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INTRODUCTION TO

ECONOMICS OF FINANCE

Prepared by

Byasdeb Dasgupta

DEPARTMENT OF ECONOMICS

UNIVERSITY OF KALYANI

26 December 2012

---------------------------------Economics UG Course Material – Economics of FinancePrepared by Byasdeb Dasgupta

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Unit 1

Introduction to various forms of business organizations:

1.1 Different Business Organizations:

Business concerns are established with the objective of making profits. They can beestablished either by one person or by a group of persons in the private sector by thegovernment or other public bodies in the public sector. A business started by only oneperson is called sole proprietorship. The business started by a group of persons can beeither a Joint Hindu Family or Partnership or Joint Stock Company or a Co -operativeform of organization.

Thus there are various forms of business organization

1. Sole Proprietorship2. Joint Hindu Family Firm3. Partnership Firm4. Joint Stock Company5. Co-operative Society

Forms of business organization are legal forms in which a business enterprise may beorganized and operated. These forms of organization refer to such aspects as ownership , riskbearing, control and distribution of profit. Any one of the above mentioned forms may beadopted for establishing a business, but usually one form is more suitable than other for aparticular enterprise. The choice will depend on various factors lik e the nature of business,the objective, the capital required, the scale of operations, state control, legal requirementsand so on. Out of the forms of private ownership listed above the first three forms (1, 2, and3) may be described as non corporate an d the remaining ( 4 and 5 ) as corporate forms ofownership. The basic difference between these two categories is that a non -corporate form ofbusiness can be started without registration while a corporate form of business cannot be setup without registration under the laws governing their functioning.

1.2 Characteristics of an ideal form of organization

Before we discuss the features, merits and demerits of different forms of organization, let usknow the characteristics of an ideal form of organization. The characteristics of an ideal formof organization are found in varying degrees in different forms of organization. Theentrepreneur, while selecting a form of organization for his business, should consider thefollowing factors.

Ease of formation: It should be easy to form the organization. The formation shouldnot involve many legal formalities and it should not be time consuming.

Adequacy of Capital: The form of organization should facilitate the raising of therequired amount of capital at a reasonabl e cost. If the enterprise requires a largeamount of capital, the preconditions for attracting capital from the public are a) safetyof investment b) fair return on investment and c) transferability of the holding.


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Limit of Liability: A business enterprise may be organized on the basis of eitherlimited or unlimited liability. From the point of view of risk, limited liability ispreferable. It means that the liability of the owner as regards the debts of the businessis limited only to the amount of capital agreed to be contributed by him. Unlimitedliability means that even the owners’ personal assets will be liable to be attached forthe payment of the business debts.

Direct relationship between Ownership, Control and Management: The responsibilityfor management must be in the hands of the owners of the firm. If the owners have nocontrol on the management, the firm may not be managed efficiently.

Continuity and Stability: Stability is essential for any business concern. Uninterruptedexistence enables the entrepreneur to formulate long-term plans for the developmentof the business concern.

Flexibility of Operations: another ideal characteristic of a good form of organizationis flexibility of operations. Changes may take place either in market conditions or thestates’ policy toward industry or in the conditions of supply of various factors ofproduction. The nature of organization should be such as to be able to adjust itself tothe changes without much difficulty.

1.3 Sole Proprietorship

Meaning: A sole proprietorship or one man’s business is a form of business organizationowned and managed by a single person. He is entitled to receive all the profits and bears allrisk of ownership.

Features: The important features of sole proprietorship are:

1. The business is owned and controlled by only one person.2. The risk is borne by a single person and hence he derives the total benefit.3. The liability of the owner of the business is unlimited. It means that his personal

assets are also liable to be attached for the pa yment of the liabilities of the business.4. The business firm has no separate legal entity apart from that of the proprietor, and so

the business lacks perpetuity.5. To set up sole proprietorship, no legal formalities are necessary, but there may be

legal restrictions on the setting up of particular type of business.6. The proprietor has complete freedom of action and he himself takes decisions relating

to his firm.7. The proprietor may take the help of members of his Family in running the business.

Advantages

1. Ease of formation: As no legal formalities are required to be observed.2. Motivation: As all profits belong to the owner, he will take personal interest in the

business.3. Freedom of Action: There is none to interfere with his authority. This freedom

promotes initiative and self-reliance.4. Quick Decision: No need for consultation or discussion with anybody.5. Flexibility: Can adapt to changing needs with comparative ease.


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6. Personal Touch: comes into close contact with customers as he himself manages thebusiness. This helps him to earn goodwill.

7. Business Secrecy: Maintaining business secrets is very important in today’scompetitive world.

8. Social Utility: Encourages independent living and prevents concentration of economicpower.

Disadvantages

1. Limited resources: one man’s ability to gather capital will always be limited.2. Limited Managerial Ability3. Unlimited Liability: Will be discouraged to expand his business even when there are

good prospects for earning more than what he has been doing for fear of losing hispersonal property.

4. Lack of Continuity: uncertain future is another handicap of this type of business. Ifthe sole proprietor dies, his business may come to an end.

5. No Economies of Large Scale: As the scale of operations are small, the owner cannotsecure the economies and large scale buying and selling. This may raise the cost ofproduction.

Suitability of Sole Proprietorship Form

From the discussion of the advantages and disadvantages of sole proprietorship above, it isclear that this form of business organization is most suited where:

1. The amount of capital is small2. The nature of business is simple in character requiring quick decisions to be taken3. Direct contact with the customer is essential and4. The size of demand is not very large.

These types of conditions are s atisfied by various types of small business such as retail shops,legal or medical or accounting profession, tailoring, service like dry cleaning or vehicle repairetc. hence sole proprietor form of organization is mostly suitable for these lines of busine sses.This form of organization also suits those individuals who have a strong drive forindependent thinking and highly venturous some in their attitude.

1.4 Joint Hindu Family

Meaning

The Joint Hindu Family, also known as Hindu Undivided Family (HUF) is a non-corporateform of business organization. It is a firm belonging to a Joint Hindu Family. It comes intoexistence by the operations of law and not out of contract.

In Hindu Law, there are two schools of thought viz Dayabhaga which is applicable in Ben galand Assam, and Mitakshara which is applicable in the rest of India. According to Mitaksharaschool, the property of the Joint Hindu Family is inherited by a Hindu Family from his father,grandfather and great grandfather, thus three successive generati ons in male line (son,grandson and great grandson ) can simultaneously inherit the ancestral propriety. They arecalled coparceners in interest and the senior most member of the Family is called karta. The


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Hindu succession act 1956, has extended to the li ne of co-parceners interest to femalerelatives of the deceased co-parcener or male relative climbing through such female relatives.Under the Dayabagha law the male heirs become members only on the death of the father.

Features

Some of the important features of the Joint Hindu Family are as follows

1. The business is generally managed by the father or some other senior member of theFamily he is called the Karta or the manager.

2. Except the Karta, no other member of the family has any right of participation in themanagement of a Joint Hindu Family firm

3. The other members of the family cannot question the authority of the Karta and theironly remedy is to get the family dissolved by mutual agreement.

4. If the Karta has misappropriated the funds of the business, he has to compensate theother co-parceners to the extent of their share in the Joint property of the family

5. For managing the business, the Karta has the power to borrow funds, but the other co -parceners are liable only to the extent of their share in the bus iness. In other words theauthority is limited.

6. The death of any member of the family does not dissolve the business of the family7. Dissolution of the Joint Hindu Family can take place only though mutual agreement

Advantages

1. Stability: The existence of the HUF does not come to an end with the death of any co -parcener, hence there is stability.

2. Knowledge and experience: There is scope for younger members of the family to getthe benefit of the knowledge and experience of the elder members of the family.

3. No Interference: The Karta has full freedom to take decisions without any interferenceby any member of the family.

4. Maximum Interest: As the Karta’s liability is unlimited, he takes maximum interest inrunning the business.

5. Specialization: By assigning work to the members as per their knowledge andexperience, the benefits of specialization and division of work may be secured.

6. Discipline: The firm provides an opportunity to its members to develop the virtues ofdiscipline, self-sacrifice and co-operation.

7. Credit Worthiness: Has more credit worthiness when compared to that of a soleproprietorship.

Disadvantages

1. No Encouragement: As the benefit of hard work of some members is shared by all themembers of the family, there is no encouragement to work hard.

2. Lazy and Inactive: The Karta takes the responsibility to manage the firm. This mayresult in the other members becoming lazy.

3. Members Initiative: The Karta alone has full control over the business and the othermembers cannot interfere with the management of the f irm. This may hampermembers initiative.

4. Duration: The life of the business is shortened if family quarrels take precedence overbusiness interest.


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5. Abuse of Freedom: There is scope for the Karta to misuse his full freedom inmanaging the business for his personal benefit.

Conclusion

This form of business organization which at one time was popular in India is now losing itspopularity. The main cause for its decline is the gradual dissolution of the Joint Hindu Familysystem, it is being replaced by sole pro prietorship or partnership firm.

1.5 Partnership Form of Organization

Generally when a proprietor finds it’s difficult to handle the problems of expansion, he thinksof taking a partner. In other words, once a business grows beyond the capacity of a soleproprietorship and or a Joint Hindu Family, it becomes unarguably necessary to formpartnership. It means that partnership grows out of the limitations of one -man business interms of limited financial resources, limited managerial ability and unlimited ris k. Partnershiprepresents the second stage in the evolution of ownership forms.

In simple words, a Partnership is an association of two or more individuals who agree tocarry on business together for the purpose of earning and sharing of profits. However aformal definition is provided by the Partnership Act of 1932.

Definition

Section 4 of the Partnership Act, 1932 defines Partnership as “the relation between personswho have agreed to share the profits of a business carried on by all or any of them acting forall”

Features of Partnership

1. Simple procedure of formation: the formation of partnership does not involve anycomplicated legal formalities. By an oral or written agreement, a Partnership can becreated. Even the registration of the agreement is not c ompulsory.

2. Capital: The capital of a partnership is contributed by the partners but it is notnecessary that all the partners should contribute equally. Some may become partnerswithout contributing any capital. This happens when such partners have special skills,abilities or experience. The partnership firm can also raise additional funds byborrowing from banks and others.

3. Control: The control is exercised jointly by all the partners. No major decision can betaken without consent of all the partners. Ho wever, in some firms, there may partnersknown as sleeping or dormant partners who do not take an active part in the conductof the business.

4. Management: Every partner has a right to take part in the management of the firm.But generally, the partnership D eed may provide that one or more than one partnerwill look after the management of the affairs of the firm. Sometimes the deed mayprovide for the division of responsibilities among the different partners dependingupon their specialization.

5. Duration of partnership: The duration of the partnership may be fixed or may not befixed by the partners. In case duration is fixed, it is called as “partnership for a fixedterm. When the fixed period is over, the partnership comes to an end.


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6. Unlimited Liability: The liability of each partner in respect of the firm is unlimited. Itis also joint and several and, therefore any one of the partner can be asked to clear thefirm’s debts in case the assets of the firm are inadequate for it.

7. No separate legal entity: The pa rtnership firm has no independent legal existenceapart from that of the persons who constitute it. Partnership is dissolved when anypartner dies or retires. Thus it lacks continuity.

8. Restriction on transfer of share: A partner cannot transfer his share t o an outsiderwithout the consent of all the other partners.

Advantages

1. Ease of formation: partnership can be easily formed without expense and legalformalities. Even the registration of the firm is not compulsory.

2. Large resources: when compared to sole -proprietorship, the partnership will havelarger resources. Hence, the scale of operations can be increased if conditions warrantit.

3. Better organization of business; as the talent, experience, managerial ability andpower of judgment of two or more persons are combined in partnership, there is scopefor a better organisation of business.

4. Greater interest in business: as the partners are the owners of the business and asprofit from the business depends on the efficiency with which they manage, they takeas much interest as possible in business.

5. Prompt decisions: as partners meet very often, they take decisions regarding businesspolicies very promptly. This helps the firm in taking advantage of changing businessconditions.

6. Balance judgement: as partners pos sesses different types of talent necessary forhandling the problems of the firm, the decisions taken jointly by the partners arelikely to be balanced.

7. Flexibility: partnership is free from legal restriction for changing the scope of itsbusiness. The line of business can be changed at any time with the mutual consent ofthe partners. No legal formalities are involved in it.

8. Diffusion of risk; the losses of the firm will be shared by all the partners. Hence, theshare of loss in the case of each partner wi ll be less than that sustained in soleproprietorship.

9. Protection to minority interest: important matters like change in the nature ofbusiness, unanimity among partners is necessary hence, the minority interest isprotected.

10. Influence of unlimited liabili ty: the principle of unlimited liability helps in two ways.First, the partners will be careful in their business dealings because of the fear of theirpersonal properties becoming liable under the principle of unlimited liability.Secondly, it helps the f irm in raising loans for the business as the financers areassured of the realization of loans advanced by them.

Disadvantages

1. Great risk; as the liability is joint and several, any one of the partners can be made topay all the debts of the firm. This aff ects his share capital in the business and hispersonal properties.

2. Lack of harmony: some frictions, misunderstanding and lack of harmony among thepartners may arise at any time which may ultimately lead to the dissolution.


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3. Limited resources: because of t he legal ceiling on the maximum number of partners,there is limit to the amount of capital that can be raised.

4. Tendency to play safe: because of the principle of unlimited liability, the partners tendto play safe and pursue unduly conservative policies.

5. No legal entity: the partnership has no independent existence apart from that of thepersons constituting it, i.e. it is not a legal entity.

6. Instability: the death, retirement or insolvency of a partner leads to the dissolution ofthe partnership. Further even any one partner if dissatisfied with the business, canbring about the dissolution of partnership. Hence partnership lacks continuity

7. Lack of public confidence: no legal regulations are followed at the time of theformation of partnership and also the re is no publicity given to its affairs. Because ofthese reasons, a partnership may not enjoy public confidence.

8. Sustainability: the advantages and drawbacks of partnership stated above indicate thatthe partnership form tends to be useful for relatively small business, such as retailtrade, mercantile houses of moderate size, professional services or small scaleindustries and agency business.

But when compared to sole proprietorship partnership is suitable for a business bigger in sizeand operations.

1.6 Corporations:

Corporations are probably the dominant form of business organization in India. Althoughfewer in number, corporations account for the lion's share of aggregate business receipts inthe Indian economy. A corporation is a legal entity doing b usiness, and is distinct from theindividuals within the entity. Public corporations are owned by shareholders who elect aboard of directors to oversee primary responsibilities. Along with standard, for -profitcorporations, there are charitable, not -for-profit corporations.Corporation is an entity owned by innumerable number of shareholders. There is separationof ownership from management in a corporation. Corporation like an individual citizen paystax – corporation tax or corporate income tax. Corporat ions may be of two types:

(a) Private limited company

(b) Public limited company

A corporation is a private limited company when its shares are issued to the closed set ofpeople like relatives, friends, acquaintances etc and is not sold to the general public.

A corporation is a public limited company when its shares are issued to the general public inthe stock exchanges. Examples of public limited company in India include Maruti, Reliance,TATA Motors etc.

Advantages:

1. Unlimited commercial life. The corporation i s an entity of its own and does notdissolve when ownership changes.

2. Greater flexibility in raising capital through the sale of stock.

3. Ease of transferring ownership by selling stock.


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4. Limited liability. This limited liability is probably the biggest advant age to

organizing as a corporation. Individual owners in corporations have limits on their

personal liability. Even if a corporation is sued for billions of dollars, individual

shareholder's liability is generally limited to the value of their own stock in thecorporation.

Disadvantages:

1. Regulatory restrictions. Corporations are typically more closely monitored by

governmental agencies, including federal, state, and local. Complying withregulations can be costly.

2. Higher organizational and operational costs . Corporations have to file articles of

incorporation with the appropriate state authorities. These legal and clerical

expenses, along with other recurring operational expenses, can contribute tobudgetary challenges.

3. Double taxation. The possibility of do uble taxation arises when companies declare

and pay taxes on the net income of the corporation, which they pay through their

corporate income tax returns. If the corporation also pays out dividends to individual

shareholders, those shareholders must declar e that dividend income as personal

income and pay taxes at the individual income tax rates. Thus, the possibility ofdouble taxation.

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Unit 2

Introduction to First Generation of Financial Commodities

2.1 First Generation of Financial Commodities:

A financial commodity or instrument refers to the vehicle through which individual

investors invest their monetary wealth and the borrower viz. companies raise finances or

funds for their business. The first gen eration of financial commodities are the old ones in the

financial markets. Their examples include bill of exchange, promissory notes, securities and

bonds and debentures, and shares. They are describes one by one in the following sections.First generation of financial commodities is known as negotiable instruments.

A negotiable instrument is a document guaranteeing the payment of a specific amount of

money, either on demand, or at a set t ime. Negotiable instruments are often defined in

legislation. For example, according to the Section 13 of the Negotiable Instruments Act,

1881 in India, a negotiable instrument is a promissory note, bill ofexchange or cheque payable either to order or to bearer.

More precisely, it is a document contemplated by a contract, which (1) warrants the

payment of money, the promise of or order for conveyance of which is unconditional; (2)

specifies or describes the payee, who is designated on and memorialized by the instrument;and (3) is capable of change through transfer by valid negotiation of the instrument.


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Since a negotiable instrument is a promise of a payment of money, the instrument itself can

be used by the holder in due course as a store of value; although instruments can be

transferred for amounts in contractual exchange that are less than the instrument’s facevalue (known as “discounting”).A negotiable instrument can serve to convey value constituting at least part of the

performance of a contract, albeit perhaps not obvious in contract formation, in terms

inherent in and arising from the requisite offer and acceptance and conveyance of

consideration. The underlying contract contemplates the right to hold the instrument as, and

to negotiate the instrument to, a holder in due course , the payment on which is at least part

of the performance of the contract to which the negotiable instrument is linked. The

instrument, memorializing (1) the power to demand payment; and, (2) the right to be paid,

can move, for example, in the instance of a ' bearer instrument', wherein the possession of

the document itself attributes and ascribes the right to payment. Certain exceptions exist,

such as instances of loss or theft of the ins trument, wherein the possessor of the note may be

a holder, but not necessarily a holder in due course. Negotiation requires a

valid endorsement of the negotiable instrument. The consideration constituted by a

negotiable instrument is cognizable as the val ue given up to acquire it (benefit) and the

consequent loss of value (detriment) to the prior holder; thus, no separate consideration is

required to support an accompanying contract assignment. The instrument itself is

understood as memorializing the right for, and power to demand, payment, and an

obligation for payment evidenced by the instrument itself with possession as a holder in due

course being the touchstone for the right to, and power to demand, payment. In some

instances, the negotiable instrument can serve as the writing memorializing a contract, thussatisfying any applicable Statute of Frauds as to that contract.

2.2 Bill of exchange

A bill of exchange or "draft" is a written order by the drawer to the drawee to pay money tothe payee. A common type of bill of exchange is the cheque, defined as a bill of exchangedrawn on a banker and payable on demand. Bills of exchange are us ed primarily ininternational trade, and are written orders by one person to his bank to pay the bearer aspecific sum on a specific date. Prior to the advent of paper currency, bills of exchange werea common means of exchange. They are not used as often today.

A bill of exchange is essentially an order made by one person to another to pay money to athird person. A bill of exchange requires in its inception three parties —the drawer, thedrawee, and the payee. The person who draws the bill is called the dr awer. He gives the orderto pay money to the third party. The party upon whom the bill is drawn is called the drawee.He is the person to whom the bill is addressed and who is ordered to pay. He becomes anacceptor when he indicates his willingness to pay the bill. The party in whose favour the billis drawn or is payable is called the payee. The parties need not all be distinct persons. Thus,the drawer may draw on himself payable to his own order.

A bill of exchange may be endorsed by the payee in favour of a third party, who may in turnendorse it to a fourth, and so on indefinitely. The "holder in due course" may claim theamount of the bill against the drawee and all previous endorsers, regardless of any


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counterclaims that may have disabled the previous payee or endorser from doing so. This iswhat is meant by saying that a bill is negotiable.

In some cases a bill is marked "not negotiable" – see crossing of cheques. In that case it canstill be transferred to a third party, but the third party can have no better right than thetransferor.

2.3 Promissory Notes

A promissory note is an unconditional promise in writing made by one person to another,signed by the maker, engaging to pay on demand to the payee, or at fixed or determinablefuture time, certain in money, to order or to bearer. Bank note is frequently referred to as apromissory note, a promissory note made by a bank and payable to bearer on demand.

2.4 Securities and Bonds and Debentures

The term security was originally used to describe financial instruments secured by physicalassets. Now countries have adopted the term as a synonym for the term financialinstrument. Securities are broadly categorized into:

debt securities (such as banknotes, bonds and debentures), equity securities, e.g., common stocks; and, derivative contracts, such as forwards, futures, options and swaps.

The company or other entity issuing the security is called the issuer. A country's regulatorystructure determines what qualifies as a security. For example, private investment pools mayhave some features of securities, but they may not be registered or regulated as such if theymeet various restrictions.

Securities may be represented by a certificate or, more typically, "no n-certificated", that is inelectronic or "book entry" only form. Certificates may be bearer, meaning they entitle theholder to rights under the security merely by holding the security, or registered, meaning theyentitle the holder to rights only if he a ppears on a security register maintained by the issuer oran intermediary. They include shares of corporate stock or mutual funds, bonds issued bycorporations or governmental agencies, stock options or other options, limited partnershipunits, and various other formal investment instruments that are negotiable and fungible.

Bonds

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is adebt security, under which the issuer owes the holders a debt and, depending on the terms ofthe bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a laterdate, termed the maturity. Interest is usually payable at fixed intervals (semi -annual, annual,sometimes monthly). Very often the bond is negotiable, i.e. the ownership of the instrumentcan be transferred in the secondary market.

Thus a bond is a form of loan or IOU: the holder of the bond is the lender (creditor),the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds providethe borrower with external funds to finance long -term investments, or, in the caseof government bonds, to finance current expenditure. Certificates of deposit (CDs) or shortterm commercial paper are considered to be money market instruments and not bonds: themain difference is in the length of the term of the instru ment.

Bonds and stocks are both securities, but the major difference between the two is that(capital) stockholders have an equity stake in the company (i.e. they are owners), whereasbondholders have a creditor stake in the company (i.e. they are lenders). Another difference i s


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that bonds usually have a defined term, or maturity, after which the bond is redeemed,whereas stocks may be outstanding indefinitely. An exception is an irredeemable bond, suchas Consols, which is perpetuity, i.e. a bond with no maturity.

Features of Bond:

(a) Principal

Nominal, principal, par or face amount — the amount on which the issuer pays interest, andwhich, most commonly, has to be repaid at the end of the term. Some structured bonds canhave a redemption amount which is different from the face amount and can be linked toperformance of particular assets such as a stock or commodity index, foreign exchange rateor a fund. This can result in an investor receiving less or more than his original investment atmaturity.

(b) Maturity

The issuer has to repay the nominal amount on the maturity date. As long as all due paymentshave been made, the issuer has no further obligations to the bond holders after the maturitydate. The length of time until the maturity date is often referred to as the term or tenor ormaturity of a bond. The maturi ty can be any length of time, although debt securities with aterm of less than one year are generally designated money market instruments rather thanbonds. Most bonds have a term of up to 30 years. Some bonds have been issued with terms of50 years or more, and historically there have been some issues with no maturity date(irredeemable).

(c) Coupon

The coupon is the interest rate that the issuer pays to the bond holders. Usually t his rate isfixed throughout the life of the bond. It can also vary with a money market index, suchas LIBOR, or it can be even more exotic. The name "coupon" arose because in the past, paperbond certificates were issued with coupons attached to them, one for each interest payment.On the due dates the bondholder would hand in the coupon to a bank in exchange for theinterest payment. Interest can be paid at different frequencies: generally semi -annual, i.e.every 6 months, or annual.

(d) Yield

The yield is the rate of return received from investing in the bond. It usually refers either tothe current yield, or running yield, which is simply the annual interest payment divided by thecurrent market price of the bond (often the clean price), or to the yield tomaturity or redemption yield, which is a more useful measure of the return of the bond,taking into account the current market pr ice, and the amount and timing of all remainingcoupon payments and of the repayment due on maturity. It is equivalent to the internal rate ofreturn of a bond.

(e) Credit Quality

The "quality" of the issue refers to the probability that the bondholders will receive theamounts promised at the due dates. This will depend on a wide range of factors. High-yieldbonds are bonds that are rated below investment grade by the credit rating agencies. As thesebonds are more risky than investment grade b onds, investors expect to earn a higher yield.These bonds are also called junk bonds.

(f) Market Price

The market price of a tradable bond will be influenced amongst other things by the amounts,currency and timing of the interest payments and capital repayme nt due, the quality of the


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bond, and the available redemption yield of other comparable bonds which can be traded inthe markets.

The price can be quoted as clean or dirty. ("Clean" refers to the actual price to be paid;"Dirty" includes an adjustment for accrued interest.)

The issue price at which investors buy the bonds when they are first issued will typicall y beapproximately equal to the nominal amount. The net proceeds that the issuer receives are thusthe issue price, less issuance fees. The market price of the bond will vary over its life: it maytrade at a premium (above par, usually because market inter est rates have fallen since issue),or at a discount (price below par, if market rates have risen or there is a high probability ofdefault on the bonds.

(g) Others

Indentures and Covenants — An indenture is a formal debt agreement that establishes theterms of a bond issue, while covenants are the clauses of such an agreement. Covenantsspecify the rights of bondholders and the duties of issuers, such as actions that the issuer isobligated to perform or is prohibited from performing. The terms may be changed only withgreat difficulty while the bonds are outstanding, with amendments to the governing documentgenerally requiring approval by a majority (or super-majority) vote of the bondholders.

Optionality: Occasionally a bond may contain an embedded option; that is, it grants option-like features to the holder or the issuer:

Callability — Some bonds give the issuer the right to repay t he bond before the maturity date

on the call dates; see call option. These bonds are referred to as callable bonds. Most callable

bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a

premium, the so-called call premium. This is mainly the case for high -yield bonds. These

have very strict covenants, restricting the issuer in its operations. To be free from these

covenants, the issuer can repay the bonds early, but only at a high cost.

Putability — Some bonds give the holder the right to force the issuer to repay the bond before

the maturity date on the put dates. These are referred to as retractable or putable bonds.

Call dates and put dates—the dates on which callable and putable bonds can be redeemed

early. There are four main categories.

Sinking fund provision of the corporate bond indenture requires a certain portion of the issueto be retired periodically. The entire bond issue can be liquidated by the maturity date. If thatis not the case, then the remainder is called bal loon maturity. Issuers may either pay totrustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchasebonds in open market, then return them to trustees.

Types of Bonds:

The following descriptions are not mutually exclusi ve, and more than one of them may applyto a particular bond.


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Fixed rate bonds have a coupon that remains constant throughout the life of the bond. Avariation are stepped-coupon bonds, whose coupon increases during the life of the bond.

Floating rate notes (FRNs, floaters) have a variable coupon that is linked to a referencerate of interest, such as LIBOR or Euribor. For example the coupon may be defined as threemonth USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically everyone or three months.

Zero-coupon bonds (zeros) pay no regular interest. They are issued at a substantial discountto par value, so that the interest is effectively rolled up to maturity (and usually taxed assuch). The bondholder receives the full principal amount on the redemption date. An exampleof zero coupon bonds is Series E savings bonds issued by the U.S. government. Zero-couponbonds may be created from fixed rate bonds by a financial institution separating ("strippingoff") the coupons from the principal. In other words, the separated coupons and the finalprincipal payment of the bond may be traded separately. See IO (Interest Only) and PO(Principal Only).

High-yield bonds (junk bonds) are bonds that are rated below investment grade by the creditrating agencies. As these bonds are more risky than investment grade bonds, investors expectto earn a higher yield.

Convertible bonds lets a bondholder exchange a bond to a number of shares of the issuer'scommon stock.

Exchangeable bonds allows for exchange to shares of a corporation other than the issuer.

Inflation linked bonds (linkers), in which the principal amount and the interest payments areindexed to inflation. The interest rate is normally lower than for fixed rate bonds with acomparable maturity (this position briefly reversed itself for short -term UK bonds inDecember 2008). However, as the principal amount grows, the payments increase withinflation. The United Kingdom was the first sovereign issuer to issue inflation linked Gilts inthe 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples ofinflation linked bonds issued by the U.S. government.

Other indexed bonds, for example equity-linked notes and bonds indexed on a businessindicator (income, added value) or on a country's GDP.

Asset-backed securities are bonds whose interest and principal payments are backed byunderlying cash flows from other assets. Examples of asset -backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralizeddebt obligations (CDOs).

Subordinated bonds are those that have a lower priority than other bonds of the issuer in caseof liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator ispaid, then government taxes, etc. The first bond holders in line to be paid ar e those holdingwhat is called senior bonds. After they have been paid, the subordinated bond holders arepaid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower creditrating than senior bonds. The main examples of subord inated bonds can be found in bondsissued by banks, and asset -backed securities. The latter are often issued in tranches. Thesenior tranches get paid back first, the subordinated tranches later.


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Covered bond are backed by cash flows from mortgages or public sector assets. Contraryto asset-backed securities the assets for such bonds remain on the issuers’ balance sheet.

Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date. Themost famous of these are the UK Consols, which are also known as Treasury Annuities orUndated Treasuries. Some of these were issued back in 1888 and still trade today, althoughthe amounts are now insignificant. Some ultra -long-term bonds (sometimes a bond can lastcenturies: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century) arevirtually perpetuities from a financial point of view, with the current value of principal nearzero.

Bearer bond is an official certificate issued without a named holder. In other words, theperson who has the paper certificate can claim th e value of the bond. Often they areregistered by a number to prevent counterfeiting, but may be traded like cash. Bearer bondsare very risky because they can be lost or stolen. Especially after federal income tax began inthe United States, bearer bonds were seen as an opportunity to conceal income or assets. U.S.corporations stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982,and state and local tax-exempt bearer bonds were prohibited in 1983.

Registered bond is a bond whose o wnership (and any subsequent purchaser) is recorded bythe issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, andthe principal upon maturity, are sent to the registered owner.

Treasury bond, also called government bond, is issued by the Federal government and is notexposed to default risk. It is characterized as the safest bond, with the lowest interest rate. Atreasury bond is backed by the “full faith and credit” of the federal government. For thatreason, this type of bond is often referred to as risk -free.

Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or theiragencies. Interest income received by holders of municipal bonds is often exempt from thefederal income tax and from the income tax of the state in which they are issued, althoughmunicipal bonds issued for certain purposes may not be tax exempt.

Book-entry bond is a bond that does not have a paper certificate. As physically processingpaper bonds and interest coupons became more expensive, issuers (and banks that used tocollect coupon interest for depositors) have tried to discourage their use. Some book-entrybond issues do not offer the option of a paper certificate, even to investors who prefer them.

Lottery bond is a bond issued by a state, usually a European state. Interest is paid like atraditional fixed rate bond, but the issuer will redeem randomly selected individual bondswithin the issue according to a schedule. Some of these redemptions will be for a highervalue than the face value of the bond.

War bond is a bond issued by a country to fund a war.

Serial bond is a bond that matures in installments over a period of time. In effect, a $100,000,5-year serial bond would mature in a $20,000 annuity over a 5 -year interval.

Revenue bond is a special type of municipal bond distinguished by its guarantee ofrepayment solely from revenues generated by a specified revenue -generating entity


15

associated with the purpose of the bonds. Revenue bonds are typically "non -recourse,"meaning that in the event of default, the bond holder has no recourse to other gover nmentalassets or revenues.

Climate bond is a bond issued by a government or corporate entity in order to raise financefor climate change mitigation or adaptation related projects or programs.

Debentures:

A debenture is a document that either creates a debt or acknowledges it, and it is a debtwithout collateral. In corporate finance, the term is used for a medium- to long-termdebt instrument used by large companies to borrow money. In some countries the term isused interchangeably with bond, loan stock or note. A debenture is thus like a certificate ofloan or a loan bond evidencing the fact that the company is liable to pay a specified amountwith interest and although the mo ney raised by the debentures becomes a part of thecompany's capital structure, it does not become share capital.[1] Senior debentures get paidbefore subordinate debentures, and there are varying rates of risk and payoff for thesecategories.

Debentures are generally freely transferable by the debenture holder. Debenture holders haveno rights to vote in the company's general meetings of shareholders, but they may haveseparate meetings or votes e.g. on c hanges to the rights attached to the debentures. Theinterest paid to them is a charge against profit in the company's financial statements.

There are two types of debentures:

1. Convertible debentures, which are convertible bonds or bonds that can be convertedinto equity shares of the issuing company after a predetermined period of tim e."Convertibility" is a feature that corporations may add to the bonds they issue tomake them more attractive to buyers. In other words, it is a special feature that acorporate bond may carry. As a result of the advantage a buyer gets from the abilityto convert, convertible bonds typically have lower interest rates than non -convertiblecorporate bonds.

2. Non-convertible debentures, which are simply regular debentures, cannot beconverted into equity shares of the liable company. They are debentures withou t theconvertibility feature attached to them. As a result, they usually carry higher interestrates than their convertible counterparts.

2.5 Shares or Stocks or Equities

An equity security is a share of equity interest in an entity such as the capital st ock of acompany, trust or partnership. The most common form of equity interest is common stock,although preferred equity is also a form of capital stock. The holder of equity is ashareholder, owning a share, or fractional part of the issuer. Unlike debt securities, whichtypically require regular payments (interest) to the holder, equity securities are not entitled toany payment. In bankruptcy, they share only in the residual interest of the issuer after allobligations have been paid out to creditors. However, equity generally entitles the holder to apro rata portion of control of the company, meaning that a holder of a majority of the equityis usually entitled to control the issuer. Equity also enjoys the right to profits and capital gain,whereas holders of debt securities receive only interest and repayment of principal regardlessof how well the issuer performs financially. Furthermore, debt securities do not have voting


16

rights outside of bankruptcy. In other words, equity holders are entitled to the "upside" of thebusiness and to control the business.

The stock of a corporation is partitioned into shares, the total of which are stated at the timeof business formation. Additional shares may subse quently be authorized by the existingshareholders and issued by the company. In some jurisdictions, each share of stock has acertain declared par value, which is a nominal accounting v alue used to represent the equityon the balance sheet of the corporation. In other jurisdictions, however, shares of stock maybe issued without associated par value.

Shares represent a fraction of ownership in a business. A business may declare different types(classes) of shares, each having distinctive ownership rules, privileges, or share values.Ownership of shares may be documented by issuance of a stock certificate. A stockcertificate is a legal document that specifies the amount of shares owned by the shareholder,and other specifics of the shares, such as the par value, if any, or the class of the shares.

Types of Stocks:

Stock typically takes the form of shares of either common stock or preferred stock. As a unitof ownership, common stock typically carries voting rights that can be exercised in corporatedecisions. Preferred stock differs from common stock in that it typically does not carry vo tingrights but is legally entitled to receive a certain level of dividend payments before anydividends can be issued to other shareholders. [3][4] Convertible preferred stock is preferredstock that includes an option for the holder to convert the preferred shares into a fixednumber of common shares, usually any time after a predetermined date. Shares of such stockare called "convertible preferred shares" (or "convertible preference shares" in th e UK).

New equity issue may have specific legal clauses attached that differentiate them fromprevious issues of the issuer. Some shares of common stock may be issued witho ut the typicalvoting rights, for instance, or some shares may have special rights unique to them and issuedonly to certain parties. Often, new issues that have not been registered with a securitiesgoverning body may be restricted from resale for certain periods of time.

Preferred stock may be hybrid by having the qualities of bonds of fixed returns and commonstock voting rights. They also have preference in the payment o f dividends over commonstock and also have been given preference at the time of liquidation over common stock.They have other features of accumulation in dividend. In addition, preferred stock usuallycomes with a letter designation at the end of the sec urity; for example, Berkshire -HathawayClass "B" shares sell under stock ticker BRK.B, whereas Class "A" shares of ORION DHC,Inc will sell under ticker OODHA until the company drops the "A" creating ticker OODH forits "Common" shares only designation. Th is extra letter does not mean that any exclusiverights exist for the shareholders but it does let investors know that the shares are consideredfor such, however, these rights or privileges may change based on the decisions made by theunderlying company.

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Unit 3

Transaction Price of a Negotiable Instrument

3.1 Transaction price of a negotiable instrument can best be understood in terms of time valueof money which states that a rupee today w orth more than a rupee tomorrow. The time valueof money is the value of money figuring in a given amount of interest earned over a givenamount of time. The time value of money is the c entral concept in finance theory.


17

For example, $100 of today's money invested for one year and earning 5% interest will beworth $105 after one year. Therefore, $100 paid now or $105 paid exactly one year from nowboth have the same value to the recipient who assumes 5% interest; using time value ofmoney terminology, $100 invested for one year at 5% interest has a future value of $105.The method also allows the valuation of a likely stream of income in the future, in such a waythat the annual incomes are discounted and then added together, thus providing a lump -sum"present value" of the entire income stream.

All of the standard calculations for time value of money derive from the most basic algebraicexpression for the present value of a future sum, "discounted" to the present by an amountequal to the time value of money. For example, a sum of FV to be received in one year isdiscounted (at the rate of interest r) to give a sum of PV at present: PV = FV − r·PV =FV/(1+r).

Some standard calculations based on the time value of money are:

Present value: The current worth of a future sum of money or stream of cash flows given a

specified rate of return. Future cash flows are discounted at the discount rate, and t he higher

the discount rate, the lower the present value of the future cash flows. Determining the

appropriate discount rate is the key to properly valuing future cash flows, whether they are

earnings or obligations.

Present value of an annuity: An annuity is a series of equal payments or receipts that occur at

evenly spaced intervals. Leases and rental payments are examples. The payments or receipts

occur at the end of each period for an ordinary annuity while they occur at the beginning of

each period for an annuity due.

Present value of a perpetuity is an infinite and constant stream of identical cash flows.

Future value is the value of an asset or cash at a specified date in the future that is equivalent

in value to a specified sum today.

Future value of an annuity (FVA) is the future value of a stream of payments (annuity),

assuming the payments are invested at a given rate of interest.

3.2 Present value of a future sum

The present value formula is the core formula for the time value of money; each of the o therformulae is derived from this formula. For example, the annuity formula is the sum of a seriesof present value calculations.

The present value (PV) formula has four variables, each of which can be solved for:

1. PV is the value at time=02. FV is the value at time=n3. i is the discount rate, or the interest rate at which the amount will be compounded

each period4. n is the number of periods (not necessarily an integer)


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The cumulative present value of future cash flows can be calculated by summing thecontributions of FVt, the value of cash flow at time t

Note that this series can be summed for a given value of n, or when n is ∞.[7] This is avery general formula, which leads to several important special cases given below.

Present value of an annuity for n payment periods

In this case the cash flow values remain the same throughout the n periods. The present valueof an annuity (PVA) formula has four variables, each of which can be solved for:

1. PV(A) is the value of the annuity at time=02. A is the value of the individual payments in each compounding period3. i equals the interest rate that would be compounded for each period of

time4. n is the number of payment periods.

To get the PV of an annuity due, multiply the above equation by (1 + i).

3.3 Present value of a growing annuity

In this case each cash flow grows by a factor of (1+g). Similar to the formula for an annuity,the present value of a growing a nnuity (PVGA) uses the same variables with the additionof g as the rate of growth of the annuity (A is the annuity payment in the first period). This isa calculation that is rarely provided for on financial calculators.

Where i ≠ g :

To get the PV of a growing annuity due, multiply the above equation by (1+ i).

Where i = g :

Present value of a perpetuity

When n → ∞, the PV of a perpetuity (a perpetual annuity) formula becomes simple division.

3.4 Present Value of Int Factor Annuity

A=P(1+r/n)^nt

Investment = 1000 Int 6.90% Compounded Qtrly (4 Times in Year) Tenure Yrs 5


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= 1000*(1+.069/4)^(5 yrs*4 qtrs in a year ) = 1000*(1+0.069/4)^20 = 1407.842172

3.5 Present value of a growing perpetuity

When the perpetual annuity payment grows at a fixed rate (g ) the value is theoreticallydetermined according to the following formula. In practice, there are few securities withprecise characteristics, and the application of this valuation approach is subject to variousqualifications and modifications. Most impo rtantly, it is rare to find a growing perpetualannuity with fixed rates of growth and true perpetual cash flow generation. Despite thesequalifications, the general approach may be used in valuations of real estate, equities, andother assets.

This is the well known Gordon Growth model used for stock valuation.

3.6 Future value of a present sum

The future value (FV) formula is similar and uses the same variable s.

3.7 Future value of an annuity

The future value of an annuity (FVA) formula has four variables, each of which can besolved for:

1. FV(A) is the value of the annuity at time = n2. A is the value of the individual payments in each compounding period3. i is the interest rate that would be compounded for each period of time4. n is the number of payment periods

3.8 Future value of a growing annuity

The future value of a growing annuity (FVA) formula has five variables, each of which canbe solved for:

Where i ≠ g :

Where i = g :

1. FV(A) is the value of the annuity at time = n2. A is the value of initial payment paid at time 13. i is the interest rate that would be compounded for each period of time4. g is the growing rate that would be compounded for each period of time


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5. n is the number of payment periods

3.9 Derivations

Annuity derivation

The formula for the present value of a regular stream of future payments (an annuity) isderived from a sum of the formula for f uture value of a single future payment, as below,where C is the payment amount and n the period.

A single payment C at future time m has the following future value at future time n:

Summing over all payments from time 1 to time n, then reversing the order of terms andsubstituting k = n - m:

Note that this is a geometric series, with the initial value being a = C, the multiplicative factorbeing 1 + i, with n terms. Applying the formula for ge ometric series, we get

The present value of the annuity (PVA) is obtained by simply dividing by :

Another simple and intuitive way to derive the future value of an annuity is to consider anendowment, whose interest is paid as the annuity, and whose principal remains constant. Theprincipal of this hypothetical endowment can be computed as that whose interest equals theannuity payment amount:

+ goal

Note that no money enters or leaves the combined system of endowment principal +accumulated annuity payments, and thus the future value of this system can be computedsimply via the future value formula:

Initially, before any payments, the present value of the system is just the endowment

principal ( ). At the end, the future value is the endowment principal (which is

the same) plus the future value of the total annuity payments ( ).Plugging this back into the equation:


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Perpetuity derivation

Without showing the formal derivation here, the perpetuity formula is derived from theannuity formula. Specifically, the term:

can be seen to approach the value of 1 as n grows larger. At

infinity, it is equal to 1, leaving as the only term remaining.Examples

Example 1: Present value

One hundred euros to be paid 1 year from now, where the expected rate of return is 5% peryear, is worth in today's money:

So the present value of €100 one year from now at 5% is €95.24.

Example 2: Present value of an annuity — solving for the payment amount

Consider a 10 year mortgage where the principal amount P is $200,000 and the annualinterest rate is 6%.

The number of monthly payments is

and the monthly interest rate is

The annuity formula for (A/P) calculates the monthly payment:

This is considering an interest rate compoun ding monthly. If the interest were only tocompound yearly at 6%, the monthly payment would be significantly different.

Example 3: Solving for the period needed to double money

Consider a deposit of $100 placed at 10% (annual). How many years are needed fo r the valueof the deposit to double to $200?

Using the algrebraic identity that if:

then


22

The present value formula can be rearranged such that:

(years)

This same method can be used to determine the length of time needed to increase a deposit toany particular sum, as long as the interest rate is known. For the period of time needed todouble an investment, the Rule of 72 is a useful shortcut that gives a reasonableapproximation of the period needed.

Example 4: What return is needed to double money?

Similarly, the present value formula can be rearranged to determine what rate of return isneeded to accumulate a given amount from an investment. For example, $100 is investedtoday and $200 return is expected in five years; what rate of return (interest rate) does t hisrepresent?

The present value formula restated in terms of the interest rate is:

see also Rule of 72

Example 5: Calculate the value of a regular savings deposit in the future.

To calculate the future value of a stream of savings deposit in the future requires two steps,or, alternatively, combining the two steps into one large formula. First, calculate the presentvalue of a stream of deposits of $1,000 every year for 20 years earning 7% interest:

This does not sound like very much, but remember - this is future money discounted back toits value today; it is understandably lower. To calculate the future value (at the end of thetwenty-year period):

These steps can be combined into a single formula:

Example 6: Price/earnings (P/E) ratio

It is often mentioned that perpetuities, or securities with an indefinitely long maturity, are rareor unrealistic, and particularly those with a growing payment. In fact, many types of assetshave characteristics that are similar to perpetui ties. Examples might include income -orientedreal estate, preferred shares, and even most forms of publicly -traded stocks. Frequently, theterminology may be slightly different, but are based on the fundamentals of time value ofmoney calculations. The app lication of this methodology is subject to various qualificationsor modifications, such as the Gordon growth model.


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For example, stocks are commonly noted as trading at a certain P/E ratio. The P/E ratio iseasily recognized as a variation on the perpetuity or growing perpetuity formulae - save thatthe P/E ratio is usually cited as the inverse of the "rate" in the perpetuity formula.

If we substitute for the time being: the price of the stock for the present value; the earningsper share of the stock for the cash annuity; and, the discount rate of the stock for the interestrate, we can see that:

And in fact, the P/E ratio is analogous to the inverse of the inte rest rate (or discount rate).

Of course, stocks may have increasing earnings. The formulation above does not allow forgrowth in earnings, but to incorporate growth, the formula can be restated as follows:

If we wish to determine the implied rate of growth (if we are given th e discount rate), we maysolve for g:

3.10 Continuous compounding

Rates are sometimes converted into the continuous compound interest rate equivalent becausethe continuous equivalent is more convenient (for example, more easily differentiated). Eachof the formulæ above may be restated in their continuous equivalents. For example, thepresent value at time 0 of a future payment at time t can be restated in the following way,where e is the base of the natural logarithm and r is the continuously compounded rate:

This can be generalized to discount rates that vary over time: instead of a constant discountrate r, one uses a function of time r(t). In that case the discount factor, and thus the presentvalue, of a cash flow at time T is given by theintegral of the continuously compoundedrate r(t):

Indeed, a key reason for using continuous compounding is to simplify the analysis of varyingdiscount rates and to allow one to use the tools of calculus. Further, for interest accrued andcapitalized overnight (hence compounded daily), continuous compounding is a closeapproximation for the actual daily compounding. More sophisticated analysis includes the useof differential equations, as detailed below.

Examples

Using continuous compounding yields the following formulas for various instruments:


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Annuity

Perpetuity

Growing annuity

Growing perpetuity

Annuity with continuous payments

These formulas assume that pa yment A is made in the first payment period and annuity endsat time t.

3.11 Differential equations

Ordinary and partial differential equations (ODEs and PDEs) – equations involvingderivatives and one (respectively, multiple) variables are ubiquitous in more advancedtreatments of financial mathematics. While time value of money can be understood withoutusing the framework of differential equations, the added sophistication sheds additional lighton time value, and provides a simple introduction before considering more complicated andless familiar situations.

The fundamental change that the differential equation perspective brings is that, rather thancomputing a number (the present value now), one computes a function (the present value nowor at any point in future). This function may then be analyzed – how does its value changeover time – or compared with other functions.

Formally, the statement that "value decreases over time" is given by defining the lineardifferential operator as:

This states that values decreas es (−) over time (∂ t) at the discount rate (r(t)). Applied to afunction it yields:

For an instrument whose payment stream is described by f(t), the value V(t) satisfiesthe inhomogeneous first-order ODE ("inhomogeneous" is because one has f ratherthan 0, and "first-order" is because one has first derivatives but no higher derivatives) – thisencodes the fact that when any cash flow occurs, the value of the instrument changes by thevalue of the cash flow (if you receive a $10 coupon, the remaining value decreases by exactly$10).

The standard technique tool in the analysis of ODEs is the use of Green's functions, fromwhich other solutions can be built. In terms of time value of money, the Green's function (for


25

the time value ODE) is the value of a bond paying $1 at a single point in time u – the value ofany other stream of cash flows can then be obtained by taking combinations of this basic cashflow. In mathematical terms, this instantaneous cash flow is modeled as a delta

function

The Green's function for the value at time t of a $1 cash flow at time u is

where H is the Heaviside step function – the notation " " is to emphasize that u isa parameter (fixed in any instance – the time when the cash flow will occur), while t isa variable (time). In other words, future cash flows are exponentially discounted (exp) by the

sum (integral, ) of the future discount rates ( for future, r(v) for discount rates), while

past cash flows are worth 0 ( ), because they havealready occurred. Note that the value at the moment of a cash flow is not well -defined – thereis a discontinuity at that point, and one can use a convention (assume cash flows have alreadyoccurred, or not already occurred), or simply not define the value at that point.

In case the discount rate is constant, this simplifies to

where is "time remaining until cash flow".

Thus for a stream of cash flows f(u) ending by time T (which can be set to for no

time horizon) the value at time t, is given by combining the values of theseindividual cash flows:

This formalizes time value of money to future values of cash flows with varying discountrates, and is the basis of many formulas in financial mathematics, su ch as the Black–Scholesformula with varying interest rates.

3.12 Discount rate

The discount rate which is used in financial calculations is usually chosen to be equal tothe Cost of Capital. The Cost of Capital, in a financial market equilibrium, will be the sameas the Market Rate of Return on the financial asset mixture the firm uses to finance capitalinvestment. Some adjustment may be made to the discount rate to take account of risksassociated with uncertain cash flows, with other developments.

The discount rates typically applied to different types of c ompanies show significantdifferences:

Startups seeking money: 50 – 100% Early Startups: 40 – 60% Late Startups: 30 – 50% Mature Companies: 10 – 25%


26

The higher discount rate for startups reflects the various disadvantages they face, compared toestablished companies:

Reduced marketability of ownerships because stocks are not traded publicly. Limited number of investors willing to invest. Startups face high risks. Over optimistic forecasts by enthusiastic founders.

One method that looks into a correct discou nt rate is the capital asset pricing model . Thismodel takes in account three variables that make up the discount rate:

1. Risk Free Rate: The percentage of return generated by investing in risk free securities suchas government bonds.

2. Beta: The measurement of how a company’s stock price reacts to a change in the market.A beta higher than 1 means that a change in share price is exaggerated compared to the rest ofshares in the same market. A beta less than 1 means that the share is stable and not veryresponsive to changes in the market. Less than 0 means that a share is moving in the oppositeof the market change.

3. Equity Market Risk Premium : The return on investment that investors require above therisk free rate.

Discount rate= risk free rate + beta*(equity market risk premium)

3.13 Discount factor

The discount factor, DF (T), is the factor by which a future cash flow must be multiplied inorder to obtain the present value. For a zero -rate (also called spot rate) , taken from a yieldcurve, and a time to cash flow (in years), the discount factor is:

In the case where the only discount rate you have is not a zero -rate (neither taken froma zero-coupon bond nor converted from a swap rate to a zero-rate through bootstrapping) butan annually-compounded rate (for example if your benchmark is a US Treasury bond withannual coupons and you only have its yield to maturity, you would use an annually-compounded discount factor:

However, when operating in a bank, where the amount the bank can lend (and therefore getinterest) is linked to the va lue of its assets (including accrued interest), traders usually usedaily compounding to discount cash flows . Indeed, even if the interest of the bonds it holds(for example) is paid semi-annually, the value of its book of bond will increase daily, thanksto accrued interest being accounted for, and therefore the bank will be able to re -invest thesedaily accrued interest (by lending additional money or buying more financial products). Inthat case, the discount factor is then (if the usual money market day count convention for thecurrency is ACT/360, in case of currencies such as USD, EUR, JPY), with the zero-rateand the time to cash flow in years:


27

or, in case the market convention for the currency being discounted is ACT/365 (AUD, CAD,GBP):

Sometimes, for manual calculation, the continuously -compounded hypothesis is a close -enough approximation of the daily -compounding hypothesis, and makes calculation easier(even though it does not have any real application as no financial instrument is continuouslycompounded). In that case, the discount factor is:

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Unit 4

Pricing of Securities in Capital Markets

4.1 Estimating return and risk of an individual security

When we refer to return to a security we generally mean the expected retu rn from thesecurity. This is different from the actual return. Expected return of a security refers to thereturn which is expected at some future point of time. The future is uncertain. Investors donot know with certainty whether the economy will be gro wing rapidly or be in recession.Investors do not know what rate of return their investments will yield. Therefore, they basetheir decisions on their expectations concerning the future. The expected rate of return on astock represents the mean of a proba bility distribution of possible future returns on the stock.

The table below provides a probability distribution for the returns on stocks A and B

State Probability Return On Return On

Stock A Stock B

1 20% 5% 50%

2 30% 10% 30%

3 30% 15% 10%

4 20% 20% -10%

The state represents the state of the economy one period in the future i.e. state 1 couldrepresent a recession and state 2 a growth economy.

The probability reflects how likely it is that the state will occur. The sum of the probabilitiesmust equal 100%.

The last two columns present the returns or outcomes for stocks A and B that will occur ineach of the four states.


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Given a probability distribution of returns, the expected return can be calculated using thefollowing equation:

N

E[R] = Σ(piRi) i=1

where E[R] = the expected return on the stock, N = the number of states, p i = the probabilityof state I, and R i = the return on the stock in state i.

In this example, the expected return for stock A would be cal culated as follows:

E[R]A = .2(5%) + .3(10%) + .3(15%) + .2(20%) = 12.5%

E[R]B = .2(50%) + .3(30%) + .3(10%) + .2( -10%) = 20%

So we see that Stock B offers a higher expected return than Stock A.

However, that is only part of the story; we haven't considere d risk.

Risk reflects the chance that the actual return on an investment may be different than theexpected return. One way to measure risk is to calculate the variance and standard deviationof the distribution of returns. We will once again use a probabi lity distribution in ourcalculations. The distribution used earlier is provided again for ease of use.

Probability Distribution:

State Probability Return On Return On

Stock A Stock B

1 20% 5% 50% 2 30% 10% 30% 3 30% 15% 10% 4 20% 20% -10%

E[R]A = 12.5%

E[R]B = 20%

Given an asset's expected return, its variance can be calculated using the following equation:

N

Var (R) = σ2 = Σpi[Ri – E(R)]2

i=1

where N = the number of states, p i = the probability of state i, R i = the return on the stock instate i, and E[R] = the expected return on the stock.

The standard deviation is calculated as the positive square root of the variance:


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SD (R) = σ = σ 2 = (σ 2)1/2 = (σ 2)0.5

The variance and standard deviation for stock A is calculated as follows:

The variance and standard deviation for stock A is calculated as follows:

σ2A = .2(.05 -.125)2 + .3(.1 -.125)2 + .3(.15 -.125)2 + .2(.2 -.125)2 = .002625

σA = (.002625)0.5 = .0512 = 5.12%

Now you try the variance and standard deviation for stock B. If you got .042 and 20.49% youare correct.

Although Stock B offers a higher expected return than Stock A, it also is riskier since itsvariance and standard deviation are greater than Stock A's.

This, however, is still only part of the picture because most investors choose to holdsecurities as part of a diversified portfolio.

4.2 Estimating Portfolio Return and Risk

Most investors do not hold stocks in isolation. Instead, they choose to hold a portfolio ofseveral stocks. When this is the case, a portion of an individual stock's risk can be eliminated,i.e., diversified away. From our previous calculations, we know that:

the expected return on Stock A is 12.5%

the expected return on Stock B is 20%

the variance on Stock A is .00263

the variance on Stock B is .04200

the standard deviation on Stock A is 5.12%

the standard deviation on Stock B is 20.49%

The Expected Return on a Portfolio is computed as the weighted average of the expectedreturns on the stocks which comprise the portfolio. The weights reflect the proportion of theportfolio invested in the stocks. This can be expressed as follows:

N

E[Rp] = Σ wiE[Ri] i=1

where E[Rp] = the expected return on the portfolio, N = th e number of stocks in the portfolio,wi = the proportion of the portfolio invested in stock I, and E[R i] = the expected return onstock i.

Note that Σwi = 1.


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For a portfolio consisting of two assets, the above equation can be expressed as:

E[Rp] = w1E[R1] + w2E[R2]

If we have an equally weighted portfolio of stock A and stock B (50% in each stock), then theexpected return of the portfolio is:

E[Rp] = .50(.125) + .50(.20) = 16.25%

The variance/standard deviation of a portfolio reflec ts not only the variance/standarddeviation of the stocks that make up the portfolio but also how the returns on the stockswhich comprise the portfolio vary together.

Two measures of how the returns on a pair of stocks vary together are the covariance and thecorrelation coefficient.

Covariance is a measure that combines the variance of a stock’s returns with the tendency ofthose returns to move up or down at the same time other stocks move up or down.

Since it is difficult to interpret the magnitude of t he covariance terms, a related statistic, thecorrelation coefficient, is often used to measure the degree of co -movement between twovariables. The correlation coefficient simply standardizes the covariance.

The Covariance between the returns on two stoc ks can be calculated as follows:

N

Cov(RA,RB) = σA,B = Σ pi(RAi - E[RA])(RBi - E[RB]) i=1

where σA,B = the covariance between the returns on stocks A and B, N = the number of states,pi = the probability of state i, R Ai = the return on stock A in state i, E[R A] = the expectedreturn on stock A, RBi = the return on stock B in state I, and E[R B] = the expected return onstock B.

The Correlation Coefficient between the returns on two stocks can be calculated as follows:

Corr. (RA,RB) = ρA,B = σAB/σAσB = Cov(RA,RB)/[SD(RA)SD(RB)]

where ρA,B=the correlation coefficient between the returns on stocks A and B, σ A,B=thecovariance between the returns on stocks A and B, σ A=the standard deviation on stock A, andσB=the standard deviation on stock B.

The covariance between stock A and stock B is as follows:

σA,B = .2(.05-.125)(.5-.2) + .3(.1-.125)(.3-.2) + .3(.15-.125)(.1-.2) +.2(.2-.125)(-.1-.2) = -.0105

The correlation coefficient between stock A and stock B is as follows:

ρA,B = -.0105/(.0512)(.2049) = -1.00


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Using either the correlation coefficient or the covariance, the Variance on a Two-AssetPortfolio can be calculated as follows:

σ2p = (wA)2σ2

A + (wB)2σ2B + 2wAwBρA,B σAσB

or

σ2p = (wA)2σ2

A + (wB)2σ2B + 2wAwB σA,B

The Standard Deviation of the Portfolio equals the positive square root of the variance.

Let’s calculate the variance and standard deviation of a portfolio comprised of 75% stock Aand 25% stock B:

σ2p =(.75)2(.0512)2+(.25)2(.2049)2+2(.75)(.25)(-1)(.0512)(.2049)= 0.00016

σp = √0.00016 = 0.0128 = 1.28%

Notice that the portfolio formed by investing 75% in Stock A and 25% in Stock B has a lowervariance and standard deviation than either Stocks A or B and the portfolio has a higherexpected return than Stock A.

This is the purpose of diversification; by forming portfolios, some of the risk inherent in theindividual stocks can be eliminated.

4.3 Estimating return of a security held in a portfolio – Capital Asset Pricing Model(CAPM)

If investors are mainly concerned with the risk of their portfolio rather than the risk of theindividual securities in the portfolio, how should the risk of an individual stock be measured?An important tool is the CAPM. CAPM concludes that the relevant risk of an individual stockis its contribution to the risk of a well -diversified portfolio. CAPM specifies a linearrelationship between risk and required return. The equation used for CAPM is as follows:

Ki = Krf + bi(Km - Krf)

where Ki = the required return for the individual security, K rf = the risk-free rate of return, b i =the beta of the individual security, K m = the expected return on the market portfolio, and (K m

- Krf) is called the market risk premium.

This equation can be used to find any of the variables listed above, given the rest of thevariables are known.

Find the required return on a stock given that the risk -free rate is 8%, the expected return onthe market portfolio is 12%, and the beta of the stock is 2.

Ki = Krf + bi(Km - Krf)

Ki = 8% + 2(12% - 8%)


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Ki = 16%

Note that you can then compare the required rate of return to the expected rate of return. Youwould only invest in stocks where the expected rate of return exceeded the required rate ofreturn.

Find the beta on a stock given that its expected return is 12%, the risk -free rate is 4%, and theexpected return on the market portfolio is 10%.

12% = 4% + βi(10% - 4%)

βi = (12% - 4%)/(10% - 4%)

βi = 1.33

Note that beta measures the stock’s volatility (or risk) relative to the market.

Unit 5

Corporate Financial Statements, Ratio Analysis, Capital Structure and Leverage,Short-term and Long-term corporate financing alternatives, Working CapitalManagement

5.1 Corporate Financial Statements

A financial statement (or financial report) is a formal record of the financial activities of abusiness, person, or other entity. In British English—including United Kingdom companylaw—a financial statement is often referred to as an account, although the term financialstatement is also used, particularly by accountants.

For a business enterprise, all the relevant financial information, presented in a structuredmanner and in a form easy to understand, are called the financial statements. They typicallyinclude four basic financial statements, accom panied by a management discussion andanalysis:

1. Statement of Financial Position : also referred to as a balance sheet, reports on acompany's assets, liabilities, and ownership equity at a given point in time.

2. Statement of Comprehensive Income : also referred to as Profit and Loss statement (ora "P&L"), reports on a company's income, expenses, and profits over a period oftime. A Profit & Loss statement provides information on the operation of theenterprise. These include sale and the various expenses incurred during theprocessing state.

3. Statement of Changes in Equity : explains the changes of the company's equitythroughout the reporting period

4. Statement of cash flows: reports on a company's cash flow activities, particularly itsoperating, investing and financing activities.

For large corporations, these statements are often complex and may include an extensive setof notes to the financial statements and explanation of financial policies and managementdiscussion and analysis . The notes typically describe each item on the balance sheet, income


33

statement and cash flow statement in further detail. Notes to financial stat ements areconsidered an integral part of the financial statements.

Balance Sheet

In financial accounting, a balance sheet or statement of financial position is a summary of thefinancial balances of a sole proprietorship, a business partnership, a corporation or otherbusiness organization. Assets, liabilities and ownership equity are listed as of a specific date,such as the end of its financial year. A balance sheet is often described as a "snapshot of acompany's financial condition". Of the four basic financial statements, the balance sheet is theonly statement which applies to a single point in time of a business' calendar year.

A standard company balance sheet has three parts: assets, liabilities and ownership equity.The main categories of assets are us ually listed first and typically in order of liquidity. Assetsare followed by the liabilities. The difference between the assets and the liabilities is knownas equity or the net assets or the net worth or capital of the company and according to theaccounting equation, net worth must equal assets minus liabilities.

Another way to look at the same equation is that assets equal liabilities plus owner's equity.Looking at the equation in this way shows how asset s were financed: either by borrowingmoney (liability) or by using the owner's money (owner's equity). Balance sheets are usuallypresented with assets in one section and liabilities and net worth in the other section with thetwo sections "balancing."

A business operating entirely in cash can measure its profits by withdrawing the entire bankbalance at the end of the period, plus any cash in hand. However, many businesses are notpaid immediately; they build up inventories of goods and they acquire buildi ngs andequipment. In other words: businesses have assets and so they cannot, even if they want to,immediately turn these into cash at the end of each period. Often, these businesses owemoney to suppliers and to tax authorities, and the proprietors do not withdraw all theiroriginal capital and profits at the end of each period. In other words businesses alsohave liabilities.

Guidelines for balance sheets of public business entities are given by the InternationalAccounting Standards Board and numerous country-specific organizations/companies.

Balance sheet account names and usage depend on the organization's country and the type oforganization. Government organizations do not generally follow standar ds established forindividuals or businesses.

If applicable to the business, summary values for the following items should be included inthe balance sheet: Assets are all the things the business owns, this will include property, tools,cars, etc.

Assets

Current assets

1. Cash and cash equivalents2. Accounts receivable3. Inventories4. Prepaid expenses for future services that will be used within a year

Non-current assets (Fixed assets)

1. Property, plant and equipment


34

2. Investment property, such as real estate held for investment purposes3. Intangible assets4. Financial assets (excluding investments accounted for using the equity

method, accounts receivables, and cash and cash equivalents)5. Investments accounted for using the equity method6. Biological assets, which are living plants or animals. Bearer biological assets are

plants or animals which bear agricultural produce for harvest, such as apple treesgrown to produce apples and sheep raised t o produce wool. [17]

Liabilities

1. Accounts payable2. Provisions for warranties or court decisions3. Financial liabilities (excluding provisions and accounts payable), such as promissory

notes and corporate bonds4. Liabilities and assets for current tax5. Deferred tax liabilities and deferred tax assets6. Unearned revenue for services paid for by customers but not yet provided

Equity

The net assets shown by the balance sheet equals the third part of the balance sheet, which isknown as the shareholders' equity. It comprises:

1. Issued capital and reserves attributable to equity holders of the parentcompany (controlling interest)

2. Non-controlling interest in equity

Formally, shareholders' equity is part of the company's liabilities: they are funds "owing" toshareholders (after payment of all other liabilities); usually, however, "liabilities" is used inthe more restrictive sense of liabili ties excluding shareholders' equity. The balance of assetsand liabilities (including shareholders' equity) is not a coincidence. Records of the values ofeach account in the balance sheet are maintained using a system of accounting knownas double-entry bookkeeping. In this sense, shareholders' equity by construction must equalassets minus liabilities, and are a residual.

Regarding the items in equity secti on, the following disclosures are required:

1. Numbers of shares authorized, issued and fully paid, and issued but not fully paid2. Par value of shares3. Reconciliation of shares outstanding at the beginning and the end of the period4. Description of rights, preferences, and restrictions of shares5. Treasury shares, including shares held by subsidiaries and associates6. Shares reserved for issuance under options and contracts7. A description of the nature and purpose of each reserve within owners' equity

Income Statement or Profit and Loss Account

Income statement (also referred to as profit and loss statement (P&L) , revenuestatement, statement of financial performance , earnings statement , operatingstatement or statement of operations) is a company's financial statement that indicates howthe revenue (money received from the sale of products and services before expenses are takenout, also known as the "top line") is transf ormed into the net income (the result after allrevenues and expenses have been accounted for, also known as Net Profit or the "bottom


35

line"). It displays the revenues recognized for a specific period, andthe cost and expenses charged against these revenues, including write-offs (e.g.,depreciation and amortization of various assets) and taxes. The purpose of the incomestatement is to show managers and investors whether the company made or lost moneyduring the period being reported.

The important thing to remember about an income statement is that it represents a period oftime. This contrasts with the balance sheet, which represents a single moment in time.

Charitable organizations that are required to publish financial statements do not produce anincome statement. Instead, they produce a similar statement that reflects funding sourcescompared against program expenses, administrative costs, and other operating com mitments.This statement is commonly referred to as the statement of activities. Revenues and expensesare further categorized in the statement of activities by the donor restrictions on the f undsreceived and expended.

The income statement can be prepared in one of two methods. The Single Step incomestatement takes a simpler approach, totalling revenues and subtracting expenses to find thebottom line. The more complex Multi -Step income statement (as the name implies) takesseveral steps to find the bottom line, starting with the gross profit. It then calculates operatingexpenses and, when deducted from the gross profit, yields income from operations. Adding toincome from operations is the difference of other revenues and other expenses. Whencombined with income from operations, this yields income before taxes. The final step is todeduct taxes, which finally produces the net income for the period measured.

Fitness Equipment Limited

INCOME STATEMENTS

(in millions)

Year Ended March 31, 2009 2008 2007

----------------------------------------------------------------------------------

Revenue $ 14,580.2 $ 11,900.4 $ 8,290.3

Cost of sales (6,740.2) (5,6 50.1) (4,524.2)

------------- ------------ ------------

Gross profit 7,840.0 6,250.3 3,766.1

------------- ------------ ------------

SGA expenses (3,624.6) (3,296.3) (3,034.0)

------------- ------------ ------------

Operating profit $ 4,215.4 $ 2,954.0 $ 732 .1

------------- ------------ ------------

Gains from disposal of fixed assets 46.3 - -

Interest expense (119.7) (124.1) (142.8)

------------- ------------ ------------

Profit before tax 4,142.0 2,829.9 589.3

------------- ------------ ------------

Income tax expense (1,656.8) (1,132.0) (235.7)

------------- ------------ ------------

Profit (or loss) for the year $ 2,485.2 $ 1,697.9 $ 353.6

DEXTERITY INC. AND SUBSIDIARIES


36

CONSOLIDATED STATEMENTS OF OPERATIONS (In millions)

Year Ended December 31, 2009 2008 2007

----------------------------------------------------------------------------------------------

Revenue $ 36,525.9 $ 29,827.6 $ 21,186.8

Cost of sales (18,545.8) (15,858.8) (11,745.5)

----------- ----------- ------------

Gross profit 17,980.1 13,968.8 9,441.3

----------- ----------- ------------

Operating expenses:

Selling, general and administrative expenses (4,142.1) (3,732.3) (3,498.6)

Depreciation (602.4) (584.5) (562.3)

Amortization (209.9) (141.9) (111.8)

Impairment loss (17,997.1) — —

----------- ----------- ------------

Total operating expenses (22,951.5) (4,458.7) (4,172.7)

----------- ----------- ------------

Operating profit (or loss) $ (4,971.4) $ 9,510.1 $ 5,268.6

----------- ----------- ------------

Interest income 25.3 11.7 12.0

Interest expense (718.9) (742.9) (799.1)

----------- ----------- ------------

Profit (or loss) from continuing operations

before tax, share of profit (or loss) from

associates and non-controlling interest $ (5,665.0) $ 8,778.9 $ 4,481.5

----------- ----------- ------------

Income tax expense (1,678.6) (3,510.5) (1,789.9)

Profit (or loss) from associates, net of tax (20.8) 0.1 (37.3)

Profit (or loss) from non-controlling interest,

net of tax (5.1) (4.7) (3.3)

----------- ----------- ------------

Profit (or loss) from continuing operations $ (7,348.7) $ 5,263.8 $ 2,651.0

----------- ----------- ------------

Profit (or loss) from discontinued operations,

net of tax (1,090.3) (802.4) 164.6

----------- ----------- ------------

Profit (or loss) for the year $ (8,439.0) $ 4,461.4 $ 2,815.6

5.2 RATIO ANALYSIS

It refers to the systematic use of ratios to interpret the financial statem ents in terms of theoperating performance and financial position of a firm. It involves comparison for ameaningful interpretation of the financial statements.


37

In view of the needs of various uses of ratios the ratios, which can be calculated from theaccounting data are classified into the following broad categories

A. Liquidity RatioB. Turnover RatioC. Solvency or Leverage ratiosD. Profitability ratios

A. LIQUIDITY RATIO

It measures the ability of the firm to meet its short -term obligations, that is capacity o f thefirm to pay its current liabilities as and when they fall due. Thus these ratios reflect the short -term financial solvency of a firm. A firm should ensure that it does not suffer from lack ofliquidity. The failure to meet obligations on due time may result in bad credit image, loss ofcreditors confidence, and even in legal proceedings against the firm on the other hand veryhigh degree of liquidity is also not desirable since it would imply that funds are idle and earnnothing. So therefore it i s necessary to strike a proper balance between liquidity and lack ofliquidity.

The various ratios that explains about the liquidity of the firm are

1. Current Ratio2. Acid Test Ratio / quick ratio3. Absolute liquid ration / cash ratio

1. CURRENT RATIO

The current ratio measures the short-term solvency of the firm. It establishes the relationshipbetween current assets and current liabilities. It is calculated by dividing current assets bycurrent liabilities.

Current Ratio = Current AssetCurrent Liabilities

Current assets include cash and bank balances, marketable securities, inventory, anddebtors, excluding provisions for bad debts and doubtful debtors, bills receivables andprepaid expenses. Current liabilities includes sundry creditors, bills payable, shor t- termloans, income-tax liability, accrued expenses and dividends payable.

2. ACID TEST RATIO / QUICK RATIO

It has been an important indicator of the firm’s liquidity position and is used as acomplementary ratio to the current ratio. It establishes th e relationship between quick assetsand current liabilities. It is calculated by dividing quick assets by the current liabilities.

Acid Test Ratio = Quick AssetsCurrent liabilities

Quick assets are those current assets, which can be converted into cash immediately orwithin reasonable short time without a loss of value. These include cash and bank balances,sundry debtors, bill’s receivables and short -term marketable securities.


38

3. ABSOLUTE LIQUID RATION / CASH RATIO

It shows the relationship between ab solute liquid or super quick current assets and liabilities.Absolute liquid assets include cash, bank balances, and marketable securities.

Absolute liquid ratio = Absolute liquid assetsCurrent liabilities

B. TURNOVER RATIO

Turnover ratios are also known as activity ratios or efficiency ratios with which a firmmanages its current assets. The following turnover ratios can be calculated to judge theeffectiveness of asset use.

1. Inventory Turnover Ratio2. Debtor Turnover Ratio3. Creditor Turnover Ratio4. Assets Turnover Ratio

1. INVENTORY TURNOVER RATIO

This ratio indicates the number of times the inventory has been converted into sales duringthe period. Thus it evaluates the efficiency of the firm in managing its inventory. It iscalculated by dividing the cost of goods sold by average inventory.

Inventory Turnover Ratio = Cost of goods soldAverage Inventory

The average inventory is simple average of the opening and closing balances of inventory.(Opening + Closing balances / 2). In certain circumstances o pening balance of the inventorymay not be known then closing balance of inventory may be considered as average inventory

2. DEBTOR TURNOVER RATIO

This indicates the number of times average debtors have been converted into cash during ayear. It is determined by dividing the net credit sales by average debtors.

Debtor Turnover Ratio = Net Credit SalesAverage Trade Debtors

Net credit sales consist of gross credit sales minus sales return. Trade debtor includessundry debtors and bill’s receivables. Aver age trade debtors (Opening + Closing balances /2)

When the information about credit sales, opening and closing balances of trade debtors is notavailable then the ratio can be calculated by dividing total sales by closing balances of tradedebtor

Debtor Turnover Ratio = Total SalesTrade Debtors


39

3. CREDITOR TURNOVER RATIO

It indicates the number of times sundry creditors have been paid during a year. It iscalculated to judge the requirements of cash for paying sundry creditors. It is calculated bydividing the net credit purchases by average creditors.

Creditor Turnover Ratio = Net Credit PurchasesAverage Trade Creditor

Net credit purchases consist of gross credit purchases minus purchase return

When the information about credit purchases, opening and closing balances of trade creditorsis not available then the ratio is calculated by dividing total purchases by the closing balanceof trade creditors.

Creditor Turnover Ratio = Total purchasesTotal Trade Creditors

4. ASSETS TURNOVER RATIO

The relationship between assets and sales is known as assets turnover ratio. Several assetsturnover ratios can be calculated depending upon the groups of assets, which are related tosales.

a) Total asset turnover.b) Net asset turnoverc) Fixed asset turnoverd) Current asset turnovere) Net working capital turnover ratio

a. TOTAL ASSET TURNOVER

This ratio shows the firms ability to generate sales from all financial resources committed tototal assets. It is calculated by dividing sales by total assets.

Total asset turnover = Total Sales Total Assets

b. NET ASSET TURNOVER

This is calculated by dividing sales by net assets.

Net asset turnover = Total SalesNet Assets

Net assets represent total assets minus current liabilities. Intangible and fictitious assets likegoodwill, patents, accumulated losses, deferred expenditure may be excluded for calculatingthe net asset turnover.

c. FIXED ASSET TURNOVER

This ratio is calculated by dividing sales by net fixed assets.


40

Fixed asset turnover = Total SalesNet Fixed Assets

Net fixed assets represent the cost of fixed assets minus depreciation.

d. CURRENT ASSET TURNOVER

It is divided by calculating sales by current assets

Current asset turnover = Total SalesCurrent Assets

e. NET WORKING CAPITAL TURNOVER RATIO

A higher ratio is an indicator of better utilization of current assets and working capital andvice-versa (a lower ratio is an indicator of poor utilization of current assets and workingcapital). It is calculated by dividing sales by working capital.

Net working capital turnover ratio = Total SalesWorking Capital

Working capital is represented by the difference between current assets and currentliabilities.

C. SOLVENCY OR LEVERAGE RATIOS

The solvency or leverage ratios throws light on the long term solvency of a firm re flecting itsability to assure the long term creditors with regard to periodic payment of interest during theperiod and loan repayment of principal on maturity or in predetermined installments at duedates. There are thus two aspects of the long -term solvency of a firm.

a. Ability to repay the principal amount when dueb. Regular payment of the interest.

The ratio is based on the relationship between borrowed funds and owner’s capital it iscomputed from the balance sheet, the second type are calculated from t he profit and loss a/c.The various solvency ratios are

1. Debt equity ratio2. Debt to total capital ratio3. Proprietary (Equity) ratio4. Fixed assets to net worth ratio5. Fixed assets to long term funds ratio6. Debt service (Interest coverage) ratio

1. DEBT EQUITY RATIO

Debt equity ratio shows the relative claims of creditors (Outsiders) and owners (Interest)against the assets of the firm. Thus this ratio indicates the relative proportions of debt and


41

equity in financing the firm’s assets. It can be calcu lated by dividing outsider funds (Debt)by shareholder funds (Equity)

Debt equity ratio = Outsider Funds (Total Debts)Shareholder Funds or Equity

The outsider fund includes long -term debts as well as current liabilities. The shareholderfunds include equity share capital, preference share capital, reserves and surplus includingaccumulated profits. However fictitious assets like accumulated deferred expenses etc shouldbe deducted from the total of these items to shareholder funds. The shareholder fun ds socalculated are known as net worth of the business.

2. DEBT TO TOTAL CAPITAL RATIO

Debt to total capital ratio = Total DebtsTotal Assets

3. PROPRIETARY (EQUITY) RATIO

This ratio indicates the proportion of total assets financed by owners. It is ca lculated bydividing proprietor (Shareholder) funds by total assets.

Proprietary (equity) ratio = Shareholder fundsTotal assets

4. FIXED ASSETS TO NET WORTH RATIO

This ratio establishes the relationship between fixed assets and shareholder funds. It iscalculated by dividing fixed assets by shareholder funds.

Fixed assets to net worth ratio = Fixed Assets X 100Net Worth

The shareholder funds include equity share capital, preference share capital, reserves andsurplus including accumulated profits. Howe ver fictitious assets like accumulated deferredexpenses etc should be deducted from the total of these items to shareholder funds. Theshareholder funds so calculated are known as net worth of the business.

5. FIXED ASSETS TO LONG TERM FUNDS RATIO

Fixed assets to long term funds ratio establishes the relationship between fixed assets andlong-term funds and is calculated by dividing fixed assets by long term funds.

Fixed assets to long term funds ratio = Fixed Assets X 100Long-term Funds

6. DEBT SERVICE (INTEREST COVERAGE) RATIO

This shows the number of times the earnings of the firms are able to cover the fixed interestliability of the firm. This ratio therefore is also known as Interest coverage or time interest


42

earned ratio. It is calculated by dividing the earnings before interest and tax (EBIT) byinterest charges on loans.

Debt Service Ratio = Earnings before interest and tax (EBIT)Interest Charges

PROFITABILITY RATIOS

The profitability ratio of the firm can be measured by calculating various profitability ratios.General two groups of profitability ratios are calculated.

a. Profitability in relation to sales.b. Profitability in relation to investments.

Profitability in relation to sales

1. Gross profit margin or ratio2. Net profit margin or ratio3. Operating profit margin or ratio4. Operating Ratio5. Expenses Ratio

1. GROSS PROFIT MARGIN OR RATIO

It measures the relationship between gross profit and sales. It is calculated by dividing grossprofit by sales.

Gross profit margin or ratio = Gross profit X 100Net sales

Gross profit is the difference between sales and cost of goods sold.

2. NET PROFIT MARGIN OR RATIO

It measures the relationship between net profit and sales of a firm. It indicates management’sefficiency in manufacturing, administrating, and selling the products. It is calculated bydividing net profit after tax by sales.

Net profit margin or ratio = Earning after tax X 100Net Sales

3. OPERATING PROFIT MARGIN OR RATIO

It establishes the relationship between total operating expenses an d net sales. It is calculatedby dividing operating expenses by the net sales.

Operating profit margin or ratio = Operating expenses X 100Net sales

Operating expenses includes cost of goods produced/sold, general and administrativeexpenses, selling and distributive expenses.


43

4. EXPENSES RATIO

While some of the expenses may be increasing and other may be declining to know thebehavior of specific items of expenses the ratio of each individual operating expenses to netsales should be calculated. The va rious variants of expenses are

Cost of goods sold = Cost of goods sold X 100Net Sales

Administrative Expenses Ratio = Administrative Expenses X 100Net sales

Selling and distribution expenses ratio = Selling and distribution expenses X 100Net sales

5. OPERATING PROFIT MARGIN OR RATIO

Operating profit margin or ratio establishes the relationship between operating profit and netsales. It is calculated by dividing operating profit by sales.

Operating profit margin or ratio = Operating Profit X 100Net sales

Operating profit is the difference between net sales and total operating expenses. (Operatingprofit = Net sales – cost of goods sold – administrative expenses – selling and distributionexpenses.)

PROFITABILITY IN RELATION TO INVESTMENTS

1. Return on gross investment or gross capital employed2. Return on net investment or net capital employed3. Return on shareholder’s investment or shareholder’s capital employed.4. Return on equity shareholder investment or equity shareholder capital employed.

1. RETURN ON GROSS CAPITAL EMPLOYED

This ratio establishes the relationship between net profit and the gross capital employed. Theterm gross capital employed refers to the total investment made in business. Theconventional approach is to divide Earnings After Tax (EA T) by gross capital employed.

Return on gross capital employed = Earnings After Tax (EAT) X 100Gross capital employed

2. RETURN ON NET CAPITAL EMPLOYED

It is calculated by dividing Earnings Before Interest & Tax (EBIT) by the net capitalemployed. The term net capital employed in the gross capital in the business minus currentliabilities. Thus it represents the long -term funds supplied by creditors and owners of thefirm.


44

Return on net capital employed = Earnings Before Interest & Tax (EBIT) X 100Net capital employed

3. RETURN ON SHARE CAPITAL EMPLOYED

This ratio establishes the relationship between earnings after taxes and the shareholderinvestment in the business. This ratio reveals how profitability the owners’ funds have beenutilized by the firm. It is calculated by dividing Earnings after tax (EAT) by shareholdercapital employed.

Return on share capital employed = Earnings after tax (EAT) X 100Shareholder capital employed

4. RETURN ON EQUITY SHARE CAPITAL EMPLOYED

Equity shareholders are en titled to all the profits remaining after the all outside claimsincluding dividends on preference share capital are paid in full. The earnings may bedistributed to them or retained in the business. Return on equity share capital investments orcapital employed establishes the relationship between earnings after tax and preferencedividend and equity shareholder investment or capital employed or net worth. It is calculatedby dividing earnings after tax and preference dividend by equity shareholder’s ca pitalemployed.

Return on equity capital employed = Earnings after tax (EAT), pref. Dividends X 100 Equity share capital employed

EARNINGS PER SHARE

IT measure the profit available to the equity shareholders on a per share basis. It is computedby dividing earnings available to the equity shareholders by the total number of equity shareoutstanding

Earnings per share = Earnings after tax – Preferred dividends (if any)Equity shares outstanding

DIVIDEND PER SHARE

The dividends paid to the shareholders on a per share basis in dividend per share. Thusdividend per share is the earnings distributed to the ordinary shareholders divided by thenumber of ordinary shares outstanding.

Dividend per share = Earnings paid to the ordinary shareholdersNumber of ordinary shares outstanding

DIVIDENDS PAY OUT RATIO (PAY OUT RATIO)It measures the relationship between the earnings belonging to the equity shareholders andthe dividends paid to them. It shows what percentage shares of the earnings are available forthe ordinary shareholders are paid out as dividend to the ordinary shareholders. It can becalculated by dividing the total dividend paid to the equity shareholders by the total earningsavailable to them or alternatively by dividing dividend per share by ear nings per share.

Dividend pay our ratio (Pay our ratio) = Total dividend paid to equity share holders


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Total earnings available to equity share holders

OrDividend per shareEarnings per share

DIVIDEND AND EARNINGS YIELD

While the earnings per share a nd dividend per share are based on the book value per share,the yield is expressed in terms of market value per share. The dividend yield may be definedas the relation of dividend per share to the market value per ordinary share and the earningratio as the ratio of earnings per share to the market value of ordinary share.

Dividend Yield = Dividend Per shareMarket value of ordinary share

Earnings yield = Earnings per shareMarket value of ordinary share

PRICE EARNING RATIO

The reciprocal of the earnings yield is called price earnings ratio. It is calculated by dividingthe market price of the share by the earnings per share.

Price earnings (P/E) ratio = Market price of shareEarnings per share

5.3 Capital Structure and Leverage

In finance, capital structure refers to the way a corporation finances its assets through somecombination of equity, debt, or hybrid securities. A firm's capital structure is then thecomposition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equityand $80 billion in debt is said to be 20% equity -financed and 80% debt-financed. The firm'sratio of debt to total financing, 80% in this example is referred to as the firm's leverage. Inreality, capital structure may be highly complex and include dozens of sourc es. Gearing Ratiois the proportion of the capital employed of the firm which come from outside of the businessfinance, e.g. by taking a short term loan etc.

The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, formsthe basis for modern thinking on capital structure, though it is generally viewed as a purelytheoretical result since it disregards many important factors in the capital structure decision.The theorem states that, in a perfect market, how a firm is financ ed is irrelevant to its value.This result provides the base with which to examine real world reasons why capitalstructure is relevant, that is, a company's value is affected by the capital structure it employs.Some other reasons include bankruptcy costs, agency costs, taxes, and informationasymmetry. This analysis can then be extended to look at whether there is in fact an optimalcapital structure: the one which maximizes the value of the firm .

For stock investors that favour companies with good fundamentals, a strong balance sheet isan important consideration for investing in a company's stock. The strength of a company'balance sheet can be evaluated by three broad categories of investment -qualitymeasurements: working capital adequacy, asset performance and capital structure.


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A company's capitalization (not to be confused with market capitalization) describes itscomposition of permanent or long -term capital, which consists of a combination of debt andequity. A company's reasonable, proportional use of debt and equity to support its assets is akey indicator of balance sheet strength. A healthy capital structure that reflects a low level ofdebt and a corresponding high level of equity is a very positive sign of financial fitne ss.

Clarifying Capital Structure-Related Terminology

The equity part of the debt -equity relationship is the easiest to define. In a company's capitalstructure, equity consists of a company's common and preferred stock plus retained earnings,which are summed up in the shareholders' equity account on a balance sheet. This investedcapital and debt, generally of the long -term variety, comprises a company's capitalization andacts as a permanent type of funding to support a company's growth and related asse ts.

A discussion of debt is less straightforward. Investment literature often equates a company'sdebt with its liabilities. Investors should understand that there is a difference betweenoperational and debt liabilities - it is the latter that forms the debt component of a company'scapitalization. That's not the end of the debt story, however.

Among financial analysts and investment research services, there is no universal agreementas to what constitutes a debt liability. For many analysts, the debt comp onent in a company'scapitalization is simply a balance sheet's long -term debt. However, this definition is toosimplistic. Investors should stick to a stricter interpretation of debt where the debt componentof a company's capitalization should consist of the following: short-term borrowings (notespayable), the current portion of long -term debt, long-term debt, and two-thirds (rule ofthumb) of the principal amount of operating leases and redeemable preferred stock. Using acomprehensive total debt figure is a prudent analytical tool for stock investors.

Capital Ratios and Indicators

In general, analysts use three different ratios to assess the financial strength of a company'scapitalization structure. The first two, the debt and debt/equity ratios, are popularmeasurements; however, it's the capitalization ratio that delivers the key insights toevaluating a company's capital position.

The debt ratio compares total liabilities to total assets. Obviously, more of the former meansless equity and, therefore, indicates a more leveraged position. The problem with thismeasurement is that it is too broad in scope, which, as a consequence, gives equal weight tooperational and debt liabilities. The same criticism can be applied to the debt/equity ratio,which compares total liabilities to total shareholders' equity. Current and non -currentoperational liabilities, particularly the latter, represent obligations that will be with thecompany forever. Also, unlike debt, there are no fixed payments of principal or interestattached to operational liabilities.

The capitalization ratio (total debt/total capitalization) compares the de bt component of acompany's capital structure (the sum of obligations categorized as debt plus the totalshareholders' equity) to the equity component. Expressed as a percentage, a low number isindicative of a healthy equity cushion, which is always more desirable than a high percentageof debt.


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Additional Evaluative Debt-Equity Considerations

Funded debt is the technical term applied to the portion of a company's long -term debt that ismade up of bonds and other similar long -term, fixed-maturity types of borrowings. No matterhow problematic a company's financial condition may be, the holders of these obligationscannot demand immediate and full repayment as long the company pays the intere st on itsfunded debt. In contrast, bank debt is usually subject to acceleration clauses and/or covenantsthat allow the lender to call its loan. From the investor's perspective, the greater thepercentage of funded debt to total debt, the better. Funded d ebt gives a company more wiggleroom.

Factors That Influence a Company's Capital -Structure Decision

The primary factors that influence a company's capital -structure decision are as follows:

Business Risk

Excluding debt, business risk is the basic risk of the company's operations. The greater thebusiness risk, the lower the optimal debt ratio. As an example, let's compare a utilitycompany with a retail apparel company. A utility compan y generally has more stability inearnings. The company has less risk in its business given its stable revenue stream. However,a retail apparel company has the potential for a bit more variability in its earnings. Since thesales of a retail apparel compa ny are driven primarily by trends in the fashion industry, thebusiness risk of a retail apparel company is much higher. Thus, a retail apparel companywould have a lower optimal debt ratio so that investors feel comfortable with the company'sability to meet its responsibilities with the capital structure [E1] in both good times and bad.

Company's Tax Exposure

Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as ameans of financing a project is attractive because the tax deductibility of the debt paymentsprotects some income from taxes.

Financial Flexibility

Financial flexibility is essentially t he firm's ability to raise capital in bad times. It shouldcome as no surprise that companies typically have no problem raising capital when sales aregrowing and earnings are strong. However, given a company's strong cash flow in the goodtimes, raising capital is not as hard. Companies should make an effort to be prudent whenraising capital in the good times and avoid stretching their capabilities too far. The lower acompany's debt level, the more financial flexibility a company has. Let's take the airl ineindustry as an example. In good times, the industry generates significant amounts of sales andthus cash flow. However, in bad times, that situation is reversed and the industry is in aposition where it needs to borrow funds. If an airline becomes too debt ridden, it may have adecreased ability to raise debt capital during these bad times because investors may doubt theairline's ability to service its existing debt when it has new debt loaded on top.

Management Style

Management styles range from a ggressive to conservative. The more conservative amanagement's approach is, the less inclined it is to use debt to increase profits. An aggressive


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management may try to grow the firm quickly, using significant amounts of debt to ramp upthe growth of the company's earnings per share (EPS).

Growth Rate

Firms that are in the growth stage of their cycle typically finance that growth through debt byborrowing money to grow faster. The conflict that arises with this method is that the revenuesof growth firms are typically unstable and unproven. As such, a high debt load is usually notappropriate. More stable and mature firms typically need less debt to finance growth as theirrevenues are stable and proven. These firms also generate cash flow, which can be used tofinance projects when they arise.

Market Conditions

Market conditions can have a significant impact on a company's capital -structure condition.Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaningthat investors are limiting companies' access to capital because of market concerns, theinterest rate to borrow may be higher than a company would want to pay. In that situation, itmay be prudent for a company to wait until market conditions return to a more normal statebefore the company tries to access funds for the plant.

Financial leverage is the degree to which a company uses fixed -income securities such asdebt and preferred equity. The more debt f inancing a company uses, the higher its financialleverage. A high degree of financial leverage means high interest payments, which negativelyaffect the company's bottom-line earnings per share.

Financial risk is the risk to the stockholders that is cause d by an increase in debt andpreferred equities in a company's capital structure. As a company increases debt andpreferred equities, interest payments increase, reducing EPS. As a result, risk to stockholderreturn is increased. A company should keep its optimal capital structure in mind whenmaking financing decisions to ensure any increases in debt and preferred equity increase thevalue of the company.

Degree of Financial Leverage

The formula for calculating a company's degree of financial leverage (D FL) measures thepercentage change in earnings per share over the percentage change in EBIT. DFL is themeasure of the sensitivity of EPS to changes in EBIT as a result of changes in debt.

Formula:

DFL = percentage change in EPS percentage change in EBIT

A shortcut to keep in mind with DFL is that if interest is 0, then the DLF will be equal to 1.

Example: Degree of Financial Leverage


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With Newco's current production, its sales are $7 million annually. The company's variablecosts of sales are 40% of sales, and its fixed costs are $2.4 million. The company's annualinterest expense is $100,000. If we increase Newco's EBIT by 20%, how much will thecompany's EPS increase?

Calculation and Answer:

The company's DFL is calculated as follows:

DFL = ($7,000,000-$2,800,000-$2,400,000)/($7,000,000-$2,800,000-$2,400,000-$100,000)

DFL = $1,800,000/$1,700,000 = 1.058

Given the company's 20% increase in EBIT, the DFL indicates EPS will increase 21.2%.

Financial Leverage and Capital Structure Policy - Modigliani And Miller's CapitalStructure TheoriesModigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely.From their analysis, they developed the capital -structure irrelevance proposition. Essentially,they hypothesized that in perfect markets, it does not matter what capital structure a companyuses to finance its operations. They theorized that the market value of a firm is determined byits earning power and by the risk of its underlying assets, and that its value is independent ofthe way it chooses to finance its investments or distribute dividends.The basic M&M proposition is based on the following key assumptions:

No taxes No transaction costs No bankruptcy costs Equivalence in borrowing costs for both companies and investors Symmetry of market information, meaning companies and investors have the same

information No effect of debt on a company's earnings before interest and taxes

Of course, in the real world, there are taxes, transaction costs, bankruptcy costs, differencesin borrowing costs, information asymmetries and effects of debt on earnings. To understandhow the M&M proposition works after factoring in corporate taxes, however, we must firstunderstand the basics of M&M propositions I and II without taxes.

Modigliani and Miller's Capital -Structure Irrelevance Proposition

The M&M capital-structure irrelevance proposition assumes no taxes and no bankruptcycosts. In this simplified view, the weighted average cost of capital (WACC) should remainconstant with changes in the company's capital structure. For example, no matter how thefirm borrows, there will be no tax benefit from interest payments and thus no changes orbenefits to the WACC. Additionally, since there are no changes or benefits from increases indebt, the capital structure does not influence a company's stock price, and the capital structureis therefore irrelevant to a company's stock price.


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However, as we have stated, taxes and bankruptcy costs do significantly affect a company'sstock price. In additional papers, Modigliani and Miller included both the effect of taxes andbankruptcy costs.

Modigliani and Miller's Trade-off Theory of Leverage

The trade-off theory assumes that there are benefits to leverage within a capital structure upuntil the optimal capital structure is reached. The theory recognizes the tax benefit frominterest payments - that is, because interest paid on debt is tax deductible, issuing bondseffectively reduces a company's tax liability. Paying dividends on equity, however, does not.Thought of another way, the actual rate of interest companies pay on the bonds they issue isless than the nominal rate of interest because of the tax savings. Studies suggest, however,that most companies have less leverage than this theory would suggest is optimal.

In comparing the two theories, the main difference between them is the potentia l benefit fromdebt in a capital structure, which comes from the tax benefit of the interest payments. Sincethe MM capital-structure irrelevance theory assumes no taxes, this benefit is not recognized,unlike the trade-off theory of leverage, where taxes, and thus the tax benefit of interestpayments, are recognized.

In summary, the MM I theory without corporate taxes says that a firm's relative proportionsof debt and equity don't matter; MM I with corporate taxes says that the firm with the greaterproportion of debt is more valuable because of the interest tax shield.

MM II deals with the WACC. It says that as the proportion of debt in the company's capitalstructure increases, its return on equity to shareholders increases in a linear fashion. Theexistence of higher debt levels makes investing in the company more risky, so shareholdersdemand a higher risk premium on the company's stock. However, because the company'scapital structure is irrelevant, changes in the debt -equity ratio do not affect WACC. MM IIwith corporate taxes acknowledges the corporate tax savings from the interest tax deductionand thus concludes that changes in the debt -equity ratio do affect WACC. Therefore, agreater proportion of debt lowers the company's WACC.

5.4 Short-term and Long-term Corporate Financing Alternatives

Why do firms need short-term finance?Cash flow from operations may not be sufficient to keep up with growth -related financingneeds. Firms may prefer to borrow now for their inventory or other short term asset needsrather than wait until they have saved enough. Firms prefer short -term financing instead oflong-term sources of financing due to:

• easier availability• usually has lower cost• matches need for short term assets, like inventory

Sources of Short-term Finances


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(a) Short-term loans.• borrowing from banks and other financial institutions for one year or less.

(b) Trade credit.• borrowing from suppliers

(c) Commercial paper.• only available to large credit - worthy businesses.

Types of Short-term Loans

(1) Promissory note• A legal instrument that spells out the terms of the loan agreement, usually the

loan amount, the term of the loan and the interest rate.• Often requires that loan be repaid in full with interest at the end of the loan

period.• Usually with a Bank or Financial I nstitution; occasionally with suppliers or

equipment manufacturers

(2) Line of Credit

• The borrowing limit that a bank sets for a firm after reviewing the cashbudget.

• The firm can borrow up to that amount of money without asking, since it ispre-approved

• Usually informal agreement and may change over time• Usually covers peak demand times, growth spurts, etc.

Trade Credit

(1) Trade credit is the act of obtaining funds by delaying payment to suppliers, whotypically grant 30 days to pay.

(2) The cost of trade credit may be some interest charge that the supplier charges on theunpaid balance.

(3) More often, it is in the form of a lost discount that would be given to firms who payearlier.

Credit has a cost. That cost may be passed along to the customer as higher prices, (furnituresales, Office Max), or borne by the seller as lower profits, or some of both.

Estimation of Cost of Short-Term Credit

Calculation is easiest if the loan is for a one year period. Effective Interest Rate is used todetermine the cost of the credi t to be able to compare differing terms.

Effective Interest Rate = Cost (interest + fees)/Amount you get to use

Example: You borrow $10,000 from a bank, at a stated rate of 10%, and must pay $1,000interest at the end of the year. Your effective rate i s the same as the stated rate:$1,000/$10,000 = 0.10 = 10%


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A discount loan requires that interest be paid up front when the loan is given. This changesthe effective cost in the previous example since you only get to use:

($10,000 - $1,000) = $9,000.

Effective rate (APR) = $1,000/$9,000 = 0.1111 = 11.11%.

Sometimes lenders require that a minimum amount, called a compensating balance be kept inyour bank account. It is taken from the amount you want to borrow. If your compensatingbalance requirement is $500, then the amount you can use is reduced by that amount.Effective Rate (APR) for a $10,000 simple interest 10% loan with a $500 compensatingbalance = $1,000/($10,000-$500) = 0.1053 = 10.53%.

Sometimes, lenders will require both discount interest ( paid in advance) and a compensatingbalance. If the interest is $1,000 and the compensating balance is $500, then the effective rate(APR) becomes:

$1,000 / $10,000 - $1,000 - $500

$1,000 / $8,500 = 11.76%

Cost of Trade Credit

Typically receive a discount if you pay early. Stated as: 2/10, net 60. Purchaser receives a2% discount if payment is made within 10 days of the invoice date, otherwise payment is duewithin 60 days of the invoice date. The cost is in the form of the lost discount if you don’ttake it.

$ Interest = Rate x Principle x Time

i.e. Int = 6% x $1,000 x 90/360 = $15

APR = $ Interest (cost) x 1

$ Net Borrowed Time

APR = $15 x 1 / 90 = 1.5% x 4 = 6.0%

$1,000 360

Say you have a loan fee of $5.00, then

APR = $15 + $5 x 1/90 = 2.0% x 4 = 8.0%

1,000 360

Commercial Paper

Commercial paper is quoted on a discount basis, meaning that the interest is subtracted fromthe face value to arrive at the price. See 3 steps below for calculati on:


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Step 1: Compute the discount (D) from face value of the commercial paper

• Discount (D) = (Discount rate x par x DTG)/365• DTG = days to go (to maturity)

Step 2: Compute the price = Face value - Discount

Step 3: Compute Effective Annual Rate (APR): $ interest you pay/ $ you get to use

Example:

$1 million issue of 90 day commercial paper quoted at 4% discount rate.

Step 1: Calculate D = 0.04 x $1 mill. x 90 = $10,000 360

Step2: Calculate price (amount you get) = $1,000,000 - $10,00

= $990,000

Step3: Calculate effective rate (APR)

= $10,000 / $990,000 = 1.010% x 4 = 4.04%

Accounts Receivables as Collaterals

A pledge is a promise that the borrowing firm will pay the lender any payments receivedfrom the accounts receivable collateral in the event of default. Since accounts receivablefluctuate over time, the lender may require certain safeguards to ensure that the value of thecollateral does not go below the balance of the loan. So, normally a bank will only loan you70 -75% of the receivable amount. Accounts receivable can also be sold outright. This isknown as factoring.

Average monthly sales = $100,000

60 day terms, so average Acct Rec balance = $200,000

Bank loans 70% of Accts Rec = $140,000

Interest is 3% over prime (say 8%) = 11% x $140,000 = $15,400

1% fee on all receivables = 1% x $100,000 x 12 = $12,000

APR = $15,400 + $12,000 x 1/1 = 19.57%$140,000

Inventory as Collateral


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A major problem with inventory financing is valuing the inventory. For this re ason, lenderswill generally make a loan in the amount of only a fraction of the value of the inventory. Thefraction will differ depending on the type of inventory. If inventory is long lived, i.e. lumber,they (lender or a customer) may loan you up to 75 % of the resale value. If inventory isperishable, i.e., lettuce, you won’t get much.

Long-term Financing of a Corporate Firm

Long-term finance refers to the capital structure of a corporate firm which comprises of long -term debt, preferred stock and commo n equity. How much a firm will hold long -term debt,preferred stock and common equity will depend upon the cost of capital.

For Investors, the rate of return on a security is a benefit of investing. For FinancialManagers, that same rate of return is a cost of raising funds that are needed to operate thefirm. In other words, the cost of raising funds is the firm’s cost of capital.

How can the firm raise capital?

(a) Bonds(b) Preferred Stock(c) Common Stock(d) Each of these offers a rate of return to investors.(e) This return is a cost to the firm.(f) “Cost of capital” actually refers to the weighted average cost of capital (WACC) - a

weighted average cost of financing sources.

Cost of Debt:

For the issuing firm, the cost of debt is:

(a) the rate of return required by investor s,(b) adjusted for flotation costs (any costs associated with issuing new bonds), and(c) adjusted for taxes.

Example: Tax-effects of financing with debt

with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)

EBT 400,000 350,000

- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000

Now, suppose the firm pays $50,000 in dividends to the stockholders.


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with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)

EBT 400,000 350,000

- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000

- dividends (50,000) 0

Retained earnings 214,000 231,000

After-tax % Cost of Debt = Before -tax % cost of debt X Marginal tax rate

Kd = kd(1 - T)

0.066 = 0.10(1 - .34)

Example:

Prescott Corporation issues a $1,000 par, 20 year bond paying the market rate of 10%.Coupons are semiannual. The bond will sell for par since it pays the market rate, butflotation costs amount to $50 per bond.

What is the pre-tax and after-tax cost of debt for Prescott Corporation?

Pre-tax cost of debt: (using Time Value of Money)

P/Y = 2 N = 40

PMT = -50

FV = -1000

PV = 950

solve: I = 10.61% = kd

After-tax cost of debt:

Kd = kd (1 - T)

Kd = .1061 (1 - .34)

Kd = .07 = 7%

So, a 10% bond costs the firm only 7% (with floatation costs) since interest is tax deductible.


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Cost of Preferred Stock:

Finding the cost of preferred stock is similar to finding the rate of return, except that we haveto consider the flotation costs associ ated with issuing preferred stock.

kp = D/P0 = (Dividend/Price)

From the firm’s point of view:

kp = D/NP0 = (Dividend/Net Price)

NP0 = price - flotation costs

Example:

If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per year and shouldbe valued at $75 per share. If flotation costs amount to $1 per share, what is the cost ofpreferred stock for Prescott?

kp = D/NP0 = (Dividend/Net Price)

= 8.00/74.00 = 10.81%

Cost of Common Stock:

There are two sources of Common Equity:

1) Internal common equity (retained earnings).

2) External common equity (new common stock issue).

Do these two sources have the same cost?

Since the stockholders own the firm’s retained earnings, the cost is simp ly the stockholders’required rate of return.

Why?

If managers are investing stockholders’ funds, stockholders will expect to earn an acceptablerate of return.

Cost of Internal Equity:

1) Dividend Growth Model

kc = D1/P0 + g

2) Capital Asset Pricing Model (CAPM)

kj = krf + βj(km - krf )


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Cost of External Equity:

Dividend Growth Model

knc = D1/NP0 + g

where NP0 is the Net proceeds to the firm after flotation costs.

Weighted Average Cost of Capital (WACC):

The weighted cost of capital is just the weighted aver age cost of all of the financing sources.

Capital

Source Cost Structure

debt 6% 20%

preferred 10% 10%

common 16% 70%

Weighted Cost of Capital

(20% debt, 10% preferred, 70% common)

WACC = 0.20 (6%) + 0.10 (10%) + 0.70 (16%) = 13.4%

4.5 Working Capital Management

Working capital (abbreviated WC) is a financial metric which represents operatingliquidity available to a business, organization or other entity, including governmental entity.Along with fixed assets such as plant and equipment, working capital is consider ed a part ofoperating capital. Net working capital is calculated as current assets minus current liabilities.It is a derivation of working capital, that is commonly used in valuation techniques such asDCFs (Discounted cash flows). If current assets are less than current liabilities, an entity hasa working capital deficiency, also called a working capital deficit .

A company can be endowed with assets and profitability but short of liquidity if its assetscannot readily be converted into cash. Positive working capital is required to ensure that afirm is able to continue its operations and that it has sufficient funds to satisfy bothmaturing short-term debt and upcoming operational expenses. The management of workingcapital involves managing inventories, accounts receivable and payable, and cash.

Current assets and current liabilities include three accounts which are of special importance.These accounts represent the areas of the business where managers h ave the most directimpact:

accounts receivable (current asset) inventory (current assets), and accounts payable (current liability)


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The current portion of debt (payable within 12 months) is critical, because it represents ashort-term claim to current assets and is often secured by long term assets. Common types ofshort-term debt are bank loans and lines of credit.

An increase in working capital indicates that the business has either increased currentassets (that it has increased its receivables or other current assets) or has decreased currentliabilities—for example has paid off some short -term creditors.

Implications on M&A: The common commercial definition of working capital for the purposeof a working capital adjustment in an M &A transaction (i.e. for a working capital adjustmentmechanism in a sale and purchase agreement) is equal to:

Current Assets – Current Liabilities excluding deferred tax assets/liabilities, excess cash,surplus assets and/or deposit balances.

Cash balance items often attract a one -for-one, purchase-price adjustment.

Decisions relating to working capital and short term financing are referred to as workingcapital management. These involve managing the relationship between a firm's short-termassets and its short-term liabilities. The goal of working capital management is to ensure thatthe firm is able to continue its operations and that it has sufficient cash flo w to satisfy bothmaturing short-term debt and upcoming operational expenses.

Decision criteria

By definition, working capital management entails short -term decisions—generally, relatingto the next one-year period — which is "reversible". These decisions are therefore not takenon the same basis as capital -investment decisions (NPV or related); rather, they will be basedon cash flows, or profitability, or both.

One measure of cash flow is provided by the cash conversion cycle—the net number of daysfrom the outlay of cash for raw material to receiving payment from the customer. As amanagement tool, this metric makes explicit the inter -relatedness of decisions relating toinventories, accounts receivable and payable, and cash. Because this number effectivelycorresponds to the time that the firm's cash is tied up in operations and unavailable for otheractivities, management generally aims at a low net count.

In this context, the most useful measure of profitability is return on capital (ROC). The resultis shown as a percentage, determined by dividing relevant income for the 12 monthsby capital employed; return on equity (ROE) shows this result for the firm's shareholders.Firm value is enhanced when, and if, the return on capital, which results from working -capital management, exceeds the cost of capital, which results from capital investmentdecisions as above. ROC measures are therefore useful as a management tool, in that theylink short-term policy with long-term decision making.

Credit policy of the firm: Another factor affecting working capital man agement is creditpolicy of the firm. It includes buying of raw material and selling of finished goods either incash or on credit. This affects the cash conversion cycle.

Management of working capital

Guided by the above criteria, management will use a combination of policies and techniquesfor the management of working capital. The policies aim at managing the currentassets (generally cash and cash equivalents, inventories and debtors) and the short termfinancing, such that cash flows and returns are acceptable.


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Cash management: Identify the cash balance which allows for the business to meet day to dayexpenses, but reduces cash holding costs.

Inventory management: Identify the level of inventory which allows for uninterruptedproduction but reduces the investment in raw materials - and minimizes reordering costs - andhence increases cash flow. Besides this, the lead times in production should be lowered toreduce Work in Process (WIP) and similarly, the Finished Goods should be kept on as lowlevel as possible to avoid over production.

Debtors management: Identify the appropriate credit policy, i.e. credit terms which willattract customers, such that any impact on cash flows and the cash conversion cycle will beoffset by increased revenue and hence Return on Capital (or vice versa).

Short term financing: Identify the appropriate source of financing, given the cash conversioncycle: the inventory is ideally financed by credit granted by the supplier; however, it may benecessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through"factoring". Another possible solution is to use services from companies like MarketInvoice which sells outstanding invoices to raise working capital for their clients.

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Unit 6

Second Generation Financial Commodities

6.1 Derivatives

A derivative is a broad term covering a variety of financial instruments whose valuesare derived from one or more underlying assets, market securities or indices. In practice, it isa contract between two parties that specifies conditions (especiall y the dates, resulting valuesand definitions of the underlying variables, the parties' contractual obligations, andthe notional amount) under which payments are to be made between the parties. The mostcommon underlying assets include: commodities, stocks, bonds, interest rates and currencies.

Derivatives are more common in the modern era, but their origins trace back severalcenturies. One of the oldest derivatives is rice futures, which have been traded on the DojimaRice Exchange since the eighteenth century. Derivatives are broadly categorized by therelationship between the underl ying asset and the derivative (such as forward, option, swap);the type of underlying asset (such as equity derivatives, foreign exchange derivatives , interestrate derivatives, commodity derivatives, or credit derivatives); the market in which they trade(such as exchange-traded or over-the-counter); and their pay-off profile.

Derivatives may broadly be categorized as “lock” or “option” products. Lock products (suchas swaps, futures, or forwards) obligate the contractual parties to the terms over the life of thecontract. Option products (such as interest rate caps) provide the buyer the right, but not theobligation to enter the contract under the terms specified.

Derivatives can be used either for risk management (i.e. to “hedge” by providing offsett ingcompensation in case of an undesired event, “insurance”) or for speculation (i.e. making afinancial "bet"). This distinction is important because the former is a legitimate, often prudentaspect of operations and financial management for many firms ac ross many industries; the


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latter offers managers and investors a seductive opportunity to increase profit, but not withoutincurring additional risk that is often undisclosed to stakeholders.

Usage

Derivatives are used by investors for the following:

hedge or mitigate risk in the underlying, by entering into a derivative contract whosevalue moves in the opposite direction to their underlying position and cancels part or allof it out;

create option ability where the value of the derivative is linked to a specific conditionor event (e.g. the underlying reaching a specific price level);

obtain exposure to the underlying where it is not possible to trade in the underlying(e.g., weather derivatives);

provide leverage (or gearing), such that a small movement in the underlying value cancause a large difference in the value of the derivative;

speculate and make a profit if the value of the underlying asset moves the way theyexpect (e.g., moves in a given direction, stays in or out of a specified range, reaches acertain level).

Mechanics and Valuation Basis

Lock products are theoretically valued at zero at the time of execution and thus do nottypically require an up-front exchange between the parties. Based upon movements in theunderlying asset over time, however, the value of the contract will fluctuate, and thederivative may be either an asset (i.e. " in the money") or a liability (i.e. "out of the money")at different points throughout its life. Importantly, either party is therefore exposed to thecredit quality of its counter party and is interested in protecting itself in an Event of default.

Option products have immediate value at the outset because they provide specified protection(intrinsic value) over a given time period ( time value). One common form of option productfamiliar to many consumers is insurance for homes and automobiles. The insured would paymore for a policy with greater liability protections (intrinsic value) and one that extends for ayear rather than six months (time value). Because of the immediate option value, the optionpurchaser typically pays an up front premium. Just like for lock products, movements in theunderlying asset will cause the option’s intrinsic value to change ov er time while it’s timevalue deteriorates steadily until the contract expires. An important difference between a lockproduct is that, after the initial exchange, the option purchaser has no further liability to itscounterparty; upon maturity, the purcha ser will execute the option if it has positive value (i.e.if it is “in the money”) or expire at no cost (other than to the initial premium) (i.e. if theoption is “out of the money”).

Hedging

Derivatives allow risk related to the price of the underlying a sset to be transferred from oneparty to another. For example, a wheat farmer and a miller could sign a futures contract toexchange a specified amount of cash for a specified amount of wheat in the future. Bothparties have reduced a future risk: for the wheat farmer, the uncertainty of the price, an d forthe miller, the availability of wheat. However, there is still the risk that no wheat will beavailable because of events unspecified by the contract, such as the weather, or that one partywill renege on the contract. Although a third party, called a clearing house, insures a futurescontract, not all derivatives are insured agains t counter-party risk.


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From another perspective, the farmer and the miller both reduce a risk and acquire a riskwhen they sign the futures contract: the farmer reduces the risk that the price of wheat willfall below the price specified in the contract and acquires the risk that the price of wheat willrise above the price specified in the contract (thereby losing additional income that he couldhave earned). The miller, on the other hand, acquires the risk that the price of wheat will fallbelow the price specified in the contract (thereby paying more in the future than he otherwisewould have) and reduces the risk that the price of wheat will rise above the price specified inthe contract. In this sense, one party is the insurer (risk taker) for one type o f risk, and thecounter-party is the insurer (risk taker) for another type of risk.

Hedging also occurs when an individual or institution buys an asset (such as a commodity, abond that has coupon payments, a stock that pays dividends, and so on) and sells it using afutures contract. The individual or institution has access to the asset for a specified amount oftime, and can then sell it in the future at a specified price accord ing to the futures contract. Ofcourse, this allows the individual or institution the benefit of holding the asset, while reducingthe risk that the future selling price will deviate unexpectedly from the market's currentassessment of the future value of the asset.

Derivatives can serve legitimate business purposes. For example, a corporation borrows alarge sum of money at a specific interest rate. The rate of interest on the loan resets every sixmonths. The corporation is concerned that the rate of inte rest may be much higher in sixmonths. The corporation could buy a forward rate agreement (FRA), which is a contract topay a fixed rate of interest six months after purchases on a notional amount of money.[9] If theinterest rate after six months is above the contract rate, the seller will pay the difference to thecorporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to theseller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increaseand stabilize earnings.

Speculation and arbitrage

Derivatives can be used to acquire risk, rath er than to hedge against risk. Thus, someindividuals and institutions will enter into a derivative contract to speculate on the value ofthe underlying asset, betting that the party seeking insurance will be wrong about the futurevalue of the underlying asset. Speculators look to buy an asset in the future at a low priceaccording to a derivative contract when the future market price is high, or to sell an asset inthe future at a high price according to a derivative contract when the future market price islow.

Individuals and institutions may also look for arbitrage opportunities, as when the currentbuying price of an asset falls below the price specified in a futures contract to sell the asset.

Types of DerivativesOTC and exchange-traded

In broad terms, there are two groups of derivative contracts, which are distinguished by theway they are traded in the market:

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated)directly between two parties, without going through an exchange or other intermediary.Products such as swaps, forward rate agreements , exotic options - and other exoticderivatives - are almost always traded in this way. The OTC derivative market is the largestmarket for derivatives, and is largely unregulated with respect to disclosure of informationbetween the parties, since the OTC market is made up of banks and other highly sophisticatedparties, such as hedge funds. Reporting of OTC amounts are difficult because trades can


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occur in private, without activity being visible on any exchange. According to the Bank forInternational Settlements , the total outstanding notional amount is US$708 trillion (as of June2011). Of this total notional amount, 67% are interest rate contracts, 8% are credit defaultswaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% areequity contracts, and 12% are other. Becau se OTC derivatives are not traded on an exchange,there is no central counter -party. Therefore, they are subject to counter-party risk, like anordinary contract, since each counter-party relies on the other to perform.

Exchange-traded derivative contracts (ETD) are those derivatives instruments that aretraded via specialized derivatives exchanges or other exchanges. A derivatives exch ange is amarket where individuals trade standardized contracts that have been defined by theexchange. A derivatives exchange acts as an intermediary to all related transactions, andtakes initial margin from both sides of the trade to act as a guarantee. The world'slargest[18]derivatives exchanges (by number of transactions) are the Korea Exchange (whichlists KOSPI Index Futures & Options), Eurex (which lists a wide range of European productssuch as interest rate & index products), and CME Group (made up of the 2007 merger ofthe Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisitionof the New York Mercantile Exchange ). According to BIS, the combined turnover in theworld's derivatives exchanges totalled USD 344 trillion during Q4 2005. Some types ofderivative instruments also may trade on traditional exchanges. For instance, hybridinstruments such as convertible bonds and/or convertible preferred may be listed on stock orbond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. PerformanceRights, Cash xPRTs and various other instruments that essentially consist of a complex set ofoptions bundled into a simple package are routi nely listed on equity exchanges. Like otherderivatives, these publicly traded derivatives provide investors access to risk/reward andvolatility characteristics that, while related to an underlying commodity, nonetheless aredistinctive.

Common derivative contract types

Some of the common variants of derivative contracts are as follows:

1. Forwards: A tailored contract between two parties, where payment takes place at aspecific time in the future at today's pre -determined price.

2. Futures: are contracts to buy or sell an asset on or before a future date at a pricespecified today. A futures contract differs from a forward contract in that the futurescontract is a standardized contract written by a clearing house that operates anexchange where the contract can be bought and sold; the forward contract is a non -standardized contract written by the parties themselves.

3. Options are contracts that give the owner the right, but not the obligation, to buy (inthe case of a call option) or sell (in the case of a put option) an asset. The price atwhich the sale takes place is known as the strike price, and is specified at the time theparties enter into the option. The option contract also specifies a maturity date. In thecase of a European option, the owner has the right to require the sale to take place on(but not before) the maturity date; in the case of an American option, the owner canrequire the sale to take place at any time up to the maturity date. If the owner of thecontract exercises this right, the counter -party has the obligation to carry out thetransaction. Options are of two types: call option and put option. The buyer of a Calloption has a right to buy a certain quantity of the underlying asset, at a specified priceon or before a given date in the future, he h owever has no obligation whatsoever to


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carry out this right. Similarly, the buyer of a Put option has the right to sell a certainquantity of an underlying asset, at a specified price on or before a given date in thefuture, he however has no obligation wh atsoever to carry out this right.

4. Binary options are contracts that provide the owner with an all -or-nothing profitprofile.

5. Warrants: Apart from the commonly used short -dated options which have a maximummaturity period of 1 year, there exists certain long -dated options as well, knownas Warrant (finance). These are generally traded over -the-counter.

6. Swaps are contracts to exchange cash (flows) on or before a specified future datebased on the underlying value of currencies exchange rates, bonds/interestrates, commodities exchange, stocks or other assets. Another term which iscommonly associated to Swap is Swaption which is basically an option on theforward Swap. Similar to a Call and Put option, a Swaption is of two kinds: a receiverSwaption and a payer Swaption. While on o ne hand, in case of a receiver Swaptionthere is an option wherein you can receive fixed and pay floating, a payer swaptionon the other hand is an option to pay fixed and receive floating.

Swaps can basically be categorized into two types:

Interest rate swap: These basically necessitate swapping only interest associated cashflows in the same currency, between two parties.

Currency swap: In this kind of swapping, the cash flow between the two partiesincludes both principal and interest. Also, the money which is being swapped is indifferent currency for both parties.

Some common examples of these derivatives are the following:

CONTRACT TYPES

UNDERLYINGExchange-traded futures

Exchange-tradedoptions

OTC swap OTC forward OTC option

Equity

DJIA IndexfutureSingle-stockfuture

Optionon DJIA IndexfutureSingle-shareoption

Equity swapBack-to-backRepurchaseagreement

StockoptionWarrantTurbowarrant

Interest rate

EurodollarfutureEuriborfuture

Option onEurodollar futureOption onEuribor future

Interest rateswap

Forward rateagreement

Interest ratecap andfloorSwaptionBasis swapBond option


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Credit Bond futureOption on Bondfuture

Creditdefault swapTotal returnswap

Repurchaseagreement

Creditdefaultoption

Foreignexchange

Currencyfuture

Option oncurrency future

Currencyswap

Currencyforward

Currencyoption

CommodityWTI crude oilfutures

Weatherderivative

Commodityswap

Iron oreforwardcontract

Gold option

6.2 Futures

In finance, a futures contract (more colloquially, futures) is a standardized contract betweentwo parties to buy or sell a specified asset of standardized quantity and quality for a priceagreed upon today (the futures price or strike price) with delivery and payment occurring at aspecified future date, the delivery date. The contracts are negotiated at a futures exchange,which acts as an intermediary between the two parties. The party agreeing to buy theunderlying asset in the future, the "buyer" of the contract, is said to be " long", and the partyagreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". Theterminology reflects the expectations of the parties —the buyer hopes or expects that the assetprice is going to increase, while the seller hopes or expect s that it will decrease in near future.

In many cases, the underlying asset to a futures contract may not betraditional commodities at all – that is, for financial futures the underlying item can beany financial instrument (also including currency, bonds, and stocks); they can be also basedon intangible assets or refe renced items, such as stock indexes and interest rates.

While the futures contract specifies a tra de taking place in the future, the purpose of thefutures exchange institution is to act as intermediary and minimize the risk of default byeither party. Thus the exchange requires both parties to put up an initial amount of cash,the margin. Additionally, since the futures price will generally change daily, the difference inthe prior agreed-upon price and the daily futures price is settled daily also (variation margin).The exchange will draw money out of one party's margin account and put it into the other's sothat each party has the appropriate daily loss or profit. If the margin account goes below acertain value, then a margin call is made and the account owner must replenish the marginaccount. This process is known as marking to market. Thus on the delivery date, the amountexchanged is not the specified price on the contract but the spot value (since any gain or losshas already been previously settled by marking to market).

A closely related contract is a forward contract. A forward is like a futures in that it specifiesthe exchange of goods for a specified price at a specified future date. However, a forward isnot traded on an exchange and thus does not have the interim partial payments du e tomarking to market. Nor is the contract standardized, as on the exchange.

Unlike an option, both parties of a futures contract must fulfill the contract on the deliverydate. The seller delivers the underlying asset to the buyer, or, if it is a cash -settled futurescontract, then cash is transferred from the futures trader who sustained a loss to the one who


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made a profit. To exit the commitment prior to the settlement d ate, the holder of afutures position can close out its contract obligations by taking the opposite position onanother futures contract on the same asset and settlemen t date. The difference in futuresprices is then a profit or loss.

Origin

The first futures exchange market was the Dōjima Rice Exchange in Japan in the 1730s, tomeet the needs of samurai who—being paid in rice, and after a series of bad harvests —needed a stable conversion to coin.

The Chicago Board of Trade (CBOT) listed the first ever standardized 'exchange traded'forward contracts in 1864, which were called futures contracts. This contract was basedon grain trading and started a trend that saw contracts created on a number ofdifferent commodities as well as a number of futures exchanges set up in countries around theworld. By 1875 cotton futures were being traded in Mumbai in India and within a few yearsthis had expanded to futures on edible oilseeds complex, raw jute and jute goods and bullion.

Standardization

Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

The underlying asset or instrument. This could be anything from a barrel of crudeoil to a short term interest rate.

The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional

amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notionalamount of the deposit over which the short term interest rateis traded, etc.

The currency in which the futures contract is quoted. The grade of the deliverable. In the case of bonds, this specifies which bonds can be

delivered. In the case of physical commodities, this specifies not only the quality of theunderlying goods but also the manner and location of deli very. For example, theNYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content andAPI specific gravity, as well as the pricing point—the location where delivery must bemade.

The delivery month. The last trading date. Other details such as the commodity tick, the minimum permissible price fluctuation.

Margin

To minimize credit risk to the exchange, traders must post a margin or a performance bond,typically 5%-15% of the contract's value.

To minimize counterparty risk to traders, trades executed on regulated futures exchanges areguaranteed by a clearing house. The clearing house becomes the buyer to each seller, and theseller to each Buyer, so that in the event of a counterparty d efault the clearer assumes the riskof loss. This enables traders to transact without performing due diligence on theircounterparty.

Margin requirements are waived or reduced in some cases for hedgers who have physicalownership of the covered commodity or spread traders who have offsetting contractsbalancing the position.


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Clearing margin are financial safeguards to ensure that companies or corporations perform ontheir customers' open futures and options contracts. Clearing margins are distinct fromcustomer margins that individual buyers and sellers of futures and options contracts arerequired to deposit with brokers.

Customer margin: Within the futures industry, financial guarantees required of both buyersand sellers of futures contracts and sellers of options contract s to ensure fulfillment ofcontract obligations. Futures Commission Merchants are responsible for overseeing customermargin accounts. Margins are determined on the basis of market risk and contract value. Alsoreferred to as performance bond margin.

Initial margin is the equity required to initiate a futures position. This is a type ofperformance bond. The maximum exposure is not limited to the amount of the initial margin,however the initial margin requirement is calculated based on the maximum estimate d changein contract value within a trading day. Initial margin is set by the exchange.

If a position involves an exchange -traded product, the amount or percentage of initial marginis set by the exchange concerned.

In case of loss or if the value of the i nitial margin is being eroded, the broker will make amargin call in order to restore the amount of initial margin available. Often referred to as“variation margin”, margin called for this reason is usually done on a daily basis, however, intimes of high volatility a broker can make a margin call or calls intra -day.

Calls for margin are usually expected to be paid and received on the same day. If not, thebroker has the right to close sufficient positions to meet the amount called by way of margin.After the position is closed-out the client is liable for any resulting deficit in the client’saccount.

Some U.S. exchanges also use the term “maintenance margin”, which in effect defines byhow much the value of the initial margin can reduce before a margin ca ll is made. However,most non-US brokers only use the term “initial margin” and “variation margin”.

The Initial Margin requirement is established by the Futures exchange, in contrast to othersecurities' Initial Margin.

A futures account is marked to marke t daily. If the margin drops below the marginmaintenance requirement established by the exchange listing the futures, a margin call will beissued to bring the account back up to the required level.

Maintenance margin: A set minimum margin per outstanding futures contract that a customermust maintain in his margin account.

Margin-equity ratio is a term used by speculators, representing the amount of their tradingcapital that is being held as margin at any particular time. The low margin requirements offutures results in substantial leverage of the investment. However, the exchanges require aminimum amount that varies depending on the contract and the trader. The broker may set therequirement higher, but may not set it lower. A trader, of course, can set it above that, if hedoes not want to be subject to margin calls.

Performance bond margin: The amount of money deposited by both a buyer and seller of afutures contract or an options seller to ensure performance of the term of the contract. Marginin commodities is not a payment of equity or down payment on the commodity itself, butrather it is a security deposit.

Return on margin (ROM) is often used to judge performance because it represents the gain orloss compared to the exchange’s perceived risk as reflected in required margin. ROM may be


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calculated (realized return) / (initial margin). The Annualized ROM is equal to(ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, thatwould be about 77% annualized.

6.3 Options

In finance, an option is a contract which gives the owner the right, but not the obligation, tobuy or sell an underlying asset or instrument at a specified strike price on or before aspecified date. The seller incurs a correspond ing obligation to fulfil the transaction that is tosell or buy, if the long holder elects to "exercise" the option prior to expiration. The buyerpays a premium to the seller for this right. An option which conveys the right to buysomething at a specific price is called a call; an option which conveys the right to sellsomething at a specific price is called a put. Both are commonly traded, though in basicfinance for clarity the call option is more frequently discussed, as it moves in the samedirection as the underlying asset, rather than opposite, as does the put.

Options valuation is a topic of ongoing resear ch in academic and practical finance. Forsimplicity of discussion, the value of an option is commonly decomposed into two parts: Thefirst of these is the "intrinsic value," which is defined as the difference between the marketvalue of the underlying and the strike price of the given option. The second part depends on aset of other factors which, through a multi -variable, non-linear interrelationship, reflectthe discounted expected value of that difference at expiration. Although options valuation hasbeen studied at least since the n ineteenth century, the contemporary approach to is based onthe Black–Scholes model which was first published in 1973.

Options contracts have been known for many centuries, however both trading activity andacademic interest increased when, starting in 1973, options were issued with standardizedterms and traded through a guaranteed clearinghouse at the Chicago Board OptionsExchange. Today many options are created in a standardized form and traded throughclearinghouses on regulated options exchanges, while other over-the-counter options arewritten as bilateral, customized contracts between a s ingle buyer and seller, one or both ofwhich may be a dealer or market -maker. Options are part of a larger class of financialinstruments known as derivative products, or simply, derivatives.

Contract Specifications

Every financial option is a contract between the two counterparties with the terms of theoption specified in a term sheet. Option contracts may be quite complicated; however, atminimum, they usually contain the following specifications:

whether the option holder has the right to buy (a call option) or the right to sell (a putoption)

the quantity and class of the underlying asset(s) (e.g., 100 shares of XYZ Co. B stock) the strike price, also known as the exercise price, which is the price at which the

underlying transaction will occur upon exercise the expiration date, or expiry, which is the last date the option can be exercised the settlement terms, for instance whether the writer must deliver the actual asset on

exercise, or may simply tender the equivalent cash amount the terms by which the option is quoted in the market to conv ert the quoted price into

the actual premium – the total amount paid by the holder to the writer

Types of OptionsThe Options can be classified into following types:


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Exchange-traded options

Exchange-traded options (also called "listed options") are a class of exchange-tradedderivatives. Exchange traded options have standardized contracts, and are settled througha clearing house with fulfilment guaranteed by the Options Clearing Corporation (OCC).Since the contracts are standardized, accurate pricing models are often available.Exchange-traded options include:

stock options,

bond options and other interest rate options

stock market index options or, simply, index options and

options on futures contracts

callable bull/bear contractOver-the-counter

Over-the-counter options (OTC options, also called "dealer options") are tradedbetween two private parties, and are not listed on an exch ange. The terms of an OTCoption are unrestricted and may be individually tailored to meet any business need. Ingeneral, at least one of the counterparties to an OTC option is a well -capitalizedinstitution. Option types commonly traded over the counter i nclude:

1. interest rate options2. currency cross rate options, and3. options on swaps or swaptions.

Other option types

Another important class of options, particularly in the U.S., are employee stock options,which are awarded by a company to their employees as a form of ince ntive compensation.Other types of options exist in many financial contracts, for example real estate options areoften used to assemble large parcels of land, and prepayment options are usually includedin mortgage loans. However, many of the valuation and risk managem ent principles applyacross all financial options.

6.4 Derivatives in India

Derivatives markets have been in existence in India in some form or other for a long time. Inthe area of commodities, the Bombay Cotton Trade Association started futures trading i n1875 and, by the early 1900s India had one of the world’s largest futures industry. In 1952the government banned cash settlement and options trading and derivatives trading shifted toinformal forwards markets. In recent years, government policy has cha nged, allowing for anincreased role for market-based pricing and less suspicion of derivatives trading. The ban onfutures trading of many commodities was lifted starting in the early 2000s, and nationalelectronic commodity exchanges were created.In the equity markets, a system of trading called “badla” involving some elements offorwards trading had been in existence for decades. However, the system led to a number ofundesirable practices and it was prohibited off and on till the Securities and Exchan ge Boardof India (SEBI) banned it for good in 2001. A series of reforms of the stock market between1993 and 1996 paved the way for the development of exchange -traded equity derivativesmarkets in India. In 1993, the government created the NSE in collabor ation with state-ownedfinancial institutions. NSE improved the efficiency and transparency of the stock markets byoffering a fully automated screen -based trading system and real -time price dissemination. In


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1995, a prohibition on trading options was lift ed. In 1996, the NSE sent a proposal to SEBIfor listing exchange-traded derivatives. The report of the L. C. Gupta Committee, set up bySEBI, recommended a phased introduction of derivative products, and bi -level regulation(i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role).Another report, by the J. R. Varma Committee in 1998, worked out various operationaldetails such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of1956, or SC(R)A, was amended so that derivatives could be declared “securities.” Thisallowed the regulatory framework for trading securities to be extended to derivatives. TheAct considers derivatives to be legal and valid, but only if they are traded on exchanges.Finally, a 30-year ban on forward trading was also lifted in 1999.

The economic liberalization of the early nineties facilitated the introduction of derivativesbased on interest rates and foreign exchange. A system of market -determined exchange rateswas adopted by India in March 1993. In August 1994, the rupee was made fully convertibleon current account. These reforms allowed increased integration between domestic andinternational markets, and created a need to manage currency risk. Figure 1 shows how thevolatility of the exchange rate between the Indian Rupee and the U.S. dollar has increasedsince 1991. The easing of various restrictions on the free movement of interest rates resultedin the need to manage interest rate risk.

In the exchange-traded market, the biggest success story has been derivatives on equityproducts. Index futures were introduced in June 2000, followed by index options in June2001, and options and futures on individual securities in July 2001 and November 2001,respectively. As of 2005, the NSE trades futures and options on 118 individual stocks and 3stock indices. All these derivative contracts are settled by cash payment and do not involvephysical delivery of the underlying product (which may be costly).

Derivatives on stock indexes and individual stocks have grown rapidly since inception. Inparticular, single stock futures have become hugely popular, accounting for about half ofNSE’s traded value in October 2005. In fact, NSE has the highest volume (i.e. number ofcontracts traded) in the single stock futures globally, enabling it to rank 16 among worldexchanges in the first half of 2005. Single stock options are less popular than futures. Indexfutures are increasingly popular, and accounted for close to 40% of traded value in O ctober2005.

NSE launched interest rate futures in June 2003 but, in contrast to equity derivatives, therehas been little trading in them. One problem with these instruments was faulty contractspecifications, resulting in the underlying interest rate de viating erratically from the referencerate used by market participants. Institutional investors have preferred to trade in the OTCmarkets, where instruments such as interest rate swaps and forward rate agreements arethriving. As interest rates in India have fallen, companies have swapped their fixed rateborrowings into floating rates to reduce funding costs. Activity in OTC markets dwarfs thatof the entire exchange-traded markets, with daily value of trading estimated to be Rs. 30billion in 2004 (FitchRatings, 2004).Foreign exchange derivatives are less active than interest rate derivatives in India, eventhough they have been around for longer. OTC instruments in currency forwards and swapsare the most popular. Importers, exporters and banks use th e rupee forward market to hedgetheir foreign currency exposure. Turnover and liquidity in this market has been increasing,although trading is mainly in shorter maturity contracts of one year or less. In a currencyswap, banks and corporations may swap it s rupee denominated debt into another currency(typically the US dollar or Japanese yen), or vice versa. Trading in OTC currency options isstill muted. There are no exchange -traded currency derivatives in India.


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Exchange-traded commodity derivatives have been trading only since 2000, and the growthin this market has been uneven. The number of commodities eligible for futures trading hasincreased from 8 in 2000 to 80 in 2004, while the value of trading has increased almost fourtimes in the same period. However, many contracts barely trade and, of those that are active,trading is fragmented over multiple market venues, including central and regional exchanges,brokerages, and unregulated forwards markets. Total volume of commodity derivatives is stillsmall, less than half the size of equity derivatives.

The use of derivatives varies by type of institution. Financial institutions, such as banks, haveassets and liabilities of different maturities and in different currencies, and are exposed todifferent risks of default from their borrowers. Thus, they are likely to use derivatives oninterest rates and currencies, and derivatives to manage credit risk. Non -financial institutionsare regulated differently from financial institutions, and this affects their incentives to usederivatives. Indian insurance regulators, for example, are yet to issue guidelines relating tothe use of derivatives by insurance companies.

In India, financial institutions have not been heavy users of exchange -traded derivatives sofar, with their contribution to total value of NSE trades being less than 8% in October 2005.However, market insiders feel that this may be changing, as indicated by the growing share ofindex derivatives (which are used more by institutions than by retai l investors). In contrast tothe exchange-traded markets, domestic financial institutions and mutual funds have showngreat interest in OTC fixed income instruments. Transactions between banks dominate themarket for interest rate derivatives, while state -owned banks remain a small presence.Corporations are active in the currency forwards and swaps markets, buying theseinstruments from banks.Why do institutions not participate to a greater extent in derivatives markets? Someinstitutions such as banks and mutual funds are only allowed to use derivatives to hedge theirexisting positions in the spot market, or to rebalance their existing portfolios. Since bankshave little exposure to equity markets due to banking regulations, they have little incentive t otrade equity derivatives. Foreign investors must register as foreign institutional investors (FII)to trade exchange-traded derivatives, and be subject to position limits as specified by SEBI.Alternatively, they can incorporate locally as a broker -dealer. FIIs have a small but increasingpresence in the equity derivatives markets. They have no incentive to trade interest ratederivatives since they have little investments in the domestic bond markets. It is possible thatunregistered foreign investors an d hedge funds trade indirectly, using a local proprietarytrader as a front.

Retail investors (including small brokerages trading for themselves) are the majorparticipants in equity derivatives, accounting for about 60% of turnover in October 2005,according to NSE. The success of single stock futures in India is unique, as this instrumenthas generally failed in most other countries. One reason for this success may be retailinvestors’ prior familiarity with “badla” trades which shared some features of d erivativestrading. Another reason may be the small size of the futures contracts, compared to similarcontracts in other countries. Retail investors also dominate the markets for commodityderivatives, due in part to their long -standing expertise in trading in the “havala” or forwardsmarkets.

Unit 7

Investment Funds


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7.1 Investment Funds

Firm that invests the pooled funds of retail investors for a fee. By aggregating the funds of alarge number of small investors into a specific investments (in line with the objectives ofthe investors), an investment company gives individual investors access to awider range of securities than the investors themselves would have been able to access. Also,individual investors are not hampered by high trading costs since the investment company isable to gain economies of scale in operations. There are two types of investment companies:open-end (mutual funds) and closed-end (investment trusts). Also called investment fund.

A collective investment vehicle is a way of investing money alongside other investors inorder to benefit from the inherent advantages of working as part of a group. These advantagesinclude an ability to

hire a professional investment manager, whic h theoretically offers the prospects ofbetter returns and/or risk management

benefit from economies of scale - cost sharing among others diversify more than would be feasible for most individual investors which,

theoretically, reduces risk.

Terminology varies with country but collective investment vehicles are often referred toas mutual funds, investment funds, managed funds, or simply funds. Around the world largemarkets have developed around collective investment and these account for a substantialportion of all trading on major stock exchanges.

Collective investments are promoted with a wide range of investment aims either targetingspecific geographic regions ( e.g. Emerging, Europe) or specified industry sectors(e.g. Technology). Depending on the country there is normally a bias towards the domesticmarket to reflect national self -interest as perceived by policymakers, familiarity, and the lackof currency risk. Funds are often selected on the basis of these specified investment aims,their past investment performance and other factors such as fees.

7.2 Institutional Investors

Institutional investors are organizations which pool large sums of money and invest thosesums in securities, real property and other investment assets. They can also include operatingcompanies which decide to invest their profits to some degree in these types of assets.

Types of typical investors include banks, insurance companies, retirement or pensionfunds, hedge funds, investment advisors and mutual funds. Their role in the economy is to actas highly specialized investors on behalf of others. For instance, an ordinary person will havea pension from his employer. The employer gives that person's pension contributions to afund. The fund will buy shares in a company, or some other financial product. Funds areuseful because they will hold a broad portfolio of investments in many companies. Thisspreads risk, so if one company fails, it will be only a small part of the whole fund'sinvestment.

Institutional investors will have a lot of influence in the management of corpo rations becausethey will be entitled to exercise the voting rights in a company. They can actively engagein corporate governance. Furthermore, because institution al investors have the freedom tobuy and sell shares, they can play a large part in which companies stay solvent, and which gounder. Influencing the conduct of listed companies, and providing them with capital are allpart of the job of investment management.


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7.3 Private Equity Fund

A private equity fund is a collective investment scheme used for making investments invarious equities (and to a lesser extent debt) securities according to one of the investmentstrategies associated with private equity. Private equity funds are typically limitedpartnerships with a fixed term of 10 years (often with annual extensions). Atinception, institutional investors make an unfunded commitment to the limited partnership,which is then drawn over the term of the fund. From investors point of view funds can betraditional where all the investors invest with equal terms or asymmetric where differentinvestors have different terms.

A private equity fund is raised and managed by inve stment professionals of a specific privateequity firm (the general partner and investment advisor). Typically, a single private equityfirm will manage a series of distinct private equity funds and will attempt to raise a new fundevery 3 to 5 years as the previous fund is fully invested.

7.4 Mutual Fund

A mutual fund is a type of professionally-managed collective investment vehicle that poolsmoney from many investors to purchase securities.[1] While there is no legal definition ofmutual fund, the term is most commonly applied only to those collective investment vehiclesthat are regulated, available to the general public and open -ended in nature. Hedge funds arenot considered a type of mutual fund.

The term mutual fund is less widely used outside of the United States and Canada. Forcollective investment vehicles outside of the United States, see articles on specific types offunds including open-ended investment companies , SICAVs, unitized insurance funds, unittrusts and Undertakings for Collective Investment in Transferable Securities .

In the United States, mutual funds must be registered with the Securities and ExchangeCommission, overseen by a board of directors or board of trustees and managed by aregistered investment advisor. They are not taxed on their income if they comply with certainrequirements.

Mutual funds have both advantages and disadvantages compared to direct investing inindividual securities. They have a long history in the United States. Today they play animportant role in household finances.

There are 3 types of U.S. mutual funds: open -end, unit investment trust, and closed -end. Themost common type, the open-end mutual fund, must be willing to buy back its shares from itsinvestors at the end of every business day. Exchange -traded funds are open-end funds or unitinvestment trusts that trade on an exchange. Open -end funds are most common, butexchange-traded funds have been gaining in popularity.

Mutual funds are classified by their principal investments. The four largest categories offunds are money market funds, bond or fixed income funds, stock or equity funds and hybridfunds. Funds may also be categorized as index or ac tively-managed.

Investors in a mutual fund pay the fund’s expenses. There is controversy about the level ofthese expenses. A single mutual fund may give investors a choice of different combinationsof expenses by offering several different types of share classes.

7.5 Hedge Fund

A hedge fund is an investment fund that can undertake a wider range of investment andtrading activities than other funds, but which is generally only open to certain types ofinvestors specified by regulators. These investors are typically institutions, such as pension


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funds, university endowments and foundations, or high -net-worth individuals, who areconsidered to have the resources to understand the nature of the funds. Hedge fundscollectively invest in a diverse range of assets, but they most commonlytrade liquid securities on public markets. They also employ a wide variety of investmentstrategies, and make use of techniques such as short selling and leverage.

Hedge funds are typically open-ended, meaning that investors can invest and withdrawmoney at regular, specified intervals. The value of an investment in a hedge fund iscalculated as a share of the fund's net asset value, meaning that increases and decreases in thevalue of the fund's investment assets (and fund expenses) are directly reflected in the amountan investor can later withdraw.

Most hedge fund investment strate gies aim to achieve a positive return oninvestment whether markets are rising or falling. Hedge fund managers typically investmoney of their own in the fund they manage, which serves to align their interests withinvestors in the fund. A hedge fund typically pays its investment manager a management fee,which is a percentage of the assets of the fund, and a performance fee if the fund's net assetvalue increases during the year. Some hedge funds have a net asset value of several billiondollars. As of 2009, hedge funds represented 1.1% of the total funds and assets held byfinancial institutions. As of April 2012, the estimated size of the global hedge fund industrywas US$2.13 trillion.

Because hedge funds are not sold to the public or retail investors, the funds and theirmanagers have historically not been subject to the same regulations that govern other fundsand investment fund managers with regard to how the fund may be structured and howstrategies and techniques are employed. Regulations passed in the UnitedStates and Europe after the 2008 credit crisis are intended to increase government oversightof hedge funds and eliminate certain regulatory gaps.

7.6 Pension Fund

A pension fund is any plan, fund, or scheme which provides retirement income. Pensionfunds are important to shareholders of listed and private c ompanies. They are especiallyimportant to the stock market where large institutional investors dominate. The largest 300pension funds collectively hold about $6 trillion in assets. In January 2008, TheEconomist reported that Morgan Stanley estimates that pension funds worldwide hold overUS$20 trillion in assets, the largest for any category of investor ahead of mutualfunds, insurance companies, currency reserves, sovereign wealth funds, hedge funds,or private equity. Although the (Japan) Government Pension Invest ment Fund (GPIF) lost0.25 percent, in the year ended March 31, 2011 GPIF was still the world's largest publicpension fund which oversees 114 trillion Yen ($1.5 trillion).

7.7 Securitisation Process

Securitization is the financial practice of pooling var ious types of contractual debt such asresidential mortgages, commercial mortgages, auto loans or credit card debt obligations andselling said consolidated debt as bonds, pass-through securities, or Collateralized mortgageobligation (CMOs), to various investors. The principal and interest on the debt, underlyingthe security, is paid back to the various investors regularly. Securities backed by mortgagereceivables are called mortgage-backed securities (MBS), while those backed by other typesof receivables are asset-backed securities (ABS).

Critics have suggested that the complexity inherent in securitization can limit investors'ability to monitor risk, and that competitive securitization markets with multiple securitizersmay be particularly prone to sharp declines in underwriting standards. Private, competitive


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mortgage securitization is believed to have played an important rol e in the U.S. subprimemortgage crisis.

In addition, off-balance sheet treatment for securitizations coupled with guarantees from theissuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capitalstructures and leading to an under -pricing of credit risk. Off-balance sheet securitizations arebelieved to have played a large role in the high leverage level of U.S. financia l institutionsbefore the financial crisis, and the need for bailouts.

The granularity of pools of securitized assets is a mitigant to the credit ris k of individualborrowers. Unlike general corporate debt, the credit quality of securitised debt is non-stationary due to changes in volatility that are time - and structure-dependent. If thetransaction is properly structured and the pool performs as expected, the credit risk ofall tranches of structured debt improves; if improperly structured, the affected tranches mayexperience dramatic credit deterioration and loss.

Securitization has evolved from its tentative beginnings in the late 1970s to an estimatedoutstanding of $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2ndquarter of 2008. In 2007, ABS issuance amounted to $3.455 trillion in the US and $652billion in Europe. WBS (Whole Business Securitization) arrangements first appeared inthe United Kingdom in the 1990s, and became common in various Commonwealth legalsystems where senior creditors of an insolvent business effectively gain the right to controlthe company.

Examples of Test Questions

Questions

Unit 1

Questions of 2 marks.

1. Name the different forms of business organizations.

2. What is meant by a corporation?

3. Define public limited company.

4. Give three examples of corporations from real life.


1. What are the characteristics of an ideal business organization?

2. What are the advantages of a corporation?

3. What are the disadvantages of a corporation?

4. What are the characteristics of a sole proprietorship firm?

5. What are the merits of a partnership firm?

6. What are the demerits of a partnership firm?


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Unit 2


1. Define negotiable instruments.

2. Give examples of negotiable instruments.

3. What is bill of exchange?

4. What is promissory note?

5. What is bond?

6. What is share?

7. What is debenture?


1. Explain what do you mean by bill of exchange?

2. Compare bond and share as negotiable instruments.

3. How many different types of stocks are there? What are the differences betweenthem?

4. How many different types of bonds are there? What are their characteristics?

5. Explain the characteristics of a bond.

Unit 3


1. What is time value of money?

2. What is meant by “A dollar today is worth more than a dollar tomorrow”?

3. How is the equilibrium price of a financial instrument like share or bond determined?

4. What is an annuity?

5. What is perpetuity?


1. If the expected income from a stock is Rs. 1000 each for three years in the form ofdividends and if the share is to be sold at price Rs. 1000 after three years what is thefair price of the share? It is given that the market rate of interest is 10% per ann um.

2. Derive the formula for present value of an annuity.


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3. Derive the formula for the present value of perpetuity.

4. Show that P/E = 1/(i-g) where the notations have their usual meaning.

5. Consider a deposit of $100 placed at 10% (annual). How many years are need ed forthe value of the deposit to double to $200?

Unit 4


1. What do you mean by expected return from a stock?

2. What do you mean by risk from a security?

3. How risk of a security is measured?

4. How the expected return from a portfolio is meas ured?

5. How the risk from a portfolio is measured?


1. Suppose the returns from Stock A during boom, moderate state and recession are10%, 7% and 2% respectively. Each one of these states is equally likely. The returnsfrom Stock B are 15%, 10% and 5% respectively during boom, moderate state andrecession. Calculate the Stock A and B’s expected returns. Also, calculate their risks.

2. Consider Stock A and B in question (1) above. An investor has put 60% of his totalwealth in Stock A and 40% in Stock B. What is the expected return from hisportfolio? What should be the maximum risk as well as the minimum risk from hisportfolio?

3. In question (2) above if the investor invests equally in the two stocks then what willbe the expected portfolio return? Also, calculate the maximum and minimum portfoliorisk.

4. Explain how in terms of CAPM the fair return of a security held in a portfolio can bedetermined.

5. Suppose the risk-free return is 4% and market return is 10%. There are two stocks – Aand B whose betas are 1.2 and 0.8 respectively. Then using CAPM find out their fairreturns. If their actual returns are 3% and 9% respectively then comment upon theirmarket prices in terms of CAPM.

Unit 5



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1. What is balance sheet of a firm?

2. What is income statement of a firm?

3. What is the basic difference between balance sheet and income statement of a firm?

4. What is meant by liquidity ratio?

5. What is meant by turnover ratio.


1. Illustrate with a suitable example the balance sheet o f a firm.

2. Illustrate with a suitable example the income statement of a firm.

3. What do you mean by ratio analysis?

4. With Newco's current production, its sales are $7 million annually. The company'svariable costs of sales are 40% of sales, and its fixed costs are $2.4 million. Thecompany's annual interest expense is $100,000. If we increase Newco's EBIT by 20%,how much will the company's EPS increase?

5. What do you mean by capital structure of a firm?

6. Why do firms need short term finance? What are the sources of short term finance?

7. Illustrate with a suitable example the cost -effect of debt financing.

8. What are the sources of long term capital? Explain them briefly.

9. What do you mean by cost of capital? Why is cost of capital important for a firm?

10. If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per yearand should be valued at $75 per share. If flotation costs amount to $1 per share, whatis the cost of preferred stock for Prescott?

11. Explain in your own words Miller Modigliani theorem.

Unit 6


1. What is derivative?

2. What is meant by futures?

3. What is meant by options?

4. How many different types of derivatives are there?

5. What is call option?


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6. What is put option?


1. Describe in your own words the derivative s market in India.

2. What is meant by margin requirement in futures trading?

3. What are the principal features of a derivative?

4. In the context of derivatives explain what do you mean by hedging?

5. Describe speculation and arbitrage in the context of derivatives trading.

Unit 7


1. Define investment fund.

2. Define institutional investor.

3. Define mutual fund.

4. What do you mean by private equity fund?

5. What is hedge fund?

6. What is pension fund?

7. What is meant by securitization?


1. Explain in your own words what do you mean by securitization?

2. Explain in your own words what do you mean by investment fund?

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