and return trade-offs in portfolio
management. It enables to draw certain implications about risk and the size of risk premium
necessary to compensate for bearing risk.
Types of risk:
i. Diversifiable/unsystematic/avoidable risk
ii. Non-diversifiable/systematic/unavoidable risk
The Model:
The model links the relevant (systematic) risk and returns of all assets/securities. The
measure/index of systematic risk is Beta Coefficient (β). It measures the sensitivity of return of
a security to changes in returns on the market portfolio. In other words, Beta Coefficient is an
index of the degree of responsiveness of security return with market return.
The beta for the market portfolio is equal to 1. It is thus an index of the systematic risk
of an individual security relative to that of the market portfolio.
The interpretation of β=1 is that the excess return for the security vary proportionately
with excess returns for the market portfolio, that is, the security has the same systematic risk as
the market as a whole.
The beta of a portfolio is simply the weighted average of the individual security betas in
the portfolio, the weights being the proportion of total portfolio market values represented buy
each security.
Thus, the beta of a security represents its contribution to the risk of a highly diversified
portfolio of securities.
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Required Return
ke = kf + (km-kf)β
SML
Risk Premium
(km-kf)β
kf
Risk β
Figure showing the Cost of Equity under CAPM
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COST OF RETAINED EARNINGS
Retained earnings are the amounts that have been kept aside by the company during times
of prosperity for the purpose of expansion and diversification of it activities.
The cost of retained may be considered as the rate of return that the existing shareholders
may obtain by investing the after-tax dividends in alternative opportunities of equal
opportunities.
Kr = D + G
NP
Where D = Expected Dividend per share
Kr = Cost of retained earnings
NP = Net Proceeds per share
G = Growth Rate
2. Cost of retained earnings after adjusting tax and cost of purchasing new securities
Kr = D + G x (1-t) x (1-b)
NP
Also called as overall cost of capital or composite cost of capital. The weighted average cost of
capital is calculated by multiplying the weights of the various sources of capital with the cost of
capital of that particular source. Weight is the proportion of each source of fund in the capital
structure.
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Calculation of Weighted Average Cost of Capital
The weighted average cost of capital is calculated by using the formula:
n
ko = Σ ktwt
t=1
where ko = Weighted average Cost of capital
k = K is the component cost
w = Weights of various types of capital employed
MARGINAL COST OF CAPITAL
The weighted average cost of new or incremental capital is known as the marginal cost
of capital.
The marginal cost of capital is the weighted average cost of new capital using the
marginal weights.
The marginal weights represent the portion of various funds the firm intends to employ.
This is a popular model explicitly relating the market value of the firm to dividend policy.
This model was developed by Myron Gordon in 1962 The Valuation formula under this model is
as under:
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What is working capital?
It is the amount of capital required for running the day-to-day activities of the business. It
is the funds required to cover the cost of operating the enterprise. It is also called as Revolving
capital or Circulating capital or short-term capital.
a Gross working capital: This is the amount of the current assets present in the
organisation..
b Net-working capital: This can be defined in two ways: (i) the excess of current
assets over current liabilities (ii) It is that portion of current assets which is financed with
long-term funds.
a Currents Assets: The term current assets refers to those assets which in the
ordinary course of business can be, or will be, converted into cash with in one year
without undergoing a diminution in value and without disrupting the operations of the
firm.
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Importance of Working Capital
38
Level of Current Assets
In the above figure, the most conservative policy is indicated by alternative A, where the
CA/FA ratio is greatest at every level of output. Alternative C is the most aggressive policy as
CA/FA ratio is lowest at all levels of output. Alternative policy which is the average policy lies
between A and B.
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Policy CA/FA Ratio Risk Return Liquidity
Aggressive Lowest Very High High Low
Average Medium Medium Average Medium
Conservative Highest Very Low Low High
The above table shows the Current Assets to Fixed Assets Ratio, Risk Level, Returns and
Liquidity for various Current Asset Policies
a. Matching Approach
In Matching approach, long term financing will be used to finance fixed assets and
permanent current assets and short term financing to finance temporary or variable current assets.
Permanent Cas
Long-term financing
Fixed Assets
Time
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b. Conservative Approach
Under a conservative plan, the firm finances its permanents assets and also a part of
temporary current assets with long-term financing. When the firm has no temporary current
assets [ex: in situation (a)], the long-term funds released can be invested in marketable securities
to build up the liquidity position of the firm.
c. Aggressive Approach
Under an aggressive policy, the firm finances a part of its permanent current assets with
short term financing. Some extremely aggressive firms may even finance a part of their fixed
assets with short-term financing.
(a)
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Short-Term Vs Long-term Financing: A Risk-Return trade-off
A firm should decide whether or not it should use short-term financing. If short term
financing has to be used, the firm must determine its portion in total financing. This decision of
the firm will be guided by the risk-return trade-off. Short-term financing may be preferred over
long-term financing over two reasons:
i. The cost advantage
ii. Flexibility
OPERATING CYCLE
Operating Cycle: The operating cycle is the length of time for a company to acquire materials,
produce the product, sell the product, and collect the proceeds from customers.
The operating cycle, which is also known as the cash-to-cash cycle, is the process of using cash
to purchase current assets that are to be sold at a profit and collected as cash.
42
.
CASH CYCLE
The duration between the purchase of a firm’s inventory and the collection of accounts
receivable for the sale of that inventory. Also known as Cash Conversion Cycle
Cash
Collections
Business
Operations
Deficit Borrow
43
Surplus Invest
Information
and Control
Cash
Payments
2. Ratio of sales
Financial structure is the mixture of all items that appear on the left hand side of the balance of
a company.
Capital structure is the mix of the long term sources of funds used by the firm.
Capital structure collective term, which refers to the various sources from which the long-term
funds are raised. The capital structure refers to the proportion of equity capital, preference
capital, reserves, debentures and other long-term debts to the total capitalisation.
44
Capitalisation refers to the total amount of securities issued by a company
45
13. Corporate tax rate
14. Cost of floatation
1. Equities only Under this form, the entire capital is raised from share holders and there is
only one class of share known as equity shares.
2. Equities and preference shares Under this form, the capital structure of a company
consists of mixture of equity and preference shares.
3. Equity shares and debentures Under this form the capital structure of a company
consists of a mixture of equity shares and debentures.
4. Equities, Preference shares and debentures Here the components of the capital
structure are equity shares, preference shares and debentures.
There are many theories put forth by the thinkers in the field of management who are of
varied views about the relationship between the effects of capital structure on the market value of
a firm.
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S = Market value of the common share of the firm
D = Market value of the firm’s Debt
3. TRADITIONAL APPROACH
47
The traditional view, which is also known as an intermediate approach, is a compromise
between the net income approach and the net operating approach. According to this view, the
value of a firm can be increased or a judicious mix of debt and equity capital can reduce the cost
of capital. This approach very clearly implies that the cost of capital decreases within the
reasonable limit of debt and then increases with leverage.
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4. Flexibility
5. Loan covenants
6. Early repayability
7. Reserve capacity
8. Marketability
9. Market conditions
10. Floatation costs
11. Capacity of raising costs
12. Agency costs
ISSUE OF SHARES
A company has an option to issue shares to raise the long-term finance for its operations.
EQUITY SHARES These are also termed as ordinary shares or common stock. The owners of these
shares are the real owners of the company.
Characteristic Features
Equity shares have a number of special features which distinguish it from other securities.
These features relate to the rights and claims of ordinary shareholders.
1. Risk Capital
2. Fluctuating Dividend
3. Changing market value
4. Growth prospectus
5. Protection against inflation
49
6. Voting rights
7. Claim assets
8. Right to control
9. Pre-emptive rights
10. Limited liability
PREFERENCE SHARES
Preference share capital represents a hybrid form of financing – it partakes some
characteristics of equity and some attributes of debentures.
Characteristic features
1. Return of income
2. Return of capital
3. Fixed dividend
4. Non participation in prosperity
5. Non participation in management
6. No voting rights
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2. These shares are particularly useful if its assets are not acceptable as collateral security for
creditor ship securities like debentures and bonds.
3. These shares save the company from payment of high interest if debentures were to be
borrowed.
4. The property need not be mortgaged as in case of debentures if these shares are issued.
5. Preference shares since they bear fixed yield and enable the company to declare higher rates
of dividend for the equity shareholders
6. The promoters can retain control over the company
DEBENTURES
The debenture is an acknowledgement of debt issued by a company for the amount of
loan taken from them and carrying a definite time period of maturity and also a certain rate of
interest. A debenture holder is a creditor of the company.
Features of debentures
1. They have a fixed maturity period
2. They carry a fixed rate of interest
3. The debentures have a claim on the company’s income
4. They have a claim on the assets of the company
5. They do not have any control over the company and
6. The debenture holders are the creditors of the company.
7. The debentures have call feature.
Types of Debentures
1. Simple or naked or unsecured debentures
2. Secured or mortgaged debentures
3. Bearer Debentures and Registered Debentures
4. Redeemable and irredeemable debentures
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5. Convertible and non-convertible debentures
6. Zero Interest Bonds
7. Zero Coupon Bonds
8. First Debentures and Second Debentures
9. Guaranteed Debentures
10. Collateral Debentures
11. Callable Bonds
12. Deep Discount Bonds
13. Inflation Adjusted Bonds
Advantages of Debentures
1. Debentures provide long-term funds to a company
2. The rate of interest payable is less than the dividend payable on shares
3. The interest paid is tax deductible
4. The investor can have a fixed and constant source of income.
5. They have a charge on the assets of the company
Disadvantages of Debentures
1. The debenture interest is a fixed obligation for the company
2. They do not carry any voting rights
3. They have no control on the company
4. The prices of debentures in the market changes with the changes in the market interest
rate.
5. These holders are only the creditors to the company but not the owners.
TERM LOANS
The debt capital of a company may consist of either debentures or bonds which are issued
to the public for subscription or term loans which are obtained directly from banks and financial
institutions. Term loans are sources of long term debt. In India, they are generally obtained for
financing large expansion, modernisation and diversification projects. Therefore, this method of
financing is also called as project financing.
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a. Eurocurrency loans
Euro currency is a freely convertible currency deposited in banks outside the country of
the origin. The rate of interest is determined by LIBOR.
b. Euro bonds
These are the bonds sold outside the country in whose currency they are denominated.
They are issued directly by the borrowers to the issuers. They are normally issued as
bearer bonds.
c. Foreign Bonds
A foreign bond is a bond denominated in the currency of the country where it is being
issued and is subjected to the laws and regulations of that country. Ex: Samurai bonds if
in Japan, Yankee Bonds in USA and Bulldog bonds if in UK.
d. American Depository Receipts
A depository receipt represents the number of foreign shares that are deposited in a bank
in a foreign country.
American Depository receipts are certificates traded in the United Sates
denominated in American Dollar.
e. Global Depository Receipts
Global Depository Receipts are the Depository receipts that traded in a foreign country
but denominated in the currency of the nation of their origin.
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INSTITUTIONAL FINANCE AVAILABLE IN INDIA.
There are various institutions in India providing finance to the business institutions in
India. Some of them are:
i. ICICI
ii. IDBI
iii. IFCI
iv. SIDBI
v. SISI
vi. IFBs of Commercial Banks
Derivatives are contracts whose payoffs depend upon the value of an ‘underlying’. The
‘underlying’ can be commodity, a stock, a stock index, a currency, or interest rate, or literally
anything-not necessarily an asset.
These are designed to shift risk from one party to another allowing an ever widening
array of risks to be traded. Derivatives mainly consist of futures and forwards (agreements to buy
or sell an asset in the future at a fixed price), options (which give you the right, but not the
obligation, to buy an asset, say a share or a lump of foreign currency, in the future at an agreed
price) and swaps (which enable you to exchange a future string of payments in one currency for
one in another).
Derivatives markets provide three essential economic functions viz., risk management,
price discovery and transactional efficiency.
1 Risk Management
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The hedger’s primary motivation is risk management. Faced with an unacceptable level
of risk, the hedger may choose to reduce or eliminate it. The objective is to use futures markets
to reduce a particular risk that be faces. This risk might relate to the price of oil, foreign
exchange rate, or some other variable. A perfect hedge is one that completely eliminates the risk.
In practice, perfect hedges are rare.
2 PRICE DISCOVERY
Futures and option markets play a vital role in discovering the future price of any
commodity or financial asset. The role of price discovery is an essential part of an efficient
economic system. The prices in the market must reflect exactly the relative cost of production
and the relative consumption utilities if optimum allocation of resources is to be achieved in an
economy. The futures and option markets provide a pricing mechanism through which relative
cost and utilities are brought to an alignment both in the present and in the future.
3 Transactional efficiency
Derivative markets allow institutions to transact more efficiently than otherwise. They
reduce the direct cost of transacting in cash/ financial markets and also provide, through clearing
houses, an efficient mechanism to deal with counter party risk. The following chapter on futures
will give the t\reader an insight into the various ways in which derivative markets contribute to
transactional efficiency.
4 Financial Engineering
The relatively new field of financial engineering refers to the practice of using
derivatives as building blocks in the creation of some specialized products. A financial engineer
selects from the wide array of puts, calls, futures, and other derivatives in the same way that a
cook selects ingredients from the spice rack or a chemist mixes compounds in the laboratory.
1. Hedgers
2. Speculators
3. Arbitrageurs
4. Intermediary Participants
(i) Brokers
(ii) Jobbers
(i) Exchange
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(iii) Custodian / Warehouse
FUTURES
A future is a financial contract which derives its value from the underlying asset.
For example, sugar cane or wheat or cotton farmers may wish to have contracts to sell their
harvest at a future date to eliminate the risk of change in price by that date. Transactions take
place through the forward or futures market. There are commodity futures and financial futures.
In the financial futures, there are foreign currencies, interest rate and market index futures.
Market index futures are directly related with the stock market.
Forwards
A forward is a contract to buy or sell at a predetermined future date for a current price
i.e., paying today’s price for the delivery of the asset at a future date. If the price goes up or
down, the asset is to be delivered on the due date and no further payment is to be made for the
difference.
Forwards are good tools to ensure that future price volatility does not entail losses to the
business. The gains of a buyer and seller are depicted in the following graph:
Payoff
Future Price
O Forward Price
Loss
Payoff
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O
Forward Price
The forward buyer will make profits if the future price is higher than the price at which the
forwarded has been struck and the forward seller will make profit if the future price is lower than
the price at which the forward deal has been struck.
Features of Forwards
Despite these limiting features, forwards flourished because they provide price
guarantee. For example, a coffee manufacturer cannot change the price of his product as and
when there is a change in the price of coffee beans. Hence to avoid the risk of a price in the raw
material, the manufacturer locks in the future prices of beans up to a particular period. He would
search for a person ho is prepared to sell him beans on various future dates for a fixed price.
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Such a person could be a speculator(or a firm that possesses or is likely to posses the required
stock of beans) who wants to protect himself against a likely fall in the value of his stock. Both
the manufacturer and the speculator can enter into a forward contract under which the coffee
manufacturer buys the forward coffee beans contract, and the stockist sell the forward beans
contract for the required quality at a particular rate. In most markets middlemen are required to
bring buyers and sellers of forward contracts together. These middlemen charge a fee, for their
services.
Futures: -
A futures contract can be defined as an agreement to buy or sell a standard quantity of a
specified instrument at a predetermined future date and at a price agreed between the parties
through an open outcry on the floor of an organised futures exchange.
It is a standardised forward contract; usually traded in the futures exchange with “mark–
to–market” on daily basis.
Features of Futures
• Futures are traded on organized exchanges with clearing associations that act as
intermediaries between the contracting parties.
• Futures are highly standardized contracts that provide for the performance of the contract
either through deferred delivery of an asset or a final cash settlement.
• Both the parties pay a margin to the clearing association. This is used as a performance
bond by contracting parties. The margin paid is generally market to the market price
every day.
• Each futures contract has an association month which represents the month of contract
delivery or final settlement, for example-a September T-bill, a March Euro, A November
Nifty futures, etc.,
Index futures
The stock index futures are the futures contract made on the major stock market index. The
stock index futures has the following characteristics:
i) It is an obligation and not an option
ii) Settlement value depends (a) on the value of stock index and the price at which the
original contract is struck and (b) on the specified times the difference between the
index value at the last closing day of the contract and the original price of the
contract.
iii) Basis of the stock index futures is the specified stock market index. No physical
delivery of stock is made.
Margin
Depending upon the nature of the buyer and seller, the margin requirement to be deposited with
the stock exchange is fixed.
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1. Location Futures Exchange No fixed location
2. Size of contract Fixed (standard) Depends on the terms
of contract
3. Maturity/ Payment date Fixed (standard) Depends on the terms
of contract
4. Counterparty Clearing House Known Bank or Client
5. Market Place Central Exchange floor in Over the telephone in
the world wide network the world wide
network
6. Valuation Marked-to-Market every No unique method of
day valuation
7. Variation margins Daily None
8. Regulations in trading Regulated by the concerned Self regulated
stock exchange
9. Credit Risk Almost non existent Depends on the
counter party
10. Settlement Through clearing house Depends on the levels
of contract
11. Liquidation Mostly by offsetting the Mostly settled by
positions, very few by actual delivery. Some
delivery by cancellation at cost
12. Transaction costs Direct costs such as: Direct costs are
commission, clearing thoroughly low but
charges, exchange fees are Indirect costs are high
high. in the form of high bid
Indirect costs such as: ask spread.
Bid-ask spreads are low
Bid ask spread: The simple difference between the selling price and buying price of an asset.
OPTION
Options are also a type of Derivatives. Option means choice. It is a firm market created
through a financial contract. This financial contract gives a right to its holder to enter into a
trade on or before a specified date.
MEANING OF AN OPTION
Options: -
An option means a choice. It gives the holder the right (but no obligation) to enter into a
deal at or before a specified future date. These options are:
Call Options (Option to purchase) and
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Put Options (Option to sell)
Depending on the type of asset, the options may be stock options, index options,
commodity options, currency options etc.,
Meaning:
In a broad sense, an Option is a claim without any liability. It is a claim contingent upon the
occurrence of certain conditions. Thus, an option is a contingent claim. More specifically, an
option is a contract that gives the holder a right, without any obligation, to buy or sell an asset at
an agreed price on or before a specified period of time.
An Option is the right, but not the obligation to buy or sell something on a specified date at a
specified price. In the securities market, an option is a contract between two parties to buy or
sell specified number of shares at a later for an agreed price.
An option is a contract in which the seller of the contract grants the buyer the right to
purchase a designated instrument or asset at a specific price, which is agreed upon at the time of
entering into a contract.
The options buyer has the right but not as obligation to buy.
But if the buyer decides to excise the options, then the seller has an obligation to deliver or late
delivery of the modifying amount at the afford price.
Option is a legal contract which gives the holder the right to buy or sell a specified amount of
underlying asset at a fixed price within a specified period of time.
- It gives the holder a right to buy (or) sell an asset
- But however he is not obliged to buy or sell it
Parties Involved:
Three parties are involved in the option trading, the option seller, buyer and the broker.
≈ The option seller or writer is a person who grants someone else the option to buy or sell.
He receives a premium on its price.
≈ The option buyer pays a price to the option writer to induce him to write the option.
≈ The securities broker acts as an agent to find the option buyer , and the seller, and
receives a commission or fee for it.
1. Buyer – takes long position i.e. buys the option.
2. Seller – takes short position i.e. sells the option.
- He writes the option.
- Hence called the writer of the option.
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Transactions:
Call option – short to long
Strike prices:
♣ In the money – An Option is said to be in the money when it is advantageous to exercise it.
For a call option, if the strike price is below the current spot price of the underlying asset, it
is said to be in the money.
For a put option, the strike price is above the current spot price of the underlying asset
♣ (At) Near the money – In this case the Exercise price = current spent price. If the option
holder does not lose or gain whether he exercise his option or buys or sells the asset from the
market, the option is said to be at-the-money
♣ Out of the money – For a call option, the strike price is above current spot price
For a put option, strike price is below the current spot price
The Option is out-of-the-money if it is not advantageous to exercise it
Stock Options:
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Shares are involved.
Index Options:
Underlying amount is stock Index.
Vohra & Bagri page no. – 238
This is useful for institutional investors. An index option to call or put is like a stock
option:
- In an index put option buyer stands to gain if the index end falls below the
predetermined exercise price.
- In an index call option, the buyer stands to loose of the index level raises
above the exercise price
SWAPS
Swaps are risk management tools, which involve the exchange of one set of financial
obligations for another, aiming at reducing the financial obligation rate of the parties involved
into the deal. Swaps can be:
Interest rate swaps
Currency Swaps
Meaning of Swap:
Swap means:
- Exchange or Substitute
- An Act of exchanging one thing for another
- “Swap is a contract between two parties to exchange a set of cash flows over a pre-determined
period of time”.
- Financial Swaps are an asset – liability management technique that permits a borrower to
access one market and then exchange the liability for another type of liability.
- An agreement between two parties to exchange a series of payments, the terms of which are
predetermined can be regarded as a financial swap.
- Swaps by themselves are not funding instruments; they are devices to obtain the
desired form of financing indirectly through reduction of risk.
Notional Capital:
It is the principal amount on which the interest calculation is made.
Basis Pints:
Basis point means 1/100th of 1%. Percentage i.e.,10 Basis Pints = 0.1%
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1. Difficulty for Broker/ dealer in identifying the counter party once a party has approached
him.
2. Swap deal cannot be terminated without the agreement between the parties involved.
3. Existence of inherent default risk.
4. Swaps are not easily tradeable because of under developed secondary markets.
5. Comparative advantage is illusory since it is for a short period of time.
6. The market is OTC but not controlled by stock exchange. Hence extra caution is needed.
Swap Facilitators:
- Swaps are internal obligations among the Swap parties.
- Swap Dealer (Swap Broker) is involved.
- Swap Broker collectives called Swap Banks (or) ‘Banks’.
a) Swap Broker:
- A mere intermediary
- Initiates the transaction and disassociates.
- Charges a fee (commission).
- Not a party to Swap.
- An economic agent helping in identifying the palatial counter parties to a
swap transaction.
- Called “Market Maker”.
b) Swap Dealer:
- Bears the financial risk involved.
- Becomes a party to the swap transaction.
- Earn profit by completing the swap transaction.
- 2 problems he faces:
i) Pricing of Swaps
ii) Managing the default risk of the counterparty.
Swap Coupon:
The fixed rate of interest on Swap.
Types of Swaps
Thee are basically two major types of swap structures (i) interest-rate swaps (IRS) and
(ii) currency swaps.
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• Only the interest payments are exchanged. They are usually netted on the settlement dates
and only the net value is exchanged between counterparties. This reduces credit risk in an
IRS.
• Any underlying loan or deposit is not affected by the swap. The swap is a separate
transaction.
A currency swap is a contractual agreement between counterparties in which one party
makes payments in one currency and the other arty makes payment in a different currency for a
stated period of time. The other important points to be noted in the case of currency swaps are:
• It usually involves an exchange of currencies between the counterparties at the outset of
the agreement and at its maturity. If there is no exchange of currencies up front, then
there must be an exchange at maturity.
• The interest payments on the settlement dates are usually paid in full, unlike in an IRS.
The interest payments on the two currencies can be calculated on a fixed or floating basis
for both currencies, or payments for one currency can be on a fixed bases and the other,
on a floating basis.
• Due to the exchange of principal as also exchange of interest payments in full (as stated
above), the credit risk in a currency swap is higher than that in an IRS.
The other popular types of swaps include commodity swaps and equity swaps.
A commodity swap is a contractual agreement between counterparties, wherein at least one
set of payments involved is set by the price of the commodity or by the price of a commodity
index.
An equity swap or an equity index swap is a contractual agreement between counterparties,
wherein at least one party agrees to pay the other a rate of return based on a stock index during
the life of the swap.
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