1

CORPORATE FINANCE:
Corporate fnance is that part of fnance that deals with the fnancial
problems of corporate enterprises. These problems include the fnancial
aspects of the promotion of new enterprises and their administration during
early development, the accounting problems connected with the distinction
between capital and income, the administrative questions created by
growth and expansion; and fnally, the fnancial adustments required for the
bolstering up or rehabilitation of a corporation which has come into fnancial
di!culties.
SCOPE OF CORPORATE FINANCE:
"t studies the fnancial operation carried on by a corporation.
"t analyses the fnancial implications involved in the promotion of
corporate enterprises.
"t assists in scanning the fnancial plans of new and established
business units.
"t examines the nature, extent and form of the capital required by
corporations.
"t scrutini#es the practices and policies of administering corporate
income.
"t loo$s into the propriety of dividend, depreciation and reserve policy
adopted by various business companies.
"t studies the nature and importance of fnancial assistance rendered to
business enterprises by the di%erent fnancial institutions.
"t examines the roles of the state in regulating and controlling the
fnancial practices and policies of corporations.

FINANCIAL INSTITUTION:
&inancial institution is an establishment that focuses on dealing with
fnancial transaction such as investment loans and deposits.
' fnancial institution is one that facilitates allocation of fnancial
resources from its source to potential users.
'gencies that purvey credit in the fnancial system of a country are
collectively $nown as fnancial institution.
CHARACTERISTICS OF FI:
(avings and investment agencies.
)rofessional s$ills
(afety, liquidity and proftability
&inancing
*ole in money mar$et
+ational importance.
CLASSIFGICATIONS OF FINANCIAL INSTITUTION:
,
MONEY MARKET INSTITUTIONS:
-oney mar$et institutions is concerned with the supply of and
demand for investible fundsfor a short term period.
CAPITAL MARKET INSTITUTIONS:
The mar$et where medium term and long term funds are borrowed
and lent is $nown as Capital -ar$et "nstitutions.
INDIAN FINANCIAL INSTITUTIONS:
(1) INDUSTRIAL FINANCE CORPORATION OF INDIA (IFCI):
./+/("(0
&irst fnancial institution set up in india in 1123 for fnancing
development proects.
'"- 4 to provide medium and long term fnance to industrial
concerns.
567/CT"8/(0
To ma$e available medium and long term credit.
To provide fnancial accommodation where the normal ban$ing
accommodation is inappropriate or recourse to capital issue
channels is impracticable.
-'+'./-/+T0
6oard of 9irectors 4one: full time chairman appointed by central
govt
;
The board consists of 1, members: , nominated by central govt,
2 by "96", , by scheduled commercial ban$s, , by cooperative
ban$s < remaining , by shareholder institutions.
&=+CT"5+(0
.ranting loans and advances
(ubscribing directly to the shares
(ubscribing to the issue of debentures
.uaranteeing loans
=nderwriting of shares
'cting as an agent
&"+'+C"'> */(5=*C/(0
The corporation had an original authori#ed capital of *s. 1?? cr,
later increased to *s. ,@1 Cr.
They are authori#ed to issue < sell bonds and debentures for
raising its wor$ing capital. The limit has been fxed < not to
exceed 1? times the amount of "&C"As paid up share capital and
retained earnings.
The corporation is also authori#ed to borrow from central govt,
*6", "96" and to accept deposits from the public, (tate govt and
local authorities for a period of less than @ yrs. The relevant limit
has been fxed not to exceed *s. 1? Cr.
"t is also empowered to raise money from foreign &inancial
"nstitution in the respective foreign currency.
C*"T"C"(-
&ailure to develop industries in bac$ward region.
+eglecting the interest of small and medium si#e industries
within the framewor$ of the B yr plan
&ailure to maintain supervision over the utili#ation of sanctioned
assistance
+ot providing equity capital
-ore attention to well established concerns which otherwise
could raise loans in the mar$et.
"ncompatibility of e!ciency of the corporation due to high
establishment and other expenses.
(2) INDUSTRIAL DEVELOPMENT BANK OF INDIA (IDBI):
./+/("(0
/stablished in 11C2 as apex institution of industrial fnance in
india.
"t functioned as a segment of *6" till 11DC feb 1C and it was
delin$ed from the *6" and made autonomous corporation fully
owned by the central govt.
.5'> 4 *eorganising and integrating the structure of existing
fnancial institution in the country so as to gear them upto cater
to the demands of rapid industriali#ation
2
"t plays an important role in the process of industriali#ation
through planning, promoting and developing new industries to fll
up the gaps in the industrial structure of the country
-'+'./-/+T0
6oard of 9irectors 4 ,, members ECentral .ovtF
659 4 given representation to *6", other fnancial institutions.
"t consists di%erent committees in order to assists in its
operation.
567/CT"8/(0
To coordinate, supplement and integrate the activities of other
existing &inancial "nstitutions including commercial ban$s.
To provide term:fnance to industry
To protect direct fnancial assistance to industrial concerns.
&=+CT"5+(0
FINANCIAL FUNCTIONS PROMOTIONAL FUNCTIONS
)rovide fnancial assistance to
industrial concerns directly in
the form of loans
)rovide indirect fnancial
assistance by way of
discounting and rediscounting
of commercial papers.
underwriting or purchase or
shares and debentures
guarantee deferred payments
and loans raised from the other
fnancial institution by
extending refnancing facilitites
guarantee underwriting
obligations of institutions
mar$eting and investment
research
techno:economic studies and
surveys
technical and administrative
assistance to industrial
concerns for promotion
management or expansion
&"+'+C"'> */(5=*C/(0
'uthori#ed capital is *s @?? cr.
6orrowings from the central govt and *6"
(ale of its bond and debentures
'ccept public deposits for not less than 1, months
6orrowings on long term basis from national indian credit funds
established by *6"
*esources by way of receipts of gifts grants donations .etc. from
govt and non govt sources
-a$ing foreign currency loans with govt approval
-59/ 5& '(("(T'+C/0
&inancial assistance
(oft loan scheme
*efnance assistance
@
'ssistance to small sector
Technical development fund
/quipment fnance scheme
Change agent
*egional development
Technology adaptation, industry studies and setting up of science
and technology par$s.
(3) INDUSTRIAL CREDIT AND INVESTMENT CORPORATION OF
INDIA (ICICI):
./+/("(0
established on an @, 111@ as public ltd company
567/CT"8/(0
To assist creation, expansion and moderni#ation of industrial
enterprises in private sector
To encourage and promote the participaqtion of private capital
both internal and external in such enterprises
To encourage and promote private ownership of industrial
investment and the expansion of investment mar$ets
-'+'./-/+T0
659 4 both indian and foreign
659 is assisted by a number of committees in day to day
operations of the corporation
&=+CT"5+(0
.ranting medium and long term loans in rupees and foreign
currencies
(ubscribes new issues of shares and debentures
(ponsor and underwrites new issue of shares and debentures
.uaranteeing loans raised by industrial concerns from other
private investment sources
.uarantee deferred payment for purchase of capital goods within
india and payment
-a$ing funds available for reinvestment by revolving investment
as rapidly as prudent
(ecuring and furnishing managerial, technical and
adfministrative services to "ndian industries
&"+'+C"'> */(5=*C/(0
'uthori#ed capital: *s1?? Cr
)aid up capital 4 indian and foreign private institution >"C,
scheduled commercial ban$, oint stoc$ companies and
individuals.
'ugmentation of resources 4 issue of debentures and borrowings
from the government of india, world ban$, =G govt and agency
for "nternational 9evelopment
'CH/"8/-/+T(0
"mportant institution
C
"nvestment center
Housing fnance
(ponser "&-*
Capital mar$et
C*"T"C"(-0
)aying attention to proects in the bac$ward areas sanctions obtained
by complex procedures.
(4) EXPORT IMPORT BANK OF INDIA (EXIM) :
./+/("(0
Iholly owned by govt of india on an 1 113,as a statuatory
corporation
Commencement of operation
)=*)5(/ 4 to promote foreign trade in india
&=+CT"5+(0
)roviding fnance to export oriented industries by way of pre:
shipment fnance and guarantees as well as rediscounting
facilities.
Conducting export feasibility studies
)roviding international merchant ban$ing services
'ssisting overseas "ndian oint venture and turn:$ey construction
proects
'ssisting exporters of capital goods, software and consultancy
services.
Conducting forfeiting operations in order to enable "ndian
exporters to have the advantage of access to quic$ fnancial
assistance
&"+'+C"'> */(5=*C/(0
'uthori#ed share capital 4 ,?? crs
I5*G"+.0
Ex!"#$%& '(")*# +,%- 4 113C une
&und created with Iorld 6an$ loan of 1? million =.(. dollars
The program covers activities li$e des$ research, overseas
travel, product adaptation and inspection services, training
.etc.
"t operates 12 lending schemes at present to help "ndian
exporters
+on 4 funded assistance is provided mainly for construction
of proect which accounted for about 33B of sanction and
DDB issues.
A&*%./ 0$%* !+ ."*-$# 1
Through an agency credit line of =( J1@ million with
"&CK"nternational &inance CorporationL ,/M"- ban$ provides
fnancial assistance by way of foreign currency term loans
to private sector and small and medium enterprises in the
country
D
'ssistance is provided for investment in plant and
machinery and product and process $now how to create
and enhance export capabilities
/M"- ban$ provides rupee term loans on matching basis to
assisted enterprises
/ligible for fnancial assistance are new proects, expansion
or moderni#ation of proects and equipment imports
&irst agency line of credit from "&C to fnancial institution
(2) SMALL SCALE INDUSTRIES DEVELOPMENT BANK OF INDIA
(SIDBI):
./+/("(0
"t was set up in 5ct 1131 as a wholly owned subsidiary of "96".
"ts authori#ed capital is *s ,@? cr with an enabling provision to
increase it to *s 1??? cr
"t is the central or apex institution which oversees, coordinates
and further strenghthens various arrangements for providing
fnancial and non:fnancial assistance to small scale,tiny and
cottage industries
567/CT"8/(0
To initiate steps for technological upgradation and moderni#ation
of existing units
To expand channels for mar$eting of ((" sector products in "ndia
and abroad
To promote employment oriented industries in semi urban areas
and to chec$ migration of population to big cities
&"+'+C"'> '(("(T'+C/0
Channeled thro the existing credit delivery system comprising of
+("C, (&Cs, ("9Cs (("9C, commercial ban$s, cooperative ban$s
and **6s.
Total no. of institution eligible for assistance from ("96" is 3C1
"t discounts and rediscounts bills arising from the sale of
machinery to small units; extends seed capital, soft loan 8 thro
national equity fund and thro seed capital schemes of speciali#ed
lending institutions refnances loans and provides services li$e
factoring, leasing and so on.
DIVIDENDS:
They are defned as the N Taxable payment declared by a companyAs
659 and given to its shareholders out of the companyAs current or retained
earnings, usually quarterlyO.
DIVIDEND POLICY:
it is that policy that a company uses to decide how much it will payout
to its shareholders.
FACTORS DETERMINING DIVIDEND POLICY:
Types of business
(tability of earnings
'ge of corporation
3
>iquidity of funds
/xtent of share distribution
+eeds for additional capital
TradePbusiness cycles
.ovt policies
Taxation policy
>egal requirements
)ost dividend rates
'bility to borrow
)olicy of control
*epayment of loan
Time for payment of dividend
THEORIES OF DIVIDEND POLICY:
*/>/8'+C/ TH/5*Q "**/>/8'+C/ TH/5*Q
D*3%$#$!% Theory hold that the dividend of a
frm has a direct e%ect on the
position of the frm in the stoc$
exchange
Theory tht hold tht the
dividend policy has no
e%ect on the share prices
of the frm
M!-*04
,%-*" #5*
#5*!"/
IalterAs model .ordonAs model -odigliani:-iller approach
6(0#*"74
'!-*0
G!"-!%74 '!-*0 M!-$&0$(%$1M$00*"
A44,'#$!
%4
*etained
earnings
represent only
the source of
fnancing of the
frm
The frm is an
equity frm. +o
external fnancing
is used and
investment
programmes are
fnanced
exclusively by
retained earnings
Capital mar$ets are perfect.
"nvestors are well informed
about the ris$ and return of
all types of securities.they
are free to buy and sell
securities
The return on
the frmAs
investment
remains
constant
The internal rate
of return and
appropriate
discount rate E$F
for the frm are
constant.
There are no transaction
cost. They can borrow with
no restrictions on the same
terms as frms do.
Cost of capital
for the frm
remains
constant.
The frm has
perpetual life and
its stream of
earnings are
perpetual
+o corporate and personal
taxes ,the tax rates are
same for dividend and
capital gains
The frm has
infnite life
+o corporate tax The frm has fxed
investment policy under
which at each yr end it
invests a specifc amount
1
as capital expenditure
'll the earnings
are distributed
or re invested in
the frm
The retention
ratio once
decided upon is
constant. Thus
the growth rate is
also constant
"nvestors are able to
predict the future dividends
and mar$et prices and only
one discount rate for the
entire period.
/)( and
dividend
remains
constant in
determining a
given value
Cost of capitalR
growth rate
'll investments are funded
either by equityor by
retained earnings
F!"',0(

Ihere ,
p 4 mar$et
price Pshare
d 4 dividend
Pshare
r 4 rate of return
on investment
by frm
$ 4 cost of
capital
e 4 earning P
share

Ihere,
p 4 mar$et
price Pshare
d 4 dividend
Pshare
r 4 rate of return
on investment by
frm
$ 4 cost of capital
e 4 earning P
share
b 4 retention ratio
g 4 growth
rateEbrF

Ihere, S present T
mar$et
value of
price of
dividends
the share
at
the end of s
period

Ihere ,
S mar$et price P share at
the end of period
S current mar$et price
S cost of equity capital
S dividend P share at the
end of the period
D*#*"'$%(#$!% !+ %! !+
%*8 45("*4
"nvestment proposed
: xxx
E:F
*etained earnings
net income 4 xxx
E:F distributed
9ividends : xxx
1?
UUU : xxx
'mount to be raised by
"ssue of new shares EaF
V xxx
+o of new shares S
aVVVVVVV
"ssue
price Pshare
I%+*"*%.* 9
$'0$.(#$!%
4
5ptimal
payment ratio
for a growth
frm is nil
)ayout ratio
for a normal
frm is
irrelevant
5ptimal
payout ratio
for a declining
frm is 1??B
Higher the
retention ratio,
higher is the
value of frm
and vice
versa.
5ptimal payout
ratio for a
growth frm is
nil.
)ayout ratio for
a normal frm is
irrelevant
The optimal
payout ratio for
a declining frm
is 1??B
Higher the retention ratio
higher is the capital
appreciation enoyed by
the share holders. The
capital appreciation is
equal to the amount of
earnings retained.
"f the frm distributed
earnings by way of
dividends the share
holders enoy dividendsS
the amount of capital
appreciation if the frm
had retained the amount
of dividends.
C"$#$.$4' +o external
fnancing.
Constant rate
of return
Constant
opportunity
cost
'ssumption of
1??B equity
funding defeat
the obective of
maximi#ation of
wealth by
leveraging
against a lower
cost of debt.
Constant *5* <
current
opportunity cost
are not in tune
with realities.
'ssumption of perfect
capital mar$et is
theoretical.
&ollowing propositions on
dividend are
impracticable0
1. "nvestors can switch
between capital
gains < dividend.
,. 9ividend are
irrelevant
;. 9ividends do not
determine the frm
value
The situation of #ero taxes
is not possible.
The assumptions of no
stoc$ WoatationPtime lag <
no taxation costs are
11
impossible.
UNIT2
R$4) (%- R*#,"% A%(0/4$4
*eturn expresses the amount which an investor actually earned on an
investment during a certain period. *eturn includes the interest, dividend
and capital gains; while ris$ represents the uncertainty associated with a
particular tas$. "n fnancial terms, ris$ is the chance or probability that a
certain investment may or may not deliver the actualPexpected returns.
The ris$ and return trade o% says that the potential return rises with an
increase in ris$. "t is important for an investor to decide on a balance
between the desire for the lowest possible ris$ and highest possible return.
R$4) A%(0/4$4
*is$ in investment exists because of the inability to ma$e perfect or accurate
forecasts. *is$ in investment is defned as the variability that is li$ely to
occur in future cash Wows from an investment. The greater variability of
these cash Wows indicates greater ris$.
8ariance or standard deviation measures the deviation about expected cash
Wows of each of the possible cash Wows and is $nown as the absolute
measure of ris$; while co:e!cient of variation is a relative measure of ris$.
&or carrying out ris$ analysis, following methods are used:
)aybac$ KHow long will it ta$e to recover the investmentL
Certainty equivalent KThe amount that will certainly come to youL
*is$ adusted discount rate K)resent value i.e. )8 of future inWows with
discount rateL
However in practice, sensitivity analysis and conservative forecast
techniques being simpler and easier to handle, are used for ris$ analysis.
(ensitivity analysis Ka variation of brea$ even analysisL allows estimating the
impact of change in the behavior of critical variables on the investment cash
Wows. Conservative forecasts include using short paybac$ or higher discount
rates for discounting cash Wows.
I%:*4#'*%# R$4)4
"nvestment ris$ is related to the probability of earning a low or negative
actual return as compared to the return that is estimated. There are , types
of investments ris$s0
1. S#(%-1(0!%* "$4)
1,
This ris$ is associated with a single asset, meaning that the ris$ will
cease to exist if that particular asset is not held. The impact of stand
alone ris$ can be mitigated by diversifying the portfolio.
(tand:alone ris$ S -ar$et ris$ T &irm specifc ris$
Ihere,
o -ar$et ris$ is a portion of the securityXs stand:alone ris$ that
cannot be eliminated trough diversifcation and it is measured by
beta
o &irm ris$ is a portion of a securityXs stand:alone ris$ that can be
eliminated through proper diversifcation
2; P!"#+!0$! "$4)
This is the ris$ involved in a certain combination of assets in a portfolio
which fails to deliver the overall obective of the portfolio. *is$ can be
minimi#ed but cannot be eliminated, whether the portfolio is balanced
or not. ' balanced portfolio reduces ris$ while a non:balanced portfolio
increases ris$.
(ources of ris$s
o "nWation
o 6usiness cycle
o "nterest rates
o -anagement
o 6usiness ris$
o &inancial ris$
R*#,"% A%(0/4$4
'n investment is the current commitment of funds done in the expectation of
earning greater amount in future. *eturns are subect to uncertainty or
variance >onger the period of investment, greater will be the returns sought.
'n investor will also li$e to ensure that the returns are greater than the rate
of inWation.
'n investor will loo$ forward to getting compensated by way of an expected
return based on ; factors :
*is$ involved
9uration of investment KTime value of moneyL
1;
/xpected price levels K"nWationL
The basic rate or time value of money is the real ris$ free rate K**&*L which
is free of any ris$ premium and inWation. This rate generally remains stable;
but in the long run there could be gradual changes in the **&* depending
upon factors such as consumption trends, economic growth and openness of
the economy.
"f we include the component of inWation into the **&* without the ris$
premium, such a return will be $nown as nominal ris$ free rate K+*&*L
NRFR < ( 1 = RRFR ) > ( 1 = *x*.#*- "(#* !+ $%?(#$!% ) 1 1
Third component is the ris$ premium that represents all $inds of
uncertainties and is calculated as follows :
Ex*.#*- "*#,"% < NRFR = R$4) "*'$,'
R$4) (%- "*#,"% #"(-* !@
"nvestors ma$e investment with the obective of earning some tangible
beneft. This beneft in fnancial terminology is termed as return and is a
reward for ta$ing a specifed amount of ris$.
*is$ is defned as the possibility of the actual return being di%erent from the
expected return on an investment over the period of investment. >ow ris$
leads to low returns. &or instance, incase of government securities, while the
rate of return is low, the ris$ of defaulting is also low. High ris$s lead to
higher potential returns, but may also lead to higher losses. >ong:term
returns on stoc$s are much higher than the returns on .overnment
securities, but the ris$ of losing money is also higher.
*ate of return on an investment cal be calculated using the following
formula:
R*#,"% < (A'!,%# "*.*$:*- 1 A'!,%# $%:*4#*-) 9 A'!,%# $%:*4#*-
He ris$ and return trade o% says that the potential rises with an increase in
ris$. 'n investor must decide a balance between the desire for the lowest
possible ris$ and highest possible return.
12
T/*4 !+ R$4)
S/4#*'(#$. R$4) : (ystematic ris$ inWuences a large number of
assets. ' signifcant political event, for example, could a%ect several of
the assets in your portfolio. "t is virtually impossible to protect yourself
against this type of ris$.
U%4/4#*'(#$. R$4) : =nsystematic ris$ is sometimes referred to as
Yspecifc ris$Y. This $ind of ris$ a%ects a very small number of assets.
'n example is news that a%ects a specifc stoc$ such as a sudden
stri$e by employees. 9iversifcation is the only way to protect yourself
from unsystematic ris$.
C"*-$# !" D*+(,0# R$4) : Credit ris$ is the ris$ that a company or
individual will be unable to pay the contractual interest or principal on
its debt obligations. This type of ris$ is of particular concern to
investors who hold bonds in their portfolios. .overnment bonds,
especially those issued by the federal government, have the least
amount of default ris$ and the lowest returns, while corporate bonds
tend to have the highest amount of default ris$ but also higher interest
rates. 6onds with a lower chance of default are considered to be
investment grade, while bonds with higher chances are considered to
be un$ bonds.
C!,%#"/ R$4) : Country ris$ refers to the ris$ that a country wonXt be
able to honor its fnancial commitments. Ihen a country defaults on its
obligations, this can harm the performance of all other fnancial
instruments in that country as well as other countries it has relations
1@
with. Country ris$ applies to stoc$s, bonds, mutual funds, options and
futures that are issued within a particular country.
F!"*$&%1Ex.5(%&* R$4) : Ihen investing in foreign countries you
must consider the fact that currency exchange rates can change the
price of the asset as well. &oreign:exchange ris$ applies to all fnancial
instruments that are in a currency other than your domestic currency.
I%#*"*4# R(#* R$4) : "nterest rate ris$ is the ris$ that an investmentXs
value will change as a result of a change in interest rates. This ris$
a%ects the value of bonds more directly than stoc$s.
P!0$#$.(0 R$4) : )olitical ris$ represents the fnancial ris$ that a
countryXs government will suddenly change its policies. This is a maor
reason why developing countries lac$ foreign investment.
M(")*# R$4) : This is the most familiar of all ris$s. 'lso referred to as
volatility, mar$et ris$ is the the day:to:day Wuctuations in a stoc$Xs
price. -ar$et ris$ applies mainly to stoc$s and options. 's a whole,
stoc$s tend to perform well during a bull mar$et and poorly during a
bear mar$et : volatility is not so much a cause but an e%ect of certain
mar$et forces. 8olatility is a measure of ris$ because it refers to the
behavior, or YtemperamentY, of your investment rather than the reason
for this behavior.
D$:*"4$3.(#$!%
9iversifcation is a ris$:management technique that mixes a wide
variety of investments within a portfolio in order to minimi#e the impact that
any one security will have on the overall performance of the portfolio.
9iversifcation lowers the ris$ of your portfolio.
CAPITAL ASSET PRICING MODEL
"n fnance, the capital asset pricing model EC')-F is used to determine
a theoretically appropriate required rate of return of an asset, if that asset is to
be added to an already well:diversifed portfolio, given that assetXs non:
diversifable ris$. The model ta$es into account the assetXs sensitivity to non:
diversifable ris$ Ealso $nown as systematic ris$ or mar$et ris$F, often
represented by the quantity beta EZF in the financial industry, as well as the
expected return of the mar$et and the expected return of a theoretical ris$:free
asset.
T5* +!"',0(
1C
The (ecurity -ar$et >ine, seen here in a graph, describes a relation between
the beta and the assetXs expected rate of return.
The C')- is a model for pricing an individual security or a portfolio. &or
individual securities, we ma$e use of the security market line E(->F and its
relation to expected return and systematic risk EbetaF to show how the mar$et
must price individual securities in relation to their security ris$ class. The
(-> enables us to calculate the reward:to:ris$ ratio for any security in
relation to that of the overall mar$et. Therefore, when the expected rate of
return for any security is deWated by its beta coe!cient, the reward:to:ris$
ratio for any individual security in the mar$et is equal to the mar$et reward:
to:ris$ ratio, thus0

The mar$et reward:to:ris$ ratio is e%ectively the mar$et ris$ premium and by
rearranging the above equation and solving for /E*iF, we obtain the C')-.
where0
is the expected return on the capital asset
is the ris$:free rate of interest such as interest arising from
government bonds
Ethe betaF is the sensitivity of the expected excess asset returns to the
expected excess mar$et returns, or also ,
is the expected return of the mar$et
is sometimes $nown as the market premiumEthe
di%erence between the expected mar$et rate of return and the ris$:
free rate of returnF.
1D
is also $nown as the risk premium
*estated, in terms of ris$ premium, we fnd that0
which states that the individual risk premium equals the market premium
times .
S*.,"$#/ '(")*# 0$%*
The SML essentially graphs the results from the capital asset pricing
model EC')-F formula. The x:axis represents the ris$ EbetaF, and the y:axis
represents the expected return. The mar$et ris$ premium is determined from
the slope of the (->.
The relationship between Z and required return is plotted on the
securities market line E(->F which shows expected return as a function of Z.
The intercept is the nominal ris$:free rate available for the mar$et, while the
slope is the mar$et premium, /ER
m
F[ R
f
. The securities mar$et line can be
regarded as representing a single:factor model of the asset price, where 6eta
is exposure to changes in value of the -ar$et. The equation of the (-> is
thus0
"t is a useful tool in determining if an asset being considered for a portfolio
o%ers a reasonable expected return for ris$. "ndividual securities are plotted
on the (-> graph. "f the securityXs expected return versus ris$ is plotted
above the (->, it is undervalued since the investor can expect a greater
return for the inherent ris$. 'nd a security plotted below the (-> is
overvalued since the investor would be accepting less return for the amount
of ris$ assumed.
A44*# "$.$%&
5nce the expectedPrequired rate of return, EER
i
F, is calculated using C')-,
we can compare this required rate of return to the assetXs estimated rate of
return over a specifc investment hori#on to determine whether it would be
an appropriate investment. To ma$e this comparison, you need an
independent estimate of the return outloo$ for the security based on either
+,%-('*%#(0 !" #*.5%$.(0 (%(0/4$4 #*.5%$A,*4, including )P/, -P6 etc.
'ssuming that the C')- is correct, an asset is correctly priced when its
estimated price is the same as the present value of future cash Wows of the
asset, discounted at the rate suggested by C')-. "f the observed price is
higher than the C')- valuation, then the asset is undervalued Eand
overvalued when the estimated price is below the C')- valuationF Ihen the
asset does not lie on the (->, this could also suggest mis:pricing. (ince the
13
expected return of the asset at time t is , a higher
expected return than what C')- suggests indicates that P
t
is too low Ethe
asset is currently undervaluedF, assuming that at time t T 1 the asset returns
to the C')- suggested price.The asset price P
?
using C')-, sometimes
called the certainty equivalent pricing formula, is a linear relationship given by
where P
T
is the payo% of the asset or portfolio.
A44*#14*.$3. "*A,$"*- "*#,"%
The C')- returns the asset:appropriate required return or discount
rate\i.e. the rate at which future cash Wows produced by the asset should be
discounted given that assetXs relative ris$iness. 6etas exceeding one signify
more than average Yris$inessY; betas below one indicate lower than average.
Thus, a more ris$y stoc$ will have a higher beta and will be discounted at a
higher rate; less sensitive stoc$s will have lower betas and be discounted at
a lower rate. .iven the accepted concave utility function, the C')- is
consistent with intuition\investors EshouldF require a higher return for
holding a more ris$y asset.
(ince beta reWects asset:specifc sensitivity to non:diversifable, i.e. mar$et
risk, the mar$et as a whole, by defnition, has a beta of one. (toc$ mar$et
indices are frequently used as local proxies for the mar$et\and in that case
Eby defnitionF have a beta of one. 'n investor in a large, diversifed portfolio
Esuch as a mutual fundF, therefore, expects performance in line with the
mar$et.
R$4) (%- -$:*"4$3.(#$!%
The ris$ of a portfolio comprises systematic risk, also $nown as undiversifable
ris$, and unsystematic risk which is also $nown as idiosyncratic ris$ or
diversifable ris$. (ystematic ris$ refers to the ris$ common to all securities\
i.e. market risk. =nsystematic ris$ is the ris$ associated with individual assets.
=nsystematic ris$ can be diversified away to smaller levels by including a
greater number of assets in the portfolio Especifc ris$s Yaverage outYF. The
same is not possible for systematic ris$ within one mar$et. 9epending on the
mar$et, a portfolio of approximately ;?:2? securities in developed mar$ets
such as =G or =( will render the portfolio su!ciently diversifed such that ris$
exposure is limited to systematic ris$ only. "n developing mar$ets a larger
number is required, due to the higher asset volatilities.
' rational investor should not ta$e on any diversifable ris$, as only non:
diversifable ris$s are rewarded within the scope of this model. Therefore, the
11
required return on an asset, that is, the return that compensates for ris$
ta$en, must be lin$ed to its ris$iness in a portfolio context : i.e. its
contribution to overall portfolio ris$iness : as opposed to its Ystand alone
ris$iness.Y "n the C')- context, portfolio ris$ is represented by higher variance
i.e. less predictability. "n other words the beta of the portfolio is the defning
factor in rewarding the systematic exposure ta$en by an investor.
T5* *B.$*%# +"!%#$*"
The E-ar$owit#F e!cient frontier. C'> stands for the capital allocation line.
The C')- assumes that the ris$:return profle of a portfolio can be
optimi#ed\an optimal portfolio displays the lowest possible level of ris$ for
its level of return. 'dditionally, since each additional asset introduced into a
portfolio further diversifes the portfolio, the optimal portfolio must comprise
every asset, Eassuming no trading costsF with each asset value:weighted to
achieve the above Eassuming that any asset is infinitely divisibleF. 'll such
optimal portfolios, i.e., one for each level of return, comprise the e!cient
frontier.6ecause the unsystematic ris$ is diversifiable, the total ris$ of a
portfolio can be viewed as beta.
T5* '(")*# !"#+!0$!
'n investor might choose to invest a proportion of his or her wealth in a
portfolio of ris$y assets with the remainder in cash\earning interest at the
ris$ free rate Eor indeed may borrow money to fund his or her purchase of
ris$y assets in which case there is a negative cash weightingF. Here, the ratio
of ris$y assets to ris$ free asset does not determine overall return\this
relationship is clearly linear. "t is thus possible to achieve a particular return
in one of two ways0
1. 6y investing all of oneXs wealth in a ris$y portfolio,
,. or by investing a proportion in a ris$y portfolio and the remainder in
cash Eeither borrowed or investedF.
,?
&or a given level of return, however, only one of these portfolios will be
optimal Ein the sense of lowest ris$F. (ince the ris$ free asset is, by defnition,
uncorrelated with any other asset, option , will generally have the lower
variance and hence be the more e!cient of the two.
This relationship also holds for portfolios along the e!cient frontier0 a higher
return portfolio plus cash is more e!cient than a lower return portfolio alone
for that lower level of return. &or a given ris$ free rate, there is only one
optimal portfolio which can be combined with cash to achieve the lowest
level of ris$ for any possible return. This is the market portfolio.
L*:*"(&* (3%(%.*)
"n finance, leverage Esometimes referred to as gearing in the =nited GingdomF
is a general term for any technique to multiply gains and losses.[1] Common
ways to attain leverage are borrowing money, buying fixed assets and using
derivatives.[2] "mportant examples are0
' public corporation may leverage its equity by borrowing money. The
more it borrows, the less equity capital it needs, so any profts or losses
are shared among a smaller base and are proportionately larger as a
result.K;L
' business entity can leverage its revenue by buying fxed assets. This
will increase the proportion of fxed, as opposed to variable, costs,
meaning that a change in revenue will result in a larger change in
operating income.K2L K@L
Hedge funds often leverage their assets by using derivatives. ' fund
might get any gains or losses on J,? million worth of crude oil by
posting J1 million of cash as margin
T/* !+ 0*:*"(&* :1
1. O*"(#$%& 0*:*"(&*:
"t is B change in earning before interest and tax divided by B
change in sale . "f company is charging fxed cost , the operating
leverage tells the /6"T will greater than sale because due to increasing
sale of fxed cost per unit will decrease and it will increase /6"T higher
than sale .
F!"',0(
O*"(#$%& L*:*"(&* < C .5(%&* $% EBIT 9 C
.5(%&* $% S(0*
This leverage is very helpful for fnance manager because , if operating
leverage is more than or suppose it is two then it means if sale will
increase 1??B then earning will increase ,??B . 't this time , fnance
,1
manager can get more loan for increasing the earning of shareholders .
2; F$%(%.$(0 0*:*"(&*
"t is second type of leverage . &inancial leverage is $nown as trading on
equity . "f any companyXs fnance manager $nows that companyXs
return on investment is more than interest on loan or borrowing
obligation . 't this time , if company needs more money , then fnance
manager gets its loan and bought the asset from same loan . (o, any
technique in which any asset is purchased with loan and trying to
increase /)( , then this is called fnancial leverage .
&ormula for calculating fnancial leverage
< C .5(%&* $% E("%$%& *" 45("* 9 C .5(%&* $% *("%$%& D*+!"*
$%#*"*4# (%- #(x
< C .5(%&* $% EPS 9 C .5(%&* $% EBIT
This formula explains the relationship between B change in /)( and B
change in /6"T and after deep study of this fnancial leverage , fnance
manager decides to get appropriate loan for buying assets .
3; C!'D$%*- 0*:*"(&*
"t is the product of operating leverage and fnancial leverage .
C!'D$%*- 0*:*"(&* < O*"(#$%& 0*:*"(&* X 3%(%.$(0 0*:*"(&*
< C .5(%&* $% EBIT 9 C .5(%&* $% 4(0* X C .5(%&* $% EPS 9 C
.5(%&* $% EBIT
] High operating leverage and high fnancial leverage combination is
high ris$y for business .
] .ood combination is that in which lower operating leverage with
high fnancial leverage
M(E!" "*(4!%4 +!" B,4$%*44 F($0,"*4
1. S#("#$%& ( D,4$%*44 E,4# +!" #5* 4()* !+ 4#("#$%& $# 4 Iell if you
are really planning a new business launch, ust because you want to
earn more money or if you are bored of your ob and a cran$y boss or
may be you thin$ that youAll be able to spend some more time with
your family, if you have your own business, then you should defnitely
give it a thought again. +one of the above reason is going to get you
success in business. 6ut yes if a person is passionate about some thing
and wants to ta$e it a step ahead or if you are physically ft and ready
for any $ind of challenge, are determined and strong willed and you are
,,
creative enough to tac$le the competition then of course you can and
should start your own business.
,. L(.) !+ L*(-*"45$ F,(0$#/ 4 This accounts for the number one
reason of the business failures. ' person who starts a new business
often lac$s a lot of management qualities which often lead to a bad
fnancing, poor purchasing, reselling and even hiring. Ihich in turn
obviously cause a lot of trouble to the business resulting in a disastrous
failure. 'lso, a person who is a bad manager could lead to conWicts
with employees, and potential lawsuits. >egal matters such as the
>ight.roup lawsuit, Ial:-art labor issues, and other employment
related problems could lead to failed businesses.
;. L*44 I%:*4#'*%# 4 )eople often start their business without even
noticing the amount of investment needed initially, this often causes a
big disaster as either the whole company goes ban$rupt or the
business itself faces big losses when the outgoing goes way above the
incoming. That is why it is very much necessary to assess the amount
of money that is needed and if possible have some extra funds in case
you need them, as you never $now when the costing can go out of
your hand. "f you plan on using loans or credit to fund your business,
youAll also want to $eep a close eye on your personal and business
credit reports to ensure youAre eligible for the best terms possible.
2. L!.(0$#/ : Iell of course you would never start a business in a place
where it doesnAt belong. ' good location gives you a lot of benefts if
selected smartly. Things you should consider before selecting your
business location0
a. Consider the niche of your business
b. Gind of customers according to your business type
c. ^uality of the location
d. 6usiness &riendly environment
e. Iell equipped neighborhood
@. P!!" P0(%%$%&: (etting up a business or " should better be saying, a
successful business, one need a foolproof plan of its establishment. '
person, who puts in a methodical e%ort and smart planning along with
hard wor$, surely achieves a lot in his business. Things that should be
considered in planning0
a. .oals and &uture Targets or )lans of your business
b. The total 5!ce set up "ncluding the employees and
infrastructure
c. &inancial 6ac$ up and -anagement
,;
d. -ar$et analysis
e. )romotional (trategies
f. 5nes strength and wea$nesses
C. L(.) !+ M!-*"%$G(#$!% #*.5%$A,*4 (%- '*#5!-4 4 "n this fast
paced world with highly competitive mar$et, a new businessman can
ust not a%ord to have a successful business running on old and
outdated technology. (o one must be fully aware and equipped with
latest technology. >i$e for e.g. these days it has become so much
necessary to have your own website. ' businessman cannot a%ord not
to have a company website. 's it gives you a brand name, a website
wor$s as your global recognition forum, people recogni#e you globally
through internet and get to $now who you are teaming up with some of
the biggest clients of the industry.
T5* '(E!" 8*()%*44*4 !+ D,4$%*44*4 .(% D* .0(44$3*- (4
D*0!80
E%#"*"*%*,"$(0:
1. =ntrained Enon professionalF and in experienced entrepreneurs in
particular trade.
,. Trading entrepreneurs entering manufacturing sector and now in
services sector
;. .reed and )rofteering: "mmediate profts and narrow vision.
2. =nwillingness to buy technology and pay to s$illed loyal wor$ers.
)oor H* functions.
@. 5ver growth or hasty growth without building systems and
organi#ation with committed, trained and motivated wor$ force Eboth
at wor$er level and at managerial levelF. " have seen many businesses
fail when entrepreneurs tried to grow in si#e signifcantly and abruptly
without gaining experience and adequate resources or capability,
graduating from an (-/ to large or from a small to medium si#ed
operations. )articularly Human resource and -ar$eting networ$ are
areas where they failed miserably.
S#",.#,"(0 8*()%*44*4:
1. Too small or too large capacity that is not right for a ;:@ years period
hori#on, only.
,. )oor mar$eting networ$ E6y far the most di!cult to develop 4
especially for (-/sF.-ost (-/s are puppets in hands of maor
distributors in the networ$.
;. Irong location causing dearth of good employees andPor raw
,2
material or logistics support and thus increased cost of product and
processes and training and development charges.
2. 5ver fnancing by debt or over capitali#ation for long term assets, or
lac$ of wor$ing capital E due to several reasons li$e poor credit
managementF or both
@. )oor technology that is already obsolete or not li$ely to be
competitive in next ;:@ years period hori#on.
C. )oor quality and completely lac$ing management systems including
lac$ of delegation.
D. )oor internal employee training and development program and
failure to involve employees, particularly in services sector. &ailure to
involve them emotionally and create motivation.
3. >ac$ of innovation culture in organi#ation with customer need in
focus.
1. >ac$ of up gradation, moderni#ation and introduction of new
products and services regularly.
1?. )oor attitude towards consumerPcustomer and their needs and
complaints E' maor problem with "ndian customer care executives
and owners ali$eF
11. >ac$ of industry and regulatory norms being followed. "n "ndia
particularly entrepreneurs tend to overloo$ norms and regulations fxed
for business derisively and contemptuously. This leads to wastage,
poor productivity and poor quality.
1,. =nstable source of raw materials and its quality at .lobally
competitive pricesF
1;. &ailure to create 6randP 6rand experience or piggybac$ing on
other brands far too much E-ore brands are dieing today than
createdF.
12. *elaxing standards or cutting costs under illusion of having arrived
EsuccessF by new businesses. "t is only matter of time before
competition and consumers catch you on wrong and wea$ foot.
1@. >ac$ of 9ocumented and well laid out policy and procedure
manuals with quality chec$ points. High reection rates or poor
products result that consumers donXt value. *emember consumer buys
till she has no option. "t is not consumer loyalty. Consumer is loyal to
no one for a few Cents o% E Gotler, )hilipF
Ex#*"%(0 (*%:$"!%'*%#(0) +(.#!"40
1. +on availability of logistics chain and too high cost of distribution
Eparticularly in traditional channelsF Hybrid channels are in thing with
web sites and emails as important channel. E "gnoring this will result
loss of business to many good frmsF
,. Too high cost of interaction with government and regulatory
agencies E"ndia: almost 1?B :1@B of sales turnoverF
;. )oor industrial and logistic infrastructure and lac$ of modern
facilities for shipment and handling.
2. .lobal competition tending to ma$e products obsolete and tending
,@
to push prices downE particularly those made in countries li$e China,
Taiwan, Gorea, -exico, and such countriesF
@. )oor labor productivity in "ndia on account of several complex
reasons
C. *ising costs of doing business. High economic rents demanded by
all.
D. -ergers and 'cquisitions ma$ing competition and capabilities unfair
to the frm.
3. )olitical interventions and political instability
1. High interest rates and cost of raising capital
1?. )oor "ndustry *5"
11. )roduct of organi#ation moving down the product >ife cycle, if one
applies.
1,. /xchange rate Wuctuations or wea$ domestic currency or wide
arbitrage gaps in foreign currency mar$ets.
1;. /ducated and aware consumers with internet technology driving
hisPher factual $nowledge about product and its availability and
alternate channels of supply.
12 High taxation in "ndia with poor infrastructure and delayed
deliveries will result in mar$ets Wooded by cheaper and well made
goods li$e from China.
1@ +ew models are being thrust on mar$et post IT5 opening li$e
organi#ed retails, -alls and -ultiplexes ma$ing traditional shop going
out of business. 8olumes and comfort will matter except for daily
necessities purchases from corner shop.
M*"&*"4 (%- (.A,$4$#$!%4
M*"&*"4 (%- (.A,$4$#$!%4 Eabbreviated MHAF refers to the aspect of
corporate strategy, corporate fnance and management dealing with the buying,
selling, dividing and combining of di%erent companies and similar entities that
can aid, fnance, or help an enterprise grow rapidly in its sector or location of
origin or a new feld or new location without creating a subsidiary, other child
entity or using a oint venture
A.A,$4$#$!%
'n (.A,$4$#$!% is the purchase of one business or company by another
company or other business entity. Consolidation occurs when two companies
combine together to form a new enterprise altogether, and neither of the
previous companies survives independently. 'cquisitions are divided into
YprivateY and YpublicY acquisitions, depending on whether the acquiree or
merging company Ealso termed a targetF is or is not listed on public stock markets.
'cquisitionY usually refers to a purchase of a smaller frm by a larger one.
(ometimes, however, a smaller frm will acquire management control of a
larger andPor longer:established company and retain the name of the latter
for the post:acquisition combined entity. This is $nown as a reverse ta$eover.
,C
'nother type of acquisition is the reverse merger, a form of transaction that
enables a private company to be publicly listed in a relatively short time
frame. ' reverse merger occurs when a privately held company Eoften one
that has strong prospects and is eager to raise fnancingF buys a publicly
listed shell company, usually one with no business and limited assets.K2L
There are also a variety of structures used in securing control over the assets
of a company, which have di%erent tax and regulatory implications0
The buyer buys the shares, and therefore control, of the target
company being purchased. 5wnership control of the company in turn
conveys e%ective control over the assets of the company, but since the
company is acquired intact as a going concern, this form of transaction
carries with it all of the liabilities accrued by that business over its past
and all of the ris$s that company faces in its commercial environment.
The buyer buys the assets of the target company. The cash the target
receives from the sell:o% is paid bac$ to its shareholders by dividend or
through liquidation. This type of transaction leaves the target company
as an empty shell, if the buyer buys out the entire assets. ' buyer
often structures the transaction as an asset purchase to Ycherry:pic$Y
the assets that it wants and leave out the assets and liabilities that it
does not. This can be particularly important where foreseeable
liabilities may include future, unquantifed damage awards such as
those that could arise from litigation over defective products,
employee benefts or terminations, or environmental damage. '
disadvantage of this structure is the tax that many urisdictions,
particularly outside the =nited (tates, impose on transfers of the
individual assets, whereas stoc$ transactions can frequently be
structured as li$e:$ind exchanges or other arrangements that are tax:
free or tax:neutral, both to the buyer and to the sellerXs shareholders.
6ased on the content analysis of seven interviews authors concluded fve
following components for their grounded model of acquisition0
1. "mproper documentation and changing implicit $nowledge ma$es it
di!cult to share information during acquisition.
,. &or acquired frm symbolic and cultural independence which is the
base of technology and capabilities are more important than
administrative independence.
;. 9etailed $nowledge exchange and integrations are di!cult when the
acquired frm is large and high performing.
,D
2. -anagement of executives from acquired frm is critical in terms of
promotions and pay incentives to utili#e their talent and value their
expertise.
@. Transfer of technologies and capabilities are most di!cult tas$ to
manage because of complications of acquisition implementation. The
ris$ of losing implicit $nowledge is always associated with the fast pace
acquisition.
B,4$%*44 :(0,(#$!%
The fve most common ways to valuate a business are
asset valuation,
historical earnings valuation,
future maintainable earnings valuation,
relative valuation Ecomparable company < comparable transactionsF,
discounted cash Wow E9C&F valuation
M!#$:*4 D*5$%- MHA
The dominant rationale used to explain -<' activity is that acquiring frms
see$ improved fnancial performance. The following motives are considered
to improve fnancial performance0
ECONOMY OF SCALE : This refers to the fact that the combined
company can often reduce its fxed costs by removing duplicate
departments or operations, lowering the costs of the company relative
to the same revenue stream, thus increasing proft margins.
ECONOMY OF SCOPE : This refers to the e!ciencies primarily
associated with demand:side changes, such as increasing or
decreasing the scope of mar$eting and distribution, of di%erent types
of products.
INCREASED REVENUE OR MARKET SHARE : This assumes that the
buyer will be absorbing a maor competitor and thus increase its
mar$et power Eby capturing increased mar$et shareF to set prices.
CROSS1SELLING : &or example, a ban$ buying a stoc$ bro$er could then
sell its ban$ing products to the stoc$ bro$erXs customers, while the
bro$er can sign up the ban$Xs customers for bro$erage accounts. 5r, a
manufacturer can acquire and sell complementary products.
SYNERGY : &or example, managerial economies such as the increased
opportunity of managerial speciali#ation. 'nother example are
,3
purchasing economies due to increased order si#e and associated bul$:
buying discounts.
TAXATION 0 ' proftable company can buy a loss ma$er to use the
targetXs loss as their advantage by reducing their tax liability. "n the
=nited (tates and many other countries, rules are in place to limit the
ability of proftable companies to YshopY for loss ma$ing companies,
limiting the tax motive of an acquiring company.
GEOGRAPHICAL OR OTHER DIVERSIFICATION 0 This is designed to
smooth the earnings results of a company, which over the long term
smoothens the stoc$ price of a company, giving conservative investors
more confdence in investing in the company. However, this does not
always deliver value to shareholders Esee belowF.
RESOURCE TRANSFER: resources are unevenly distributed across
frms E6arney, 1111F and the interaction of target and acquiring frm
resources can create value through either overcoming information
asymmetry or by combining scarce resources.KCL
VERTICAL INTEGRATION 0 8ertical integration occurs when an
upstream and downstream frm merge Eor one acquires the otherF.
There are several reasons for this to occur. 5ne reason is to internalise
an externality problem. ' common example is of such an externality is
double marginali#ation. 9ouble marginali#ation occurs when both the
upstream and downstream frms have monopoly power, each frm
reduces output from the competitive level to the monopoly level,
creating two deadweight losses. 6y merging the vertically integrated
frm can collect one deadweight loss by setting the downstream frmXs
output to the competitive level. This increases profts and consumer
surplus. ' merger that creates a vertically integrated frm can be
proftable.KDL
I ACFUI1HIRE Y0 'n Yacq:hireY Eor acquisition:by:hireF may occur
especially when the target is a small private company or is in the
startup phase. "n this case, the acquiring company simply hires the
sta% of the target private company, thereby acquiring its talent Eif that
is its main asset and appealF. The target private company simply
dissolves and little legal issues are involved. 'cqui:hires have become a
very popular type of transaction in recent years.Kcitation neededL
ABSORPTION OF SIMILAR BUSINESSES UNDER SINGLE
MANAGEMENT: similar portfolio invested by two di%erent mutual
funds E'hsan *a#a Ghan, ,??1F namely united money mar$et fund and
united growth and income fund, caused the management to absorb
united money mar$et fund into united growth and income fund._PrefR
,1
However, on average and across the most commonly studied variables,
acquiring frmsX fnancial performance does not positively change as a
function of their acquisition activity.

Therefore, additional motives for merger
and acquisition that may not add shareholder value include0
DIVERSIFICATION: Ihile this may hedge a company against a
downturn in an individual industry it fails to deliver value, since it is
possible for individual shareholders to achieve the same hedge by
diversifying their portfolios at a much lower cost than those associated
with a merger. E"n his boo$ One Up on Wall Street, )eter >ynch
memorably termed this YdiworseifcationY.F
MANAGERJS HUBRIS : managerXs overconfdence about expected
synergies from -<' which results in overpayment for the target
company.
EMPIRE1BUILDING : -anagers have larger companies to manage and
hence more power.
MANAGERJS COMPENSATION: "n the past, certain executive
management teams had their payout based on the total amount of
proft of the company, instead of the proft per share, which would give
the team a perverse incentive to buy companies to increase the total
proft while decreasing the proft per share Ewhich hurts the owners of
the company, the shareholdersF
UNIT3
C($#(0 '(")*#
' .($#(0 '(")*# is a market for securities Edebt or equityF, where business
enterprises EcompaniesF and governments can raise long:term funds. "t is defned
as a mar$et in which money is provided for periods longer than a year,[1]
Kdead linkL as the raising of short:term funds ta$es place on other mar$ets
Ee.g., the money marketF. The capital mar$et includes the stock market Eequity
securitiesF and the bond market EdebtF. &inancial regulators, such as the =GXs
Financial Services ut!ority E&('F or the "#S# Securities and $xc!ange %ommission E(/CF,
oversee the capital mar$ets in their designated urisdictions to ensure that
investors are protected against fraud, among other duties.
Capital mar$ets may be classifed as primary markets and secondary markets. "n
primary mar$ets, new stoc$ or bond issues are sold to investors via a
mechanism $nown as under&riting. "n the secondary mar$ets, existing
securities are sold and bought among investors or traders, usually on a
securities exc!ange, over't!e'counter, or elsewhere.
65(# D!*4 Fiscal Policy M*(%K
.overnment spending policies that inWuence macroeconomic
;?
conditions. These policies a%ect tax rates, interest rates and government
spending, in an e%ort to control the economy.
34.(0 !0$./ is the use of government expenditure and revenue collection
EtaxationF to inWuence the economy.&iscal policy can be contrasted with the
other main type of macroeconomic policy, monetary policy, which attempts
to stabili#e the economy by controlling interest rates and spending. The two
main instruments of fscal policy are government expenditure and taxation.
Changes in the level and composition of taxation and government spending
can impact the following variables in the economy0
'ggregate demand and the level of economic activity;
The pattern of resource allocation;
The distribution of income.
E.!%!'$. *@*.#4 !+ 34.(0 !0$./
.overnments use fscal policy to inWuence the level of aggregate demand in
the economy, in an e%ort to achieve economic obectives of price stability,
full employment, and economic growth. (eynesian economics suggests that
increasing government spending and decreasing tax rates are the best ways
to stimulate aggregate demand. This can be used in times of recession or low
economic activity as an essential tool for building the framewor$ for strong
economic growth and wor$ing towards full employment. "n theory, the
resulting defcits would be paid for by an expanded economy during the
boom that would follow; this was the reasoning behind the )e& *eal.
.overnments can use a budget surplus to do two things0 to slow the pace of
strong economic growth, and to stabili#e prices when inWation is too high.
Geynesian theory posits that removing spending from the economy will
reduce levels of aggregate demand and contract the economy, thus
stabili#ing prices.
/conomists debate the e%ectiveness of fscal stimulus. The argument mostly
centers on cro&ding out, a phenomenon where government borrowing leads to
higher interest rates that o%set the stimulative impact of spending. Ihen the
government runs a budget defcit, funds will need to come from public
borrowing Ethe issue of government bondsF, overseas borrowing, or moneti+ing
the debt. Ihen governments fund a defcit with the issuing of government
bonds, interest rates can increase across the mar$et, because government
borrowing creates higher demand for credit in the fnancial mar$ets. This
causes a lower aggregate demand for goods and services, contrary to the
obective of a fscal stimulus. +eoclassical economists generally emphasi#e
crowding out while Geynesians argue that fscal policy can still be e%ective
especially in a liquidity trap where, they argue, crowding out is minimal.
;1
(ome classical and neoclassical economists argue that crowding out completely
negates any fscal stimulus; this is $nown as the ,reasury -ie&Kcitation neededL,
which Geynesian economics reects. The Treasury 8iew refers to the
theoretical positions of classical economists in the 6ritish Treasury, who
opposed GeynesX call in the 11;?s for fscal stimulus. The same general
argument has been repeated by some neoclassical economists up to the
present.
"n the classical view, the expansionary fscal policy also decreases net
exports, which has a mitigating e%ect on national output and income. Ihen
government borrowing increases interest rates it attracts foreign capital from
foreign investors. This is because, all other things being equal, the bonds
issued from a country executing expansionary fscal policy now o%er a higher
rate of return. "n other words, companies wanting to fnance proects must
compete with their government for capital so they o%er higher rates of
return. To purchase bonds originating from a certain country, foreign
investors must obtain that countryXs currency. Therefore, when foreign
capital Wows into the country undergoing fscal expansion, demand for that
countryXs currency increases. The increased demand causes that countryXs
currency to appreciate. 5nce the currency appreciates, goods originating
from that country now cost more to foreigners than they did before and
foreign goods now cost less than they did before. Consequently, exports
decrease and imports increase.[2]
5ther possible problems with fscal stimulus include the time lag between
the implementation of the policy and detectable e%ects in the economy, and
inWationary e%ects driven by increased demand. "n theory, fscal stimulus
does not cause inWation when it uses resources that would have otherwise
been idle. &or instance, if a fscal stimulus employs a wor$er who otherwise
would have been unemployed, there is no inWationary e%ect; however, if the
stimulus employs a wor$er who otherwise would have had a ob, the stimulus
is increasing labor demand while labor supply remains fxed, leading to wage
inWation and therefore price inWation.
ROLE OF SEBI:
(/6"Xs functions include0
*egulating the business in stoc$ exchanges and any other securities
mar$ets
*egistering and regulating the wor$ing of collective investment
schemes, including mutual funds.
)rohibiting fraudulent and unfair trade practices relating to securities
mar$ets.
)romoting investorXs education and training of intermediaries of
securities mar$ets.
;,
)rohibiting insider trading in securities, with the imposition of
monetary penalties, on erring mar$et intermediaries.
*egulating substantial acquisition of shares and ta$eover of
companies.
Calling for information from, carrying out inspection, conducting
inquiries and audits of the stoc$ exchanges and intermediaries and self
regulatory organi#ations in the securities mar$et.
Geeping this in view, (/6" has issued a new set of comprehensive guidelines
governing issue of shares and other fnancial instruments, and has laid down
detailed norms for stoc$:bro$ers and sub:bro$ers, merchant ban$ers,
portfolio managers and mutual funds.
5n the recommendations of the )atel Committee report, (/6" on ,D 7uly
111@, permitted carry forward deals. (ome of the maor features of the
revised carry:forward transactions as directed by (/6" are0
Carry forward deals permitted only on stoc$ exchanges which have
screen based trading system.
Transactions carried forward cannot exceed ,@B of a bro$erXs total
transactions on any one day.
1?:day limit for carry forward and squaring o% allowed only till the D@th
day Eor the end of the ffth settlementF.
9aily margins to rise progressively from ,?B in the frst settlement to
@?B in the ffth.
5n ,C 7anuary111@, the government promulgated an ordinance amending
the (/6" 'ct, 111,, and the (ecurities Contracts E*egulationF 'ct, 11@C.
"n accordance with the amendment adudicating mechanism will be created
within (/6" and any appeal against this adudicating authority will have to be
made to the (ecurities 'ppellate Tribunal, which is to be separately
constituted. These appeals will be heard only at the High Courts.
The main features of the amendment to the (ecurities Contract E*egulationF
'ct, 11@C, are0
The ban on the system of options in trading has been lifted.
The time limit of six months, by which stoc$ exchanges could amend
their bye:laws, has been reduced to two months.
'dditional trading Woors on the stoc$ exchanges can be established
only with prior permission from (/6".
;;
'ny company see$ing listing on stoc$ exchanges would have to comply
with the listing agreements of stoc$ exchanges, and the failure to
comply with these, or their violation, is punishable.
GOVERNMENT REGULATION AFFECTING CAPITAL MARKET:
H!8 -!*4 #5* &!:*"%'*%# $%?,*%.* #5* 4*.,"$#$*4 '(")*#K
.overnments generally say they donXt li$e to ta$e an active role in the
securities mar$et Eexcept for regulating itF; however, there are methods and
policies by which the governmentXs actions may have an indirect inWuence
on the mar$et.
&iscal policies that a%ect the taxation of capital gains, dividends and interest
gains may eventually have an e%ect on mar$et activity. &or example,
favorable policies such as tax cuts could persuade investors to become more
active in buying and selling securities, while unfavorable policies might
cause individuals to move to fxed:income securities or alternative
investments Esuch as real estate or other appreciable assetsF.
&urthermore, through monetary policies, governments can indirectly involve
themselves in the mar$et by adusting interest rates and ta$ing part in open:
mar$et operations. "n theory, cutting rates will discourage investors and
companies from putting Eor par$ingF their money into fxed:income
investments : the lower rates instead may encourage borrowing for
investment purposes.
The mar$et is also a%ected by the bills and laws passed by the various levels
of government. This can occur for those laws directed specifcally at the
securities mar$et or those that have an indirect a%ect.
5n the indirect side, if the government reduces spending in areas such as
health care or defense, companies in these sectors will li$ely sell o% as they
rely in part on government funds.
F$4.(0 !0$./
&iscal policy is the means by which a government adusts its
levels of spending in order to monitor and inWuence a nationXs economy. "t is
the sister strategy to monetary policy with which a central ban$ inWuences a
nationXs money supply. These two policies are used in various combinations
in an e%ort to direct a countryXs economic goals. Here we ta$e a loo$ at how
fscal policy wor$s, how it must be monitored and how its implementation
may a%ect di%erent people in an economy.
6efore the .reat 9epression in the =nited (tates, the
governmentXs approach to the economy was laisse# faire. 6ut following the
(econd Iorld Iar, it was determined that the government had to ta$e a
;2
proactive role in the economy to regulate unemployment, business cycles,
inWation and the cost of money. 6y using a mixture of both monetary and
fscal policies Edepending on the political orientations and the philosophies of
those in power at a particular time, one policy may dominate over anotherF,
governments are able to control economic phenomena.
H!8 F$4.(0 P!0$./ 6!")4

&iscal policy is based on the theories of 6ritish economist 7ohn -aynard
Geynes. 'lso $nown as Geynesian economics, this theory basically states that
governments can inWuence macroeconomic productivity levels by increasing
or decreasing tax levels and public spending. This inWuence, in turn, curbs
inWation Egenerally considered to be healthy when at a level between ,:;BF,
increases employment and maintains a healthy value of money. ETo read
more on this subect, see Can Geynesian /conomics *educe 6oom:6ust
Cycles` and How "nWuential /conomists Changed 5ur History.F
B(0(%.$%& A.#
The idea, however, is to fnd a balance in exercising these inWuences.
&or example, stimulating a stagnant economy runs the ris$ of rising inWation.
This is because an increase in the supply of money followed by an increase in
consumer demand can result in a decrease in the value of money : meaning
that it will ta$e more money to buy something that has not changed in value.
>etXs say that an economy has slowed down. =nemployment levels are up,
consumer spending is down and businesses are not ma$ing any money. '
government thus decides to fuel the economyXs engine by decreasing
taxation, giving consumers more spending money while increasing
government spending in the form of buying services from the mar$et Esuch
as building roads or schoolsF. 6y paying for such services, the government
creates obs and wages that are in turn pumped into the economy. )umping
money into the economy is also $nown as Ypump primingY. "n the meantime,
overall unemployment levels will fall.
Iith more money in the economy and less taxes to pay,
consumer demand for goods and services increases. This in turn re$indles
businesses and turns the cycle around from stagnant to active.
"f, however, there are no reins on this process, the increase in economic
productivity can cross over a very fne line and lead to too much money in
the mar$et. This excess in supply decreases the value of money, while
pushing up prices Ebecause of the increase in demand for consumer
productsF. Hence, inWation occurs.
&or this reason, fne tuning the economy through fscal policy alone can be a
di!cult, if not improbable, means to reach economic goals. "f not closely
monitored, the line between an economy that is productive and one that is
infected by inWation can be easily blurred
;@
65(# $4 SEBIK
S*.,"$#$*4 (%- Ex.5(%&* B!("- !+ I%-$( ESEBIF is an apex body for
overall development and regulation of the securities mar$et. "t was set up on
'pril 1,, 1LMM. To start with, (/6" was set up as a non:statutory body. >ater
on it became a statutory body under the (ecurities /xchange 6oard of "ndia
'ct, 111,. The 'ct entrusted (/6" with comprehensive powers over
practically all the aspects of capital mar$et operations.
R!0* F,%.#$!%4 !+ SEBI
The role or functions of (/6" are discussed below.
1. To protect the interests of investors through proper education and
guidance as regards their investment in securities. &or this, (/6" has
made rules and regulation to be followed by the fnancial
intermediaries such as bro$ers, etc. (/6" loo$s after the complaints
received from investors for fair settlement. "t also issues boo$lets for
the guidance and protection of small investors.
,. To regulate and control the business on stoc$ exchanges and other
security mar$ets. &or this, (/6" $eeps supervision on bro$ers.
*egistration of bro$ers and sub:bro$ers is made compulsory and they
are expected to follow certain rules and regulations. /%ective control is
also maintained by (/6" on the wor$ing of stoc$ exchanges.
;. To ma$e registration and to regulate the functioning of intermediaries
such as stoc$ bro$ers, sub:bro$ers, share transfer agents, merchant
ban$ers and other intermediaries operating on the securities mar$et. "n
addition, to provide suitable training to intermediaries. This function is
useful for healthy atmosphere on the stoc$ exchange and for the
protection of small investors.
2. To register and regulate the wor$ing of mutual funds including =T" E=nit
Trust of "ndiaF. (/6" has made rules and regulations to be followed by
mutual funds. The purpose is to maintain e%ective supervision on their
operations < avoid their unfair and anti:investor activities.
@. To promote self:regulatory organi#ation of intermediaries. (/6" is given
wide statutory powers. However, self:regulation is better than external
regulation. Here, the function of (/6" is to encourage intermediaries to
form their professional associations and control undesirable activities
of their members. (/6" can also use its powers when required for
protection of small investors.
C. To regulate mergers, ta$eovers and acquisitions of companies in order
to protect the interest of investors. &or this, (/6" has issued suitable
guidelines so that such mergers and ta$eovers will not be at the cost of
small investors.
;C
D. To prohibit fraudulent and unfair practices of intermediaries operating
on securities mar$ets. (/6" is not for interfering in the normal wor$ing
of these intermediaries. "ts function is to regulate and control their
obectional practices which may harm the investors and healthy growth
of capital mar$et.
3. To issue guidelines to companies regarding capital issues. (eparate
guidelines are prepared for frst public issue of new companies, for
public issue by existing listed companies and for frst public issue by
existing private companies. (/6" is expected to conduct research and
publish information useful to all mar$et players Ei.e. all buyers and
sellersF.
1. To conduct inspection, inquiries < audits of stoc$ exchanges,
intermediaries and self:regulating organi#ations and to ta$e suitable
remedial measures wherever necessary. This function is underta$en for
orderly wor$ing of stoc$ exchanges < intermediaries.
1?. To restrict insider trading activity through suitable measures. This
function is useful for avoiding undesirable activities of bro$ers and
securities scams.
UNIT4
LEASE FINANCING:
>ease fnancing, or often referred to ust as a Nlease,O is a
contractual agreement in which a company, identifed on the contract as the
lessor grants the individual or group of individuals leasing the
productPequipment, identifed on the contract as the lessee, the ability to
operate the equipment for a given amount of time, identifed as the term of
leasing, while ma$ing specifc monthly payments to the lessor or leasing
company.
IMPORTANCE NF LEASE FINANCING
>easing industry plays an important role in the economic
development of a country by providing money incentives to lessee. The
lessee does not have to pay the cost of asset at the time of signing the
contract of leases. >easing contracts are more Wexible so
lessees can structure the leasing contracts according to their needs for
fnance. The
lessee can also pass on the ris$ of obsolescence to the lessor by acquiring
those appliances, which have high technological obsolescence. To day, most
of us are
familiar with leases of houses, apartments, o!ces, etc.
12;2 TYPES OF LEASE AGREEMENTS
;D
>ease agreements are basically of two types. They are EaF
&inancial lease and EbF
5perating lease. The other variations in lease agreements are EcF (ale and
lease bac$
EdF >everaged leasing and EeF 9irect leasing.
FINANCIAL LEASE
>ong:term, non:cancellable lease contracts are $nown as fnancial
leases. The
essential point of fnancial lease agreement is that it contains a condition
whereby the
lessor agrees to transfer the title for the asset at the end of the lease period
at a
nominal cost. 't lease it must give an option to the lessee to purchase the
asset he has
used at the expiry of the lease. =nder this lease the lessor recovers 1?B of
the fair
value of the asset as lease rentals and the lease period is D@B of the
economic life of
the asset. The lease agreement is irrevocable. )ractically all the ris$s
incidental to the
asset ownership and all the benefts arising there from are transferred to the
lessee
who bears the cost of maintenance, insurance and repairs. 5nly title deeds
remain
with the lessor. &inancial lease is also $nown as acapital leaseA. "n "ndia,
fnancial
leases are very popular with high:cost and high technology equipment.
OPERATING LEASE
;3
'n operating lease stands in contrast to the fnancial lease in almost all
aspects. This
lease agreement gives to the lessee only a limited right to use the asset. The
lessor is
responsible for the up$eep and maintenance of the asset. The lessee is not
given any
uplift to purchase the asset at the end of the lease period. +ormally the lease
is for a
short period and even otherwise is revocable at a short notice. -ines,
Computers
hardware, truc$s and automobiles are found suitable for operating lease
because the rate of obsolescence is very high in this $ind of assets.
SALE AND LEASE BACK
"t is a sub:part of fnance lease. =nder this, the owner of an asset sells
the asset to a
party Ethe buyerF, who in turn leases bac$ the same asset to the owner in
consideration
of lease rentals. However, under this arrangement, the assets are not
physically
exchanged but it all happens in records only. This is nothing but a paper
transaction.
(ale and lease bac$ transaction is suitable for those assets, which are not
subected
depreciation but appreciation, say land. The advantage of this method is that
the
lessee can satisfy himself completely regarding the quality of the asset and
after
possession of the asset convert the sale into a lease arrangement. The sale
and lease
bac$ transaction can be expressed with the help of the following fgure.
=nder this transaction, the seller assumes the role of a lessee and the buyer
assumes
the role of a lessor. The seller gets the agreed selling price and the buyer
gets the lease
;1
rentals. "t is possible to structure the sale at agreed value Ebelow or above
the fair mar$et priceF and to adust di%erence in the lease rentals. Thus the
e%ect of proft
Ploss on sale of assets can be deferred.
LEVERAGED LEASING
=nder leveraged leasing arrangement, a third party is involved beside lessor
and
lessee. The lessor borrows a part of the purchase cost Esay 3?BF of the asset
from the
third party i.e., lender and the asset so purchased is held as security against
the loan.
The lender is paid o% from the lease rentals directly by the lessee and the
surplus after
meeting the claims of the lender goes to the lessor. The lessor, the owner of
the asset
is entitled to depreciation allowance associated with the asset.
DIRECT LEASING
=nder direct leasing, a frm acquires the right to use an asset from the
manufacturer
directly. The ownership of the asset leased out remains with the
manufacturer itself.
The maor types of direct lessor include manufacturers, fnance companies,
independent lease companies, special purpose leasing companies etc
12;O ADVANTAGES OF LEASING
There are several extolled advantages of acquiring capital assets on lease0
(1) SAVING OF CAPITAL0 >easing covers the full cost of the
equipment used in the
business by providing 1??B fnance. The lessee is not to provide or pay any
margin
-anufacturer >essor >essee >ender money as there is no down payment. "n
this way the saving in capital or fnancial
2?
resources can be used for other productive purposes e.g. purchase of
inventories.
(2) FLEXIBILITY AND CONVENIENCE0 The lease agreement can be
tailor: made
in respect of lease period and lease rentals according to the convenience and
requirements of all lessees.
(3) PLANNING CASH FLO6S: >easing enables the lessee to plan its
cash Wows
properly. The rentals can be paid out of the cash coming into the business
from the
use of the same assets.
(4) IMPROVEMENT IN LIFUADITY: >easing enables the lessee to
improve their
liquidity position by adopting the sale and lease bac$ technique.
ADVANTAGES OF USING LEASING AS A SOURCE OF FINANCE
I%#"!-,.#$!%
The use of leasing is a popular method of funding the acquisition of capital
assets. However, these methods are not necessarily suitable for every
business or for every asset purchase. There are a number of considerations
to be made, as described below0
C*"#($%#/ 0 5ne important advantage is that a hire purchase or leasing
agreement is a medium term funding facility, which cannot be withdrawn,
provided the business ma$es the payments as they fall due. The uncertainty
that may be associated with alternative funding facilities such as overdrafts,
which are repayable on demand, is removed.
However, it should be borne in mind that both hire purchase and leasing
agreements are long term commitments. "t may not be possible, or could
prove costly, to terminate them early.
B,-&*#$%& 0 The regular nature of the hire purchase or lease payments
Ewhich are also usually of fxed amounts as wellF helps a business to forecast
cash Wow. The business is able to compare the payments with the expected
revenue and profts generated by the use of the asset.
F$x*- R(#* F$%(%.*
"n most cases the payments are fxed throughout the hire purchase or lease
agreement, so a business will $now at the beginning of the agreement what
their repayments will be. This can be benefcial in times of low, stable or
rising interest rates but may appear expensive if interest rates are falling.
21
5n some agreements, such as those for a longer term, the fnance company
may o%er the option of variable rate agreements. "n such cases, rentals or
installments will vary with current interest rates; hence it may be more
di!cult to budget for the level of payment.
T5* E@*.# O+ S*.,"$#/
=nder both hire purchase and leasing, the fnance company retains legal
ownership of the equipment, at least until the end of the agreement. This
normally gives the fnance company better security than lenders of other
types of loan or overdraft facilities. The fnance company may therefore be
able to o%er better terms.
The decision to provide fnance to a small or medium si#ed business depends
on that businessX credit standing and potential. 6ecause the fnance
company has security in the equipment, it could tip the balance in favour of
a positive credit decision.
M(x$',' F$%(%.*
Hire purchase and leasing could provide fnance for the entire cost of the
equipment. There may however, be a need to put down a deposit for hire
purchase or to ma$e one or more payments in advance under a lease. "t may
be possible for the business to Xtrade:inX other assets which they own, as a
means of raising the deposit.
T(x A-:(%#(&*4
Hire purchase and leasing give the business the choice of how to ta$e
advantage of capital allowances.
"f the business is proftable, it can claim its own capital allowances
through hire purchase or outright purchase.
"f it is not in a tax paying position or pays corporation tax at the small
companies rate, then a lease could be more benefcial to the business.
The leasing company will claim the capital allowances and pass the
benefts on to the business by way of reduced rentals.
INTRODUCTION TO VENTURE CAPITAL
8enture Capital is a form of Yris$ capitalY. "n other words, capital that is
invested in a proect Ein this case : a businessF where there is a substantial
element of ris$ relating to the future creation of profts and cash Wows. *is$
capital is invested as shares EequityF rather than as a loan and the investor
requires a higherYrate of returnY to compensate him for his ris$.
The main sources of venture capital in the =G are venture capital frms
and Ybusiness angelsY : private investors. (eparate Tutor,u revision notes
cover the operation of business angels. "n these notes, we principally focus
2,
on venture capital frms. However, it should be pointed out the attributes
that both venture capital frms and business angels loo$ for in potential
investments are often very similar.
65(# $4 :*%#,"* .($#(0K
8enture capital provides long:term, committed share capital, to help
unquoted companies grow and succeed. "f an entrepreneur is loo$ing to
start:up, expand, buy:into a business, buy:out a business in which he wor$s,
turnaround or revitalise a company, venture capital could help do this.
5btaining venture capital is substantially di%erent from raising debt or a loan
from a lender. >enders have a legal right to interest on a loan and repayment
of the capital, irrespective of the success or failure of a business . 8enture
capital is invested in exchange for an equity sta$e in the business. 's a
shareholder, the venture capitalistXs return is dependent on the growth and
proftability of the business. This return is generally earned when the venture
capitalist YexitsY by selling its shareholding when the business is sold to
another owner.
8enture capital in the =G originated in the late 13th century, when
entrepreneurs found wealthy individuals to bac$ their proects on an ad hoc
basis. This informal method of fnancing became an industry in the late
11D?s and early 113?s when a number of venture capital frms were
founded. There are now over 1?? active venture capital frms in the =G,
which provide several billion pounds each year to unquoted companies
mostly located in the =G.
65(# )$%- !+ D,4$%*44*4 ("* (##"(.#$:* #! :*%#,"* .($#(0$4#4K
8enture capitalist prefer to invest in Yentrepreneurial businessesY. This
does not necessarily mean small or new businesses. *ather, it is more about
the investmentXs aspirations and potential for growth, rather than by current
si#e. (uch businesses are aiming to grow rapidly to a signifcant si#e. 's a
rule of thumb, unless a business can o%er the prospect of signifcant
turnover growth within fve years, it is unli$ely to be of interest to a venture
capital frm. 8enture capital investors are only interested in companies with
high growth prospects, which are managed by experienced and ambitious
teams who are capable of turning their business plan into reality.
F!" 5!8 0!%& -! :*%#,"* .($#(0$4#4 $%:*4# $% ( D,4$%*44K
8enture capital frms usually loo$ to retain their investment for
between three and seven years or more. The term of the investment is often
lin$ed to the growth profle of the business. "nvestments in more mature
businesses, where the business performance can be improved quic$er and
easier, are often sold sooner than investments in early:stage or technology
companies where it ta$es time to develop the business model.
65*"* -! :*%#,"* .($#(0 3"'4 !D#($% #5*$" '!%*/K
2;
7ust as management teams compete for fnance, so do venture capital
frms. They raise their funds from several sources. To obtain their funds,
venture capital frms have to demonstrate a good trac$ record and the
prospect of producing returns greater than can be achieved through fxed
interest or quoted equity investments. -ost =G venture capital frms raise
their funds for investment from external sources, mainly institutional
investors, such as pension funds and insurance companies.
8enture capital frmsX investment preferences may be a%ected by the
source of their funds. -any funds raised from external sources are structured
as >imited )artnerships and usually have a fxed life of 1? years. Iithin this
period the funds invest the money committed to them and by the end of the
1? years they will have had to return the investorsX original money, plus any
additional returns made. This generally requires the investments to be sold,
or to be in the form of quoted shares, before the end of the fund.
8enture Capital Trusts E8CTXsF are quoted vehicles that aim to
encourage investment in smaller unlisted Eunquoted and '"- quoted
companiesF =G companies by o%ering private investors tax incentives in
return for a fve:year investment commitment. The frst were launched in
'utumn 111@ and are mainly managed by =G venture capital frms. "f funds
are obtained from a 8CT, there may be some restrictions regarding the
companyXs future development within the frst few years.
65(# $4 $%:!0:*- $% #5* $%:*4#'*%# "!.*44K
The investment process, from reviewing the business plan to actually
investing in a proposition, can ta$e a venture capitalist anything from one
month to one year but typically it ta$es between ; and C months. There are
always exceptions to the rule and deals can be done in extremely short time
frames. -uch depends on the quality of information provided and made
available.
The $ey stage of the investment process is the initial evaluation of a
business plan. -ost approaches to venture capitalists are reected at this
stage. "n considering the business plan, the venture capitalist will consider
several principal aspects0
: "s the product or service commercially viable`
: 9oes the company have potential for sustained growth`
: 9oes management have the ability to exploit this potential and control the
company through the growth phases`
: 9oes the possible reward ustify the ris$`
: 9oes the potential fnancial return on the investment meet their investment
criteria`
"n structuring its investment, the venture capitalist may use one or
more of the following types of share capital0
Ordinary shares
These are equity shares that are entitled to all income and capital after
the rights of all other classes of capital and creditors have been satisfed.
22
5rdinary shares have votes. "n a venture capital deal these are the shares
typically held by the management and family shareholders rather than the
venture capital frm.
Preferred ordinary shares
These are equity shares with special rights.&or example, they may be
entitled to a fxed dividend or share of the profts. )referred ordinary shares
have votes.
Preference shares
These are non:equity shares. They ran$ ahead of all classes of ordinary
shares for both income and capital. Their income rights are defned and they
are usually entitled to a fxed dividend Eeg. 1?B fxedF. The shares may be
redeemable on fxed dates or they may be irredeemable. (ometimes they
may be redeemable at a fxed premium Eeg. at 1,?B of costF. They may be
convertible into a class of ordinary shares.
oan capital
8enture capital loans typically are entitled to interest and are usually,
though not necessarily repayable. >oans may be secured on the companyXs
assets or may be unsecured. ' secured loan will ran$ ahead of unsecured
loans and certain other creditors of the company. ' loan may be convertible
into equity shares. 'lternatively, it may have a warrant attached which gives
the loan holder the option to subscribe for new equity shares on terms fxed
in the warrant. They typically carry a higher rate of interest than ban$ term
loans and ran$ behind the ban$ for payment of interest and repayment of
capital.
8enture capital investments are often accompanied by additional
fnancing at the point of investment. This is nearly always the case where the
business in which the investment is being made is relatively mature or well:
established. "n this case, it is appropriate for a business to have a fnancing
structure that includes both equity and debt.
5ther forms of fnance provided in addition to venture capitalist equity
include0
1 C0*("$%& D(%)4 : principally provide overdrafts and short to
medium:term loans at fxed or, more usually, variable rates of interest.
1 M*".5(%# D(%)4 1 organise the provision of medium to longer:term
loans, usually for larger amounts than clearing ban$s. >ater they can play an
important role in the process of Ygoing publicY by advising on the terms and
price of public issues and by arranging underwriting when necessary.
2@
1 F$%(%.* 5!,4*4 1 provide various forms of installment credit,
ranging from hire purchase to leasing, often asset based and usually for a
fxed term and at fxed interest rates.
F(.#!"$%& .!'(%$*4 : provide fnance by buying trade debts at a
discount, either on a recourse basis Eyou retain the credit ris$ on the debtsF
or on a non:recourse basis Ethe factoring company ta$es over the credit ris$F.
G!:*"%'*%# (%- E,"!*(% C!''$44$!% 4!,".*4 1 provide
fnancial aid to =G companies, ranging from proect grants Erelated to obs
created and safeguardedF to enterprise loans in selective areas.
M*GG(%$%* 3"'4 1 provide loan fnance that is halfway between
equity and secured debt. These facilities require either a second charge on
the companyXs assets or are unsecured. 6ecause the ris$ is consequently
higher than senior debt, the interest charged by the me##anine debt provider
will be higher than that from the principal lenders and sometimes a modest
equity Yup:sideY will be required through options or warrants. "t is generally
most appropriate for larger transactions.
M()$%& #5* I%:*4#'*%# 1 D,* D$0$&*%.*
To support an initial positive assessment of your business proposition,
the venture capitalist will want to assess the technical and fnancial
feasibility in detail.
/xternal consultants are often used to assess mar$et prospects and the
technical feasibility of the proposition, unless the venture capital frm has the
appropriately qualifed people in:house. Chartered accountants are often
called on to do much of the due diligence, such as to report on the fnancial
proections and other fnancial aspects of the plan. These reports often follow
a detailed study, or a one or two day overview may be all that is required by
the venture capital frm. They will assess and review the following points
concerning the company and its management0
: -anagement information systems
: &orecasting techniques and accuracy of past forecasting
: 'ssumptions on which fnancial assumptions are based
: The latest available management accounts, including the companyXs
cashPdebtor positions
: 6an$ facilities and leasing agreements
: )ensions funding
: /mployee contracts, etc.
The due diligence review aims to support or contradict the venture
capital frmXs own initial impressions of the business plan formed during the
initial stage. *eferences may also be ta$en up on the company Eeg. with
suppliers, customers, and ban$ersF.
2C
F$%(%.$%& 4#(&*4
There are typically six stages of venture round fnancing o%ered in 8enture
Capital, that roughly correspond to these stages of a companyXs
development.[2.]
S**- M!%*/ : >ow level fnancing needed to prove a new idea, often
provided by 1angel investors. Crowd funding is also emerging as an
option for seed funding.
S#("#1,: /arly stage frms that need funding for expenses associated
with mar$eting and product development
F$"4#1R!,%- ( S*"$*4 A "!,%- ): /arly sales and manufacturing funds
S*.!%-1R!,%-: Ior$ing capital for early stage companies that are
selling product, but not yet turning a proft
T5$"-1R!,%-: 'lso called -e##anine fnancing, this is expansion money
for a newly proftable company
F!,"#51R!,%-: 'lso called bridge fnancing, 2th round is intended to
fnance the Ygoing publicY process
S#",.#,"*
8enture capital frms are typically structured as partners!ips, the general partners
of which serve as the managers of the frm and will serve as investment
advisors to the venture capital funds raised. 8enture capital frms in the
=nited (tates may also be structured as limited liability companies, in which case
the frmXs managers are $nown as managing members. "nvestors in venture
capital funds are $nown as limited partners. This constituency comprises both
high net worth individuals and institutions with large amounts of available
capital, such as state and private pension funds, university financial endo&ments,
foundations, insurance companies, and pooled investment vehicles, called funds of
funds E&o&F.
T/*4
8enture Capitalist frms di%er in their approaches. There are multiple factors,
and each frm is di%erent.[2/]
(ome of the factors that inWuence 8C decisions include0
6usiness situation0 (ome 8Cs tend to invest in new ideas, or Wedgling
companies. 5thers prefer investing in established companies that need
support to go public or grow.
(ome invest solely in certain industries.
2D
(ome prefer operating locally while others will operate nationwide or
even globally.
8C expectations often vary. (ome may want a quic$er public sale of the
company or expect fast growth. The amount of help a 8C provides can
vary from one frm to the next.
R!0*4
Iithin the venture capital industry, the general partners and other
investment professionals of the venture capital frm are often referred to as
Yventure capitalistsY or Y8CsY. Typical career bac$grounds vary, but, broadly
spea$ing, venture capitalists come from either an operational or a fnance
bac$ground. 8enture capitalists with an operational bac$ground tend to be
former founders or executives of companies similar to those which the
partnership fnances or will have served as management consultants.
8enture capitalists with fnance bac$grounds tend to have investment banking or
other corporate finance experience.
'lthough the titles are not entirely uniform from frm to frm, other positions
at venture capital frms include0
V*%#,"* ("#%*"4 \ 8enture partners are expected to source
potential investment opportunities EYbring in dealsYF and typically are
compensated only for those deals with which they are involved.
P"$%.$(0 \ This is a mid:level investment professional position, and
often considered a Ypartner:trac$Y position. )rincipals will have been
promoted from a senior associate position or who have commensurate
experience in another feld, such as investment ban$ing or management
consulting.
A44!.$(#* \ This is typically the most unior apprentice position within
a venture capital frm. 'fter a few successful years, an associate may
move up to the Ysenior associateY position and potentially principal and
beyond. 'ssociates will often have wor$ed for 14, years in another
feld, such as investment ban$ing or management consulting.
E%#"*"*%*,"1$%1"*4$-*%.* E/"*F \ /"*s are experts in a particular
domain and perform due diligence on potential deals. /"*s are engaged
by venture capital frms temporarily Esix to 13 monthsF and are
expected to develop and pitch startup ideas to their host frm although
neither party is bound to wor$ with each other. (ome /"*s move on to
executive positions within a portfolio company.
23
N**- !+ :*%#,"* .($#(0
There are enterpreneurs and many other people who come up with
bright ideas but lac$ the capital for the investment what these venture
capitals do are to facilitate and enable the start up phase.
Ihen there is an owner relation between the venture capital providers
and recievers, their mutual interest for returns will increase the frms
motiviation to increase profts.
8enture capitalists have invested in simlar frms and proects before
and, therefore, have more $nowledge and experience. This $nowledge
and experience are the outcomes of the experiments through the
sucesses and failures from previous ventures, so they $now what wor$s
and what does not, and how it wor$s. Therefore, through venture
capital involvement, a portfolio frm can initiate growth, identify
problems, and fnd recipies to overcome them.
S#",.#,"* !+ #5* +,%-4
-ost venture capital funds have a fxed life of 1? years, with the possibility of a
few years of extensions to allow for private companies still see$ing liquidity.
The investing cycle for most funds is generally three to fve years, after
which the focus is managing and ma$ing follow:on investments in an existing
portfolio. This model was pioneered by successful funds in Silicon -alley
through the 113?s to invest in technological trends broadly but only during
their period of ascendance, and to cut exposure to management and
mar$eting ris$s of any individual frm or its product.
"n such a fund, the investors have a fxed commitment to the fund that is
initially unfunded and subsequently Ycalled downY by the venture capital
fund over time as the fund ma$es its investments. There are substantial
penalties for a limited partner Eor investorF that fails to participate in a capital
call.
"t can ta$e anywhere from a month or so to several years for venture
capitalists to raise money from limited partners for their fund. 't the time
when all of the money has been raised, the fund is said to be closed, and the
1?:year lifetime begins. (ome funds have partial closes when one half Eor
some other amountF of the fund has been raised. Y8intage yearY generally
refers to the year in which the fund was closed and may serve as a means to
stratify 8C funds for comparison. This [20] shows the di%erence between a
venture capital fund management company and the venture capital funds
managed by them.
21
C!'*%4(#$!%
8enture capitalists are compensated through a combination of management
fees and carried interest Eoften referred to as a Ytwo and ,?Y arrangementF0
M(%(&*'*%# +**4 \ an annual payment made by the investors in
the fund to the fundXs manager to pay for the private equity frmXs
investment operations.K,3L "n a typical venture capital fund, the
general partners receive an annual management fee equal to up to ,B
of the committed capital.
C(""$*- $%#*"*4# \ a share of the profts of the fund Etypically ,?BF,
paid to the private equity fundAs management company as a
performance incentive. The remaining 3?B of the profts are paid to
the fundXs investorsK,3L (trong limited partner interest in top:tier
venture frms has led to a general trend toward terms more favorable
to the venture partnership, and certain groups are able to command
carried interest of ,@4;?B on their funds.
6ecause a fund may be run out of capital prior to the end of its life, larger
venture capital frms usually have several overlapping funds at the same
time; doing so lets the larger frm $eep specialists in all stages of the
development of frms almost constantly engaged. (maller frms tend to
thrive or fail with their initial industry contacts; by the time the fund cashes
out, an entirely:new generation of technologies and people is ascending,
whom the general partners may not $now well, and so it is prudent to
reassess and shift industries or personnel rather than attempt to simply
invest more in the industry or people the partners already $now.
MUTUAL FUNDS
' mutual fund is a professionally managed type of collective
investment scheme that pools money from many investors to buy stoc$s,
bonds, short:term money mar$et instruments, andPor other securities
65(# $4 ( M,#,(0 F,%-K
' mutual fund is ust the connecting bridge or a fnancial intermediary that
allows a group of investors to pool their money together with a
predetermined investment obective. The mutual fund will have a fund
manager who is responsible for investing the gathered money into specifc
securities Estoc$s or bondsF. Ihen you invest in a mutual fund, you are
buying units or portions of the mutual fund and thus on investing becomes a
shareholder or unit holder of the fund.
'll mutual funds are variations of these three asset classes. &or example,
while equity funds that invest in fast:growing companies are $nown as
growth funds, equity funds that invest only in companies of the same sector
@?
or region are $nown as specialty funds.
>etXs go over the many di%erent Wavors of funds. IeXll start with the safest
and then wor$ through to the more ris$y.
M!%*/ M(")*# F,%-4
The money mar$et consists of short:term debt instruments, mostly Treasury
bills. This is a safe place to par$ your money. Qou wonXt get great returns, but
you wonXt have to worry about losing your principal. ' typical return is twice
the amount you would earn in a regular chec$ingPsavings account and a little
less than the average certifcate of deposit EC9F.
B!%-9I%.!'* F,%-4
"ncome funds are named appropriately0 their purpose is to provide current
income on a steady basis. Ihen referring to mutual funds, the terms Yfxed:
income,Y Ybond,Y and YincomeY are synonymous. These terms denote funds
that invest primarily in government and corporate debt. Ihile fund holdings
may appreciate in value, the primary obective of these funds is to provide a
steady cashWow to investors. 's such, the audience for these funds consists
of conservative investors and retirees.

6ond funds are li$ely to pay higher returns than certifcates of deposit and
money mar$et investments, but bond funds arenXt without ris$. 6ecause
there are many di%erent types of bonds, bond funds can vary dramatically
depending on where they invest. &or example, a fund speciali#ing in high:
yield un$ bonds is much more ris$y than a fund that invests in government
securities. &urthermore, nearly all bond funds are subect to interest rate ris$,
which means that if rates go up the value of the fund goes down.
B(0(%.*- F,%-4
The obective of these funds is to provide a balanced mixture of safety,
income and capital appreciation. The strategy of balanced funds is to invest
in a combination of fxed income and equities. ' typical balanced fund might
have a weighting of C?B equity and 2?B fxed income. The weighting might
also be restricted to a specifed maximum or minimum for each asset class.
' similar type of fund is $nown as an asset allocation fund. 5bectives are
similar to those of a balanced fund, but these $inds of funds typically do not
have to hold a specifed percentage of any asset class. The portfolio
manager is therefore given freedom to switch the ratio of asset classes as
the economy moves through the business cycle.
EA,$#/ F,%-4
&unds that invest in stoc$s represent the largest category of mutual funds.
.enerally, the investment obective of this class of funds is long:term capital
growth with some income. There are, however, many di%erent types of
@1
equity funds because there are many di%erent types of equities. ' great way
to understand the universe of equity funds is to use a style box, an example
of which is below.
The idea is to classify funds based on both the si#e of the companies
invested in and the investment style of the manager. The term value refers
to a style of investing that loo$s for high quality companies that are out of
favor with the mar$et. These companies are characteri#ed by low )P/ and
price:to:boo$ ratios and high dividend yields. The opposite of value is
growth, which refers to companies that have had Eand are expected to
continue to haveF strong growth in earnings, sales and cash Wow. '
compromise between value and growth is blend, which simply refers to
companies that are neither value nor growth stoc$s and are classifed as
being somewhere in the middle.
&or example, a mutual fund that invests in large:cap companies that are in
strong fnancial shape but have recently seen their share prices fall would be
placed in the upper left quadrant of the style box Elarge and valueF. The
opposite of this would be a fund that invests in startup technology
companies with excellent growth prospects. (uch a mutual fund would reside
in the bottom right quadrant Esmall and growthF.
G0!D(09I%#*"%(#$!%(0 F,%-4
'n international fund Eor foreign fundF invests only outside your home
country. .lobal funds invest anywhere around the world, including your home
country.
"tXs tough to classify these funds as either ris$ier or safer than domestic
investments. They do tend to be more volatile and have unique country
andPor political ris$s. 6ut, on the Wip side, they can, as part of a well:
balanced portfolio, actually reduce ris$ by increasing diversifcation.
'lthough the worldXs economies are becoming more inter:related, it is li$ely
that another economy somewhere is outperforming the economy of your
home country.
S*.$(0#/ F,%-4
This classifcation of mutual funds is more of an all:encompassing category
that consists of funds that have proved to be popular but donXt necessarily
belong to the categories weXve described so far. This type of mutual fund
@,
forgoes broad diversifcation to concentrate on a certain segment of the
economy.
(ector funds are targeted at specifc sectors of the economy such as
fnancial, technology, health, etc. (ector funds are extremely volatile. There
is a greater possibility of big gains, but you have to accept that your sector
may tan$.
*egional funds ma$e it easier to focus on a specifc area of the world. This
may mean focusing on a region Esay >atin 'mericaF or an individual country
Efor example, only 6ra#ilF. 'n advantage of these funds is that they ma$e it
easier to buy stoc$ in foreign countries, which is otherwise di!cult and
expensive. 7ust li$e for sector funds, you have to accept the high ris$ of loss,
which occurs if the region goes into a bad recession.
(ocially:responsible funds Eor ethical fundsF invest only in companies that
meet the criteria of certain guidelines or beliefs. -ost socially responsible
funds donXt invest in industries such as tobacco, alcoholic beverages,
weapons or nuclear power. The idea is to get a competitive performance
while still maintaining a healthy conscience.
I%-*x F,%-4
The last but certainly not the least important are index funds. This type of
mutual fund replicates the performance of a broad mar$et index such as the
(<) @?? or 9ow 7ones "ndustrial 'verage E97"'F. 'n investor in an index fund
fgures that most managers canXt beat the mar$et. 'n index fund merely
replicates the mar$et return and benefts investors in the form of low fees.
A-:(%#(&*4 !+ ',#,(0 +,%-4
-utual funds have advantages compared to direct investing in individual
securities.
K;L
These include0
"ncreased diversifcation
9aily liquidity
)rofessional investment management
'bility to participate in investments that may be available only to
larger investors
(ervice and convenience
.overnment oversight
/ase of comparison
@;
D$4(-:(%#(&*4 !+ ',#,(0 +,%-4
-utual funds have disadvantages as well, which include
K2L
0
&ees
>ess control over timing of recognition of gains
>ess predictable income
+o opportunity to customi#e
CONCEPT OF MUTUAL FUNDS:
ADVANTAGES OF MUTUAL FUND
(.
+o.
'dvantage )articulars
1;
P!"#+!0$!
D$:*"4$3.(#$!
%
-utual &unds invest in a well:diversifed portfolio of
securities which enables investor to hold a diversifed
investment portfolio Ewhether the amount of investment
is big or smallF.
2;
P"!+*44$!%(0
M(%(&*'*%#
&und manager undergoes through various research
wor$s and has better investment management s$ills
which ensure higher returns to the investor than what he
can manage on his own.
@2
3; L*44 R$4)
"nvestors acquire a diversifed portfolio of securities even
with a small investment in a -utual &und. The ris$ in a
diversifed portfolio is lesser than investing in merely , or
; securities.
4;
L!8
T"(%4(.#$!%
C!4#4
9ue to the economies of scale Ebenefts of larger
volumesF, mutual funds pay lesser transaction costs.
These benefts are passed on to the investors.
2; L$A,$-$#/
'n investor may not be able to sell some of the shares
held by him very easily and quic$ly, whereas units of a
mutual fund are far more liquid.
O;
C5!$.* !+
S.5*'*4
R-utual funds provide investors with various schemes
with di%erent investment obectives. "nvestors have the
option of investing in a scheme having a correlation
between its investment obectives and their own
fnancial goals. These schemes further have di%erent
plansPoptions
P; T"(%4("*%./
&unds provide investors with updated information
pertaining to the mar$ets and the schemes. 'll material
facts are disclosed to investors as required by the
regulator.
M; F0*x$D$0$#/
"nvestors also beneft from the convenience and
Wexibility o%ered by -utual &unds. "nvestors can switch
their holdings from a debt scheme to an equity scheme
and vice:versa. 5ption of systematic Eat regular
intervalsF investment and withdrawal is also o%ered to
the investors in most open:end schemes.
L; S(+*#/
-utual &und industry is part of a well:regulated
investment environment where the interests of the
investors are protected by the regulator. 'll funds are
registered with (/6" and complete transparency is
forced.
DISADVANTAGES OF MUTUAL FUND
(.
+o.
9isadvantage )articulars
1;
C!4#4 C!%#"!0
N!# $% #5*
H(%-4 !+ (%
I%:*4#!"
"nvestor has to pay investment management fees and
fund distribution costs as a percentage of the value of his
investments Eas long as he holds the unitsF, irrespective
of the performance of the fund.
2; N!
C,4#!'$G*-
P!"#+!0$!4
The portfolio of securities in which a fund invests is a
decision ta$en by the fund manager. "nvestors have no
right to interfere in the decision ma$ing process of a fund
@@
manager, which some investors fnd as a constraint in
achieving their fnancial obectives.
3;
D$B.,0#/ $%
S*0*.#$%& (
S,$#(D0*
F,%- S.5*'*
-any investors fnd it di!cult to select one option from
the plethora of fundsPschemesPplans available. &or this,
they may have to ta$e advice from fnancial planners in
order to invest in the right fund to achieve their
obectives.
D$4(-:(%#(&*4 !+ I%:*4#$%& M,#,(0 F,%-4:
1; P"!+*44$!%(0 M(%(&*'*%#: (ome funds doesnAt perform in
neither the mar$et, as their management is not dynamic enough to explore
the available opportunity in the mar$et, thus many investors debate over
whether or not the so:called professionals are any better than mutual fund or
investor him self, for pic$ing up stoc$s.
2; C!4#4 4 The biggest source of '-C income, is generally from
the entry < exit load which they charge from an investors, at the time of
purchase. The mutual fund industries are thus charging extra cost under
layers of argon.
3; D$0,#$!% : 6ecause funds have small holdings across di%erent
companies, high returns from a few investments often donXt ma$e much
di%erence on the overall return. 9ilution is also the result of a successful fund
getting too big. Ihen money pours into funds that have had strong success,
the manager often has trouble fnding a good investment for all the new
money.
4; T(x*4 : when ma$ing decisions about your money, fund
managers donXt consider your personal tax situation. &or example, when a
fund manager sells a security, a capital:gain tax is triggered, which a%ects
how proftable the individual is from the sale. "t might have been more
advantageous for the individual to defer the capital gains liability.
@C
BROAD MUTUAL FUND TYPES
1; EA,$#/ F,%-4
/quity funds are considered to be the more ris$y funds as compared to other
fund types, but they also provide higher returns than other funds. "t is
advisable that an investor loo$ing to invest in an equity fund should invest
for long term i.e. for ; years or more. There are di%erent types of equity
funds each falling into di%erent ris$ brac$et. "n the order of decreasing ris$
level, there are following types of equity funds0
a. A&&"*44$:* G"!8#5 F,%-4 1 "n 'ggressive .rowth &unds, fund
managers aspire for maximum capital appreciation and invest in less
researched shares of speculative nature. 6ecause of these speculative
investments 'ggressive .rowth &unds become more volatile and thus,
are prone to higher ris$ than other equity funds.
b. G"!8#5 F,%-4 1 .rowth &unds also invest for capital appreciation
Ewith time hori#on of ; to @ yearsF but they are di%erent from
'ggressive .rowth &unds in the sense that they invest in companies
that are expected to outperform the mar$et in the future. Iithout
entirely adopting speculative strategies, .rowth &unds invest in those
@D
companies that are expected to post above average earnings in the
future.
c. S*.$(0$#/ F,%-4 1 (peciality &unds have stated criteria for
investments and their portfolio comprises of only those companies that
meet their criteria. Criteria for some speciality funds could be to
investPnot to invest in particular regionsPcompanies. (peciality funds
are concentrated and thus, are comparatively ris$ier than diversifed
funds.. There are following types of speciality funds0
i. S*.#!" F,%-4: (peciality &unds have stated criteria for
investments and their portfolio comprises of only those
companies that meet their criteria. Criteria for some speciality
funds could be to investPnot to invest in particular
regionsPcompanies. (peciality funds are concentrated and thus,
are comparatively ris$ier than diversifed funds.. There are
following types of speciality funds0
ii. F!"*$&% S*.,"$#$*4 F,%-4: &oreign (ecurities /quity &unds
have the option to invest in one or more foreign companies.
&oreign securities funds achieve international diversifcation and
hence they are less ris$y than sector funds. However, foreign
securities funds are exposed to foreign exchange rate ris$ and
country ris$.
iii. M$-1C( !" S'(001C( F,%-4: &unds that invest in companies
having lower mar$et capitali#ation than large capitali#ation
companies are called -id:Cap or (mall:Cap &unds. -ar$et
capitali#ation of -id:Cap companies is less than that of big, blue
chip companies Eless than *s. ,@?? crores but more than *s. @??
croresF and (mall:Cap companies have mar$et capitali#ation of
less than *s. @?? crores. -ar$et Capitali#ation of a company can
be calculated by multiplying the mar$et price of the companyXs
share by the total number of its outstanding shares in the
mar$et. The shares of -id:Cap or (mall:Cap Companies are not
as liquid as of >arge:Cap Companies which gives rise to volatility
in share prices of these companies and consequently, investment
gets ris$y.
iv. O#$!% I%.!'* F,%-4>: Ihile not yet available in "ndia, 5ption
"ncome &unds write options on a large fraction of their portfolio.
)roper use of options can help to reduce volatility, which is
otherwise considered as a ris$y instrument. These funds invest in
big, high dividend yielding companies, and then sell options
against their stoc$ positions, which generate stable income for
investors.
d. D$:*"4$3*- EA,$#/ F,%-4 1 /xcept for a small portion of investment
in liquid money mar$et, diversifed equity funds invest mainly in
@3
equities without any concentration on a particular sectorEsF. These
funds are well diversifed and reduce sector:specifc or company:
specifc ris$. However, li$e all other funds diversifed equity funds too
are exposed to equity mar$et ris$. 5ne prominent type of diversifed
equity fund in "ndia is /quity >in$ed (avings (chemes E/>((F. 's per
the mandate, a minimum of 1?B of investments by />(( should be in
equities at all times. />(( investors are eligible to claim deduction
from taxable income Eup to *s 1 la$hF at the time of fling the income
tax return. />(( usually has a loc$:in period and in case of any
redemption by the investor before the expiry of the loc$:in period
ma$es him liable to pay income tax on such incomeEsF for which he
may have received any tax exemptionEsF in the past.
e. EA,$#/ I%-*x F,%-4 1 /quity "ndex &unds have the obective to match
the performance of a specifc stoc$ mar$et index. The portfolio of these
funds comprises of the same companies that form the index and is
constituted in the same proportion as the index. /quity index funds
that follow broad indices Eli$e (<) C+M +ifty, (ensexF are less ris$y
than equity index funds that follow narrow sectoral indices Eli$e
6(/6'+G/M or C+M 6an$ "ndex etcF. +arrow indices are less diversifed
and therefore, are more ris$y.
f. V(0,* F,%-4 1 8alue &unds invest in those companies that have sound
fundamentals and whose share prices are currently under:valued. The
portfolio of these funds comprises of shares that are trading at a low
)rice to /arning *atio E-ar$et )rice per (hare P /arning per (hareF and
a low -ar$et to 6oo$ 8alue E&undamental 8alueF *atio. 8alue &unds
may select companies from diversifed sectors and are exposed to
lower ris$ level as compared to growth funds or speciality funds. 8alue
stoc$s are generally from cyclical industries Esuch as cement, steel,
sugar etc.F which ma$e them volatile in the short:term. Therefore, it is
advisable to invest in 8alue funds with a long:term time hori#on as ris$
in the long term, to a large extent, is reduced.
g. EA,$#/ I%.!'* !" D$:$-*%- Y$*0- F,%-4 1 The obective of /quity
"ncome or 9ividend Qield /quity &unds is to generate high recurring
income and steady capital appreciation for investors by investing in
those companies which issue high dividends Esuch as )ower or =tility
companies whose share prices Wuctuate comparatively lesser than
other companiesX share pricesF. /quity "ncome or 9ividend Qield /quity
&unds are generally exposed to the lowest ris$ level as compared to
other equity funds.
2; D*D# 9 I%.!'* F,%-4
&unds that invest in medium to long:term debt instruments issued by private
companies, ban$s, fnancial institutions, governments and other entities
belonging to various sectors Eli$e infrastructure companies etc.F are $nown
as 9ebt P "ncome &unds. 9ebt funds are low ris$ profle funds that see$ to
@1
generate fxed current income Eand not capital appreciationF to investors. "n
order to ensure regular income to investors, debt Eor incomeF funds
distribute large fraction of their surplus to investors. 'lthough debt securities
are generally less ris$y than equities, they are subect to credit ris$ Eris$ of
defaultF by the issuer at the time of interest or principal payment. To
minimi#e the ris$ of default, debt funds usually invest in securities from
issuers who are rated by credit rating agencies and are considered to be of
Y"nvestment .radeY. 9ebt funds that target high returns are more ris$y.
6ased on di%erent investment obectives, there can be following types of
debt funds0
a. D$:*"4$3*- D*D# F,%-4 1 9ebt funds that invest in all securities
issued by entities belonging to all sectors of the mar$et are $nown as
diversifed debt funds. The best feature of diversifed debt funds is that
investments are properly diversifed into all sectors which results in
ris$ reduction. 'ny loss incurred, on account of default by a debt
issuer, is shared by all investors which further reduces ris$ for an
individual investor.
b. F!.,4*- D*D# F,%-4> 1 9ebt funds that invest in all securities issued
by entities belonging to all sectors of the mar$et are $nown as
diversifed debt funds. The best feature of diversifed debt funds is that
investments are properly diversifed into all sectors which results in
ris$ reduction. 'ny loss incurred, on account of default by a debt
issuer, is shared by all investors which further reduces ris$ for an
individual investor.
c. H$&5 Y$*0- D*D# +,%-4 1 's we now understand that ris$ of default is
present in all debt funds, and therefore, debt funds generally try to
minimi#e the ris$ of default by investing in securities issued by only
those borrowers who are considered to be of Yinvestment gradeY. 6ut,
High Qield 9ebt &unds adopt a di%erent strategy and prefer securities
issued by those issuers who are considered to be of Ybelow investment
gradeY. The motive behind adopting this sort of ris$y strategy is to earn
higher interest returns from these issuers. These funds are more
volatile and bear higher default ris$, although they may earn at times
higher returns for investors.
d. A44,"*- R*#,"% F,%-4 1 'lthough it is not necessary that a fund will
meet its obectives or provide assured returns to investors, but there
can be funds that come with a loc$:in period and o%er assurance of
annual returns to investors during the loc$:in period. 'ny shortfall in
returns is su%ered by the sponsors or the 'sset -anagement
Companies E'-CsF. These funds are generally debt funds and provide
investors with a low:ris$ investment opportunity. However, the security
of investments depends upon the net worth of the guarantor Ewhose
name is specifed in advance on the o%er documentF. To safeguard the
interests of investors, (/6" permits only those funds to o%er assured
return schemes whose sponsors have adequate net:worth to guarantee
C?
returns in the future. "n the past, =T" had o%ered assured return
schemes Ei.e. -onthly "ncome )lans of =T"F that assured specifed
returns to investors in the future. =T" was not able to fulfll its promises
and faced large shortfalls in returns. /ventually, government had to
intervene and too$ over =T"Xs payment obligations on itself. Currently,
no '-C in "ndia o%ers assured return schemes to investors, though
possible.
e. F$x*- T*"' P0(% S*"$*4 1 &ixed Term )lan (eries usually are closed:
end schemes having short term maturity period Eof less than one yearF
that o%er a series of plans and issue units to investors at regular
intervals. =nli$e closed:end funds, fxed term plans are not listed on
the exchanges. &ixed term plan series usually invest in debt P income
schemes and target short:term investors. The obective of fxed term
plan schemes is to gratify investors by generating some expected
returns in a short period.
3; G$0# F,%-4
'lso $nown as .overnment (ecurities in "ndia, .ilt &unds invest in
government papers Enamed dated securitiesF having medium to long term
maturity period. "ssued by the .overnment of "ndia, these investments have
little credit ris$ Eris$ of defaultF and provide safety of principal to the
investors. However, li$e all debt funds, gilt funds too are exposed to interest
rate ris$. "nterest rates and prices of debt securities are inversely related and
any change in the interest rates results in a change in the +'8 of debtPgilt
funds in an opposite direction.
4; M!%*/ M(")*# 9 L$A,$- F,%-4
-oney mar$et P liquid funds invest in short:term Ematuring within one yearF
interest bearing debt instruments. These securities are highly liquid and
provide safety of investment, thus ma$ing money mar$et P liquid funds the
safest investment option when compared with other mutual fund types.
However, even money mar$et P liquid funds are exposed to the interest rate
ris$. The typical investment options for liquid funds include Treasury 6ills
Eissued by governmentsF, Commercial papers Eissued by companiesF and
Certifcates of 9eposit Eissued by ban$sF.
2; H/D"$- F,%-4
's the name suggests, hybrid funds are those funds whose portfolio includes
a blend of equities, debts and money mar$et securities. Hybrid funds have
an equal proportion of debt and equity in their portfolio. There are following
types of hybrid funds in "ndia0
a. B(0(%.*- F,%-4 1 The portfolio of balanced funds include assets li$e
debt securities, convertible securities, and equity and preference
shares held in a relatively equal proportion. The obectives of balanced
funds are to reward investors with a regular income, moderate capital
appreciation and at the same time minimi#ing the ris$ of capital
C1
erosion. 6alanced funds are appropriate for conservative investors
having a long term investment hori#on.
b. G"!8#51(%-1I%.!'* F,%-4 1 &unds that combine features of growth
funds and income funds are $nown as .rowth:and:"ncome &unds.
These funds invest in companies having potential for capital
appreciation and those $nown for issuing high dividends. The level of
ris$s involved in these funds is lower than growth funds and higher
than income funds.
c. A44*# A00!.(#$!% F,%-4 1 -utual funds may invest in fnancial assets
li$e equity, debt, money mar$et or non:fnancial EphysicalF assets li$e
real estate, commodities etc.. 'sset allocation funds adopt a variable
asset allocation strategy that allows fund managers to switch over
from one asset class to another at any time depending upon their
outloo$ for specifc mar$ets. "n other words, fund managers may switch
over to equity if they expect equity mar$et to provide good returns and
switch over to debt if they expect debt mar$et to provide better
returns. "t should be noted that switching over from one asset class to
another is a decision ta$en by the fund manager on the basis of his
own udgment and understanding of specifc mar$ets, and therefore,
the success of these funds depends upon the s$ill of a fund manager in
anticipating mar$et trends.
C. C!''!-$#/ F,%-4
Those funds that focus on investing in di%erent commodities Eli$e
metals, food grains, crude oil etc.F or commodity companies or
commodity futures contracts are termed as Commodity &unds. '
commodity fund that invests in a single commodity or a group of
commodities is a speciali#ed commodity fund and a commodity fund
that invests in all available commodities is a diversifed commodity
fund and bears less ris$ than a speciali#ed commodity fund. Y)recious
-etals &undY and .old &unds Ethat invest in gold, gold futures or shares
of gold minesF are common examples of commodity funds.
P; R*(0 E4#(#* F,%-4
&unds that invest directly in real estate or lend to real estate
developers or invest in sharesPsecuriti#ed assets of housing fnance
companies, are $nown as (peciali#ed *eal /state &unds. The obective
of these funds may be to generate regular income for investors or
capital appreciation.
M; Ex.5(%&* T"(-*- F,%-4 (ETF)
/xchange Traded &unds provide investors with combined benefts of a
closed:end and an open:end mutual fund. /xchange Traded &unds
follow stoc$ mar$et indices and are traded on stoc$ exchanges li$e a
single stoc$ at index lin$ed prices. The biggest advantage o%ered by
these funds is that they o%er diversifcation, Wexibility of holding a
single share Etradable at index lin$ed pricesF at the same time.
C,
*ecently introduced in "ndia, these funds are quite popular abroad.
L; F,%- !+ F,%-4
-utual funds that do not invest in fnancial or physical assets, but do
invest in other mutual fund schemes o%ered by di%erent '-Cs, are
$nown as &und of &unds. &und of &unds maintain a portfolio comprising
of units of other mutual fund schemes, ust li$e conventional mutual
funds maintain a portfolio comprising of equityPdebtPmoney mar$et
instruments or non fnancial assets. &und of &unds provide investors
with an added advantage of diversifying into di%erent mutual fund
schemes with even a small amount of investment, which further helps
in diversifcation of ris$s. However, the expenses of &und of &unds are
quite high on account of compounding expenses of investments into
di%erent mutual fund schemes.
"nWationis the process in which the price level is risingand money is losing
value.
"nWation is not the increase in the price of one item.
"nWationis the increase in the price of all items by similar percentages.
' one:time ump in the price level is not inWation.
"nWation is an ongoingprocess
C(,4*4 !+ I%?(#$!%
The !asic causes of in"ation #ere covered at $S level% This note considers
the demand and supply&side courses in more detail includin' the impact of
C;
chan'es in the exchan'e rate and the prices of 'oods and services in the
international economy%
C!4# P,45 I%?(#$!%
Cost:push inWation occurs when businesses respond to rising production
costs, by raising prices in order to maintain their proft margins. There are
many reasons why costs might rise0
R$4$%& $'!"#*- "(8 '(#*"$(04 .!4#4 perhaps caused by inWation in
countries that are heavily dependent on exports of these commodities or
alternatively by a fall in the value of the pound in the foreign exchange
mar$ets which increases the =G price of imported inputs. ' good example of
cost push inWation was the decision by 6ritish .as and other energy suppliers
to raise substantially the prices for gas and electricity that it charges to
domestic and industrial consumers at various points during ,??@ and ,??C.
R$4$%& 0(D!," .!4#4 : caused by wage increases which exceed any
improvement in productivity. This cause is important in those industries
which are alabour:intensiveA. &irms may decide not to pass these higher costs
onto their customers Ethey may be able to achieve some cost savings in
other areas of the businessF but in the long run, wage inWation tends to move
closely with price inWation because there are limits to the extent to which
any business can absorb higher wage expenses.
H$&5*" $%-$"*.# #(x*4 $'!4*- D/ #5* &!:*"%'*%# 4 for example a rise
in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties
or perhaps a rise in the standard rate of 8alue 'dded Tax or an extension to
the range of products to which 8'T is applied. These taxes are levied on
producers EsuppliersF who, depending on the price elasticity of demand and
supply for their products, can opt to pass on the burden of the tax onto
consumers. &or example, if the government was to choose to levy a new tax
on aviation fuel, then this would contribute to a rise in cost:push inWation.
Cost:push inWation can be illustrated by an inward shift of the short run
aggregate supply curve. This is shown in the diagram below. Ceteris paribus,
a fall in (*'( causes a contraction of real national output together with a rise
in the general level of prices.
C2
D*'(%- P,00 I%?(#$!%
9emand:pull inWation is li$ely when there is full employment of resources
and when (*'( is inelastic. "n these circumstances an increase in '9 will
lead to an increase in prices. '9 might rise for a number of reasons 4 some
of which occur together at the same moment of the economic cycle
A -*"*.$(#$!% !+ #5* *x.5(%&* "(#*, which has the e%ect of
increasing the price of imports and reduces the foreign price of =G
exports. "f consumers buy fewer imports, while foreigners buy more
exports, '9 will rise. "f the economy is already at full employment,
prices are pulled upwards.
A "*-,.#$!% $% -$"*.# !" $%-$"*.# #(x(#$!%. "f direct taxes are
reduced consumers have more real disposable income causing
demand to rise. ' reduction in indirect taxes will mean that a given
amount of income will now buy a greater real volume of goods and
services. 6oth factors can ta$e aggregate demand and real .9) higher
and beyond potential .9).
T5* "($- &"!8#5 !+ #5* '!%*/ 4,0/ 4 perhaps as a
consequence of increased ban$ and building society borrowing if
interest rates are low. -onetarist economists believe that the root
causes of inWation are monetary 4 in particular when the monetary
authorities permit an excessive growth of the supply of money in
C@
circulation beyond that needed to fnance the volume of transactions
produced in the economy.
R$4$%& .!%4,'*" .!%3-*%.* (%- (% $%."*(4* $% #5* "(#* !+
&"!8#5 !+ 5!,4* "$.*4 4 both of which would lead to an increase in
total household demand for goods and services
F(4#*" *.!%!'$. &"!8#5 $% !#5*" .!,%#"$*4 4 providing a boost to
=G exports overseas.
The e%ects of an increase in '9 on the price level can be shown in the next
two diagrams. Higher prices following an increase in demand lead to higher
output and profts for those businesses where demand is growing. The
impact on prices is greatest when (*'( is inelastic.
"n the frst diagram the (*'( curve is drawn as non:linear. "n the second, the
macroeconomic equilibrium following an outward shift of '9 ta$es the
economy beyond the equilibrium at potential .9). This causes an
$%?(#$!%("/ &( to appear which then triggers higher wage and other
factor costs. The e%ect of this is to cause an inward shift of (*'( ta$ing real
national output bac$ towards a macroeconomic equilibrium at Qfc but with
the general price level higher than it was before.
CC

T5* 8(&* "$.* 4$"(0 Q R*x*.#(#$!%41$%-,.*- $%?(#$!%S
*ising expectations of inWation can often be self:fulflling. "f people expect
prices to continue rising, they are unli$ely to accept pay rises less than their
expected inWation rate because they want to protect the real purchasing
power of their incomes. &or example a booming economy might see a rise in
inWation from ;B to @B due to an excess of '9. Ior$ers will see$ to
negotiate higher wages and there is then a danger that this will trigger a
awage:price spiralA that then requires the introduction of deWationary policies
such as higher interest rates or an increase in direct taxation.
CD
I%?(#$!% $%?,*%.*4 $% #5* B"$#$45 *.!%!'/
The diagram summarises some of the $ey inWuences on inWation. *eading
from left to right0
o A:*"(&* *("%$%&4 comprise basic pay T income from overtime
payments, productivity bonuses, proft:related pay and other
supplements to earned income
o P"!-,.#$:$#/ measures output per person employed, or output per
person hour. ' rise in productivity helps to $eep unit costs down.
However, if earnings to people in wor$ are rising faster than
productivity, then unit labour costs will increase
o T5* &"!8#5 !+ ,%$# 0(D!," .!4#4 is a $ey determinant of inWation in
the medium term. 'dditional pressure on prices comes from higher
import prices, commodity prices Ee.g. oil, copper and aluminiumF and
also the impact of indirect taxes such as 8'T and excise duties.
o P"$.*4 also increase when businesses decide to increase their proft
margins. They are more li$ely to do this during the upswing phase of
the economic cycle.