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MODULE-1

Financial Markets
A financial market is a market in which people trade financial securities, commodities, and
other fungible items of value at low transaction costs and at prices that reflect supply and
demand. Securities include stocks and bonds, and commodities include precious metals or
agricultural products.
In economics, typically, the term market means the aggregate of possible buyers and sellers of
a certain good or service and the transactions between them.
The term "market" is sometimes used for what are more strictly exchanges, organizations that
facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This
may be a physical location (like the NYSE, BSE, LSE, JSE) or an electronic system
(like NASDAQ). Much trading of stocks takes place on an exchange; still, corporate
actions (merger, spinoff) are outside an exchange, while any two companies or people, for
whatever reason, may agree to sell stock from the one to the other without using an exchange.
Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a
stock exchange, and people are building electronic systems for these as well, similar to stock
exchanges.
A capital market is a financial market in which long-term debt or equity-backed securities are
bought and sold. Capital markets are defined as markets in which money is provided for periods
longer than a year.[1] Capital markets channel the wealth of savers to those who can put it to
long-term productive use, such as companies or governments making long-term
investments.[a] Financial regulators, such as the Bank of England (BoE) or the U.S. Securities
and Exchange Commission (SEC), oversee the capital markets in their jurisdictions to protect
investors against fraud, among other duties.
Modern capital markets are almost invariably hosted on computer-based electronic
trading systems; most can be accessed only by entities within the financial sector or the treasury
departments of governments and corporations, but some can be accessed directly by the
public.[b]There are many thousands of such systems, most serving only small parts of the
overall capital markets. Entities hosting the systems include stock exchanges, investment
banks, and government departments. Physically the systems are hosted all over the world,
though they tend to be concentrated in financial centres like London, New York, and Hong
Kong.
A capital market can be either a primary market or a secondary market. In primary markets,
new stock or bond issues are sold to investors, often via a mechanism known as underwriting.
The main entities seeking to raise long-term funds on the primary capital markets are
governments (which may be municipal, local or national) and business enterprises (companies).
Governments issue only bonds, whereas companies often issue either equity or bonds. The
main entities purchasing the bonds or stock include pension funds, hedge funds, sovereign
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wealth funds, and less commonly wealthy individuals and investment banks trading on their
own behalf. In the secondary markets, existing securities are sold and bought among investors
or traders, usually on an exchange, over-the-counter, or elsewhere. The existence of secondary
markets increases the willingness of investors in primary markets, as they know they are likely
to be able to swiftly cash out their investments if the need arises.
A second important division falls between the stock markets (for equity securities, also known
as shares, where investors acquire ownership of companies) and the bond markets(where
investors become creditors).[2]
As money became a commodity, the money market became a component of the financial
markets for assets involved in short-term borrowing, lending, buying and selling with original
maturities of one year or less. Trading in money markets is done over the counterand
is wholesale.
There are several money market instruments, including treasury bills, commercial
paper, bankers' acceptances, deposits, certificates of deposit, bills of exchange, repurchase
agreements, federal funds, and short-lived mortgage- and asset-backed securities.[1] The
instruments bear differing maturities, currencies, credit risks, and structure and thus may be
used to distribute exposure.[2]
Money markets, which provide liquidity for the global financial system, and capital
markets make up the financial market.
The money markets are used for the raising of short term finance, sometimes for loans that are
expected to be paid back as early as overnight. Whereas the capital markets are used for the
raising of long term finance, such as the purchase of shares/equities, or for loans that are not
expected to be fully paid back for at least a year.[1]
Funds borrowed from the money markets are typically used for general operating expenses, to
cover brief periods of liquidity. For example, a company may have inbound payments from
customers that have not yet cleared, but may wish to immediately pay out cash for its payroll.
When a company borrows from the primary capital markets, often the purpose is to invest in
additional physical capital goods, which will be used to help increase its income. It can take
many months or years before the investment generates sufficient return to pay back its cost,
and hence the finance is long term.[2]
Together, money markets and capital markets form the financial markets as the term is
narrowly understood.[c] The capital market is concerned with long term finance. In the widest
sense, it consists of a series of channels through which the savings of the community are made
available for industrial and commercial enterprises and public authorities.

Financial risks

Asset-backed risk- Risk that the changes in one or more assets that support an asset-backed
security will significantly impact the value of the supported security. Risks include interest
rate, term modification, and prepayment risk.
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Credit risk- Credit risk, also called default risk, is the risk associated with a borrower going
into default (not making payments as promised).Investor losses include
lost principal and interest, decreased cash flow, and increased collection costs. An investor can
also assume credit risk through direct or indirect use of leverage. For example, an investor may
purchase an investment using margin. Or an investment may directly or indirectly use or rely
on repo, forward commitment, or derivative instruments.

Foreign investment risk- Risk of rapid and extreme changes in value due to: smaller markets;
differing accounting, reporting,or auditing standards; nationalization, expropriation or
confiscatory taxation; economic conflict; or political or diplomatic changes. Valuation,
liquidity, and regulatory issues may also add to foreign investment risk.

Liquidity risk- This is the risk that a given security or asset cannot be traded quickly enough
in the market to prevent a loss (or make the required profit). There are two types of liquidity
risk:

Asset liquidity - An asset cannot be sold due to lack of liquidity in the market -
essentially a sub-set of market risk. This can be accounted for by:
Widening bid-offer spread
Making explicit liquidity reserves
Lengthening holding period for VaR calculations
Funding liquidity - Risk that liabilities:
Cannot be met when they fall due
Can only be met at an uneconomic price
Can be name-specific or systemic
Market risk- The four standard market risk factors are equity risk, interest rate risk, currency
risk, and commodity risk:

Equity risk is the risk that stock prices in general (not related to a particular
company or industry) or the implied volatility will change. Equity risk is "the
financial risk involved in holding equity in a particular investment." Equity risk
often refers to equity in companies through the purchase of stocks, and does not
commonly refer to the risk in paying into real estate or building equity in
properties.[1] The measure of risk used in the equity markets is typically the
standard deviation of a security's price over a number of periods. The standard
deviation will delineate the normal fluctuations one can expect in that particular
security above and below the mean, or average. However, since most investors
would not consider fluctuations above the average return as "risk", some
economists prefer other means of measuring it.

Interest rate risk is the risk that interest rates or the implied volatility will change.
Interest rate risk is the risk that arises for bond owners from fluctuating interest
rates. How much interest rate risk a bond has depends on how sensitive its price
is to interest rate changes in the market. The sensitivity depends on two things,
the bond's time to maturity, and the coupon rate of the bond.
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Currency risk is the risk that foreign exchange rates or the implied volatility will
change, which affects, for example, the value of an asset held in that currency.
Foreign exchange risk (also known as FX risk, exchange rate
risk or currency risk) is a financial risk that exists when a financial transaction
is denominated in a currency other than that of the base currency of the company.
Foreign exchange risk also exists when the foreign subsidiary of a firm maintains
financial statements in a currency other than the reporting currency of the
consolidated entity. The risk is that there may be an adverse movement in
the exchange rate of the denomination currency in relation to the base currency
before the date when the transaction is completed.[1][2] Investors and businesses
exporting or importing goods and services or making foreign investments have
an exchange rate risk which can have severe financial consequences; but steps
can be taken to manage (i.e., reduce) the risk.

Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil)
or implied volatility will change. Commodity risk refers to the uncertainties of
future market values and of the size of the future income, caused by the
fluctuation in the prices of commodities.[1] These commodities may
be grains, metals, gas, electricity etc. A commodity enterprise needs to deal with
the following kinds of risks:
a. Price risk is arising out of adverse movements in the world prices,
exchange rates, basis between local and world prices. The related price
area risk usually has a rather minor impact.
b. Quantity or volume risk Volume risk is a commodity risk which refers
to the fact that a player in the commodity market has uncertain quantities
of consumption or sourcing, i.e. production of the respective
commodity.[1] Examples of other circumstances which can cause large
deviations from a volume forecast are weather (e.g. temperature-changes
for gas consumption), the plant-availability, the collective customer
outrage, but also regulatory interventions.
c. Cost risk (Input price risk) A cost overrun, also known as a cost
increase, underrated or budget overrun, involves
unexpected costs incurred in excess of budgeted amounts due to an
underestimation of the actual cost during budgeting. Cost overrun should
be distinguished from cost escalation, which is used to express
an anticipated growth in a budgeted cost due to factors such as inflation.
Cost overrun is common in infrastructure, building,
and technology projects. For IT projects, a 2004 industry study by
the Standish Group found an average cost overrun of 43 percent; 71
percent of projects came in over budget, exceeded time estimates, and
had estimated too narrow a scope; and total waste was estimated at $55
billion per year in the US alone.
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d. Political risk Political risk is a type of risk faced

by investors, corporations, and governments that political decisions,
events, or conditions will significantly affect the profitability of a
business actor or the expected value of a given economic
action.[1] Political risk can be understood and managed with reasoned
foresight and investment. The term political risk has had many different
meanings over time.[2] Broadly speaking, however, political risk refers to
the complications businesses and governments may face as a result of
what are commonly referred to as political decisionsor "any political
change that alters the expected outcome and value of a given economic
action by changing the probability of achieving business
objectives".[3]Political risk faced by firms can be defined as "the risk of a
strategic, financial, or personnel loss for a firm because of such
nonmarket factors as macroeconomic and social policies (fiscal,
monetary, trade, investment, industrial, income, labour, and
developmental), or events related to political instability (terrorism, riots,
coups, civil war, and insurrection)."[4] Portfolio investors may face
similar financial losses. Moreover, governments may face complications
in their ability to execute diplomatic, military or other initiatives as a
result of political risk.

Financial Instruments
Financial instruments are monetary contracts between parties. They can be created, traded,
modified and settled. They can be cash (currency), evidence of an ownership interest in an
entity (share), or a contractual right to receive or deliver cash (bond).

Futures and options

Derivatives Instruments are a Financial Contracts which solve the primary purpose of
hedging the asset price fluctuation. It Derives value from its underlying assets, hence it is called
as derivatives. There are various types of derivative used world wide, but in India currently we
have Two Exchange Traded Derivatives namely Futures and Options

Apart form hedging, trader uses these instruments as it offers better leverage, convenience in
holding Long and Short positions, Low Cost to trade compared to Equity delivery and enable
traders to profit sideways movement using options.

1. Futures contracts gives Rights with Obligations to the Traders, hence the open
position is settled on the maturity date.
2. Option Contracts gives Rights to the Buyer with NO OBLIGATION, hence he
needs to pay some premium to the seller to get the contract. Seller of the Option
has the Obligations
Call Option Buyers Has Rights to Buy
Put Option Buyers Has Rights to Sell
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Equities
Equities are a type of security that represents the ownership in a company. Equities are traded
(bought and sold) in stock markets. Alternatively, they can be purchased via the Initial Public
Offering (IPO) route, i.e. directly from the company. Investing in equities is a good long-term
investment option as the returns on equities over a long time horizon are generally higher than
most other investment avenues. However, along with the possibility of greater returns comes
greater risk. Equities are the type of security where ownership in a company can be represented.
Equities are traded (bought and sold) in the stock market. In India share trading actively takes
place in NSE and BSE. Some people trade on a daily basis as their profession, whereas normal
investors invest in stock market and hold a stock for couple of months/years to book their profit.

Equities give a good amount of return on investment among all the other instruments, but there
is also a substantial risk in investing in equities, if you invest without knowledge. Getting
trained in stock trading and analysis can help you earn good amount of side income.

Mutual funds

A mutual fund allows a group of people to pool their money together and have it professionally
managed, in keeping with a predetermined investment objective. This investment avenue is
popular because of its cost-efficiency, risk-diversification, professional management and sound
regulation. You can invest as little as Rs. 1,000 per month in a mutual fund. There are various
general and thematic mutual funds to choose from and the risk and return possibilities vary
accordingly. In India mutual funds are very popular because the initial investment is very less
and moreover risk is also diversified. Mutual fund allows a group of people to invest money
together and have it professionally managed. Mutual funds also have sound regulation so there
is no question of insecurity. There are many thematic mutual funds to choose from, the risk
and return ratio may differ according to the plan.

Bonds
Bonds are fixed income instruments which are issued for the purpose of raising capital. Both
private entities, such as companies, financial institutions, and the central or state government
and other government institutions use this instrument as a means of garnering funds. Bonds
issued by the Government carry the lowest level of risk but could deliver fair returns. Bonds
are issued by both private and government entities to raise their working capital. Bonds are
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also called as fixed income instruments. Central and state government both issue bonds and
private organizations like private companies, private financial instruments also issue bonds to
garner their funds. Government bonds carry the lowest amount of risk but they take time to
give the returns. As far as return on investment is concerned private bonds offers betters returns
but they carry high amount of risk.

Deposits
Investing in bank or post-office deposits is a very common way of securing surplus funds.
These instruments are at the low end of the risk-return spectrum. Almost every Indian family
has a savings account or fixed deposit or post-office deposits. This is one of the most common
ways to keep their surplus funds and to earn with that money.

The return on investment is very low but it is almost risk free and secured.Keeping money in
deposits cannot fulfill your long term financial goal. Investing your money smartly is very
essential.

Cash equivalents
These are relatively safe and highly liquid investment options. Treasury bills and money market
funds are cash equivalents. All the securities that can be readily converted to cash within 3
months can be called as cash and cash equivalents. In Case of immediate requirement the cash
/ bank balance helps a lot, so it is good to create corpus in saving account which can be used
only in case of financial emergency. Gold can be purchased in Demat format under ETF
schemes, This are available in India, Traded in NSE and an investor as buy even Just 1/2 Gram.

Financial services
The Indian financial services industry has undergone a metamorphosis since1990. Before its
emergence the commercial banks and other financial institutions dominated the field and they
met the financial needs of the Indian industry. It was only after the economic liberalisation that
the financial service sector gained some prominence. Now this sector has developed into an
industry. In fact, one of the worlds largest industries today is the financial services industry.
Financial service is an essential segment of financial system. Financial services are the
foundation of a modern economy. The financial service sector is indispensable for the
prosperity of a nation.

In general, all types of activities which are of financial nature may be regarded as financial
services. In a broad sense, the term financial services means mobilisation and allocation of
savings. Thus, it includes all activities involved in the transformation of savings into
investment. Financial services refer to services provided by the finance industry. The finance
industry consists of a broad range of organisations that deal with the management of money.
These organisations include banks, credit card companies, insurance companies, consumer
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finance companies, stock brokers, investment funds and some government sponsored
enterprises. Financial services may be defined as the products and services offered by financial
institutions for the facilitation of various financial transactions and other related activities.
Financial services can also be called financial intermediation. Financial intermediation is a
process by which funds are mobilised from a large number of savers and make them available
to all those who are in need of it and particularly to corporate customers. There are various
institutions which render financial services. Some of the institutions are banks, investment
companies, accounting firms, financial institutions, merchant banks, leasing companies,
venture capital companies, factoring companies, mutual funds etc. These institutions provide
variety of services to corporate enterprises. Such services are called financial services. Thus,
services rendered by financial service organisations to industrial enterprises and to ultimate
consumer markets are called financial services. These are the services and facilities required
for the smooth operation of the financial markets. In short, services provided by financial
intermediaries are called financial services.

Functions of financial services

1. Facilitating transactions (exchange of goods and services) in the economy.
2. Mobilizing savings (for which the outlets would otherwise be much more limited).
3. Allocating capital funds (notably to finance productive investment).
4. Monitoring managers (so that the funds allocated will be spent as envisaged).

5. Transforming risk (reducing it through aggregation and enabling it to be carried by those

more willing to bear it).

Characteristics or Nature of Financial Services

From the following characteristics of financial services, we can understand their nature:

1. Intangibility: Financial services are intangible. Therefore, they cannot be standardized or

reproduced in the same form. The institutions supplying the financial services should have a
better image and confidence of the customers. Otherwise, they may not succeed. They have to
focus on quality and innovation of their services. Then only they can build credibility and gain
the trust of the customers.
2. Inseparability: Both production and supply of financial services have to be performed
simultaneously. Hence, there should be perfect understanding between the financial service
institutions and its customers.

3. Perishability: Like other services, financial services also require a match between demand
and supply. Services cannot be stored. They have to be supplied when customers need them.

4. Variability: In order to cater a variety of financial and related needs of different customers
in different areas, financial service organisations have to offer a wide range of products and
services. This means the financial services have to be tailor-made to the requirements of
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customers. The service institutions differentiate their services to develop their individual
identity.

5. Dominance of human element: Financial services are dominated by human element. Thus,
financial services are labour intensive. It requires competent and skilled personnel to market
the quality financial products.

6. Information based: Financial service industry is an information based industry. It involves

creation, dissemination and use of information. Information is an essential component in the
production of financial services.

Importance of Financial Services

The successful functioning of any financial system depends upon the range of financial services
offered by financial service organisations. The importance of financial services may be
understood from the following points

1. Economic growth: The financial service industry mobilises the savings of the people, and
channels them into productive investments by providing various services to people in general
and corporate enterprises in particular. In short, the economic growth of any country depends
upon these savings and investments.

2. Promotion of savings: The financial service industry mobilises the savings of the people by
providing transformation services. It provides liability, asset and size transformation service
by providing huge loan from small deposits collected from a large number of people. In this
way financial service industry promotes savings.
3. Capital formation: Financial service industry facilitates capital formation by rendering
various capital market intermediary services. Capital formation is the very basis for economic
growth.

4. Creation of employment opportunities: The financial service industry creates and provides
employment opportunities to millions of people all over the world.

5. Contribution to GNP: Recently the contribution of financial services to GNP has been
increasing year after year in almost countries.

6. Provision of liquidity: The financial service industry promotes liquidity in the financial
system by allocating and reallocating savings and investment into various avenues of economic
activity. It facilitates easy conversion of financial assets into liquid cash.

Types of Financial Services

1. Banking Under this an individual can deposit his or her money and can get return in the
form of interest and also borrowers can get loan by paying interest to bank periodically.
2. Insurance By using this one can get peace of mind as one can buy insurance policies
like life insurance, fire, marine, health and general insurance which ensures that person in
the event of any mishap can get his or her money back from insurance company.
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3. Stock Market One can invest his or her funds into stock market also where one gets
dividends and also capital appreciation, if one makes right investment decision than return
from equity markets are much greater than that of fixed deposits parked in banks.
4. Treasury or Debt instruments Under this one can invest his or her money into
government bonds and also debt instruments of private and public firms.
5. Wealth Management There are many firms where one can jus park their money and
then these companies invest money across different assets classes like commodity,
derivatives, money market, currency etc in order to generated superior returns for their
clients.
6. Mutual Funds These funds track asset class and generate returns accordingly so a debt
fund will track returns of debt and money market, an equity mutual fund would give returns
according to performance of stock market and so on.
7. Tax consultants and audit firms These organizations help people in determining their
tax liability, advising their clients on how to save tax and also filing of their tax returns on
time.

Financial Instruments
Financial instruments are monetary contracts between parties. They can be created, traded,
modified and settled. They can be cash (currency), evidence of an ownership interest in an
entity (share), or a contractual right to receive or deliver cash (bond).

Financial instruments are assets that can be traded. They can also be seen as packages of capital
that may be traded. Most types of financial instruments provide an efficient flow and transfer
of capital all throughout the world's investors. These assets can be cash, a contractual right to
deliver or receive cash or another type of financial instrument, or evidence of ones

Types of Financial Instruments

Equities
Equities are a type of security that represents the ownership in a company. Equities are traded
(bought and sold) in stock markets. Alternatively, they can be purchased via the Initial Public
Offering (IPO) route, i.e. directly from the company. Investing in equities is a good long-term
investment option as the returns on equities over a long time horizon are generally higher
than most other investment avenues. However, along with the possibility of greater returns
comes greater risk.

Mutual funds
A mutual fund allows a group of people to pool their money together and have it
professionally managed, in keeping with a predetermined investment objective. This
investment avenue is popular because of its cost-efficiency, risk-diversification, professional
management and sound regulation. You can invest as little as Rs. 1,000 per month in a
mutual fund. There are various general and thematic mutual funds to choose from and the risk
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and return possibilities vary accordingly.

Bonds
Bonds are fixed income instruments which are issued for the purpose of raising capital. Both
private entities, such as companies, financial institutions, and the central or state government
and other government institutions use this instrument as a means of garnering funds. Bonds
issued by the Government carry the lowest level of risk but could deliver fair returns.

Deposits
Investing in bank or post-office deposits is a very common way of securing surplus funds.
These instruments are at the low end of the risk-return spectrum.

Cash equivalents
These are relatively safe and highly liquid investment options. Treasury bills and money
market funds are cash equivalents.

Long-Term Financing
Long-term financing is usually needed for acquiring new equipment, R&D, cash flow
enhancement, and company expansion. Some of the major methods for long-term financing
are discussed below.

Equity Financing
Equity financing includes preferred stocks and common stocks. This method is less risky in
respect to cash flow commitments. However, equity financing often results in dissolution of
share ownership and it also decreases earnings.The cost associated with equity is generally
higher than the cost associated with debt, which is again a deductible expense. Therefore,
equity financing can also result in an enhanced hurdle rate that may cancel any reduction in
the cash flow risk.

Corporate Bond
A corporate bond is a special kind of bond issued by any corporation to collect money
effectively in an aim to expand its business. This tern is usually used for long-term debt
instruments that generally have a maturity date after one year after their issue date at the
minimum.

Some corporate bonds may have an associated call option that permits the issuer to redeem it
before it reaches the maturity. All other types of bonds that are known as convertible
bonds that offer investors the option to convert the bond to equity.

Capital Notes
Capital notes are a type of convertible security that are exercisable into shares. They are one
type of equity vehicle. Capital notes resemble warrants, except the fact that they usually dont
have the expiry date or an exercise price. That is why the entire consideration the company
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aims to receive, for the future issuance of the shares, is generally paid at the time of issuance
of capital notes.

Many times, capital notes are issued with a debt-for-equity swap restructuring. Instead of
offering the shares (that replace debt) in the present, the company provides its creditors with
convertible securities the capital notes and hence the dilution occurs later.

Short-Term Financing
Short-term financing with a time duration of up to one year is used to help corporations
increase inventory orders, payrolls, and daily supplies. Short-term financing can be done using
the following financial instruments

Commercial Paper
Commercial Paper is an unsecured promissory note with a pre-noted maturity time of 1 to 364
days in the global money market. Originally, it is issued by large corporations to raise money
to meet the short-term debt obligations.

It is backed by the bank that issues it or by the corporation that promises to pay the face value
on maturity. Firms with excellent credit ratings can sell their commercial papers at a good
price.

Asset-backed commercial paper (ABCP) is collateralized by other financial assets. ABCP is

a very short-term instrument with 1 and 180 days maturity from issuance. ACBCP is typically
issued by a bank or other financial institution.

Promissory Note
It is a negotiable instrument where the maker or issuer makes an issue-less promise in writing
to pay back a pre-decided sum of money to the payee at a fixed maturity date or on demand
of the payee, under specific terms.

Asset-based Loan
It is a type of loan, which is often short term, and is secured by a company's assets. Real estate,
accounts receivable (A/R), inventory and equipment are the most common assets used to back
the loan. The given loan is either backed by a single category of assets or by a combination of
assets.

Repurchase Agreements
Repurchase agreements are extremely short-term loans. They usually have a maturity of less
than two weeks and most frequently they have a maturity of just one day! Repurchase
agreements are arranged by selling securities with an agreement to purchase them back at a
fixed cost on a given date.

Letter of Credit
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A financial institution or a similar party issues this document to a seller of goods or services.
The seller provides that the issuer will definitely pay the seller for goods or services delivered
to a third-party buyer.

The issuer then seeks reimbursement to be met by the buyer or by the buyer's bank. The
document is in fact a guarantee offered to the seller that it will be paid on time by the issuer
of the letter of credit, even if the buyer fails to pay.

Overview of Indian Capital Market

Indian capital markets have been receiving global attention, especially from sound investors,
due to the improving macroeconomic fundamentals. The presence of a great pool of skilled
labor and the rapid integration with the world economy increased Indias global
competitiveness. No wonder, the global ratings agencies Moodys and Fitch have awarded
India with investment grade ratings, indicating comparatively lower sovereign risks. The
Securities and Exchange Board of India (SEBI), the regulatory authority for Indian securities
market, was established in 1992 to protect investors and improve the microstructure of capital
markets. In the same year, Controller of Capital Issues (CCI) was abolished, removing its
administrative controls over the pricing of new equity issues. In less than a decade later, the
Indian financial markets acknowledged the use of technology (National Stock Exchange started
online trading in 2000), increasing the trading volumes by many folds and leading to the
emergence of new financial instruments. With this, market activity experienced a sharp surge
and rapid progress was made in further strengthening and streamlining risk management,
market regulation, and supervision.
The securities market is divided into two interdependent segments:

The primary market provides the channel for creation of funds through issuance of new
securities by companies, governments, or public institutions. In the case of new stock issue, the
sale is known as Initial Public Offering (IPO).

The secondary market is the financial market where previously issued securities and financial
instruments such as stocks, bonds, options, and futures are traded.

ROLE AND IMPORTANCE OF CAPITAL MARKET IN INDIA

Capital market has a crucial significance to capital formation. For a speedy economic
development adequate capital formation is necessary. The significance of capital market in
economic development is explained below:-

1. Mobilization Of Savings And Acceleration Of Capital Formation :- In developing

countries like India the importance of capital market is self evident. In this market, various
types of securities helps to mobilize savings from various sectors of population. The twin
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features of reasonable return and liquidity in stock exchange are definite incentives to the
people to invest in securities. This accelerates the capital formation in the country.

2. Raising Long - Term Capital :- The existence of a stock exchange enables companies to
raise permanent capital. The investors cannot commit their funds for a permanent period but
companies require funds permanently. The stock exchange resolves this dash of interests by
offering an opportunity to investors to buy or sell their securities, while permanent capital with
the company remains unaffected.

3. Promotion Of Industrial Growth :- The stock exchange is a central market through which
resources are transferred to the industrial sector of the economy. The existence of such an
institution encourages people to invest in productive channels. Thus it stimulates industrial
growth and economic development of the country by mobilizing funds for investment in the
corporate securities.

4. Ready And Continuous Market :- The stock exchange provides a central convenient place
where buyers and sellers can easily purchase and sell securities. Easy marketability makes
investment in securities more liquid as compared to other assets.
5. Technical Assistance :- An important shortage faced by entrepreneurs in developing
countries is technical assistance. By offering advisory services relating to preparation of
feasibility reports, identifying growth potential and training entrepreneurs in project
management, the financial intermediaries in capital market play an important role.

6. Reliable Guide To Performance :- The capital market serves as a reliable guide to the
performance and financial position of corporate, and thereby promotes efficiency.

7. Proper Channelization Of Funds :- The prevailing market price of a security and relative
yield are the guiding factors for the people to channelize their funds in a particular company.
This ensures effective utilization of funds in the public interest.

8. Provision Of Variety Of Services :- The financial institutions functioning in the capital

market provide a variety of services such as grant of long term and medium term loans to
entrepreneurs, provision of underwriting facilities, assistance in promotion of companies,
participation in equity capital, giving expert advice etc.

9. Development Of Backward Areas :- Capital Markets provide funds for projects in

backward areas. This facilitates economic development of backward areas. Long term funds
are also provided for development projects in backward and rural areas.

10. Foreign Capital :- Capital markets makes possible to generate foreign capital. Indian firms
are able to generate capital funds from overseas markets by way of bonds and other securities.
Government has liberalized Foreign Direct Investment (FDI) in the country. This not only
brings in foreign capital but also foreign technology which is important for economic
development of the country.

11. Easy Liquidity :- With the help of secondary market investors can sell off their holdings
and convert them into liquid cash. Commercial banks also allow investors to withdraw their
deposits, as and when they are in need of funds.
 15

What Is Primary Market

The primary market is also known as new issues market. Here, the transaction is conducted
between the issuer and the buyer. In short, the primary market creates new securities and offers
them to the public. For instance, Initial Public Offering (IPO) is an offering of the primary
market where a private company decides to sell stocks to the public for the first time. An
important point to remember here is that in the primary market, securities are directly purchased
from the issuer.

Capital or equity can be raised in primary market by any of the following four ways:

1. Public Issue

As the name suggests, public issue means selling securities to public at large, such as IPO. It
is the most vital method to sell financial securities.

2. Rights Issue

Whenever a company needs to raise supplementary equity capital, the shares have to be offered
to present shareholders on a pro-rata basis, which is known as the Rights Issue.

3. Private Placement

This is about selling securities to restricted number of classy investors like frequent investors,
venture capital funds, mutual funds and banks comes under Private Placement.

4. Preferential Allotment

When a listed company issues equity shares to a selected number of investors at a price that
may or may not be pertaining to the market price is known as Preferential Allotment.

The primary market is also known as the New Issue Market (NIM) as it is the market for
issuing long-term equity capital. Since the companies issue securities directly to the investors,
it is responsible to issue the security certificates too. The creation of new securities facilitates
growth within the economy.

What Is Secondary Market

In secondary market, the securities issued in the primary market are bought and sold. Here, you
can buy a share directly from a seller and the stock exchange or broker acts as an intermediary
between two parties.
 16

The secondary market is actually formed by another layer of investors who deal with primary
market investor to buy and sell financial securities such as bonds, futures and stocks. These
dealings happen in the proverbial stock exchange.

National Stock Exchange (NSE) and New York Stock Exchange (NYSE) are some popular
stock exchanges. Majorly, the trade happens between investors without any involvement with
the company that issued the securities in the primary market.

The secondary market is further divided into two kinds of market.

1. Auction Market

The auction market is a place where buyers and sellers convene at a place and announce the
rate at which they are willing to sell or buy securities. They offer either the bid or ask prices,
publicly. Since all buyers and sellers are convening at the same place, there is no need for
investors to seek out profitable options. Everything is announced publicly and interested
investors can make their choice easily.

2. Dealer Market

In a dealer market, none of the parties convene at a common location. Instead, buying and
selling of securities happen through electronic networks which are usually fax machines,
telephones or custom order-matching machines.

Interested sellers deliver their offer through these mediums, which are then relayed over to the
buyers through the medium of dealers. The dealers possess an inventory of securities and earn
their profit through the selling. A lot of dealers operate within this market and therefore, a
competition exists between them to deliver the best offer to their investors. This makes them
deliver the best price to the investors. An example of a dealer market is the NASDAQ.

The secondary markets are important for price discovery. The market operations are carried
out on stock exchanges.

A variation to the dealer market is the OTC market. OTC stands for Over the Counter market.
The concept came into existence during the early 1920s period through Wall Street trading,
which implied the prevalence of an unorganized system of dealers who conducted trades via
networks. Stock shops existed to buy and sell shares over-the-counter. In other words, these
were unlisted stocks which were sold privately.

Over time, the notion of OTC underwent a change. These days the over-the-counter denotes
those stocks which are not traded over NYSE, NASDAQ or American Stock Exchange
 17

(AMEX). The over-the-counter implies those stocks which are traded on the pink sheets or
on over-the-counter bulletin boards (OTCBB). Pink sheets are a name given to the daily list
of stocks published with ask and bid prices by the National Quotation Bureau. The OTCBB
service is offered by the National Association of Securities Dealers (NASD) which accurately
displays the last sale prices, real time quotations and other volume information of over-the-
counter securities.

METHODS OF RAISING CAPITAL IN PRIMARY MARKET

Public Issue -Here prospectus is issued, and a public appeal is made to subscribe the new
shares / debentures issued by the company. Shares are allocated in response to application
received. Some companies sell shares directly to the public while some take help of share
brokers. The company appoints an advertising agency to advertise about the issue of shares.

Rights Issue -Rights issue means new shares are offered to the existing shareholders on the
pro-rata basis. When company wants to raise additional capital, securities are first offered to
the existing shareholders. If the shareholders do not want to buy shares, then the company can
sell the shares to the outside public.

Private Placement -Private Placement of shares means the company sells its shares to a small
group of investors. It can sell to banks, insurance companies, financial institutions, etc. It is an
economical and quick method of selling securities. The company does not sell its shares to the
public.

Corporate Finance and Financial Management

Corporate finance is the area of finance dealing with the sources of funding and the capital
structure of corporations, the actions that managers take to increase the value of the firm to the
shareholders, and the tools and analysis used to allocate financial resources. Corporate
finance is primarily concerned with maximizing shareholder value through long-term and
short-term financial planning and the implementation of various strategies. Everything from
capital investment decisions to investment banking falls under the domain of corporate finance.

Scope of Corporate Finance

Capital investment decisions are an important part of corporate finance. These decisions
include

Deciding whether the dividends should be offered to shareholders or not

 18

Sanctioning or rejecting proposed investment. If the investment is approved, it is also to be

decided whether the company should pay with debt of equity or both.
Managing of short term assets and liabilities, investments, inventory control and other short
term financial issues by the financial manager

Corporate finance understands the financial problems of a company and prevents them
beforehand. It also deals with the financial aspects, promotion and administration of new
enterprises.

Significant Role of Corporate Finance:

Capital investment decisions play a significant role in corporate financing. These decisions
include:

Approving or rejecting the proposed investment. And if approved, should the company
pay for it with debt or equity or with both.
Whether or not the dividends should be given to shareholders on their investment in the
company.
Short-term assets and liabilities, inventory control, investments and other short-term
financial issues are to be managed by a financial manager.

According to the Encyclopedia of Social Sciences corporate finance is related to

understanding and preventing the financial problems of a corporation. The financial aspects
of new enterprises, its promotion and administration during early development is dealt under
corporate finance. Also it is concerned by the distinction between funds and revenue
generated.

The five basic corporate finance functions

1. Raising capital to support company operations and investments (aka, financing

functions);

2. Selecting those projects based on risk and expected return that are the best use of a
company's resources (aka, capital budgeting functions);

3. Management of company cash flow and balancing the ratio of debt and equity
financing to maximize company value (aka, financial management function);

4. Developing a company governance structure to encourage ethical behavior and

actions that serve the best interests of its stockholders (aka, corporate governance
function)
5. Management of risk exposure to maintain optimum risk-return trade-off that
maximizes shareholder value (aka, risk management function).
 19

Financial management refers to the efficient and effective management of money

(funds) in such a manner as to accomplish the objectives of the organization. It is the
specialized function directly associated with the top management. Financial
Management means planning, organizing, directing and controlling the financial activities such
as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.

Objectives of Financial Management

Profit maximization occurs when marginal cost is equal to marginal revenue. This is the
main objective of Financial Management.
Wealth maximization means maximization of shareholders' wealth. It is an advanced goal
compared to profit maximization.[3]
Survival of company is an important consideration when the financial manager makes any
financial decisions. One incorrect decision may lead company to be bankrupt.
Maintaining proper cash flow is a short run objective of financial management. It is
necessary for operations to pay the day-to-day expenses e.g. raw material, electricity bills,
wages, rent etc. A good cash flow ensures the survival of company.
Minimization on capital cost in financial management can help operations gain more profit.

Scope of Financial Management

Estimating the Requirement of Funds: Businesses make forecast on funds needed in both
short run and long run, hence, they can improve the efficiency of funding. The estimation
is based on the budget e.g. sales budget, production budget.
Determining the Capital Structure: Capital structure is how a firm finances its overall
operations and growth by using different sources of funds.[4] Once the requirement of funds
has estimated, the financial manager should decide the mix of debt and equity and also
types of debt.
Investment Fund: A good investment plan can bring businesses huge returns.

Importance of financial management

Cost Analysis
It is important to do a regular review of the expenses incurred by the business,
especially when employees are authorized to spend on behalf of the business. Each
line item should be questioned from the standpoints of necessity and worth. One
owner took a hard look at the phone bill and realized the business did not need six
separate, hard-line numbers. The six numbers were needed at one time, but that was
before the advent of cell phones. Another owner took a look at a seldom used, yet
 20

expensive piece of equipment that was incurring maintenance, insurance, and storage
costs. The business discovered it could rent this machine when needed and save on
the overall costs, plus the dollars realized from selling the equipment could be used
for more useful purposes.
Monthly Cash Flow Analysis
Cash flow analysis compares cash revenues (aka inflows) with cash outlays (aka
outflows) of a business on a month-by-month basis. This allows for the consideration
of how seasonal factors impact the cash flows of the business. For example, many
retail businesses will slow down expenditures in January and February due to a
reduction in post-holiday spending by consumers. It also makes it easier to plan for
growth and reserve funds for equipment needed to meet an expected increase in sales.
Ratio Analysis
Ratio Analysis compares the financial health of the business to industry norms and
to historical financial measures of the business as well. Several broad categories
include: Growth, Efficiency, Profitability, and Liquidity. Growth ratios provide an
indication of how the business is handling an increase in sales. For example, sales
may be up 15% from the previous year a good thing! However, if related costs have
increased by 30%, then there is a problem. Perhaps this growth has been achieved
from using employee overtime and high-cost inventory purchasing options
Credit and Collections
The extension of credit is a powerful tool to use for increasing sales; however, it does
impose a greater risk. Businesses need to develop policies related to who is granted
credit and the terms associated with credit sales. In addition, the business needs to
have an aggressive and timely strategy for addressing those customers who are late
with payments. The longer an account goes unpaid, the likelihood of collection
decreases.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs
and profits and future programmes and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
 21

Choice of factor will depend on relative merits and demerits of each source and period
of financing.

4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance manager.
This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintainance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.

Investment, financing and dividend decisions

Investment Decision
Investment decision or capital budgeting involves the decision of allocation of capital or
commitment of funds to long-term assets that would yield benefits in the future. Two important
aspects of the investment decision are:

(a) the evaluation of the prospective profitability of new investments, and

(b) the measurement of a cut-off rate against that the prospective return of new
investments could be compared. Future benefits of investments are difficult to
measure and cannot be predicted with certainty. Because of the uncertain future,
investment decisions involve risk. Investment proposals should, therefore, be
evaluated in terms of both expected return and risk. Besides the decision for
investment managers do see where to commit funds when an asset becomes less
productive or non-profitable.

There is a broad agreement that the correct cut-off rate is the required rate of return or the
opportunity cost of capital. However, there are problems in computing the opportunity cost of
capital in practice from the available data and information. A decision maker should be aware
of capital in practice from the available data and information. A decision maker should be
aware of these problems. This decision relates to careful selection of assets in which funds will
be invested by the firms. A firm has many options to invest their funds but firm has to select
the most appropriate investment which will bring maximum benefit for the firm and deciding
or selecting most appropriate proposal is investment decision.
 22

The firm invests its funds in acquiring fixed assets as well as current assets. When decision
regarding fixed assets is taken it is also called capital budgeting decision.

Factors Affecting Investment/Capital Budgeting Decisions

1. Cash Flow of the Project: Whenever a company is investing huge funds in an investment
proposal it expects some regular amount of cash flow to meet day to day requirement. The
amount of cash flow an investment proposal will be able to generate must be assessed properly
before investing in the proposal.

2. Return on Investment: The most important criteria to decide the investment proposal is
rate of return it will be able to bring back for the company in the form of income for, e.g., if
project A is bringing 10% return and project is bringing 15% return then we should prefer
project B.

3. Risk Involved: With every investment proposal, there is some degree of risk is also
involved. The company must try to calculate the risk involved in every proposal and should
prefer the investment proposal with moderate degree of risk only.

4. Investment Criteria: Along with return, risk, cash flow there are various other criteria
which help in selecting an investment proposal such as availability of labour, technologies,
input, machinery, etc. The finance manager must compare all the available alternatives very
carefully and then only decide where to invest the most scarce resources of the firm, i.e.,
finance.
Investment decisions are considered very important decisions because of following reasons:

They are long term decisions and therefore are irreversible; means once taken cannot
be changed.
Involve huge amount of funds.
Affect the future earning capacity of the company.

Importance or Scope of Capital Budgeting Decision:

Capital budgeting decisions can turn the fortune of a company. The capital budgeting decisions
are considered very important because of the following reasons:

1. Long Term Growth: The capital budgeting decisions affect the long term growth of the
company. As funds invested in long term assets bring return in future and future prospects and
growth of the company depends upon these decisions only.

2. Large Amount of Funds Involved: Investment in long term projects or buying of fixed
assets involves huge amount of funds and if wrong proposal is selected it may result in wastage
of huge amount of funds that is why capital budgeting decisions are taken after considering
various factors and planning.

3. Risk Involved: The fixed capital decisions involve huge funds and also big risk because the
return comes in long run and company has to bear the risk for a long period of time till the
returns start coming.
 23

4. Irreversible Decision: Capital budgeting decisions cannot be reversed or changed

overnight. As these decisions involve huge funds and heavy cost and going back or reversing
the decision may result in heavy loss and wastage of funds. So these decisions must be taken
after careful planning and evaluation of all the effects of that decision because adverse
consequences may be very heavy.

Financing Decision
Financing decision is the second important function to be performed by the financial manager.
Broadly, her or she must decide when, where and how to acquire funds to meet the firms
investment needs. The central issue before him or her is to determine the proportion of equity
and debt. The mix of debt and equity is known as the firms capital structure. The financial
manager must strive to obtain the best financing mix or the optimum capital structure for his
or her firm. The firms capital structure is considered to be optimum when the market value of
shares is maximized. The use of debt affects the return and risk of shareholders; it may increase
the return on equity funds but it always increases risk. A proper balance will have to be struck
between return and risk. When the shareholders return is maximized with minimum risk, the
market value per share will be maximized and the firms capital structure would be considered
optimum.Once the financial manager is able to determine the best combination of debt and
equity, he or she must raise the appropriate amount through the best available sources. In
practice, a firm considers many other factors such as control, flexibility loan convenience, legal
aspects etc. in deciding its capital structure. The second important decision which finance
manager has to take is deciding source of finance. A company can raise finance from various
sources such as by issue of shares, debentures or by taking loan and advances. Deciding how
much to raise from which source is concern of financing decision.
Mainly sources of finance can be divided into two categories:

1. Owners fund.
2. Borrowed fund.

Share capital and retained earnings constitute owners fund and debentures, loans, bonds, etc.
constitute borrowed fund.
The main concern of finance manager is to decide how much to raise from owners fund and
how much to raise from borrowed fund.

While taking this decision the finance manager compares the advantages and disadvantages of
different sources of finance. The borrowed funds have to be paid back and involve some degree
of risk whereas in owners fund there is no fix commitment of repayment and there is no risk
involved. But finance manager prefers a mix of both types. Under financing decision finance
manager fixes a ratio of owner fund and borrowed fund in the capital structure of the company.

Factors Affecting Financing Decisions:

While taking financing decisions the finance manager keeps in mind the following factors:
 24

1. Cost: The cost of raising finance from various sources is different and finance managers
always prefer the source with minimum cost.

2. Risk: More risk is associated with borrowed fund as compared to owners fund securities.
Finance manager compares the risk with the cost involved and prefers securities with moderate
risk factor.

3. Cash Flow Position: The cash flow position of the company also helps in selecting the
securities. With smooth and steady cash flow companies can easily afford borrowed fund
securities but when companies have shortage of cash flow, then they must go for owners fund
securities only.

4. Control Considerations: If existing shareholders want to retain the complete control of

business then they prefer borrowed fund securities to raise further fund. On the other hand if
they do not mind to lose the control then they may go for owners fund securities.

5. Floatation Cost: It refers to cost involved in issue of securities such as brokers commission,
underwriters fees, expenses on prospectus, etc. Firm prefers securities which involve least
floatation cost.

6. Fixed Operating Cost: If a company is having high fixed operating cost then they must
prefer owners fund because due to high fixed operational cost, the company may not be able
to pay interest on debt securities which can cause serious troubles for company.

7. State of Capital Market: The conditions in capital market also help in deciding the type of
securities to be raised. During boom period it is easy to sell equity shares as people are ready
to take risk whereas during depression period there is more demand for debt securities in capital
market.

Dividend Decision
Dividend decision is the third major financial decision. The financial manager must decide
whether the firm should distribute all profits, or retain them, or distribute a portion and retain
the balance. Like the debt policy, the dividend policy should be determined in terms of its
impact on the shareholders value. The optimum dividend policy is one that maximizes the
market value of the firms shares. Thus if shareholders are not indifferent to the firms dividend
policy, the financial manager must determine the optimum dividend payout ratio. The payout
ratio is equal to the percentage of dividends to earnings available to shareholders. The financial
manager should also consider the questions of dividend stability, bonus shares and cash
dividends in practice. Most profitable companies pay cash dividends regularly. Periodically,
additional shares, called bonus share (or stock dividend), are also issued to the existing
shareholders in addition to the cash dividend.
This decision is concerned with distribution of surplus funds. The profit of the firm is
distributed among various parties such as creditors, employees, debenture holders,
shareholders, etc.
 25

Payment of interest to creditors, debenture holders, etc. is a fixed liability of the company, so
what company or finance manager has to decide is what to do with the residual or left over
profit of the company.

The surplus profit is either distributed to equity shareholders in the form of dividend or kept
aside in the form of retained earnings. Under dividend decision the finance manager decides
how much to be distributed in the form of dividend and how much to keep aside as retained
earnings.

To take this decision finance manager keeps in mind the growth plans and investment
opportunities.

If more investment opportunities are available and company has growth plans then more is kept
aside as retained earnings and less is given in the form of dividend, but if company wants to
satisfy its shareholders and has less growth plans, then more is given in the form of dividend
and less is kept aside as retained earnings.

This decision is also called residual decision because it is concerned with distribution of
residual or left over income. Generally new and upcoming companies keep aside more of retain
earning and distribute less dividend whereas established companies prefer to give more
dividend and keep aside less profit.

Factors Affecting Dividend Decision: The finance manager analyses following factors
before dividing the net earnings between dividend and retained earnings:

1. Earning: Dividends are paid out of current and previous years earnings. If there are more
earnings then company declares high rate of dividend whereas during low earning period the
rate of dividend is also low.

2. Stability of Earnings: Companies having stable or smooth earnings prefer to give high rate
of dividend whereas companies with unstable earnings prefer to give low rate of earnings.

3. Cash Flow Position: Paying dividend means outflow of cash. Companies declare high rate
of dividend only when they have surplus cash. In situation of shortage of cash companies
declare no or very low dividend.
4. Growth Opportunities: If a company has a number of investment plans then it should
reinvest the earnings of the company. As to invest in investment projects, company has two
options: one to raise additional capital or invest its retained earnings. The retained earnings are
cheaper source as they do not involve floatation cost and any legal formalities. If companies
have no investment or growth plans then it would be better to distribute more in the form of
dividend. Generally mature companies declare more dividends whereas growing companies
keep aside more retained earnings.

5. Stability of Dividend: Some companies follow a stable dividend policy as it has better
impact on shareholder and improves the reputation of company in the share market. The stable
dividend policy satisfies the investor. Even big companies and financial institutions prefer to
invest in a company with regular and stable dividend policy.
 26

There are three types of stable dividend policies which a company may follow:
(i) Constant dividend per share: In this case, the company decides a fixed rate of dividend
and declares the same rate every year, e.g., 10% dividend on investment.

(ii) Constant payout ratio: Under this system the company fixes up a fixed percentage of
dividends on profit and not on investment, e.g., 10% on profit so dividend keeps on changing
with change in profit rate.
(iii) Constant dividend per share and extra dividend: Under this scheme a fixed rate of
dividend on investment is given and if profit or earnings increase then some extra dividend in
the form of bonus or interim dividend is also given.

6. Preference of Shareholders: Another important factor affecting dividend policy is

expectation and preference of shareholders as their expectations cannot be ignored by the
company. Generally it is observed that retired shareholders expect regular and stable amount
of dividend whereas young shareholders prefer capital gain by reinvesting the income of the
company.

They are ready to sacrifice present day income of dividend for future gain which they will get
with growth and expansion of the company.

Secondly poor and middle class investors also prefer regular and stable amount of dividend
whereas wealthy and rich class prefers capital gains. So if a company is having large number
of retired and middle class shareholders then it will declare more dividend and keep aside less
in the form of retained earnings whereas if company is having large number of young and
wealthy shareholders then it will prefer to keep aside more in the form of retained earnings and
declare low rate of dividend.

7. Taxation Policy: The rate of dividend also depends upon the taxation policy of government.
Under present taxation system dividend income is tax free income for shareholders whereas
company has to pay tax on dividend given to shareholders. If tax rate is higher, then company
prefers to pay less in the form of dividend whereas if tax rate is low then company may declare
higher dividend.

8. Access to Capital Market Consideration: Whenever company requires more capital it can
either arrange it by issue of shares or debentures in the stock market or by using its retained
earnings. Rising of funds from the capital market depends upon the reputation of the company.
If capital market can easily be accessed or approached and there is enough demand for
securities of the company then company can give more dividend and raise capital by
approaching capital market, but if it is difficult for company to approach and access capital
market then companies declare low rate of dividend and use reserves or retained earnings for
reinvestment.

9. Legal Restrictions: Companies Act has given certain provisions regarding the payment of
dividends that can be paid only out of current year profit or past year profit after providing
depreciation fund. In case company is not earning profit then it cannot declare dividend.
 27

Apart from the Companies Act there are certain internal provisions of the company that is
whether the company has enough flow of cash to pay dividend. The payment of dividend
should not affect the liquidity of the company.

10. Contractual Constraints: When companies take long term loan then financier may put
some restrictions or constraints on distribution of dividend and companies have to abide by
these constraints.

11. Stock Market Reaction: The declaration of dividend has impact on stock market as
increase in dividend is taken as a good news in the stock market and prices of security rise.
Whereas a decrease in dividend may have negative impact on the share price in the stock
market. So possible impact of dividend policy in the equity share price also affects dividend
decision.

Objectives of corporate finance

OBJECTIVE OF CORPORATE FINANCIAL DECISIONS

At the very outset, it should be made clear that the ultimate goal of corporate financial decisions
is the maximisation of owners economic welfare. Although there is unanimity on the
achievement of this goal, the literature on the subject contains divergent views on its
achievement. Whereas, earlier views have suggested profit maximisation, later views suggest
wealth maximisation as a means to achieving the maximisation of owners economic welfare.

FIG. 1.1 Profit maximisation

1.3.1 Profit Maximisation

Total Revenue and Total Cost: Profit maximisation simply means maximising the income of
the firm. Traditionally, a business firm is regarded as an economic entity whose fundamental
objective is the maximisation of profits. Economists are of the view that profits can be
 28

maximised when the difference of total revenue over total cost is maximum; or in other words,
total revenue is greater than total cost by the greatest amount (Baumol, 1959).

As shown in Fig. 1.1, the firm expands its sales up to Point A just to cover cost. Sales beyond
this point give rise to profits. But economies of scale are reaped only upto a certain point,
beyond which total revenue tends to decline and is equal to the cost again at Point B. So profit
is possible only between the two points, A and B. It is the highest where the difference of the
revenue over the cost is the largest. The trend of the profit is shown with the help of the profit
curve.

Average Cost: Although the difference between total cost and total revenue is a reasonable
way of showing profit maximisation, it is a bit clumsy for accurate measurement. Therefore,
the usual and more accurate analysis of the firms profit maximising output is carried out in
terms of unit cost and revenue.

Hall and Hitch (1949) are of the view that firms aim at long-term profit maximisation and,
therefore, set their price (P) or output on the average cost principle in order to cover average
variable cost (AVC), average fixed cost (AFC) and a normal profit margin.

The use of average cost is preferable to the use of marginal cost insofar as firms do not know
with certainty the prospective demand and the marginal cost. Moreover, firms believe that full-
cost price is the right price that allows a fair profit and covers the cost of production - when
plant is normally utilised.

FIG. 1.2 Profit maximisation with marginal cost and revenue

Marginal Cost and Marginal Revenue: Empirical studies show that it is the equality of
marginal cost and marginal revenue that determines maximum profit (Earley, 1955; 1956).
Profits can be maximised where the marginal cost is equal to marginal revenue.To take the
simplest case, where marginal revenue is constant or the sale of the last unit of output on
account of constant prices does not lead to a lowering of the price of the product, the marginal
revenue curve would be straight horizontal as shown in Fig. 1.2. Maximum profits are earned
 29

at output q where marginal revenue is equal to marginal cost. At any point of output less than
that, marginal revenue is greater than marginal cost which means that increasing output will
provide more revenue than the cost of production.

Output can be increased only up to point q because beyond that point, marginal cost would be
greater than the marginal revenue and profits will decline. At point q, the profit per unit is equal
to price, p, minus average cost, c, and the total profit would be shown by the area of the
rectangle, abpc. However, Machlup (1967) is of the view that the marginal tools should give
the same results as the average tools and lead to the same unique price- output combination
that maximises profit.

Merits and Demerits: The concept of profit maximisation is deeply rooted in economic
theory. Its appropriateness is justified on the following grounds:

1. This concept is analogous to rational behaviour of a firm.

2. It ensures that the ultimate survivor in the corporate world is the profit maximiser.
3. It helps in the acquiring of monopoly powers in the imperfect product market.

However, the concept of profit maximisation has been facing vehement refutations in recent
decades. It is often argued that this concept held good in the nineteenth century in the case of
single entrepreneur firms where the same person was the owner, manager and the financer. The
only aim of the single owner was to increase his individual wealth. But, nowadays, firms are
characterised by limited liability and by a divorce between management and ownership, and
even the management is not concentrated in the person of one man. There exist different interest
groups associated with a firm, whose interests do not coincide. For example, while the interest
of the equity-holders lies in high dividend, that of the creditors lies in timely payment of interest
and in secured repayment of their loans. The managers, on the contrary, are interested in
professional achievements and not necessarily in higher profits. Similarly, the sales executives
may be more interested in total volume of sales rather than in profits. The objective of profit
maximisation fails to serve such multi-dimensional interests and so it is regarded as
inappropriate.

Again, the concept of profit maximisation was appropriate in the eighteenth or nineteenth
century when long-term investment was a rare phenomenon. Short-term profitability was used
by firms as the only yardstick of success. Naturally, the distinction between investments for
current profits and those for future pay-off was never stressed upon. But with technological
advancement, it is now possible to think of projects requiring long-term investment that
necessitate long-term profit planning, taking into consideration risk factors and the qualitative
aspects of future activities. Unfortunately, the objective of profit maximisation proves
incapable of making a distinction between returns received in different time periods as also of
analysing the risk factor.

Yet again, the accounting profit that appears in the profit and loss account does not reflect
opportunity cost. Sometimes it is argued that the profit and loss account shows the missed
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opportunities in an indirect way if failure to acquire an asset generates lower profits. But it does
not provide an absolute figure against which one can compare profits with the result that it is
very difficult to know whether profits are lower than they ought to be.

Last but not least, the criticism laid against the profit maximization objective is that the
computation of profits is not accurate in the generality of cases. Their accuracy depends upon
perfect cost estimates that are seldom correct insofar as the allocation of overheads is not
properly made.

1.3.2 Objective of Wealth Maximisation

In view of the limitations to the objective of profit maximisation, it is suggested that the
objective of the corporate financial decisions should be the maximisation of the value of the
firm or of the corporate wealth. The value of corporate wealth may be interpreted in terms of
the value of the companys total assets. The value of total assets is the sum of the firms
productive assets, (A) and the value of wealth created by the firm through the use of productive
assets, (W). The value of corporate wealth, (V) can be expressed in the form of an equation as
follows:

The amount of wealth created is nothing but the present value of the future net proceeds of the
firms present and future assets.

Alternatively, the value of corporate wealth (V) is represented by the market value of claim
against the assets. The claims are represented by the market value of debt (D) and equity capital
(E). The value of corporate wealth can thus be expressed by the following equation:

Thus the value of corporate wealth can be interpreted in two ways, and this does not imply any
divergence. It is rather two sides of the same coin. Bringing together the two equations, we can
write:

The value of equity depends directly on the amount of wealth creation. The larger the wealth
creation, the greater the market value of the equity shares. Therefore, the value of total assets
is equal to the value of debt and equity shares. The valuation of equity and debt is explained
in Chapter 4 and that of assets is discussed in Chapter 5. It is suggested that the readers go
through the relevant portions in these chapters.
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1.3.3 Appraisal of the Objective of Maximisation of Corporate Wealth

The objective of maximisation of corporate wealth is acceptable to all the parties

shareholders, creditors, employees, management and society directly or indirectly related to
the firm. The shareholders benefit by the higher value of their shares. As far as the firms
creditors are concerned, any increase in corporate wealth provides them greater protection with
respect to interest and repayment of the loan. This is particularly because the creditors have a
prior claim on the firms earnings and assets. The interest of the employees is better served
with an increase in corporate wealth, because the firm can only increase or maximise its wealth
in harmony with increased benefits to its employees. Moreover, employees are a part of the
firm, thus with an increase in the size of the corporate cake, their share is automatically larger.
The wealth of a firm is a part of societys wealth. When the former is maximised there is a
positive contribution to the latter. However, the extent to which a firm contributes to societys
wealth depends upon how far the gain is equally distributed among the different sections of
society and how far the firm is committed to its social obligations. Last but not least, the
existence of the management depends upon the prosperity of the firm. Maximisation of
corporate wealth therefore serves the interests of the management.

However, there are a couple of problems related to the objective of maximising corporate
wealth. First, this objective may not always be compatible with the firms social obligations.
And, second, more importantly, there exists the agency problem that needs some explanation.

MODULE-2
CORPORATE FINANCE AN INSIGHT

Corporate Finance Money makes a business go and that money comes from different
sources, namely equity and debt. Corporate finance is the study of sources of finance and how
to use the money raised to add maximum value to the shareholders' wealth.

It discusses topics such as:

1. Models for calculation of cost of common stock, cost of preferred stock and cost of debt;
2. Calculation of weighted average cost of capital and its use in investment appraisal
techniques such as net present value, internal rate of return, profitability index, payback
period, etc.;
3. Accounting for risk in investment appraisal techniques using sensitivity analysis, scenario
analysis, etc.;
4. Decision about whether to declare a dividend or whether reinvest the money in business;
5. Working capital management: management of inventories, receivables and cash;
6. Calculation of investment performance valuation parameters such as ROI, ROE, etc.
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7. Financial risk management using derivatives and other techniques

Corporate finance managers are one of the most common users of financial accounting
information and they need to coordinate with other functions of the business such as
production, marketing, administration, etc.

Types of corporate finance

SHORT TERM:
Bank overdrafts.
Trade credit from suppliers.
Accrual accounts.
LEASED FINANCE:
Operating lease.
Financial lease.
Leasing plant and machinery against outright purchase.
LONG TERM (via Borrowing):
Bank loan.
Merchant bank loan.
Debentures - Fixed rate of return loans for investors (no shareholder rights).
LONG TERM (via Equity Issue):
Company flotation on the stock exchange.
Issuing new shares.

'Capital Investment'
Capital investment refers to funds invested in a firm or enterprise for the purpose of furthering
its business objectives. Capital investment may also refer to a firm's acquisition of capital
assets or fixed assets such as manufacturing plants and machinery that is expected to be
productive over many years. Sources of capital investment are manifold and can
include equity investors, banks, financial institutions, venture capital and angel investors.

Uses of Capital
Capital investment is concerned with the deployment of capital for long-term uses. Companies
make continual capital investment to sustain existing operations and expand their businesses
for the future. The main type of capital investment is in fixed assets to allow increased
operational capacity, capture a larger share of the market and in the process, generate more
revenue. Companies may also make capital investment in the form of equity stakes in other
companies' operations, which indirectly benefits the investor companies by building business
partnerships or expanding into new markets.

Sources of Capital
Companies make conscious decisions about what kind of capital investment and how much of
it they should have over time. This spells out the funding requirements and therefore affects
 33

the choice of financing sources. The first funding option is always a company's own operating
cash flow, which sometimes may not be enough to satisfy the amount of capital expenditures
required. It is more likely than not that companies will resort to outside financing, debt or/and
equity to make up for any internal cash flow shortfall.
Capital investment is meant to benefit a company in the long run, but it nonetheless has some
short-term downsides. Intensive, ongoing capital investment tends to reduce earnings in the
interim, strain on liquidity from payment demand on interest and maturing principals, and
dilute earnings and ownership if new equity is used.

Working Capital
Funds raised as long-term capital should be for long-term purposes of capital investment to
make comparable returns and adequately cover related financing costs. However, to maintain
uninterrupted operations, companies need to have extra current assets over total current
liabilities as an added assurance for meeting any due obligations. Short-term funds set aside as
such are commonly referred to as working capital and may come from long-term capital, whose
longer maturity dates are typically beyond the due dates of any current liabilities. As a result,
companies sacrifice some long-term return to ensure short-term liquidity.

Needs of Capital Budgeting/Investment

1. Long-term Implications of Capital Budgeting: A capital budgeting decision has its effect
over a long time span and inevitably affects the companys future cost structure and growth. A
wrong decision can prove disastrous for the long-term survival of firm. On the other hand, lack
of investment in asset would influence the competitive position of the firm. So the capital
budgeting decisions determine the future destiny of the company.
2. Involvement of large amount of funds in Capital Budgeting: Capital budgeting decisions
need substantial amount of capital outlay. This underlines the need for thoughtful, wise and
correct decisions as an incorrect decision would not only result in losses but also prevent the
firm from earning profit from other investments which could not be undertaken.
3. Irreversible decisions in Capital Budgeting: Capital budgeting decisions in most of the
cases are irreversible because it is difficult to find a market for such assets. The only way out
will be scrap the capital assets so acquired and incur heavy losses.
4. Risk and uncertainty in Capital budgeting: Capital budgeting decision is surrounded by
great number of uncertainties. Investment is present and investment is future. The future is
uncertain and full of risks. Longer the period of project, greater may be the risk and uncertainty.
The estimates about cost, revenues and profits may not come true.
5. Difficult to make decision in Capital budgeting: Capital budgeting decision making is a
difficult and complicated exercise for the management. These decisions require an over all
 34

assessment of future events which are uncertain. It is really a marathon job to estimate the
future benefits and cost correctly in quantitative terms subject to the uncertainties caused by
economic-political social and technological factors.
6. Large and Heavy Investment: The proper planning of investments is necessary since all
the proposals are requiring large and heavy investment. Most of the companies are taking
decisions with great care because of finance as key factor.
7. Permanent Commitments of Funds: The investment made in the project results in the
permanent commitment of funds. The greater risk is also involved because of permanent
commitment of funds.
8. Long term Effect on Profitability: Capital expenditures have great impact on business
profitability in the long run. If the expenditures are incurred only after preparing capital budget
properly, there is a possibility of increasing profitability of the firm.
9. Complicacies of Investment Decisions: Generally, the long term investment proposals have
more complicated in nature. Moreover, purchase of fixed assets is a continuous process. Hence,
the management should understand the complexities connected with each projects.
10. Maximize the worth of Equity Shareholders: The value of equity shareholders is
increased by the acquisition of fixed assets through capital budgeting. A proper capital budget
results in the optimum investment instead of over investment and under investment in fixed
assets. The management chooses only most profitable capital project which can have much
value. In this way, the capital budgeting maximize the worth of equity shareholders.
11. Difficulties of Investment Decisions: The long term investments are difficult to be taken
because decision extends several years beyond the current account period, uncertainties of
future and higher degree of risk.
12. Irreversible Nature: Whenever a project is selected and made investments as in the form
of fixed assets, such investments is irreversible in nature. If the management wants to dispose
of these assets, there is a heavy monetary loss.
13. National Importance: The selection of any project results in the employment
opportunity, economic growth and increase per capita income. These are the ordinary positive
impact of any project selection made by any company.

Factors which affect capital investment decisions:

The outlook of the management.
Opportunities which are created by technological changes.
 35

Strategy of the competitor.

Cash flow budget.
Fiscal Incentives.
Market Forecast.
Other non-economic factors.

Correlation between risk and return

Low levels of uncertainty or risk are associated with low potential returns, whereas high levels
of uncertainty or risk are associated with high potential returns. According to the risk-return
tradeoff, invested money can render higher profits only if the investor is willing to accept the
possibility of losses.
To know relationship between risk and return may be main topic of any investor because
investor is always interest (zest) to get high return at low risk. But if he succeeds to quantify
the relationship and its direction, he can manage his investment with better way.

Our aim to discuss this concept is to explain what type of relationship between risk and return
may happen.

Relationship between risk and return means to study the effect of both elements on each
other. We measures the effect of increase or decrease risk on return of investment. Following
is the main type of relationship of risk and return

What is the relationship between risk and return in finance?

Risk means you have the possibility of losing some, or even all, of your original investment.
Low levels of uncertainty (low risk) are associated with low potential returns. High levels of
uncertainty (high risk) are associated with high potential returns.
 36

Risk-Return relationship model

1.Direct Relationship between Risk and Return

(A) High Risk - High Return

According to this type of relationship, if investor will take more risk, he will get more
reward. So, he invested million, it means his risk of loss is million dollar. Suppose, he is
earning 10% return. It means, his return is Lakh but he invests more million, it means his risk
of loss of money is million. Now, he will get Lakh return.

(B) Low Risk - Low Return

It is also direct relationship between risk and return. If investor decreases investment. It
means, he is decreasing his risk of loss, at that time, his return will also decrease.

2. Negative Relationship between Risk and Return

(A) High Risk Low Return

Sometime, investor increases investment amount for getting high return but with increasing
return, he faces low return because it is nature of that project. There is no benefit to increase
investment in such project. Suppose, there are 1,00,000 lotteries in which you will earn the
 37

prize of You have bought 50% of total lotteries. But, if you buy 75% of lotteries. Prize will
same but at increasing of risk, your return will decrease.

(B)Low Risk High Return

There are some projects, if you invest low amount, you can earn high return. For example,
Govt. of India need money. Because, govt. needs this money in emergency and Govt. is
giving high return on small investment. If you get this opportunity and invest your money,
you will get high return on your small risk of loss of money.

(OR)
Low levels of uncertainty (low risk) are associated with low potential returns. High levels of
uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the
balance between the desire for the lowest possible risk and the highest possible return. This is
demonstrated graphically in the chart below. A higher standard deviation means a higher risk
and higher possible return.

A common misconception is that higher risk equals greater return. The risk/return tradeoff tells
us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just
as risk means higher potential returns, it also means higher potential losses.

On the lower end of the scale, the risk-free rate of return is represented by the return on U.S.
Government Securities because their chance of default is next to nothing. If the risk-free rate
is currently 6%, this means, with virtually no risk, we can earn 6% per year on our money.

The common question arises: who wants to earn 6% when index funds average 12% per year
over the long run? The answer to this is that even the entire market (represented by the index
fund) carries risk. The return on index funds is not 12% every year, but rather -5% one year,
25% the next year, and so on. An investor still faces substantially greater risk and volatility to
get an overall return that is higher than a predictable government security. We call this
additional return the risk premium, which in this case is 6% (12% - 6%).

Determining what risk level is most appropriate for you isn't an easy question to answer. Risk
tolerance differs from person to person. Your decision will depend on your goals, income and
personal situation, among other factors.
 38

Time value of money in corporate finance

The time value of money (TVM) is the idea that money available at the present time is worth
more than the same amount in the future due to its potential earning capacity. This core
principle of finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received. TVM is also referred to as present discounted value.

Basic Time Value of Money Formula and Example

Depending on the exact situation in question, the TVM formula may change slightly. For
example, in the case of annuity or perpetuity payments, the generalized formula has additional
or less factors. But in general, the most fundamental TVM formula takes into account the
following variables:

FV = Future value of money

PV = Present value of money

i = interest rate

n = number of compounding periods per year

t = number of years

Based on these variables, the formula for TVM is:

FV = PV x (1 + (i / n)) ^ (n x t)

Concept
Money loses its value over time which makes it more desirable to have it now rather than later.
There are several reasons why money loses value over time. Most obviously, there is inflation
which reduces the buying power of money.
But quite often, the cost of receiving money in the future rather than now will be greater than
just the loss in its real value on account of inflation. The opportunity cost of not having the
money right now also includes the loss of additional income that you could have earned simply
by having received the cash earlier. Moreover, receiving money in the future rather than now
may involve some risk and uncertainty regarding its recovery. For these reasons, future cash
flows are worth less than the present cash flows.
Time Value of Money concept attempts to incorporate the above considerations into financial
decisions by facilitating an objective evaluation of cash flows from different time periods by
converting them into present value or future value equivalents. This ensures the comparison of
'like with like'.
 39

The present or future value of cash flows are calculated using a discount rate (also known as
cost of capital, WACC and required rate of return) that is determined on the basis of several
factors such as:
Higher the rate of inflation, higher the return that investors would
Rate of inflation
require on their investment.

Higher the interest rates on deposits and debt securities, greater the
Interest Rates loss of interest income on future cash inflows causing investors to
demand a higher return on investment.

Greater the risk associated with future cash flows of an investment,

Risk Premium higher the rate of return required by an investors to compensate for
the additional risk.
Consider a simple example of a financial decision below that illustrates the use of time value
of money.

Agency Problem : features and solution

An agency relationship occurs when a principal hires an agent to perform some duty. A conflict,
known as an "agency problem," arises when there is a conflict of interest between the needs of
the principal and the needs of the agent.

In finance, there are two primary agency relationships:

Managers and stockholders

Managers and creditors

1.Stockholders versus Managers If the manager owns less than 100% of the firm's common
stock, a potential agency problem between mangers and stockholders exists.

Managers may make decisions that conflict with the best interests of the shareholders. For
example, managers may grow their firms to escape a takeover attempt to increase their own
job security. However, a takeover may be in the shareholders' best interest.

2. Stockholders versus Creditors Creditors decide to loan money to a corporation based on

the riskiness of the company, its capital structure and its potential capital structure. All of these
factors will affect the company's potential cash flow, which is a creditors' main concern.
Stockholders, however, have control of such decisions through the managers.

Since stockholders will make decisions based on their best interests, a potential agency problem
exists between the stockholders and creditors. For example, managers could borrow money to
repurchase shares to lower the corporation's share base and increase shareholder return.
Stockholders will benefit; however, creditors will be concerned given the increase in debt that
would affect future cash flows.Motivating Managers to Act in Shareholders' Best Interests
 40

There are four primary mechanisms for motivating managers to act in stockholders' best
interests:

Managerial compensation
Direct intervention by stockholders
Threat of firing
Threat of takeovers

1. Managerial Compensation

Managerial compensation should be constructed not only to retain competent managers, but to
align managers' interests with those of stockholders as much as possible. This is typically done
with an annual salary plus performance bonuses and company shares.

Company shares are typically distributed to managers either as:

Performance shares, where managers will receive a certain number shares based on the
company's performance Executive stock options, which allow the manager to purchase shares
at a future date and price. With the use of stock options, managers are aligned closer to the
interest of the stockholders as they themselves will be stockholders.

2. Direct Intervention by Stockholders

Today, the majority of a company's stock is owned by large institutional investors, such as
mutual funds and pensions. As such, these large institutional stockholders can exert influence
on mangers and, as a result, the firm's operations.

3. Threat of Firing

If stockholders are unhappy with current management, they can encourage the existing board
of directors to change the existing management, or stockholders may re-elect a new board of
directors that will accomplish the task.

4. Threat of Takeovers

If a stock price deteriorates because of management's inability to run the company effectively,
competitors or stockholders may take a controlling interest in the company and bring in their
own managers.

Solutions: Agency Problem

Principal-Agent Relationship

The agency problem does not exist without a relationship between a principal and an agent.
In this situation, the agent performs a task on behalf of the principal. This may arise due to
different skill levels, different employment positions or restrictions on access.
 41

For example, a principal will hire a plumber the agent to fix plumbing issues. Although
the plumbers best interest is to make as much income as he can, he is given the responsibility
to perform in whatever situation results in the most benefit to the principal.

Incentives

The agency problem arises due to an issue with incentives. An agent may be motivated to act
in a manner that is not favorable for the principal if the agent is presented with an incentive to
act in this way. For example, in the plumbing example earlier, the plumber may make three
times as much money by recommending a service the agent does not need. An incentive
(three times the pay) is present, and this causes the agency problem to arise.

Reducing and Eliminating the Agency Problem

The agency problem may be minimized by altering the structure of compensation. If the
agent is paid not on an hourly basis but by completion of a project, there is less incentive to
not act on the principals behalf. In addition, performance feedback and independent
evaluations hold the agent accountable for their decisions.

Historical Example of Agency Problem

In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated to
make the company appear to have more money than what was actually earned. These
falsifications allowed the companys stock price to increase during a time when executives
were selling portions of their stock holdings. Although management had the responsibility to
care for the shareholders best interests, the agency problem resulted in management acting in
their own best interest.