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Financial Management

Financial Management

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Sections

  • WHAT IS FINANCIAL MANAGEMENT?
  • OBJECTIVES OF FINANCIAL ACCOUNTING
  • ACCOUNTING
  • USERS OF FINANCIAL INFORMATION
  • ACCOUNTING Vs FINANCIAL MANAGEMENT
  • MANAGEMENT
  • IMPORTANT FINANCIAL DECISIONS
  • FINANCIAL MANAGEMENT INTERFACE
  • INTERFACE
  • ENVIRONMENT OF CORPORATE FINANCE
  • FINANCE
  • ORGANISATIONAL FORM - CRITERIA
  • FINANCIAL SYSTEM
  • DEVELOPED FINANCIAL MARKET
  • FINANCIAL ASSET
  • FINANCIAL ASSET - CHARACTERISTICS
  • CHARACTERISTICS
  • MONEY MARKET
  • MONEY MARKET - INSTRUMENTS
  • CALL MONEY MARKET
  • COMMERCIAL BILLS
  • DISCOUNT & ACCEPTANCE MARKET
  • TREASURY BILLS
  • REPURCHASE (REPO) AGREEMENTS
  • COMMERCIAL PAPER – RBI GUIDELINES
  • GUIDELINES
  • CERTIFICATE OF DEPOSIT
  • CD – RBI GUIDELINES
  • INTER-BANK PARTICIPATION
  • INTER-CORPORATE LOANS
  • FINANCIAL INTERMEDIARIES
  • RBI
  • MONEY MARKET – SHORTCOMINGS
  • MONEY MARKET – RECENT DEVELOPMENTS
  • DEVELOPMENTS
  • DISCOUNT & FINANCE HOUSE OF INDIA
  • INDIA
  • MONEY MARKET Vs CAPITAL MARKET
  • MARKET
  • WHY LONG TERM FINANCE?
  • SOURCES OF LONG TERM FINANCE
  • PRIMARY MARKET - CLASSIFICATION
  • SEBI GUIDELINES – PRIMARY MARKET
  • NEW ISSUES MARKET - FUNCTIONS
  • PUBLIC ISSUES – IPO and SEO
  • SEBI GUIDELINES – PUBLIC ISSUE
  • PRIVATE PLACEMENT & BOD
  • RIGHTS OFFERING
  • RIGHTS OFFERING - GUIDELINES
  • BOOK BUILDING - 1995
  • GREEN-SHOE OPTION
  • LISTING OF SECURITIES
  • LISTING PROCEDURE
  • LISTING – SEBI GUIDELINES
  • LISTING DRAWBACKS
  • SHARE BUYBACK - 1988
  • SEBI GUIDELINES – SHARES BUYBACK
  • BUYBACK
  • SEBI GUIDELINES – SHARE BUYBACK
  • SECONDARY MARKET
  • PRIMARY VS SECONDARY MARKET
  • STOCK EXCHANGE
  • FAQ’s – STOCK EXCHANGE
  • TYPES OF ORDERS
  • TRADING SYSTEM
  • SETTLEMENT OF TRANSACTIONS
  • SPECULATION
  • VOLATILITY & SPECULATION
  • CONTROL OF SPECULATION
  • CAPITAL MARKET - SHORTCOMINGS
  • RECENT DEVELOPMENTS
  • FOREX MARKET
  • DERIVATIVE STRATEGY
  • WHAT IS TIME VALUE OF MONEY?
  • TIME VALUE - CHARACTERISTICS
  • COMPOUNDING & DISCOUNTING
  • PERIOD OF CASH FLOWS
  • WHY RISK & RETURN?
  • WHAT IS RETURN?
  • WHAT IS RISK?
  • INVESTMENT CONCEPTS
  • RISK DIVERSIFICATION
  • MARKOWITZ PORTFOLIO THEORY
  • RISK OF A PORTFOLIO
  • CAPITAL ASSET PRICING MODEL
  • SECURITY MARKET LINE (SML)
  • EFFICIENT FRONTIER
  • EFFICIENT MARKET THEORY
  • MEASUREMENT OF RISK
  • VALUATION OF SECURITIES
  • SKILLS OF A SUCCESSFUL INVESTOR
  • BALANCING INVESTING SKILLS
  • BOND VALUATION
  • ARBITRAGE PRICING MODELS
  • MEANING OF COST OF CAPITAL
  • CAPITAL STRUCTURE
  • COST OF A SPECIFIC SOURCE
  • COST OF PREFERENCE CAPITAL
  • COST OF EQUITY CAPITAL
  • REALISED YIELD APPROACH
  • NET WEALTH CREATION
  • RISK PREMIUM APPROACH
  • PRICE – EARNINGS RATIO
  • COST OF RETAINED EARNINGS
  • WEIGHTED AVERAGE COST OF CAPITAL
  • CAPITAL
  • MARGINAL COST OF CAPITAL
  • MARGINAL COST SCHEDULE
  • CAPEX - CHARACTERISTICS
  • CAPEX APPRAISAL
  • APPRAISAL CRITERIA
  • WORKING CAPITAL
  • WORKING CAPITAL - LEVELS
  • QUALITY OF WORKING CAPITAL
  • MATCHING CONCEPT
  • PERMANENT & FIXED WC
  • WORKING CAPITAL - FINANCING
  • CONSERVATIVE FINANCING
  • AGGRESSIVE FINANCING
  • YIELD CURVE
  • INVENTORY MANAGEMENT
  • INVENTORY DECISION MAKING
  • ECONOMIC ORDER QUANTITY
  • EOQ MODEL
  • EOQ - DERIVATION
  • QUANTITY DISCOUNTS & EOQ
  • DETERMINING CHANGE IN PROFIT - ∆π
  • ORDER POINT
  • SAFETY STOCK
  • INVENTORY VALUATION
  • ABC ANALYSIS
  • ABC CLASSIFICATION
  • DEBTORS MANAGEMENT
  • CREDIT POLICY VARIABLES - I
  • CREDIT POLICY VARIABLES - II
  • CREDIT SCORING
  • DISCRIMINANT ANALYSIS
  • DAY’S SALES OUTSTANDING - DSO
  • CREDIT GRANTING DECISION
  • REPEAT ORDER
  • CONCEPT OF TREASURY
  • TREASURY MANAGEMENT
  • CASH HOLDING MOTIVES
  • OPTIMAL CASH HOLDING
  • BAUMOL’S MODEL
  • FINANCING CURRENT ASSETS
  • BANK FINANCING
  • FACTORING
  • TANDON COMMITTEE - 1975
  • OTHER COMMITTEES
  • COST ACCOUNTING
  • COSTING
  • COSTS - DEFINITION
  • CLASSIFICATION - NATURE
  • CLASSIFICATION - ELEMENTS

FINANCIAL MANAGEMENT

Course Code: 501 & 502 Prof. Subir Sen – Faculty Member ICFAI
E-Mail: subir@ibsindia.org / 9830697368 Ref:
1) Financial Management – Prasanna Chandra 2) Financial Management – I. M. Pandey 3) Financial Management – Khan & Jain 4) Financial Management – James Van Horne 5) Financial Institutions & Markets – L. M. Bhole 6) Indian Financial System – M. Y. Khan

INTRODUCTION

2

WHAT IS FINANCIAL MANAGEMENT?
– Book Keeping – It is the process of recording of financial information relating to business operations in a systematic and orderly manner. – Financial Accounting – It is the process of identifying financial transactions, followed by condensation and classification, then subsequently summarizing and recording them with the objective of communicating them for analysis and interpretation. – Financial Management – It involves the presentation of accounting information in a way so as to assist the management in financial decision making and enhancing shareholder value.
3

To furnish periodical government returns. To prevent asset – liability mismatch (ALM). To assess tax liability. To assist in management decision making.OBJECTIVES OF FINANCIAL ACCOUNTING – – – – – – – – – To keep systematic records. 4 . To ascertain operational profit or loss. To prevent errors and fraud. To assess organizational health. To protect business properties.

USERS OF FINANCIAL INFORMATION – – – – – – – – – – – Shareholders. Acquirers (i. Bankers. Local Bodies. Government. Court. 5 . Managers. Creditors.e. Investors & Prospective Investors. General Public. Employees. Due Diligence Exercise).

ACCOUNTING Vs FINANCIAL MANAGEMENT – – – – – – – – – – Users of Information : External – Internal Type of Analysis : Whole – Part Data Used : Raw Data – Semi finished Data Nature of Analysis : Historical – Futuristic Unit of Measurement : Quantitative – Qualitative Periodicity : Long Term – Short Term Precision : Very High – Low to Medium Nature : Objective – Subjective Legal Compulsion : Very High – Low Nature of Content : Low to Medium – Very High 6 .

IMPORTANT FINANCIAL DECISIONS        How to evaluate CAPEX decisions? Where to park idle funds? How many days inventory to carry? What should be its credit policy? How should it raise long-term finance? How much dividend to pay to shareholders? How to gauge and monitor performance? 7 .

Private Placement – Term Loans. – Venture Capital – Deferred Payment – Internal Accruals 8 . Rights Issue. Institutional Finance – Overdraft. ECB.ROLE OF A FINANCIAL MANAGER  Financing / Mobilizing – Promoters Contribution – Public Issue. Cash Credit – Hire-Purchase / Leasing – Subsidies – Capital & Revenue – International Finance – GDR.

Taxes – Working Capital – Inventory. Interest. Mutual Funds.ROLE OF A FINANCIAL MANAGER  Investing / Deploying – – Land & Building – Plant & Machinery – Furniture & Fixture – Shares. Debtors – Loan Repayment 9 . Bonds. Derivatives – Dividend.

ROLE OF A FINANCIAL MANAGER  Planning & Control – Capital Budgeting – Treasury Management – Working Capital Management – Capital Structure Planning – Cost Control – Forecasting & Budgeting – Performance Analysis – Internal Audit 10 .

FINANCIAL MANAGEMENT INTERFACE      Finance – Marketing – How much credit to extend to customers? Finance – Production – How many days inventory to keep? Finance – Human Resource – How many new recruits to be made? Finance – Operations – How should CAPEX decisions be evaluated? Finance – Top Management – What is should be the pricing of an IPO? 11 .

ENVIRONMENT OF CORPORATE FINANCE   Form of business organization – Sole Proprietorship – Partnership – Company – Listed & Unlisted Regulatory Framework – Industrial (NIP) & Trade Policy (NTP) – Foreign Exchange Management Act – MRTP Act – Income Tax Act – Companies Act – SEBI Act 12 .

ORGANISATIONAL FORM .CRITERIA Criteria for choosing an organizational form – Initial set-up costs – Government strictures and regulations – Speedy decision making – Fund raising capability – Degree of liability involved – Life span – Extent and nature of taxation – Reputation and image – Public domain and secrecy  13 .

FINANCIAL MARKETS & INSTITUTIONS 14 .

FINANCIAL SYSTEM Leakages = Taxes Government Injections = Public Exp Fiscal Crisis Rent + Wages + Profit +Royalty Leakages = Savings Liquidity Crisis Consumers Exports Producers Imports Injections = Investments Land + Labour + Capital +Technology Injections = Forex Leakages = Forex BOP Crisis 15 .

e.DEVELOPED FINANCIAL MARKET – – – – – – – – – – – – Economic & Industrial Growth Controlled Inflation – No Deficit Financing Stable Monetary Policy Highly organized banking system Presence of Central Bank Variety of Credit Instruments Rural market penetration Large number of intermediaries Efficient price discovery mechanism Size & Volumes (i. breadth & depth) Existence of Secondary Markets Low Transaction Costs 16 .

Marketability basically indicates that there is an exit route prior to the maturity period. They can be either classified as marketable or nonmarketable. The categories of financial assets listed in order of their marketability – Equity Shares – Mutual Funds – Derivatives – Debentures / Bonds – Govt. Securities 17 .FINANCIAL ASSET  It refers to a claim on the repayment of a certain sum of money at the end of a maturity period.

FINANCIAL ASSET CHARACTERISTICS           Continuous ready market Inter & Intra asset transferability Easy liquidity Security value Tax exemption Element of risk Hedging options Low transaction costs Streamlining returns Variety of durations 18 .

– Informal networks. – No single homogeneous marketplace. 19 . for all practical purposes we take it at as one year. Though there is no strict definition of near money. – Exit route is nascent. – It deals with short-term financial assets with a duration upto one year. – Intermediaries are absent.MONEY MARKET  The money market is the collective name given to institutions that deal in various grades of near money. – Low risk – Low return.

INSTRUMENTS Call Money Market Commercial Bills Market Acceptance Market Treasury Bills Market Repurchase Agreements (Repo’s) Commercial Paper Certificate of Deposit Inter – Bank Participation Certificate Inter – Corporate Loans MM Mutual Funds 20           .MONEY MARKET .

– Meet CRR or ALM criteria. usually less than 14 days. but negotiable. 21 . – Interest rates are very volatile. The loans are repayable on demand either at option of the lender or borrower. – Minimum deal size is very high. – Confidentiality is maintained. – Credibility is very critical for dealings. The major players in this segment are – banks and stock brokers. It provides an equilibrium mechanism for balancing short term deficits and surpluses.CALL MONEY MARKET  Call Money Market – Extremely short term duration. – Sudden surge in demand-supply for funds.

Types of commercial bills – – Demand & Usance / Time – Documentary & Clean – Inland & Foreign (Letter of Credit) – Supply & Accommodation 22  . The buyer accepts it by issuing a promissory note to pay the amount unconditionally on or before a specified date. Its validity is usually between (30-120) days.COMMERCIAL BILLS Commercial Bill – It is a document which arises out of a genuine trade transaction on credit terms.

– Strong banking credibility is essential.DISCOUNT & ACCEPTANCE MARKET  Discount market refers to a market of short term genuine trade bills. which are discounted by financial intermediaries. The seller gets immediate credit at a discount rate. – Interest rates are stable. 23 . whereas the buyer gets a convenient credit on the condition to pay on the specified date. – Large segment is in the unorganised sector. – Collaterals are preferred. except in the unorganised sector. like commercial banks.

e. – Durations – 91/182/364 days. – Auctions are the preferred route. – Credit rating of such instruments is very high. – Ordinary TB are subscribed directly by the public.TREASURY BILLS Treasury bills are short term borrowings by the GoI through the RBI. – They are transferable and tax free. banks). – Discount rates usually vary between (6-8)%. – It acts as a benchmark for banks and institutions. – Ad-hoc TB are meant for OMO (i.  24 . It is a promissory note issued under a discount usually for a period not exceeding a year.

  25 .REPURCHASE (REPO) AGREEMENTS In a repo transaction. the lender parts with a security (usually a treasury bill) to a borrower with an agreement to repurchase them at the end of a fixed period at a specified price. The normal duration of a repo is usually between (3-7) days. The difference between the purchase price and the original price is the cost of the borrower. In reverse repo a transaction is viewed from the point of view of supplier of funds. also known as repo-rate. Thus whether a transaction is a repo or a reverse repo depends largely on which party initiated the transaction.

– No assets are pledged. – Securitisation – borrowing directly from the public. – Recent origin – 1990’s. – Can also have an interest bearing form. unsecured. – Merchant bankers are generally not involved. – Company’s earning power is the only guarantee. – Minimising transaction costs.COMMERCIAL PAPER A commercial paper is an unsecured promissory note issued by a corporate. 26  . HNI) at a discount rate with a duration not exceeding a year. approved by the RBI.e. to the general public (i.

A minimum current ratio of 1. Maturity period (3-6) months. Listing on at least one national level stock exchange. Working capital limit exceeding Rs. Minimum Rating of P2 from CRISIL.COMMERCIAL PAPER – RBI GUIDELINES A tangible net worth not less than Rs. 27            .33:1. Issue not exceeding 20% of Working Capital. Minimum face value Rs. Underwriting not available. 10cr. Competitive interest rates and flexible. 25cr. A debt-service ratio not less than 2. 25 lacs. lot size of 4 units.

partially secured. – Document of title similar to time deposits. – Intermediation with HNI’s. – Promissory note. 28 . – Repayable on a fixed maturity date. – Issued at a discount to face value. – Transferable by endorsement and delivery. – Subject to SLR and CRR norms.CERTIFICATE OF DEPOSIT  Certificate of Deposit is a short term deposit instruments issued by banks and financial institutions to raise large sums of money. – Very nascent market in India.

29 . Ceiling limit – 10% of aggregate deposits. with a minimum lot size of 2 units. 5 lacs. Banks to maintain CRR & SLR on CD proceeds. No premature buy-back. Transferable after 30 days. Lock-in period 30 days. Maturity period (3-12) months.CD – RBI GUIDELINES        Normal face value in multiples of Rs.

– Period of participation period (90-180) days.INTER-BANK PARTICIPATION  IBPC enable commercial banks to fund their short-term working capital needs from within the periphery of the banking system. – Banks classified (Health Code-1) permitted to issue with risk. – Without risk – Subject to SLR and CRR norms. 30 . – Types of participation – with or without risk. – With risk – 90 days restriction. – Introduced in 1970. – Participation direct or indirect (re-discounting).

– Transaction size is large. – Tenure seldom exceeds 7 days. – Personal credibility is an important driver. – High degree of confidentiality is involved. – Call notice – Payable on demand. – Interest rates are highly volatile. – No collaterals / pledges are involved. 31  .INTER-CORPORATE LOANS ICL is an extremely short-term working capital arrangement between two corporates under terms and conditions mutually agreed upon.

. It aims at bringing in the scope of MM instruments and short-term surpluses within the ambit of retail investors. – Earlier MMFS’s were governed by the RBI.e. – No entry or exit load. Fixed management fee. – A MMFF is usually closed-ended.50 crore. – Minimum corpus of a MMMF is Rs. but w.MONEY MARKET MUTUAL FUNDS  A MMMF invests primarily in MM instruments of very high quality short-term maturities. – Short-term lock-in period of (15–30) days.f March 2007 they now come under the ambit of SEBI. 32 – No ceiling limits in investments.

FINANCIAL INTERMEDIARIES  A financial intermediary is basically an institution that lends liquidity to a financial system. thereby facilitating a financial transaction. Intermediaries in the money market – – Reserve Bank of India – Commercial Banks – Co-Operative Banks – Post Offices – Central Government 33 .

regulating. – The bank rate. 34  . – Open market operations (OMO). and controlling the Indian Financial System. promoting. monitoring. – Banker to the government. Its functions include – – Issuing of currency. – Bankers bank. – FOREX control.RBI It is the apex body responsible for guiding. – Monitoring liquidity through CRR & SLR.

Nascent hedging market. High transaction costs. Dominance of developmental institutions. 35 . Unscrupulous practices in unorganised sector.MONEY MARKET – SHORTCOMINGS           Lack of coordination across institutions. Lack of secondary market. of intermediaries. Inactive and erratic transaction volumes. Monopolistic market structures. Limited no. Seasonal fluctuation in interest rates.

Interest rates have been made competitive. Increasing debt-based mutual funds. Increasing breadth and depth of the market. 36 . Establishment of DFHI. Importance of credit rating. Transparency in offerings. Exemption from stamp duties.MONEY MARKET – RECENT DEVELOPMENTS           Integration of unorganised sector. Introduction of innovative instruments. Stable monetary policy.

re-discount. It was jointly promoted by the RBI. trusts for short-term capital shortages. It’s paid-up capital is Rs. – Buy-back arrangements of treasury bills. buy. – Discount. acquire money market instruments. – Support corporate.200 cr. . Commercial Banks & FI’s. – Lend and borrow funds and MM instruments. sell. and is entitled to borrow upto 10 times its net worth. 37 – Market building & advisory role.DISCOUNT & FINANCE HOUSE OF INDIA  DHFI commenced its operations in 1988 with the objective to develop and stabilize a secondary MM.

SOURCES & RAISING OF LONG TERM FINANCE 38 .

MONEY MARKET Vs CAPITAL MARKET Term Period – Short Term Vs Medium to Long Term Requirements – Working Capital Vs Fixed Capital Face Value – High Vs Low Secondary Markets – No / Nascent Vs Yes Intermediaries – No Vs Yes Lot Size – Minimum Vs Maximum Apex Regulatory Body – RBI Vs SEBI Market Building – No Vs Yes Processing Period – Short Vs Medium to Long Contract – Informal Vs Formal Players – Corporates – Individuals 39            .

WHY LONG TERM FINANCE? Long term finance is required for expansion. The duration of such projects usually range between (5-8) years. 40    . and are irreversible. It comprises of – – Project Implementation – Gestation – Break-Even Point They are usually characterised by huge investments. Using working capital to finance long-term projects will lead to a asset – liability mismatch. and diversification projects. modernisation. commitment of the top management.

SOURCES OF LONG TERM FINANCE      Capital – – Equity Capital – Preference Capital Debt – – Bonds – Debentures Hybrid – – Partly & Fully Convertible Debentures – Secured Premium Notes Internal Accruals – Subsidies & Exemptions – 41 .

PRIMARY MARKET . Market where a firm goes to existing shareholders at a time subsequent to its commence of business for raising additional capital. Market where a firm goes to the investing public at a time subsequent to its IPO for raising additional capital (SEO). (IPO). There are usually issued at a discount to the market price. whose shares are already listed at any recognised stock exchange (RO). 42 . Prior to an IPO stocks are usually unlisted and closely held.CLASSIFICATION    Market where a firm goes to the investing public for the first time.

SEBI GUIDELINES – PRIMARY MARKET    Maximum reservation available in case of an IPO – – Employees – 10% – Mutual Funds – 20% – Foreign Institutional Investors – 15% – Financial Institutions – 20% – Group Companies – 10% Reservations applicable for a maximum of any two of the above categories. 43 . Reservations are not available for the general public.

economic risk. analysis and processing of data surrounding new projects. 44  . including target market share. – Risk Analysis – Probability of failure of the project on account of changes in critical variables. The basic services surrounding such information includes – – Business Viability – Appropriateness of project capacity.PRIMARY MARKET . financial risk. Eg.FUNCTIONS Origination – It refers to the work of systematic investigation. – Technical Feasibility – Cost benefit analysis of appropriate technologies. operational risk.

PRIMARY MARKET . 45 . – Size of the Issue – Type of Instrument – Pricing of the Issue – Timing of the Issue – Structure of the Issue – Distribution of the Issue – Market Building Such services are usually offered Merchant Bankers.FUNCTIONS   Advisory – It refers to assessment of factors which may improve the quality of capital issues and ensure its success.

It is therefore a specific guarantee for the marketability of the issue. of units of a specific instrument of a specific issue in the event of public not subscribing to the desired extent. – Outright purchase. – Consortium blocks. – Standing behind the issue. 46  .FUNCTIONS Underwriting – It refers to an pre-agreement whereby the underwriter undertakes to subscribe to a specified no.PRIMARY MARKET .

NEW ISSUES MARKET .Red Herring Prospectus 47 . The different methods of distribution are – – Public Issue . This service is usually performed by Lead Managers who maintain direct contact with the investors.Prospectus – Private Placement & Bought Out Deals – Rights Issue – Book Building .FUNCTIONS  Distribution – It is the function of sale of securities to ultimate investors.

Names of Directors – Capital Structure – Subscription – Opening & Closing Dates 48 – Future Projections – Risk Factors  .PUBLIC ISSUES – IPO and SEO The issuing company directly offers to the general public a fixed no. of shares at a stated price through a document called prospectus. Technically it is known as invitation to an offer. if any – Existing & Proposed Activities – Factory Location. It contains – Name & Address of the Company – Issue Structure – Reservations.

Details of group companies. Justification of premium (if any). Company’s management. 49 . Highlighting of risk factors. At least 30 collection centres. Minimum application 100/500 depending on price. Subscription period (3-10) working days. history and businesses.SEBI GUIDELINES – PUBLIC ISSUE           Abridged prospectus with every application. A compliance report to be submitted within 45 days. No collection in cash.

PRIVATE PLACEMENT & BOD This method of sale consists of outright sale of securities to an Investment Banker. 50  . The difference is called the spread. – Promoters diluting their stake to comply with listing agreements. The investment banker may offload the securities immediately or at an opportune time. – Market building is not required. – Suitable for small companies. minimum cost. – Reduces the risk of timing of issue. The transaction is usually carried out at a negotiated price. – Risk of take-over.

or sell-off the right. of units of a security at a predetermined price. It provides an option to an existing shareholder to buy a specified no. 51 . accept the right – partially or fully. but at the same price. A company can come out with rights issue either after 2 years of incorporation or after 1 year of the previous issue. The ratio-of-rights can vary across different categories of shareholders. within a specific time period.RIGHTS OFFERING     It is a method a raising funds by an existing listed company. whichever is earlier. A shareholder may reject the right.

A rights offering has to be open for a minimum duration of 45 days. A rights issue is not required to be underwritten. Act 1988. Any part of the issue remaining unsubscribed by the public has to taken over by the promoters. The cost of the issue is minimum.GUIDELINES       The draft rights issue should contain all information as listed in the prospectus U/S 81 of the Companies. 52 . It gives the promoters the scope to raise their stakes.RIGHTS OFFERING .

– Revision of band. prior to 3 days of close of issue. – Maximum permissible band width is 20%. – Demand accessible on a continuous basis.BOOK BUILDING . 53 . – Fresh bid is permissible. Book building exercise is usually carried on through a price band (Floor & Ceiling Price).1995  It is a process through which demand for the securities proposed to be issued is solicited and the price for such a security is assessed for the determination of the size of the issue through a draft document (Red Herring Prospectus). – The exercise has to be open for (3-13) days.

54 . His responsibility is to intervene in the secondary market. A maximum of 15% the total issue size can used for this purpose. when the market price falls below the issue price. Such intervention can be carried out for a maximum period of 30 days. In this process a book – runner is appointed as a stabilising agent.GREEN-SHOE OPTION      Green-Shoe option is a mechanism to bring about stability in stock prices in the post – issue phase to generate shareholder confidence.

– Transparency for shareholders.LISTING OF SECURITIES Listing of securities mean that the securities are admitted for official trading on a recognised stock exchange. – Benchmarking against index or other stocks. – Offers wide publicity. SEBI makes listing agreement prior to the equity offering mandatory. Conditional listing is not permitted. – Source for future rights offering. 55  . Advantages of listing – – Ensures liquidity and continuous pricing. – Facilitates pledging of securities.

– Agreements with top managerial personnel. – Prospectus & Underwriting Agreement. dividend. – Memorandum & Articles of Association. – Capital structure. prior to entering into an agreement with a stock exchange – – Brief history of operations. including top 10 promoters. 56 . – Nature of instrument. bonus. – Last 3 years audited balance sheet.LISTING PROCEDURE  The following documents are to be submitted to CLA with prescribed format & fee. – Shareholding pattern.

5 crore as issued capital should go in for dual listing.  57 . – At least 40% of each class of securities must be offered to the public.LISTING – SEBI GUIDELINES Listing conditions to be fulfilled by a company – – Minimum issued capital Rs. and 5 newspapers having regional-level circulation. – Listing norms should be complied within 30 days from the closing of subscription . – Companies having more than Rs. 3 crores. – The issue to be advertised through at least 2 newspapers having national-level circulation.

hence may be used by competitors to gain unfair advantage. Fear of Takeover – Vested interests wishing to take-over from the current management can acquire shares from the market. Discloses vital information to competitors – Information submitted for the purpose of listing lies on public domain. 58 .LISTING DRAWBACKS     Leads to speculation – May lead to manipulation of prices in a way as may be detrimental to the interests of the company. Degrades company’s reputation – Negative information about companies gets easily percolated to the press.

It may lead to de-listing. It is an exit route for cash-rich companies without viable investment opportunities.1988 Buyback is a process of cancellation of shares out of free reserves to the extent of 25% of paid-up capital. – Injecting leverage into the capital structure. 59 – Minimise odd lots. – Reverse dilution of equity.   . – Increase underlying share-value. Advantages – – To prevent take-over bids.SHARE BUYBACK .

– Open Offer – It is based on ruling market price. – Repurchase Odd Lots – Shareholders possessing odd lots are given priority. – ESOP – The stock options given to employees are cancelled and bought back. Repurchase odd lots. Dutch auction. It is also known as reverse book–building.SEBI GUIDELINES – SHARES BUYBACK  Various modes of buy–back – tender. open offer. – Tender Offer – It is based on one fixed price. – Dutch Auction – Shares offered at the lowest price are given first priority. 60 . ESOP.

SEBI GUIDELINES – SHARE BUYBACK Prior SEBI approval. Special resolution needs to be passed by the board approving maximum price. Buyback once announced cannot be withdrawn. Daily purchase details to be reported.       61 . spot transactions and private placement not permissible. Buyback through negotiated deals. Transaction based on immediate payment through Escrow Account.

– Scope for diversification. 62  .SECONDARY MARKET It is a physical or virtual market place where listed securities are traded through open–outcry system or through a secret–bidding process. – Promotion of equity culture. – Marketability of long term funds. – Barometers of the economy. – Benchmark for improved performance. – Efficient flow of capital. Its advantages – – Provides additional liquidity to securities.

PRIMARY VS SECONDARY MARKET         Status of Securities – New Vs Existing Existence – Virtual Vs Physical / On Line Structure & Set Up – No Vs Yes Rules & Regulations – No Vs Yes Information – Ad-hoc Vs Continuous Control – Decentralised Vs Centralised Purpose – Start Up Vs Diversification Public Involvement – Direct Vs Indirect 63 .

and duly approved by SEBI. set up under the Securities Contract Regulation Act. 64   . – A copy of the rules and regulations of the stock exchange. 1956. A stock exchange applying for recognition has to make an application to the Central Govt.STOCK EXCHANGE Every stock exchange operating in India is recognised by the Central Government. – Prescribed fees. in the prescribed manner containing – – Organisation structure of the exchange.

Why are there differences in opinion? Because markets are not perfect. Which is the oldest stock exchange in India? BSE.FAQ’s – STOCK EXCHANGE      What is a stock exchange? It is a market place where investments can be bought and sold. Why were stock exchanges formed? To add liquidity to investments. (circa 1875) 65 . Why do people trade in a stock exchange? Because the buyer expects the prices will rise and the seller expects that prices will fall.

TYPES OF ORDERS   Order – An order is a requisition placed by an investor to buy or sell a particular stock(s) for a certain consideration. However. an investor is required to register himself with a broker. prior to placing any order. What are the various types of orders? – Open Order (High) – Market Order Confidence on the Broker – Span Order – Limit Order (Low) – Fixed Price Order 66 .

and execute deals. login & place requisitions.TRADING SYSTEM   Earlier trading in stock exchanges was carried out through a open–outcry system in the trading ring. – Tackle unprecedented growth of the stock market. – Protection of investor’s interest. Automated systems are either order or quote driven. The system witnessed various limitations – Lack of secrecy. – Entry of FII’s. VSAT-network based trading system enable participants to view online information. 67 . – Scope for manipulations.

– Through square-off. Delivery is said to be bad if the seller fails to give delivery on due date. – Through carry–forward (i. badla). What are the various ways of settlement? – Through payment or delivery.e. 68 .SETTLEMENT OF TRANSACTIONS     Delivery – It involves the handover of the stocks by the seller on due date for a consideration. Settlement Date – It is the date announced by the stock exchange on which settlement has to be made. Settlement – It is the process through which the buyer fulfils his obligations against delivery of stocks.

it refers to an exposure in a derivative without basic exposure in the underlying instrument. and/or malafide intentions. it involves taking exposure in a financial asset. In the futures market. What are the drawbacks of speculation? – Excessive volatility. It is characterised by short term view. Companies & genuine investors interests are harmed. What are the benefits of speculation? – Enhances liquidity of the market.SPECULATION    What is speculation? – In the spot market. 69 . without having an intention to buy it. lack of funds.

– Insider trading. – Multiple listing. 70 . – Excess money supply. – Low interest rates. – Limited floating stock.VOLATILITY & SPECULATION  Speculation leads to volatility. Major reasons for volatility – – Take over bid. but volatility is not always the result of speculation.

– Reducing carry forward duration. – Controlling settlement price. – Restriction on volumes. – Suspension of trading.CONTROL OF SPECULATION  Measures adopted by the stock exchange – Imposing or increasing margins. – Price bands. – De-listing. badla) charges – Transfer from Specified to Cash category.e. – Enhancing backwardation (i. 71 .

Functions – Regulation of stock exchanges. Objectives – To promote the interest of investors.SEBI – ACT. 1992. – To regulate the securities market. – Promote research and code of conduct. mutual funds. brokers. – Prohibition of fraudulent and unfair practices. and substantial acquisition. – To ensure efficient services by intermediaries.   72 . – Prevent insider trading. – Educate investors & intermediaries.

– Power to grant recognition of new stock exchanges. 1992. – Power to compel listing. – Power to direct enquiries and investigations. – Power to call for information from brokers. Powers – Power to call for returns from stock exchanges. – Power to frame rules and regulations of stock exchanges. – Power to levy fees on merchant banking activities. – Power to grant registration to brokers.SEBI – ACT.  73 .

74 . Prevalence of insider trading. Excessive volatility. Lack of professionalism. Dominance by FII’s. Scarcity of floating stocks.CAPITAL MARKET . Cumbersome settlement procedure. Dominance by large-cap stocks. Lack of sufficient liquidity.SHORTCOMINGS           More of speculative trading than cash trading. Lack of transparency and corporate governance.

75 . Standardisation of accounting practices. Prohibiting insider trading. International issues and listing. Trading in derivatives. Free and fair pricing of securities. Electronic trading and depository system. Protecting investors interest.RECENT DEVELOPMENTS           Regulation of intermediaries. Encouraging market building activities. Fair pricing of odd-lots.

ICICI – Insurance Companies – Mutual Funds – Pension Funds – FII’s – Agricultural Financing Institutions – Specialised Institutions – IRBI. EXIM Bank – NBFC  Hire Purchase & Leasing  Finance & Investment 76  .FINANCIAL INTERMEDIARIES Intermediaries in the capital market – – Financial Institutions – IFCI. IDBI.

100. A foreign currency can be quoted in two ways – – Direct Quote ($ 1 = Rs.42.00) – Indirect Quote (Rs.00 = $ 2. however in the long run it is quoted on the basis of PPP Theory. 77 . but payable in a foreign currency.38) In the short run currency is quoted on the basis of demand–supply. Trading in FOREX can be done in the spot market as well in the future market.FOREX MARKET    Foreign exchange includes all deposits and credits which are drawn in a home currency.

DERIVATIVES MARKET A derivative is a financial instrument whose value is derived from a another underlying instrument. Investing in a derivative in isolation to make profit in price fluctuations is known as speculating. The act of investing in a derivative to protect own position is known as hedging. a derivative which gives the investor the right to sell is 78 referred to as a put.    . The basic objective of of a derivative is to transfer known sources of risk. A derivative which gives the investor the right to buy is referred to as a call.

On the settlement date price falls to 110.7) b) 125 (p=0. his profit would have been reduced from 3000 to 2000.e. 1000). which would of cost him @ 2 (i. On the strike date if A had bought a put option of 500 shares of XYZ @ 125.3). Therefore A suffers a loss of 4000. However. So a derivative transaction is basically a trade-off 79 between risk and return. he would have made a profit of 2500.DERIVATIVE STRATEGY     A buys 100 shares of XYZ @ 150 with the following expectation – a) 200 (p=0. . on the settlement date if the price increased to 180.

TIME VALUE OF MONEY 80 .

The difference between the two is technically called the spread.e. decreases if the spread is negative. Value of money is basically a function of – a) interest rates b) inflation. purchasing power). 81 . (i. Therefore. value of money remains constant.e. interest – inflation) – Interest rates > the value of money – Inflation < the value of money Therefore. If the spread is zero. if the spread is positive value increases over time. money represents what it can buy (i.WHAT IS TIME VALUE OF MONEY?    Value of Money – Money does not have any inherent value.

– In an inflationary period. The logic – – Individuals in general. 82 . prefer current consumption over future consumption. – Money can be employed effectively to generate returns. Money today is more valuable than money receivable tomorrow.CHARACTERISTICS   The value of money changes over time. Therefore money over different time periods cannot be evaluated without adjusting.TIME VALUE . purchasing power of money falls over time.

COMPOUNDING & DISCOUNTING Compounding refers to a process of adjusting to find out the – – future value of a single cash flow – future value of an annuity Discounting refers to a process of adjusting to find out the – – present value of a single cash flow – present value of an annuity   83 .

Recurring deposit. Equated Monthly Installments) Perpetuity – It refers to a series of constant cash flows for a infinite time span.PERIOD OF CASH FLOWS Annuity – It refers to a series of constant cash flows for a finite time span. Reverse Mortgage)   84 . (Eg. (Eg. Pension Funds.

RISK & RETURN 85 .

– Transaction Cost – The cost of entering and exiting an investment. 86 . Other important criteria for appraising an investment – – Liquidity – The ease with which the investment can be converted into cash. any deviation may lead to a AL mismatch. – Convenience – It refers to the ease with which the implications can be understood by an investor. – Duration – It refers to the life of the investment. – Tax – Shelter available as per IT laws.WHY RISK & RETURN?  It is the most preferred and robust criteria for appraising investment in financial assets.

What are the different sources of return – – Initial Return – Periodical Return – Terminal Return 87 .WHAT IS RETURN?   Return – – It is the excess value received by an investor for foregoing current consumption.

– Financial Risk .Business Risk. Liquidity Risk Default Risk. – Economic Risk .Currency Risk. 88   . Market Risk.WHAT IS RISK? Risk – – It is the probability that the desired return may not be achieved.Interest Rate Risk. Inflation Risk. What are the different sources of risk – – Operational Risk .

INVESTMENT CONCEPTS Notion of Return – Stream of benefits – Measure = Mean + IRR Notion of Risk – Volatility in return – Measure = Standard Deviation + Beta Low Risk High Risk   89 .

return is the dominant factor – If return is constant.INVESTMENT CONCEPTS Notion of Portfolio – Return adds up. risk is the dominant factor Notion of Trade-off – Risk exposure . Risk does not Notion of Dominance – If risk is constant.VaR Notion of Diversification – Do not keep all your eggs in one basket     90 .

the ice-cream company would register a return of 30%. ice-cream company would register a return of 10%. What would be your investment strategy? 91 . If the hot wave dominates the planet. cold wave dominates the planet. while the coffee company would register a return of 10%. If on the other hand. either of which is equally likely to prevail.RISK DIVERSIFICATION  Illustration: Consider a hypothetical planet. while the coffee company would register a return of 30%. in which a given year is either under hot or cold wave. Let us assume that there are two companies constituting the entire market – coffee and ice-cream.

with a possible risk of 10%. whereas holding individual securities was yielding an expected return of 92 20% with a risk factor of 10%. so our expected return would still be 20%. while the other half would earn 10%.RISK DIVERSIFICATION  Solution: If we invested in only one of the two companies. our expected return will be 20%. If. we split our investment between the two companies in equal proportion. But in the second instance there is no possibility of deviation of returns. . half of our investment will earn a return of 30%. Diversification results in 20% expected return without risk.

of Securities .RISK DIVERSIFICATION Correlation: The Magical Factor Total Risk (%) r=+1 Unsystematic Risk r=0 r= -1 40 Systematic Risk 93 No.

– Risk and return is linearly related.MARKOWITZ PORTFOLIO THEORY  A portfolio theory is all about investing in a mix of securities that lies on the efficient frontier. The theory he came up with is popularly known as the Mean-Variance Criteria. Harry M. – Investors have identical expectations. Assumptions: – Investor decisions are based on risk and return. 94 . Markowitz in his pioneering study in 1950 was the first to identify the benefits of diversification. – Investors are risk averse. – Investors try to maximize return.

RISK OF A PORTFOLIO σ p2 = ω x2*σ *σ x*σ y*ρ x y we – h re 2 x + ω y2*σ 2 y + 2 ω x* ω y σ 2 =V ria c o p rtfo p(x y a n e f o lio . ) p ω x =%ofinvestmntinsecurityx e ω y =%ofinvestmntinsecurityy e σ σ x =S n a d v tio o s c rityx ta d rd e ia n f e u 95 .

goes to William Sharpe for which he got the Nobel Prize for Economics in 1990. The return varies according to the riskiness of the stock in terms of the market. Riskiness is measured in terms of beta. The basic contention is higher the risk (i.e. An Index). . 96 beta).CAPITAL ASSET PRICING MODEL     The credit for developing CAPM. The model was later extended by Lintner and Mossin. It is called the Single Index Model because it attempts to capture the return from a stock in terms of the market (i. they renamed it as Single Index Model. higher is the return.e.

SECURITY MARKET LINE (SML)     According to CAPM in a well functioning market in which stocks are correctly priced. The relationship is given by – Expected Return = Risk free rate of return + Beta * (Expected market return – Risk free rate of return) The excess of expected market return over risk free rate of return is known as the risk premium of market. there should be relationship between risk and return of an individual stock. 97 . CAPM therefore assumes a perfect market condition and a linear relationship between risk and return.

EFFICIENT FRONTIER  Expected Return (IRR) Any Portfolio lying on the Efficient Frontier curve is called an Efficient Portfolio SML Risk Premium Inefficient Portfolio’s Risk-Free Rate of Return Risk 98 .

99 . – Investors to do not have an edge over information. – Significant volumes.EFFICIENT MARKET THEORY  The market takes to into account all relevant facts relating to the financial performance of a firm in pricing a security. – Low transaction cost. Characteristics – – Large number of buyers and sellers. – Established communication channels. – Investors are rational and logical. – Price takers and not price movers.

A beta of 0.2 implies that 10% change in the market will lead to a 12 % change in the stock price. A beta of 1.the or Var (y) stock price (y) on the market index (x) 100 .8 implies that 10% change in the market will lead to a 8 % change in the stock price. Beta (β ) = nΣ xy – (Σ x * Σ y) nΣ x2 – (Σ x)2 Cov of y) Statistically.MEASUREMENT OF RISK Beta measures the volatility of a stock with respect to the market. beta is the regression coefficient (x. A beta of 1 implies that 10% change in the market will lead to a 10% change in the stock price.

SR 101 .SOME INDICATORS 1) IRR Equation: x – LRR = 0 – NPV (LRR) LRR – HRR NPV (LRR) – NPV (HRR) where x = IRR 2) Variance (Total Risk) = Σ x2 – Σ x 2 n n 3) Correlation r = nΣ xy – (Σ x * Σ y) √ {nΣ x2 – (Σ x)2} * √ {nΣ y2 – (Σ y)2} 4) Systematic Risk = Total Risk * r2 5) Unsystematic Risk = TR .

VALUATION OF SECURITIES 102 .

What is market value? – Market Value = Price at which it was last transacted.VALUATION OF SECURITIES     What is intrinsic value? – Intrinsic Value = Present value of future benefit(s). Since markets are inefficient (informational gaps) – – Intrinsic Value ≠ Market Value What should be your investment strategy? – If Market Value < Intrinsic Value = Buy – If Market Value > Intrinsic Value = Sell – If Intrinsic Value = Market Value = Hold 103 .

– Reading between the lines. – Strong analytical and forecasting skills. Market timing abilities – – Identifying trends and trends reversal. – Feeling the pulse of the market. – Finding bargains. – Contrary thinking. 104 .SKILLS OF A SUCCESSFUL INVESTOR   Stock selection abilities – – Strong knowledge of sectors.

BALANCING INVESTING SKILLS Market timing abilities Good Poor Concentrated Portfolio Constant Beta Diversified Portfolio Constant Beta 105 Stock selection abilities Concentrated Portfolio Managed Beta Diversified Portfolio Managed Beta Poor Good .

I=Annual Interest Payable P=Principal or Par Value. n=Maturity Period kd=Discounting Rate 106 .BOND VALUATION   Bond – A bond (also known as a debenture) is a debt instrument containing an unconditional promise to pay interest at a certain rate of interest (also known as coupon rate) which is either fixed or floating and pay back the principal sum at the end of a duration. Basic Bond Valuation Model V=Σ I + P (1+kd)n (1+kd)n where V=Intrinsic Value. which is determined in advance.

g=growth rate in 107 dividend (constant) . with or without management control. Dividend Capitalisation Model – It represents present value of dividend streams coupled with expected price.EQUITY VALUATION   Equity – It denotes risk capital. P1 = D1 (ks – g) where P=Price. Return on equity is highly volatile and has the largest duration among all classes of financial assets. D1 = expected dividend (Rs) ks=expected rate of return.

ARBITRAGE PRICING MODELS Whitbeck-Kisor Model – Return is a function of multiple factors.7 (DPS%) – 0. P/E = 7.8 (EPSσ) – Growth in EPS is the most important factor that positively affects P/E. not only risk. 108   . – Dividend growth positively affects P/E in a small way.2 (EPS%) + 1. – Volatility in EPS negatively affects P/E in a very insignificant way.

COST OF CAPITAL 109 .

MEANING OF COST OF CAPITAL Definition – It is the minimum rate of return that a company must earn in order to satisfy the contributories who have made investments in parity with risk and tenure. It is the financial yardstick against which discounting is done. The cost of capital to a company is the weighted average cost of all the individual sources of finance which comprises – – Cost of debentures and term loans – Cost of preference shares – Cost of equity shares 110   .

CAPITAL STRUCTURE

Definition – It refers to a judicious mix of various long-term sources of finance deployed by a company. The broad objective is to minimise the cost of capital and maximize wealth of the shareholders. Factors that affect capital structure decisions – – Cost of capital and tenure – Expected cash inflows and outflows – Nature of business, industry cycle – Dilution of control – Floating costs. – Risk attitude of the top management – Flexibility and exit costs

111

COST OF A SPECIFIC SOURCE
It is measured as the rate of discount which equates the present value of the expected payments to that source of finance with the net funds received from that source of finance. P=Σ t=1 Ct
 
n

(1+kd)t where P = net funds received from the source Ct= expected payment to the source at the end of year t
112

COST OF DEBT

The cost of debt capital is measured as the rate of discount which equates the present value of post-tax interest repayments with the net proceeds of the debt issue. P=Σ
t=1 n

C(1-t) F + (1+kd)t (1+kd)n

The multiplication by (1-t), where t is the tax rate applicable to the firm, is necessary to reflect the fact that the interest on debt is a tax deductible expense. F represents the redemption value.
113

P) *100 n (F+P)/2 It is based on amortisation of the cost of an asset evenly over its effective life period (n). the following approximation may also be used – kd = C(1-t) + (F . which is fairly close to the correct value.COST OF DEBT  For obtaining a quick estimate.  114  . of the cost of debt.

P=Σ D F + t=1 (1+kd)t (1+kd)n where F represents the redemption value.  115 . and D represents annualised dividend.COST OF PREFERENCE CAPITAL  The cost of debt capital is measured as the rate of discount which equates the present value of dividend (usually fixed) payments with the netn proceeds of the capital issue.

However. CAPM. Bond Yield + Risk Premium Approach. To cope with this several approaches have been proposed. P/E Approach. They are – Dividend Capitalisation Approach. the estimation of the return expected by equity holders cannot be determined with near certainty. The rate of return expected by suppliers of debt and preference capital can be ascertained with a fair degree of certainty.COST OF EQUITY CAPITAL    Equity capital of a firm is raised through raising of external equity and retention of current earnings. 116 . Realised Yield Approach.

REALISED YIELD APPROACH

According to this approach the yield (rate of return) earned by equity shareholders historically is regarded as a close proxy of the return expected by them, which by proxy represents its cost. Yt = D t + P t -1 P t-1 where – Yt = Yield Dt = Current Dividend (%) Pt = Current Price P t-1 = Previous Price
117

NET WEALTH CREATION

The following is referred to as wealth ratio – Wt = Dt + Pt P t-1 Therefore, the yield for an n period is – Yn = (W1 * W2 * W3 * …… Wn)1/n – 1 where – W1 = D1 + P1 P0 W2 = D2 + P2 P1
118

RISK PREMIUM APPROACH

According to this approach the ERR of equity investors of a firm equals – – ERR = Yield on Lt bonds(%) + Risk Premium(%) The logic is equity investors should be compensated for bearing additional risk. There is no foolproof way of assessing the risk premium. It usually varies at +x% (beta) depending on the capital market. Some analysts look at the operating and financial leverage of the company and adjust the risk premium accordingly. – T. Leverage = O. Leverage * F. Leverage 119

120 .PRICE – EARNINGS RATIO  The P/E ratio is an indication of the return expected by equity holders. where – – P/E0 = Market Price (P0) and EPS0 – P/E1 = Market Price (P1) EPS1 – Average P/E = P/E0 + P/E1 +……+ P/En n  This measure is quite accurate when pay-out ratio is constant.

This means the expected rate of return has to be adjusted for income tax and capital gains tax.COST OF RETAINED EARNINGS It is calculated as the post tax rate of return available to an investor. where –  kr = ks * (1-tp) (1-tg) – kr = Cost of retained earnings – ks= Expected return of equity holders – tp= Personal income tax rate – tg= Personal capital gains tax rate 121  .

80% Proportions may be based on book value or market value. Suppose a firm uses equity costing 16% and debt costing 9%. 122 .40% = 11.4*16% + 0. the cost of capital will be – – Cost of Capital = 0.40% + 5.6*9% = 6. If the proportions in which equity and debt are used are respectively 40% and 60%.WEIGHTED AVERAGE COST OF CAPITAL   A firms cost of capital is the weighted average cost of various sources of long-term finance used by it.

– Marginal cost of capital is directly 123 proportional to volume of finance. Generally the weighted average cost of capital tends to rise as the firm seeks more and more capital. – Usually suppliers of capital wants to be increasingly compensated for taking additional amounts of exposure. This indicates that marginal cost of capital is zero.  . irrespective of the magnitude of financing.MARGINAL COST OF CAPITAL It is assumed that risk composition of new projects and financing mix remaining constant. cost of capital remains unchanged. In reality this is not so.

MARGINAL COST SCHEDULE Average Cost of Capital Marginal cost of capital (X+2)% X% (X+1)% Volume of financing Volume of Financing (Debt) 124 .

CAPITAL EXPENDITURE DECISIONS 125 .

– They are irreversible in nature. – They provide an array of choices. therefore. – They have the ability to make or destroy a company. 126 .CHARACTERISTICS  CAPEX is characterised by the following – – These decisions involve large financial outlays. Exit barrier is very high. – They require full support and commitment of the top management. decisions are very critical and complex.CAPEX .

Long term funds principle. Sunk costs must be ignored. 127 . They should be converted to net cash flows. Cost of long-term funds should not be included. Opportunity costs associated with utilisation of resources should be taken into account.CAPEX APPRAISAL        All costs and benefits are measured in terms of cash flows and not profits. Incremental approach should be followed.

APPRAISAL CRITERIA
Payback Period Accounting Rate of Return Net Present Value Cost Benefit Ratio Internal Rate of Return

    

128

WORKING CAPITAL MANAGEMENT

129

WORKING CAPITAL

Working capital primarily refers to the level of liquidity in a business. Liquidity broadly refers to the investments in current assets; it normally has a duration not exceeding one year. It is considered the life-line of any business. Excessive liquidity should be avoided because it pulls down a firms profitability, as idle investment does not contribute to margins. On the other hand inadequate liquidity can impair the solvency of the business because of its inability to meet short-term obligations, thereby affecting its credit rating.
130

Critical Working Capital – It includes hard core cash. debtors and cash. Net Working Capital – It refers to the difference between current assets and current liabilities. It includes creditors and outstanding expenses. however. a negative working capital need not always be associated with poor financials.LEVELS    Gross Working Capital – It refers to the firms composite investment in current assets. Current liabilities includes the obligations of the business which are likely to mature within one year. It broadly includes – inventory.WORKING CAPITAL . Net working capital may be positive or negative. 131 .

132 .QUALITY OF WORKING CAPITAL     The quality of WC is equally important as its quantity. A high level of volatility results in assets becoming NPA (i.e. Quality of working capital implies investment in current assets with an acceptable level of volatility. NPA’s severely impairs the quality of working capital. A financial manager also needs to diligently apply the Matching Concept to maintain quality of WC. An asset whose realisability extends beyond 6 months is said to non-performing. non-performing assets).

MATCHING CONCEPT t Curren porary Tem Assets Capital Employed (Rs) ts t A sse Curren t manen Per Short Term Financin g Long Term Financin g 133 ssets A Fixed Capacity / Production (Units) .

CYCLE Cash Creditor s Raw Materials Work – In Process Finished Goods Overhead s Debtors 134 .WORKING CAPITAL .

Of its total investments approximately 1/3 of is blocked in WC. 135 . IT) the requirements of WC is comparatively lesser than in manufacturing. insurance. approximately 2/3 total investments is blocked in WC.WORKING CAPITAL . the requirements of WC is even lesser than in service (except for organised sector). However. telecom. approximately 90% total investments is blocked in WC. However. banking. However. In a service business (i.e.REQUIREMENTS    Nature of Business – In a manufacturing business the requirements of WC are the maximum. In a retail business.

high volatility (measured in terms of standard deviation) in sales should not be confused with seasonality. Production Policy – A conservative management may decide to maintain a higher level of WC than an aggressive one on the fear of losing customers.WORKING CAPITAL .    136 . Eg. airconditioners. soft-drinks.REQUIREMENTS Seasonality of Operations – Businesses which are highly seasonal in nature (sales in certain periods differ significantly from other periods) require higher amounts of WC in peak months rather than in slack month. However.

irrespective of the policy of the managements calls for higher levels of WC. 137 . Different stages are obviously characterized by different levels of competition. again on the fear of losing customers. As higher levels of competitions calls for higher investment in raw materials as well as finished goods and more credit being extended to customers. While creditors will demand advance payment against supplies.WORKING CAPITAL .REQUIREMENTS    Market Competition – It also partially depends on the product-life cycle as the industry cycle in which the firm is present. Higher levels of competition.

Government documentations – C form & Way Bill. order bookings and location of supplier. attractive rates – full container bookings. Information on price hikes coming from formal as well as informal channels.WORKING CAPITAL . 138 .REQUIREMENTS        Supply Conditions – Supply conditions also influences requirements of WC. Supply conditions may include – Promptness. Seasonality of raw materials. uncertainty in transit time). Attractive discounts / commissions against purchasing in bulk. Transporters arrangements (Eg.

139 .PERMANENT & FIXED WC     Permanent WC is the minimum level of WC a firm should maintain a sufficient level of current assets to ensure continuity in its business and pay its creditors on time. Variables WC represents the fluctuations in WC over and above the permanent level depending upon internal and external circumstances. WC going below the permanent level will lead to loss of market share. leading to loss of goodwill. default in suppliers payment. Permanent WC may be a constant or increasing function over time.

e. overdraft) or against discounting of bills (i. inventory and debtors).WORKING CAPITAL . Securitization – Adding liquidity to a pool of 140 book debts. Creditors – This includes the raw-materials supplied by creditors against deferred payment.      .FINANCING Working capital may be financed from the following one or more sources – Promoters – This includes the investment made by the promoters in the WC of the firm (i. cash credit). Bankers – It extends credit against hypothecation of inventory (i.e.e.

CONSERVATIVE FINANCING t Curren porary Tem Assets Capital Employed (Rs) ts t A sse Curren t manen Per Short Term Financin g ssets A Fixed Long Term Financin g 141 Capacity / Production (Units) .

AGGRESSIVE FINANCING urrent C orary Temp Assets Capital Employed (Rs) ssets tA urren C nent a Perm s Asset Fixed Short Term Financin g Long Term Financin g 142 Capacity / Production (Units) .

According to the liquidity preference theory the tenure usually increases the risk involved (i. The relationship between maturity of debt (i.e. tenure) cost of capital is usually upward sloping. 143 . uncertainty in forecasting long-term interests).YIELD CURVE    A firm has to make trade-off between following a conservative or aggressive financing policy. This trade-off is guided by the following factors – a) cost of capital b) flexibility. in the long-term it reaches a plateau. the lender compensates the risk with a higher interest rate. Therefore.e. However.

It has broadly three components – Raw Materials – These are the basic inputs that goes into the manufacturing process. 144 . usually 50%).e. Investment in inventory is next only to P&M. It normally represents full absorption of raw materials and partial absorption of overheads (i. Work-In-Process – It refers to inventory in the intermediary stage of production. All the other components in WC revolves around inventory.INVENTORY MANAGEMENT      Inventory is the basic cornerstone of liquidity in a business. Finished Goods – Items of production when they are ready for sale.

 Carrying Cost – It includes opportunity cost of locked up inventory. 145 . loss of market share.  Shortage Cost – It includes costs concomitant with cash purchase. production slowdown. storage. transportation.INVENTORY DECISION MAKING  Decisions revolving around inventory management – – What should be the size of the order (EOQ)? – When should the order be placed (safety stock)?  The decisions revolves around three types of costs –  Ordering Cost – It includes requisitioning. and transfer costs. expediting. insurance and obsolescence.

Inventory costs can be decomposed into – cost of ordering and cost of carrying. Stocks can be replenished immediately. Similarly. Tradeoff assumptions – Short-term demand forecast is available. 146        .ECONOMIC ORDER QUANTITY Large orders reduces ordering costs but increases carrying costs. Cost per order is constant. irrespective of size. Carrying cost is fully variable. large safety stock reduces shortage costs but increases carrying costs. Production is uniform during the year.

EOQ MODEL Total Cost Costs(Rs ) Carrying Cost Ordering Cost EOQ Order Size (Qty) 147 .

DERIVATION Total Cost = Ordering Cost + Carrying Cost TC = (U/Q * F) + (Q/2 * P * C) where – U = Annual Demand / Usage Q = Order Size F = Cost per Order C = % Carrying Cost P = Price per Unit Q = √ [(2 * F * U) / (P * C)] TC = Total Cost 148   .EOQ .

This in principle violates the applicability of the EOQ model. 149    . If change in profit is (-) then stick to EOQ.QUANTITY DISCOUNTS & EOQ The standard EOQ model assumes that price per unit is constant irrespective of order size. However. If change in profit is (+) then EOQ needs to be upgraded to Optimal Ordering Qty. in reality qty discounts are associated with order size. Steps – Determine the order qty assuming no discount is available. the EOQ model can still be adjusted to determine the ordering qty. However. However.

U/Q’)*F] [Q’(P-D)*C/2 – Q*P*C/2] where – U = Annual Demand / Usage Q = Order Size F = Cost per Order C = % Carrying Cost P = Price per Unit without Discount D = Discount per Unit (Rs.) Q* = EOQ assuming no qty discount Q’ = Minimum order qty to avail discount 150 .DETERMINING CHANGE IN PROFIT ∆π ∆π = [U*D + (U/Q* .

It provides protection against stock-out. Order Point = Lead time (days) * Average daily usage / consumption.ORDER POINT The basic EOQ model assumes – stocks can be replenished instantly. However. A safety stock is required since lead time as well as average consumption are both likely to vary. this is not so reality. the model assumes that orders be placed when inventory level reaches zero. Adjusted Order Point = Order point + Safety stock. Put differently.     151 . Therefore. Therefore.

In such a case – Safety stock = (Maximum usage * Maximum lead time) – (Average usage * Average lead time) Stock out refers to a situation where the inventory level falls below the safety stock. 152 . a higher safety stock is required to prevent a stock-out.SAFETY STOCK      If the consumption / usage pattern only varies – Safety stock = (Maximum – Average) Daily usage * Lead time (days) If the consumption pattern as well as lead time varies. Cost associated with it refers to opportunity loss and reputation.

Work-In-Process through Marginal or Absorption Costing. because of higher tax outflow).INVENTORY VALUATION      Inventory valuation is critical to the reflection of the financial position of the firm. So a trade-off is very essential.e. 153 . On one side it improves the current ratio. Selection of methodology is critical to valuation. Raw materials are usually valued through – FIFO. Finished Goods through BIN Cards. but on the other side it reduces profits (i. LIFO or Weighted Average method.

A representing 15% of the items that accounts for 70% of the value. 154 The objective is to focus on A and ignore C. It explains that 20% of the inventory units accounts for 80% of the inventory value. B representing 30% of the items representing 20% of the value. It classifies inventory into three broad categories.ABC ANALYSIS      In most organizations inventory follows the Pareto’s (80:20) Rule. C representing 55% of the items representing 10% of the value. ABC analysis is based on this empirical reality. .

They would be A items. 15% 45% 100% Number of items A items B items C items 155 . managed most carefully.ABC CLASSIFICATION Value of Inventory 100% 90% 70% Suppose 15% of our items accounted for 70% of our sales.

It has to make a trade-off between the two repelling forces. Debts beyond 180 days needs to classified separately in the Balance Sheet. bad debts). Credit evaluation and monitoring is critical for 156 successful management of WC (i. but pressure from competition forces them to sell on credit (i.e. risk of losing market share). it minimizes investment in WC). and may be qualified as NPA’s. .DEBTORS MANAGEMENT     While firms would like to sell on cash (i.e. Normal credit usually ranges between (15-60) days and 90 days in exceptional cases.e.

At one end of the spectrum lies a choice not to extend any credit. Collateral. 157 . At the other end of the spectrum lies a choice to extend credit to any customer irrespective of the low credit rating. irrespective of the high credit rating. Type I & II errors associated with credit evaluation. Between the two extremes lies several practical trade-offs based on credit evaluation bases – Character.I      Credit Standards – It revolves around a benchmark for accepting or rejecting an account for credit opening. Conditions.CREDIT POLICY VARIABLES . Capacity. Capital.

158 . Liberalizing the cash discount means lesser investment in WC. Cash Discount – To induce customers to buy against cash or make payment before scheduled tenure firms generally offer a cash discount to motivate customers to make prompt payment. till when supplies will be made.CREDIT POLICY VARIABLES .II    Credit Limit – Credit limit refers to the maximum days /amount outstanding to be provided to a customer one time/repeat. as well as squeezing of profit margins. Collection Effort – It includes a slew of comprehensive measures aimed at timely and speedy collection.

Rate the customer on a relevant scale (E. Find the factor score by multiplying the score with the weight. Find the Customer Rating Index.g. the end objective). Fannie Mae) is a method of credit evaluation which adds a degree of objectivity to the 5C method. 159        . Likert). Classify the customer (i. It involves the following process – Identify the factors relevant for credit evaluation. by adding all the factor scores.e. Assign weights to these factors based on relative importance.CREDIT SCORING Credit scoring (E.g.

DISCRIMINANT ANALYSIS + + + + o o o o + + + o + o + o + + o + + + + o 160 Current Ratio (Risk) o o o + + Return on Investment .

The trend in DSO reflects how well the company has managed the bargaining power of its customers.DSO    The DSO of a given company at a given time “t” is defined as the ratio of debtors at that point of time with the average daily sales during the credit period. The average DSO when compared with the credit norms of the company gives an indication of degree of slack in debtors management.DAY’S SALES OUTSTANDING . DSOt = Average receivables at time “t” Average sales during the credit period 161 .

CREDIT GRANTING DECISION  To determine the credit worthiness of a one time or repeat customer the following thumb rule based on expected profit may also be applied –  Ep = p (r-c) – q*c where Ep = Expected profit p = probability the customer pays his dues q = probability the customer defaults r = expected revenues c = cost of production or goods sold       162 .

Ep = {p1 (r1 – c1) – q*c1} + p1*{p2*(r2-c2) – q2*c2} where – p1 = probability the customer pays his dues in order1 p2 = probability the customer pays his dues in order2 q1 = probability the customer defaults in order1 q2 = probability the customer defaults in order2 163 . However. the probability that he would default on the second order would be lesser than the probability of default on the first order.REPEAT ORDER        A repeat order is normally accepted if the customer does not default on the first order. once the customer pays for the first order.

interest rates. Cash is the focal point of fund flow in a business. and foreign exchange. 1-3) %. A cash-rich firm is better prepared to tap opportunities arising from fluctuations in commodity prices. security prices. While the proportion of total assets is very small (i. . it is the most idle resource of a firm 164 and hence has an opportunity cost. its efficient management is crucial for solvency. However.CONCEPT OF TREASURY     Treasury includes cash and short-term money market instruments.e.

TREASURY MANAGEMENT       Successful treasury management has a direct impact on profitability as well. It requires – Reliable forecasting and established reporting systems. 165 . Float refers to the difference between book balance in bank ledger and actual funds available. Electronic funds transfer has considerably reduced the cash holding requirement of most firms. Improving cash collections and delaying disbursals. Achieve optimal utilization and conservation of funds. Managing the float is critical for treasury management.

as a standard practice it is advisable to enforce suitable risk management practices (i. derivatives) to guard against downward risks. Precautionary: It necessitates the holding of cash to safeguard against fluctuations in lead time and consumption pattern. Speculative: It influences the holding of cash above the desired levels to take advantage of price fluctuations.e. However.CASH HOLDING MOTIVES    Transaction: It emphasizes the need to maintain the desired levels of cash to facilitate the smooth running of production and sales. 166 .

If a firm maintains a large cash balance. 167 .OPTIMAL CASH HOLDING      Cash holding models attempts to answer the following two questions – When should the transfers be effected between money market securities and cash? What should be the magnitude of these transfers? If a firm maintains a small cash balance. it has to sell securities (and buy them later). This will lead to high conversion costs. but opportunity costs will be comparatively higher. but low opportunity costs. its conversion costs would be low.

BAUMOL’S MODEL Total Cost Costs(Rs ) Opportunity Cost Conversion Cost Optimal Cash Balance Conversion Size(Rs.) 168 .

EOQ .DERIVATION   Total Cost = Ordering Cost + Carrying Cost TC = (U/Q * F) + (Q/2 * P * C) where – U = Annual Demand / Usage Q = Order Size F = Cost per Order C = % Carrying Cost P = Price per Unit Q = √ [(2 * F * U) / (P * C)] TC = Total Cost 169 .

. Steps – Determine the order qty assuming no discount is available. If change in profit is (-) then stick170 to 170 EOQ. However. However. in reality qty discounts are associated with order size.QUANTITY DISCOUNTS & EOQ    The standard EOQ model assumes that price per unit is constant irrespective of order size. the EOQ model can still be adjusted to determine the ordering qty. If change in profit is (+) then EOQ needs to be upgraded to optimal ordering qty. This in principle violated the applicability of the EOQ model. However.

DETERMINING CHANGE IN PROFIT ∆π ∆π = [U*D + (U/Q* .) Q* = EOQ assuming no qty discount 171 171 .U/Q’)*F] [Q’(P-D)*C/2 – Q*P*C/2] where – U = Annual Demand / Usage Q = Order Size F = Cost per Order C = % Carrying Cost P = Price per Unit without Discount D = Discount per Unit (Rs.

Downward changes are permitted till it reaches a LL. Determine UL & RP through Miller & Orr Model. then it is increased to RP.MILLER & ORR MODEL     Criticizing the completely deterministic assumptions of the Baumol’s Model. 172 . cash balance changes form a normal distribution. of periods become sufficiently large. then it is reduced to RP. the Miller & Orr Model assumes that changes in cash balances over a given period are random in size as well as in direction. According to this model upward changes in cash balance is allowed till it reaches an UL. As the no.

The “Return Point” (RP) and “Upper Control Limit” (UL) is calculated accordingly – RP = 3 3 * b * σ2 + LL where – 4*I RP = Return Point b = Fixed Cost per Order I = Daily Interest on Marketable Securities σ2 = Daily Cash Variance UL = 3RP – 2LL 173 .MILLER & ORR MODEL   In the Miller & Orr Model the “Lower Control Limit” (LL) is set by the management based on its risk perspectives.

A series of cash forecasts leads to the culmination of a cash budget.      . It is an important tool for treasury management 174 and control. Accruals are not taken into account. It provides information on timing and magnitude of cash flows. A cash budget includes revenue as well as capital transactions.CASH BUDGET A cash budget is a summary statement of a firm’s expected cash inflows and outflows over a projected time period.

salaries & wages) and / or provisions – (dividends. Financing may also be done through accrued expenses – (electricity.FINANCING CURRENT ASSETS     During the normal course of business certain sources for financing CA are spontaneous and accrue in the normal course of business – Trade Credit – Once the suppliers confidence in the firm is instilled it will offer generous credit to the extent of (30-90) days. Cost of trade credit needs to be weighed vis-à-vis the incentive sacrificed in the form of cash discount. On an average trade credit amounts to (40-50)% of total CL. 175 . taxes).

176 . Interest is charged only on the balance actually utilized. irrespective of utilization. It is payable on demand. risk is borne by the borrower. and margin money. Overdraft – Overdraft is similar to C/C only that the limit is offered against liquid financial assets. In the event of default.BANK FINANCING    Bank financing for CA is generally guided by three criteria – creditworthiness. It can undertake the following forms – Cash Credit – It is a borrowing arrangement upto a preset limit against inventory and/or receivables. Interest in an O/D account is charged from the day of disbursement. collaterals.

FACTORING

   

It is a transaction where firm sells of its receivables to a financial institution (i.e. factor) with a objective of financing its current assets. In factoring the risk of default is borne by the factor. It has the following advantages Adds liquidity to the business. Reduces the risk of NPA’s. Reduces cost of administration and monitoring. Outsourcing from experts in managing and collecting receivables. Credit information and financial counseling.
177 177

TANDON COMMITTEE - 1975

 

The working capital gap (CA-CL) without any borrowing, should be partly funded through bank finance, rest through long-term borrowings and equity. Ascertaining Maximum Permissible Bank Borrowing. The lower of the three is treated as MPBB. a) 75% of working capital gap. 25% of total current assets from long-term sources. The balance is calculated as – b) (0.75 * CA) – CL (without bank borrowings) c) 0.75(CA – Core CA) – Current Liabilities.

178

OTHER COMMITTEES

 

Subsequently the Chore Committee came out with a report in 1979; Krishnaswamy Committee in 1980; Marathe Committee in 1982; Kannan Committee in 1997; Nayak Committee in 1991. All the committees emphasized primarily on SME financing (i.e. inclusive growth). Recommended periodical financial forecasts from the borrower (usually quarterly – Credit Monitoring Arrangement - CMA Forms – I to VI). Facilitate simplified borrowing process – MPBB = 20% of Net Sales; Margin Requirement = 5%
179

180 . Cost accounting can be viewed as translating the Supply Chain (the series of events in the production process that. in concert. Operational Planning & Control. Applications . Key Decisions. profitability or social use of funds.COST ACCOUNTING   Cost accounting is that part of management accounting which establishes budgets and actual cost of operations. departments or product and the analysis of variances.Product Costing. processes. Managers use cost accounting to support decision making to reduce a company's costs and improve its profitability. result in a product) into financial values.

The broad techniques are – Process Costing. Marginal Costing. Cost audit is an audit of efficiency of the costing techniques while the work is in process. rather than external users. 181 . Standard Costing. Costing refers to the processes and techniques for ascertaining costs. cost accounting need not follow standards such as GAAP. and what to compute is decided pragmatically on the managers requirements. because its primary use is for internal managers.COSTING     As a form of management accounting. Throughput Costing.

labor cost.TECHNIQUES   Process Costing is a model that identifies activities in an organization and assigns the cost of each activity to products and services according to the actual consumption by each: it assigns indirect costs (overheads) into direct costs. Standard costing deals with variance analysis which breaks down the variation between actual cost and standard costs into various components (volume.) so managers can understand why costs were different from what was planned and take appropriate action to correct the situation. 182 .COSTING . etc. material cost.

T is the rate at which the system produces goal units. where costs equals revenue). Throughput Costing seeks to increase the velocity or speed at which throughput (T) is generated into products and services with respect to an organization's constraint. whether it is internal or external to the organization. 183 .TECHNIQUES   Marginal Costing deals with decomposition of costs into fixed and variable components with the intention of identifying the break-even point (i.e. Marginal costs refer to the incremental costs for producing one additional unit of production.COSTING .

Costs can be also classified depending on the specific circumstances.e. It is a sacrifice in monetary terms (i. normality. release of value) for the acquisition or creation or value addition of economic resources (ACC). Costs can be classified in accordance with – nature. 184 . behaviour. control.DEFINITION     Cost refers to an amount of expenditure (actual or notional) incurred or attributable to a specific thing or process (CIMA). function.COSTS . elements. or managerial decisions.

It is the smallest unit of an organization for which costs can be ascertained separately. Indirect Costs – It means a cost which cannot be conveniently identified with or allocated to a particular cost centre.NATURE   Direct Cost – It means a cost which can be conveniently identified with or allocated to a particular cost centre.CLASSIFICATION . it is incurred generally or commonly for a no. of cost centres. They are also known as responsibility centres. 185 .

In the process they are transformed into final products. 186 . Labour Cost – It includes the physical and/or mental efforts of human beings expended in the transformation of principal substances into final products.CLASSIFICATION .ELEMENTS    Material Cost – These are the principal substances used in the manufacturing of a product or service. Overheads – It is the cost of services provided to compliment labour costs in the transformation process and includes notional costs as well.

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