Business

Environment
and
concepts
for
US
C-ertified
P-ublic
A-ccountant

“Nothing great has ever been achieved except by those who dared to believe that
something inside them was superior to circumstances.”
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First edition
 Contents
Your learning space includes
Preface……………………………………
Introduction………………………….
Sections
Section A – Corporate Governance (17-27%)
Internal Control Framework
Enterprise Risk Management Framework

Section B – Economic concept and analysis(17-27%)

Micro economics
Macro economics
Internal economics
Business Strategy and Market analysis

Section C – Financial Management(11-21%)

Concepts and tools
Finacial Valuation
Capital Budgeting
Financing options
Working capital management
Ratio and measures for working capital management

Section D – Information technology(15-25%)

Information Technology Governance
Roles of Information Technology in Business
Emerging Technologies
Information Security/Availability
Processing integrity
Accounting system cycles
System development and maintenance
Section E – Operations management(15-25%)
Financial and non financial measures of performance
Cost accounting
Process management
Planning techniques

Section F – Study Tips

Section G – Paper pattern
P reface

It is our pride and pleasure that we place before the readers thoroughly detailed
and conceptual book for Paper Of Business Environment and Concepts of US
CPA programme. Our in house experts have put best of their knowledge in
creation of this book.
Important features of the book
• It is written in simple and user friendly language and provide proper
structured knowledge without compromising technical details
• It provides a comprehensive study of corporate governance, macro and
micro economics, concepts of financial management, IT aspects and
operations management..
• All concepts are explained with examples to make it easy to understand
• The book contains all the chapters to cater requirement of syllabus
prescribed by AICPA
• Every chapter is followed by practice questions for better understanding
of concepts.

We look forward to suggestions and comments from readers.

 Introduction
Welcome to Business Environment and Concepts
Section A – Corporate Governance
This section focuses on corporate rights and responsibilities, accounting policies
and controls. The section also gives an insight to methods that can be
incorporated for managing risks related to controls.
Section B – Economic concept and analysis
This area covers the following material:

1. Fundamental microeconomic and macroeconomic concepts;

2. Changes in economic and business cycles , their reasons and measures
3. How business strategies are impacted by the economy and markets
4. How globalization impacts individual companies and how it has resulted
in shifts in economic power among nations
5. Various forms of risks encountered and means of mitigating those risks

Section C – Financial Management

This area covers the following:
Concepts of financial management, as well as other areas of management and
accounting
1. The capital budgeting process
2. Short term and long term financing strategies,
3. Techniques for capital management,
4. Methods for financial valuation, including the determination of fair value
5. Ratios and other quantitative techniques for working capital
6. Various categories of risk faced by a business and ways to mitigate those
risks

Section D – Information technology

This section mostly focuses on accounting controls and organizational risks
along with COBIT work.
Section E – Operations management

Cost recording, processing management are covered in this section.

Section A

Corporate
Governance
COSO, Internal Control, and COSO Cube

COSO
INTERNAL CONTROL –
INTEGRATED

FRAMEWORK AND COSO CUBE

Introduction
The 'Committee of Sponsoring Organizations of the Tread way Commission' ('COSO') is
a joint initiative to combat corporate fraud. It was established in the United States by
five private sector organizations, dedicated to guiding executive management and
government entities in relevant aspects of organizational governance, business ethics,
internal control, business risk management, fraud and financial reports.

COSO has established a common internal control model against which companies and
organizations can evaluate their control systems.

COSO has the support of five support organizations:

1. The Institute of Management Accountants (IMA),

2. The American Accounting Association (AAA),
3. The American Institute of Certified Public Accountants (AICPA),
4. The Institute of Internal Auditors (IIA) and
5. Financial Executives International (FEI).

Vision

Its vision is to be a recognized thought leader in the global marketplace on the

development of guidance in the areas of risk and control which enable good
organizational governance and reduction of fraud.

Historyy

COSO was organized in 1985 to sponsor the National Commission on Fraudulent

Financial Reporting, an independent private-sector initiative that studied the causal
factors that can lead to fraudulent financial reporting. It also developed
recommendations for public companies and their independent auditors, for the SEC
and other regulators, and for educational institutions.

Wholly independent of each of the sponsoring organizations, the Commission included

representatives from industry, public accounting, investment firms, and the New York
Stock Exchange.
The first chairman of the National Commission was James C. Treadway, Jr., Executive
Vice President and General Counsel, Paine Webber Incorporated and a former
Commissioner of the U.S. Securities and Exchange Commission. Hence, the popular
name "Treadway Commission." Currently, the COSO Chairman is Paul J. Sobel.

COSO provides a road map to a fundamental foundation of internal control to ensure

that the risks an organization takes are monitored and mitigated through sound
business decisions.

Organizations that formally adopt the 2013 Framework may achieve numerous
benefits, including but not limited to the following:

• Prioritizing andfocusing to manage processes that are most likely to have an

impact on accomplishing significant goals and objectives
• Re-evaluating and strengthening the internal control structure, particularly at
the entity level
• Identifying internal control lacuna for remediation Improving financial
reporting assurance
• Identifying opportunities to streamline controls and reduce inefficiencies and
redundancies
• Assessing compliance areas such as the reduction and deterrence of fraud or the
protection of health information
• Advancing and aligning enterprise risk management with internal control
• Improving corporate governance
• Providing the ability to integrate compliance requirements into internal control
• Improving healthcare delivery through uniform internal control application
• Allowing external auditors, partners to increase reliance on the entity’s internal
control
• Improving the organization’s ability to manage change

The COSO 2013 Framework

The original COSO framework was developed in 1992, with the most recent version
published in 2013. To understand the framework, one must understand what it covers.
According to COSO, internal control:
 • Focuses on achieving objectives in operations, reporting and/or compliance
• Is an ongoing process
• Depends on people’s actions, not merely written policies and procedures
• Provides assurance senior management of security to a reasonable degree
• Can be adapted to the needs of the whole organization as well as each
department, unit or process

The 2013 Framework focuses on five integrated components of internal control:

control environment, risk assessment, control activities, information and
communication, and monitoring activities (see Exhibit 1). The updated 2013
Framework:

Exhibit:1 COSO CUBE

 • Clarifies the application of the 2013 Framework in today’s environment with the
various business models, technology, and related risks.
• Codifies criteria that can be used in developing and evaluating the effectiveness
of systems of internal controlmaking explicit 17 principles, each with points of
focus (see Exhibit 2)

Relationship of Objectives andComponents

A direct relationship exists between objectives, which are what an entity wants to
achieve, components, which represent whatis to be done to achieve the objectives, and
the organizational structure of the entity. The relationship can be depicted in the form
of a cube.

• The three categories of objectives—operations, reporting, and compliance—are

represented by the columns.
• The five components are represented by the rows.
• An entity’s organizational structure is represented by the third dimension.

The COSO framework explains that “an effective system of internal control redu ces, to
an acceptable level, the risk of not achieving” objectives. When developing your
system, make sure that:

• All five components are present and working properly

• The five components work together as an integrated system
• It allows the organization to predict external circumstances that could impair
the achievement of your objectives and prepare for them appropriately
• It follows reporting regulations, rules and standards
• It complies with applicable laws, regulations, etc.

Exhibit 2.5 components and 17 principles of internal control

5 components 17 principles
Controlenvironment 1.Demonstratescommitmenttointegrityandethical values
2. Exercises oversightresponsibility
3. Establishesstructure,authority,andresponsibility

4. Demonstratescommitmenttocompetence

5. Enforcesaccountability.
 Risk assessment 6.Specifies suitableobjectives
7. Identifiesandanalyzesrisk

8. Assesses fraudrisk

9. Identifiesandanalyzessignificantchange

Controlactivities 10.Selectsanddevelopscontrolactivities
11. Selectsanddevelopsgeneralcontrolsovertechnology
12. Deployscontrolactivitiesthroughpoliciesandprocedur
es
Information and Uses relevantinformation
13.
communication 14. Communicatesinternally

15. Communicatesexternally

Monitoring activities 16. Conductsongoingand/orseparateevaluations

17. Evaluatesandcommunicatesdeficiencies

Source: Adapted from the COSO “Internal Control – Integrated Framework”

• Expands reporting objectives to support internal, financial and nonfinancial

reporting, and operational and compliance objectives

• Emphasizes the need for judgment in evaluating whether a company achieves

effective internal control
• Focuses on accountability for internal control throughout the organization
starting at the board level and senior management
• Explicitly considers IT controls and identifies the need for fraud risk
consideration not limited to financial statements but also within compliance and
operations.

After going through the COSO framework, senior management and other decision -
makers in organization should use it to assess current internal control system. Does
system meet all of the effectiveness standards? If not, make plans on how to improve it
according to COSO’s model.

Lower-level managers and employees should also familiarize themselves with the
COSO framework. Offer suggestions based on the document to senior management. Put
together a committee of employees at all levels to brainstorm ideas for a stronger
internal control system.
In addition, every employee should take their role in preventing fraud seriously.
Conduct work in a way that supports the COSO framework. For example, follow anti -
fraud policies without exception and always file timely, accurate reports.

Limitations
The COSO framework is a great place to commence when designing or modifying a
system of internal controls. However, it is not without limitations.

For instance, the framework is broad in order to apply to a wide array of industries
and processes. This can be problematic for complex businesses having varied
operations and complex data systems.

They also mention that “proper execution of the COSO framework is dependent on the
ability to establish a strong, formal control environment; however, the framework
provides minimal implementation guidance.” Small businesses and startups may feel
overwhelmed and unsupported, leading them to use a model with a more detailed
framework instead.

In addition, framework is not designed well to deal with objectives that fall under
multiple categories. Not every task fits neatly into operations, reporting or
compliance. Risk management experts wonder, “what about financial reporting that
must be reliable to be compliant? Where do you draw the line between data processing
for doing business and data processing for financial reporting?”

If you’re looking to create a system of internal controls or improve upon current one,
the COSO framework is one worthy option.

Components of Internal Control

• The control environment is a set of standards, processes, and structures that
provide the basis for carrying out internal control across the organization.

The board of directors and senior management set the tone at the top
regarding the importance of internal control including expected standards of
conduct. Management reinforces expectations at the various levels of the
organization. The control environment comprises the integrity and ethical
values of the organization; the parameters enabling the board of directors to
carry out its governance oversight responsibilities; the organizational
structure and assignment of authority and responsibility; the process for
attracting, developing, and retaining competent individuals; and the rigor
around performance measures, incentives, and rewards to drive
accountability for performance. The resulting control environment has a
pervasive impact on the overall system of internal control.
 According to the Institute of Internal Auditors (IIA), a control environment is
the foundation on which an effective system of internal control is built and
operated in an organization that strives to

1) Achieve its strategic objectives,

2) Provide reliable financial reporting to internal and external stakeholders,
3) Operate its business efficiently and effectively,
4) Comply with all applicable laws and regulations, and
5) Safeguard its assets.

Factors that set the tone, influencing the control consciousness of its peopleare
as below :

• I - Integrity and ethical values,

• C - Commitment to competence,

• H - Human resource policies and practices,

• A - Assignment of authority and responsibility,

• M - Management's philosophy and operating style,

• B - Board of Director's or Audit Committee participation, and

• - Organizational structure.

• The risk assessment forms the foundation for determining how risks will be
managed. A risk is defined as the possibility that an event will occur and
adversely affect the achievementof organizational objectives. It requires
management to consider the impact of possible changes in the internal and
external environment and to potentially take action to manage the impact.

Every entity faces a variety of risks from external and internal sources. Risk is
defined as the possibility that an event will occur and adversely affect the
achievement of objectives. It involves a dynamic and iterative process for
identifying and assessing risks to the achievement of objectives. Risks to the
achievement of these objectives from across the entity are considered relative t o
established risk tolerances. Thus, risk assessment forms the basis for
determining how risks will be managed.
A precondition to risk assessment is the establishment of objectives, linked at
different levels of the entity. Management specifies objectives within categories
relating to operations, reporting, and compliance with sufficient clarity to be
able to identify and analyze risks to those objectives. Management also
considers the suitability of the objectives for the entity. Risk assessment also
 requires management to consider the impact of possible changes in the external
environment and within its own business model that may render internal
control ineffective.

Risks that may affect an entity's ability to properly record, process, summarize
and report financial data:

• Changes in the Operating Environment (e.g. Increased Competition)

• New Personnel

• New Information Systems

• Rapid Growth

• New Technology

• New Lines, Products, or Activities

• Corporate Restructuring

• Foreign Operations

• Accounting Pronouncements

• Control activities are actions described in policies, procedures, and standards

that help management mitigate risks in order to ensure the achievement of
objectives. Control activities may bepreventive or detective in nature and may
be performed at all levels of the organization.

Control activities are performed at all levels of the entity, at various stages
within business processes, and over the technology environment. They may be
preventive or detective in nature and may encompass a range of manual and
automated activities such as authorizations and approvals, verifications,
reconciliations, and business performance reviews. Segregation of duties is
typically built into the selection and development of control activities. Where
segregation of duties is not practical, management selects and develops
alternative control activities.

Various policies and procedures that help ensure those necessary actions are
taken to address risks affecting achievement of entity's objectives:

• P - Performance reviews (review of actual against budgets, forecasts)

 • I - Information processing (checks for accuracy, completeness, authorization)

• P - Physical controls (physical security)

• S - Segregation of duties

• Information is obtained or generated by management from both internal and

external sources to support internal control components. Communication based
on internal and external sources is used to disseminate important information
throughout and outside of the organization, as needed to respond to and
support meeting requirements and expectations. The internal communication of
information throughout an organization also allows senior management to
demonstrate to employees that control activities should be taken seriousl y.

Information is vital for the entity to carry out internal control responsibilities to
support the achievement of its objectives. Management obtains or generates and
uses relevant and quality information from both internal and external sources to
support the functioning of other components of internal control. Communication
is the continual, iterative process of providing, sharing, and obtaining necessary
information. Internal communication is the means by which information is
disseminated throughout the organization, flowing up, down, and across the
entity. It enables personnel to receive a clear message from senior management
that control responsibilities must be taken seriously. External communication is
twofold: it enables inbound communication of relevant external information,
and it provides information to external parties in response to requirements and
expectations.

Methods and records established to record, process, summarize, and report

transactions and to maintain accountability of related assets and liabilities.
Must accomplish:

• Identify and record all valid transactions.

• Describe on a timely basis.

• Measure the value properly.

• Record in the proper time period.

• Properly present and disclose.

• Communicate responsibilities to employees.

 • Monitoring activities are basically periodic or ongoing evaluations to verify
that each of the five components of internal control, including the controls that
affect the principles within each component is present and functioning around
their products.

Ongoing evaluations, separate evaluations, or its combination are used to ascertain

whether each of the five components of internal control, including controls to the
principles within each component, is present and functioning. Ongoing evaluations,
built into business processes at different levels of the entity, provide timely
information. Separate evaluations, conducted periodically, will vary in scope and
frequency depending on assessment of risks, effectiveness of ongoing evaluations,
and other management considerations. Findings are evaluated against criteria
established by regulators, recognized standard-setting bodies or management and
the board of directors, and deficiencies are communicated to management and the
board of directors as appropriate.

Theabove components work to establish the foundation for sound internal control
within the organization through directed leadership, shared values and a culture that
emphasizes accountability for control. The various risks facing the company are
identified and assessed routinely at all levels and within all functions in the
organization.

Control activities and other mechanisms are proactively designed to address and
mitigate the significant risks. Information critical to identifying risks and meeting
business objectives are communicated through established channels across the
company. The entire system of internal control is monitored continuously, and
problems are addressed and mitigated timely.

What can happen when Internal Controls are weak or non-existent?

When we recommend improving controls, we often hear three basic arguments for not
implementing our recommendations:

• There is not enough staff to have adequate segregation of duties.

• It is too expensive.

• The employees are trusted and controls are not necessary.

These arguments represent pitfalls to unsuspecting management. Each argument is in

itself a problem that needs to be resolved.
 • The problem of not having enough staff or other resources should be discussed
with seniors. In most cases, compensating controls can be implemented in
situations where one person has to do all of the business-related transactions
for a department.

• If implementing a recommended control seems too expensive, be sure to

consider the full cost of a fraud that could occur because of the missing control.
In addition to any funds that may be lost, consider the cost of time that would
have been spent by the department during the time of an investigation of the
matter, and the cost of hiring a new employee. Fraud is always expensive and
the prevention of fraud is worth the cost.

• Finally consider the issue of trust. Most employees are trustworthy and
responsible, which is an important factor in employee relations and
departmental operations. However, it is also the responsibility of
administrators to remain objective. Experience and history shows that it is
often the most trusted employees who are involved in committing frauds.

When a system of internal control is determined to be effective, senior management

and the board of directors have reasonable assurance, relative to the application
within the entity structure, that the organization:

• Achieves effective and efficient operations when external events are considered
unlikely to have a significant impact on the achievement of objectives or where
the organization can reasonably predict the nature and timing of external events
and mitigate the impact to an acceptable level

• Understands the extent to which operations are managed effectively and

efficiently when external events may have a significant impact on the
achievement of objectives or where the organization can reasonably predict the
nature and timing of external events and mitigate the impact to an acceptable
level

• Prepares reports in conformity with applicable rules, regulations, and standards

or with the entity’s specified reporting objectives

• Compliance with applicable laws, rules, regulations, and standards.

Types of Internal Controls

There are different types of internal controls with a specific purpose. They all aim to
improve a company's efficiency and performance while mitigating risks.

These include:
Preventive controls: The objective is to keep errors from occurring in the first place
and ensure that all the departments are meeting their goals.

For example, management team can check the organization’s inventory, security
systems, equipment and other assets authorize employees to perform specific tasks
and approve various procedures.

Detective controls: The objective is to identify the cause of problems and

irregularities within your organization. This includes comparing information about
current performance to forecasts, budgets and previous results in order to determine
company performance.

Corrective controls:The objective is to correct errors. For example, your company's

management team may recommend backing up data in order to recover essential
information in the event of a crash or security breach. This type of audit usually
includes detective and preventive controls.

Main Objective of Internal Controls

The main objective of every type of internal control within an organization is to assure
ethical and efficient functioning in the following three areas:

Operations: Internal controls assist an organization operate at peak efficiency when it

comes to finances, personnel and business procedures. They also aid organizations in
loss prevention and future projections.
Reporting: Internal controls make all types of reporting more accurate, financial or
otherwise. Their objective is to identify problems, solve them and then prevent them in
the future, all while documenting things thoroughly and accurately.

Compliance: Internal controls aim to ensure that a company is in compliance with all
internal and external rules and regulations that pertain to its industry. This includes
everything from manufacturing to labor laws, branding and even OSHA standards.

Other Objectives
The objectives of each audit may be different. An objective is a desired goal or
condition for that specific event. This is a list of common internal audit control
objectives.

• Authorization: ensures that all transactions are authorized and approved by a

responsible associate before that transaction is recorded
• Completeness: ensures that your records are not any missing entries
• Accuracy: ensures that your transactions have been entered correctly and in a
timely manner
• Validity: ensures that your transactions are lawful in nature and do not contain
any misrepresentations
• Physical Safeguards & Security: ensures that physical assets are safely guarded
and only authorized personnel may access them
• Error Handling: ensures that when errors are discovered management is
notified and the errors are corrected in a timely manner
• Segregation of Duties: ensures that no one individual is reporting, collecting,
and processing a single transaction

Overall Benefits of Internal Controls

The objectives of internal controls go beyond the horizons of preventing fraud and
theft. When executed correctly, they can reduce risk, waste and abuse. These audits
prove a company's compliance with applicable laws and regulations, protect its
resources against loss due to mismanagement and maintain reliable financial data.

Any company big or small can benefit from internal controls. However, small
businesses are more vulnerable to fraud and experience higher median loss compared
to established companies. Corruption, employee theft and data omission from financial
records are common. For this reason, small business owners need to be extra careful to
perform internal controls on a regular basis.

Internal control helps entities achieve important objectives and sustain and improve
performance. COSO’s Internal Control—Integrated Framework (Framework) enables
organizations to effectively and efficiently develop systems of internal control that
adapt to changing business and operating environments, mitigate risks to acceptable
levels, and support sound decision making and governance of the organizati on.

Designing and implementing an effective system of internal control can be challenging;

operating that system effectively and efficiently every day can be daunting. New and
rapidly changing business models, greater use and dependence on technology,
increasing regulatory requirements and scrutiny, globalization, and other challenges
demand any system of internal control to be agile in adapting to changes in business,
operating and regulatory environments.

An effective system of internal control demands more than rigorous adherence to

policies and procedures: it requires the use of judgment. Management and boards of
directors use judgment to determine how much control is enough. Management and
other personnel use judgment every day to select, develop, and deploy controls across
the entity. Management and internal auditors, among other personnel, apply judgment
as they monitor and assess the effectiveness of the system of internal control.

The Framework assists management, boards of directors, external stakeholders, and

others interacting with the entity in their respective duties regarding internal control
without being overly prescriptive. It does so by providing both understanding of what
constitutes a system of internal control and insight into when internal control is being
applied effectively.
For management and boards of directors, the Framework provides:

• A means to apply internal control to any type of entity, regardless of industry or

legal structure, at the levels of entity, operating unit, or function
• A principles-based approach that provides flexibility and allows for judgment in
designing, implementing, and conducting internal control—principles that can
be applied at the entity, operating, and functional levels
• Requirements for an effective system of internal control by considering how
components and principles are present and functioning and how components
operate together
• A means to identify and analyze risks, and to develop and manage appropri - ate
responses to risks within acceptable levels and with a greater focus on anti-
fraud measures
• An opportunity to expand the application of internal control beyond financial
reporting to other forms of reporting, operations, and compliance objectives
 • An opportunity to eliminate ineffective, redundant, or inefficient controls that
provide minimal value in reducing risks to the achievement of the entity’s
objectives

For external stakeholders of an entity and others that interact with the entity,
application of this Framework provides:

• Higher confidence in the board of directors’ oversight of internal control

systems
• Higher confidence regarding the achievement of entity objectives
• Higher confidence in the organization’s ability to identify, analyze, and respond
to risk and changes in the business and operating environments
• Higher understanding of the requirement of an effective system of internal
control
• Higher understanding that through the use of judgment, management may be
able to eliminate ineffective, redundant, or inefficient controls

Limitations

The Framework recognizes that while internal control provides reasonable assurance
of achieving the entity’s objectives, limitations do exist. Internal control cannot prevent
bad judgment or decisions, or external events that can cause an organization to fail
toachieve its operational goals. In short, even an effective system of internal control
can experience a failure.

Limitations may result from the:

• Suitability of objectives established as a precondition to internal control

• Reality that human judgment in decision making can be faulty and subject to
bias
• Breakdowns that can occur because of human failures such as simple errors
• Ability of management to override internal control
• Ability of management, other personnel, and/or third parties to circumvent
controls through collusion
• External events beyond the organization’s control

These limitations preclude the board and management from having absolute assurance
of the achievement of the entity’s objectives—that is, internal control provides
reasonable but not absolute assurance. Notwithstanding these inherent limitations,
management should be aware of them when selecting, developing, and deploying
controls that minimize, to the extent practical, these limitations.
COSO Framework implementation Approach

Phase 1 Phase 2 Phase 3 Phase 4 Phase 5

Planning& Assessment Remediation Design, testing Optimizationof
scoping &documentatio planning &reporting effectiveness of
n &implementatio internalcontrol
n ofcontrols

COSO defines internal control as “a process, affected by an entity’s board of directors,

management, and other personnel, designed to provide reasonable assurance
regarding the achievementof objectives relating to operations, reporting, and
compliance.”
COSO provides further characterization of the objectives, which allow organizations
to focus on different aspects of internal control: “Operational objectives pertain to
effectiveness and efficiency of the entity’s operations, including operationa l and
financial performance goals and safeguarding assets against loss. Reporting
objectives pertain to internal and external financial and nonfinancial reporting and
may encompass reliability, timeliness, transparency, or other terms as set forth by
regulators, recognized standard setters, or the entity’s policies.

Stakeholders play an important role in implementing the Framework. For example,

senior management and members of the board of directors should generally be clear
in the Framework andits implementation benefits, costs, and approach. They may
already have a broad understanding of the necessity for an effective internal control
system, and some may perform or support internal controls as a part of their daily
routine. It is possible however; that there may notbe a full understanding of what is
essential to implement the Framework. This can be resolved through
propercommunication, training, and integration as well as a strong, supportive tone
at the top, which are all elements imbedded within the Framework.

Once awareness among the most seniors is established, the organization needs to
formulate an overall plan for implementation, including mechanisms for gaining
support throughout the organization. An implementation team should be staffed with
individuals who have expertise in internal control and a strong working knowledge
ofthe organization to minimize the learning curve. The implementation team should
first spend time developing a project implementation plan, including plans for
assessing, designing, implementing, and maintaining systems of internal control. The
approach that follows is one of many different ways the Framework can be
implemented within organization.
Phase 1: Planning and scoping.
Planning
In good-managed project, the planning phase usually is the most important. Once
support for implementation is available and the responsible team is defined, the next is
to develop the implementation plan. Several key aspects should be considered in the
plan, including a timelines, the number and types of resourcesrequired, and the
determination of roles and responsibilities of the implementation team. Because many
competing priorities are being handled simultaneously at any point in time, the
timeline should be flexible enough to accommodate priorities. This might mean
pushing the documentationof one process back and accelerating another, which
requires flexibility from the implementation team and the full cooperation of
management.
Depending on the timeline urgency, the organization should consider the size of the
implementation team and determine if the established team has sufficient knowledge
of and experience withthe covered processes. It is common for a team to be
supplemented with additional resources from professional firms, which can help keep
the timeline on target, document and test specific complex processes, or take
advantage of lessons learned from other implementation efforts.

Scoping
Scope is determined by the range of activities and by the period of record that are to be
evaluated. Using COSO’s guidance, an organization’s management should focus on
areas with the highest risks that could affect the organization’s ability to achieve its
strategies and objectives. So, the scope should be considered before, during, and after
the planning phase. Whenimplementing the 2013 Framework, the team should gain an
understanding of the objectives and sub-objectives set by management during the
strategic planning process to identify the risks of failing to meet those objectives of
operations, reporting, and compliance.

Phase 2: Assessment and Documenting.

Risk assessment
Organizations are not immune to fraud schemes. Resource limitations, operational
complexity, and constant changes provide a challenge to adopt adequate preventive
controls that defer fraud and increase the likelihood of timely detection.
The revised 2013 Framework places emphasis on the need to consider the potential for
fraud in assessing risks to the achievement of objectives.
An understanding of the organization’s risk for fraud will provide insight into where to
focus management’sassessment efforts and also potentially identify risks that could
result in significant monetary or reputational loss to the organization if not prop erly
mitigated. Although many organizations have informally contemplated fraud risks in
the past, the 2013 Framework highlights several points of focus that should be
considered during Fraud Risk Assessment:

• Consider various types of fraud like fraudulent reporting, possible loss of assets,
and corruption resulting from the various ways that fraud and misconduct can
occur.

• Assess incentives and pressures. E.g. management bonuses tied to the

achievement of specific operational or financial measurements, which may
inadvertently pressure management to artificially and fraudulently inflate
numbers.

• Assess opportunities for unauthorized acquisition, use, or disposal of assets;

alteration of the entity’s reporting records; or other inappropriate acts.

• Assess attitudes and rationalizations. How management and other personnel

might engage in or justify inappropriateactions and considers situations and
circumstances that may elevate the likelihood of inappropriate actions.

Documenting

A) Identify the scope selected for documentation.

Even after management selects key processes, it may not be possible or prudent to
include every aspect of each process in a review of internal controls. This is especially
true with large organizations that could have decentralized parts of a process that vary
from the rest of the process. In these situations, management should evaluate the
process againstthe entity’s established risk tolerance to determine whether excluding
the process and related controls is an acceptable risk to achieving the entity’s
objectives.

B) Review existing documentation.

Provided that documentation is available, this step might give management and the
team a good understanding of the current control structure and provide assistance to
plan for location visits and personnel interviews. If the documentation is formalized
and complete, it will allow quick understanding ofbusiness processes and focus on any
process changes since the documentation was last updated.
Documentation might be provided to the team with a number of policies and
procedures and some detailed employee manuals for performing various job
responsibilities. The information can be a good starting point and allows the team to
gain a more detailed understanding of some of the activities in the process. However,
the documentation might be more tailored to explaining job responsibilities and
specific job activities rather than explaining how a transaction flows through a system,
where risks may exist for processing errors, and what internal controls are in place.

C) Conduct interviews.
With the information obtained in its review of the existing documentation, the team
can conduct personnel interviews. Interviews are a very important part of the process.
The information gleaned during interviews provides the evidence to make informed
decisions about the department’s compliance with the process. It may be helpful to
create an outline of interview questions or preliminary gaps identified to facilitate the
interviews. If existing documentation issparse or does not exist, an outline of interview
questions that highlight the common control points in the processes being discussed
would be beneficial. The geographic spread of some national and global organizations
can make in-person interviews challenging and expensive;if necessary, interviews may
be conducted using technology to eliminate the need for face-to-face meetings. In
addition, using well-tailored questionnaires in such situations can also be very
effective. In our example, given the complexity of a revenue cycle, the team may
determine that it will take numerous interview sessions to fully understand the
revenue process.

D. Identify risks, controls, and gaps of processes.

During the review of existing documentation and while performing interviews, one
should identify the risks, controls, and gaps related to the existing processes. For
control structures that are mature and complete, this process might include noting
changes since the last time that the process and control documentation was
updated. For other control structures, building the foundation for control
documentation and remediation plans might requiretaking detailed notes about
process risks, controls, and related gaps.

E. Prepare final process documentation inbuilt with controls.

Whether an organization uses governance, risk, and compliance system or manual

tools such as word processing and spreadsheet software, the basic components of
the documentation process are the same.

Phase 3: Remediation planning and

implementation
Remediation
Remediation plans should consider the severity of each of the identified deficiencies by
prioritizing the remediation of more severe deficiencies ahead of those deficiencies
that are less severe.
Remediation implementation
Remediation plans may require significant time commitments from process owners or
changes to current business processes. So, before commencing the remediation
implementation, it is important to confirm plans with and establish buy-in from those
who will be involved. Successful and sustainable remediation efforts depend on input
and commitment from process owners. Additionally, process owners will be able to
assist in evaluating the effectiveness of the proposed remediation actions and also
provide valuable insights into the remediation process including the reasonableness of
objectives, proposed milestones, and the timing of project completion.
It is important to make sure the updated remediation plans remain focused on
addressing the control deficiencies noted in the gap assessment phase and that the
focus has not shifted to processes that were not identified as deficient or to processes
with lower-rated deficiencies.

Phase 4: Design, testing, and reporting

ofcontrols
After selecting the key controls for testing, one is ready to design the individual
procedures for testing each control. In designing a test of controls, it is important to
understand both the risk to be mitigated and the related control description, which
detail potential problems with the underlying activity or transaction that is intended to
be mitigated.

The control description depicts how the related control actuallyfunctions.

Understanding both the risk to be mitigated and the control description allows the
organization to design tests of controls that will apply to the design and operating
effectiveness of the controls rather than just operating effectiveness. For example, if a
control functions as designed but does not fully address the risk being mitigated, then
the tester may conclude that the control was not designed correctly, though it
performed exactly as described. In this example, the tester would determine that the
control has a design deficiency.

After understanding the risk and the related control description, the organization
should consider the nature, timing, and scope of testing in orderto prepare test scripts,
which are the detailed steps to be performed and include the nature, timing, and extent
of testing along with the recommended documentation to be gathered.

Various methods are used to perform tests of controls and to create test plans. Each
method should be evaluated based on the complexity and timing of the underlying
control. It is possible that multiple methods of testing may be needed.
The two common testing methods for controls related to 2013 Framework
implementation are observation and documentation examination. Other
testingmethods include inquiry, re-performance, and data analytics.
Phase 5: Optimization of effectiveness of
internal control
Alignmentofriskandcontrolstothestrategy and objectives of theorganization
One of the primary ways to optimize the effectiveness of internal controls is to
continuously align an organization’s risk and controls to the organization’s objectives.
An organization adopts a mission and vision, sets strategies, establishes objectives it
wants to achieve, and formulates plans for achieving them.
Over the period, strategies, objectives, and plans are updated and changed in resp onse
to new competitors, a changing regulatory environment, dynamic world economic
conditions, internal resource limitations, and other challenges to the organization.
Similarly, the alignment of risk and controls to the revised strategies, objectives, an d
plans also must be updated and changed.

COSO’s objectives and components of internal control support the organization in its
efforts to concurrently align its risk and controls to its objectives. These objectives and
components are relevant to an entire entity and to itssubsidiaries, divisions, or any of
its individual operating units, functions, or other subsets of the entity. An
organizationwill realize that the 2013 Framework will not only provide a basis for the
initial alignment of its risk and controls to its mission and vision but will also provide
an ongoing basis for realignment as the organization’s strategies, objectives, and plans
are updated and changed.
Process control structures
When an organization reviews its process control structures, it should consider
various types of control activities such as reconciliation, supervisory, physical, and
verification controls to determine the optimal balance or mix of controls that will
mitigate the identified risks. Each of these types of controls can be designed as
preventive or detective in nature.
Preventive versus detective
Control activities can be preventive or detective, and organizations usually select a mix
that is optimal as suitable for their business model. The major difference between
preventive and detective control activities is the timing of when the control activ ity
occurs.
A preventive is designedto avoid an unintended event or result at the time of initial
occurrence while a detective control is designed to discover an unintended event or
result after the initial processing has occurred but before the ultimate objective has
concluded. In both cases, the critical part of the control activity is the action taken to
correct or avoid an unintended event.
Manual versus Automated
As with preventive and detective controls, most business processes have a mix of
manual and automated controls; depending on the availability of technology in the
organization.
Automated controls tend to be more reliable, subject to whether technology general
controls are implemented and operating, because these controls are less susceptible to
human judgment and error and typically are more efficient. However, the
implementation of an automated control may not be practical due to limitations in the
organization’s current technology. Inthis case, a manual control could be designed to
address the risk in question. It is important that the precision of the manual control
when mitigating certain risks that might be complex or require specialized knowledge.
Continuous monitoring
To assess the adequacy and effectiveness of internal controls, a continuous monitoring
process may provide stronger support than scheduled monitoring that may occur on a
periodic basis. Continuous monitoring usually involves the automated testing of all
transactions and system activities within a given business process area versus testing
based on sampling criteria, so continuous monitoring can offer a more comprehensive
view of portions of the status of the control environment. The IIA Global Technology
Audit Guide publication, “Continuous Auditing: Coordinating Continuous Auditing and
Monitoring to Provide Continuous Assurance,” summarizes the following principles of
continuous monitoring:
• “Purpose – consider the business objective and critical success factors.
• “Risk – determine likely obstacles that would inhibit the organization’s success.
• “Response – align diverse sources of data to discover and corroborate emerging
risks such as configurable conditions, changes, event logging, financial
transactions, and unstructured data.
• “Timing – detect control issues in real time.
• “Action – track deficiencies for corrective action.”

Determining the root cause of control failures

The root causes of control failures often are elusive. Sometimes process owners and
organizational personnel are reluctant to discuss the real reasons for a control failure
due to fear of retribution or embarrassment. Other times, the real reason for a control
failure is hidden behind the breakdown of two or more controls involving several
processes, personnel, and perhaps even IT systems. In any case, it is important to
determine the root causes of the primary drivers of control failures so that the
remediation action can directly address the needed process enhancement.

Several formal methods exist to determine the root cause of control breakdowns or
other events. In its simplest form, root cause analysis is simply continuing to ask
“why?” until the primary reason is identified. Each “why?” question is like peeling a
layer of an onion away until only the core remains. It is only with the exposure of the
core of the control failure that an organization canaccurately create and implement
remediation actions that directly address the root cause of the deficiency.

1 Which of the following is true related to internal control objectives of

information systems?

A Main responsibility of viable internal control rests with the internal audit division.
A secure system may possess inherent risks due to management's analysis of trade -
B
offs identified by cost-benefit studies.
C Control objectives mainly emphasize output distribution issues.
D An entity's corporate culture is not relevant to the objectives.

2. As per COSO, which of the following considers the need to respond in an

organized manner to significant changes resulting from international exposure,
acquisitions, or executive transitions?

A Control activities
B Risk assessment
C Monitoring activities
Information and
D
communication

3. As per COSO, establishing, maintaining, and monitoring an effective internal

control system can do each of the following, except

A Ensure an entity's financial survival.

Promote an entity's compliance with laws and
B
regulations.
C Help an entity achieve performance targets.
D Provide protection for an entity's resources.

4.BCCI created a decision aid, linked to its data warehouse, to enable senior
management to monitor, in real time, changes in oil production at its oil wells in
Kazakhstan. This is an example of:

A Internal, financial reporting

Internal, nonfinancial
B
reporting.
C External, financial reporting.
External, nonfinancial
D
reporting.

5. In COSO Cube, each of the following are components of internal control except

A Monitoring.
B Control activities.
C Operations control.
D Risk assessment.

6. New york Fried Opossums reports annually on its environmental impact to the
Commonwealth of New York. It is an example of:

A Internal, financial reporting.

Internal, nonfinancial
B
reporting.
C External, financial reporting
External, nonfinancial
D
reporting

7. As per COSO, which of the following is a compliance objective?

A To maintain adequate staffing to keep overtime expense within budget.
B To maintain a safe level of carbon dioxide emissions during production.
C To maintain material price variances within published guidelines.
D To maintain accounting principles that conform to GAAP.

8. It is the process of identifying, analyzing, and managing the risks involved in

achieving the organization's objectives.

A Control activities.
B Control environment.
Information and
C
communication.
D Risk assessment.

9. Which of the following is fundamental component of internal control is the core

or foundation of any system of internal control.

A Control activities.
B Control environment.
Information and
C
communication.
D Risk assessment.
PRINCIPLES OF INTERNAL CONTROL

COSO
17 PRINCIPLES OF INTERNAL
CONTROL
Introduction
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) updated
its Internal Control — Integrated Framework. The updated principles-based framework,
which supersedes the original 1992 framework, now explicitly describes its principles rather
than simply implying them, thus making it easier for companies to apply the principles. The
revised COSO framework’s 17 principles of effective internal control are as follows:

Internal Control
Principles
Component
1. Demonstrate commitment to integrity and ethical values
2. Ensure that board exercises oversight responsibility
3. Establish structures, reporting lines, authorities and
Control environment responsibilities
4. Demonstrate commitment to a competent workforce
5. Hold people accountable

1. Specify appropriate objectives

2. Identify and analyze risks
3. Evaluate fraud risks
Risk assessment
4. Identify and analyze changes that could significantly affect
internal controls

1. Select and develop control activities that mitigate risks

2. Select and develop technology controls
Control activities
3. Deploy control activities through policies and procedures

1. Use relevant, quality information to support the internal

control function
Information and
2. Communicate internal control information internally
communication
3. Communicate internal control information externally

1. Perform ongoing or periodic evaluations of internal controls

(or a combination of the two)
Monitoring
2. Communicate internal control deficiencies
 Following is the table of 17 Principles of COSO Internal Controls Model with the key points
for each principle.

Control Environment
Principles Key Points
1 Sets the tone at the top
The organization 2 Establishes standards of conduct
1 demonstrates a
commitment to integrity 3 Evaluates adherence to standards of
and ethical values conduct
4 Addresses deviations in a timely
manner
5 Establishes oversight responsibilities
The board of directors 6 Applies relevant expertise
demonstrates
7 Operates independently
2 independence from
management and exercises ProvidesoversightonControlEnviro
8 nment,Risk Assessment, Control
oversight of the develop-
ment and performance of Activities, Information and
internal control Communication,andMonitoring
Activities
Management establishes, 9 Considers all structures of the entity
with board oversight, 10 Establishes reporting lines
3 structures, reporting lines,
and appropriate authorities Defines,assigns,andlimitsaut
11 horitiesand responsibilities
and responsibilities in the
pursuit
of objectives
12 Establishes policies and practices
The organization 13 Evaluates competence and addresses
4 demonstrates a shortcomings
commitment to attract, 14 Attracts, develops and retains
develop, and retain individuals
 competent individuals in
alignment with objectives
The organization holds
individuals accountable for
5 their internal control
responsibilities in the
pursuit of objectives
Risk Assessment
Principles
The organization specifies
6 objectives with sufficient
clarity to enable the
identification and
assessment of risks relating
to objectives:
– Operations Objectives
15 Plans and prepares for succession
Enforcesaccountabilitythroughstruct
16 ures,authorities andresponsibilities
Establishes performance measures,
17 incentives and rewards
Evaluates performance measures,
18 incentives and rewards for ongoing
relevance
19 Considers excessive pressures
Evaluatesperformanceandreward
20 sordisciplines individuals
Key Points
21a Reflects management’s choices
22a Considers tolerances for risk
23 Includes operations and financial
performance goals
24 Forms a basis for committing of
resources
21b Complies with applicable accounting
standards
 – External Financial
Reporting Objectives
– External Non-Financial
Reporting Objectives
– Internal Reporting
Objectives
– Compliance Objectives
The organization identifies
risks to the achievement
of its objectives across the
7
entity and analyzes risks as
a basis for determining
how the risks should be
managed
The organization considers
8 the potential for fraud in
assessing risks to the
achievement of objectives
The organization identifies 35 Assesses changes in the external
and assesses changes that
9
could significantly impact the 36 Assesses changes in the business model
system of internal control
Control Activities
Principles
22b Considers materiality
25 Reflects entity activities
21c Complieswithexternallyestablished
standardsand frameworks
22c Considers the required level of
precision
25 Reflects entity activities
21a Reflects management’s choices
22c Considers the required level of
precision
25 Reflects entity activities
21d Reflects external laws and regulations
22a Considers tolerances for risk
26 Includesentity,subsidiary,division,oper
atingunit,and functionallevels
27 Analyzes internal and external factors
28 Involves appropriate levels of
management
29 Estimates significance of risks identified
30 Determines how to respond to risks
31 Considers various types of fraud
32 Assesses incentives and pressures
33 Assesses opportunities
34 Assesses attitudes and rationalizations
environment
37 Assesses changes in leadership
Key Points
 38 Integrates with risk assessment
39 Considers entity-specific factors
The organization selects 40 Determines relevant business processes
10 and develops control 41 Evaluates a mix of control activity types
activities that contribute
to the mitigation of risks 42 Considers at what level activities are
to the achievement of applied
objectives to acceptable 43 Addresses segregation of duties
levels
Determinesdependencybetweentheus
44 eoftechnology
inbusinessprocessesandtechnologyge
neralcontrols
The organization selects
11 and develops general Establishes relevant technology
control activities over 45 infrastructure control activities
technology to support Establishes relevant security
the achievement of 46 management process control activities
objectives Establishes relevant technology
47 acquisition, develop- ment, and
maintenance process control activities
Establishespoliciesandprocedur
48 estosupport
deploymentofmanagement’sdir
The organization deploys ectives
control activities through 49 Establishesresponsibilityandacco
12 policies that establish what untabilityfor executing
is expected and procedures policiesand procedures
that put policies into action 50 Performs in a timely manner
51 Takes corrective action
52 Performs using competent personnel
53 Reassesses policies and procedures
Information and Communication
Principles Key Points
 54 Identifies information requirements
55 Captures internal and external sources
The organization obtains or of data
13 generates and uses 56 Processes relevant data into
relevant, quality information
information to support the
57 Maintains quality throughout
functioning of other
processing
components of internal
control 58 Considers costs and benefits
59 Communicates internal control
The organization internally information
communicates information, 60 Communicates with the board of
14 including objectives and directors
responsibilities for internal
61 Provides separate communication
control, necessary to
lines
support the functioning of
other components of 62 Selects relevant method of
internal control communication

The organization 63 Communicates to external parties

communicates with 64 Enables inbound communications
external parties regarding
65 Communicates with the board of
matters affecting the
directors
15 functioning of other
components of internal 66 Provides separate communication
control lines
67 Selects relevant method of
communication
Monitoring Activities
Principles Key Points
68 Considers a mix of ongoing and
The organization selects, separate evaluations
develops, and performs 69 Considers rate of change
ongoing and/or separate 70 Establishes baseline understanding
evaluations to ascertain 71 Uses knowledgeable personnel
 whether the components 72 Integrates with business processes
16
of internal control are
73 Adjusts scope and frequency
present and functioning
74 Objectively evaluates
75 Assesses results
The organization evaluates
and communicates internal Communicatesdeficienciestoparties
76 responsiblefor
control deficiencies in a
17 correctiveactionandtoseniormanag
timely manner to those
parties responsible for ementandthe board ofdirectors
taking corrective action,
including senior 77 Monitors corrective actions
management and the
board of directors, as
appropriate

Following is the table of 17 Principles of COSO Internal Controls Model with examples for
each principle.
Following is the list of 5 components with 17 Principles of COSO Internal Controls Model
with explanations.

Control Environment.
“The control environment is the set of standards, processes, and structures that provide the
basis for carrying out internal control across the organization.
The board of directors and senior management establish the tone at the top regarding the
importance of internal control and expected standards of conduct.”

The seven factors in the 1992 Framework relating to an effective control environment are
integrity and ethical values; commitment tocompetence; board of directors or audit
committee; management’s philosophy and operating style; organizational structure;
assignment of authority and responsibility; and human resource policies. These factors are
capturedin the Control Environment’s five principles in the 2013 Framework, which are:
1. The organization demonstrates a commitment to integrity and ethical values.
2. The board of directors demonstrates independence from management and exercises
oversight of the development and performance of internal control.
3. Management establishes, with board oversight, structures, reporting lines, and
appropriate authorities and responsibilities in the pursuit of objectives.
4. The organization demonstrates a commitment to attract, develop, and retain
competent individuals in alignment with objectives.
5. The organization holds individuals accountable for their internal control
responsibilities in the pursuit of objectives.
The 2013 Framework links the various components of internal controland demonstrates
that the control environment is the foundation for a sound system of internal control.

Risk Assessment
“Risk assessment involves a dynamic and iterative process for identifying and analyzing risks
to achieving the entity’s objectives, forming a basis for determining how risks should be
managed. Management considers possible changes in the external environment and within
its own business model that may impede its ability to achieve its objectives.”

The 1992 Framework focused on management’s process for objective setting at an entity -
wide and activity level, risk analysis, and managing change. The 2013 Framework recognizes
that many organizations are taking a risk-based approach to internal control and that the
Risk Assessment includes processes for risk identification, risk analysis, and risk r esponse;
that risk tolerances and an acceptable level of variation in performance should be
considered in the assessment of acceptable risk levels; and the discussion of risk severity
includes velocity and persistence in addition to impact and likelihood. Most significantly, the
Risk
Assessment component now includes a separate principle to address the risk of fraud in the
organization i.e. Principle 8.
The 2013 Framework includes more extensive discussion about the types of fraud and
management override of controls and the organization’s response to fraud risk.
It states, “A system of internal control over financial reporting is designed and implemented
to prevent or detect, ina timely manner, a material omissionfrom or a misstatement of the
financial statements due to error or fraud.” Assessment of this principle may require
additional attention by organizations that did not focus their assessment of fraud risk at the
specific financial statement account, transaction, or assertion level.
The four principles relating to Risk Assessment are:
1. The organization specifies objectives with sufficient clarity to enable the
identification and assessment of risks relating to objectives.
2. The organization identifies risks to the achievement of its objectives across the entity
and analyzes risks as a basis for determining how the risks should be managed.
3. The organization considers the potential for fraud in assessing risks to the
achievement of objectives.
4. The organization identifies and assesses changes that could significantly impact the
system of internal control.

Control Activities
“Control activities are the actions established by the policies and procedures to help ensure
that management directives to mitigate risks to the achievement of objectives are carried
out. Control activities are performed at all levels of the entity, at various stages within
business processes, and over the technologyenvironment. They may be preventive
ordetective in nature and may encompass a range of manual and automated activities such
as authorizations and approvals, verifications, reconciliations, and business performance
reviews.

Segregation of duties is typically built into the selection and development of control
activities. Where segregation of duties is not practical, management selects and develops
alternative control activities.”
The fundamental concepts in the 1992 Framework related to Control Activities have not
changed in the three principles listed in the 2013 Framework. However, the most significant
changes to this component results from changes in technology over the last 20 years and
include:
An updated discussion on general information technology controls from 1992 to today’s
technology
An expanded discussion of the relationship between automated controls and GITCs and how
they link to the business processes. In connection with the organization’s evaluation of
effective internal control over financial reporting, we believe that this change in emphasis
provides an efficient approachfor management to focus on theeffectiveness of automated
controls at the financial statement assertion level, and linking those application controls to
relevant GITCs. It is not necessary to identify and test all GITCs but rather only those that
are relevant to risks related to financial reporting objectives.
As a result of Sarbanes-Oxley reform, organizations have a deeper understanding of how
control activities are effectively designed and implemented. However, we believe that many
registrants have focused their attention on the effectiveness of the Control Activities
component in the assessment of internal control over financial reporting at the expense of
the other four components. The 2013 Framework’s requirement for all relevant principles to
be present and functioning and the requirement for all components to function in an
integrated manner will encourage greater attention and emphasis on the effectiveness of
internal control over financial reporting across the 17 principles and five components,
beyond Control Activities.
The three principles relating to Control Activities are:

1. The organization selects and develops control activities that contribute to the
mitigation of risks to the achievement of objectives to acceptable levels.
2. The organization selects and develops general control activities over technology to
support the achievement of objectives.
3. The organization deploys control activities through policies that establish what is
expected and in procedures that put policies into action.

Information and Communication.

“Information is necessary for the entity to carry out internal control responsibilities in
support of achievement of its objectives.
Communication occurs both internally and externally and provides the organization with the
information needed to carry out day-to-day internal control activities. Communication
enables personnel to understand internal control responsibilities and their importance to
the achievement of objectives.”
The importance of having the right information communicated to managers at the right
time has become a key to successful business operations and effective internal control as
organizations have become more complex in their structure and global operations and
become more dependent on technology. Changes in the Information and
This component include:

• An expanded discussion about the verification of the source of information and its
retention when information is used to support reporting objectives to external
parties
• Additional discussion on the impact of regulatory requirements on the reliability and
protection of information
• An examination of the impact of technology and other communications mechanisms
on the speed, means, and quality of the flow of information
• Additional consideration of how the organization interacts with third-party service
providers outside of its legal and operational boundaries.

The three principles relating to Information and Communication are:

1. The organization obtains or generates and uses relevant, quality information to
support the functioning of internal control.
2. The organization internally communicates information, including objectives and
responsibilities for internal control, necessary to support the functioning of internal
control.
3. The organization communicates with external parties about matters affecting the
functioning of internal control.

MonitoringActivities.
“Ongoing evaluations, separate evaluations, or some combination of the two are used to
ascertain whether each of the five components of internal control, including c ontrols to
effectthe principles within each component, are present and functioning. Findings are
evaluated and deficiencies are communicated in a timely manner, with serious matters
reported to senior management and to the board.”

COSO always intended that monitoring activities would address how all of the components
of internal control are applied and whether the overall system of internal control operates
effectively. The 2013 Framework distinguishes between a management review control as a
control activity and a monitoring activity. A management review control that is a control
activity responds toa specified risk and is designed todetect and correct errors. However, a
management review control that is a monitoring activity would ask why the errors exis t, and
then assign the responsibility of fixing the process tothe appropriate personnel. A
monitoring activity assesses whether the controls in each of the five components are
operating as intended.
Ongoing evaluations are built into the routine operations and are performed on a real-time
basis. A separate evaluation is conducted periodically by objective management personnel,
internal audit, and external parties.
The two principles relating to Monitoring Activities are:

1. The organization selects, develops, and performs ongoing and/or separate

evaluations to ascertain whether the components of internal control are present and
functioning.
2. The organization evaluates and communicates internal control deficiencies in a
timely manner to those parties responsible for taking corrective action, including
senior management and the board of directors, as appropriate.
1. ABC Corp. is implementing technology to improve the monitoring of internal control.
Which of the followingdescribes how technology may be effective at improving internal
control monitoring?

Technology can identify conditions and circumstances that indicate that controls have
A
failed or risks are present.
B Technology can ensure that items are processed accurately.
C Technology can provide information more quickly.
D Technology can control access to terminals and data.

2. As per COSO control principles, organizational objectives mainly relate to which

fundamental component of internal control:
A Control activities.
B Control environment.
C Risk assessment.
D Monitoring.

3. As per COSO control principles, information quality mainly relates to which fundamental
component of internal control:

A Control activities.
B Control environment.
C Information and communication.
D Monitoring.

4. Mr. A of ABC Corp. has learned that the controller is probably embezzling money to fund
an expensive drug and gambling activity. Ideally, Mr.A should communicate this
information to:

A Controller.
B Boss.
C An anonymous hotline set up.
D Employees.

5. Employees of ABC Corp.are under pressure to do the right thing; management properly
deals with signs that problems exist and resolves the issues; and dealings with customers,
suppliers, employees, and other parties are based on honesty and fairness. According to
COSO, the above scenario indicates of which of the following?

A Strategic goals
B Operational excellence
C Reporting reliability
D Tone at the top
TYPES AND LIMITATIONS OF ACCOUNTING CONTROL

TYPE AND LIMITATIONS

ACCOUNTING CONTROL
Limitations of Internal Controls

Internal control in accounting includes procedures and policies that increase

the reliability of your financial data and help prevent fraud. They include
processes like separating duties and steps, keeping employees accountable,
securing your cash and monitoring financial transactions.

However, there are still critical issues such as human error and misjudgment,
managerial override, collusion and lack of understanding of controls that can
negatively impact company's accounting if further steps are not taken care to
address them.

One weakness of an internal control system is that it's only useful whendown
team actually understands the system and actually follows the procedures.

E.g., there might have a policy that accounting employees shouldn't leave the
company's financial statements open on their desktops while they're away
from their desks. However, they might not understand that this still applies
when taking a quick break to get some coffee because this can expose your
confidential information to others who pass by.

To educate employees, train them on exactly which processes to use and

include scenarios where they'd apply them. One should also clarify individual
responsibilities, emphasize the reasoning for internal controls and explain the
consequences of not following them. Promote them to come with any
questions to avoid further misunderstandings.

A system of controls does not provide absolute assurance that the control
objectives of an organization will be achieved. Instead, there are several
inherent limitations in any system that reduces the level of assurance.

The 2013 Framework there are limitations relatedto a system of internal

control. For example, certain events or conditions are beyond an organization’s
control, and no system of internal control will always do what it was designed
to do. Controls are performed by people and are subject to human error,
uncertainties inherent in judgment, management override, and their
circumvention due to collusion. An effective system of internal control
recognizes their inherent limitations and addresses ways to minimize these
risks by the design, implementation, and conduct of the system of internal
control. However, an effective system will not eliminate these risks. An
effective system of internal control provides reasonable assurance, not
absolute assurance, that the entity will achieve its defined operating, reporting,
and compliance objectives.

Limitations are as follows:

1. Collusion.

Two or more people who are intended by a system of control to keep watch
over each other could instead collude to circumvent the system.
Even if you provide employees with comprehensive training so that they
understand how your accounting internal controls work, this doesn't guarantee
your staff will work together to follow them. In some cases, you might find that
a few employees to whom you've assigned duties have worked together to
commit fraud. For example, you might have one employee enter a transaction
into your accounting system and another confirms the payment or receipt.
These two employees could conspire together to enter and approve a fake
supply expense and use the money for themselves.

In addition, managers alone might also make decisions to override your

accounting internal controls, whether for fraudulent purposes or other
reasons. For example, managers could let certain employees bypass steps while
away on vacation, or they could override controls to manipulate financial data
and steal from the business.

There are simple steps you can take to avoid such scenarios. In addition to
regularly rotating employees when you segregate duties, you should also make
it clear that your company will punish those who commit fraud and perform
regular audits to catch suspicious transactions. Internal audits can help identify
instances where managers bypass controls.

Your internal control systems can be overcome if multiple employees work

together to perform fraud. Although each employee may face internal controls
that limit what they can do by themselves, they can go around this limit by
pairing with someone who can. One of your employees may be authorized to
enter a voucher into your accounting system but isn’t allowed to print che ques.
Another employee may be authorized to print cheques but can’t set up to enter
vouchers. If these two employees work together, they can overcome the limits
each one faces individually to produce a fake cheque. There’s no way to
overcome collusion other than having trustworthy employees.

2. Human error& Misjudgment.

A person involved in a control system could simply make a mistake, perhaps

forgetting to use a control step. Or, the person does not understand how a
control system is to be used, or does not understand the instructions
associated with the system.

Even if you properly train employees and don't have fraudulent behaviors
happening in your organization, human error and misjudgment can still
happen. When business is really busy and a lot of checks are coming in, an
accounting employee might not carefully evaluate each check to determine if
it's fake or authentic. As a result, she might not notice that the check's bank
logo looks questionable and just endorse it for deposit, which will lead to the
check eventually bouncing.

Accounting staff might also encounter unusual situations they've never seen
before, and they may not know how to handle them. Perhaps an employee
accidentally erases some important data from a customer's account and is
unsure how to recover it, or maybe there's an unusual transaction that the
accounting assistant doesn't know how to enter. These issues can especially
occur if your company has high turnover and hires new employees with less
experience. In either case, this lack of experience can cause worker to make the
wrong judgment call or even take no action and cause an error in accounting
system.

To help overcome these limitations of an internal control system, it helps to

perform regular internal audits to check for errors and have new employees
receive mentorship and thorough training. One should also avoid understaffing
accounting department during busy, stressful periods and allow your
employees proper time off to avoid errors from fatigue.

A lot of internal controls are set up based on professional judgment. One hires
staff based on how evaluation of their character. One judges what
responsibilities to give each of workers based on how well one believe they can
do their jobs. As setting up internal controls isn’t an exact science, one has to
rely on the information and try to set up the best rules and processes.
Sometimes, professional judgment is wrong. One fails to set up an internal
control, or doesn’t assign the right task to the right employee.

3. Management override.

Management team who has the authority to do so can override any aspect of a
control system for personal advantage.

A common practice of internal controls is to override the control. Although

there may have policies and procedures in place, there may be exceptions to
the rule where people are allowed to skip certain steps.
For example, assume that there is an employee with the authorization to
approve invoices up to $10,000. If manager is on vacation and an important
invoice arrives for $15,000, the employee may decide to override the
company’s internal control policy to approve the invoice and get it paid.
Although these situations may not produce bad results, an auditor will want to
see you using controls consistently. Having an internal auditor can help you
understand where your controls are falling short or being misused. The first
step is to understand that your internal controls can be overcome. Although it’s
great to have internal controls, there are limits in all controls, and you must
continually evaluate whether they’re working correctly.

4. Missing segregation of duties.

A control system might have been designed with an insufficient segregation of

duties, so that person can interfere with its proper operation.

5 Organizational Structure

Deficiencies in organizational structure make internal control ineffective.

 6 Size of the Organization:
Small organizations have very low levels of internal control, which are
almost negligible due to more interference by owners and management.

7 Unusual Transactions:
The internal control procedures normally fail to keep a check on unusual
transactions.

8. Costly:
The implementation of internal control procedures and processes
involves incurring costs in terms of time, effort and resources.

9. Abuse of Power:
Members at the top-level management may override or interfere with
control.
10. Obsolescence:
Control system may become redundant with passage of time if not updated
with change in the size and nature of business.
11 . Frequent follow-up measures:
Follow-up procedures need to be frequent to ensure its effectiveness, which
is extremely time-consuming.
Internal Control Deficiencies with Examples
As auditors (whether internal and external), are required by standards or by
law or by client’s request to assess the adequacy and the effectiveness of
internal controls. For example, incompanion with independent auditor report
of SEC listed company’s financial statement, SOX required external auditor to
provide an opinion on the adequacy and the effectiveness of internal control
over financial reporting (ICoFR) of the company.

However, principally, the management, not the auditor, who has ultimate
responsibility to assess the adequacy and effectiveness of internal controls.
Basically, the assessment of internal control consists of two aspects:

1. The adequacy of the design of internal control.

Internal control is designed to provide reasonable assurance of the
achievement of objectives, by mitigating significance general and specific
risks. Or, in financial audit engagement, internal control is designed to
prevent or detect material misstatement in the financial statement.
2. The operating effectiveness of controls.
Controls are operating as designed and whether the person performing
the control possesses the necessary authority and qualifications.

Control Deficiency:

"A shortcoming in some aspects (principle, attribute, components) of the

system of internal control, and no compensating controls, and has the potential
to adversely affect the ability of the entity to achieve its objectives." When a
deficiency is existing, management needs to assess the impact of deficiency on
the effectiveness of the internal control. Control deficiencies can be categories
by its reporting purpose:
Deficiencies in Internal Control over Operations, Compliance, and Reporting
other than External Financial Reporting:

• Major non-conformities.
• Minor non-conformities.

Deficiencies in Internal Control over Financial Reporting

• Material Weaknesses
• Significant Weaknesses.

Deficiencies in Internal Control over Operations, Compliance, and Reporting other

than External Financial Reporting:

Major Non-conformities:

Any deficiencies in internal control that relates to compliance, operation, and

non-financial reporting activities that adversely affects the probability that the
entity will achieve its objectives.

Example of MAJOR non-conformity:

• Shipping a product that does not meet quality requirements.

• Making unauthorized changes to product design and manufacturing
specifications.
• Not completing routing maintenance of assets, especially those relate to
public safety (e.g.: aircraft).
• Improper medicine doses to hospitals patients.
• Frequent misreporting of incidences of non-compliance to regulators.
• Missing important information supporting budgeting and forecasting
activities.
• Improper treating, storing, or disposing of hazardous wastes.
• Improper reporting child labour found at supplier’s factories.
• Acquiring inaccurate data for use in actuarial valuations.
• Using product which violated intellectual right – e.g. installing unlicensed
program.

Minor Non-conformities:

Any deficiency relating to compliance, operation, and non-financial reporting

activities that does not adversely affect the probability that the entity will
achieve its objectives.

Multiple minor non-conformities when considered collectively may result in a

determination that a major non-conformity exists. Example: 7% incidences of
failing to keep in maintenance schedule, which exceed 5% tolerable exceptions,
would result a conclusion of major non-conformity.

Example of MINOR non-conformities:

 • Failing to document portion of the quality systems.
• Not inspecting an instrument which passed its calibration date.
• Failing to conduct routine maintenance of assets needed to keep a
warranty alive.
• Filing a compliance statement with a regulator after the required filing
date.
• Not retaining a record for future reference.
• Using in accurate data to prepare MIS for internal analysis.

Material Weaknesses:

A condition in which there is a deficiency or combination of deficiencies, in

internal control such there is a reasonable possibility that a material
misstatement of the entity’s financial statements will not be prevented,
detected, or corrected on a timely basis. The existence of a material weakness
precludes an organization from asserting that the entity’s system of internal
control over external financial reporting is effective.

A material weakness is when a company's internal controls—activities, rules,

and processes designed to prevent significant financial statement irregularities
and improve operation efficiency—is ineffective. If a deficiency in internal
control is a material weakness, it could result in a material misstatement in a
company's financial statements. It makes the company's financial statement
data unreliable and ineffective for assessing the company's financial health and
determining a reasonable company stock price.

When an audit is conducted and a material weakness in the company's internal

controls is detected, the auditor reports the material weakness to the audit
committee. Every publicly-traded company in the US must have a qualified
audit committee.

The audit committee, a part of the board of directors, requires that the
company's management take steps to fix the controls and rectify the material
weakness.
Example of material weaknesses:

Each of the following is an indicator of a control deficiency that should be

regarded as at least a significant deficiency and a strong indicator of a material
weakness in internal control:

• Ineffective oversight of the entity’s financial reporting and internal

control by those charged with governance.
• Restatement of previously issued financial statements to reflect the
correction of a material misstatement.
• Identification by the auditor of a material misstatement in the financial
statements for the period under audit that was not initially identified by
the entity’s internal control. This includes misstatements involving
estimation and judgment for which the auditor identifies likely material
adjustments and corrections of the recorded amounts.
• An ineffective internal audit function or risk assessment function at an
entity for which such functions are important to the monitoring or risk
assessment component of internal control, such as for very large or
highly complex entities.
• For complex entities in highly regulated industries, an ineffective
regulatory compliance function. This relates solely to those aspects of
the ineffective regulatory compliance function for which associated
violations of laws and regulations could have a material effect on the
reliability of financial reporting.
• Identification of fraud of any magnitude on the part of senior
management.
• Failure by management or those charged with governance to assess the
effect of a significant deficiency previously communicated to them and
either correct it or conclude that it will not be corrected.
• An ineffective control environment. Control deficiencies in various other
components of internal control could lead the auditor to conclude that a
significant deficiency or material weakness existsin the control
environment.
Significant Deficiency:

A deficiency or combination of deficiencies less severe than a material

weakness yet may be important enough to merit attention by the board of
directors. Multiple significant deficiencies when considered collectively may
result in a determination that a material weakness exists.

Example of significant weaknesses:

Deficiencies in the following areas ordinarily are at least significant deficiencies

in internal control:

• Controls over the selection and application of accounting principles that

are in conformity with generally accepted accounting principles. Having
sufficient expertise in selecting and applying accounting principles is an
aspect of such controls.
• Antifraud programs and controls.
• Controls over non routine and nonsystematic transactions.
• Controls over the period-end financial reporting process, including
controls over procedures used to enter transaction totals into the
general ledger; initiate, authorize, record, and process journal entries
into the general ledger; and record recurring and nonrecurring
adjustments to the financial statements.

Other types of Deficiency

1. Inadequate documentation / records

Documentation provides evidence of the underlying transactions. It is the

input in proper financial records. Financial documents should be pre-
numbered to ensure all transactions are recorded and accounted for.
This will help to prevent recording of the same transaction twice, as
there should not be any duplicate numbers in your system. With proper
numbering of documentation, tracing documents that relate to follow up
 queries/claims and questions from customers or owners of prior
transactions will be easy.

Proper documentation would most probably provide satisfactory answers

to most, if not all, financial transaction related questions. Furthermore,
adequate documentation will ease the process of compiling financial
records and completing tax returns.

2. Key business cycles not properly defined

Owners don’t see the need to create written policies and procedures or
just even basic flowcharts defining the key business processes, as some
small business processes appear to be uncomplicated. However, this is
one of the most unused control tools where the most value can be added
with little effort. An effective procedure can align business objectives and
help establish best practice operating procedures. As businesses have
different focus areas, different cycles will be important to your business
but for most businesses the following processes will be critical.

Sales and Accounts Receivable, Cash Management, Banking Procedures,

Purchases, and Accounts Payable. For a business selling goods, inventory
controls will be an important cycle. Documenting key controls in each of
these cycles will provide transparency and consistency. Specific roles and
responsibilities in each of these cycles can easily be assigned to specific
individuals. When improvements and changes are made to your
processes, employees can quickly be informed, trained, and brought up
to speed.

3. Lack of control with authorization of transactions

Authorization of purchases should occur before the commitment of

resources. Depending on the size of the business, levels of authority can
be introduced to better eliminate the risk of inappropriate spending. For
example, with orders above a certain dollar value, say $1,000, more than
one quotation should be obtained which could ultimately reduce your
overall expenditure. Authorizing of transactions before placing orders
provides the owners/managers the opportunity to evaluate different
 purchasing options, and make sure items or services obtained will
support the business objectives.

4. No oversight and review

Small business owners many times get so involved in the day to day
operations of the business that they tend to neglect performing basic
review procedures. Business owners should take some time and interest
in the financial records. This is an important aspect of fraud prevention.
Not a lot of time is required to review monthly revenues, expenditure
reports, inventory reports, budget vs. actual amounts, and variance
reports. Having a more hands on approach will give the owner invaluable
feedback on how the business is performing and where any potential
problem areas or poor performance areas may exist. Review of the
financial records is a critical component and input for better decision
making. The frequency of the review of financial data depends on the
volume of transactions and type of business, however, the review of
financial data should generally be conducted on a monthly basis.

5. Ineffective information systems

Small businesses run on lean resources and very little time is often spent
evaluating information systems. Investing time in this area could add a
lot of efficiencies in the long run. List the systems in your business and
the key performance measures you need from each. Working
systematically though these will help you stay competitive and
efficient. Many user-friendly software systems are out there which could
shorten processing and operating cycles.

6. Lack of physical & logical security

Lack of physical security of business assets and resources could result in

the loss or damage to assets and resources. Access to equipment, petty
cash, and check stock should be restricted to appropriate individuals and
stored or locked in an appropriate secure location. Computer equipment
 and networks should be password protected and computer passwords
should be changed regularly. Having firewalls and protective devices or
software on computer systems is an important component to help
prevent security breaches. Protection of personal information and
banking information are becoming increasingly important with the
increase in risk of identity/credit card theft. Personal and employee data
should be encrypted and stored in secure folders.

7. No formal ethical policies and procedures

This control may not seem to be crucial for the success of a business, but
without clear guidelines on the use of the business assets and
expectations, in terms of integrity and ethics from employees, businesses
can expose themselves to inefficiencies and misappropriation of assets.
A code of ethics is an open disclosure of the way an organization
operates. A well written and thoughtful ethics policy can serve as a
communication vehicle that reflects important values and goals of the
business. It can provide guidelines of how employees should deal with
potential misbehavior and/or misappropriation of assets and can provide
alignment with regard to company values and commitments.

8. Job roles and responsibilities not clearly defined

Employees are your most important assets and as a small business you
are very reliant on your employees. They are representatives with
customers, suppliers, and competitors. For this valuable resource to be
effective in your business you will need to provide clear direction and
define appropriate roles and responsibilities for each employee. Job
roles and responsibilities should be clear and preferably be in writing.
This will ease the process of separating duties discussed in the next
section. New employees will quickly be able to reference back to their
responsibilities and understand their roles better.

9. Lack of separation of duties

 Small businesses are susceptible to fraud by their own employees as they
may have a few employees with multiple roles. Each employee should
have specific job responsibilities, preferably in writing to ensure there is
no confusion in assigned job roles and responsibilities. Generally,
assigning different people the responsibilities of authorizing transactions,
recording transactions, and maintaining custody of related assets such as
cash and credit cards provides for more effective internal control and
less opportunities for misappropriation of assets.

10. Insufficient disaster recovery, backups and business continuity

plans (BCP).

The importance of backups and business continuity are many times

under-emphasized. Systems can be designed so that back-ups are
performed automatically and on a regular basis. Backups should be
made based on transaction volume and stored off-site. To re-create data
can be painful, time consuming, or not practical at all. Business
Continuity plans outline how recovery will be accomplished in case of a
disaster. Long term power outages or disruptions, offices not available
for long periods of time, and loss of staff on a large scale are not that
uncommon and can happen. Planning ahead for disasters before they
strike is important to the survival of your business. A disaster recovery
plan typically consists of an emergency plan, disaster recovery plan, and
a continuity plan.

Types of Internal Controls

Internal controls are the policies and procedures that a business puts
into place in order to protect its assets, ensure its accounting data is
correct, maximize the efficiency of its operation and promote an
atmosphere of compliance among its employees. There are three main
types of internal controls: detective, preventative and corrective.
As the name suggests, corrective internal controls are put into place to
correct any errors that were found by the detective internal controls.
When an error is made, employees should follow whatever procedures
have been put into place to correct the error, such as reporting the
problem to a supervisor. Training programs and progressive discipline for
errors are other examples of corrective internal controls.

Detective Internal Controls

Detective internal controls are designed to find errors after they have
occurred. They serve as part of a checks-and-balances system and to
determine how efficient policies are. Examples include surprise cash
counts, taking inventory, review and approval of accounting work,
internal audits, peer reviews, and enforcement of job descriptions and
expectations. Detective internal controls also help protect assets. For
instance, if a cashier does not know when her cash drawer will be
counted, she may be more likely to be honest.

Detective internal controls are those controls that are used after the fact
of a discretionary event. Think of Sherlock Holmes, walking onto the
scene of an event, trying to piece together what happened.
 • What caused the event to occur?
• What process failed that allowed the event to occur?
• Is there a policy that can be implemented to keep the event from
happening again in the future?

Some examples of detective controls are internal audits, reviews,

reconciliations, financial reporting, financial statements, and physical
inventories.

Preventative Internal Controls

Preventative internal controls are put into place to keep errors and
irregularities from happening. While detective controls usually occur
irregularly, preventative controls usually occur on a regular basis. They
range from locking the building before leaving to entering a password
before completing a transaction. Other preventative controls include
testing for clerical accuracy, backing up computer data, drug testing of
employees, employee screening and training programs, segregation of
duties, enforced vacations, obtaining approval before processing a
transaction and having physical control over assets.

Preventative internal controls are those controls put in place to avert a

negative event from occurring. For example, most applications have
checks and balances built-in to avoid or minimize entering incorrect
information. There are also physical controls or administrative preventive
controls, such as segregation of duties that are routinely performed by
companies.

Assigning one person to write checks, and another staff member to

authorize the payments, are segregation of duties that fall under the
umbrella of preventative controls from an administrative standpoint.
Others, like video surveillance or posting security guards at entry points
verifying ID credentials and restricting access, are illustrative of physical
safeguards.
Training programs, drug testing, firewalls, computer and server backups
are all types of preventative internal controls that avoid asset loss and
undesirable events from occurring.

Corrective Internal Controls

As the name suggests, corrective internal controls are put into place to
correct any errors that were found by the detective internal controls.
When an error is made, employees should follow whatever procedures
have been put into place to correct the error, such as reporting the
problem to a supervisor. Training programs and progressive discipline for
errors are other examples of corrective internal controls.

Corrective internal controls are typically those controls put in place after
the detective internal controls discover a problem. These controls could
include disciplinary action, reports filed, software patches or
modifications, and new policies prohibiting practices such as employee
tailgating. They are usually put into place after discovering the reasons
why they occurred in the first place.

OTHER CONTROLS
Feed forward controls are future-oriented which attempt to detect and
anticipate problems or deviations from the standards in advance of their
occurrence (at various points throughout the processes). They are in-
process controls and are much more active, aggressive in nature,
allowing corrective action to be taken in advance of the problem.

Feed forward controls thus anticipate problems and permit action to be

taken before a problem actually arises.

Feed forward control devices are of two broad categories: diagnostic and
therapeutic.
Diagnostic controls seek to determine what deviation is taking (or has
taken) place. The sales manager, for instance, who receives the monthly
sales figures, is virtually working with a diagnostic control device. It will
no doubt indicate deviations from the acceptable standard but not why.
Discovering the ‘why’ is often the most difficult part of the process.
DIFFERENCE BETWEEN FEEDBACK AND FEED FORWARD CONTROL
SYSTEMS
Internal controls in a computer environment

The two main categories are application controls and general controls.

Application controls

Application controls include both automated and manual procedures that

ensure that only authorized data are completely and accurately processed by
that application.

Application controls can be classified as

(1) Input controls,
(2) Processing controls, and
(3) Output controls.

Input controls check data for accuracy and completeness when they enter the
system. There are specific input controls for input authorization, data
conversion, data editing, and error handling.
Processing controls establish that data are complete and accurate during
updating. Run control totals, computer matching, and programmed edit checks
are used as processing controls.

Output controls ensure that the results of computer processing are accurate,
complete, and properly distributed. Table 2 provides more detailed examples
of each type of application control. Not all of the application controls discussed
here is used in every information system. Some systems require more of these
controls than others, depending on the importance of the data and the nature
of the application.

These are manual or automated procedures that typically operate at a business

process level and apply to the processing of transactions by individual
applications. Application controls can be preventative or detective in nature
and are designed to ensure the integrity of the accounting records.

Accordingly, application controls relate to procedures used to initiate, record,

process and report transactions or other financial data. These control s help
ensure that transactions occurred, are authorized and are completely and
accurately recorded and processed.

Application controls apply to data processing tasks such as sales, purchases and
wages procedures and are normally divided into the following categories:

(i) Input controls

Examples include batch control totals and document counts, as well as manual
scrutiny of documents to ensure they have been authorized. An example of the
operation of batch controls using accounting software would be the checking of
a manually produced figure for the total gross value of purchase invoices
against that produced on screen when the batch-processing option is used to
input the invoices. This total could also be printed out to confirm the totals
agree.

The most common example of programmed controls over the accuracy and
completeness of input are edit (data validation) checks when the software
checks that data fields included on transactions by performing:
• Reasonableness check, e.g. net wage to gross wage
• Existence check, e.g. that a supplier account exists
• Character check, e.g. that there are no alphabetical characters in a sales
invoice number field
• Range check, e.g. no employee’s weekly wage is more than $5,000
• Check digit, e.g. an extra character added to the account reference field
on a purchase invoice to detect mistakes such as transposition errors during
input.

When data is input via a keyboard, the software will often display a screen
message if any of the above checks reveal an anomaly, eg ‘Supplier acc ount
number does not exist’.

(ii) Processing controls

An example of a programmed control over processing is a run-to-run control.

The totals from one processing run, plus the input totals from the second
processing, should equal the result from the second processing run. For
instance, the beginning balances on the receivables ledger plus the sales
invoices (processing run 1) less the cheques received (processing run 2) should
equal the closing balances on the receivable ledger.

(iii) Output controls

Batch processing matches input to output, and is therefore also a control over
processing and output. Other examples of output controls include the
controlled resubmission of rejected transactions or the review of exception
reports (e.g. the wages exception report showing employees being paid more
than $1,000).

(iv) Master files and standing data controls

Examples include one-for-one checking of changes to master files, eg customer

price changes are checked to an authorized list. A regular printout of master
files such as the wages master file could be forwarded monthly to the
personnel department to ensure employees listed have personnel records.

General controls
General controls include software controls, physical hardware controls,
computer operations controls, data security controls, controls over the systems
implementation process, and administrative controls

These are policies and procedures that relate to many applications and support
the effective functioning of application controls. They apply to mainframe,
mini-frame and end-user environments.

General IT controls that maintain the integrity of information and security of

data commonly include controls over the following:
 • Data Centre and network operations
• system software acquisition, change and maintenance
• Program change
• Access security
• Application system acquisition, development, and maintenance

6. Which of the following is a general control instead of a transaction control

activity?

Technology development policies and

A
procedures.
B Reconciliations.
C Physical controls over assets.
D Controls over standing data.

7. Information technology controls are classified into the categories of

preventive, detective, and corrective. Which of the following is a preventive?

A Contingency planning.
B Hash total.
C Echo check.
D Access control
 software.

8. Which of the following is an example of a general control for a computerized

system?

Restricting entry of sales transactions to only valid credit

A
customers.
Creating hash totals from Social Security numbers for the
B
weekly payroll.
Restricting entry of accounts payable transactions to only
C
authorized users.
Restricting access to the computer center by use of biometric
D
devices.

9. Which of the following is not a deficiency of internal control?

Human judgment in decision making may

A
be faulty.
B External forces may attack the system.
Management may override internal
C
control.
D Controls may be circumvented by collusion.

10. Which of the following is an instance of a detective control?

A Use of pre-formatted screens for data entry.
B Comparison of data entry totals to batch control totals.
Limited access to the computer operations center to data-processing
C
staff only.
Appointing a file librarian to maintain custody of the program and
D
data files.

11. ABC Company’s new shift timing process requires hourly employees to
select an identification number and then choose the punch-in or punch-out
button. A video camera captures an image of the employee using the system.

Which of the following can the new system be expected to change the least?

Fraudulent reporting of employees'

A
hours.
B Errors in employees' overtime.
Inaccurate accounting of employees'
C
hours.
D Recording of other employees' hours.
INTERNAL CONTROL ROLES AND RESPONSIBILITIES
ROLES AND RESPONSIBILITIES
Board Member’s Role in Internal Controls

The Board of Directors has the overall responsibility for internal control relating to financial
reporting and an important part of the Board’s work is to issue controlling instructions. The
Board establishes a Work Programme that clarifies the Board’s responsibilities and regulates
the internal distribution of work between the Board, its Committees and the Management.

The control environment represents the basis for the internal control over financial
reporting. An important part of the control environment is that decision paths, authorities
and responsibilities must be clearly defined and communicated between various levels in
the organisation and that the control documents are available in the form of internal
policies, handbooks, guidelines and manuals. Thus, important part of the Board’s work is to
prepare and approve a number of fundamental policies, guidelines and frameworks. These
include, among other things, the Board’s rules of procedure, Instructions for the President,
Investment policies, financial policies and the Insider policy. The aim of these policies is to
create a basis for sound internal control.

The Board also focuses on ensuring that the organizational structure provides distinct roles,
responsibilities and processes that benefit the effective management of the operation’s
risks and facilitate goal fulfillment. Part of the responsibility structure includes an obligation
for the Board to evaluate the operation’s performance and earnings on a regular basis,
through appropriate report packages containing income statements, balance sheets,
analyses of important key figures and comments pertaining to the business status of each
operation. The Board has established an Audit Committee to assist the Board specifically in
the financial reporting.

Directors should have to conduct reviews of the effectiveness of the company’s or group’s
internal controls systems. Regular reviews performed by independent third parties will
focus board members’ attention on the issue and adequacy of internal controls.

Following are key roles that board members should keep in mind when it comes to internal
controls.

1. It should comprise of individuals who have sufficient independence from

management—in action, in appearance, and in actuality. Independence strengthens
the board’s ability to enforce accountability by management and helps to avoid the
perception of conflict of interest, both by staff and by the public.
2. Review the development and implementation of internal controls by the CEO or
senior management. Even the smallest organizations can implement some degree of
internal control, and it is the board’s responsibility to ensure that management is
implementing and enforcing them.
3. Review management’s response to accounting and reporting control deficiencies and
weaknesses. A control deficiency or weakness is a serious issue that has been
identified by an internal or external audit function. The Board is responsible for
holding management accountable for responding to and acting on these findings
timely.
4. Work with management to establish standards of conduct and an ethically
sound tone at the top. The board should help to define expectations about financial
reporting transparency, integrity, and ethical values. The tone at the top trickles
down through the organization and sets a consistent tone and overall standar d for
conduct.
5. Maintain whistleblower policy to report business conduct issues or nefarious activity.
Having a weak or inconsistent reporting policy can discourage those who would
otherwise report on internal control or conduct issues.

According to the Association of Certified Fraud Examiners ‘Report to the Nations’, an

anonymous phone or email “hotline” is the most frequently reported detection
method in the initial finding of fraud. A hotline is inexpensive and easy to set up for
any organization, regardless of size.
6. Define and evaluate the skills and expertise needed among its members to be able to
understand and identify issues affecting the organization. E.g., the treasurer should
have a strong understanding of finance and accounting to perform his or her duties
successfully.
7. Engage in “constructive challenge” conversations with management. The ability to
identify and verbalize focused questions allows board members—who have limited
 time—to leverage their experience and maximize their benefit to the non-profit
organization. The board should require follow-up and corrective action for all issues
identified through this process.
8. Create oversight structures, such as committees to focus on specialized topics. For
example, an audit committee should be created to oversee internal controls and
promote transparency over the organization’s financial reporting.
9. Consider the organization’s internal and external risks and challenge management’s
assessment of those risks. Identifying an organization’s potential risks is key
components in creating controls that will help the organization reach its goals. Risks
should be considered on a continual basis as the organization or business
environment changes or grows.
10. Exercise fiduciary responsibilities to stakeholders and practice due care in oversight,
which includes preparing for and attending meetings, reading the financials,
attending board training if needed, and other various duties that promote the
organization’s success and well-being.

Out of a board member’s many responsibilities, internal control oversight is one of the most
important roles in helping an organization reach its goals.

Management and Support Staff Role in Internal Controls

Management is responsible for maintaining an adequate system of internal control.
Management is responsible for communicating the expectations and duties of staff as part
of a control environment. They are also responsible for assuring that the other major areas
of an internal control framework are addressed.

The governing board’s responsibilities for internal controls primarily involve oversight,
authorization and ethical leadership. Generally, governing boards do not design internal
controls or prepare the written policies they adopt. The governing board relies upon
management, especially the chief executive officer (CEO), to create the policies needed to
ensure that services are provided effectively and assets safeguarded.
 The CEO in turn relies upon managers and department heads to recommend and
implement procedures that lower identified risks. Each board member should carefully
review and seek to understand policies and procedures presented to them for ratification.
Within the managerial ranks, the CEO provides the leadership needed to establish and guide
an integrated internal control framework. The CEO establishes a positive “tone at the top”
by conducting an organization’s affairs in an honest and ethical manner and establishing
accountability at all levels of the organization. If the CEO does not demonstrate st rong
support for internal controls, the organization as a whole will be unlikely to practice good
internal controls.

Even though the CEO leads the entity’s approach to the control framework, it is the
operational managers and department heads who are the front line for implementing and
monitoring internal controls. Managers and department heads are generally responsible for
identifying potential risks, designing and implementing controls for their areas of
responsibility, and keeping current with events and changes that affect the controls they
have put into place. Operational managers, however, rely upon the CEO to provide the
leadership and the entity-wide communication needed to foster an integrated internal
control framework.
The governing board shapes the organization’s tone-at-the top by demonstrating integrity,
honesty and ethical behavior in its handling of decisions and sensitive issues. Finance
officers and operational managers support the internal control initiatives of the CEO and the
governing board in daily operations. All levels of management must work together to create
an integrated framework that lowers risk to an acceptable level and assists the organization
in meetings its goals and objectives.

Management is responsible for the integrity and objectivity of the information in these
financial statements. Some of the information in the financial statements is based on
management’s best estimates and judgment and gives due consideration to materiality.

Furthermore, every employee plays a role in either strengthening or weakening the

Institution’s internal control system. Therefore, all employees need to be aware of the
concept and purpose of internal controls.

Management seeks to ensure the objectivity and integrity of data in its financi al statements
through careful selection, training, and development of qualified staff; through
organizational arrangements that provide appropriate divisions of responsibility; through
communication programs aimed at ensuring that regulations, policies, standards, and
managerial authorities are understood throughout the Department; and through conducting
an annual assessment of the effectiveness of the system of internal control over financial
reporting.

Employees are responsible for the following:

• Fulfilling the duties and responsibilities established in their job description and
meeting applicable performance standards.
 • Taking all reasonable steps to safeguard University assets and resources against
waste, loss, damage, unauthorized use, or misappropriation.
• Reporting breakdowns in internal control systems or suggesting improvements to
their supervisor.
• Refraining from using their position to secure unwarranted privileges.
• Attending education and training programs as appropriate to increase awareness and
understanding

Managers have these responsibilities:

• Documenting policies and procedures to be followed in performing unit functions.

• Maintaining a work environment that encourages employees to understand the
purpose of policies and procedures and that supports the maintenance of a positive
internal control environment.
• Identifying the objectives for implementing cost effective internal controls designed
to meet those objectives.
• Regularly testing the internal controls implemented to determine if they ar e
functioning as decided.
• Listening to employee suggestions regarding the internal control systems.

Internal Auditor’s Role in Internal Controls

The role of the internal auditor is that of an objective advisor with respect to the design and effectiveness
of internal controls implemented by management. The internal auditor examines and reports to the
governing board about the design and effectiveness of internal controls. The internal auditor will test how
well existing internal controls are functioning, and recommend necessary changes and improvements.
Ideally the internal auditor will work closely, but independently, with management and the audit
committee to strengthen the system of internal controls and adapt it to new risks and changing
conditions.

Auditors play a role in a system of internal controls by performing evaluations and making
recommendations for improved controls.

The internal auditor should report directly to the governing board or, if the board has established an audit
committee, then to that committee. The more independent the internal auditor is from management, the
more likely his or her work is to serve the organization’s needs. Broadly speaking, the internal auditor
supplements management oversight by independently monitoring whether adopted policies and
procedures are being followed. The internal auditor’s work should focus on areas with the greatest
inherent risk of error or fraud.

The internal audit helps an organization to accomplish its objectives by bringing a systematic, disciplined
approach to evaluate and improve the effectiveness of risk management, control and governance
processes.

Consistent with its mission, the Internal Audit Department provides management with information,
appraisals, recommendations, and counsel regarding the activities examined and other significant issues.

Independence is essential to the effectiveness of the internal audit function. In carrying out the duties
and responsibilities, the Director of Internal Audit will issue reports to the Vice President and General
Counsel in charge of the internal audit function, Senior Vice President, and the Vice President concerned.
The Director of Internal Audit will meet with the Finance and Audit Committee of the Board of Trustees
periodically to report the plans for audit activity, the results of audit activity, and to provide any other
information required. The Director of Internal Audit has direct access to the President and the Board
should matters of immediate significance arise which demand such attention.

Internal audit functions include:

• Performing examinations of operating and financial controls

• Conducting efficiency and effectiveness reviews
• Conducting reviews of compliance with laws and other external regulations
• Evaluating the design and execution of internal controls.
• Conduct timely implementation of risk-based internal audits as directed by controller complying
with annual audit plan.
• Assist on various audit projects and matters and ensure to have initial focus on revenue
assurance.
• Conduct risk evaluation of assigned functional area or department in established timeframe.
• Contribute to Office of Internal Oversight as well as Evaluation Services (IES) risk evaluation of
internal audit of organization.
• Implement internal audit tasks in areas of risk management and internal control.
• Perform all assigned audit assignment at financial, operational and administrative processes and
systems.
• Evaluate internal audit suitability, efficiency, cost-effectiveness and internal controls
effectiveness.
• Identify level of conformance with established rules, regulations, policies and procedures;
• Examine validity and reliability of financial, accounting and other data and report any deviations.
• Participate in audit engagement planning, reporting, scoping, execution and follow-up as defined.
• Study and learn company policy and procedures.
• Evaluate comprehensive business processes and transactions to analyze productiveness of
controls and risk alleviation.
 • Identify internal audit control environment enhancement opportunities.
• Conduct testing adhering with accreditation and varied regulatory requirements.
• Support development of internal audit programs for operational audits and special reviews etc.

Audit Committee’s Role in Internal Controls

The primary purpose of a company’s audit committee is to provide oversight of the financial reporting
process, the audit process, the company’s system of internal controls and compliance with laws and
regulations.

The audit committee can expect to review significant accounting and reporting issues and recent
professional and regulatory pronouncements to understand the potential impact on financial statements.
An understanding of how management develops internal interim financial information is necessary to
assess whether reports are complete and accurate.

The committee reviews the results of an audit with management and external auditors, including matters
required to be communicated to the committee under generally accepted auditing standards. Controls
over financial reporting, information technology security and operational matters fall under the purview
of the committee.

The audit committee is responsible for the appointment, compensation and oversight of the work of the
auditor. As such, CPAs report directly to the audit committee, not management.

Audit committees meet separately with external auditors to discuss matters that the committee or
auditors believe should be discussed privately. The committee also reviews proposed audit approaches
and handle coordination of the audit effort with internal audit staff. When an internal audit function
exists, the committee will review and approve the audit plan, review staffing and organization of the
function, and meet with internal auditors and management on a periodic basis to discuss matters of
concern that may arise.

Audit committees must have authority over their own budgets and over external auditors. It is through
these protections that investors will come to trust the financial reports released by companies.

While boards should seek members who can provide a diverse range of competent perspectives based on
their experience and expertise, it is nevertheless imperative that board members are knowledgeable and
conversant in the language of finance and accounting. This need is particularly acute for the audit
committee.

More commonly found in the corporate environment, audit committees are also being established in
school districts, and to a lesser extent in local governments. Generally, the role of the audit committee is
to help the governing board understand and collaborate with the annual (external) audit process. The
traditional responsibilities of the audit committee are: to review and discuss with the external auditor the
risk assessment developed as part of its audit planning process; to receive and review the draft audit
report and management letter; to assist the board in interpreting these documents; and to make a
recommendation to the board regarding the acceptance of the annual audit report.

Same way, the audit committee can act as a liaison between the internal auditor and the board. Possible
additional roles for the audit committee include:

• Making recommendations to the board regarding the appointment of the internal auditor.

• Assisting in the oversight of the internal audit function, including reviewing the annual internal audit
plan to ensure that high risk areas and key control activities are periodically evaluated and tested.

• Reviewing the results of internal audit activities.

• Monitoring implementation of the internal auditor’s recommendations.

• Participating in the evaluation of the performance of the internal audit function

Key matters commonly included within a charter cover the following:

• Purpose;
• Authority;
• Composition;
• Meetings;
• Responsibilities:
• Financial reporting;
• Working with the external auditor
• Working with the internal audit activity
• Risk management and internal control;
• Compliance with laws, regulations, ethical requirements, internal policies and industry standards;
• Management and reporting of fraud;
• Reporting responsibilities;
• Evaluating performance;
 • Review of the audit committee charter; and
• Other responsibilities as deemed important.

12. AS per COSO, which of the following provides an instance of a top-level review as a
control activity?

Computers are owned by the entity are secured and periodically compared with
A
amounts shown in the records.
A comprehensive marketing plan is implemented, and management reviews actual
B
performance to decide the scope to which benchmarks were achieved.
C Reconciliations are done of daily wire transfers with positions reported centrally.
Verification of medical claim status determines whether the charge is appropriate for
D
the policy holder.

13. ABC Corp. has an ERP system which has assigned responsibility for determining who has
what access rights within the ERP system. Based on this, to whom is it most likely that
ABC Corp. has assigned this responsibility?

A Internal auditors.
B Other personnel.
C Management
D Support functions
14. The IT department at ABC Corp. has learned phishing attempts that rely on social
engineering to break financial systems. Information about these should be
communicated to:

A Internal auditors.
B Other Staff.
C All Staff.
D Support functions.

15. As per COSO framework, if an organization outsources certain activities within the
business to third party:

A Responsibility also transfers to the third party.

B The responsibilities never transfer to the third party.
The responsibilities only transfer if the outside party explicitly agrees to accept
C
responsibility.
D The organization is no longer accountable for the outsourced activities.

16. As per COSO, the presence of a written code of conduct provides for a control
environment that can

A Override an entity's history and culture.

B Encourage teamwork in the pursuit of an entity's objectives.
C Ensure that competent evaluators are implementing and monitoring internal controls.
Verify that information systems are providing persuasive evidence of the
D
effectiveness of internal controls.
INTERNAL CONTROL MONITORING
PURPOSE AND TERMINOLOGY
Monitoring Helps Corporate Governance

Over the past decade, organizations have invested heavily in improving the quality of their
internal control systems. They have made the investment as they believe:

(1) Good internal control is good business — it helps organizations to ensure that operating,
financial and compliance objectives are met, and

(2) Many organizations are required to report on the quality of internal controls over
financial reporting which allow them to develop specific support for their certifications and
assertions.

Internal control is designed to assist organizations in achieving their objectives. The five
components of COSO’s Internal Control (the COSO Framework) work in line to mitigate the
risks of an organization’s failure to achieve those objectives.

The COSO recognizes that management’s assessment of internal control often has been a
time-consuming task that involves a significant amount of annual testing. Effective
monitoring system can help streamline the assessment process, but many organizations do
not understand this important component of internal control. As a result, they underutilize
it in supporting their assessments of internal control.
Figure 1 shows the comprehensive nature of monitoring and illustrates how effective
monitoring considers the collective effectiveness of all five components of internal control.

Monitoring in Internal Control Process

Corporate governance has generally a broad scope. It includes both social and institutional
aspects. Corporate governance is the system by which companies are directed and
managed. It influences how the objectives of the company are decided and achieved, how
risk is monitored & assessed, & how performance is optimized.

Corporate governance is the system of principles, policies, procedures, and clearly defined
responsibilities and accountabilities used by stakeholders to overcome the conflicts of
interest inherent in the corporate form. It is the interaction between various participants in
shaping company’s performance and the way it is proceeding towards. Corporate
governance deals with determining ways to take effective strategic decisions and developed
added value to the stakeholder.

It ensures transparency which ensures strong and balance economic development. It also
ensures that the interests of all shareholders are safeguard.
It affects the operational risk and, hence, sustainability of a corporation.
The quality of a corporation’s corporate governance affects the risks and value of the
corporation. Effective and strong corporate governance is essential for the efficient
functioning of markets.

Corporate governance has become increasingly important for the council and as a result, in
2009 we reviewed our code of corporate governance, our annual assurance process and the
work of the corporate governance group.

Compliance with our code of corporate governance and any national guidance is carried out
through an annual assurance test. The results of this test are monitored by the corporate
governance group which is chaired by the Chief Executive and reported to the senior
leadership team, the audit committee and council through the annual governance
statement.

The chief executive and leader will prepare the annual governance statement as part of the
annual statement of accounts giving their opinion on whether the corporate governance
arrangements are adequate and are operating effectively.

Internal corporate governance controls play a vital role in ensuring the success of a business
organization and preventing corporate fraud.

Internal control activities that ensure proper corporate governance include:

• Monitoring by board
• Internal audits and robust policies
• Proper balance of power
• Performance based remuneration
• Monitoring by majority shareholders and other stakeholders

Monitoring by board

The board should monitor the corporate governance of the company through continuous
review of its internal structure. It ensures that there are defined lines of accountability for
management throughout the company.
The board should also monitor and review:
 Corporate strategy

Major plans of action

Risk policy

Annual budgets and business plans

Corporate performance

Major capital expenditures, acquisitions and

divestitures

Governance practices and changes

Selection, compensation and succession

planning of executives

Internal audits and policies

Regular internal audits have to be carried out by auditors employed by the organization in
order to assess the health of governance processes, operational health and financial
reporting.

Robust internal control policies should also be designed and implemented to ensure that
the company lives up to its obligations to investors, stakeholders, employees, the
environment, the government and the public at large.
Proper balance of power

A separation of powers and responsibilities between management groups ensures proper

system of checks and balances in place, with one group implementing policies and another
ensuring that these are implemented and functioning in the right manner.

Performance based remuneration

Executive pay is expected to be linked to performance to ensure that management is

rewarded for operating the company keeping in mind the rights of investors and other
stakeholders.

Monitoring by shareholders and other stakeholders

Individuals and institutions that have large have the right to monitor the performance of the
management, acting as an effective internal control measure.

PURPOSE OF MONITORING

As control activities help to ensure that risk management actions are carried out,
monitoring helps to ensure that control activities and other planned actions to affect
internal control are carried out properly and in a timely manner, and that the end result is
effective internal control.

Separate evaluations such as self-assessments as done by departmental employees and

internal audits, are periodic evaluations of internal control components resulting in a formal
report on internal control.

How Does Monitoring help the Governance Process?

Unmonitored controls tend to deteriorate over time. Monitoring, as defined in the COSO
Framework, is implemented to help ensure “that internal control continues to operate
effectively.”

When monitoring is designed and implemented appropriately, organizations benefit

because they are more likely to:
 Identify and correct internal Produce more accurate and
control problems on a timely reliable information for use in
basis. decision-making.

Prepare accurate and timely
financial statements.
Be in a position to provide
periodic certifications or
assertions on the
effectiveness of internal
control.

Over the period of time effective monitoring can lead to organizational efficiencies and
reduced costs associated with public reporting on internal control because problems are
identified and addressed in a proactive, rather than reactive, manner.

Fundamentals of Effective Monitoring

COSO’s Monitoring Guidance builds on two fundamental principles originally established in :

 Ongoing and/or separate evaluations
enable management to determine
whether the other components of internal
control continue to function over time,
and

Internal control deficiencies are identified

and communicated in a timely manner to
those parties responsible for taking
corrective action and to management and
the board as appropriate.

The monitoring guidance further suggests that these principles are best achieved through
monitoring that is based on three broad elements:

1. Establishing a foundation for monitoring, including

(a) A proper tone from the top;
(b) An effective organizational structure that assigns monitoring roles to people
with appropriate capabilities, objectivity and authority.
(c) A starting point or “baseline” of known effective internal control from which
ongoing monitoring and separate evaluations can be implemented.

2. Designing and executing monitoring procedures focused on persuasive information

about the operation of key controls that address meaningful risks to organizational
objectives.

3. Assessing and reporting results, which includes evaluating the severity of any
identified deficiencies and reporting the monitoring results to the appropriate
personnel and the board for timely action and follow-up if needed.

Monitoring Processes
Organizations may select from a wide variety of monitoring procedures, including but not
limited to:
 Periodic evaluation and testing of controls by internal audit,

Continuous monitoring programs built into information systems,

Analysis of, appropriate follow-up on, operating reports or metrics that might
identify anomalies indicative of a control failure,

Supervisory reviews of controls, such as reconciliation reviews as a normal

part of processing,

Self-assessments by boards and management regarding the tone they set in

the organization and the effectiveness of their oversight functions,

Audit committee inquiries of internal and external auditors

Quality assurance reviews of the internal audit department.

Continued advancements in technology and management techniques ensure that internal

control and related monitoring processes will change over time. However, the fundamental
concepts of monitoring, as outlined in COSO’s Monitoring Guidance, are designed to stand
the test of time.

Guidance to Move Monitoring Forward

Management can begin the monitoring process by encouraging the people with control
system responsibility to read COSO’s Monitoring Guidance and consider how best to
implement it or whether it has already been incorporated into certain areas. Further,
personnel with appropriate skills, authority and resources should be charged by
management with addressing these four fundamental questions:

1. Have the meaningful risks to our objectives been identified, for example, the risks
related to producing accurate, timely and complete financial statements?
 2. Which controls are “key controls” which support a conclusion regarding the
effectiveness of internal control in those risk areas?
3. What information will be persuasive in telling us whether the controls are continuing
to operate effectively?
4. Are we presently performing effective monitoring that is not well utilized in the
evaluation of internal control, resulting in unnecessary and costly further testing?

Management and BOD should understand the concepts of effective monitoring and how it
serves their respective interests. As the board learns more about monitoring, it will develop
the knowledge necessary to ask management in relation to any area of meaningful risk,
“How do you know the internal control system is working?”

COSO’s Guidance on monitoring is designed to help organizations answer these and other
questions within the context of their own unique circumstances — circumstances that will
change over time. As they progress in achieving effectiveness in monitoring, organizations
likely will have the opportunity to further improve the process through the use of such tools
as continuous monitoring software and exception reports tailored to their processes.

It also covers other concepts important to effective and efficient monitoring which include:

• The characteristics associated with the objectivity of the evaluator;

• The period of time and the circumstances by which an organization can rely on
adequately designed indirect information — when used in combination with ongoing
or periodic persuasive direct information — to conclude that internal control
remains effective;
• Determining the sufficiency and suitability of information used in monitoring to
ensure that the results can adequately support conclusions about internal control;
and
• Ways in which the organization can make monitoring more efficient without
reducing its effectiveness.

Many organizations, through applying the concepts set forth in the guidance, should
improve the effectiveness and efficiency of their internal control systems. To that end,
COSO’s Monitoring Guidance is designed to help organizations

(1) Identify effective monitoring where it exists and use it to the maximum and

(2) Identify less effective or efficient monitoring requiring improvements. In both instances,
the internal control system may be improved, increasing the likelihood that organizational
objectives will be achieved.
Implementing an internal control system designed around your organization’s specific risks
is a necessity for any organization. Internal controls must be properly designed a nd
implemented to be useful in achieving your organizations strategic, operating, compliance,
and reporting objectives. Internal controls allow an organization’s management piece of
mind knowing everything is operating properly without having to oversee ev ery facet of the
organization.

Monitoring internal controls is essential to ensure controls are operating efficiently.

Monitoring involves the use of evaluations by management and third-parties of the controls
in place to identify issues and communicate these issues to the appropriate parties for
corrective action to be taken. Implementing a competent monitoring system can be
incredibly cost-effective to your organization in resolving issues timely and efficiently.

Your organization’s monitoring system may consist of ongoing activities, separate

evaluations, or a combination of the two; all of which are focused on your organization’s
identified risks. Management should emphasize a general ethical environment through daily
actions and behavior, and setting “the tone at the top” as it is more commonly referred to,
can help to ensure that the assessment procedures in place are being followed with
diligence. Setting a schedule for daily, weekly, and monthly monitoring techniques is
imperative.

Management must also hold team accountable for understanding issues identified and a
timeline for corrective improvements.

Below are some internal control monitoring procedures that can be tailored in organization:

Implement independent verifications, such as reconciliations, by personnel of

different levels on a timely basis.

Perform walkthroughs of your transaction recording processes to verify all

required steps are taken.

Schedule an internal audit.

Use bench marking to compare your report results to similar departments,

companies, or industries.

Consult information technology specialists regularly to learn about security

setting updates and current technology and cyber security risks.

Learn your software; many applications, such as Quick Books, have security
settings that may be beneficial in safeguarding confidential information.
The Terminology of Control Monitoring
Individuals responsible for monitoring various internal controls throughout an enterprise
are evaluators who must have the skills, knowledge, and authority to enable them to
(1) Know the risks that can substantially affect the organization's objectives,
(2) Detect critical controls related to managing or mitigating risks, and
(3) Review the monitoring of appropriately persuasive information about the effectiveness
of the internal control system.
Such evaluators often include the persons from management, Internal Auditors and line
personnel and sometimes board members too.
The two primary attributes of effective evaluators are

Objectivity.

Competence

Competence—Itrelates to the expertise, knowledge, and experiencethat a competent

auditor is the auditor who has the knowledge, training, skills andexperience sufficient to be
able to successfully do the work of the audit.

When assessing the internal auditors' competence, the auditor should obtain or update
information from prior years about such factors as—
 Educational level and professional experience of internal
auditors.

Professional certification and continuing education.

Audit policies, programs, and procedures.

Practices regarding assignment of internal auditors.

Supervision and review of internal auditors' activities.

Quality of working-paper documentation, reports, and

recommendations.

Evaluation of internal auditors' performance.

Objectivity—The internal auditor shows the highest level of professional objectivityin

gathering, evaluating, and communicating information about the activity or processbeing
examined.

When assessing the internal auditors' objectivity, the auditor should obtain or update
information from prior years about such factors as—
 Whether the internal auditor reports to an officer of sufficient status to ensure
broad audit coverage and adequate consideration of, and action on, the findings and
recommendations of the internal auditors.

Whether the internal auditor has direct access and reports regularly to the board of
directors, the audit committee, or the owner-manager.

Whether the board of directors, the audit committee, or the owner-manager

oversees employment decisions related to the internal auditor.

Policies to maintain internal auditors' objectivity about the areas audited,

including—

Policies prohibiting internal auditors from auditing areas where relatives are
employed in important or audit-sensitive positions.

Policies prohibiting internal auditors from auditing areas where they were recently
assigned or are scheduled to be assigned on completion of responsibilities in the
internal audit function.

In assessing competence and objectivity, the auditor considers information obtained from
previous experience with the internal auditor, from management personnel, and from a
recent external quality review, if performed, of the internal audit function's activities.

The auditor may also use professional internal auditing standards as criteria in making the
assessment. The extent of testing will vary in light of the intended effect of th e internal
auditors' work on the audit. If the auditor determines that the internal auditors are
sufficiently competent and objective, the auditor should then consider how the internal
auditors' work may affect the audit.
Monitoring Levels

Monitoring by BOD—
Control monitoring by the board, its committees, or others charged with includes evaluating
management's own monitoring process and ideally should include an assessment of the risk
of management override of controls.

Self-assessmentis normally done when persons responsible for a particular unit or function
determine the effectiveness of controls for their activities. The term is often used to
describe assessments made by the personnel who operate the control called as self -review,
but may also refer to peer or supervisory review within the same unit that the control was
created.
The Nature or Quality of Controls
Control is a primary goal-oriented function of management in an organisation. It is a process
of comparing the actual performance with the standards of the company to ensure that
activities are performed as per plans and if not then taking corrective action.
Manager also needs to monitor and evaluate the activities of his subordinates. It helps in
taking corrective actions by the manager in the given timeline to avoid contingency or
company’s loss.Controlling is performed at the lower, middle and upper levels of the
management.

Features of Controlling
An effective control system has the following features:

It assists in achieving organizational goals.

Facilitates optimum utilization of resources.

It evaluates the accuracy of the standard.

It also sets discipline and order.

Motivates the employees and boosts employee morale.

Ensures future planning by revising standards.

Improves overall performance of an organization.

It also minimizes errors.

Controlling and planning are correlated for controlling gives an important input into the
next planning cycle. Controlling is a backwards-looking function which brings the
management cycle back to the planning function. Planning is a forward-looking process as it
deals with the forecasts about the future conditions.
 Nature of Controlling

Based on the above definitions the following natures or characteristics of controlling can be
presented below:

1. Control is a Function of Management

Control is a follow-up action to the other functions of management performed by managers

to control the activities assigned to them in the organization.

2. Control is based on Planning

Control is designed to evaluate actual performance against predetermined standards set -up
in the organization. Plans serve as the standards of desired performance. Planning sets the
course in the organization and control ensures action according to the chosen course of
action in the organization.

Unless one knows what he wants to achieve in the organization, he cannot say whether he
has done right or wrong in the organization. Control is the Last step in management process
but it begins with the setting up a plan in the organization.

3. Control is a Dynamic Process

It involves continuous review of standards of performance and results in corrective action,

which may lead to changes in other functions of management.

4. Information is the Guide to Control

Control depends on the information regarding actual performance. Accurate and ti mely
feedback is essential for effective control action. An efficient system of reporting is required
for a sound control system.

5. The Essence of Control is Action

The performance of control is achieved only when corrective action is taken on the basis of
feedback information. It is only action, which adjust performance to predetermined
standards whenever deviations occur. A good system of control facilities timely action so
that there is minimum waste of time and energy.
6. Continuous Activity

Control is a continuous process. It involves constant revision and analysis of standards

resulting from the deviations between actual and planned performance.

7. Delegation

An executive can take corrective action only when he has been delegated necessary actions
for it. A person has authority to control these functions for which he is directly accountable.
Moreover, control becomes necessary when authority is delegated because the delegator
remains responsible for the duty.

8. Control is Future oriented.

Control involves the comparison between actual and standards. So corrective action is
designed to improve performance in future.

9. Control is a Universal Function

Control is universal function of management. Every manager has to exercise control over
the subordinates’ performance, no manager can get things done without the process of
controlling. Once a plan becomes operational, follow-up action is required to measure
progress, to uncover deficiencies and to take corrective actions.

10. It is Positive exercise.

The function of controlling is positive. It is to make things happen i.e. to achieve the goal by
means of the planned activities. Controlling should never be viewed as being negative.

Key controls
Those controls which are vital to monitor to support a conclusion about the internal control
system's ability to manage or mitigate meaningful risks. Identifying key controls helps
ensure that the organization directs monitoring resources where they can pr ovide the most
value.
A Key Control has the following characteristics:

• It is required to provide reasonable assurance that material errors will be prevented

or timely detected.
 • It is the only control that covers a risk of material misstatement
• If it fails, it is highly improbable that other control could detect the control absence.

• It is a control that covers more than one risk or support a whole process execution

• It is usually part of entity-level controls or high-level analytic controls

• It need to be tested to provide assurance over financial assertions

Key performance indicators

A Key Performance Indicator is a measurable value that demonstrates how effectively a
company is achieving key business objectives. Organizations use KPIs at multiple level s to
evaluate their success at reaching targets. High-level KPIs may focus on the overall
performance of the business, while low-level KPIs may focus on processes in departments
such as sales, marketing, HR, support and others.

They are the critical indicators of progress toward an intended result. KPIs provides a focus
for strategic and operational improvement, create an analytical basis for decision making
and help focus attention on what matters most.
As Peter Drucker famously said, “What gets measured gets done.”
Key risk indicators
Key Risk Indicators (KRIs) are critical predictors of unfavorable events that can adversely
impact organizations. They monitor changes in the levels of risk exposure and contribute to
the early warning signs that enable organizations to report risks, prevent crises and mitigate
them in time.
KRIs aremetrics used to measure risks that the business is exposed to. It acts as an early
warning system, like an alarm that goes on when the company’s risk exposure exceeds
tolerable levels. In this way, KRIs helps you to monitor risks and take early action to prevent
or mitigate crises.
KRIs should be measurable and quantifiable. Examples are as follows:

• Financial KRIs: economic downturn, regulatory changes

• People KPIs: high staff turnover, low staff satisfaction
• Operational KPIs: system failure, IT security breach

However, it’s worth noting that the word “key” is important. KRIs is not about monitoring
every single risk facing the business. Instead, they focus on the most critical indicators for
managing the highest risks and these will vary from business to business in line with the
company’s objectives and priorities. What constitutes a key risk for one business may or
may not be important for another.

How are KRIs related to KPIs?

KRIs and KPIs are closely linked. In medium sized company, they’re often kept very separate.
It may be a case that companies see performance management (KPIs) and risk management
(KRIs) as two very different things. E.g. the business may have a risk register that is
developed and managed entirely separately from performance indicators.
KPIs answer the question, “How are we doing against our goals?”
While KRIs answer the question, “What is the likelihood that we might not achiev e our
goals?” or, to put it another way, “What might prevent us from achieving our goals?”
One can’t have one without the other if you want to manage both performance and risk
effectively.

It’s therefore important to integrate KRIs into your performance management framework by
linking KRIs to KPIs. This way, by establishing the right risk indicators for your business and
monitoring ongoing performance through related KPIs, you can track performance and risk
at the same time in one streamlined process. Risk and performance become properly
aligned.
While KPIs help organisations understand how well they are doing in relation to their
strategic plans, KRIs help them understand the risks involved and the likelihood of not
delivering good outcomes in the future. This means KRIs can be the flipside or KPIs.
Here are three examples that illustrate this relationship:
A company might establish a KPI to measure IT system performance and a complementary
KRI to track IT vulnerability to cyber-attacks.
Perhaps a company creates a KPI to monitor its market share growth because that’s a key
business objective. A KRI linked to the same goal could monitor the risks of losing market
share due to customer shifts or new competition.
A company might measure staff engagement or staff satisfaction as important KPIs and
monitor the likelihood of losing key staff and the risks to their employer brand as KRIs.
So, KPIs and KRIs are not the same. KRIs helps to quantify risks, while KPIs help to measure
business performance.

Quality of Evidences in Control Monitoring

To be persuasive evidence, the evidence should satisfy the following four attributes.
4 Attributes of Persuasive Evidence

Relevance

Timeliness Reliability

Sufficiency

Relevance: The relevance refers to its relationship to the assertion or to the objective of the
control being tested. For example, a control may be worded “Bank reconciliations are
reviewed and approved by the Controller." What is the relevant evidence for this control?
Bank reconciliations with the documented evidence of review and approval by the
controller.
Reliability: The reliability of evidence refers to the nature and source of the evidence and
circumstances under which it is obtained. Usually, there are several scenarios.
 • Evidence obtained from an independent third party is more reliable than evidence
obtained from internal organization sources.
• Evidence obtained is more reliable if the organization has an effective internal
control system.
• Evidence obtained from secure information systems is more reliable than manually
manipulated information.
• Evidence obtained directly is more reliable than evidence obtained indirectly.
• Evidence based on independent analysis/calculation by auditors or testers is more
reliable.
• Evidence provided by original documents is more reliable than evidence provided by
copies.

Sufficiency: The sufficiency refers to the amount of evidence that is adequate and
convincing to support the conclusions drawn by management and auditors.
For example, a control may word “All payment checks over $15,000 must obtain dual
signatures by project managers based on the delegation of authorities.” Is one check with
proper dual signatures sufficient to support the conclusion that the control is in place and
effective? The answer is NO.
Management and auditors should gather sufficient evidence through effective sampling.
How much is sufficient? Sufficiency is a professional judgment so there is no fixed number.
Management and auditors should demonstrate their judgment in determining the size of
population to review in order to support their conclusions. Management and auditors also
should demonstrate their sampling methods, i.e. random sampling, judgmental sampling or
fixed interval sampling, etc.
Timeliness: The timeliness of evidence has two meanings:
1) Evidence obtained should be in a proper time period; and
2) The timing of the testing procedure used to test the assertion or control.
For example, if you test a control for year 2020, the evidence occurred in 2018 or 2017
won’t support the effectiveness of the control in 2020.
5 Types of Evidence
The four attributes together make persuasive evidence. After discussing the attributes of
evidence, let’s discuss the types of evidence. Usually, there are five types of evidence.

Physical

Analytical
Confirmation
procedures

Re-performance Dcoumentation

1. Physical evidence:
It first includes physical examination. Physical examination is a combination of
observation and inspection. This type of evidence is usually associated with assets,
i.e. inventory and cash. For example, auditors count inventory at the year -end or
count petty cash quarterly. Physical evidence also includes observation and inquires.
When there is no documented evidence for a control, testers or auditors need to
observe or inquire then document what has been observed and inquired as the
evidence for the control.

2. Confirmation: It represents evidence obtained from a third party. For example, a

service-use organization may require SOC 1 (Service Organization Controls Type 1) or
SOC 2 (Service Organization Controls Type 2) report from the service organization to
meet SSAE 16 (Statement on Standards for Attestation Engagements No.
16) requirements. Another example is to require bank statements directly from a
bank.
3. Documentation: It includes records or documents, whether internal or external, in
paper form, electronic form, or other media. Inspecting documentation is an often
used testing method. An example of inspection used as a test of controls is
inspection of records for evidence of authorization and approval.

4. Re-performance: It is not only a testing method but also a form of evidence. But also
involves the independent execution of procedures or controls that were originally
performed by organization personnel. A familiar example of re-performance is to
recalculate key spreadsheets confirming their accuracy, then document the
procedures performed and draw conclusions.

5. Analytical procedures: They are often used by external auditors to help auditors
understand an organization’s business and changes in business. It consists of
evaluations of financial information and includes the investigation of significant
differences from expected amounts.

An example is using analytical procedures to assess an organization’s ability to

continue as a going concern. However, analytical procedures are rarely used to test
internal controls.
17. Within COSO Framework, which of the following components is designed to assure that
internal controls continue to operate effectively?

A Control environment.
B Risk assessment.
C Information and communication.
D Monitoring.

18. Which of the following are reasons to monitor internal controls?

A People forget, quit jobs, getlazy.
B Machines fail.
C Advances in technology.
D All above.

19. As per COSO framework, persons who monitor controls should have which of the
following sets of characteristics?

A Competence and objectivity.

B Respect and judgment.
C Judgment and objectivity.
D Authority and responsibility.

20. As per COSO, main purpose of monitoring internal control is to assure that the internal
control system remains adequate to address changes in

A Risks.
B The law.
C Technology.
D Operating procedures.

21. Which of the following is the definition of a compensating control?

A A control that accomplishes the same objective as another control.

B A condition within an internal control system requiring attention.
The targets against which the effectiveness of internal control are
C
evaluated.
D Metrics that reflect critical success factors.

22. Mr. A of ABC Corp. has developed software that assiststo monitor key production risks at
company factories. In order to reduce costs, his approach to monitoring risks is likely to
be:

A Monitor all risks using indirect information.

B Monitor all risks using direct information.
Monitor important risks using indirect information and less important risks using
C
direct information.
Monitor important risks using direct information and less important risks using
D
indirect information

23. The manager of a warehouse is given a new product line to manage with new inventory
control procedures. Which of the following COSO internal control monitoring-for-change
continuum is affected by the new product line?
A Control baseline but not change management
B Change management but not control baseline
Neither control baseline nor change
C
management
D Both control baseline and change management

INTERNAL CONTROL MONITORING

CHANGE CONTROL PROCESS
Monitoring Process
In January 2009 COSO issued Guidance on Monitoring Internal Control Systems. It was
intended to provide in depth input on how to apply the monitoring component of the
original COSO framework. It is required for all parties working with internal control to
understand how a monitoring framework and foundation can improve the effectiveness of
business processes.

Internal control processes have raised issues since the inception of the Sarbanes-Oxley Act
of 2002. Management is required to assess internal control systems and provide quarterly
certifications. Further, external auditors are required to audit management’s assessment in
conjunction with an audit of the financial statements. The framework for establishing
internal control systems was developed by COSO. The original framework, Internal Control –
Integrated Framework was introduced in 1992 and clarified with the issuance of guidance
for smaller companies in 2006.

Monitoring of internal control is performed through application of ongoing evaluations and

separate evaluations. These evaluations ascertain whether other components of internal
control continue to function as intended. In addition, these evaluations facilitate
identification of internal control deficiencies and communicate them to appropriate officials
responsible for corrective actions. Serious deficiencies are communicated to higher levels of
management and to the board of directors when appropriate.

Business risks change over time. The internal control system needs to be capable of
determining that the controls in place are relevant and effective in addressing new risks. A
monitoring process should be capable of addressing the need for revisions in the design of
controls based on changing risk. Effective internal control systems must be capable of
containing risks at an acceptable level to ensure effective and efficient operations on
concurrent basis.

Monitoring is a process of assessing risks linked to achieving operational objectives. The

COSO model requires establishing a monitoring foundation consisting of procedures for
evaluating risks. Monitoring activities include assessment of controls and reporting the
results of the assessment together with any required corrective action steps

An effective monitoring is dependent on establishing an effective “tone at the top” of the

organization and a high priority on effective internal controls. It requires that the top
management team and BOD should be involved in the evaluation process. Monitoring of
internal control is dependent on the selection and usage of evaluators which have a solid
understanding of internal control. They also need to have suitable capabilities, resources,
and authority to conduct a meaningful assessment of internal control.

Evaluators should be competent and objective in addition to having a thorough knowledge

of the internal control system and its related processes. It is very much essential that
evaluators understand how the controls should operate and what constitutes a control
deficiency. Objectivity is determined based on an evaluator’s ability to assess the internal
control system without any concern for personal consequences resulting from the
evaluation. There should not be vested interest in manipulation of the results of the
evaluation either for personal benefit or self-preservation.
A monitoring system requires that the management team will ensure objectivity and select
competent evaluators.

If “tone at the top” is weak and ineffective, then any monitoring system is destined for
failure. Every aspect and component of internal control is dependent on the attitude and
beliefs communicated and conveyed by the management. If there is a negative approach
toward monitoring, this will be reflected in the attitudes of employees and how they
perform the monitoring process. Management and the board set the tone at the top and it
is important for them to walk and not just the talk.

The board is responsible for governance and oversight in their role of providing guidance to
the management team. Boards of public companies have legal responsibilities that were
enhanced by the Sarbanes-Oxley Act of 2002. This has translated into more competent
boards of both public and private companies.

Continuous monitoring and finding ways to improve workplace operations can help an
organization stay on financial track and keep delivering top quality products and services.
You need to monitor workplace operations so you can develop strategies to improve
procedures and protocols.

Monitoring operations requires management oversight, employee feedback and customer

reviews. It can help provide specific directions for employees, which can lead to improved
time management and increased productivity.

Improving workplace operations requires analyzing collected data to identify the underlying
problems and to find resolutions and methods to deal with them.

Monitoring Activity Constituents

Monitor and Control Process - Inputs
Project ManagementPlan

The subsidiary plans and the project baselines form the basis of controlling the project, as it
mainly involves focusing on all the aspects of the project. It includes the following subsidiary
plans which are explained under the process of developing a project management plan.

Project Documents

• Assumption log - The assumption log contains information about expectations and
pain points identified as affecting the project.
• Basis of estimates - Basis of estimates indicates how the various estimates were
derived and can be used to decide on how to respond to the difference of opinion.
• Cost forecasts - Based on the project’s previous performance, the cost forecasts are
used to determine if the project is within defined ranges and to identify if any
necessary change requests arise.
• Issue log - The issue log is used to document and monitor who is responsible for
resolving specific issues within a scheduled date.
• Lessons learned register - The lessons learned register might contain information on
effective responses for variances and corrective and preventive actions.
 • Milestone list - The milestone list shows the scheduled dates for particular
milestones and is also used to check if the planned milestones have been
accomplished.
• Quality reports - The quality report includes quality management issues; which are
also known as suggestions for the process, project, and product improvements;
corrective actions recommendations and the summary of findings.
• Risk register - It provides details on the threats and opportunities that have occurred
during the execution of the project.
• Risk report –It provides information on the overall project and specified individual
risks.
• Schedule forecasts - Based on the project’s earlier performance, the schedule
forecasts are used to determine if the project is within the defined tolerance ranges
for schedule and to identify any necessary change requests.

Work Performance Data

It is an output of the Direct and Manage Project Work process where the data is collected,
analyzed, and integrated to produce work performance information for providing a sound
foundation for taking project decisions.

Agreements

The agreement includes terms and conditions, and may also integrate other items that the
buyer specifies regarding what the seller is to perform or provide. If the project i s
outsourcing part of the work, the project manager needs to oversee the contractor’s work
to make certain that all the agreements meet the specific needs of the project while
adhering to organizational procurement policies.

Enterprise Environmental Factors

The Enterprise Environmental Factors are conditions that are not under the control of the
project team are as follows:

• Government or Industry Standards - Includes aspects like, regulatory agency

regulations, codes of conduct, product standards, quality standards, and
workmanship standards which influence the process of monitoring and controlling
the project work.
• Existing Human Resources - The level of skills, disciplines, and knowledge, such as
design, development, legal, contracting of the organization that influences the
monitoring and controlling process.
 • Stakeholder Risk Tolerances – An important aspect at any given stage of the project
work. The project manager should understand the tolerance level of the stakeholder
as to how much negative impact can he sustain during the project's lifecycle.
• Commercial Databases - Acquiring knowledge of standardized cost estimating data,
along with the industry risk study information, and risk databases from the
previously undertaken projects to have a better understanding of the current project
working procedure.
• Project Management Information System - PMIS are system tools and techniques
used in project management to deliver information. Project managers use the
methods and tools to collect, combine and distribute information through electronic
and manual means.

Organizational Process Assets

Organizational process assets are the plans, processes, policies, procedures, and knowledge
bases specific to and used by the performing organization. Organizational process assets
may be grouped into two categories:
 Processes and Procedures

Corporate Knowledge Base

Processes and Procedures

The Processes and Procedures under the organizational process assets can be segregated
into three stages:

1. Initiating and Planning: Implementing guidelines and criteria's used for tailoring the
organization's standard processes and procedures to satisfy the specific needs of the
project.
Effective planning of organizational standards such as policies, product and project
life cycles and methods to maintaining quality policies and procedures are necessary
for monitoring and controlling the project.

2. Executing, Monitoring and Controlling: A method to change the existing control

procedures and also to document how the changes are approved and validated. The
process also includes keeping a tab on the financial control procedures, issue and
defect management procedures, organizational communication requirements,
Change and risk control procedure along with Process measurement and lessons
learned database.
 3. Closing: During the closing stage, the project manager will monitor the project
closure guidelines, which includes focusing on the lessons learned, final project
audits, evaluations and product validations.

Corporate Knowledge Base:

It will comprise of various baselines of the policies, procedures and project documents. It
also includes financial databases containing information on labor hours, incurred costs,
budgets, and project costs overshoot.

A project manager should also know historical information and lessons learned from
previous project records and performance. For a project manager, should also have
corporate knowledge of the issues and defects so that he can control and resolute the same
in any problems arise.

Finally, the corporate knowledge base also should have information on components that
include insights into the process measurement databases and information on the project
files from previous projects (Ex. scope, cost, schedule baselines and project calendars)

Monitoring: Tools and Techniques

Expert Judgment

To ensure that the project performance matches with the expectation, the project manager,
in collaboration with the project management team uses expert judgment to interpret the
information provided by the monitor and control processes.
These insights must be taken from individuals or groups who are specialized in the topics
like:

Earned Value Analysis,

Interpretation and contextualization of data,

Techniques to estimate duration and costs,

Trend analysis,

Technical knowledge of the industry and focus area of the project,

Risk management, and

Contract management.

Data Analysis: Data analysis techniques that can be used include but are not limited to:

• Alternatives analysis: Alternatives analysis is used to select the corrective actions or

a combination of corrective and preventive measures to implement when a deviation
occurs in the project management process.
• Cost-benefit analysis: Cost-benefit analysis helps to determine the best corrective
action regarding cost in case of project deviations.
• Earned value analysis: Earned value provides an integrated perspective on the scope,
schedule, and cost performance.
 • Root cause analysis: Root cause analysis focuses on identifying the main reasons for
a problem. It can be used to determine the reasons for a deviation and the areas the
project manager should focus on in order to achieve the objectives of the project.
• Trend analysis: It is used to forecast future performance based on past results. It
looks ahead in the project for expected slippages and warns the project manager
ahead of time that there may be problems later in the schedule if established trends
persist. Trend analysis can be used to recommend preventive actions if necessary.
• Variance analysis: It reviews the variance between planned and actual performance.
This can include duration estimates, cost estimates, resources utilization, resources
rates, technical performance, and other metrics.

Variance analysis may be conducted in each Knowledge Area based on its particular
variables. In Monitor and Control Project Work, the variance analysis reviews the
variances from an integrated perspective considering cost, time, technical, and
resource variances about each other to get an overall view of variance on the
project. This allows for the appropriate preventive or corrective actions to be
initiated.

Decision Making: It involves all the individuals, project management teams, and
stakeholders to agree upon a single decision through the process of voting. It enables the
project to operate within the project management scope.

Meetings: Meetings may be face-to-face, formal, informal or virtual. It might comprise of

project team members stakeholders and others involved in the undertaken project. The
agenda is to circulate information regarding the project and to make sure that the
expectations are clearly understood and met.

Monitoring and Control Work Process - Outputs

Change Requests

When both the planned results and actual results are compared, change requests will direct
the project to expand, adjust, or reduce in the project and product scope, quality
requirements, schedule and cost baselines. This will pave the way for the collection and
documentation of new requirements and can impact the project management plan,
documents or product deliverables.
Change requests may include the below-mentioned aspects:
 Corrective Action: A deliberate activity that realigns the
performance of the project work with the project
management plan

Preventive Action: An intended activity that ensures

the future performance of the project work is
associated with the project management plan

Defect Repair: A calculated activity to modify an

unusual product or product component.

Work Performance Reports

Physical representation of work performance information is compiled into project

documents, focused on generating decisions, actions, and awareness. To maintain, store
and distribute information, representation in the form of a project document is necessary.
These work performance reports are a sub-division of project documents, and these reports
may be provided for key stakeholders.

Project Management Plan Updates

Changes identified during this process may affect the overall project management plan.
These changes, after being processed through the appropriate change control process can
lead to project management plan updates.

Project management plan elements that may be updated include are

• Scope management plan

• Requirements management plan
• Schedule management plan
• Cost management plan
• Quality management plan
 • Scope baseline
• Schedule baseline
• Cost baseline

Project Documents Updates

Project documents that may be updated include:

• Schedule and cost forecast: A document that stores information on the schedule and
cost limit of the concerned project.
• Work performance report: A document that contains the information on the number
of hours that have been spent, the quality standards that have been met and the
overall ability of the team.
• Issue log: A document that contains the information about all the issues that arose
during the project monitoring and controlling process and the time taken to resolve
the issue and the outcome of the action taken.

Brief Monitoring Process

 Few examples of processes for monitoring controls as below:

• Continuous monitoring programs

• Analysis of, and appropriate follow-up on, operating reports or metrics that
identify anomalies indicating control failure
• Supervisory reviews of controls e.g. reconciliations
• Self-assessments by boards regarding the tone they set in the organization
and their effectiveness
• Audit committee discussions of internal and external auditors
• Quality assurance reviews of the internal audit division

COSO Model of Control Monitoring

A. Establish a foundation for monitoring through :

(1) A positive tone at the top;

(2) An effective organizational structure that assigns monitoring roles to people with
appropriate capabilities, objectivity, and authority; and

(3) A starting point or “baseline” of known effective internal control from which
ongoing monitoring and separate evaluations can be implemented.
B. Design and execute monitoring processes focused on persuasive information about
the operation of key controls that address meaningful risks to organizational
objectives.

C. Assess and report of control evaluation results including the severity of any
identified deficiencies and monitoring results to the appropriate personnel and the
board for timely action and follow-up.
 Source: COSO Guidance on Monitoring (2008)

Baseline Understanding of Internal Control Effectiveness

Being part of establishing a foundation for monitoring, COSO specifies a conceptual 4 stage
process for moving from an initial understanding of control effectiveness to an enhanced
understanding of control effectiveness, including an assessment of the presence and effects
of changes in controls or risks.

The following picture illustrates this process called as the “monitoring-for-change

continuum.”
1. Set up a control baseline
Commencing with an area in which controls on risk are well understood, or do
extensive assessment to gain an understanding of controls and risk within a specific
area of the organization. This baseline provides a starting point for enhanced
monitoring.

2. Identify changes
Detect changes in the operations or design of controls or in related risks which often
includes ongoing and separate evaluations to identify, and address the potential
changes in, internal control effectiveness.

3. Manage changes
When changes happen, reviewwhether that controls remain effective despite
identified changes in controls and/or risks.

4. Revalidate control baselines

• Ideally, continuous monitoring procedures will use highly persuasive information.

Where they can routinely revalidate the conclusion that controls is effective, thus
maintaining a continuous control baseline.
• When continuous monitoring uses less-persuasive information, or when the level
of risk warrants, monitoring will need to revalidate control operation through
separate evaluations using appropriately persuasive information.
Effective change control processes

Usually Entity operations constantly evolve. Internal control processes must

anticipate and react to these changes. To identify conditions that create change,
entities often create information systems to capture and report on these activities.

It is said that “The more things change, the more they stay the same.” When this
expression is applied to internal control, it means that, even though the entity and
its risks are always changing, internal control should remain effective and efficient
despite these changes.

According to the COSO internal control framework, risks change over time;
management must determine whether and how the entity's internal control system
can address future risks.

Hence management's ongoing monitoring activities should carefully assess whether

the entity reconsiders the design of controls when risks change. It must also verify
the continued operation of existing controls designed to reduce these risks to an
acceptably low level.
Hence COSO emphasizes that Monitoring is a fundamental process for analyzing
risks andunderstanding of how controls may or may not manage or mitigate these
risks. This facilitates correcting control deficiencies before they impact the
achievement of the entity's objectives.

Implementation of an effective change control and management system preliminary

requires the support of the senior management. A well-defined change control
process should be described in the quality manual, supported by properly written
operational procedures.

A robust change control system is required for ensuring that the organization’s
facilities, equipment, procedures, processes and systems remain in correct and
compliant state. Managing changes formally and appropriately is critical and having
the appropriate subject matter experts identified to evaluate each change, is a key.

Change control is designed to prevent unintended consequences that may occur

when making a change. Below are essential steps to ensure change initiative is
successful.

1. Identify what is needed to be improved

Since most change occurs to improve a process, a product, or an outcome, it is
critical to identify the focus and to clarify goals. This also involves identifying the
resources and individuals that will facilitate the process and lead the endeavor. Most
change systems acknowledge that knowing what to improve creates a solid
foundation for clarity, ease, and successful implementation.
2. Present a Solid Case to Stakeholders
There are several types of stakeholders that include upper management, process
owners, and those who are directly charged with instituting the new normal. All have
different expectations and experiences and there must be a high level of "buy-in" from
across the spectrum. The process of onboarding the different constituents vary with each
change framework, but provide plans that require the time, patience, and
communication.

3 .Plan for the Changes

It is the "roadmap" that identifies the beginning, the route and the destination. One also
integrate resources to be leveraged, the scope or objective, and costs into the plan. A
critical element of planning is a multi-step process rather than sudden, unplanned
changes. It involves outlining the project with clear steps with measurable targets,
incentives, measurements, and analysis. For example, a well-planed and
controlled change management process for IT services will dramatically reduce the
impact of IT infrastructure changes on the business.

4. Resources and Data for Evaluation

Resource identification is crucial element. These can include infrastructure, equipment,
and software systems. Also consider the tools needed for re-education, retraining, and
rethinking priorities and practices.
Many models identify data gathering and analysis as an underutilized element. The clarity
of clear reporting on progress allows for better communication, proper and timely
distribution of incentives, and measuring successes and milestones.

5. Communication
This is the basic common thread that runs through the entire practice of change
management. Identifying, planning, onboarding, and executing a good change
management plan is dependent on good communication.
There are psychological and sociological realities inherent in group cultures. Those
already involved have established skill sets, knowledge, and experiences. Providing clear
and open lines of communication is a critical element in all change modalities.
The methods advocate transparency and two-way communication structures that
provide avenues to vent frustrations applaud what is working, and seamlessly change
what doesn't work.

6. Monitor Resistance, Dependencies, and Budgeting Risks

 Resistance is part of change management, but it can threaten the success of a project.
Most resistance occurs due to fear. It also occurs because there is a fair amount of risk
associated with change – the risk of impacting dependencies, return on investment risks,
and risks associated with allocating budget to something new.
Anticipating and preparing for resistance by arming leadership with tools to manage it
will aid in a smooth change lifecycle.

7. Success
Recognizing milestone achievements is an essential part of any project. When managing
a change through, it’s important to recognize the success of teams and individuals
involved. This will help in the adoption of both your change management process as well
as adoption of the change itself.

8. Review, Revise and Improve

As much as change is difficult, it is also an ongoing process. Even change management

strategies are commonly adjusted throughout a project. Like communication, this should
be woven through all steps to identify and remove roadblocks. And, like the need for
resources and data, this process is only as good as the commitment to measurement and
analysis.

Change management should be part of the entity's risk assessment to identify potential areas of
fraud, the effectiveness of the controls, and their likelihood for failure.

Specific types of changes are as follows:

 Changes in operations—A divestiture,
acquisition, restructuring, or regulatory change
can result in increased risks.

Team change—Increase in turnover or new

senior management can cause significant
impacts on the entity's controls.

Changing technologies or systems—New

technologies can cause control failures during
the transitional period. As a practical example,
consider how the Internet, mobile phones,
tablet PCs, and wearable computing have and
will affect internal control risks.

Rapid growth—Current controls may be unable

to keep pace with sudden growth.

Control change management must consider costs benefit analysis. Specifically, modifying
information systems to address changes should be done conceptually.
24. As per COSO, what is the first monitoring step in evaluating the effectiveness of an
internal control system?

A Establishing a control baseline.

B Identifying changes in internal control that have taken place.
Re-evaluating the design and implementation to establish a new
C
baseline.
Periodically revalidating operations where no known change has
D
occurred.

25. ABC Corp. has an automated system that monitors system access events and reports in
real time, to the IT security manager. This type of monitoring is:

A Continuous.
B Self.
C XBRL-enabled.
D Supervisory.

26. Mr. A is responsible for setting system access parameters in ABC Corp’s ERP system.
Every month, he reviews any issues related to setting access parameters and writes a
report about them. This type of monitoring is:

A Continuous.
B Self.
C Oversight.
D Supervisory.

27. Due to 70% growth year after year, monitoring internal controls at country wide retail
chain has come under tremendous pressure. As per COSO, which of the following would
be appropriate to help restore effective monitoring?

A Decrease in the size of the corporate internal audit activities.

Consolidating the data in the operational reports reviewed by the chief internal
B
auditor.
C Shifting monitoring responsibility to store managers and district managers.
D Having managers to sign the corporate compliance policy on an annual basis.

28. A change control process would not include following?

A Change request form.

B Approval process.
C Outsourcing.
D Documentation.

29. In a large public unit, evaluating internal control procedures should be the responsibility
of

A Accounting management staff reporting to the CFO.

B Internal audit team reporting to the board of directors.
Operations management team who report to the chief operations
C
officer.
D Security management team who report to the chief facilities officer.
COSO Enterprise Risk Management:
Strategy and Risk
Enterprise Risk Management (ERM)

Over the last decade, a number of business leaders have recognized potential
risk management shortcomings and begun to embrace the concept of
enterprise risk management as a way to strengthen their organization’s risk
oversight. They have realized that to wait up to the risk event occurs is too late
for effectively addressing significant risks and they have proactively explored
ERM as a business process to enhance how they manage risks to the enterprise.

The objective of ERM is to develop a holistic view of the significant risks to the
achievement of the entity’s most important objectives. ERM seeks to create a
top-down, enterprise view of all the significant risks which might impact. ERM
attempts to address a basket of all types of risks that might have an impact
positively and negatively on the potential of the business.

ERM is a plan-based business strategy which aims to identify, assess, and

prepare for any dangers, hazards, and other potentials for disaster—both
physical and figurative—that may interfere with an organization's operations
and objectives.
It not only calls for organizations to identify all the risks they face and to decide
which risks managing actively, but also involves making that plan of action
available to all stakeholders and potential investors, as part of their annual
reports. Industries such as aviation, construction, public health, international
development, energy, finance, and insurance all utilize ERM.

Corporates have been managing risk by buying insurance: property

insurance for literal, detrimental losses due to fires, thefts, and natural
disasters; and lipotential insurance and malpractice insurance to deal with
lawsuits and claims of damage, loss, or injury. But another key element in ERM
is a business risk i.e. obstacles associated with technology, supply chains, and
expansion—and the costs and financing of the same.
More recently, companies have managed such risks through the capital
markets with derivative instruments which help them manage the ups and
downs movements in currencies, interest rates, commodity prices, and
equities.

Modern businesses face a much more diverse collection of obstacles and

potential dangers. How companies manage the risks that define easy
measurements or a framework for management also falls under ERM. These
potentials for exposure include crucial risks such as reputation, day-to-day
operational procedures, legal and human resources management, financial,
and other controls related to the Sarbanes-Oxley Act of 2002 (SOX), and overall
governance.

Project managers and professionals who work with ERM focus on assessing the
risks relevant to their companies or industries, prioritizing those risks, and
making informed decisions on how to handle them. The risk management plans
they create estimate the impact of various disasters and outline possible
responses if one of these disasters materializes. For example,
the Environmental Protection Agency (EPA) requires facilities that deal with
extremely hazardous substances to develop risk management plans to address
what they are doing to mitigate danger and what they will do if an accident
occurs.

In addition to just-in-case plans and products, such as a list of alternate

suppliers or an insurance policy, companies that successfully manage their risks
also adopt routine practices to manage the potential hazards they have
identified.

Leadership of ERM
ERM is used to create top-down, enterprise view of risks to the entity,
responsibility for setting the tone and leadership for ERM resides with
executive management and the board of directors. They are the ones who have
the enterprise view of the organization and they are considered as being
ultimately responsible for understanding, managing, and monitoring the most
significant risks affecting the enterprise.
Top management is responsible for designing and implementing the ERM
process for the organization. They determine what process should be in place
and how it should function, and they are tasked with keeping the process active
and alive.

The board of director’s role is to provide risk oversight by:

(1) Understanding and approving management’s ERM process and

(2) Overviewing the risks identified by the ERM process to ensure

management’s risk- taking actions are within the stakeholders’ appetite.

Advantages of ERM

• Greater awareness about the risks faced and the potential to respond
effectively
• Enhanced confidence about the achievement of strategic objectives
 • Improved compliance with legal, regulatory and reporting requirements
• Increased efficiency and effectiveness of operations

In creating ERM initiatives, companies should focus on the downside and upside
of risk. The traditional approach was to concentrate on negatives—the losses
from currency or interest rate trades in financial markets, for instance, or
financial losses that might be caused by a disruption in a supply chain or may
be a cyber-attack that impairs a company's information technology.

In upside, companies are supposed to consider competitive opportunities and

strategic advantages that might arise out of management of risk. Some of th ese
"better decisions" involve items like plant or office location at abroad based on
a risk analysis that would examine the political environment in a country.

It also includes focusing on preventive measures that help a company avoid

potential disasters down the road. For example, some of these actions may
include determining when and how physical assets need to be maintained and
replaced.

This way, the company can avoid unexpected and costly plant and equipment
failure that might result in shutdowns, explosions or other events that put a
company's employees, communities and public profile at risk. Understanding
that their most important and valuable asset is their goodwill, some companies
work proactively when dealing with disasters.

Elements of an ERM Process

Because risks constantly emerge and evolve, it is important to understand that
ERM is an ongoing process. Unfortunately, some view ERM as a project that has
a beginning and an end. While the initial launch of an ERM process might
require aspects of project management, the benefits of ERM are only realized
when management thinks of ERM as a process that must be active and alive,
with ongoing updates and improvements.

The following diagram shows the core elements of an ERM process. Before
looking at the details, it is important to focus on the oval shape and the arrows
that connect the individual components that comprise ERM. The clockwis e flow
of the diagram depicts the ongoing nature of ERM. Once management begins
ERM, they are on a continuous journey to regularly identify, assess, respond to,
and monitor risks related to the organization’s core business model.

As ERM provides information about risks affecting the organization’s

achievement of its core objectives, the starting point of an ERM process is
gaining an understanding of what currently drives value for the business and
what’s in the strategic plan that displays new value drivers for the business.

To ensure that the ERM process is helping management keep an eye on

internal or external events that might trigger risk opportunities or threats to
the business, a strategically integrated ERM process begins with a rich
understanding of what’s most important for the business’ short-term and long-
term success.

Let’s take an example of a public company. A primary objective for most public
companies is to grow shareholder value. In such case, ERM should begin by
considering what currently drives shareholder value for the business e.g., what
are the entity’s key products, what gives the entity a competitive advantage,
what are the unique operations that allow the entity to deliver products and
services, etc.

In addition to that, ERM also begins with an understanding of the organization’s

plans for growing value through new strategic initiatives outlined in the
strategic plan (e.g., entry into new geographic market locations, launch of a
new product /service, or the acquisition of a competitor, etc.).

With better understanding of the current and future drivers of value for the
enterprise, management is in a position to passthrough the ERM process by
having management focus on identifying risks that might impact the continued
success of each of the key value drivers.

How risks emerge that impede the successful launch of a new strategic
initiative? Using this strategic lens as the foundation for identifying risks helps
keep management’s ERM focus on risks that are most important to the short-
term and long- term vipotential of the enterprise.

With knowledge of the most significant risk on the entity, management seeks
to evaluate whether the current manner in which the entity is managing risks is
sufficient and effective. In some cases, management may determine that they
and the board are willing to accept a risk while for other risks they seek to
respond in ways to reduce or avoid the potential risk exposure.

FullCircular Focus on All Types of Risks

ERMemphasizes on identifying risks to the strategies causes some to
erroneously conclude that ERM is only focused on “strategic risks” and not
concerned with operational, compliance, or reporting risks. Rather, when
deploying a strategic lens as the point of focus to identify risks, the goal is t o
think about any kind of risk – strategic, operational, compliance, reporting, or
whatever kind of risk – that might impact the strategic success of the
enterprise.

So when ERM is focused on identifying, assessing, managing, and monitoring

risks to the potential of the enterprise, the ERM process is positioned to be an
important strategic tool where risk management and strategy leadership are
integrated. It also helps remove management from the risk management
process by encouraging management to individually and collectively think of
any and all types of risks that might impact the entity’s strategic success.
Output of an ERM
The objective of an ERM is to generate an understanding of the top risks that
management collectively believes are the current most critical risks to the
strategic success of the enterprise.

Questions to consider when Implementing ERM

• What are the main components of our business strategy?
• What internal factors could impede or derail each of these components?
• What external factors could impede or derail each of the components?
• Do we have the right systems and processes in place to address these
internal and external risks?

Actions to take Actions to Avoid

• Gain support of top
management and the board
• Engage a broad base of
managers and employees in the
process
• Start with a few key risks and
build ERM incrementally
• Use existing knowledge, skills
and resources in management,
internal audit, compliance etc.
• Embed ERM into the fabric of
the organisation
• Take a holistic, portfolio view of
risks across the enterprise
• Never treat ERM as a project –
ERM is a process
• Don’t get bogged down in details
and history – ERM should be
strategic and forward-looking
• Avoid relying only on a few key
staff – make ERM everyone’s job
• Don’t take a silo approach to risks.
Don’t ignore how risks might
impact on other parts of the
business
• Avoid obsessing too much about
categorizing risks – rather than
ensuring that the key risks have
been identified and mitigation
plans developed
• Never assume that the risk
register is complete – there will
always be ‘unknown unknowns’
and the biggest enemy of
effective ERM is complacency
Importance of ERM
Following five realities are forcing management and boards to take a
fresh look at risk and crisis management. An effectively functioning ERM
process is important because it can help them address new realities.

I. The time may come – sooner or later when the fundamentals of the
business are about to change. Risk management is about securing
positioning in the marketplace. Management of strategic uncertainties
requires an understanding of the key assumptions underlying the
strategy and monitoring changes in the business environment to ensure
that these assumptions remain valid over time.
II. It is not what we know that matters but what we don’t know that makes
the sense. The question should be: Is our approach to assessing risk
identifying emerging risks and telling us something we don’t know?
III. Most businesses are boundary-less. A strategic perspective applied to
operational risks suggests the need for an end-to-end enterprise view of
the value chain, requiring consideration of upstream and downstream
relationships. What happens if any critical component of this chain were
lost for an indeterminate period of time?
IV. Sooner or later, there will be a crisis which can test the company. Even
the most effective risk management cannot prevent this. Yet companies
 spend a lot of time guessing at probabilities and ignoring the speed of
impact, the persistence of impact over time and the organization’s
response readiness.
V. Management and directors are struggling between risk management and
risk oversight. The risk oversight is evolving. CEOs fear an overlay and
non-value-added activity that is out of sync with the rhythm of the
business. It makes sense to start both risk management and risk
oversight at the same place – with the formulation of strategy, including
an understanding of the key assumptions underlying the strategy.

Following are other areas of Importance:

VI. Exploring Opportunities considering risk enables management to identify

new opportunities and the challenges of opportunities. For example,
considering the risks and opportunities of block chain, RPA technologies
may enable management to identify new applications of those
technologies
VII. Identifying and Managing Entity-Wide Risk enables considering the
interactions of risks across the entity and their unique effects on various
segments of the entity.
VIII. Increasing Positive and Reducing Negative Outcomes by better
identifying and managing risks, ERM enables entities to achieve excellent
performance.
IX. ERM enables assessing the risks of performance potential and acting
to reduce undesirable variance.
X. Better Deployment of Resources: Every risk demands resources. Better
risk assessments and responses enable excellent resource allocations.
XI. Organizational survival depends on expecting and responding to changing
risks. ERM improves survival potential and organizational resilience.

ENTERPRISE RISK MANAGEMENT MISCONCEPTIONS

• ERM is for giantcorporates

Although large companies spend more time and cost on ERM, it doesn’t
mean the benefits to SME companies are insignificant. Smaller
businesses are also susceptible to many risks and threats as their large
company counterparts. They may be different in scope and magnitude,
the need to proactively assess, monitor and manage them remains the
same. In reality, many smaller companies often receive a greater benefit
from ERM as the inherent risks may pose a much greater threat.
Management’s potential to deal with them can be limited due to lack of
experience, fear of time and cost and perceived lack of access to tools.

• No clear Understanding of Value

In general, management at smaller to mid-level companies do not fully

understand the value ERM creates. There are many benefits including
providing government regulators and rating agencies with a level of
comfort about their internal risk management profile.

With globalized threats being leveled upon even the smallest of entities,
these regulators and rating groups have begun to inquire and pose more
risk management questions to these small to mid-size insurance entities.
An ERM program guides the company to routinely address risk in key
 areas including financial, operational, market, underwriting, pricing,
credit-liquidity and strategic risk. It also improves companywide
communication. To ensure success, it requires management and the
board to become involved in the essential task of enterprise risk
management. This group is the driver and blood of an entity’s continuing
ERM program.

• It is a One Time Exercise

There is a misconception that ERM is primarily a one-time exercise

designed exclusively to detect and mitigate issues. While addressing and
resolving risks are obviously a crucial step in the ERM lifecycle, it is only
the beginning. Ongoing oversight needs to happen to ensure risk factors
are consistently discussed, monitored and refined as the entity evolves.

There are continuous steps that should not be part of a one-time event,
but rather become part of the standard operating assessment which will
allow tokeep evaluating new sources of risk while assessing and
mitigating those previously identified.

• RequiresSignificant Investment in Technology

Heavy investments in tools and technology are not required when

launching an ERM program. It’s important to remember that ERM is
about defining risks specific to an organization, documenting them and
developing an approach to address each one.

Many are surprised to learn that in the initial stages of implementation,

documentation and monitoring can be done using basic tools such like
Word and Excel. A company starting out with ERM can take the process
slowly and gradually expand to the point where more advanced tools
may be used but are certainly not mandatory.

• Lack of Expertise

Apparently people may get the impression for the need to hire an
experienced risk officer to coordinate ERM process. For companies just
starting with ERM, this is not the case. It’s important to remember that
ERM is not a one-size-fits-all process and COSO is there to guide and
 accommodate companies with diverse needs. The fact is that companies
often have key personnel in place that understand their specific
organizational areas, risks and tasks, as well as their management
processes.

These knowledgeable and skilled personnel can be involved in the

assessment process to avoid some of the aforementioned fears and
concerns. What most needed is a general coordinator knowledgeable in
ERM to help guide them, step by step, through the process of leveraging
internal human and other resources to achieve the desired ERM
objectives.

Correcting Some Misconceptions of ERM

ERM is not simply a listing of risks but it includes the

practices, including creating an appropriate culture, to
manage risks.

ERM is not the same as internal control. It includes a

broader task than internal control where ERM considers
risk appetite and strategy as central concerns.

ERM cannot be an add-on task that functions

independent of the organization's structure and
processes. In fact, ERM must be integrated into the
organization.

Board of Director's Role in ERM

Board has a responsibility to ensure optimal risk oversight of their companies.

As outlined above, it involves ensuring appropriate capabilities in place in all of
the five core dimensions of ERM:
Risk transparency and insight,

Risk appetite and strategy,

Risk-related processes and decisions,

Risk organization and governance, and

Risk culture.

All boards should consider following actions, across these five

dimensions, when aiming for best practices in the organisation.

a. Ask from management the establishment of a top-down ERM

program that addresses key risks across the company and elevates
risk discussions to the strategic level.
b. Ask a risk heat map that identifies and collates exposures across
the company, reveals linkages between exposures, and identifies
fundamental risk drivers.
c. Ask an in-depth, prioritized analysis of the top three to five risks
that can really make or break the business—the company’s key
exposures.
d. Ask integrated, multi-factor scenario analysis that includes
assumptions about a wide range of economic and business-specific
drivers
e. Set up a board-level risk review process and require from
management insightful risk reports.
f. Set up a clear understanding of risk capacity based on metrics that
management can measure and track.
g. Define a strategy statement that clarifies risk appetite, risk
ownership, and the strategy to be used for the company’s key risks.
 h. Ask management to formally integrate risk thinking into core
management processes, e.g., strategic planning, capital allocation,
and financing.
i. Set up risk governance and risk-related committee structures at
board level, and review board composition to ensure effective risk
oversight.
j. Produce a clear interaction model between the board and
management to ensure an effective risk dialogue.
k. Ask that management conduct a diagnostic of the organization’s
risk culture and formulate an approach to address gaps.
l. Go through top management’s compensation structure to ensure
performance is also measured in light of risks taken.

ERM Glossary

• Business Model-The core aspect of an organization, including its vision,

mission, strategies, infrastructure, policies, offering and processes.
• Risk Categories– Strategic, financial, operational, or hazard.
• Chief Risk Officer-Senior risk professional engaged in ERM in an organization.
• Risk Optimization– The balance between risk seeking and risk avoidance.

• Risk Attitude– The manner in which an organization and its stakeholders

collectively perceive, assess and treat risk.

• Risk Appetite– The event on perils and levels of impact an organization

intends to retain, treat, and monitor.
• Risk Tolerance– The level of residual risk that an organization and its
stakeholders are willing to bear within a given strategy.
• Executive Goals– The executives’ strategic goals set the direction for the
operational and tactical objectives developed by the remainder of the
organization.

• Strategic Management-The coordination of interrelated activities of

functional areas of a business to achieve an established purpose.
• Vision Statement-The aspirational description of what an organization will
accomplish in the long-term future.
• Mission Statement– A broad expression of an entity’s goals

• Risk Criteria-Reference standards, measure, or expectations used in judging

the significance of a given risk in context with strategic goals.
• Risk Maturity Model-Tool to help measure results and monitor progress.

• Stakeholder– AN individual or organization that is directly or indirectly

involved with or affected by an organization’s decisions and activities.

• Values– Those outcomes that satisfy stakeholders, including economic

performance, social justice,and environmental stewardship.

• Risk Perception-Gives their values and goals, the manner in which individuals
and organizations observe and perceive volatile situations.

• Risk Position-A party’s risk appetite plus risk tolerance, the willingness to pay
to accept volatile projects and pay to transfer volatile situations to theirs
parties.
• Materiality– The measure of a significant variance from an expected
outcome.

• SWOT Analysis– Used to determine strengths and weaknesses within the

organization and an external evaluation of possible opportunities and
 threats.
• Economic Intelligence– The information used to evaluate changes in
macroeconomic information for production, distribution, and consumption
of goods and services with country data on labor, finance, and taxation that
affect risk management decisions.
• Business Intelligence-The enterprise information management technologies
designed to plan and control the decision-making information flows that
affect upside and downside risk analysis and extract, transform, and load
systems data into an integrated structure.
• Risk Intelligence-Is both a process and a product. It consists of the
organizational potential to collect and collate data, statistics and information
concerning risk/volatility. This is followed by the systematic analysis,
interpretation, and presentation for this information, culminating in decision
making that produces the most favorable outcome under existing
circumstances.

• Key Performance Indicator (KPI) – A financial or non-financial measurement

that defines how successfully an organization is progressing toward its long-
term goals.
• Key Risk Indicator (KRI) – A financial or non-financial metric used to help
define and measure potential losses.
• Corporate Governance– The mechanism and procedures that determine
how corporations are run.

• Performance Management Scorecards– Summarizes performance status

information from multiple source systems. They enable management to
monitor both changes in financial results and progress toward key
operational targets that are linked to strategic plans and goals.
• Risk Factors– the quantitative and qualitative criteria used in the evaluation
of the relative loss exposure levels in financial accounts, work flow processes
and risk events.
• Leading Indicator– A predictor of change at the beginning of an economic
cycle.
• Lagging Indicator– A consequence of change at the end of an economic
cycle.
• Business Intelligence Information User Roles-The functional and
organizational parameters used to evaluate how information requirements
relate to job responsibilities.
• Decision Role Analysis– A process that determines what kinds of decisions
are needed, where in the organizational structure those decisions should be
made and to what extent each manager should be involved.

• Business Intelligence Reports-The multidimensional slices of information

that connect system users to performance scorecards and analytics for
enterprise-wide decision making
• Dimensional Design-A business intelligence method used to convert
transaction data into hierarchical structures for enterprise- wide decision
analysis
• Metadata-The data about data that provide context for analyzing
transaction facts with efficient structure for grouping hierarchical
information.
• Performance Benchmarking– A process for comparing results to
comparable organizations and best practices.

• Data Mining– The process of extracting hidden patterns form data that is
used in a wide range of applications for research and fraud detection.

• Notification Log– A control document used to monitor risk threshold alert

 message sent to system users.
• Master Data Management-A set of processes and tools that consistently
defines and manages the no transactional data entities of an organization:
also called organization reference data.

• Risk Information Mapping-Connects or maps enterprise risk information

source applications to business reporting cycles and process responsibilities
for managing risk controls activities at specific points in the organization.
• Tone At the Top-The environment an organization’s senior executives create
by clearly communicating expectations to employees and other
stakeholders, leading by example, linking governance with transparency and
encouraging ethical behavior.
• Resource– Any element that can change in value or level.

• Event-An occurrence or series of occurrence that causes a change in a

resource’s value or level.

• Impact-A positive or negative consequence or change in value or level of a

resource.

• Loss Exposure– Any condition or situation that presents a possibility of loss,

whether or not an actual loss occurs.

• Risk Register– A tool developed at the risk owner level that links specific
activities, processes, projects, or plans to a list of identified risks and results
of risk analysis and evaluation and that is ultimately consolidated at the
enterprise level.

• Risk Center– A discrete unit within an organization, having a leader and

specific objectives, and disposing of specific resources, at which level a
particular risk ( or group of risks) is most appropriately and effectively
managed.
 • Risk Owner– An individual accountable for the identification, assessment,
treatment, and monitoring of risks in a specific environment.
• Critical Path– The sequence of activities in a project that take the longest
time to complete and determine the overall time length of the project.
• Scope Creep– A project management phenomenon that occurs when
unplanned activities are added to existing activities are increased, resulting
in a project that exceeds its original budget or time schedule.

• Scope Statement- A clarifying project document that details the objective to

be accomplished, products, or deliverables, potential costs, and gains, and
success measurements.

• Slack Time– The difference between either the latest start time and the
earliest start time, or the latest finish time and the earliest finish time for
activities in a project[‘s critical path.
• Framework– An approach to project planning and execution in which
portions of the project are divided by requirements or problem statements
and addressed separately, but in a way that will integrate.

ERM and strategy

The COSO framework in fact emphasizes that ERM really helps an organisation
better understand how its mission, vision and core values provide the foundation
for understanding what types and amount of risk are acceptable when defining the
strategy which results in three different ways that risk arises in the process:
 • The potential that strategy and business objectives may not align with the
mission, vision and core values
• The type and amount of risk that the organisation potentially exposes itself
to by choosing a particular strategy
• The types and amount of risk inherent in carrying out its strategy and
achieving business objectives and the acceptpotential of this level of risk
and, ultimately, value

Possibility of misaligned strategy and business objectives

An organization’s mission and vision provide a top-down view of the tolerable

types and amount of risk for the entity. It helps the organisation to establish
boundaries and focus on how decisions may affect strategy. An organisation that
understands its mission and vision can set strategies that will yield the desired risk
profile. A misaligned strategy increases the probpotential that the organisation
may not realize its mission and vision, or may compromise its values, even if the
strategy is successfully carried out.
E.g. the risk of strategy not aligning with mission and vision, the framework
provides an example of a healthcare company. Such an organisation would
consider the risks associated with providing high-quality care and convenient and
timely access and being a terrific place to practice medicine. Considering its high
regard for quality, service of skill, the organisation is likely to seek a strategy that
has a lower risk profile related to quality of care and patient service. This may
mean offering in-patient and/or out-patient services, but not being a primary on-
line presence. On the other side, if the organisation had stated its mission in terms
of innovation in approaches or advanced delivery channels, it may have adopted a
strategy with a different risk profile.

There are many examples of an organisation pursuing a strategy that doesn’t align
with its stated core values. For example, a company developed a strategy that it
believed would result in great commercial success. However, that strategy was not
aligned with its stated core values. As a result, individuals charged with pursuing
company’s business objectives made decisions that, ultimately, resulted in the
company’s demise. As latest examples, we see the impact on otherwise well-
respected companies, such as Volkswagen, Uber.

The key is that those involved with strategy setting and the boards that oversee
the process, to leverage the principles of ERM to help the organisation avoid
misaligning a strategy. The board can provide the organisation with insight to
ensure the strategy it chooses supports the entity’s broader mission and vision for
management and board consideration.

Implications from the chosen strategy

ERM does not create the strategy, but it helps in understanding the risks
associated with alternative strategies being considered and with the adopted
strategy. Decisions shall be made on the trade-offs inherent in development of a
strategy. Each alternative strategy has its risks which are the implications arising
from the strategy. The BOD and management need to determine if the strategy
works in alignment with the organization’s risk appetite and how it will help enable
the establishment of business objectives and allocation of resources that,
ultimately, will lead to value creation and enhanced performance. Stated
differently, the organisation needs to evaluate how the chosen strategy could
affect the entity’s risk profile, specifically the types and amount of risk to which the
organisation is potentially exposed. Failure to properly consider such implications
may result in unintended consequences.

During evaluation of potential risks that may arise from strategy, management
should also consider any critical assumptions if any that underlie the chosen
strategy. These assumptions form an important part of the strategy and may relate
to any of the considerations that form part of the entity’s business context. ERM
provides valuable insight into how sensitive changes to assumptions would affect
achieving the strategy.

The organisation may consider what risks may result from the chosen strategy –
risks related to innovations may be more pronounced, risks to the potential to
provide high-quality services may elevate in the wake of cost-management
initiatives and risks related to managing new partnerships. Those other risks result
from the choice of strategy. Yet, the question is still outstanding whether the entity
is likely to achieve its mission and vision with this strategy, or whether there is an
elevated risk to achieving the set goals.

Risk in implementing the strategy and business objectives

Risk is a consideration in many strategy-setting processes. And risk is often

evaluated primarily in relation to its potential effect on pre decided strategy. Or it
can be said that the discussions focus on risks to the existing strategy: we have a
strategy in place, so what could affect the relevance and vipotential of that
strategy.

An organisation must consider whether it has the capabilities in terms of various

resources to carry out the strategy. Lack of the same creates a risk to strategy
achievement. Often, the risks become important enough that an organisation may
wish to revisit its strategy and consider revising it or selecting one with a more
suitable risk profile.

The risk to carrying out strategy may also be viewed through the horizons of
business objectives. A company can use a variety of tools and techniques to assess
risks using a common measure. Wherever possible, it should use similar units for
measuring risk for each objective. Doing so will help to align the severity of the risk
with established performance measures.

Assessing risk to the strategy and business objectives requires an organisation to

understand the relationship between risk and performance – referred to in the
ERM framework as the ‘risk profile’. An entity’s risk profile provides a composite
view of the risk at a particular level of the entity or aspect of the business model.

This combined view allows management to consider the type, severity and
interdependencies of risks and how they may affect performance. The organisation
should initially understand the potential risk profile when evaluating alternative
strategies. Once a strategy is chosen, the focus shifts to understanding the current
risk profile for that chosen strategy and related business objectives.

Summary

A key responsibility is to contribute to and oversee the development and execution

of the organization’s strategies and business objectives. Since the inception of
ERM, it has become common to consider the risks to achieving a given strategy
and related business objectives. Boards routinely question management on their
capabilities to achieving their strategy and business objectives and receive periodic
updates on the organization’s progress in doing so. It focuses on the risks
embedded in strategy and business objectives remains critically important.

However, there are two other aspects of risk that arise during the strategic
planning process. The first, the possibility of misaligned strategy and business
objectives relates to the risks that arise when a seemingly sound strategy doesn’t
align with the organization’s mission, vision and core values as it can result in
consequences, as evidenced by corporate failures in the past decades. The second
is related to the potential unintended consequences of a strategy chosen. A
strategy viewed through one eye may seem appropriate, but there may be hidden
risks that could have adverse consequences to the organisation.

Performance Measurement of ERM

1. Accomplishment of ERM objectives:

To assess the value or success of ERM, management must first articulate
clearly what ERM is intended to accomplish. Examples of objectives include
reducing performance variance potential to an acceptable level, enhancing
management’s dialogue with the board, aligning strategy and corporate
culture with the defined risk appetite, protecting the organization’s
reputation, and positioning the organization as an “early mover” in dealing
with emerging market opportunities and risks, among others. Once an
objective is defined, relevant measures would be used to address progress
towards achieving it.

For example, assuming the objective is to update risk management

capabilities continuously in a business environment, success measures could
 include specific improvements in narrowing variances in capabilities for
managing specific risks and tracking the maturity of the organization’s
potentials in specific areas to a more defined and managed state.

2. Reshaping strategy in advance of disruptive change:

When the fundamentals of the business arechanging, is executive
management able to secure “early mover” position in the marketplace to
capitalize on emerging market opportunities and risk?
If changes occur in critical underlying assumptions the strategy due to
external events and developments, are they identified on a timely basis to
avoid the organization being placed in the untenable position of executing a
flawed or obsolete business model?
Are changesin the business environment reasonably monitored to ensure
that strategic assumptions remain valid over time?
Assessments of strategic risks and the effects of potentially disruptive
changes in the external environment can provide valuable insights into the
strategy-setting process, as they can spur actions that can preserve
enterprise value that took a long time to build.

3. Effective assessments of operational risk to improve preparedness for the

unexpected:
In the global world, corporates are literally boundary less. A strategic
perspective applied to operational risks focuses on an end-to-end enterprise
view of the value chain, including upstream and downstream relationships.
This enables management to focus on what would happen if any critical
component of this chain were lost for an indeterminate time period.
If the potential loss of a component is high in terms of its impact on business
model continuity, the organization’s response readiness should be assessed.
The success measure is the corporate’s potential to navigate the unexpected
loss.

4. Integration of risk assessment with core management processes:

 The relevance of the ERM process is relevant if it is integrated with the
activities that matter to the success of the business. The scope and extent of
integration varies from industry to industry and is highly dependent on
management’s operating style.
The integration scope could include strategy setting, annual business
planning, performance management, budgeting and capital expenditure
funding. Such integration reduces the risk that ERM will be perceived across
the organization as a stand-alone appendage and instillsin the board and
executive management greater confidence that strategies, plans and
performance reporting are more robust, leading to more effective execution
in delivering expected results.

5. Informed and effectively functioning board risk oversight process:

Management and BOD typically desire a clear line between risk
management and risk oversight. When both risk management and risk
oversight start at the same place – with the formulation of strategy,
including an understanding of the key assumptions the strategy and the ERM
process results in actionable reporting around the critical enterprise risks
and how they are being managed relativeto the corporate’s risk appetite,
the dialogue between executive management and the board is properly
focused and in line with how the business is run and managed.

6. Identification of emerging risks well in advance and implementation of early

warning systems:
If focused on identifying emerging risks and informing decision-makers
about what they don’t know, risk assessment and monitoring processes
reduce the likelihood of the corporaterisk out of ignorance, thereby
reducing exposure to unacceptable losses.

Early warning systems enhance strategy setting through highweightage on

data analytics, scenario analysis, stress testing and intelligence gathering to
anticipate risk, monitor continued validity of strategic assumptions and
assess the impact of alternative futureson projected performance.
7. Reduction in performance variance potential:

A firm may encounter fewer changes in reported results due toa more
systematic, anticipatory and proactive risk evaluation process, (b) improved
risk measures, and (c) preventive controls that detects risk at the source
Improved risk measures, metrics and monitoring integrated with key
performance indicator reporting facilitates the shift from “guessing” to
“knowing” as well as from “reacting” to “proactive”. These changes provide
evidence of improved risk management over time.

8. Reducing the number of or avoiding risk incidents or near misses:

If a company can demonstrate fewer risk incidents or loss events than the
industry average, it has clear evidence of excellent performance. Workplace
safety is a practical example of risks where such benchmarking is possible.
Information about risk responses, risk measures, risk incidents, near misses,
best practices and status of improvement plans made available across the
corporate facilitates knowledge sharing and continuous process
improvements.

9. Reduction in cost and improvement in shareholder value:

As analysts, rating agencies, regulators and others learn to differentiate

between various firms’ risk management capabilities, corporates able to put
in place effective ERM capabilities should realize a lower cost of capital over
time in relation to the firms choosing to do nothing at all. If a firm’s
reputation gains as its risk management are considered in the marketplace
as a differentiating skill relative to its peers, then the company’s borrowing
costs should decline and its share valuations should increase accordingly.

10.Increased risk sensitivity and awareness :

 A material shift incorporate leading to an increased focus on and
reinforcement of risk management is an indicator of increased awareness
and effectiveness.
For example, in a trading operation, a desirable risk culture appropriately
balances business activities and control activities so that neither one is too
disproportionately strong relative to the other; meaning competitive
pressure exists between the two.

While in manufacturing, achievement of a demanding goal for a historically high

target of injury-free days in the production process may require a cultural shift to
modify behavior. In capital-intensive industries, a cultural shift tomore robust
evaluations of the attractiveness of investment opportunities might mean factoring
uncertainty into probabilistic assessments of discounted future cash flows or
modeling different projections based on different assumptions. In these cases, risk
management is actually integral part in managing the business as it addresses
potential obstacles that may prohibit the achievement of a critical business
objective or imperative.

ERM Challenges

Very few companies find ERM implementation easy as it requires a rare

combination of consensus, strong executive management and an appreciation for
various program sensitivities. Despite the effort required, ERM is worth it as it
forces most corporates to step back and identify their risks, which is one of the
first steps to protecting capital and driving shareholder value. As boards evaluate
ERM, however, they usually come away with more questions than answers.
While each company faces specific issues, the more challenging ERM issues are
generally consistent across companies and are largely unrelated to industry,
geography, regulation or competitive landscapes. By reviewing some of common
challenges, as well as the creative solutions that have been applied by other
corporates, management will be better equipped to develop and revamp their own
enterprise risk management programs.

1. Assessing ERM’s Value

Issue: In an economy driven by positive return on investment, corporates often

struggle to demonstrate sufficient ERM value to justify costs. While traditional
investment decisions are evaluated using common risk and reward metrics such as
return on equity, return on assets and risk adjusted return on capital, ERM value
drivers are less prescriptive. Despite growing guidance, ERM remains largely
voluntary.

Solution: Many corporates establish ERM value, risks and costs using a traditional
business case. The typical business case looks at ERM value in four categories.
One of them is shareholder value added, such as equity premium driven by
positive public perception, an improved credit rating score, and the integration of
risk results with operations. Next is avoided risk, such as reduced volatility through
hedging or insurance products and reduced risk through incremental controls.
Another category is hard savings such as risk infrastructure and process
consolidation, reduced insurance and costs, and reduced regulatory capital
requirements. Finally, other qualitative advantages can include improved risk
transparency and awareness, improved risk management coordination and
accountpotential, improved risk and financial statement metrics, and the
elimination of risk management activities.

After evaluating value, many companies look at ERM implementation costs and
risks. While most companies manage risk as a matter of standard business
practice, ERM programs typically involve enhanced risk assessment processes, risk
and business integration, and governance concerns. These activities may require
new resources, technologies, policies and process enhancements–all of which
assume varying degrees of capital expenditures.

As an alternative, management may implement ERM on a pilot basis or as an ERM

program. This program typically involves a prominent business unit with large
financial risk and a business unit with higher nonfinancial exposures such as
strategic, reputation or operational risk.

2. Privilege

Issue: An ERM program allows management to quantify the company’s risks. As

risk information becomes increasingly event-driven, company lawyers may raise
issues regarding risk distribution to external regulators, auditors and constituents.
Corporates must balance risk visibility and legal exposure.
Solution: The easiest way to provide risk insight while protecting sensitive
information is to gather and report risk data according to broad categories without
providing specifics regarding contracts, legal cases, projects, events, counterparties
and products. Alternatively, risk information may be documented in qualitative
terms. While the more conservative approach is more commonly applied by
companies, the industry appears to be moving towards greater risk transparency.

Corporates with a more liberal approach typically manage data sensitivity issues
using several techniques. For example, companies can conduct all risk assessment
activities under legal supervision, with the objective of making the output
privileged.

Alternative ERM approaches where privilege is not available or where the company
does not wish to include producing multiple risk reports and distributing them
according to business need and relying on “confidential” and “for internal use
only” protections.

3. Defining Risk

Issue: One of the biggest challenges is setting up a consistent and commonly

applied risk nomenclature. Any inconsistencies between risk definitions are likely
to destroy the program’s success.

Solution: Setting up a formal risk management framework and common criteria

can be accomplished through teams comprised of at least one representative from
each significant business unit and shared service function. The most critical goal of
the group is to establish the definition of risk itself. While each risk category may
be distinct, the definition of risk must be consistent and supported by clear
guidance. Team must also create a risk list to define and rank all the risks faced by
the corporate.

4. Risk Assessment Method

Issue: ERM assessments are donethrough a variety of approaches and tools,
including surveys, interviews and historical analysis. Each one offers its own value
and drawbacks that must be closely reviewed to determine corporate
suitpotential.

Solution: The risk assessment method applied is largely based on the number of
respondent’sfeedback, corporate culture and most relevant familiarity with risk
management. Face-to-face interviews are helpful as they facilitate risk
management education and guidance, encourage discussion and allow for data
collection. Automated tools can also be applied with broad risk management
knowledge.
Also, the risk assessment method is generally tailored to the audience. For
example, many corporates administer executive risk assessments using a group
interview session and apply individual techniques to management or technical
personnel.

5. Qualitative and Quantitative

Issue: A key decision for many corporates is whether risks are assessed using
qualitative or quantitative metrics. Such key decision is driven by commitment to
ERM, its view regarding privilege and overall cost.
The qualitative method provides general indicators rather than specific risk.
Qualitative results are presented as high, medium and low risks. Qualitative
assessments may be open to interpretation.
Qualitative assessments are many times favored as they require less sophisticated
risk aggregation methods, mathematical support and user training which mean
lower implementation costs. Conversely, qualitative results are generally criticized
for their limited relationship with key financial statement and budgetary indicators.

Additionally, some critics suggest qualitative results are generally more difficult to
interpret, which limits managementspotential to assign account potential and
remediate.
Solution: While companies adopt the qualitative risk assessment approach, the
industry is shifting towards quantitative risk measurement. Companies that are in
transition to the quantitative assessments, do so using a phased approach and will
apply narrow risk ranges that expand the risk severity scale from three categories
as high, medium and low to five or more very high, high, moderate, low and very
low.

6. Time Frame

Issue: The time frame of ERM is largely based on the corporate’s intent to use ERM
risk results and its willingness to invest in risk management.
Many companies use ERM results for quarterly or annual planning, while many
integrate ERM results into annual budgeting and longer-term strategic planning
processes.

The shorter-term time framei.e less than 12 months is generally preferred as it

requires less user training, provides increased risk estimation accuracy and is
generally less expensive than the longer-term alternative while the longer-term
solution is applied where management values risk visibility beyond the annual
financial period. Regardless of the approach, the risk assessment time frame must
be consistent with intended ERM program objectives.

Solution: Companies appear to be shifting from the short-term to a longer-term or

hybrid risk assessment solution. Additionally, companies are also utilizing a rolling
over time horizon (e.g., 1 to 1.5 year) to mitigate annual assessment limitations
such as reduced risk visibility and time to mitigate as the year progresses.

7. Multiple Scenarios

Issue: Taking scenarios as e.g. The ERM team asks a respondent to assess the
likelihood of counterparty default and its loss impact during the current fiscal year.
The respondent determines that there is a 80% probability of at least one
counterparty default with a low financial impact over the defined time period.
There is also a 10% probability of at least one counterparty default with a high
financial impact.
The above situation shows an issue associated with basic risk assessment methods.

Solution: There are 2 approaches to the problem. Under the basic approach,
respondents provide a loss severity based on their estimates. For example, the
corporate recognizes a significant investment in a year. Then severity considering
all four potential loss events, portfolio sizes, historical loss records and the
company’s investment stress test results, loss is estimated. If the respondent
estimates $500,000 in loss severity, it roughly equates to $1, 25,000 per loss event.

The more advanced method requires identifying a distinct loss severity for all
potential events and calculating a mathematical average. To minimize
computational requirements, companies often limit the number of likelihood
scenarios and potential outcomes. The decision to pursue a basic or complex
method is largely based oncorporate’s familiarly loss concepts, the risk assessment
method employed and the level of risk tolerance definition.

8. ERM Ownership

Issue: Who is the realowner of ERM is often unclear and commonly disputed at the
board, audit committee and management levels.

Solution: Most of the times, risk is primarily owned by line management with
oversight from independent risk, compliance and management functions. The
broader question for ownership is less clear and largely based on board and audit
committee, established risk management function and infrastructure, and
corporate risk philosophy.

9. Risk Reporting

Issue: Corporates struggle with following two risk reporting issues:

1) What information should be shared with various internal and external
stakeholders?

2) How to communicate Risk?

Solution: Most corporates have multiple risk owners with different accountabilities
and needs. As top companies establish risk packages in line with recipient
responsibilities and specified delegation of authorities. Such Risk packages are
created for the board/audit committee, management risk oversight committee,
business unit leaders and line management. Reports are typically generated from a
common risk database and taxonomy where information varies based on risk type
and impact.

E.g. Board reports present risks that exceed a defined threshold, describe high
value strategic, emerging and high exposureswhich also exclude superfluous
information. Business unit and line reports may illustrate mid-level exposures,
tactical risks and transactional compliance data.

The external reporting is often less challenging. Public corporates are often
required to share certain risk information through financial statements, annual
meetings, quarterly earnings announcements, public presentations and various
regulatory responses. While external reporting requirements are fairly prescriptive,
corporates attempt to use ERM results to formulate or support risk assertions.

Barring prescriptive external reporting requirements, corporates vary with respect

to internal risk reporting format.Loss severity is typically applied by companies that
prefer to view maximum potential loss unadjusted for potentialevent occurrence.
As a compromise, many corporates report a combination of risk results and
designate primary metric to allocate capital.

10. Stress Tests

Issue: It allows management to assess the extent by which business operations

may be negatively affected by prescribed events and gauge the corporate’s
potential to respond. Corporates often struggle to balance the need for meaningful
simulation and stress tests against a nearly infinite number of potential scenarios.
Similarly, corporates frequently struggle to identify and predict unknown or
unlikely risks.

Solution: As there is no general consensus regarding the number and type of

simulations to perform, bank regulatory guidance requires financial institutions to
forecasts under macroeconomic scenarios. As worst case scenario is also not
specifically defined, examples suggest stress tests show “extreme” scenarios rather
than catastrophic events.

Corporates typically address adverse events through periodic and highly targeted
brainstorming sessions where these events are reviewed to determine what
management action will be required. The brainstorming sessions are limited to
executives and performed during a regularly scheduled committee meeting.

Opportunities for Leveraging an ERM Initiative

1) Strengthen integration of ERM

For an ERM initiative to be successful it has to be viewed as a strategic tool.
Onehas to link it to strategy and position risk thinking with strategic execution.
Executives speak the language of strategy. Management needs to consider the
risks to the strategy, such as what might prevent the company from executing it, as
well as the risks of the strategy, such as pursuing the wrong strategy or triggering
unintended risks from the successful pursuit of an initiative.

Another link between ERM and strategy are the assumptions that the strategy is
based on. If ERM provides more insight on those assumptions, then the strategy
has a better chance at success.

2) Interdependencies and clusters of risk drivers

ERM is to throw more light on how different risks can interact to create bigger
risks. ERM can provide a good tool to do that since it gathers thinking and
information about different risks all in one place.

One of the arguments for not adopting ERM is that good managers should always
be thinking about the risks and carving them out into a separate function could
provide a false sense of security among front-line managers that they are being
managed by others. But now people are realizing that risks don't behave in
isolation and a risk does not know organogram. If they attack, they will attack in a
variety of places. Since ERM is a more holistic and lied across the corporate, it can
help corporates to see those interactions better.

3) Strengthen metrics to monitor risks

ERM provides insight to get a better understanding of what drives risks and the
indicators that risks are increasing or decreasing. Generally Management
dashboards are loaded with performance indicators, but not risk indicators.The
corporate should be putting together key risk indicators (KRIs) along with key
performance indicators (KPIs)through an ERM program.

The current system for monitoring risks has room for improvement as KPIs are
historical and based entirely on internal data, while KRIs are forward looking and
can pull data from various external and internal sources.

4) Ready for top risks

ERM has a great opportunity to help corporates respond to risks when they are
triggered. Companies should have be ready for each of its top risks. Need to think
on the game plan if the risk is realized.

ERM can put detailed information in the plan and can be used in various parts of
the corporate that could be affected by the triggered risk.

5) Barriers in ERM implementation

There are some common barriers :

• Think about risk without ERM

• It's too costly versus the return to get from it
• Don't have the resources and manpower to devote to it
• It creates too much complexity
• There is no measurable return on investment
• It fuels up bureaucracy
There is an opportunity to identify and understand these barriers in the corporate
to ERM and overcome them. One needs to find strategies to navigate around the
barriers.

Link risk management to the strategy and business model of the corporate. Enable
more robust conversations about risk in the corporate.

"Risk and strategy is the link, and ERM is strategic tool."

Mission, Vision, Values, and Strategy in ERM

The starting point of ERM is an entity's mission, vision, values, and strategy.

Where Mission is why the entity exists. It states what

the entity wants to achieve.

Where vision is the entity's aspirations for future.

It states what it wants to achieve and be known for and
as.

Where Core values are the entity's beliefs and ideals

about morality; influences individuals’ and behavior.

Where strategy is corporate's plan to achieve its mission

and vision and application of its core values.

ERM Management

It includes focus on the following elements:

Corporate culture—It is the way that people in the corporate think and
behave. It reinforces the corporate's mission and strategy when it supports
these written documents with positive actions and behaviors.

Capabilities Development—Companies shall hire, promotes, and nurture skills

and competence. One critical competence is the capacity to adapt to change,
including changes in technology.

ERM practices—ERM is dynamic which requires adaptation to projects,

initiatives, and innovative technologies. It is also integrated into all divisions,
units, and functions.

Integration with strategy and performance—It shall be integrated with

corporate's strategy, mission, vision and goals.

Strategy management and business objectives—Well defined and

implemented ERM provides an entity with a “reasonable expectation” of
achieving strategic goals.

Reasonable achieving of goals are not guarantees of success. Unforeseen

events will occur; risks cannot be predicted with certainty. However, the
chances of success increase to the extent that corporate regularly reviews and
revises its ERM practices to changing conditions.

Value linking through risk appetite—ERM occurs in relation to corporate's risk

appetite. The corporate's risk appetite is reflected in its mission, values, and
strategy.
30. Which of the following is not a strategy risk of a scooter rental company?

A Customer accident and damage incidents may be higher than expected.

B Customers may choose only low-margin scooters.
The corporate has a well-defined plan to achieve its mission and vision and apply its
C
core values.
D Scooters may be stolen.

31. The ERM component which includes mail, meeting minutes and reports
as important elements is

A Governance and Culture.

B Performance.
C Review and Revision.
Information, Communication, and
D
Reporting.

32. To demand higher performance usually requires accepting more

_________.

A Tolerance
B Vision
C Risk
D Performance
 severity

33. Mr.P’s Pot, Pots, and Pottery, located in Colorado, hosts parties where
customers sample high-end products (by smoking, eating candy, or in aerial
diffusers) while making pots and pottery. In assessing the company's
business strategy, which of the following would be less important?

Does our business strategy align with our

A
mission?
Does our business strategy align with our core
B
values?
C Do we understand the risks of our strategy?
D Will we achieve the goals that we have set?

34. As compared to a risk-averse entity, the ERM of a more risk-aggressive

entity demands __________.

A Greater integration
A discrete, autonomous ERM
B
unit
C Lower-velocity data
Lower performance
D
expectations
35. Match the statements below with the categories in ERM:

• We will improve the quality of life of …

• We will be known for outstanding …
• We will treat our customers and employees with respect …

1 core values, 2 risk appetite, 3

A
mission
B 1 strategy, 2 values, 3 vision
C 1 tolerance, 2 mission, 3 appetite
D 1 mission, 2 vision, 3 core values
Enterprise Risk Management
Components , Principles and Terms
Enterprise Risk Management (ERM)
The business environment at present is one in which boards of directors and
senior management would face rapid changes, complexities and risks. Such an
environment, also presents them with significant new opportunities too.
Organizations can enhance their abilities to be successful in both addressing
risks and taking advantage of opportunities by enhancing their enterprise risk
management processes and integrating ERM fully into their strategy setting
and performance processes.

Enhancing ERM processes commences with a clear understanding of the role of

ERM in assisting the management to make better decisions and achieve their
strategy and business objectives. The updated COSO ERM Framework clarifies
both the relationship between strategy and risk and that the objective of ERM
is to assist the organization to achieve its strategy and business objectives.
Understanding key points is not only critical for success but important in setting
and communicating the risk culture in organization.

The ERM framework is one of two widely accepted risk management standards
to manage risks in an increasingly turbulent, unpredictable business scenario.

The initial objective of COSO was to study financial reporting and develop
recommendations to prevent fraud.

Its first “standard,” Internal Control – Integrated Framework, was released in

1992 and provided a comprehensive framework for assisting organizations to
assess and improve internal control systems. Afterits release, organizations
began to realize there was a gap in the internal control framework.
On one way it was helpful in reducing risks around fraudulent behavior and
regulatory compliance, and on other way there was no way to identify and
assess which risks the organization needed to put controls around.

As 2004 COSO framework includes strategy setting in its definition of ERM, the
fact is that the Sarbanes-Oxley Act and its requirements for public companies
to test and certify financial reporting controls was a strong motivating factor in
developing the standard.

Originally, ERM consisted of four categories – Strategic, Operations, Reporting,

and Compliance – two of these directly relate to corporate governance.

Though the original standard includes strategic objectives as a category, the

reason for including it was to ensure the organization’s strategies “align with
operations, reporting, and compliance activities.”

Later, the 2004 COSO ERM framework focused more on what can be audited
instead of identifying threats and opportunities, where the real value in ERM
lies. The standard was a comfortable fit for organizations where risk was driven
by audit.

And the latest COSO ERM framework retains many of the same characteristics
as the original; it places greater emphasis on strategy.

On feedback, it was explained that the original COSO ERM framework was
solely concerned with internal control. Hence to address this and other issues
too, an updated standard in 2017 with the title Enterprise Risk Management –
Integrating with Strategy and Performance was released.

While the connection of risk management and strategy was emphasized in the
earlier framework, the 2017 updated framework putsweight on the importance
of integrating risk considerations when designing and implementing strategies
to accomplish the organization’s performance goals and objectives.

Instead of using a cube to illustrate the link between the four categories and
the eight components of the risk management process, the new standard uses
ribbon-type diagram that includes five categories throughout
an organization’s lifecycle (see below). It explains that three ribbons in the
diagram are there to represent common processes that “flow through the
entity while the other two ribbons represent the supporting mechanisms.

Instead of focusing more on strategic objectives, the new framework places

greater emphasis on culture and dives deeper into concepts like risk appetite.

COSO’s new ERM framework includes five components or categories with 20

principles spread throughout each component.
Those components are as below:
Governance and Culture – It forms the basis of the other
components by providing guidance on board oversight
responsibilities, operating structures, leadership’s tone, and
attracting, developing, and retaining the right individuals.

Strategy & Objective-Setting – It focuses on strategic

planning and how the organization can understand the
effect of internal and external factors on risk. This section
provides guidance on analyzing business context, defining
risk appetite, and formulating objectives.

Performance – After strategy development, it moves on to

identify and assess risks that could affect its ability to
achieve these goals. This section not only helps guide the
organization’s risk identification and assessment, but
also how to prioritize and respond to risks. After all, an
organization is only as good as its performance, which is
bigger than just risk management.

Review and Revision – At some point after risks have been

prioritized and a course of action been chosen, the
organization moves into the review and revision phase
where it assesses any changes that have taken place. This is
also the opportunity to understand how the ERM process in
the organization can be improved upon.

Information, Communication, and Reporting – The last

component of the COSO ERM framework involves sharing
information from internal and external sources throughout
the organization. Systems are used to capture, process,
manage, and report on the organization’s risk, culture, and
performance.
ERM Assessment

ERM is an iterative process. As organization has issued risk reports doesn’t

mean the work is done. With data about risk treatments and processes in hand,
a review and refinement of governance, strategy, and risk management
processes should also take place.

Organizations shallassure that they can manage risk by assessing the entity's
capacity to manage risk. Such assessments

• May be voluntary or may be required by law regulation.

• Should provide assurance that:

1. The five components and 20 principles are present and functioning.

2. The components and principles are fully integrated, to ensure that
decisions and actions respond appropriately in changing environments.
3. The controls needed to achieve the principles are present and
functioning.
Reference: 2017 Committee of Sponsoring Organizations of the Treadway
Commission (COSO).

Evaluating COSO 2017 ERM Principles

There are three sections (Standard Practices / Documentation and

Questionnaire)in each following diagram under each principle which inform this
audit program:

a. Ideally, what would this COSO principle look like in practice?

b. What documents would an auditor request to validate that practices are
in line with COSO principles?
c. What questions might an auditor ask to validate that practices are in line
with COSO principles?

Governance & Culture

1) Exercises Board Risk Oversight:

 Board is trained in ERM.
ERM is a specific responsibility listed in the Board charter; is charter
reviewed and updated somewhat regularly?
What is their meeting frequency?

Charter, meeting minutes, Ethics policy, cultural statements

Has the Board trained on ERM oversight?

What does the board see as their responsibility?
Do they understand risk management?
Are they comfortable with the risks at the institution?
Do they have info to make decisions on risk? Happy with frequency?
How are risk decisions considered in other areas?
Risk appetite and tolerance defined?
How is risk impacting the decisions of the board?

2) Establishing Operating Structures

 There is a risk committee of the Board.
There is a risk management department.
There is a position for a qualified risk manager

All of the above is documented in charters, job descriptions, org charts,

reporting matrix, policies and procedures, etc. Matrix of some kind that
shows requirements

Is there a risk committee or is the responsibility in another committee for

oversight?
Are you satisfied with the current risk organization?

3) Defines Desired Culture:

 Defined risk culture needs to be something in the middle that works
with your organization’s strategy.
Risk and risk management are addressed in the strategic plan.
Acknowledge that culture is a big part of risk management.
Tone at the top, mood in the middle, behavior at the bottom.
All should line up with the mission, vision, values.

Strategic plan, mission, vision, values, exit surveys; climate surveys;

financial incentives, hotline complaint patterns, etc.

What is the defined risk culture for this organization?

Has the culture been documented and approved by management and
the board?
What are the incentives in the organization?
Do all necessary elements match up?
4) Demonstrates Commitment to Core Values
Reflected in the budget
Whistleblower policy
Non-retaliation policy
Types of channels exist
Managing cases properly
Process for investigations
Training
Task force reports

Strategic plan, mission, vision, values, exit surveys; climate surveys;

financial incentives, hotline complaint patterns, etc.

Conduct an anonymous cultural survey.

What actions is management taking to demonstrate commitment to these
values?
5) Attracts, Develops, and Retains Capable Individuals

Skilled, capable, credentialed individuals doing the jobs.

Job descriptions require specific certifications and experience.
Should have an HR program that recruits, evaluates candidates.
Succession planning process, low turnover, annual evaluations

HR policies and procedures; professional growth procedures; performance

evaluations; recruiting plans; recruiting files and notes; market surveys;
succession plans

Do present risk management personnel have adequate skills,

certifications, and experience?
Is there turnover in key positions? If yes, why?
When criteria are met, are there promotions from within?
Any statistics from performance evaluations?
How are we bridging the risk mgt gaps?
Strategy & Objective Setting

6) Analyzes Business Context

Benchmarking with peer institutions: Enrollment, retention, performance
indicators for faculty and students, etc.
Where is the resources spent?
Legislative impact if any?
Publicly available risk information—industry specific, when available
External political, economic, social, technology, legal, and environmental
factors are considered
Internal capital, people, process, and technology factors are considered

Business context report

List or sources used in analysis

How was the business context analyzed?

Were internal and external factors considered (see list above)?
Were the results documented?
What are our competitors/peers doing?
Meeting expectations?
Resources sufficient?
7) Defines Risk Appetite

Risk definition exercises conducted with management to establish

tolerable limits.
Expressions implemented should include target, range, ceiling, and floor
as well as capacity and profile.
A report with the result of existing risks, acceptance, tolerance, to present
to the Board to drive the setting/evaluating risk appetite

Business context report

List or sources used in analysis
Verizon Risk Report

Are you satisfied with the current risk appetite ?

What are the thresholds where the Board gets involved?
What is the tolerance of the board?
8) Evaluates Alternative Strategies

Multiple strategies for addressing risk are evaluated

ERM tabletop exercises could assist with identifying strategies
One valid strategy is risk acceptance

Documentation showing that multiple strategies have been considered

Are you happy?

Resources sufficient?
How would a funding decrease impact risk?
Formulates Business Objectives

Budget and forecasting process

Different levels considered: department, management, and university
Business objectives are aligned with organizational strategy

Mission, vision, goals, objectives, values

Budget, forecasts; Strategic plan all tie into business objectives
List of business objectives that show how they align with strategy

Are business objectives defined?

Are these objectives aligned with organizational strategy?
Are resources sufficient?
Identify Risks

There is a defined, documented risk universe that impacts performance,

strategy, and business objectives
What could prevent us from achieving objectives?
Brainstorming meetings
KPI'S
Iterative/continuous assessment
1:1 meetings with key management
Peer institute collaboration
Research
Online survey
Any/all of the above
Final result: A risk inventory

Risk register; meeting minutes; survey results; interview notes; financial

reports; risk inventory

Is there clear understanding how risks emerge?

Is there a repeatable risk identification process?
Who was involved? How often?
Does the process take into consideration an adequate risk universe?
Does the process result in an adequate risk inventory?
Assesses Severity of Risk

Input into this process will be the risk inventory from above:
Very subjective, but can make it objective
Can be measured by financial thresholds
External look at how it impacted others; external environment
considered
Reputational risks; health and safety considered
Utilizes impact, likelihood, qualitative, quantitative, and
frequency measures
Output from this process will be the same risk inventory with severity
added to each item and a heat map or other depiction or how risks rank
on a severity scale

Risk severity assessment process documents:

Risk Report - is there an assessment of severity; does it include scales?
A heat map or other depiction or how risks rank on a severity scale

Did the process take into consideration necessary measures ?

Have risks been adequately ranked? Is there a report?
Are you happy?
Whether Resources sufficient?
Prioritizes Risk - how the university will respond vs. measuring severity

Input for this process will be same risk inventory with severity added to
each item
It considers business strategy, objectives, and appetite; bias is avoided
Output for this process will be the risk/severity inventory put in priority
order

Risk raking process

Risk/severity inventory ranked by priority

Are you happy with how risks are ranked?

Were business strategy, objectives, and appetite taken into
consideration?
Was bias avoided?
Implements Risk Responses

Input for this will be the risk inventory put in priority order
A response plan for each prioritized risk which utilizes the following
categories: accept, avoid, pursue, reduce, and share and takes into
consideration business strategy and objectives, priorities, appetite, and
severity; also cost/benefit
Evidence the response plan has been implemented
Plans in place - KPI's measuring risk response
Presenting to the Board periodically
Risk champion/risk owner
Policies updated when risks/responses are identified

Documented risk response designation process

Risk inventory with corresponding response(s); Action plans;
reports to board or mgmt.; team membership; external
reviews/audits

Is the response plan appropriate?

Are we happy with how we plan to respond? responded?
Did we go too far? Not far enough?
Are the risks mitigated?
Has the Board signed off on residual risks?
Develops Portfolio View

An advanced process
Risk is known from A to Z
Risk identification and responses are in line with company
strategy at the entity level
Risk management is driven by the organization’s strategy and
objectives, top down

Copy of the risk portfolio

Can all risks in the inventory be tied to a strategic imperative?

Are you happy? Resources sufficient?
Review and Revision

9) Assesses Substantial Change

Change management at the entity level takes risk management into

consideration (“Substantial change may lead to new or changes risks…”)
Effects of change are evaluated
Post mortems are done after a risk event that reviews
responses and their effectiveness

Entity change management documentation showing risk is considered

* Post mortem process/notes

Was risk taken into consideration when substantial changes occurred in

entity strategic plans?

Are you happy? Resources sufficient?

Reviews Risk and Performance

Treat it like an audit

Periodic sign offs and reviews
Reports to senior management and the board
Monitoring by risk management function of the risk owners
Follow up process

ERM review process

ERM review results/report

Are you happy with the risk management process?

Is risk being managed as we intended?
Are gaps closed?
Pursues Improvement in Enterprise Risk Management

Where can improvements be made?

Timely/periodic reviews
Training
Updates received
Resources available

QA process/program
Evidence of changes needed and changes made

Is our ERM working as intended?

Is continuous improvement part of the ERM process?
When was the last ERM program assurance evaluation?
How often is the process evaluated?
Are you happy? Resources sufficient?
Information, Communication, & Reporting

18) Leverages Information and Technology

The risk management process is automated using software designed

for ERM
Leverage from feedback, research, benchmarking, newspapers,
websites, failures of other organizations, etc.
Keeping up-to-date with trends, innovations
Training/networking with other risk managers

Prospectus of ERM software used

Sample reports from the ERM tool
Sample of resources used to keep up-to-date with latest ERM trends

Are you using technology to help manage ERM?

How do you stay up-to-date with ERM innovations?
How often is your ERM training updated?
Are you happy? Resources sufficient?
19) Risk Information Communication

Everyone who needs risk information gets it in a timely manner

Alert system, if necessary
System of communication is in place and tested periodically
Communication occurs top to bottom - Board, senior mgmt; students;
faculty; staff; stakeholders

Communication plan/process
Sample surveys, emails, posters, coasters, pens, swag, etc.
Anything that shows the communication plan/process is used and is
working

How often is risk information communicated and to whom?

Are there committees and teams who meet regularly?
Are you happy? Resources sufficient?
Has risk communication been effective?
Reports on Risk, Culture, and Performance

Board gets scheduled reports

Senior management gets scheduled reports
Annual risk report
Reports using key indicators

Reporting schedule
Copies of the above reports and survey results
Evidence of action taken on gaps found.

What groups are getting risk reports?

Is the Board informed about risk on a regular basis?
Is senior management part of the risk management process?
Stakeholders?
Is action taken to close gaps?
Are you happy? Resources sufficient?
Glossary of ERM Terms

COSO - COSO stands for the “Committee of Sponsoring Organizations of the

Treadway Commission.” It was initially organized by five major U.S. professional
associations and includes included representatives from industry, public
accounting, investment firms, and the New York Stock Exchange. COSO provides
thought leadership through the development of frameworks and guidance on
enterprise risk management, internal control and fraud deterrence.

COSO’s guidance on enterprise risk management has become one of the leading
frameworks used to design and manage ERM programs. Along with the ISO 31000
standard, COSO’s “Enterprise Risk Management—Integrating with Strategy and
Performance (2017)”, is considered state-of-the-art guidance for modern, effective
ERM programs.

Control – It refers to the processes put in place by management that seek to

reduce the likelihood of risk events occurring and their impact should risk events
materialize. Risk controls are sometimes also referred to as risk mitigations. While
some practitioners will differentiate between the terms, in our experience the
differences do not provide practical benefits and the terms controls and
mitigations can be used interchangeably.

Control Effectiveness - A rating of how well risk mitigations are expected to reduce
the impact and/or likelihood of an associated risk event. For example, high control
effectiveness indicates that the controls should significantly reduce the negative
outcomes associated with a risk. Control effectiveness is typically rated on a 1 to 5
scale and is often the subject of audit and simulation activities to verify that
controls are in place and functioning as expected.

Cost of Risk – It is a measure of the cost of managing risks and incurring losses.
Total cost of risk is the sum of all aspects of an organization's operations that relate
to risk, including retained losses and related loss adjustment expenses, risk control
costs, transfer costs, and administrative costs.
Credit Risk – It is the risk that an organization will incur losses due to the default or
downgrade of counterparty. E.g. if a customer does not pay an account receivable
this would represent a crystallized credit risk. In order to limit customer credit risk
companies usually go through a variety of processes including, the development of
credit risk policies, up front credit checks on new clients and regular review of aged
accounts receivable

Enterprise Risk Management (ERM) - It is the process by which the board of an

organization identifies and manages risks to the organization, its strategic
objectives and its stakeholders. It shares common perspectives with other risk
management disciplines. What sets ERM apart, however, is that it focuses on risks
that could interfere with an organization’s strategy and or that emerge from the
pursuit of the business strategy.

It typically involves board members, senior executives and business unit leaders.
Risks identified and managed through the ERM process will generally apply to the
organization overall and will include forward looking risks related to business
disruption, market shifts, regulatory changes and more. As such, ERM is considered
a component of corporate governance, strategic planning and strategic execution.

It is a complementary process to other more specific forms of risk management. It

is common for these specific risk processes to be rolled up and summarized in one
or more risk entries within the overall ERM program.

ERM Software - Systems used to automate ERM processes, including data

gathering, risk monitoring, analysis and reporting. There are three broad categories
used to facilitate ERM programs:

• Manual tools like spreadsheets and presentation documents,

• Large integrated GRC suites and
• Customized ERM tools.

GRC – It stands for governance, risk and compliance. It is used to denote a business
area that oversees these functions. It is also often used to describe software
systems that integrate functions of governance, risk management and compliance
management into a single platform. Many of these systems have grown out of
compliance functions detailed compliance management remains their primary
focus. See our article on enterprise risk management tools for more information.

Health and Safety Risk – It relates to the safety and health of employees,
customers, suppliers and other individuals who interact with the organization.

Heat Map - It is a visual grid that plots the potential impact of an event against the
likelihood of it occurring. The purpose is to convey the organization’s overall risk
profile at a point in time.

They are represented in a 5 x 5 matrix that results in a 25-square grid. The heat
map gets its name from the colors that are used to colour each of the grid squares.
Individual risks or summarized categories are plotted on the heat map based on
their likelihood and impact scores.

Incident - An event that could lead to loss or disruption to an organization's

operations, services or functions. It is typically thought of a risk event that has
actually occurred. An event may be described as a risk while there is uncertainty of
it occurring. Once it has happened, it is termed an incident. The number of
incidents that occur during a given timeframe may be key risk indicators for other
enterprise risks.

Inherent Risk - The rating of risk before the effects of any risk mitigation steps have
been considered. It shows the level of risk that would be faced if the organization
were to accept the risk without taking any steps to mitigate it. It is usually
calculated as the product of inherent likelihood times the inherent impact of an
event. It is generally rated higher than residual risk, which is the rating of a risk
after risk mitigations have been taken into account.

Integrated Risk Management (IRM) – It is a continuous, proactive, systematic

approach to identifying, assessing, acting on, and communicating risk from an
organization-wide, aggregate perspective. It is typically viewed as synonymous
with enterprise risk management (ERM), although some prefer the term IRM to
emphasize that the discipline is pulling together risk management practices from
across an organization into a unified framework.

Key Risk Indicators (KRIs) - These are metrics that indicate that a risk event may
happen in the near future (leading indicator) or that a risk event has already
occurred (trailing or lagging indicator). E.g. imagine that a firm is concerned that
customer service levels and customer satisfaction levels are decreasing due to
changes made in its operations. Lagging indicators could include metrics as
number of complaints to the office of the President, number of negative social
media mentions, increased support ticket rates, customer satisfaction scores and
more. Both leading and lagging risk indicators allow risk managers to identify
changing risk profiles faster, so that management teams and boards can take
corrective action more quickly.

Likelihood - The probability of a specific risk event occurring. In an ERM context, it

is one of the two primary axes of a heat map and one of the two factors used to
generate a risk score (along with impact). It is typically assessed using a 1 – 5 scale
(ranging from “rare” to “almost certain”).

Liquidity Risk - Exposure to adverse impacts stemming from the mismatch of cash
inflows and outflows. It crystallizes where an organization is at least temporarily
unable to meet its payment obligations as they come due.

Market Risk - The risk that a company may experience losses due to external
market drivers such as interest rates or foreign currency rates. If a company has a
large portfolio of variable interest rate debt then it has market risk related to
interest rates.

Mitigation – It typically refers to the processes put in place by management that

seek to reduce the likelihood of risk events occurring and their impact should risk
events materialize. They are also referred to as risk controls.

Operational Risk - This is the risk driven by exposure to uncertainty arising from
daily tactical business activities. An example of an operational risk is the failure to
provide financial statements to the Board for their review.

Post-Event Mitigation – They are activities and measures that an organization uses
in response to a risk event, in order to lessen the impact of a risk event and/or
recover to a desired state more quickly. Insurance is a traditional form of post-
event mitigation. An insurance policy does not stop a risk event from occurring but
can help lessen the financial impact after the fact.
In an operations example, a cyber-incident response plan is a post-event mitigation
for a cyber-breach risk event. In a financial example, if a company has a large
portfolio of variable interest rate debt then it has market risk related to interest
rates.

Pre-Event Mitigation - They are measures and activities that have been put in place
to lessen the negative consequences of a risk event before it occurs. They focus on
lessening the likelihood that a risk event will occur. E.g., an organization concerned
about the risk of a service outage at an important data center caused by a power
outage may choose to implement a redundant power source as a proactive
preventative measure.
Residual Risk - It represents the net level of risk facing organization after risk
controls. Because risk mitigations can moderate both the impact and likelihood of
a risk event, residual risk is usually calculated as the product of residual likelihood
times the residual impact of an event. Itdiffers from inherent risk, which is the
gross risk facing the organization before considering the moderating effects of risk
mitigations.

Risk Appetite - A description of the amount and types of risk that an organization
wishes to take in order to achieve its desired objectives. It usually starts with a
broadly written organizational-wide statement and then provides a series of more
refined statements for certain situations. It can be qualitative, quantitative, or a
mix of both.

Risk Appetite Framework - The overall approach, including policies, processes,

controls, and systems through which risk appetite is established, communicated,
and monitored within an organization. It includes an overall risk appetite
statement that is usually followed by a series of more specific statements for
certain situations (usually by risk category). It also includes roles and
responsibilities of establishing and monitoring of the risk appetite framework. The
risk appetite framework should align closely with the organization’s strategy.

Risk Capacity -- Risk capacity usually refers to the total amount of risk that
organization can bear without touching its critical objectives or corporate viability.
This is typically an amount higher than the upper risk thresholds that are set within
the risk appetite framework. Risk capacity can be both quantitative and qualitative
and is often used to describe financial thresholds e.g. the maximum financial loss in
dollar terms that can be absorbed or the maximum capital that can be exposed. It
is sometimes used as a synonym for risk tolerance.

Risk Profile -Risk profile usually refers to a summary of the top risks facing an
organization i.e. the aggregate level of residual risk across the ERM program. It is
used as a baseline or barometer of total enterprise risk. In recent years, risk
profiles have evolved to be presented in objective-centric views, which identify the
organization’s top strategic objectives and their associated levels of risk .

Risk Register - It is a summary listing of the organization’s risks, along with their
rating and a summary of the actions being taken in response to the risk. Risk
registers used in enterprise risk management are unique in that they tend to focus
on a relatively small number of strategic or enterprise-wide risks. These enterprise
risks are monitored and reported on to the executive team and board of directors
on a regular basis. Enterprise risk registers may incorporate summary information
from more granular departmental risk registers.

Risk Tolerance - It may be used as a synonym for risk appetite or a synonym for risk
capacity. Still others use it in a more granular fashion to track and monitor
variances against key risk indicators.

Risk Transfer - Risk transfer is a risk treatment approach that uses legal contracts
to shift residual risk from one party to another. E.g. purchase of an insurance
policy, by which a specified risk of loss is passed from the policyholder to the
insurer.

Risk Treatment - It refers to the strategies and steps taken to reduce, remove,
avoid, transfer or otherwise alter the level of a risk. Risk treatment approaches are
taken in order to bring risk levels in line with the desired risk thresholds set by the
board of directors and executive team in the organization’s risk appetite. The final
approach to risk treatment is risk acceptance, which typically occurs once
mitigations have been applied and a management team agreed to accept the
remaining level of residual risk.

Risk Velocity - The speed at which a risk is expected to emerge from root causes,
crystallize into an actual risk event and then translate into consequences. Risk
velocity can also be thought of as Time to Impact. Some ERM practitioners use risk
velocity as an additional variable to assess risks, in addition
to likelihood and impact.

For example, two serious risks may have the same rating of likelihood and impact,
but one risk may occur and lead to consequences immediately, whereas the other
develops slowly over a period of months or years. The risk with high velocity is
likely to be managed with more intense controls, including the monitoring of
leading key risk indicators. Common examples of high velocity risks are cyber
security breaches, industrial accidents and public relations problems. Sample low
velocity risks are changing market preferences and customer behaviour, political
shifts, and regulatory changes.

Root Cause - It is a preceding event or condition that triggers or otherwise leads to

the occurrence of a risk event. They are a core component of risk bow tie diagrams
and are used in root cause analysis to proactively identify and mitigate risk drivers
before they trigger risk events.

Root Cause Analysis -It seeks to identify and mitigate root causes before they
trigger or contribute to risk events. Mitigating at a root cause level is a form of
proactive risk management. It also can be a more efficient approach to risk
management, as many risks may share a common root cause and preventing a risk
event is often much less expensive that mitigating its impact once it has occurred.
It is made easier through visual approaches, such as bow tie diagrams, and through
ERM software tools with built-in root cause analysis, including the Essential ERM
system.

Strategic Risk - Strategic risk Exposure to uncertainty arising from long-term

business planning and execution. For example, strategic risk might arise from
making poor business decisions from the substandard execution of decisions, from
inadequate resource allocation, or from a failure to respond well to changes in the
business environment. It is often a primary risk category within enterprise risk
management programs, including risks related to reputation, brand, business
model, economic trends and competition.

Stress Testing - It is a simulation technique often used in the banking industry. It is

also used on asset and liability portfolios to determine their reactions to different
financial situations. Additionally, stress tests are used to gauge how certain
stressors will affect a company, industry or specific portfolio. Stress testing

Value at Risk (VaR) - It is a quantitative risk measurement technique that is used to

estimate the risk of a financial investment. It is measures the amount of potential
loss that could happen in a portfolio of investment over a period of time. It gives
the probability of losing more than a given amount on a given portfolio over a
period of time. Value at risk is commonly used by financial institutions to provide a
quantified estimate of potential downside of an investment or portfolio.

36. ABC Corp. mines for minerals in developed countries. It is currently

assessing aspects of risk to determine which risks are most and least
important. This analysis most likely occurs as a part of which component in
the ERM framework?

A Governance and Culture

B Performance
C Strategy and Objective-Setting
Information, Communication, and
D
Reporting
37. ABC Corp. recently implemented an initiative to attract and retain web
programmers and systems analysts as a part of its expanded web
development to support online sales. This most likely occurs as a part of
which component in the ERM framework?

A Governance and Culture

B Performance
C Strategy and Objective-Setting
Information, Communication, and
D
Reporting

38. As per the COSO Framework, uncertainty in ERMis :

A The impact of events or the time it would take to recover.

B The state of not knowing how or if potential events may manifest.
C The possibility that events will occur and affect the achievement of objectives.
The boundaries of acceptable variation in performance related to achieving
D
business objectives.

39. COSO's framework encompasses each of the following, except

Enhancing risk response

A
decisions.
Decreasing inherent risk
B
appetite.
Improving deployment of
C
capital.
D Seizing opportunities.
40. ABC Corp. recently completed a systematic analysis of the political,
economic, social, technological, legal conditions forthe short and the long
term. This analysis most likely occurs as a part of which component in the
ERM framework?

A Governance and Culture

B Performance
C Strategy and Objective-Setting
Information, Communication, and
D
Reporting

41. XYZ Company recently implemented a whistleblower system to facilitate

the reporting of events and concerns related to potential violations of its
code of conduct. It most likely occurs as a part of which component in the
ERM framework?

A Governance and Culture

B Performance
C Strategy and Objective-Setting
Information, Communication, and
D
Reporting
Enterprise Risk Management
Governance and Culture
Enterprise Risk Management (ERM)
Governance, or internal oversight, sets up the manner in which decisions are
made and how these decisions are executed. It forms the basis of the other
components by providing guidance on board oversight responsibilities,
operating structures, leadership’s tone, and attracting, developing, and
retaining the right individuals.

Governance is the systems and processes that ensure the overall effectiveness
of an entity – whether a business, government or multilateral institution.
Effective governance provides the oversight, structure and culture needed to
establish the goals of the organization, the means to pursue them and the
ability to understand any associated risks.

The ERM Framework puts weight that governance, including strong oversight, is
a prerequisite to effectively identifying, assessing and addressing the full
spectrum of risks to the organization. Incorporating risks into the governance
structure, systems and processes is critical for overcoming the challenges many
organizations face in managing these risks – such as organizational silos,
quantification challenges and organizational biases.
It sets the organization’s tone, reinforcing the importance of, and establishing
oversight responsibilities for, enterprise risk management. While culture
pertains to ethical values, desired behaviors, and understanding of risk in the
entity.

Board Risk Oversight

The BOD provides oversight of the strategy and executes governance

responsibilities to support management to achieve strategy and business
objectives.
Accountability and Responsibility

The BODhas main responsibility for risk oversight while on the other
hand management had responsibility for the day-to-day management of
risk.

The board shall have the skills, experience, and knowledge to exercise its
risk oversight function. The expertise needed to exercise oversight may
change with the business.
 The board shall be independent of management. Potential challenges to
board member independence are as follows:

Financial interest in the entity

Employment in an “executive capacity” in company.

Acting in a capacity to advise the board as a consultant.

A contractual relationship with the entity as a supplier,

customer, or service provider.

Substantial donations made to the entity

Personal relationship with key stakeholders

Membership on a board with a potential conflict of

interest.

Holding a position on the board with extension.

The board shall understand the potential for organizational biases like
dominant personalities and should challenge management to overcome
from them.

Establish Operating Structures

The organization sets up operating structures that support the strategy

and business objectives.
Operating Structure and Reporting Lines

The operating structure tracks how an organisation fulfills its daily

responsibilities and aligns with legal and management structure.

Influences on an entity's operating structure include the following:

Strategy and business objectives and risks

Nature, size, and geographical locations of the business

Delegation of authority, accountability, and

responsibility across all levels

Reporting lines may be direct or secondary and

communication channels

Third party reporting requirements like financial, tax,

regulatory etc.

A. Structures of ERM

Many companies are having risk committees appointed by the

board. Many organizations may have multiple risk committees. All
such committees that are responsible for managing risk should
include statements of committee authority, committee
 membership, and frequency of meetings, responsibilities, and
operating principles.

B. Authority and Responsibility

In entities with one BOD: Management designs and implements

practices to achieve strategy and objectives.

In entities with dual-board: a supervisory board focuses on long-

term strategy while the management board oversees daily
operations.

Risk management is improved when:

• Management delegates responsibility to achieve objectives.

• Management identifies transactions for review and approval.
• Management identifies and assesses new emerging risks.

Define Desired Culture

The management exhibits the desired behaviors that shape the

entity's desired culture.
Culture and Behavior

There are Internal and external factors which may influence the
organizational culture are listed below:

Internal factors include:

Managerial judgment

The level of authority delegated to employees

Physical layout of the workplace whether decentralized or centralized.

System of rewards, recognition, accountability, and compensation

While external factors include regulatory compliances and

expectations from customers and investors.

With reference to risk, organizational culture exists on pillars

of risk averse, risk neutral, and risk aggression.

A risk-aware culture may permit both approaches, if both are

within the organization's tolerance and appetite.Corporates may
choose to be more risk averse within the context of the entity's
overall risk appetite.For example, an aggressive sales unit may
focus on sales without careful attention to regulatory compliance.

Judgment

It includes taking thoughtful and rational decisions from available

information. It is required when very little or adverse information
exists about alternatives or in periods of disruption to strategy,
objective, performance, or risk profiles.

It is susceptible to bias when over- or under-confidence exists in

the organization's capabilities. Management composition with
extensive experience, capabilities are likely to evidence better
judgment than those with less experience, fewer capabilities.

The organizational culture influences risk identification,

assessment, and response.

For example:

1. Culture and strategy—A risk-averse organization may decline

to pursue a strategy of mining, and drilling on suburban land
where the risks of environmental or health harm is high.

2. Culture and risk assessment—Organizations may view the

same event as either a negative or positive risk. For example,
a risk-averse retail organization may view E Commerce as a
threat to its business. In contrast, a risk-aggressive retail
company may see it as an opportunity to increase sales and
market share.

3. Culture and resource allocations—An organisation may

allocate more resources to increase its confidence in
achieving objectives. In contrast, a risk-seeking entity may
allocate fewer resources in pursuit of specific objectives.
For example, a risk-averse entity might purchase insurance
to help achieve a business objective while a risk-seeking
entity may go for self-insure.
 4. Risk responses—A risk-averse organisation may respond more
quickly to variations in performance as compared with a risk-
aggressive entity.

Aligning Core Values, Decision Making, and Behaviors

A failure to follow core values is generally due to following reasons:

An inappropriate tone at the top exists

The board fails to provide oversight of management.

Middle and functional managers are not aligned with

the mission and core values.

Risk is not integrated into strategy setting and planning.

Unclear and untimely responses to risk and performance

outcomes.

Excessive risk taking is not investigated.

Management or team deliberately acts inconsistently

with core values.

Commitment to Core Values

Reflecting Core Values throughout the Organization

The flow of values within an organization is a tone which establishes a

common understanding of core values and desired behaviors by all.
The tone and culture alignment of an organization enables
stakeholders to feel confident that the organization will act in line
with its core values.
A. Adopting Risk-Aware Culture

It includes:

Strong leadership endorsement of risk awareness and

clear tone.

A participative management that encourages employees

to discuss risks, strategy and objectives through open
and honest discussions.

Aligning risk awareness with behaviors and performance

evaluation, including salary and incentive programs that
align with the organization's core values.

Promoting risk awareness throughout the entity

including the statement that risk awareness is critical to
success and survival.

B. Accountability for Actions taken

It consists of documenting and adhering to policies for accountability.

 Accountability is in the form of evidence when:

• Management clearly communicates expectations of

accountability.
• Management communicates risk information throughout the
organization.
• Employees commit to business objectives, targets and
performance.
• Management communicatesfor deviations from standards and
behaviors as inappropriate.

C. Open Communication

In the risk-aware culture, Risk management is a part of all staff

responsibilities. Open communication and transparency enables
management and employees to work together for Risk Management.

D. Variances in Core Values and Behaviors

Variances from standards shall be addressed in a timely and

consistent manner. Responses to variances depend on the magnitude
of the deviation range from termination to official warning.

Retention of Capable Team Personnel

Company is committed to develop human capital that aligns with its strategy
and business objectives.

• Competence Evaluation—Management defines the human capital

needed to achieve its strategy and business objectives in line with Board
Members.

• Attracting and Retaining Individuals—Management establishes cultures,

structures and processes to attract, train, mentor, evaluate, and retain
through various incentives, training programmes and credentialing
competent individuals.

• Rewards—Incentives and rewards programmes should be established by

management in line with the entity's short- and long-term objectives.
Designing incentive systems requires consideration of related risks and
responses.
 Nonmonetary rewards may be important components of performance
rewards. Management consistently applies performance measures and
regularly reviews the entity's measurement and reward system.

• Pressure Management—various types of pressure exist, including

performance targets, regular cycles of specified tasks, unexpected
business changes, and economic downturns. Organizations may seek to
influence pressure by rebalancing workloads, increasing resource levels.
Too much pressure many times results from unrealistic performance
targets, conflicting business objectives of differing stakeholders, and an
imbalance between short-term financial rewards and longer-term
objectives.
42. Out of following options, which is an important threat to accountability
in ERM practices?

A Excessive communication
B when management says one thing and does another
C Escalation
D Deviations

43. In a risk-aware organization,

A The organizational culture is independent of management.

B The organizational culture is risk averse.
C Investments in not required technologies will be minimized.
D The organizational culture is closely linked to the organization's strategy and objectives.

44. In an organization with a dual BOD’ structure,

The management committee reviews strategy while the supervisory board

A
oversees operations.
The management board reviews operations while the governing board reviews
B
strategy.
C The under-board reviews operations while the over-board reviews strategy.
 The management board manages risk portfolio while the chief risk officer
D
coordinates risk.

45. As per COSO ERM framework, which of the following is less likely to
impede the independence of a board member?

Mr. A was a partner of the accounting firm that conducted the organization's
A financial statement audit six years ago but has no existing business or
contractual relationships with the entity currently.
Mr. B has a consulting contract with the organization related to facilitating
B
marketing and sales promotion.
C Mr. C is a board member of the organization's major competitor.
D Mr. D has served on the board for 15 years.
Enterprise Risk Management
Strategy and Objective Setting
Enterprise Risk Management (ERM)

It focuses on strategic planning and how the organization can understand the
effect of internal and external factors on risk. It provides guidance on analyzing
business context, defining risk appetite, and formulating objectives.

Enterprise risk management, strategy, and objective-setting work together in

the strategic-planning process. A risk appetite is established and aligned with
strategy; business objectives put strategy into practice while serving as a basis
for identifying, assessing, and responding to risk.

Analyze the Business Context

It consists of the trends, events, relationships, and many other factors that may
influence, clarify, or change an entity's strategy and business objectives. The
risk-aware organization counts the substantial effects on its risk profile. As
business context may be dynamic or static, complex or simple, and may not be
unpredictable.
The external factors and stakeholders influence the business context. For
example, a regulatory agency may grant a license to operate or may force an
entity to shut down. An investor may withdraw capital if he disagrees with an
entity's strategy of performance.

The external environment can be categorized by political, economic, social,

technological, legal, environmental eventsas described in the following image.
On the other side, the internal environment is made of strategy and business
objectives from within the organisation.

The following figure depicts the factors influencing internal environment:

How Business Context affects Risk Profile.

The business context may affect risk profile of the entity at following three
stages:

• Past performance informs an organization's expected risk profile.

• Current performance provides evidence of trends and influences on the
risk profile
• Future expected performance helps an entity shape and create its risk
profile

Define Risk Appetite

The organization defines risk appetite with reference to creating, preserving,

and realizing value.
Applying Risk Appetite

A. Corporates have tendency to develop strategy and risk appetite

simultaneously and allow them to co-evolve.
B. Some may be capable of risk appetite quantification and others may
define the same in words.

Determining Risk Appetite

Managementshall make an informed choice of an appropriate risk appetite.

Many approaches exist to determine and express risk appetite. For some
entities, “low” or “high” appetite may be sufficient. Othersmayprefer a detailed
approach: for example, by expressing risk appetite in financial results or
measurement of a beta of its stock.

Risk appetite may include:

• Risk profile whichis a combined assessment of risks, including

consideration of risk types, severity, and interdependence.
• Risk capability which is the maximum amount of risk that an entity can
absorb in pursuing business objectives.
• ERM capability and maturity that shows thatcorporates with more
mature and capable ERM initiatives are likely to have greater insight into
risk appetite and influences on risk capacity than are entities with less
mature and less capable ERM functions.

Risk Appetite Articulation

Risk appetite may be relative to strategy and business objectives, its categories,
or performance targets. The following imageshows articulation of risk appetite
of University.
Source: Committee of Sponsoring Organizations of the Treadway Commission
(COSO)

The example shownbelow depicts howan organization “cascades” risk

appetitethrough various statements that align high-level strategy and
objectives, with lower strategies. It shows the alignment of mission, vision,
values, strategy, objectives, and risk appetite.
Risk Appetite Usage

1. It guides resource allocations including to operating units. In making such

allocations, management may allocate more resources to business
objectives with a lower risk appetite and fewer resources to business
objectives with a higher risk appetite.

2. Risk appetite shall align and articulate with related concepts such as risk
tolerance and risk triggers

Source:Committee of Sponsoring Organizations of the Treadway Commission

(COSO).

Evaluate Alternative Strategies

The company evaluates alternative strategies and their substantial impact on
the risk profile.

• It aligns with the mission, vision, and core values and organization's risk
appetite
• The companyshall understand the implications of the chosen strategy
related to the business context, resources, and organizational
capabilities. It shall also understand the assumptions underlying the
strategy.
• Popular approaches for strategy evaluation include a SWOT (strengths,
weaknesses, opportunities, threats)analysis.

The following illustrates one organization's approach to evaluating

alternative strategies.
Source:Committee of Sponsoring Organizations of the Treadway Commission
(COSO).
Periodical reevaluation and assessment of the strategy shall be carried out. A
change in strategy shall be implemented if the organization determines that
the current business context leads it to exceed its risk capacity or requires
more than available resources than are available.

Formulate Business Objectives

The organization takes in to account risk while establishing the business

objectives at various levels in alignment with strategy.

A. The first COSO ERM provides categories of business objectives.

B. Objectives shall align with the strategy.
 C. Management shallunderstand the implications of defined and opted
business strategy.

A defined and opted strategy shall have a reasonable expectation of

achievement within the organization's risk appetite and resources available.

Setting measures of performance and targets.

Organizations set targets to monitor performance and support the

achievement of business objectives.

The followingdepicts business objectives and related performance measures

and targets.
Source:Committee of Sponsoring Organizations of the Treadway Commission
(COSO).

Understanding Tolerance.

Tolerance is the acceptable level of variation in performance.

 • While risk appetite is broad, tolerance is operational and focused.
Specifically, tolerance should be measurable and measured. In contrast,
risk appetite may be quantified or may be stated in words.

• Performance variance can exceed or below targeted performance.

Exceeding variation is positive sign while below variation is negative sign.

Tolerance may be set at different levels from target performance, as

shown below.i.e. tolerance limits need not be symmetrical.

Source:Committee of Sponsoring Organizations of the Treadway Commission

(COSO).
46. A firm determines that bitcoin investments are highly risky. For its
portfolio, it sets a minimum investment of 5% and a maximum investment of
10% in bitcoin. This is an example of :

Risk target (minimum) and risk roof

A
(maximum).
Risk roof (minimum) and risk target
B
(maximum).
Risk floor (minimum) and risk ceiling
C
(maximum).
Risk ceiling (minimum) and risk floor
D
(maximum).

47. Which of the following for risk appetite related to factory accidents is
acceptable?

• “Low”
• “ < 3 per year”

A Neither
B Both
“Low” but not “ < 3 per
C
year.”
“ < 3 per year” but not
D
“Low.”
48. In ERM, ______ focuses on the strategy development and goals while
_____ focuses on the strategy implementation and variation from plans.

A tolerance; triggers
B key indicators; risk appetite
C risk appetite; tolerance
internal control; portfolio view
D
of risk
Enterprise Risk Management
ERM and Performance
Enterprise Risk Management (ERM) and Performance
Risks that may affect the achievement of strategy and business objectives need
to be identified and assessed. Risks are prioritized by severity in the context of
risk appetite. The organization then selects risk responses and takes a portfolio
view of the amount of risk it has assumed. The results of this process are
reported to key risk stakeholders.

After an organization develops its strategy, it then moves on to identify and

assess risks that could affect its ability to achieve these goals. This not only
helps to guide the organization’s risk identification and assessment, but
also how to prioritize and respond to risks. After all, an organization is only as
good as its performance, which is bigger than just risk management.

Identify Risk

The organization identifies risk that impacts the performance of strategy and
business objectives.

Specifically, the entity uses operating structures to identify new emerging risks
to enable timely responses. Such risks may arise from:
 A change in business objectives

A change in business context.

Customer preferences for products

Regulation that results in new entity requirements

Discovery of detrimental environmental effects from fracking

Cascading effects from previous changes.

Disruptive effects may also occur from events or circumstances. Examples of

potentially disruptive effects include:
 Emerging technologies

Role and use of big data and data analytics which may help to improve the
ability of both the entity and its competitors to identify risks and their
implications.

Depleting natural resources, which may affect demand, supply and location
of products and services.

Rise of virtual entities, such as bots and AI (termed as artificial intelligence)–

driven intelligent systems, which can influence the supply, demand, and
distribution channels of markets.

Mobile workforces (e.g., the widespread availability of online, temporary

labor, free lancers).

Difficulty of finding and retaining appropriate skills and talent of manpower.

Shifts in lifestyle, healthcare, and demographics

Risk Inventory

A risk inventory is a listing of an entity's list of known risks. Risk inventories are
more useful when risks are bifurcated—for example, by financial, customer,
compliance, or IT risks.
The following image illustrates that risks may have differing levels of impact.

For example, Risk no.1 impacts the strategy, risk no. 2 impacts business
objectives, risk no.3 affects entity-level objectives, and risk 4 impactsentity-
level objective.

Source: Committee of Sponsoring Organizations of the Treadway Commission

(COSO).

Approaches and Methods of Risk Identification

Multiple approaches exist to identifying risks. Risk identification may be

integrated into:

1. Ongoing processes, such as budgeting, planning and performance

reviews, and
 2. Activities targeted at risk identification such as questionnaires,
workshops, and interviews.

Many approaches to risk identification are technology-based Larger and

more complex organizations are likely to use multiple risk identification
methods.

Risk identification methods may include:

• Cognitive computing—It includes AI methods of data mining and

analysis.
• Past events to help predict future occurrences. Data sources may
include third-party databases that provide industry data about
potential risks.
• Interviews that inquire individual's knowledge of past and potential
events.
• Key risk indicators (KRIs) are qualitative or quantitative measures
that help identify risk changes.
• Process analysis involves charting a defined process to better
understand the interrelationships of its inputs, tasks, outputs, and
responsibilities. Once mapped, risks can be identified and
considered in relation to business objectives.
• Workshops bring individuals from divergent functions and levels to
draw on the group's collective knowledge and develop a list of
risks.
• When entities make assumptions explicitly, risk assessments
improve. In one case, management set objectives based on an
assumption that the exchange rate for a local currency would
remain unchanged.

Well-formed V/s vague risk statements.

Precise risk statements are preferred to vague risk statements. The example in
the following figure illustrates precise and imprecise risk statements:
Source: Committee of Sponsoring Organizations of the Treadway Commission
(COSO).

Theory of Prospect and the “framing” of risks

• Theory of Prospect argues that losses are more consequential than gains
and that how a risk is “framed” influences how people respond to it. E.g.
when a risk is framed as a gain, most people prefer the sure thing. In
contrast, when a risk is framed as a loss, most people prefer risky
alternative.

• It matters to ERM as the way that a risk is presented can influence

people's response to it.
Assess Severity of Risk

The risks severity should be assessed at multiple levels. Risks at higher levels
are more likely to influence the entity's overall reputation and brand than risks
that occur at lower levels.

The next imageshows four scenarios that relate to addressing differing levels of
risk severity.

1. In scenario 1, risk 1 could affect the overall business objectives and entity
objective 1. For example, a safety failure, if severe can adversely impact
the entity's business objectives.
2. In scenario 2, risk 2 could impact entity-level business objectives but not
the overall business objectives. For example, unprocessed backlog of
transactions may pose a risk to unit level business objectives but not
overall objectives. However, if the backlog grows, overall objectives could
be hampered.
 3. In scenario 3, two risks have moderately severe assessments, but they
may affect business objectives adversely and the entity as a whole and
therefore are assessed as more severe.
For example, an inability to recruit competent Staff (risk 1) is a low risk to
each operating unit but may be worsened in an economic downturn (risk
2). Hence, the two risks together pose severe impact than in alone.
4. In scenario 4, some risks may adversely affect the entire entity. E.g., the
risk of a hostile takeover by competitors impacts the strategy of the
entity but may not impact business-level objectives.

Source: Committee of Sponsoring Organizations of the Treadway Commission

(COSO).

Selecting Severity Measures

Severity measures should be in line with the size, complexity, and nature of the
entity and its risk appetite. It may include following:
 1. Theeffect of a particular risk which may be stated as a
possible range of impacts that may be positive or negative.
2. Likelihood—Thepossibility of a risk occurring expressed as a
probability or as a frequency. For example:
a. Qualitative—“The possibility of fire in a manufacturing
plant within the next 6 months is far away.”
b. Quantitative—The possibility of fire in a manufacturing
plant within the next 6 months is 10 %.”
c. Frequency—“Fire in a manufacturing plant is likely to
occur once every 2 years.”
3. Risk severity should be assessed on the uniform time horizon
as strategy and business objectives. Mission, vision, and core
values related risks should be assessed on a longer time
horizon.
4. Risk assessment may use qualitative approaches like
interviews, workshops or quantitative approaches like
Decision Trees.

The following example illustrates the alignment of business objectives and risk
with measures of risk severity.
Source: Committee of Sponsoring Organizations of the Treadway
Commission (COSO).

Risk assessment should consider:

• Inherent risk i.e. the risk in the absence of efforts to

address it;
• Target residual risk which can be the desired amount
of risk after actions to address it and
• Actual residual risk which can be the realized risk after
taking actions to address it.

Actual residual risk should ideally be less than or equal to target residual
risk. When actual residual risk exceeds target risk, additional actions shall
be taken to reduce risk.
Risk assessment results

Risk assessment results are often mapped on a heat map as described below in
following image, which maps risk likelihood against risk impact. The heat map is
color coded to indicate risk severity. Management may use the risk profile to
confirm that performance is within tolerance and that risk is within appetite.

Source: Committee of Sponsoring Organizations of the Treadway

Commission (COSO).
 B. A risk-aware organization identifies things that will prompt a
reassessment of risk severity. They are often changes in the
business context but may also include changes in risk appetite.

Examples of potential changes include an increase in customer

complaints, a down critical economic index, a sales decrease, or a
spike in employee turnover or accidents. Triggers may also come
from a competitor—such as the recall of a competitor's product or
the competitor releasing a new competing product.

C. Bias may result in a risk being over or underestimated. The careful

presentation of risks may reduce potential biases.

Prioritize Risks

The corporate prioritizes risks as a basis for selecting risk responses.

Prioritization assesses risk severity compared to risk appetite.

Higher importance may be given to risks that are likely to approach risk
appetite.

The criteria for Risks prioritizing include as below:

 Adaptability—The capacity of an entity to adapt risks
(e.g., responding to changing demographics)

Velocity—The speed with which a risk affects to an

entity. A high-velocity risk may move the entity quickly
away from the acceptable variation in performance.

Persistence—For how much period of time, a risk

impacts an entity e.g., the persistence of adverse media
coverage and its impact on sales

Recovery—The capacity of an entity to return to

tolerance. Recovery excludes the time taken to return to
tolerance, which is considered part of persistence, not
recovery.

Risks with similar severity may receive different priorities. For example, two
risks may be assessed as “medium” severity, but one may receive higher
priority due to its greater velocity and persistence.

Example 1:

Risk Priority

Inlarge restaurant, responding to the risk that customer complaints remain

unresolved and attract adverse attention in social media is considered a higher
priority than responding to the risk of protracted contract negotiations with
vendors and suppliers.

Example 2:

Risk Profile to Risk Appetite

A utility company's mission is to be the most reliable electricity provider in its

region. A recent increase in the power outages indicates that the company is
approaching its risk appetite and is less likely to achieve its business objectives
of providing reliable service.

Implement Risk Responses

The organization identifies and selects risk responses. Acceptable risk response
categories include:

• Accept—No action is taken.It is appropriate when the risk is already

within risk appetite.
• Avoid—Removing the risk, which mean ceasing a product line, declining
to expand to a new geographical market, or selling a division.
• Pursue—It is to accept increased risk to achieve improved performance.
This may include adopting more aggressive growth strategies, expanding
operations, or developing new products and services.
• Reduce—It is an act to reduce the severity of the risk. This includes many
possible business decisions that reduce risk to an amount of severity
aligned with the target residual risk profile and risk appetite.
• Share—It is to reduce the severity of the risk by transferring or sharing a
portion of it. Common techniques include outsourcing to
specialist service providers, purchasing insurance.

In some situations, an entity may need to review its business objectives and
strategy as a part of responding to a severe risk exposure.

Influences on management's decision to select and deploy risk responses

include the business context, costs and benefits, obligations and expectations,
risk priority, risk appetite, and risk severity.
It is often easier to measure the costs of risk responses than their benefits as
costs are more tangible and measurable than are expected losses.

Example

Risk Profile to Risk Appetite

A company dealing with insurance products implements risk response to

address new regulatory requirements requiring confidentiality for customer
data across the insurance industry. This would be requiring investments in
technology infrastructure, changes in work processes and added staff to
implement the company's objectives related to regulatory compliance.

Develop a Portfolio View

• Through usage of portfolio view of risk. it enables an organization to

identify risks which are severe at the entity level. It enables management
to assess whether the entity's residual risk profile aligns with its risk
appetite.

• Multiple methods are available for creating a portfolio view of risk. One is
to begin with major risk categories aligned with metrics such as capital at
risk.

The followingimage demonstrates a portfolio view of risk which begins

with a strategy view and proceeds to entity objective, business objective,
risk, and risk categories views.
Source: Committee of Sponsoring Organizations of the Treadway
Commission (COSO).

A portfolio view may represent different levels of integration. COSO

suggests four levels of risk integration, which are presented below.
 Minimal integration I.e. the risk view. The entity identifies and assesses risk at
an event level. The focus is on events, not objectives. An example is focusing
on the risk of a breach of an IT system with reference to the risk of complying
with regulations.

Limited integration—It is a risk category view where an entity identifies and

assesses risk at the risk inventory level. E.g. the creation of a compliance
department will aid the entity in managing the risk of complying with local
regulations.

Partial integration—It is risk profile view where an entity identifies and

assesses risk at the business objective level and considers dependencies
among objectives.

Full integration—It is basically portfolio view where an entity identifies and

assesses risk at the strategy and business objectives level. Higher integration
improves support for risk-related decision making. As compared to the
previous examples, the board and management focus more on the
achievement of strategy.

Analyzing the Portfolio View

• The portfolio view considers both quantitative and

qualitative risk assessment methods.
 • “Stress test” should be carried out at the risk portfolio, to
assess the effect of hypothetical changes in the business
context. It is likely to reveal new and emerging risks and to
clarify the adequacy of planned risk responses.

Terms
Assumption—An belief about a characteristic of the
future that underlies an organization's ERM plan. E.g., a
business might assume that the demand for Internet
will not change substantially.

Bot—A software application that is designed for

automated tasks on the internet. For example, bots to
search specified content from websites. Also called an
internet bot or web robot.

Key performance indicators (KPIs)—They are

considered as High-level performance measures of
historical performance of an entity.

Performance Measures —They are measurable defined

targets that are compared with outcomes. For example,
a goal zero incidents at a factory is a performance
measure.

Severity—A measurement of considerations such as the

likelihood and impact of events it takes to recover from
events.

Stress testing— A testing of a risk portfolio using

simulation techniques. In a stress test, the assumptions
about risk are manipulated to assess how different
stress tests would affect a risk portfolio.
49. Management of ABC Corp. has decided to respond to a particular risk by
hedging with futures contracts. It is an example of :

A Avoidance.
B Acceptance.
C Reduction.
D Sharing.

50. Which of the following is the best risk statement with reference to
management's role in a major IT project undertaken by a large
telecommunications company?

A The risk that management disregards project communications and meetings

The risk that management disregards project communications and meetings,
B
resulting in inadequate oversight, because of management's lack of focus
The risk that management disregards project communications and meetings,
C which reduces project quality and the likelihood of successful integration with
other systems
The risk that management disregards project communications and meetings,
D despite frequent efforts by the project management team to inform executive
management of the importance of their involvement and engagement

51. Match each statement with the suitable term:

I. After implemented controls, the desired level of the risk of a major cyber-
attack is low.
II. Before considering controls, the level of risk of a major cyber-attack is high.
 III. After considering implemented controls, the level of the risk of a major
cyber-attack is medium.

Internal control; inherent risk; target residual

A
risk
target residual risk; internal control; inherent
B
risk
target residual risk; actual residual risk;
C
assessed risk
target residual risk; inherent risk; actual
D residual risk

52. A heat map, as a part of assessing risks plots the___________________ on the

vertical axis against the___________________ on the horizontal axis.

A likelihood rating; impact ratings

B inherent risk; risk appetite
target residual risk, actual residual
C
risk
D internal control; inherent risk

53. As per COSO E R MFramework, each of the following is considered as part of a

risk assessment, except

A Inherent risk.
B Unknown risk.
Actual residual
C
risk.
Target residual
D
risk.
54. ABC Corp. actively monitors a foreign country's political events when a supply
chain disruption occurs within the country that exceeds 100 days. As per COSO
principles, it is following which of the following risk-response strategies?

A Share.
B Avoid.
C Accept.
D Reduce.
Enterprise Risk Management
Monitoring, Review and Revision
Enterprise Risk Management (ERM)
By reviewing entity performance, an organization can consider how well the
enterprise risk management components are functioning over time and in light
of substantial changes, and what revisions are needed.

At some junction,once risks have been prioritized and a course of action been
chosen, the organization moves into the review and revision phase where it
assesses any changes that have taken place. It is the opportunity to understand
how the ERM process in the organization can be improved upon.

Assess Material Changes

The company identifies and assesses changes that may materially affect
strategy and business objectives.
Material changes introducenew or altered risks, which shall be identified and
integrated into the organization's risk portfolio. Hence, organizations should
continually monitor for emerging or changed risks.

Identifying material changes, its effect evaluation, and responding to the

changes are related processes. Post reviews, following material changes, can
help deriving the learnings that can be applied to future events.

Examples of material changes are as follows:

In case of internal environment:

• Fast growth—when operations take up quickly, existing structures,

activities, information systems, or resources may be inadequate to
address expanding roles and responsibilities. Risk oversight roles and
responsibilities need to be defined accordingly. E.g. supervisors may fail
to adequately supervise additional night shifts.

• Innovation—Innovations come with new risks. Like introducing consumer

sales through mobile devices may need for new access controls.
 • Changes in leadership—A new management team member may
misunderstand the entity's culture or focus on performance to the
exclusion of tolerance.

While in case of the external environment, a changing regulatory or economic

environment can increase pressures or operating requirements. This may
introduce new emerging risks. E.g. Industry-wide restrictions may regulate
production and Distribution Channel.

Review Risk and Performance

The organization reviews entity performance and considers related risks.

Periodically, organizations shall review their ERM capabilities and practices.

Such reviews seek answers to questions such as:

How is the performance of the Entity?

This will identify variances and seek their causes which may include using
measures relating to objectives or other key metrics.
E.g. an entity committing to open few new office locations every year to
support its longer-term growth strategy to build a presence across the country.
It has determined that it could continue to achieve its strategy with only
fivelocations opening and would be taking on more risk than desired if it
opened ten or more locations. The organization evaluates the same and if the
growth is less than planned, the organization may revisit the strategy.

How risks influence performance?

Review of performance confirms whether risks were previously identified or

whether new, emerging risks have occurred. It also reviews whether the actual
risk levels are within the tolerance limits. For example, reviewing performance
helps to confirm that the risk of delays due to additional requirements f or
construction did occur and affected the number of new locations opened and
whether the number of locations to be opened is still within the range of
acceptable performance.

Whether sufficient risk exists to attain its target?

During Target Failure, the organization shalldecide if the failure is due to the
impact of risks or due to insufficient risk to achieve the target.

Using the same above example related to opening new locations, imagine that
the entity opens only 2 offices where it is observed that the planning teams
operate below capacity and that other resources are set aside and remain
unused which support the opening of new locations. Hence, insufficient risk
was taken by the entity despite having allocated sufficient resources.
Accuracy of risk estimates

When risk assessment is wrong, the organization reviews why it was and to
answer that the organization must challenge the understanding of the business
context and the assumptions derived in the initial risk assessment. It shall also
decide whether new information will refine the risk assessment.

Suppose that in the earlier example, the entity opens two offices. It also
observes that the estimated amount of risk was lower than the actual risks that
occurred.

An observation that performance is outside the tolerance or say risk profile is

significantly differed from expected may motivate a review of business
objectives, strategy, culture, and target performance, severity of risk analysis,
risk prioritization, risk responses, or risk appetite.

Again revising risk appetite would require review and approval by the board or
other risk oversight body.

Pursue ERM Improvement

The organization pursues improvement of its ERM activities and functions.

Evaluation of the same may be fruitfully embedded in ongoing business
processes and practices. Separate, periodic evaluations are also useful.
Opportunities to improve ERM may arise in any of the following areas:
• New technology for efficiency.
o For example, emerging data mining and automation methods can
provide quick assessments of customer satisfaction, Sales
Performance and many others like criteria.

• Historical Shortcomings

o Reviewing performance can identify various shortcomings including

the causes of past failures which would induce ERM efforts.

o For example, Powder manufacturer sees that it has insufficiently

captured past currency fluctuation risks. It sets up new monitoring
processes to improve its assessment of these risks.

• Changes may be required to support changing risks or governance

structures.

o For example, in one company, the ERM function reported to the

chief financial officer. But to improve its alignment of strategy and
ERM, the entity created a strategy committeeto whom the ERM
function was reported. These changes enabled the organization to
better align its strategy with its ERM function.

• Risk Appetite

o Performance reviews enable risk appetite refinement.

o For example, management monitored the new launched product
performance over a year and determined that the market was less
volatile than projected. Based on that, management assesses
whether it can increase its risk appetite for similar product
launches.

• Risk Categories—
 Continuous improvements can define the patterns and
relationships that lead revision in risk categories.

o For example, one firm did not include cyber risk in threat list until
it began offering online products. After offering online products, it
revised its categories to include cyber risk.

• Communications

o Performance review can identify outdated or inadequate

communication processes.

o For example, an organization determines that employees are not

reading emails for monitoring emerging risks. In response to the
same, the organization works with supervisor staff to highlight the
relevance of these communications.

• Benchmarking

o Review of peer industry data may provide insight into industry

performance tolerance.
o For example, during a benchmarking exercise, a global shipping
company discovers that operations in Asia are performing far
below its major competitor. Due to that, it revisits its strategy and
objectives to increase its performance in Asia.

• Pace of Change

o Management shall consider the pace of business context change

and disruption occurrence.

o For example, a software developer company that develops a

mobile app will have more frequent opportunities to improve its
ERM processes than a company in the clothes business, a stagnant
industry at present.
55. ABC Corp. reviews its ERM practices. Which question is least likely to
investigate as a part of review?

What is the relationship between our strategy and

A
objectives?
B How did the entity perform?
Are we taking sufficient risks to attain desired
C
performance?
D Were risk estimates accurate?

56. ABC Corp. launches a new product which is performing better than
expected and that the volatility of sales is less than expected. Which of the
following is the organization most likely to do?

A Review its internal control procedures.

Investigate new technologies to improve product
B
performance.
C Revise its tolerance and decrease its risk appetite
D Review its ERM practices.

57. Which of the following is less likely to trigger a review and revision to
ERM practices?

The purchase and implementation of a system that enables real-time

A
monitoring of customer satisfaction and complaints.
B A sales growth rate that is 3 times that which was expected.
C A 5% increase in calls to the whistleblower hotline.
D Firing the CRO.
Enterprise Risk Management
Communication and Reporting
Enterprise Risk Management (ERM)
Enterprise risk management requires a continual process of obtaining and
sharing necessary information, from both internal and external sources, which
flows up, down, and across the organization.

The last component of the COSO ERM framework involves sharing information
from internal and external sources throughout the organization. Systems are
used to capture, process, manage, and report on the organization’s risk,
culture, and performance.

Leverage Information Systems

The organization leverages the information and technology systems to support

ERM Framework.
Obtaining and using information assets to support ERM functions may include
the following:

• For governance and culture-related practices, information on standards

of conduct and individual performance relating to those standards is very
much vital. For example, Consultancy firms have specific standards of
conduct to help maintain independent relationships with clients. Annual
staff training reinforces those standards, and management gathers
information by testing the staff's knowledge.
• For strategy and objective-setting, the organization may value
information on stakeholder standards of risk appetite. Investors and
customers may express their expectations through analyst calls, postings,
terms and conditions, and others. These actions will provide information
on the risk an organization may be willing to accept and the strategy that
it follows.
• For performance, organizations may need information of their
competitors to assess risk. For example, a large residential real estate
house may assess the risk of loss of share to smaller firms by reviewing
their competitors’ commission pricing models and online marketing. If
competitors’ commission rates are low and aggressive and their online
presence is widespread, the large company may review its ability to
achieve its sales targets.
• For review and revision-related practices, organizations may value
information on emerging ERM trends. Such information may be available
at ERM conferences and industry-specific blogs and consortiums.

Relevant information may be organized or unorganized. The following is

example of structured and unstructured internal data sources.
Source: Committee of Sponsoring Organizations of the Treadway Commission
(COSO).

Example 1

Unstructured Information in Decisions Making

A retailer uses artificial intelligence system to derive sources like social media
posts and restructure data on the customer experience. Through this,
management gains insights from social media about behavior pattern of
customers including historical trends and preferences. These would help in risk
reduction of over or under inventory levels. Would in last reduce costs and
improve customer satisfaction.

Example 2

Compliance Requirements

A pharma company's goal is to expand its market share by new drug

development targeted to a specific patient population. For its approval,
regulators demand information that meets compliance requirements like
testing results and conclusions regarding drug safety. These mainly rely on data
such as the demographics of the testing population, number of side effects,
duration and type of proposed application. Data is captured from internal
patient physiology and experience.

An entity using an environmental health and safety software platform can

compile data on health and safety incidents from multiple operating facilities
shortly after they occur. Root cause can be determined and recorded in the
system at the time of the incident. This information can then be compiled by
the organization for trend analysis to understand the facilities with more
significant or frequent safety issues.

Three key elements for Effective data management:

I. Data and information management considers governance processes for

identifying data and risk owners and making them accountable.
II. Various Processes and controls help an organization create and maintain
reliable data. For example, organizations may have processes to identify
instances and patterns and whether that data meets requirements and
standards. Managing data requires more than processes and controls
usage to ensure its quality. It also involves preventing issues of quality
from occurring in the first place through strong governance processes.
III. Architecture of Data management is the fundamental design of the
technology and related data. It includes models, policies, standards that
determine which data is collected and how it is stored, arranged,
integrated, and used in systems and in the organization.

Further criteria in data management:

 • Organizations implement standards and rules for structuring information
so that the data can be sorted, indexed, retrieved, and shared with both
internal and external stakeholdersand protecting its long-term value.

• Emerging technologies support task execution. Examples of such activity

include robotics in production processes, the Internet of Things in home,
smart appliances, and wearable technologies designed for monitoring
human activities.

Example

Risk Reduction through Wearable Technologies

A healthcare unit seeks to reduce incidents of elderly patients missing

doses of medicines. These wearable devices help identify cases of missed
doses and track some measures of patient health.

Communicate Risk Information

Important internal communications include below:

• The organization’s strategy, business goals, and performance

expectations.
• Expected behavior and values that define the organization's culture.
• The value and importance of ERM.
• The organization's risk appetite and tolerance level.
• Expectations in cases of ERM weakness or failure.

Stakeholder Information needs Communication methods

group
Board of • Significantchangestotheint • Boardmeetingpre-
directors ernaland readsandpresentations
externalbusinessenvironme • External/third-
Provides
ntandthe organization’s partymaterials(e.g.,industry,tradeand
strategic
approach to thesechanges professional journals, media reports,
oversight for
• Risksthatarefallingoutsid peer company
critical risks to
the entity etherisk appetite websites,keyinternalandexternalin
ortolerance dices)
• Overalleffectivenessofriskr

esponses
Operationalmanag • Significant changes to the Written internal documents (e.g.,
•

ement internal and external

briefing documents, dashboards,
environment impactingperformance evaluations,
Oversees day-
strategy and riskappetite presentations,
to-day
• Significantchangestoariskorr questionnairesandsurveys,policiesandpro
operations
iskprofile cedures,FAQs)
that
• Informal/verbal communications
incorporate • Statusandeffectivenessofrisk
risk responses (e.g.,one-on-one
responses discussions,meetings)
Employees • Natureoftheriskresponsesa • Trainingandseminars(e.g.,liveoronli

Perform day- ndimpacts netraining,

to-day onrolesandresponsibilities webcastandothervideoforms,w
operations • Importanceoftheriskr orkshops)
that esponse • Materials,meetingsorinteractions

incorporate activitiestotheorgan • Electronicmessages(e.g.,emails,socia

risk ization lmedia,text messages,
responses instantmessaging)
• Publicevents(e.g.,roadshows,townha
llmeetings,
industry/technicalconferences)

Communication between the board and management commences with

understanding of the organization's strategy and business goals.

Board members shall have a thorough understanding of the business

including its strategy and value and cost drivers. Board and management
discussion of risk appetite may occur in periodic meetings or in specially
called for meetings to discuss specific events, such as cyber terrorism,
chief executive succession, or mergers.
 Stakeholder group Information needs Communication methods
Investors • Entity’s approach for • Annualgeneralmeetingofsharehold
Providecapitalt managing significant ers
o changestotheinternalandexter • Annualreport,riskfilingor10-K
theentitywitha nalenvironment
• Integratedreport
n expectation leadingtoESG-
of relatedimpactsordependencie • Proxy
financialreturns s
• Understandingofhowthee
ntityidentifies,
assessesandmanagesitsESG
-relatedrisks (e.g.,climate-
relatedrisks)6
Suppliers • Entity’sstandardsforsuppliersw • Suppliercodeofconduct
Supply goods or hichmayinclude areas such as
• Reportcard,including,forexample,qual
services to the ethics, integrity, legal ity,delivery, quantity delivered,
entity standards, performance history, incident
compliance,healthandsafetyan report andcomments
denvironment
• Managementmeetings7
• Supplier performance
against the entity’s ESG-
relatedstandards
Customers • Informationonhowthepro • Responsible marketing practices
Purchases the ductwasmade (e.g.,promoting
entity’s goods (e.g.,ingredients,countryof accuratefactsabouttheproduct)
or services origin,factory • Productlabeling(e.g.,nutritionfacts)
information) • Licensed, certified or
• Information on how to use authorized retailers
the product and (e.g.,pharmacists)
whetheritmayimpactthecon
• Focusgroups
sumer’shealth
andsafety(e.g.,sideeffectsofpha
rmaceuticals)
NGOs and • Entity’sapproachformitigatinga • Annualgeneralmeetingofsharehold
communities gainstnegative ers
Hold entities impactstoNGOinterests(e.g.,de • Integratedreport
accountable for forestationfrom palm
• Sustainabilityreport
impacts on oilextraction)
their interest • Understandingofhowtheen • Website
groups (e.g., titybenefitsthe • One-on-
environment, localandglobalenvironme oneengagementorfacilitatedstake
society) ntandsociety holder meetings
(e.g.,volunteerhours,emplo
yeemonetary
contributionstocancerres
earch)

Communicating Methods of risk information may include:

A. Electronic messages like email, social media, textmessages.

B. Third-party materials including industry, trade journals and
reporting internal and external performance indices;
C. Informal and verbal communications;
D. Public events including presentations to investor groups and at
conferences;
E. Training and seminars, including live and webcasts;
F. Written internal displays, including documents, dashboards,
surveys, policies, and procedures; and
G. Additional methods for sensitive matters, such as a whistleblower
introduction and defined procedures for serious violations.

Example

Communication with the Board

A company improved risk communication through its governance structure

revision. It framed board committee for risk and created chief risk officer (CRO)
position to ensure risk discussion of strategy at the board level. Through which
important risk issues are discussed in the presence of board. This better
integrated risk and strategy discussions and increased board clarity about risk.

Report on Risk, Culture, and Performance

Various users of Risk report may include management, the BOD, risk
owners, assurance providers, and other external stakeholders.

Types of reporting.

• The portfolio view of risk reports defines the severity of risks at the
organization level. These also highlight the greatest risks to the
organization, and relationships between specific risks and
opportunities.
• The profile view of risk is narrower and more so focused than the
portfolio view. It outlines risk severity but focuses on levels within
the organization. For example, the risk profile of a division or
operating unit may be an important report for management.
• Analysis of root causes enables users to understand assumptions
and changes underpinning the portfolio and profile views of risk.
• Sensitivity analysis measures the sensitivity of changes in key
assumptions embedded in strategy and the potential effect on
strategy and business goals.
• Analyses of new, emerging, and changing risks provide the
forward-looking view to anticipate changes to the risk inventory,
effects on resource requirements and allocation, and the
anticipated performance of the organization.
 • Key performance indicators (KPIs) measure the tolerance level of
the organization.
• Trend analyses evaluate movements and changes in the portfolio
view of risk, risk profile, and performance of the organization.
• Disclosures of incidents, breaches, and losses provide insight into
the effectiveness of risk responses.
• Reports to track ERM plans and initiatives summarize ERM practices
and results. Reports on investments in ERM resources.

Reporting risk also include both formal and informal information

sharing.

• The board may have informal discussions about the implications

and risks of various strategies. Formal reporting on the same
plays a significant role in the boardreview of the ERM practices.
• Board reporting should also focus on the links among strategy,
business goals, risk, and performance and should include the
organization's portfolio view of risk.

Reporting on culture is difficultas culture measurement is a complex

task.

Reports about culture:

Cultural trends like number and significance of reports to a

whistleblower, benchmarking within an industry, compensation
systems and their implications for behavior, reviews of trends in
behaviorand surveys of risk attitudes and awareness.

Key risk indicators (KRIs) measure emerging risks. They are usually
quantitative but may be qualitative too. KRIs is often reported with
key performance indicators which provide high-level measures of
organizational performance.

A key risk indicator might anticipate potential customer collection

issues so that the credit function can be more proactive before any
risk occurs.
 Example

Key Risk Indicators

A corporation wants to retain competent staff. The objective that

supports retaining competent staff has a target of turnover rate of
less than 2% per annum. A key risk indicator would be a percentage of
personnel eligible to retire within three years. If more than 2% of are
eligible to retire, it indicates that risk to the target is potentially
manifesting.

A key performance indicator (KPI) is the actual turnover rate. KPIs are
based on historical performance and while analyzing it can establish
baselines, the KPI rate trending upward will not always identify a
manifesting risk.

Important Terms are defined as below :

o Key performance indicators (KPIs)—High-level measures of historical

performance of an organization.
o Key risk indicators (KRIs)—Leading indicators of emerging risks.
o Portfolio view—A composite view of risk the organization
faces, which positions management and the board to consider the
types, severity, and interdependencies of risks and how they may
affect the organization's performance relative to its strategy and
business goals.
o Risk inventory—A list of the organization's known risks.
o Risk owners—Managers who are accountable for the effective
management of identified risks.
Conclusion: The Five Components and 20 Principles of Risk Management

COSO’s latest ERM framework now includes five components or categories with
20 principles spread throughout each component. Those are summarized as
below:

1. Governance and Culture –

Forms the basis of the other components by providing guidance on board

oversight responsibilities, operating structures, leadership’s tone, and
attracting, developing, and retaining the right individuals.
 Exercises board risk oversight: The board of directors
provides oversight of the strategy and carries out
governance responsibilities to support management in
achieving strategy and business objectives.

Establishes operating structures: The organization

establishes operating structures in the pursuit of strategy
and business objectives.

Defines desired culture: The organization defines the desired

behaviors that characterize the entity’s desired culture.

Demonstrates commitment to core values: The organization

demonstrates a commitment to the entity’s core values.

Attracts, develops and retains capable individuals: The

organization is committed to building human capital in
alignment with the strategy and business objectives.

2. Strategy & Objective-Setting

 This component focuses on strategic planning and how the organization
can understand the effect of internal and external factors on risk. This
section provides guidance on analyzing business context, defining risk
appetite, and formulating goals.

Analyzes business context: The organization considers

potential effects of business context on risk profile.

Defines risk appetite: The organization defines risk appetite

in the context of creating, preserving and realizing value.

Evaluates alternative strategies: The organization evaluates

alternative strategies and potential impact on risk profile.

Formulates business objectives: The organization considers

risk while establishing the business objectives at various
levels that align and support strategy.

3. Performance

After an organization develops its strategy, it then moves on to identify

and assess risks that could affect its ability to achieve these goals. This
section not only helps guide the organization’s risk
identification and assessment, but also how to prioritize and respond to
risks. After all, an organization is only as good as its perform ance, which
is bigger than just risk management.
 Identifies risk: The organization identifies risk that impacts
the performance of strategy and business objectives.

Assesses severity of risk: The organization assesses the

severity of risk.

Prioritizes risks: The organization prioritizes risks as a basis

for selecting responses to risks.

Implements risk responses: The organization identifies and

selects risk responses.

Develops portfolio view: The organization develops and

evaluates a portfolio view of risk.

4. Review and Revision

At some point after risks have been prioritized and a course of action
been chosen, the organization moves into the review and revision phase
where it assesses any changes that have taken place. This is also the
opportunity to understand how the ERM process in the organization can
be improved upon.
 Assesses substantial change: The organization identifies and
assesses changes that may substantially affect strategy and
business objectives.

Reviews risk and performance: The organization reviews

entity performance and considers risk.

Pursues improvement in enterprise risk management: The

organization pursues improvement of enterprise risk
management.

5. Information, Communication, and Reporting

The last component of the COSO ERM framework involves sharing

information from internal and external sources throughout the
organization. Systems are used to capture, process, manage, and report
on the organization’s risk, culture, and performance.

Leverages information technology: The organization

leverages the entity’s information and technology systems to
support enterprise risk management.

Communicates risk information: The organization uses

communication channels to support enterprise risk
management.

Reports on risk, culture and performance: The organization

reports on risk, culture and performance at multiple levels
and across the entity.
58. As both highlight risk severity, the _______ risk view is from the
organization-wide level while the _______ risk view is from the perspective
of units or levels with the organization.

incident, root
A
cause
root cause,
B
incident
C portfolio, profile
D profile, portfolio

59. Key risk indicators (KRI) are called as :

A Indicators of internal control quality.

B More or less equivalent to KPIs.
C Predictive and usually quantitative.
D Used by risk-aware, risk-averse entities.
60. X,Y and Z are builders of expensive offices. They want to create a report
on the risks that they face in their HR function. Which level of reporting
would be appropriate?

A Portfolio view
B Risk view
C Risk category view
D Risk profile view

61. Data from _____ is structured, while data from ________ is

unstructured.

Board meeting minutes; a governmental report that is used by a beverage

A
company
Staffing increases or decreases due to restructuring; email about decision
B
making and performance.
Emerging interest in a new product from a competitor; an organization's risk
C
tolerance level
Marketing reports from site tracking services; government-produced
D
geopolitical reports and studies
Enterprise Risk Management
Fraud Risk Management
Fraud
Definition:

Fraud is an intentional and deceptive action designed to provide the

perpetrator with an unlawful gain or to deny a right to a victim. It can occur in
finance, real estate, investment, and insurance or any other sector. It can be
observed in the sale of property, such as land, personal property like art and
collectibles, as well as intangible property like stocks and bonds.

Types of fraud include tax fraud, credit card fraud, wire fraud, securities fraud,
and bankruptcy fraud.

It involves the false representation of facts, whether by intentionally

withholding important information or providing false statements to another
party for the specific purpose of gaining something that may not have been
provided without the deception.
Many times, the perpetrator of fraud is aware of information that the intended
victim is not, allowing the perpetrator to deceive the victim. At heart, the
individual or company committing fraud is taking advantage of information
asymmetry; specifically, that the resource cost of reviewing and verifying that
information can be significant enough to create a disincentive to fully invest in
fraud prevention.

Proving that fraud has taken place requires the perpetrator to have committed
specific acts. The perpetrator has to provide a false statement as a material
fact. Second, the perpetrator had to have known that the statement was
untrue. Third, the perpetrator had to have intended to deceive the victim.
Fourth, the victim has to demonstrate that it relied on the false statement. And
fifth, the victim had to have suffered damages as a result of acting on the
intentionally false statement.

Generally Fraud risk exists in every organization. It is kind of inherent risk.

Even Principle No. 8 of COSO's principles states that “The organization

considers the potential for fraud in assessing risks to the achievement of
objectives.”

What Is Fraud Risk?

 The vulnerability that an organization faces from individuals capable of

combining all three elements of the fraud triangle is fraud risk.

 Fraud risk can come from sources both internal and external to the
organization.

 Risks that are present before management action are described as inherent
risks.

 The risks that remain after management action are described as residual
risks.
 Objective: make residual risks significantly smaller than inherent risks.

Categorizing Fraud

COSO defines fraud as “any intentional act or omission designed to deceive

others, resulting in the victim suffering a loss and/or the perpetrator achieving
a gain” (COSO Executive Summary).

COSO suggests four categories of fraud:

Reporting fraud: financial

An intentional misstatement/(s) in accounting and Financial Statements.

(a) It includes a goal of improving financial results by

overstating income or assets, understating losses or
expenses, or misleading disclosures.

(b) Or may misstate to evade or avoid taxes.

(c) Improper revenue recognition through various

backdated agreements or shipping more products to
retailers than they request.

Reporting fraud: nonfinancial

It includes employees may override controls, including system controls, to

falsify nonfinancial reportsincluding environmental, health, safety, production,
quality reports.

Many times it results from management setting unrealistic performance

targets.
E.g.: falsifying employee credentials to improve the company's goodwill (e.g.,
our COO has an MBA).

Misappropriation of assets

It includes theft or misuse of tangible or intangible assets by employees,

customers, vendors, hackers, or criminal organizations.

Examples—Fictitious invoices from vendors, False claims by customers for

damaged or returned goods.

Other illegal acts and corruption

It includes violations of regulations that may have a substantial impact on the

financial statements
Examples—bribes, kickbacks.

IT and Fraud (Two Edged Sword)

IT can play both ways

(A) facilitate fraud and

(B) Prevent and detect fraud

A poorly designed system increases fraud risk.

Examples:

Hackers may gain unauthorized access to accounting applications and change

financial information.

System controls may include safe mechanisms that can be overridden in some
circumstances. These may facilitate inappropriate access to systems, resulting
in changes to financial data.

Fraud Risk Management Principles

COSO's five fraud risk management principles are mentioned in following

picture.
The comprehensive approach recognizes and emphasizes the fundamental
difference between internal control lacunas resulting in errors and weaknesses
resulting in fraud.

An organization that simply adds the fraud risk assessment to the existing
internal control assessment may not thoroughly examine and identify
possibilities for intentional acts designed to:

• Misstate financial information

• Misstate non-financial information

• Misappropriate assets

• Perpetrate illegal acts or corruption

Implementing a specific and more focused fraud risk assessment as a separate

fraud risk management process provides greater assurance that the
assessment’s focus remains on intentional acts. The comprehensive approach is
also likely to result in a more robust and comprehensive assessment of fraud
risk. It also provides the additional structure needed for comprehensive fraud
risk management. If organizations use the more simplified approach (just
performing the fraud risk assessment), they can combine those results with the
2013 COSO Framework’s results to yield more robust prevention and detection
mechanisms.
 Source:COSO's Five Risk Management Principles

COSO revised its 1992 Internal Control — Integrated Framework in 2013 to

incorporate 17 principles. These 17 principles are associated with the five
internal control components COSO established in 1992. This guide’s five fraud
risk management principles fully support, are entirely consistent with, and
parallel the 2013 COSO Framework’s 17 internal control principles. The
correlation between the fraud risk management principles and the 2013 COSO
Framework’s internal control components and principles is as follows:

COSO Framework Component.

Source : Committee of Sponsoring Organizations of the Treadway Commission
(COSO).

Principle 1—Control Environment

The firm establishes and communicates a fraud risk management program that
demonstrates the expectations of the BOD and senior management and their
commitment to high integrity and ethical values regarding managing fraud risk.

Main points include:

• Aligning fraud risk program to organizations’ goals and risks.

• Set up fraud risk governance roles and responsibilities throughout the
organization.
• Documenting program and communicating throughout organization.
Principle 2—Risk Assessment

Companies perform comprehensive fraud risk assessments to identify specific

fraud schemes and risks, assess their likelihood and significance, evaluate
existing fraud control activities, and implement actions to mitigate residual
fraud risks.

The definition of a risk assessment is a systematic process of identifying

hazards and evaluating any associated risks within a workplace, then
implementing reasonable control measures to remove or reduce them.

• When completing a risk assessment, it is important to clearly define

some keywords:
• An accident is ‘an unplanned event that results in loss’
• A hazard is ‘something that has the potential to cause harm’
A risk is ‘the likelihood and the severity of a negative occurrence (injury, ill -
health, damage, loss) resulting from a hazard.’

Additional training may be required if you need to complete or re -assess your

risk management

The foundation for the prevention and detection of fraud is a structured risk
assessment that addresses the actual risks faced by the organization as
determined by its purpose, industry (products or services), complexity, scale,
and exposure to network risks. The goal of the assessment is to determine the
type, likelihood, and potential cost of risks in a traditional expected value
framework. This allows the organization to tailor program efforts toward cost
effective mitigation, which may include a greater or lesser toleration of a
specific risk.

Assessing fraud risks necessarily involves looking at how employees—including

top management—interact with the resources of the organization. Their
incentives and opportunities compose one of the legs of the Fraud Triangle that
is mostly determined by the organization itself. As such, the risk assessment
effort has to be very clear and detailed about how controls, policies, and
procedures interact with specific roles. It is important to note that the sources
of these risks may be external as well as internal, especially in highly networked
and data dependent operations.

Managing the risk assessment process:

 • Include it in appropriate management, including all organizational
management levels and functions.
• Usage of data analytics features to assess risks and evaluate responses.
• Assess fraud risk on periodic basis.
• Documentation of Risk Assessment.

Risk assessments:

• Analyze internal and external risks.

• Consider risks of various types of frauds.
• Consider the risk of management overriding controls.
• Estimate the probability and materiality of identified risks.
• Assess various staff and departments in relation to the fraud triangle i.e.
opportunity, incentives and pressure, attitudes or rationalizations.

Fraud controls and effectiveness:

• Identify existing fraud controls and their effectiveness.

• Determine risk responses.

Principle 3—Control Activities

The organization selects, develops, and deploys preventive and detective fraud
control activities to mitigate the risk of fraud events occurring or not being
detected in a timely manner.
Fraud risk management needs to be embedded in an organization’s DNA in the
form of written policies, defined responsibilities, and on-going procedures that
implement an effective program. There needs to be a clear role for the Board
and top management in setting these policies with reporting in place to convey
the required information about the program and its performance to them. The
tone from the top will be reflected in the perception of fraud prevention and
detection throughout the organization.

It is important to have a responsible person with adequate resources and

access to top management running the program. This person should be
charged with designing and evaluating the program, and for communicating it
throughout the organization as appropriate.

Main points include:

• Promote fraud deterrence through preventive and detective controls.

• Control activities should also consider following :

(a) Industry-specific factors.

(b) Control Applications to differing organizational levels.

(c) Risk of management override of controls.

(d) Integration with fraud risk assessments.

(e) Multiple, synergistic fraud control activities.

(f) Advanced data analytics procedures like identifying anomalous transactions

on concurrent basis.

(g) Control through policies and procedures.

Principle 4—Information and Communication

Itsets up a communication process to gather information about potential fraud

and adopts a coordinated approach to investigation and corrective action
against fraud.

• Sets up fraud investigation and response protocols.

• Adopts and document investigations.
• Communicate investigation results.
• Implement corrective actions.
• Evaluate investigation performance.

Principle 5—Monitoring Activities

The organization performs concurrent evaluations to realize the presence of
the five principles of fraud risk management and its functioning and
communicates fraud risk management program defects in a timely manner to
parties responsible for taking corrective action, including senior management
and the board of directors.

Creating information that does not get to the right person to take action is
useless. One of the key elements in the initial planning for a fraud prevention
program is to set up responsibilities and processes to ensure that timely
information is reported to someone who can address a problem. These systems
trigger responses that have strong legal implications, so one of the essential
components is review for legal rights of affected parties and compliance with
applicable law.

Fraud can be taken down a notch, even if it cannot be completely eliminated. A

systematic program following these five principles is the place to start.
Focal points to consider:

• Ongoing independent evaluation.

• Influences on scope and frequency of monitoring
• Known and emerging fraud issues.
• Set up appropriate management criteria.
• Evaluate, communicate, and correct the deficiencies identified through
monitoring.

The Fraud Risk Management Process

Model 1: Managing revenue recognition fraud risk

Revenue recognition is among the most frequent reporting frauds.

Relevant questions in such Fraud Risk programme would include:

 What are the primary sources and drivers of revenue?

Are revenues mainly from sales of consumer goods or a

small number of large transactions?

Are recording of revenue transactions automated or

manual?

Identify industry-specific fraud risks of revenue?

Identify revenue recognition incentives or pressures in

the organization? Like what are the Incentives and
Penalties?

What data related to revenue are being used by external

stakeholders?

Model 2:Managing fraud risk through HR procedures

Following HR procedures would help in managing fraud risk:

 Background, credit, and criminal checks of employees,
suppliers, and business partners.

Providing Fraud risk management training to identify

and manage entity and industry-specific risks.

Executing Performance Evaluation and compensation

programs—e.g., Bonus programs, short-term bonuses
for sales or earnings targets?

Conducting Annual surveys including assessments of

ethics, misconducts, malpractices, trainings on how to
report concerns or misbehavior

Conducting Exit interviews with discussion of possible

fraud and misconduct in the organization

Segregation of duties

Transaction-level controls e.g., Data entry authorization

approvals.

Implementation of a whistleblower system

The COSO framework related to Fraud Risk also considers a framework for
using data analytics to prevent, detect, and investigate fraud. It can address all
aspects of the fraud triangle:

• In case of Incentive and pressure, Data analytics can identify

management practices and business processes that encourage
 employees to bypass defined controls including risks of behavior and
excess spending.
• In case of Opportunities, it can prevent fraud through monitoring of key
controls. Concurrent audit of key controls is often possible through data
analytic tools.
• Attitudes and rationalization—Data analytics can deter fraud by causing
mountebanks to not engage in fraud because they know of monitoring
programs, and, by detecting communications that indicate fraudulent
activity.

Plan of Data Analytics to Support Fraud Risk Management

• Analytics design—Assess fraud risk; align risks to data sources and data
availability; create work calendar and deliverables.
• Data collection—Align data to planned tests and validate.
• Organizing Data and calculation—Define work plan; do analytics to
available data;, use advanced techniques including text mining, statistical
analysis, and pattern analysis.
 • Data analysis—Evaluate results. Develop and implement models to
prioritize risks. Consider the model to improve relevance and accuracy of
results.
• Findings, observations —Request supporting documents to assist in
making results actionable. Determine escalation procedures to
determine report levels, develop remediation plan for identified issues.

Potential Data Analysis Tools for Fraud Risk Management

• Data stratification—Sort data of payments, journal entries, surveys, or

employee or any kind of material data.
• Risk scoring—Give weight and compare fraud risk factors.
• Data visualization—Detect patterns, changes and trends.
 • Trend analysis—Do data analysis over the period of time and across
locations.
• Variance analysis—Detect anomalies like unusual transactions, missing
transactions.
• Statistical analysis and modeling—It is used with continuous auditing and
monitoring systems.
• Integration of external data sources like new fraud risks, industry trends,
regulatory actions, economic indicators

62. An employee survey related to fraud risk includes this statement:

“Employees who report suspected improprieties are protected from
reprisal.” It relates to which of the following fraud management principles ?

A Establishing a fraud risk management program

B Selecting, developing, and deploying fraud controls
Selecting, developing, and deploying evaluation and monitoring
C
processes
Establishing a communication program to obtain information about
D
potential frauds

63. ABC Corp. uses a fraud risk assessment heat map that charts the
significance and the likelihood of frauds as a part of its fraud risk
management program. The heat map best relates to which of the following
activities?
A Establishing a fraud risk management program
B Selecting, developing, and deploying fraud controls
Selecting, developing, and deploying evaluation and monitoring
C
processes
D Performing a comprehensive fraud risk assessment

64. ABC Corp. is introducing a data analytics program to manage the risk of
vendor fraud. Which of the following activities would occur last in this
process?

Determine the risk of management override of controls over

A
purchases.
B Determine reporting procedures for vendor anomalies.
Screen data to remove html tags from harvested vendor
C
data.
D Validate scraped data to match to existing vendor files.

65. XYZ company that has few levels of management with wide spans of
control, each of the following mitigates management override of
controls except

Establishes an effective and anonymous whistleblower program with which

A
employees can feel comfortable reporting any irregularities.
Establishes a corporate culture in which integrity and ethical values are highly
B
appreciated.
C Having two officers who significantly influence management and operations.
D Having an effective internal auditor function.
66. MNO Corp, a financial services corporation, has a unit responsible for
conducting regular, recurring reviews to prevent and detect fraud. T his
should be part of the ______ function.

A IT
B HR
C Legal
Internal
D
audit

67. The employee survey related to fraud includes statement: “We are
discouraged from sharing our passwords with others.” This best relates to
which of the following fraud management principles?

A Establishing a fraud risk management program

B Selecting, developing, and deploying fraud controls
Selecting, developing, and deploying evaluation and monitoring
C
processes
Establishing a communication program to obtain information about
D
potential frauds

68. For the past 5 years, the management of ABC Corp has paid money to the
Minister of Trade and Technology to obtain government contracts to
purchase computers, software. These activities have increased ABC Corp.
sales by 20%. These can best be described as

Reporting fraud:
A
nonfinancial.
B Misappropriate of assets.
C Corruption and illegal acts
D Reporting fraud: financial.
 Enterprise Risk Management
Regulatory Frameworks and Provisions

Enterprise Risk Management (ERM) :

Regulatory Framework

Introduction

Corporate governance is gaining extreme importance in economy as large

companyis having separation of shareholders from control officers and
directors.In present times, importance has grown as a series of corporate
scandals occurred in the recent past.

Corporate governance is the system of rules, practices, and processes by which

a firm is directed and controlled. Corporate governance essentially involves
balancing the interests of a company's many stakeholders, such as
shareholders, senior management executives, customers, suppliers, financiers,
the government, and the community. Since corporate governance also provides
the framework for attaining a company's objectives, it encompasses practically
every sphere of management, from action plans and internal controls to
performance measurement and corporate disclosure.

Governance refers specifically to the set of rules, controls, policies, and

resolutions put in place to dictate corporate behavior. Proxy advisors and
shareholders are important stakeholders who indirectly affect governance, but
these are not examples of governance itself. The board of directors is pivo tal in
governance, and it can have major ramifications for equity valuation.
A company’s corporate governance is important to investors since it shows a
company's direction and business integrity. Good corporate governance helps
companies build trust with investors and the community. As a result, corporate
governance helps promote financial viability by creating a long-term
investment opportunity for market participants.

Company law establishes a three-portion pyramid, with the shareholders in the

bottom, the directors in the middle, and the officers on top. The shareholders'
right to vote to elect directors and vote on certain major changes like a merger
and acquisition depicts their primary hold into corporate control.

Directors are responsible for implementing corporate policy. Directors select,

compensate, and remove corporate officers who are at the top of the pyramid
and accountable for the day-to-day operations of the firm. It is important to
emphasize that shareholders vote on directors but have no direct input
regarding officers, a point frequently tested over the years.

Officers execute their responsibilities through teams and staff who are working
within the scope of their authority and they follow the directions of superiors
or otherwise take actions in the best interests of their employers.
This shows key corporate governance provisions of the Sarbanes-Oxley Act of
2002 (SOX), which was enacted in response to the Enron scandals and related
regulatory pronouncements.

SOX is a big intrusion by federal law into what had previously been the entirely
state-law domain of corporate governance.

Itis also to be noted that SOX provisions are applicable only to public
companies including their wholly-owned subsidiaries, and all publicly traded
non-U.S. companies doing business in the U.S.

Corporate Responsibility

Corporate responsibility (CR) is concerned with the sustainability of an

organisation over the long term. At its core, corporate responsibility seeks to
add value to an organization’s activities by ensuring they have a positive impact
on society, the environment and the economy. The traditional model of CR
includes the workplace, marketplace, community and environment.

As corporate responsibility continues to mature, one of the key shifts we ’ve

seen in recent years is a move toward “values.” A company’s approach to
impact is a reflection of that company’s values -- and the values of its
customers, employees and (increasingly) investors. It’s a shift that has been
accelerated by the current political climate, in which companies have had to
publicly stand up -- both individually and collaboratively -- for values like
inclusion, empathy and environmental preservation in the face of questionable
policy decisions.
Itis also to be noted that CEOs and CFOs are often involved in companies'
financial wrongdoing, so it is very much natural that it contains several
provisions dealing with responsible corporate governance that have crucial
aspects upon the accuracy of firms' financial reporting.

These include:

Audit committees

The primary purpose of a company’s audit committee is to provide oversight of

the financial reporting process, the audit process, the company’s system of
internal controls and compliance with laws and regulations.

The audit committee can expect to review significant accounting and reporting
issues and recent professional and regulatory pronouncements to understand
the potential impact on financial statements. An understanding of how
management develops internal interim financial information is necessary to
assess whether reports are complete and accurate.

The committee reviews the results of an audit with management and external
auditors, including matters required to be communicated to the committee
under generally accepted auditing standards. Controls over financial reporting,
information technology security and operational matters fall under the purview
of the committee.
Audit committees monitor the internal audit function and overseen the
financial reporting processes and annual financial statement audit. But SOX
created a much larger role for public company audit committees and changed
their composition.

Audit committees shall have authority over their own budgets and over
external auditors. It is through these protections that investors will come to
trust the financial reports released by companies.

While boards should seek members who can provide a diverse range of
competent perspectives based on their experience and expertise, it is
nevertheless imperative that board members are knowledgeable and
conversant in the language of finance and accounting. This need is particularly
acute for the audit committee.

Before SOX Era, CEOs and CFOs involved in financial frauds, compensated, and
terminated their company's outside auditor. Hence to strengthen corporate
governance by reducing the control of top management, SOX requires public
companies to create audit committees that will choose, compensate, oversee,
and terminate their company's auditors. Audit reports are now addressed to
the audit committee rather than to corporate management.
Independent directors

Independent Director acts as a guide, coach, and mentor to the Company. The
role includes improving corporate credibility and governance standards by
working as a watchdog and help in managing risk. Independent directors are
responsible for ensuring better governance by actively involving in various
committees set up by company

The independent directors are required because they perform the following
important role:

1. facilitate withstanding and countering pressures from owners;

2. fulfill a useful role in succession planning;
3. on issues such as strategy, performance, risk management, resources,
key appointments and standards of conduct he shall support in gaining
independent judgment to bear on the board’s deliberations
4. while evaluating the performance of board and management of the
company bring an objective view
5. scrutinizing, monitoring and reporting management’s performance
regarding goals and objectives agreed in the board meetings
6. safeguard the interests of all stakeholders, particularly the minority
shareholders;
7. balance the conflicting interest of the stakeholders;
8. satisfying themselves that financial controls and systems of risk
management are in operation and check on the integrity of financial
information
 9. in situations of conflict between management and shareholder’s interest,
aim towards the solutions which are in the best interest of the company
10. establishing the suitable levels of remuneration of

• executive directors,
• key managerial personnel
• senior management

SOX require audit committees to be composed entirely of neither

independent directors who are neither officers of the company nor consultants
who collect significant fees from the company. At least one of the audit
committee members shall be a “financial expert.”

Whistleblowers

Audit committees shall set up procedures for receiving, retaining, and treating
complaints by whistleblowers about accounting procedures and internal
controls and protecting the confidentiality of those complainants.

A whistleblower is anyone who has and reports insider knowledge of illegal

activities occurring in an organization. Whistleblowers can be employees,
suppliers, contractors, clients, or any individual who becomes aware of illegal
business activities. Whistleblowers are protected from retaliation under various
programs created by the Occupational Safety and Health Administration
(OSHA), Sarbanes Oxley Act, and the Securities and Exchange Commission
(SEC). The protection of federal employees is under the Whistleblower
Protection Act of 1989.
A whistleblower is a person who comes forward and shares his/her knowledge
on any wrongdoing which he/she thinks is happening in the whole organisation
or in a specific department. A whistleblower could be an employee, contractor,
or a supplier who becomes aware of any illegal activities.

To protect whistleblowers from losing their job or getting mistreated there are
specific laws. Most companies have a separate policy which clearly states how
to report such an incident.

A whistleblower can file a lawsuit or register a complaint with higher

authorities who will trigger a criminal investigation against the company or any
individual department.

There are two types of whistleblowers: internal and external. Internal

whistleblowers are those who report the misconduct, fraud, or indiscipline to
senior officers of the organisation such as Head Human Resource or CEO.

External whistleblowing is a term used when whistleblowers report the

wrongdoings to people outside the organisation such as the media, higher
government officials, or police.
The crime or wrongdoing could be in the form of fraud, deceiving employees,
corruptions, or any other act which misleads people.

Advisers Engagement

In order to ensure that audit committees can be as effective as possible, SOX

grants authority to each such committee to hire independent legal counsel and
other advisers “as it determines necessary to carry out its duties.”

Officer certification of financial statements

To impose accountability for the accuracy of firms' financial statements,

SOX's Section 302 requires:

Each public company's CEO and CFO shall certify that:

i. They have reviewed the quarterly and annual reports that their
companies shall file with the SEC;
ii. To their knowledge, the reports do not contain any materially untrue
statements or half-truths; and
iii. Based on their knowledge, the financial information is fairly presented.

They shall certify that:

iv. They are responsible for establishing and maintaining their

company's internal financial controls.
v. They have designed such controls to ensure the relevant material
information is made known to them.
vi. They have recently evaluated the effectiveness of the internal controls.
vii. They have presented in the report their conclusions about the controls'
effectiveness.

CEOs and CFOs shall certify that they have reported to the auditors and the
audit committee regarding all material deficiencies and weaknesses in the
controls and any fraud, whether or not material, that involves management or
other employees playing a significant role in the internal controls.
Misleading auditors

SOX Section 303 makes it a crime for any officer, director, or person acting
under their direction to violate SEC rules by fraudulently influencing, coercing,
manipulating, or misleading an auditor for the purpose of rendering financial
statements misleading.

When auditors ask for information, relationships are key. Audit clients and
subsidiaries and their directors should co-operate. Delaying the provision of
requested information, or knowingly or recklessly making a false, misleading or
deceptive statement to the auditor, can lead to sanctions. Auditors also need
information from external parties, but if they provide misleading or false
information, unless fraud can be shown, there is no remedy.

Clawbacks

A claw back is a contractual provision whereby money already paid to an

employee must be returned to an employer or benefactor, sometimes with a
penalty.

Many companies use claw back policies in employee contracts for incentive -
based pay like bonuses. They are most often used in the financial industry.
Most claw back provisions are non-negotiable. Clawbacks are typically used in
response to misconduct, scandals, poor performance, or a drop in company
profits.

Following the financial crisis of 2008, clawback clauses have become more
common since they allow company cover incentive pay from CEOs if there is
misconduct or any discrepancies in the company's financial reports.
Clawbacks are also written into employee contracts so employers can control
bonuses and other incentive-based payments. The clawback acts as a form of
insurance in case the company needs to respond to a crisis such as fraud or
misconduct, or if the company sees a drop in profits. The employee must also
pay back monies if the employer feels his or her performance has been poor.

Clawbacks are different from other refunds or repayments because they often
come with a penalty. In other words, an employee must pay additional funds to
the employer in case the clawback is put into effect.

Clawback provisions prevent people from using incorrect information and are
used to put a balance between community development and corporate
welfare. For example, they can help to prevent the misuse of accounting
information by employees in the financial industry.

Section 304 provides that if an issuer shall materially restate its financial
statements as a result of “misconduct,” which apparently need not be
intentional, the CEO and CFO shall reimburse the company for incentives
received due to the misstatement for any profits they realized from sale of the
company's stock during that period.

Clawbacks are considered an important part of the business model because

they help to restore the confidence and faith of investors and the public into a
company or industry. For example, banks implemented clawback provisions
following the financial crisis as a way to correct any future mistakes by their
executives.

Enhanced Financial Disclosures

SOX's contains provisions that even more directly impact financial reporting
practices:

SOX's Section 401 contained several provisions to limit financial monkey

business:

Off-balance sheet Items

Off-balance sheet (OBS) items is a term for assets or liabilities that do not
appear on a company's balance sheet. Although not recorded on the balance
sheet, they are still assets and liabilities of the company. Off-balance sheet
items are typically those not owned by or are a direct obligation of the
company. For example, when loans are securitized and sold off as investments,
the secured debt is often kept off the bank's books. An operating lease is one of
the most common off-balance items.

Off-balance sheet items are an important concern for investors when assessing
a company's financial health. Off-balance sheet items are often difficult to
identify and track within a company's financial statements because they often
only appear in the accompanying notes. Also, of concern is some off-balance
sheet items have the potential to become hidden liabilities. For
example, collateralized debt obligations (CDO) can become toxic assets, assets
that can suddenly become almost completely illiquid, before investors are
aware of the company's financial exposure.

SOX provides that quarterly and annual financial reports filed shall disclose all
material off-balance sheet transactions, arrangements, obligations, and
relationships with entities that might have a material impact on the financial
statement.

It also provides to figure out how to reduce the use of “special purpose
entities” to facilitate misleading off-balance sheet transactions.

Pro forma (Provisional) financials

Pro forma financial statements are financial reports issued by an entity, using
assumptions or hypothetical conditions about events that may have occurred in
the past or which may occur in the future. These statements are used to
present a view of corporate results to outsiders, perhaps as part of an
investment or lending proposal. A budget may also be considered a variation on
pro forma financial statements, since it presents the projected results of an
organization during a future period, based on certain assumptions.

Here are several examples of pro forma financial statements:

• Full-year pro forma projections. This is a projection of a company's year-to-

date results, to which are added expected results for the remainder of
the year, to arrive at a set of full-year pro forma financial statements.
This approach is useful for projecting expected results both internally to
management, and externally to investors and creditors.

• Investment pro forma projection. A company may be seeking funding, and

wants to show investors how the company's results will change if they
invest a certain amount of money in the business. This approach may
result in several different sets of pro forma financial statements, each
designed for a different investment amount.
 • Historical with acquisition. This is a backward-looking projection of a
company's results in one or more prior years that includes the results of
another business that the company wants to purchase, net of acquisition
costs and synergies. This approach is useful for seeing how a prospective
acquisition could have altered the financial results of the acquiring entity.
You can also use this method for a shorter look-back period, just to the
beginning of the current fiscal year; doing so gives investors a view of
how the company would have performed if a recent acquisition had been
made as of the beginning of the year; this can be a useful extrapolation of
the results that may occur in the next fiscal year.

• Risk analysis. It may be useful to create a different set of pro forma

financial statements that reflect best-case and worst-case scenarios for a
business, so that managers can see the financial impact of different
decisions and the extent to which they can mitigate those risks.

• Adjustments to GAAP or IFRS. Management may believe that the financial

results it has reported under either the GAAP or IFRS accounting
frameworks are inaccurate, or do not reveal a complete picture of the
results of their business (usually because of the enforced reporting of a
one-time event). If so, they may issue pro forma financial statements that
include the corrections they believe are necessary to provide a better
view of the business. The Securities and Exchange Commission takes a dim
view of this kind of adjusted reporting, and has issued regulations about
it in their Regulation G.

In response, the SEC issued Regulation G, which does not restrict use of pro
forma but imposes a wide range of limitations upon the use of pro forma
results, including a requirement that public companies disclosing such results
include the most directly comparable GAAP financial measures and
reconciliation.

Improper loans
Section 402 of SOX prohibits public companies from making personal loans to
their top officers and directors. It makes it unlawful for an issuer “directly or
indirectly … to extend or maintain credit, to arrange for the extension of credit,
or to renew an extension of credit, in the form of a personal loan” to any of its
directors or executive officers.

Such loans are now permitted only if they are made:

• On market terms
• In the ordinary course of business
• Available to the public and insiders

Internal financial controls Audit

Section 302 of SOX requires for executive certification while Section 404
provides that each annual report should also contain an “internal control
report” stating the responsibility of management for establishing and
maintaining an adequate internal control structure so that accurate financial
statements can be prepared.
The report shall also contain an assessment at of the end of the most recent
fiscal year, of the effectiveness of the internal control structure and
procedures. Importantly, Section 404 also requires outside auditors to evaluate
the internal control assessment of the company as well as the financial
statements. Thus, outside auditors of public companies audit both the financial
statements and the internal financial reporting process that creates them.

Code of Ethics for CFO

Section 406 of SOX provides public companies to disclose whether or not they
have adopted a code of ethics for senior officers such as CFOs, comptrollers,
principal accounting officers, and, if not, the reasons to be stated. The code is
to address such matters as conflicts of interest, accurate financial reporting,
and compliance with governmental rules and regulations.
This Code is applicable to chief executive officer, chief financial officer,
controller, or persons performing similar functions. By this the companies
expect honest and ethical conduct from all of our employees but we expect the
highest possible honest and ethical conduct from our Senior Financial Officers.
Companies can expect the Senior Financial Officers to set an example for other
employees and to foster a culture of transparency, integrity, and honesty.
Compliance with this Code is a condition of employment, and violations of this
Code may result in disciplinary action, up to and including termination of
employment. This Code supplements Employee Code of Conduct and Ethics,
which sets forth the fundamental principles and key policies and procedures
that govern the conduct of all of our employees. Senior Financial Officers are
bound by the requirements and standards set forth in this Code and the
Employee Code of Conduct and Ethics.

Financial expert

During the Enron times,detecting massive accounting frauds were not possible,
Section 407 requires that at least one member of the audit committee should
be “financial expert.”
In order to comply with the rules each reporting company should do the following:

• Its board of directors should evaluate the members of its audit committee to
determine whether or not it has at least one member who qualifies as an audit
committee financial expert and, if so, whether or not such person is
independent of management.

• If the board determines that its audit committee does not have a member
who qualifies as an audit committee financial expert and is independent of
management, the board should consider whether or not any other member of
the board who is independent of management qualifies as an audit committee
financial expert. If so, the board should consider rearranging committee
assignments to assign the person qualifying as an audit committee financial
expert to the audit committee. If not, the board should consider recruiting an
individual to serve on the audit committee who is independent of management
and qualifies as an audit committee financial expert.

• If it does not have an audit committee financial expert, the company should
consider disclosing, together with its explanation of why it does not have such
an expert, any attributes of the audit committee financial expert definition that
are satisfied by members of the company's audit committee and, if applicable,
the audit committee's use of outside experts.
The company should evaluate whether or not a member of its audit committee
meets the definition of audit committee financial expert set forth in the final
rules. If it does not, it should consider recruiting one. While the rules do not
allow companies to consider the collective expertise of the audit committee, if
a company does not have one member that is an audit committee financial
expert, it may disclose the fact that various members of the audit committee
satisfy certain or all of the attributes of an audit committee financial expert. In
addition, a company may consider disclosing the use of outside experts hired
by the audit committee to assist the committee on specific matters.

The SEC has published rules defining an “audit committee financial expert” to
meanas below:

• A person understanding of GAAP and financial statements

• A person having ability to assess the general application of these
principles in connection with accounting for estimates, accruals, and
reserves
• A personhaving experience in preparing, auditing, analyzing, or
evaluating financial statements that present a breadth and level of
complexity comparable to those presented by the issuer's financial
statements, or experience actively supervising persons engaged in such
activities
• A personhaving an understanding of internal controls and procedures for
financial reporting
• A personhaving an understanding of audit committee functions

To qualify, an individual must have gained the foregoing attributes through any
of the following means:

• Education and experience

1) In a position as a principal financial or accounting officer, controller,
public accountant, or auditor, or
2) In a position involving similar functions;
• Experience in actively supervising a principal financial or accounting
officer, controller, public accountant, or auditor (or an individual
performing similar functions);
• Experience in overseeing or assessing companies or public accountants in
the preparation, auditing, or evaluation of financial statements; or
 • Other relevant experience.

Corporate and Criminal Fraud Accountability

SOX provides for various provisions to increase criminal penalties and other
forms of accountability for financial fraud and wrongdoings.

Sections 801 to 807 of the Sarbanes Oxley Act of 2002 are known collectively as
the Corporate and Criminal Fraud Accountability Act. The Act details criminal
penalties for securities fraud and protects employees-turned-whistleblower of
publicly traded companies from retaliatory actions by their employers.

The Corporate and Criminal Fraud Accountability Act includes the following
sections:

According to the Corporate and Criminal Fraud Accountability Act, it is illegal

for any individual to carry out the following activities with respect to
documents that pertain to federal investigations and bankruptcy filing
processes:
 • Alteration
• Destruction
• Mutilation
• Concealment
• Cover up
• Falsification
• Making false entries

Such an illegal activity is punishable by the imposition of fines or the maximum

of a 20 year jail sentence or both.

Section 802 responded directly to the case of accounting firm Arthur Andersen
to shred two tons of Enron documents once it knew that it was being
investigated by the SEC for potential wrongdoing in connection with its audits
of Enron. This resulted in two new criminal statutes.

• Destruction, alteration, or falsification of records in federal investigations

and bankruptcy—One statute subjects to fine and/or imprisonment of
not more than 20 years anyone who “knowingly alters, destroys,
mutilates, conceals, covers up, falsifies, or makes a false entry in any
record, document, or tangible object with the intent to impede, obstruct,
or influence the investigation or proper administration of any matter
within the jurisdiction of any agency or department of the United States”
or in any bankruptcy case filed under Chapter 11. Obviously, this
provision punishes obstruction of justice beyond just SEC proceedings.

• Destruction of corporate audit documents—The second statute, as

supplemented by SEC rule, requires "any accountant" who audits a public
company to "maintain all audit or review working papers” for 7 years
after the conclusion of the audit.

Section 806 provides a civil damages action for public company whistleblowers
who are threatenedvia demotion, suspension, harassment against for providing
information in an investigation or participating as a witness or otherwise in a
proceeding involving federal securities law violations or other frauds that might
damage shareholders. The provision covers investigations conducted by federal
agencies, members of Congress or their staffs, or any person with supervisory
authority over the employee. Whistleblowers are similarly protected when they
file or assist in the filing of proceedings alleging a violation of these provisions
forbidding fraud against shareholders. Whistleblowers are protected from
retaliation if their belief that legal violations have occurred is reasonable, even
if mistaken.

White-Collar Crime Penalty Enhancements

The key provisionsin SOX contained in Section 302 which required CEOs and
CFOs to personally certify the financial statements they signed and internal
controls they created and Section 404 which required those internal controls to
be audited.

Section 906 imposes criminal punishments upon those officers who

“intentionally” certify SEC filings containing inaccurate financial statements.
Punishments can run as high as up to $5 million in fines and 20 years in jail.

Other provisions increase punishments for conspiracy to commit securities

fraud, for committing mail and wire fraud, and for criminally violating the
Employee Retirement Income Security Act (ERISA).

Corporate Fraud Accountability

Section 301 requires audit committees to set up procedures to protect
whistleblower confidentiality and Section 806 enables a whistleblower suffering
retaliation to sue for damages.

Article XI's Section 1107 makes it a crime to retaliate against an informant

providing truthful information relating to the commission of any federal crime
to law enforcement officers. Maximum potential punishment is a fine and/or
up to 10 years in prison.
69. As per Sarbanes-Oxley Act of 2002, anyone who knowingly alters,
destroys, covers up, or makes a false entry in any record or document to
obstruct or influence the investigation of any matter within the jurisdiction
of any department or agency of USA may be imprisoned for up to:

A Five years.
B Ten years.
Fifteen
C
years.
Twenty
D
years.

70. As per the Sarbanes-Oxley Act of 2002, Audit committee members are
required, , to maintain following traits?

A Integrity.
B Diligence.
C Independence.
D Proficiency.

71. A public company audit committee shall have all of the following except:

A An understanding of GAAP and financial statements.

Experience in preparing or auditing financial statements of comparable
B
companies and application of such principles in connection with accounting for
 estimates, accruals, and reserves.
C Experience with internal auditing controls.
D Experience on a public company's compensation committee.

72. Public company audit committees shall contain which of the following?

A majority of independent
A
directors
B An accounting expert
C A financial expert
D A legal expert

73. CFO has been complicit in public company's accounting fraud. He

consults a lawyer as it becomes time for filing firm's 10-K with the SEC. He is
a little uncomfortable about what he might have to do. The lawyer will likely
tell that he will have to certify all of the following matters except:

A He has reviewed the 10-K.

B CPA license is active.
That he, along with the CEO, is responsible for establishing and maintaining
C
his company's internal controls.
That he has recently evaluated the effectiveness of the firm's internal
D
controls.
74. Every audit committee of a public company shall have at least one of the
following:

Legal expert understands the liabilities those public companies can face if
A
they misreport financial information.
B Financial expert understands GAAP and financial statements.
C Ethics expert is familiar with Immanuel Kant's writings.
D Accounting expert is familiar with the AICPA Code of Professional Conduct.

75. Public company third party audit firms shall audit their clients':

A Financial statements.
B Internal controls.
C Financial statements and internal controls.
Neither financial statements nor internal
D
controls.

76. Public company CEOs and CFOs shall certify that:

They are responsible for set up and maintaining their firm's internal financial
A
controls.
They have hired an excellent firm and have delegated ultimate responsibility for
B
the accuracy of financial statements.
They have taken lie detector tests regarding the accuracy of the financial
C
statements.
They are subject to firm codes of ethics policing the accuracy of financial
D
statements.
77. Which of the following officers of a public company shall certify that the
accuracy of their firms' financial statements as filed with the SEC?

CEO and
A
CAO
CAO and
B
CFO
C CFO and CEO
CEO and
D
COO

78. Which of the following is correct regarding the requirements of the

Sarbanes-Oxley Act of 2002 for an issuer's board of directors?

Each member of the board of directors shall be independent from management

A influence, based on the member's prior and current activities, economic and
family relationships, and other factors.
The BOSshall have an audit committee entirely composed of members who are
B
independent from management influence.
The majority of members of the board of directors shall be independent from
C
management influence.
The BODshall have a compensation committee, a nominating committee, and an
D
audit committee, each of which is composed entirely of independent members.
Section B
 Economic
Concepts
And
Analysis

Introduction to Economic Concepts

Q: What is general meaning of Economics?
A: Economics is the study of the allocation of scarce economic resources among alternative
uses.

Q: What is the meaning of Economics from Business perspective?

A: From a business perspective, economics is concerned with studying the production,
distribution and consumption of goods and services, generally so as to maximize
desired outcomes.

Q: What are branches of Economics?

A: Economics can be classified into three main categories
1. Macro Economics
2. Micro Economics
3. International Economics

Q: What is Macro Economics?

A: Macro Economics studies the economic activities and outcomes of a group of entities
taken together, typically of an entire nation or major sectors of a national economy.
Major areas of interest include aggregate output, aggregate demand and supply, price
and employment levels, national income, governmental policies and regulation,
international implications etc.

Q: What is Micro Economics?

A: Micro Economics studies the economic activities of distinct decision-making entities,
including individuals, households, and business firms. Major areas of interest include
demand and supply, prices and outputs, the effects of external forces on the economic
activities of these individual decision makers etc.

Q: What is International Economics?

A: International Economics studies economic activities that occur between nations, it also
studies the outcomes that result from these activities. Major areas of concern include
reasons for international economic activity, socioeconomic issues, balance of payments
accounts, currency exchange rates, international transfer pricing, and globalization,
which is a consequence of widespread international economic activity.

Q: What are the factors covered under Economic activity?

A:
1. The factors that determine economic activity, including demand and supply, for
individual firms, industries and entire nations, and the effects of changes in those
factors on economic activity.
2. The characteristics of major economic environments (called “market structures”) in
which firms operate and the effects of market structure on the short-term and long-
term operations of an entity.
3. Measures of national economic activity and the factors and actions that change that
activity, including business cycles, inflation/deflation and government policy.
 4. Why international economic activity occurs and the issues that result from that
activity at both the national and entity levels, including the role of exchange rates
and international transfer prices.
5. The reasons for and nature of globalization of business and economic activity,
including globalization of trade, production, and capital markets, and the shifts in
economic power that have occurred and continue to occur as a result of
globalization.
6. The processes by which an entity can analyze its economic environment and the
relationship between that environment and the internal characteristics of the entity.

Q: Explain the Use of Graphs in Economics ?

A:

➢ Many economic concepts and relationships are depicted using graphs.

➢ These graphs often show the relationship between two variables, an independent
variable and a dependent variable.

➢ In most cases, in economics, the independent variable is shown on the vertical axis
(called the Y-axis) and the dependent variable is shown on the horizontal axis
(called the X-axis).
➢ Thus, the variable plotted using values on the X (horizontal) axis (the dependent
variable) depend on the value shown on the Y (vertical) axis (the independent
variable).
➢ The point at which the plotted relationship (i.e., the “graphed line”) intersects the Y-
axis (at the left end of the X-axis) is called the “intercept.”

➢ By historic convention, in economics, price is plotted (measured) on the vertical axis

and quantity on the horizontal axis. Thus, a conventional graph that plots price and
quantity would show the following:

The above graph shows that the higher the price, the lower the quantity, or vice versa.

Q: What is Ceteris Paribus in Economics?

A: In economics, any influence that other variables (other than the one shown on the
graph) may have on the dependent variable is assumed to be held constant, a concept
referred to in economics as ceteris paribus.

Q: Explain the relationship between the variables?

A: The relationship between variables may be positive, negative, or neutral.

These are further explained in the following graphs:

a) For Positive relationship between variables: The dependent variable moves in
the same direction as the independent variable.

b) For Negative relationship between variables: The dependent variable moves in

the opposite direction from the independent variable

c) For Neutral relationship between variables: One variable does not change as the
other variable changes. (This indicates that the variables are not interdependent.)

Q: Explain Time series Graph?

A: When the independent variable is time, the vertical axis shows the behaviour of the
dependent variable over time and is called a “time series graph.” Such a graph might
take the following form:
Q: Can the graphic relationship be expressed in the mathematical formulas?
A: Relationships shown in graphic form often can be expressed as mathematical formulas.
Such formulas provide quantitative expressions of the relationships between variables
and are basic to making economic projections.

➢ The basic equation for a straight-line plot on a graph can be expressed as:

U = y + q (x)

Where:

o U = unknown value of the variable y being determined and/or plotted.

o y = the value of the plotted line where it crosses the Y'axis; called the
“intercept” (or “Y-intercept”). In economic graphs, this is commonly the value
of Y where X = 0.
o q = the value by which the value of y changes as each unit of the x variable
changes; this expresses the slope of the line being plotted.
o x = the value (number of units) of the variable x.

Note: Any letters can be used to represent the two variables being plotted, and the
expression can be rearranged. For example, the same formula could be, and sometimes
is, written as:
Y = mx + b
Where:
o Y = unknown value of Y.
o m = slope of the plotted line.
o x = value of the variable x.
o b = Y-intercept.
 Example
A common accounting example would include the determination of total cost for various
levels of production using fixed cost and variable cost; it could be expressed as:
TC = FC + VC (Units)

• Where:
• TC = total cost.
• FC = fixed cost (incurred independent of the level of production; the Y-intercept).
• VC = variable cost per unit of variable X produced; the change in total cost as the
number of units of variable X are produced (also, the slope of the total cost line).
• Units = number of units of the variable X produced.

a. If the value of FC and VC are known, TC can be computed and plotted for any
number of levels of production (units).

Q: What is economic systems?

A: The nature of economic activity, at the microeconomic, macroeconomic, and
international levels, depends on the political environment (or economic system) within
which the economic activity takes place. The two major economic systems can be found
at opposite ends of a continuum of economic systems. There are two types of Economic
systems:
➢ Command economic system
➢ Market (Free-Enterprise) Economic System

Q: What is command economic system?

A: Command Economic System—A system in which the government largely determines
the production, distribution, and consumption of goods and services. Communism and
socialism are prime examples of command economic systems.
Q: What is Market economic system?
A: Market (Free-Enterprise) Economic System—A system in which individuals,
businesses, and other distinct entities determine production, distribution, and
consumption in an open (free) market. Capitalism is the prime example of a market
economic system.

Note:
The material in this area of study assumes a free market economic
system
Introduction and Free-Market Model

A. CHARACTERISTICS OF A FREE MARKET ECONOMY:-

1. Individuals and business firms depend on each other. Individuals depend on

business firms for money (income) to use in the purchase of goods and services
provided by the business firms. Business firms depend on individuals for
economic resources to carry out production and for the money (purchase price)
individuals pay for goods and services provided by the firms.

2. Consumers are king in the free economy. What gets produced by business firms
and how those goods and services are distributed depends on the preferences
(needs and wants) of individuals who have the ability (money resources) to pay
for those goods and services.

3. What to produce depends on availability of resources and technology..

4. Business firms will produce goods and services only if the price at which those
goods and services are sold to individuals is equal to or greater than the cost
(price) of the economic resources acquired from individuals.(Profit is the goal)

5. The dollar value of flows provides a means of measuring the level of activity in the
economy. For example, the flows in the model, when supplemented by the
effects of government (taxes, spending, etc.), financial institutions (savings,
investments, etc.), and foreign exchange (imports, exports, etc.) provide a basis
for measuring the gross domestic product (GDP) of the economy. These
aggregate measures are covered in detail in the section on macroeconomics.

6. Profit is the driving force of businessman.

7. Capital intensive techniques are generally used for production.

.
B. FLOW MODEL IN A FREE MARKET ECONOMY:-

In a free-market economy, economic decisions are made by individual decision-making entities,

including individuals and business firms.

The roles and relationships of these decision-making entities (individuals and business firms) are
depicted in the following two-sector model. In the top half of the model (flow lines [1] and [2]):
[1]—Business firms acquire economic resources from individuals, including:

a. Labor—human work, skills, and similar human effort

b. Capital—financial resources (e.g., savings) and man-made resources (e.g.,

equipment, buildings, etc.)

c. Natural resources—land, minerals, timber, water, etc.

d. These resources, called factors of production, are essential to the production of

(other) goods and services, and they are scarce.
n the top half of the model (flow lines [1] and [2]):
[2] Individuals receive compensation from business firms for the use of those individuals’
resources, including:
a. Wages, salaries, and profit sharing for labor

b. Interest, dividends, rental and lease payments for capital

c. Rental, lease, and royalty payments for natural resources

d. Because of the reciprocal relationship (in the top half of the model) between the
economic resources provided by individuals and the compensation received for those
resources, the cost of production (price of economic resources) to business firms is equal
to the money compensation (income) of individuals.

[3] The bottom half of the model (flow lines [3] and [4]):
1. Individuals use the compensation received for their economic resources to pay for goods
and services acquired from business firms.

2. Business firms produce goods and services, which are purchased by individuals.
3. As a consequence of the reciprocal relationship (in the bottom half of the model)
between goods and services produced by business firms and the payment for those
goods and services by individuals, the cost of purchasing (price of goods and services) to
individuals is equal to the money income of business firms.
Demand
Demand is willingness to buy a good/ service at a given price and at a given time.
Effective demand depends upon 3 conditions
1. Desire
2. Means to purchase
3. Willingness to use those means for that purchase (financial ability)
It can be measured and analyzed for an individual, or for a market
Determinants of Demand:-
1. Price:- There is inverse relationship between price and demand. If price rises demand falls and
vice- versa.. Therefore demand curve is downward sloping curve..

Price

Quantity demand

2. Size of market—As the size of the market for a commodity changes, the demand for a
commodity may change. For example, if the population of individuals in a market increases, the
market demand for a commodity (e.g., clothes) may increase, or vice versa.
3. Income or wealth of market participants—As the income or level of wealth of market
participants change, the demand for a commodity may change. An increase in the income of
individuals in the market may increase demand for normal (or preferred) goods (e.g., vegetables)
and decrease the demand for inferior (or less than preferred) goods (e.g., course grains). A
decrease in the income of individuals in the market may increase demand for inferior goods and
decrease the demand for normal goods.
4. Preferences of market participants—As the tastes of individuals in the market change, the
demand for a commodity may change. The change in preference from computer to laptop , will
increase the demand for laptop. A boycott of a good or service would cause an inward shift
(reduction) in demand for that good/service.
5. Change in prices of other goods and services:-A change in the price of other goods and
services may change the demand for a particular commodity. The effect of a change in other
prices depends on whether the other goods/services are substitutable for or complementary to
a particular commodity.
a)Substitute commodities satisfy the same basic purpose for the consumer as another
commodity. The demand for a commodity may increase when the prices of substitute
commodities increase, and vice versa. For example, the demand for Pepsi may increase as the
price of Coke (a substitute for Pepsi) increases.
b)Complementary commodities are those that are used together. Therefore, the demand for a
commodity may increase when the price of a complementary commodity decreases, or vice
versa. For example, the demand for Butter may increase when the price of Bread decreases
because consumers buy more Bread and, thus, more butter.
6.Expectations of price changes:-When individuals expect future changes in the price of a
particular commodity, they may change their current demand for that commodity. For example,
if prices are expected to increase in the near future, current demand may increase in
anticipation of the price increase. Conversely, an anticipated price decrease may cause current
demand to decrease.
7. Organized boycott:-An organized boycott of a particular commodity will likely decrease the
demand for that commodity.

B) Individual demand and Market Demand:-

Individual Demand:-A demand schedule for an individual shows the quantity of a commodity that
will be demanded at various prices during a specified time, ceteris paribus (holding variables
other than price constant). The graphic representation of a demand schedule presents a demand
curve with a negative slope.

Price Demand (Mr.X)

10 5000
20 4000
30 3000
40 2000
50 1000
A market demand schedule shows the quantity of a commodity that will be demanded by all
individuals (and other entities) in the market at various prices during a specified time, ceteris
paribus.It is total of individual demand. A market demand curve, like an individual demand curve,
is negatively sloped.

Price Mr X Mr. Y Market

10 50 40 90
20 40 30 70
30 30 20 50
40 20 10 30
50 10 5 15

Important Distinction:- It is important to distinguish a change in the quantity of a commodity

demanded (Expansion- Contraction) from a change in the demand (Increase-Decrease) for a
commodity.
A. Change in quantity demanded is movement along a given demand curve (for an individual or
for the market) as a result of a change in price of the commodity. Variables other than price are
assumed to remain unchanged.

Price

Demand

B. Change in demand results in a shift of the entire demand curve, which is caused by changes in
variables other than price. As shown in the earlier Market Demand Curves graph, the demand
curve will shift to the left and down when aggregate demand decreases and to the right and up
when aggregate demand increases.
 Price

Demand
V. Derived Demand—The demand for a good or service that results from the demand for
another related good or service. Derived demand for a good or service is driven by changes in
demand for the good or service that require that (input) good or service. For example, the
demand for cement is driven by the demand for buildings that require the use of cement. A. The
demand for most raw materials and intermediate goods is derived demand. It is the use of those
raw materials and intermediate goods in the provision of other goods or services that creates
the demand for them.

Elasticity

I) Elasticity Definition :- It measures how much there will be change in demand due to change in
any factor.Elasticity measures the percentage change in a market factor (e.g., demand) as a
result of a given percentage change in another market factor. Elasticity measures often have
specific practical applications. For example, elasticity is used in estimating the change in demand
(and total revenue) likely to result from a change in price.

Definition

Elasticity: Measures the percentage change in a factor(e.g., demand) seen as a result of a given
percentage change in another factor (e.g., price, income, price of related goods etc.).
II) Elasticity of Demand—Elasticity of demand (ED) measures the percentage change in quantity
of a commodity demanded as a result of a given percentage change in the price of the
commodity.

There are 3 types of Elasticity of demand:

1) Price elasticity of demand

2) Cross elasticity of demand

3) Income elasticity of demand

Formula:-
 ED = % change in quantity demanded / % change in price

Expanded, the formula is:

ED = (Change in quantity demanded/Quantity demanded) / (Change in price/Price)

NOTE:-

Three different values can be used as the denominators in the calculation:

1. The percentage quantity demanded and price—Elasticity is measured at a point on the

demand curve—the original quantity and price.

2. The average of the old and new quantity and price—Elasticity is measured as the average of
the demand curve; called the “midpoint” or “arc” method.

3. The new quantity and price—Elasticity is measured at a point on the demand curve—the new
quantity and price.
NOTE: Whichever values are used, the calculation will result in a negative value (called the
“elasticity coefficient”) because for normal goods/services, the change in quantity demanded will
be the opposite of the change in price. The elasticity coefficient (value), however, is
conventionally referred to as an absolute value (i.e., the negative sign is ignored).

Practical:

1. Using the Percentage Values: Assume that as a result of a change in price from $2 to $2.50,
demand decreased from 1200 units to 900units. Using the old (percentage) quantity and price,
the calculation would be:

% change in quantity: 1,200 − 900 = 300/200 = .25

% change in price: $2.50 − $2.00 = $ .50/2.50 = .2

ED = 25/20.= 1.25

III) Types of Price Elasticity of demand:-

1. Perfectly inelastic demand: Here, there is no change in quantity demand due to change in
price. Ep= 0

Curve: Vertical straight line

Example: Medicines
2. Relatively inelastic demand: Here, there is small change in quantity demand due to change in
price. EP<1

Curve: Downward steeper

Example: Food, Electricity

3. Unitary Elastic demand: Here, % change in quantity demand and price is same. Ep= 1

Curve: downward Rectangular hyperbola

4. Relatively elastic demand: Here, % change in quantity demand is greater than percentage
change in price. Ep>1

Curve: Downward flatter

Example: Luxurious goods like AC, Car

5. Perfectly elastic demand: Here a small change in price brings a huge change in demand. Ep=
Infinite

Curve: Horizontal staright line

Example: Perfect Competition

IV) Total Expenditure method:

Price elasticity of demand shows the relationship between a change in price and the change in
quantity demanded of a good or service. If the relationship shows that a good/service is price
elastic (an elasticity coefficient greater than 1), the percentage change in demand will be greater
than the percentage change in price. If the relationship shows that a good/service is price
inelastic (an elasticity coefficient less than 1), the percentage change in demand will be less than
the percentage change in price. The demand for some goods and services is more sensitive to a
change in price than the demand for other goods and services.

V) Factors affecting Price elasticity of Demand:-

1. Availability of substitutes—The more substitutes there are for a good/service, the more elastic
the demand for that good/service will be. When there are substitutes available, consumers can
switch to an alternative good/service, resulting in a more elastic demand for the good/service for
which there was a price change. When there are virtually no substitutes for a good/service,
demand will be inelastic. There are few substitutes for gasoline; therefore, it is price inelastic.

2. Extent of necessity—The more necessary a good/service, the more inelastic the demand for
that good/service will be. A good/service that is highly necessary will be more insensitive to price
changes than a good/service that is a luxury. Critical healthcare is necessary; therefore, it is
highly price inelastic.

3. Share of disposable income—The larger the share of disposable income devoted to a

good/service, the more elastic the demand for the goods/service will be. When a good/service
consumes a large part of disposable income, consumers tend to be more sensitive to price
changes, making demand more elastic.

4. Postchange time horizon—The longer the time following a price change for a good/service,
the more elastic demand for the good/service tends to be. Over time, consumers are able to gain
more information about substitute goods/services, more alternatives may become available, and
constraints on consumer switching (e. g., contracts, prepayments, etc.) will expire. As a
consequence, consumers may adjust their buying behavior, thus increasing the elasticity for the
good/service for which there was a price change.

5. Importance of Price Elasticity—Price elasticity of demand is important to a firm because it

indicates the extent to which a firm is likely to be able to pass on increases in its cost of inputs to
its customers.
If demand for a good or service is inelastic, then the firm can increase its selling price with less
negative financial impact.

VI) Elasticity of Supply—Elasticity of supply (ES) measures the percentage change in the quantity
of a commodity supplied as a result of a given percentage change in the price of the commodity;
therefore, it is computed as:

ES = % change in quantity supplied / % change in price

This formula expresses the slope of the supply curve when showing the supply
graphically.
A. Expanded, the formula is:

ES = (Change in quantity supplied / Prechange quantity supplied) / (Change in

price / Prechange price)
B. As with the calculation of elasticity of demand, the above calculation can use the
following as the denominator:
 1. New quantity and new price

2. Average of old and new quantity

and price
C. The calculation of elasticity of supply would be done in the same manner as the
calculation of elasticity of demand, and the resulting outcomes could be:

VII) Cross Elasticity of Demand—Measures the percentage change in quantity of a commodity

demanded as a result of a given percentage change in the price of another commodity.

Ec= ∆Dx/Dx * Py/∆Py

Types of Cross Elasticity of demand:

1. Positive---- When 2 goods are substitutes
2. Negative—When 2 goods are Complementary
3. Zero—When 2 goods are unrelated
4. Infinite—When 2 goods are Perfect Substitutes

VIII) Income Elasticity of Demand:-

It measuresthe percentage change in quantity of a commodity demanded as a
result of a given percentage change in income.

The formula for the income elasticity of demand (IED) is:‐

IED = % change in quantity demanded % change in
consumerincome
Types of Income Elasticity of Demand:-
- Supply

Supply is the quantity of a commodity provided at alternative prices during a specified time. Like
demand, supply can be measured and analyzed for an individual producer, for all producers of a
good or service (market supply), or in the aggregate for all providers of all goods and services in
an economy.
This lesson considers supply at the individual producer and market levels; the macroeconomics
subsection includes consideration and review of aggregate (or economy) supply.
Definition
Supply: The quantity of a commodity provided either by an individual producer or by all
producers of a good or service (market supply) at alternative prices during a specified time.

I. Individual Supply and Market Supply:-

A. A supply schedule for an individual producer shows the quantity of goods or services that the
producer is
willing to provide (supply) at alternate prices during a specified time, ceteris paribus.

The graphic representation of a supply schedule presents a supply curve, which normally has a
positive slope.

B. AtAt P2, the higher price, the quantity supplied (Q2) is greater than the quantity supplied (Q1)
at P1, the
lower price. Producers normally are willing to provide higher quantities of goods and services
only at higher prices because higher production costs are normally incurred in increasing
production in the shortrun. The higher production costs (known as the principle of increasing
costs) occurs because theadditional resources used to increase production typically are not as
efficient in producing the
commodity as the resources previously used.
II. Market Supply
A. A market supply schedule shows the quantity of a commodity that will be supplied by all
providers in
the market at various prices during a specified time, ceteris paribus. A market supply curve, like
anindividual supply curve, is positively sloped.

As the market supply curve S1 shows, holding other variables constant, as price increases,
aggregate
supply for a commodity (quantity) increases. However, if certain other non- price variables in the
market
change, aggregate supply will change and a new market supply curve will result (S2 or S0)

Determinants of Supply:-
1. Number of providers—As the number of providers of a commodity increase, the market
supply of
the commodity increases, or vice versa. An increase in market supply will result in a new supply
curve, shown as S2 in the graph above. The new supply curve shows more of the commodity
being provided at a given price. If the number of suppliers of the product decreases, the supply
curve would move (up and left) to S0, showing less of the commodity provided at a given price.

2. Cost of inputs (economic resources) change—As the cost of inputs to the production process
changes (e.g., labour, rent, raw materials, etc.), so also will the supply curve. An increase in input
prices would cause per unit cost to increase and the supply curve would shift up and to the left
(S1 to S0), indicating less output at a given price. A decrease in input prices would reduce per
unit cost and would shift the curve from S1 to S2, with more output at a given price.

3.Price of Related commodities—Changes in the price of other commodities that use the same
inputs as a
given commodity will result in more or less demand for the inputs, will change the cost of inputs
for the given commodity, and, thus, will change the supply of that commodity.

4. Government influences—If government taxes or subsidizes the production of a commodity, it

effectively increases cost (taxes) or decreases cost (subsidizes) of the product. Thus, government
can influence aggregate supply through its taxation and subsidization programs.

5. Technological advances—Improvements in technology for the production of a commodity

reduces the per-unit cost and subsequently shifts the supply curve down and to the right (S1 to
S2),showing more of a commodity provided at a given price.

6. Prices of other productive goods— A change in the prices of other goods and services may
cause producers to shift production to those goods or services if they provide a higher return.

7. Expectation of price changes—When producers expect the selling price of their good or
service to be higher in the future, they may increase supply in anticipation of the selling price
increase.
Conversely, if they expect the selling price to be lower in the future, they may decrease supply in
anticipation of the selling price decrease.

Important Distinction—It is important to distinguish a change in the quantity of a commodity

supplied from a change in supply of a commodity.
A. Change in the quantity supplied is movement along a given supply curve (for an individual
provider or
for the market) as a result of a change in price of the commodity. Variables other than price are
assumed to remain unchanged.

Price

Supply
B. Change in supply results in a shift of the entire supply curve that is caused by changes in
variables other
than price. As shown in the Market Supply Curves graph, the supply curve will shift right and
down when
aggregate supply increases (S1 to S2), and to the left and up when aggregate supply decreases
(S1 to S0).

Price

Supply

Inputs and the Cost of Production

I) Inputs— Inputs are resources needed by the producer to produce other goods and servies. In
the free-market model, it was shown that business firms acquire economic resources in order to
produce (other) goods and services. These inputs to the production process are the major
determinants of a firm's supply curve. Production depends on availability of inputs. There are 4
factors of Production 1. Land 2.Labour 3.Capital 4. Entrepreneur

II. Periods of Analysis

The analysis of cost of production (and other areas of economics) distinguishes between analysis
in the short run and analysis in the long run.

a) Short-run—The time period during which the quantity of at least one input to the production
process cannot be varied; the quantity of at least one input is fixed.

b) Long-run—The time period during which the quantity of all inputs to the production process
can be varied; no inputs are fixed.

III Short-Run Cost Analysis:-

1.Total Cost (TC)—Because some costs cannot be changed in the short run, total production
costs are separated into fixed costs and variable costs. It is summation of fixed cost and variable
cost.

TC= TFC+ TVC

2. Total fixed cost (FC)—Incurred costs that cannot be changed with changes in the level of
output (including no output). They are not a function of output in the short run. Ex: Property
taxes, Rent, Insurance, etc.

3. Total variable cost (VC)—Costs incurred for variable inputs and that will vary directly with
changes in the level of output. It increases with increase in the production. Ex: raw materials,
most labor, electricity, etc
IV) Different Average Cost:-

1. Average fixed cost: It is fixed cost per unit. It is found out by dividing total fixed cost by the
number of units of output produced. It falls as output rises. It is downward sloping curve ,
Convex, rectangular hyperbola curve. It is always positive

2. Average Variable Cost:- It is variable cost per unit of output. It first falls and then rises due to
Law of Variable Proportion in the short run. It is a “U” shaped curve.
AVC= TVC/Q

3. Average Total Cost. It is summation of average fixed cost and average variable cost. It is a “U”
shaped curve.
V) Marginal Cost (MC)—The dollar cost of producing one additional unit of physical output. It is
computed as the difference between successive total costs or, because only variable costs
change, successive total variable costs. In short, it is additional cost of producing one more unit..

VI)marginal product (MP)— The change in physical output that will result from one additional
unit of physical input. Notice that this measures physical output that results from physical input;
it does not measure in terms of dollars. It is computed as the change in total output that results
from using one additional unit of a particular factor of production (input).

VII) Relationship between Average cost and Marginal Cost:-

1. When average cost falls as a result of increase in production, marginal cost is less than
average cost

2. When average cost is minimum, marginal cost is equal to average cost (AC=MC)

3. When average cost rises, marginal cost is more than average cost
VII) Revenue and Output Concepts—Costs, as described above, are incurred in order to provide
goods and services (output). The benefit derived from the sale of those goods and services
(output) is commonly referred to as “revenue.” Revenue concepts parallel those of cost.

A. Revenue—The amount earned as a result of providing goods or services

B. Total Revenue (TR)—The total amount earned as a result of providing goods or

services during a period. In the simplest context, it is the quantity provided (sold)
multiplied by the price per unit sold, TR= P*Q

C. Average Revenue (AR)—The average price (revenue) per unit for the total units
sold. Average revenue is computed by dividing total revenue by the total quantity
of units sold and may be expressed as AR = TR/Q.

D. Marginal Revenue (MR)—The dollar increase in revenue that results from the sale
of one additional physical unit of output. Marginal revenue is computed as the
change in total revenue as a result of selling one additional unit.

E. Marginal Revenue Product (MRP)—The additional dollars revenue that will result
from one additional unit of physical input. Notice that whereas this (MRP)
measures revenue from input, marginal revenue (MR) measures
additional revenue from output. MRP per unit of input measures the average
increase in revenue attributable to each unit of input added. It is computed by
dividing the marginal revenue product by the increase in the number products
(output) resulting from adding one additional unit of input.
IX) Law of Diminishing Returns (Law of Variable Proportion)

➢ In the foregoing graphs, the ATC, AVC and MC curves all have a general “U” shape. That
shape is basic to each curve and occurs because of eventual diminishing returns from
adding more variable inputs. In the short run, as the quantity of variable inputs increases,
output initially increases, causing AC, AVC, and MC to decrease.
➢ However, at some quantity of variable inputs, the addition of more units, in combination
with the fixed input(s), results in decreasing output per unit of variable input. Simply put,
at some point the quantity of variable inputs begins to overwhelm the fixed factor(s)
resulting in inefficiencies and diminishing return on marginal units of variable inputs. As a
consequence of diminishing returns as inputs increase, ATC, AVC, and MC all begin to
increase. Thus, their curves are “U” shaped.

(X)Long-Run Cost Analysis— Returns to (or economies of) scale is a long-run concept. In the long
run, all costs are considered variable, including plant size. Thus, plants of various sizes can be
assumed in the long run, but in the short run, a plant of a particular size will operate. By plotting
the short-run average cost (SAC) curve of plants of various sizes (1–4), the long-run average cost
(LAC) curve can be constructed.

F. As shown, the LAC is determined by the relevant segments of SAC for plants 1, 2,
3, and 4. This curve (LAC) shows the minimum average cost of production with
various size plants. Note that:

1. Up to the quantity at Q1, plant 1 is the most efficient size plant.

2. From the quantity at Q1 to Q2, plant 2 is the appropriate size plant, and
from Q2 to Q3, plant 3 is the appropriate size.

3. Above the quantity at Q3, plant 4 is the appropriate size plant.

G. The long-run average cost curve (LAC) is also “U” shaped, reflecting that as plant
size (scale) increases there are various returns to (or economics of) scale. Three
possible cost outcomes exist:
1. Economies of (or increasing return to) scale—As shown where the LAC
curve is decreasing, quantity of output increases in greater proportion
than the increase in all inputs, primarily due to specialization of labor
and equipment.

2. Neither economy nor diseconomy of (constant return to) scale—As

shown at the bottom of the LAC curve, output increases in the same
proportion as inputs.

3. Diseconomies of (or decreasing return to) scale—As shown where the

LAC curve is increasing, quantity of output increases in lesser proportion
than the increase in all inputs, primarily due to problems of managing
very large-scale operations.
Market Equilibrium

A) Market Equilibrium
When in a market both demand and supply are equal ,then market attains Equilibrium. .
Graphically, the market equilibrium price for a commodity occurs where the market demand
curve and the market supply curve intersect. It is balanced stage. Here the Equilibrium price and
Equilibrium Quantity is determined.
DIAGRAM:

EXPLANATION OF THE DIAGRAM:-

Equilibrium for the commodity occurs at the intersection (E) of the demand and supply
curves. The equilibrium price is EP, and the equilibrium quantity is EQ. For the given
supply and demand curves, at the equilibrium price (EP), the quantity of the commodity
demanded (i.e., that can be sold) is exactly equal to the quantity of the commodity that
will be supplied at that price. There will be no shortage or surplus of the commodity in
the market.
B)Shortages and surpluses in quantity occur when the actual price (AP) of the commodity is less
(shortage) or more (surplus) than the equilibrium price (EP).

DIAGRAM:-

NOTE:- When attained, market equilibrium will continue until there is a change in demand for
and/or supply of the commodity. The shifts in the demand and/or supply curves that result will
change market equilibrium.

C) CHANGE IN EQUILIBRIUM:-

The effect of change(s) in demand and/or supply on market equilibrium depends on whether
demand changes, supply changes, or both change.

1) Change in Market Demand (Only)—An increase in market demand D1 to D2 due to an

increase in the size of the market (or increased income, changes in consumer preferences, etc.)
causes the demand curve to shift up and to the right. If there is no change in market supply, the
results will be an increase in both the equilibrium price (EP1 to EP2) and equilibrium quantity
(EQ1 to EQ2). A decrease in market demand would cause both equilibrium price and equilibrium
quantity to decrease.
2) Change in Market Supply (Only)—An increase in market supply (S1 to S2) due to an increase in
the number of providers in the market (or lower cost of inputs, technological advances, etc.)
causes the supply curve to shift down and to the right. If there is no change in market demand,
the results will be a decrease in equilibrium price (EP1 to EP0) and an increase in equilibrium
quantity (EQ1 to EQ2). A decrease in market supply causes a higher equilibrium price and a lower
equilibrium quantity.
3. Changes in Both Market Demand and Market Supply—The effect of simultaneous changes in
both market demand and market supply depends on the direction of the changes (increase or
decrease) and the relative magnitude of each change.
a. Increases in both market demand and market supply will shift both curves to the right
resulting in a higher equilibrium quantity, but the resulting equilibrium price will depend on the
magnitude of each change. The equilibrium price could remain unchanged, increase, or
decrease.

b. Decreases in both market demand and market supply will shift both curves to the left resulting
in a lower equilibrium quantity, but the resulting equilibrium price will depend on the magnitude
of each change.

c. The effects of a simultaneous increase in one market curve (demand or supply) and a decrease
in the other market curve (supply or demand) on market price and market equilibrium can be
determined only when the specific magnitude of each change is known.
D) Governmental Influences on Equilibrium:-

A. Tax and Subsidies—As noted earlier, government taxation and subsidization have the
effect of either increasing or decreasing the effective cost of production (supply). For
example, a tax on a commodity at the production level increases the cost and shifts the
market supply curve up and to the left. If demand remains constant, equilibrium price
increases and equilibrium quantity decreases. Government subsidies have the opposite
effect.

B. Rules, policies, Regulation—Similarly, the imposition of government regulations on

business tends to increase the cost of production (i.e., compliance costs) and shift the
market supply curve up and to the left when compared with what the market supply
curve would be in the absence of regulatory costs.

C. Rationing—By imposing a rationing system, government can change market demand and
thereby equilibrium in the market. Rationing would be intended to shift the demand
curve down and to the left, thus lowering equilibrium price and equilibrium quantity.

D. Price ceiling/ Price floor—Government also can affect the price of a commodity through
price fiat by establishing an (artificial) price ceiling or price floor. These artificial prices
result in disequilibrium in the market. An imposed market ceiling (less than free-market
equilibrium price) results in market supply being less than market demand at the
imposed price. Market demand and market supply are not in equilibrium. An imposed
market floor (greater than free-market equilibrium price) results in market supply being
more than market demand at the imposed price.
Introduction to Market Structure

A) Definition of Market:-

A market is a place where buyers and sellers meet .It is any facility (e.g., physical location, virtual
system, etc.) that enables sellers (supply) and buyers (demand) to interact for the exchange of
specific goods or services. Within a market, sellers compete with one another for buyers’
demand for a particular good or service. Markets may be categorized based on the extent to
which competition among sellers exists.

Characteristics of Market:-

a) Many buyers and sellers

b) Goods or service

c) One price at a given time

d) Knowledge about market conditions

B) Types of Market Structures

The extent to which competition exists, or does not exist, in an industry or market determines
how prices are established, operating results at various levels of production, and other
performance characteristics. Four assumptions as to market structure are considered in the
following lessons:

1. Perfect competition

2. Perfect monopoly

3. Monopolistic competition

4. Oligopoly

C) Profit Concepts:-

In the study of market structures, two economic concepts of profit are important to understand.
These two concepts—economic profit and normal profit—

.
1. Economic Profit/Loss—An economic concept that measures profit/loss as revenue less
both explicit and implicit expenses.
 ➢ Explicit expenses: Expenses incurred as the result of actual payments (or contractual
obligations) to others; they are the costs incurred in the operation of a firm as normally
recognized for accounting purposes including, for example, salaries/wages, raw material,
rent, etc.
➢ Implicit expenses do not involve actual payments, but are the cost implied in the benefit
lost from using an asset in one way rather than an alternative way, a concept known as
“opportunity cost.” Typical implicit expenses would include the pay that could be
received working for another firm rather than operating your own business or the rent
that could be received by renting a facility you own rather than using it to operate your
own business. Implicit expenses can be difficult to quantify and normally are not
recognized for accounting purposes.

1. Economic profit/loss can be expressed as:

Economic Profit/Loss=Revenue−Explicit expenses−Implicit expenses
2. Normal Profit—An economic term used to describe the unique circumstance when a
firm's revenue is exactly equal to the sum of its explicit and implicit expenses.

➢ It is the special condition of economic profit/loss (described above) for which there is
neither profit nor loss. The firm's revenue is just sufficient to cover explicit and implicit
expenses.
➢ Normal profit can be expressed as:

Normal Profit=Revenue−Explicit expenses−Implicit expenses=0

➢ From a societal perspective, a firm earning a normal profit is using its resources
completely efficiently. The firm's revenue is sufficient to just cover both explicit expenses
and implicit expenses, but it is not earning an amount greater than what is just necessary
to continue to operate; such an amount would be considered “excess profit.”
3. Accounting Profit/Loss—A measure of profit or loss as determined by using generally
accepted accounting principles (GAAP) for the recognition of revenues and expenses. Unlike
the economic concepts of economic profit/loss and normal profit which recognize both
explicit and implicit costs in their determination, GAAP generally only recognizes explicit
revenues and expenses in the determination of accounting profit/loss. Thus, the condition of
accounting profit/loss can be expressed as:
Accounting Profit/Loss=Explicit Revenue−Explicit Expenses=Net Income/Net Loss

Example
Tilochana a senior accountant with the firm of P, L and BE, CPAs, is considering going into private
practice as a sole practitioner. She currently earns $110,000 per year with P, L and BE, a position
she could continue to hold if she does not go into private practice.
Tilochana estimates that she can generate $200,000 in revenue during her first year in private
practice. In addition, she has determined that for the first year, office rental will cost $1,500 per
month, salary and benefits for an assistant $6,000 per month, and other operating expenses
$2,000 per month.

Accounting Profit/Loss = $200,000 − $18,000 Rent − $72,000 Salary − $24,000 Operating

expenses = $200,000 − $114,000 = $86,000 Accounting profit
Economic Profit/Loss = $200,000 − $18,000 Rent − $72,000 Salary − $24,000 Operating expenses
− $110,000 Opportunity of continuing at P, L and BE = $200,000 − $224,000 = $24,000 Economic
loss
Normal profit would occur if (and only if) the total of both explicit and implicit expenses exactly
equals total revenue. In this example, normal profit would exist if the total of explicit and implicit
costs were $200,000, the same amount as revenue.
 Summary of Market structure
Types of Market in an US Economy:-

1. Perfect competition—It does not exist in an USA Economy, it is a myth. the

framework of a perfectly competitive market provides a useful model for
understanding fundamental economic concepts and for evaluating other market
structures.
2. Monopoly—Here there is a single provider of a good or service for which there are
no close substitutes. Monopolistic firms do exist in the U.S. economy. Historically,
public utilities have been permitted to operate as monopolies with the justification
that market demand can be fully satisfied at a lower cost by one firm than by two or
more firms. To limit the economic benefits of such monopolies, governments
generally impose regulations, which affect pricing, output and/or profits.
Monopolies also can exist as a result of exclusive ownership of raw materials or
patent rights. In most cases, however, exclusive ownership monopolies are of short
duration as a result of the development of close substitutes, the expiration of rights,
or government regulation.
3. Monopolistic competition—It is very Common in the U.S. economy, especially in
general retailing where there are many firms selling similar (but not identical)
goods and services. It is realistic market. Because their products are similar,
monopolistic competitive firms engage in extensive non-price competition,
including advertising, promotion, and customer service initiatives, free samples , all
of which are common in the contemporary U.S. economy.

4. Oligopoly—Here number of sellers are few. Such markets exist for a number
of industries in the U.S. The markets for many metals (steel, aluminum, copper, etc.) are
oligopolistic. So also are the markets for such diverse products as
automobiles, cigarettes and oil. Here firms avoid price Competition due to fear
of price war but there exist Non price Competition like Advertiseme, free samples,
etc.
Perfect Competition
A)Characteristics:-

1. A large number of independent buyers and sellers, each of which is too small to separately
affect the price of a commodity.

2. All firms sell homogeneous products or services.

3. Firms can enter or leave the market easily.

4. Resources are completely mobile.

5. Buyers and sellers have perfect information.

6. Government does not set prices.

7. No Transportation cost

8. Firm is price taker and Industry price maker

9. Example: Agriculture Industry

B) Perfect Competition is a Myth. It is unrealistic market ,A market (or industry) meeting all of
these criteria is virtually impossible to identify. Nevertheless, analysis under assumed conditions
of perfect competition is useful in understanding pricing, production, profit, and related
elements.

C) In a perfectly competitive market, a firm is a “price taker” and Industry is a price maker , a
firm can sell any quantity of its commodity at the market price. Therefore, for firms in a
perfectly competitive market, the demand curve is a straight line at the market price.

D)While the demand (and marginal revenue) curve for a firm in perfect competition is a straight
horizontal line at the price set by the market that cannot be affected by the individual firm, the
demand curve for the entire market (market demand) is downward sloping.
a) Market demand will increase/decrease (shift) only if all suppliers lower/raise prices.

E) Short-Run Analysis
A. In the short run a firm can either earn Supernormal Profit, Normal Profit or firm may
incur losses. In the short run, a firm in a perfect competition environment will maximize
profit when total revenue exceeds total costs by the greatest amount, or where its
marginal revenue is equal to (rising) marginal cost. Said another way, it maximizes profit
 when the amount received (revenue) from the last unit sold equals the incremental
(marginal) cost of producing that unit. Since, in perfect competition, each unit will be sold
at the market price, marginal revenue is (the same as) market price. The relevant graph
for an individual firm in a competitive market would show:

➢ For the individual firm, price (P1) is set by the market; the firm must take the market
price. Short-run profit would be maximized where MC intersects MR (also P1 and D),
labeled PMAX at Q1 in the graph. Each unit of output up to that quantity would add more
to the total revenue than to the total cost; therefore total profit would increase. Units
after that quantity (Q1) would cost more to produce than the price at which the
additional units could be sold; therefore, the amount of profit would decline with each
additional unit greater than Q1.
➢ In the above graph, total revenue would be P1 × Q1 and total cost would be P2 × Q1,
which is less than P1 × Q1. Total profit would be (P1 − P2) × Q1, or on a per-unit basis
PMAX − C. If, however, market demand (which is also marginal revenue and price) shifts
downward, with the same cost structure, the results would be different, depending on
the relationship between MR and ATC.

1. MR = ATC—At this level, the firm would break even (at P2 in the graph above).

2. MR less than ATC but greater than AVC—At this level, the firm would cover
variable cost but not total cost. The excess of sales price (also D) over AVC would
contribute to paying fixed cost (in the short run).

3. MR less than AVC—At this level, the firm would shut down because each unit it
produces fails to cover the direct cost of producing the unit.
F) Long-Run Analysis
A. In the long run firm can only earn Normal profit as entry for other firms is very
easy..When firms in a perfectly competitive market are making economic profit in the
short run (as in the graph above), in the long run more firms will enter the market. As
more firms enter the market, supply (output) increases and the market price will fall until
all firms just break even. Conversely, when firms in a perfectly competitive market are
suffering losses in the short run, some of the firms will exit the market, causing the
market price to increase until all firms just break even. Therefore, in a perfectly
competitive market, in the long run firms can earn only normal profits; there are no
(economic) excess profits.

B. Because demand, price, and marginal revenue are the same, long-run equilibrium occurs
where marginal revenue, marginal cost, and the lowest long-run average cost intersect.

G) Firm Strategy
a) In a perfectly competitive market, there is no product differentiation; all firms sell an identical
product or service. Therefore, firms must focus on innovation in production, distribution, and
sales processes rather than on the good or service sold.

b) Lowest cost producer will get success in the market..

Monopolistic Competition

Characteristics:-
1. There are many sellers in this market
2. Each seller sells differentiated product
3. Firms can easily enter and leave the Industry
4. There exist Non- Price Competition in this market
5. Consumer gets variety of products in this Industry
6. Sales Expenses are very high in this market
7. Many types of brand exist

8.This market environment has elements of both perfect competition and perfect
monopoly.

Short-Run Analysis

A) A monopolistic competitive environment has a downward sloping demand curve that is

highly elastic. It is downward sloping because of product differentiation and highly elastic
because there are close substitutes for the good or service. Again, optimum profit (and
output) occur where MR = MC (provided P > AVC). The following graph is representative:

MR = MC at Q1 with a price of P1. Whether the firm makes a profit, breaks even, or has a
loss depends on its average cost curve (AC) at Q1. The following short-run results are
possible:

1. Profit: If AC < P1
2. Break even: If AC = P1
3. Loss: If AC > P1
Long-Run Analysis:-

A. If firms in a monopolistic competitive environment experience short-run profits, in

the long run, more firms will enter the industry. More firms in the industry result in
a lower demand curve for each firm. Equilibrium will result where the demand
curve becomes tangential to the average cost curve and each firm just breaks even.
Conversely, if firms are experiencing losses in the long run, firms will leave the
industry and the demand curve will shift up so that remaining firms just break even.
(Normal Profit)
B. A firm in a monopolistic competitive environment incorrectly allocates economic
resources in the long run (when compared with firms in perfect competition)
because the price at which it sells is greater than the marginal cost of production.
Further, such firms operate with smaller-scale plants than the optimum and,
consequently, more firms than would exist in perfect competition.

Firm Strategy:-

A. Firms attempt to differentiate their product or service by focusing on product

development and innovation.
B. To differentiate existing products/services and to develop successful new products,
firms will engage in extensive market research.
C. In addition, these firms engage in extensive advertising and development of
customer relations.
D. When competing online, these firms will be concerned with providing a convenient
online shopping experience, providing complete and accurate product descriptions,
and offering a competitive return policy.
 Oligopoly
Characteristics:-
1. There are few Sellers (3-20)
2. Firms either sell homogeneous product (Pure oligopoly) or differentiated product
(Differentiated Oligopoly)
3. Substantial barriers to entry (Entry is difficult)
4. Non Price Competition (Advertisement, Discounts, Free samples)
5. Price leadership
6. Price war
7. Indeterminate demand curve
8. Kinked demand curve
9. Price Rigidity
Types of Collusion:-
➢ Overt collusion, in which firms (a cartel) conspire to set output, price, or profit, is
illegal in the United States. The Organization of Petroleum Exporting Countries
(OPEC) is an example of a cartel.
➢ Tacit collusion occurs when the firms tend to follow price changes initiated by the
price leader in the market. Tacit collusion (firms do not conspire in setting output,
price, or profits) is not illegal in the United States.
Kinked Demand Curve under Oligopoly:-
 Explanation of Kinked Demand Curve:-

➢ Because there are few firms in an oligopolistic market, the actions of each firm
are known by, and affect, other firms in the market. Therefore, if one firm lowers
its price to increase its share of the market (demand), other firms in the market
are likely to reduce their prices as well. In the extreme, a “price war” will result.
Consequently, oligopolistic firms tend to compete on factors other than price
(e.g., quality, service, distinctions, etc.).

➢ The kinked demand curve results from the fact that there are few firms, each of
which knows and responds to the actions of other firms. If you assume from that
characteristic that rival firms will lower prices if you lower your price but will
not raise prices if you raise your price, the demand curve will kink at the
established current price. That reflects that prices will be more elastic above the
kink (if a firm raises its price, it loses a disproportionate number of customers)
and more inelastic below the kink (if a firm lowers its price, others will too, so it
won't gain a disproportionate number of customers).

➢ With the kinked demand curve, the MR curve will have a vertical portion at the
quantity of the kink.

➢ If MC changes along the vertical portion of the MR curve, neither quantity nor
price would change. The quantity will be at the level where MR = MC, and,
because MR is vertical, there is no change in quantity (Q1 in the graph). The
price will not change either; it will still be at the level of the kink in the demand
curve (P1 in the graph).

Short run and Long run analysis:-

In the short run, the oligopolistic firm will produce where MC = MR and may make a profit,
break even, or have a loss, depending on the relationship between price and average cost
for the quantity produced. In the long run, however, firms incurring losses (because
average cost exceeds market price) will cease to operate in the industry. Further, firms
operating at a profit (because average cost is less than market price) can continue to make
profits in the long run because new firms are restricted from entering the market.

As with monopolies and monopolistically competitive firms, oligopolistic firms produce at

the quantity of output where MR = MC and, therefore, where P > MC. Consequently, the
oligopolistic firm under allocates resources to production and produces less, but charges
more than would occur in a perfectly competitive market.

Firm Strategy:-

1. Because firms operating in an oligopoly market are interdependent, they must focus
considerable strategic attention on the actions and anticipated actions of competitors,
especially with respect to the setting of price.

2. In order to avoid price wars, firms tend to compete on factors other than price, including
the quality of their good/service, customer relations, loyalty programs, and the like.

3. When faced with the prospect of new entrants into the industry, firms may take strategic
action to discourage such entry, including developing excess capacity to provide its
good/service, enhancing relationships with distributors, and engaging in extensive
advertising of its good/service to make it more difficult for new entrants to penetrate the
market.
 Summary of Market structure
Types of Market in an US Economy:-

4. Perfect competition—It does not exist in an USA Economy, it is a myth. the

framework of a perfectly competitive market provides a useful model for
understanding fundamental economic concepts and for evaluating other market
structures.
5. Monopoly—Here there is a single provider of a good or service for which there are
no close substitutes. Monopolistic firms do exist in the U.S. economy. Historically,
public utilities have been permitted to operate as monopolies with the justification
that market demand can be fully satisfied at a lower cost by one firm than by two or
more firms. To limit the economic benefits of such monopolies, governments
generally impose regulations, which affect pricing, output and/or profits.
Monopolies also can exist as a result of exclusive ownership of raw materials or
patent rights. In most cases, however, exclusive ownership monopolies are of short
duration as a result of the development of close substitutes, the expiration of rights,
or government regulation.
6. Monopolistic competition—It is very Common in the U.S. economy, especially in
general retailing where there are many firms selling similar (but not identical)
goods and services. It is realistic market. Because their products are similar,
monopolistic competitive firms engage in extensive non-price competition,
including advertising, promotion, and customer service initiatives, free samples , all
of which are common in the contemporary U.S. economy.

4. Oligopoly—Here number of sellers are few. Such markets exist for a number
of industries in the U.S. The markets for many metals (steel, aluminum, copper, etc.) are
oligopolistic. So also are the markets for such diverse products as
automobiles, cigarettes and oil. Here firms avoid price Competition due to fear
of price war but there exist Non price Competition like Advertiseme, free samples,
etc.
 MCQS

Introduction to Economic Concepts

1.The equation for the graphic plot of a linear economic variable is D = b + m(a), where m > 0.
Which of the following is the slope of the economic "curve" represented by this equation?

a) Positive
b) Negative
c) Neutral
d) Inverse
2. Measures of the economic activity of an entire nation would be included in the study of
a) Micro Economics
b) Macro Economics
c) International Economics
d) Political Economics

3. Graphs are a means of depicting the relationship between two variables. These variables are
usually identified as
a) Horizontal and vertical
b) Positive and Negative
c) Dependent and Independent
d) Dependent and Independent

4. What are branches of Economics?

a) Macro Economics
b) Micro Economics
c) International Economics
d) All of the above

5. It is study of individual units

a) International Economics
b) Micro Economics
c) Micro Economics
d) None of the above

6. What is Ceterus Paribus in Economics?

a) All is good
b) Other factors being constant
c) Nothing is important
d) Decision making is important

7. The relationship between variable can be

a) Positive
b) Negative
c) Neutral
d) All of the above

8. When the independent variable is time, the vertical axis shows the behaviour of the
dependent variable over time and is called a _____________
a) Time series graph
b) Demand graph
c) Supply Graph
d)None of the above

9. A system in which the government largely determines the production, distribution, and
consumption of goods and services is known as _______________
a) Controlled Economy
b) Market Economy
c) Political Economy
d) None
10. A system in which individuals, businesses, and other distinct entities determine production,
distribution, and consumption in an open (free) market is _____________

a) Controlled Economy

b) Socialist Economy

c) Capitalist Economy

d) None

-Introduction and Free Market Model

1. ___________ is king in free market Economy

a) Producer
b) Consumer
c) Government
d) None of the above

2. ____________ is the motive of producers in Free Economy

a) Profit
b) Consumer welfare
c) Growth of business
d) None

3. Business firms depends on individual for_____

a) Capital
b) Labour
c) Both a and b
d) None of the above

4. Individuals receive __________ from business firms

a) Wages
b) Interest
c) Both a and b
d) None of the above

DEMAND

1. Demand is willingness to buy a good/ service at a given price and at a given

______
a) place
b) Consumer
c) time
d) None of the above

2. There is_____________relationship between price and demand

a) Positive
b) neutral
c) Negative
d) None of the above

3. Inferior goods and demand have _____________ relationship

a) Positive
b) Negative
c) Neutral
d) None

4. When 2 goods are substitutes their relationship is _____________

a) Positive
b) negative
c) neutral
d) None

5. When 2 goods are complementary their relationship is __________

a) Positive
b) Negative
c) Neutral
d) None

6. A market demand schedule shows the quantity of a commodity that will be

demanded by all _______________
a) Market
b) Individuals
c) groups
d) None

7. The demand for a good or service that results from the demand for another
related good or service is known as ________________
a) Derived demand
b) Individual demand
c) Market demand
d) None of the above

8. Expansion and Contraction of demand is due to change in _________

a) Income
b) Price of related goods
c) Price
d) None of the above

9. In Increase/ Decrease of demand, the curve ___________

a) Moves along the same curve
b) Shifts to the right/left
c) Both
d) None of the above

Supply
1. Supply and price have ___________ relationship
a) positive
b) Negative
c) Neutral
d) None

2. If technology changes supply ________

a) Decreases
b) Increases
c) None
d) Both a and b

3. When in future price increases supply ________

a) decreases
b) increases
c) Both
d) None

4. In Expansion of supply, supply curve moves towards __________

a) left
b) right
c) downwards
d) None
5. When supply increases entire supply curve shifts to the ____________
a) right
b) left
c) downwards
d) None

6. Supply is different from stock. This statement is _____

a) False
b) true
c) partially true
d) None
Market Equilibrium

1. When demand equals supply, the market attains ___________

a) Stability
b) Equilibrium
c) Growth
d) None

2. When demand increases and supply is constant, the equilibrium price _______
a) falls
b) rises
c) constant
d) None
3. When supply increases and demand constant, the equilibrium price __________
a) falls
b) rises
c) constant
d) None

4. When demand and supply both increases in the same proportion the
equilibrium price is ________
a) falls
b) rises
c) constant
d) None

5. When demand rises, supply constant, the equilibrium quantity ________

a) rises
b) falls
c) constant
d) None

Consumer demand and Utility theory

1. _______ is want satisfying power of a commodity
a) Satisfaction
b) Demand
c) satisfaction
d) None

2. _________ is additional utility by consuming one extra unit

a) Average utility
b) Marginal utility
c) Consumers utility
d) None

3. Total utlity increases at ________ rate

a) increasing rate
b) diminishing rate
c) normal rate
d) None

4. As, per law of diminishing marginal utility marginal utility always _________
a) rises
b) falls
c) zero
d) negative

5. Indifference curve is ___________ to the origin

a) concave
b) convex
c) positive
d) None

6. Higher level of Indifference curve shows _________ level of satisfaction

a) lower
b) higher
c) medium
d) None

7. Indifference curves __________ touch axis

a) cannot
b) always
c) sometimes
d) None

8. A curve showing combinations of two goods which represents _________ level

of satisfaction is known as Indifference curve
a) same
b) different
c) Both a and b
d) None
Inputs and the Cost of Production

1. There are __________ factors of production

a) 2
b) 4
c) 6
d) 8

2. Average variable cost is a ______ shaped curve

a) “U”
b) “V”
c) oval
d) None

3. Average fixed cost _______ as output rises

a) rises
b) falls
c) remains zero
d) None

4. AFC=
a) TVC/Q
b) TFC/Q
c) TC/Q
d) None

5. AVC=
a) TVC/Q
b) TFC/Q
c) TC/Q
d) None

6. In short run atleast one input remains _______

a) variable
b) fixed
c) both a and b
d) cant say

7. In the long run all factors becomes _________

a) fixed
b) variable
c) cant say
d) Both a and b

8. Law of returns to scale is applicable in ___________

a) Short run
b) Long run
c) Both
d) cant say

9. Long run average cost curve is a ______________ shaped curve

a) “U”
b) “V”
c) Oval
d) rectangular hyperbola

10.Production is an _________ activity

a) Economic
b) Non Economic
c) Neutral
d) None

Introduction to Market Structure

1. Economic Profit is __________

a) TR- Accounting cost
b) TR- Economic cost
c) TR- Variable cost
d) None

2. _____________ is cost of self employed resources

a) Implicit cost
b) Variable cost
c) Fixed cost
d) None

3. _________ is a place where buyers and sellers meet to exchange goods and
services
a) E- Commerce
b) Market
c) Competition
d) None

4. ____________ is actual cost recorded in books of accounts

a) Economic Cost
b) Accounting cost
c) Variable cost
d) None

Perfect Competition
1. In perfect competition sellers are in ___________ numbers
a) small
b) large
c) few
d) None

2. In perfect competition in the long run firm earns _____ profit

a) Normal
b) Supernormal
c) Average
d) None

3. Products are ____________ in Perfect Competition

a) Heterogeneous
b) homogeneous
c) unique
d) None

4. In the short run firm earns ________ profit

a) Supernormal
b) Normal
c) Losses
d) Any of the above

5. Entry and exit is __________ in Perfect Competition

a) restricted
b) free
c) difficult
d) cant say
 Macro-economics
Introduction to Macroeconomics
Macroeconomics is a branch of economics that studies how an overall economy—the market
systems that operate on a large scale—behaves. Macroeconomics studies economy-wide
phenomena such as inflation, price levels, rate of economic growth, national income, gross
domestic product (GDP), changes in unemployment etc.

Economic Flow Model

The circular flow model in four sector economy provides a realistic picture of the circular flow in
an economy. Four sector model studies the circular flow in an open economy which comprises of
the household sector, business sector, government sector, and foreign sector.
The foreign sector has an important role in the economy. When the domestic business firms
export goods and services to the foreign markets, injections are made into the circular flow
model. On the other hand, when the domestic households, firms or the government imports
something from the foreign sector, leakage occurs in the circular flow model.

The circular flow of income in four sector economy can be explained by the flowing diagram:

From the viewpoint of the circular flow of income, each sector has dual roles to play in the
economy; while a sector receives certain payments from other sectors, it pays back to those
sectors as well. The circular flow of income in different sectors can be expressed as follows:

Household Sector

Receipts

The household sector receives factor income in the form of rent, wages, interest, and profit from
the business sector. It also receives transfer payments from the government sector.

Payments

The income of the household sector flows into the business sector, government sector and
capital markets in the form of consumption expenditure, taxes and savings respectively.

Government Sector

Receipts

The major source of income for the government sector include the taxes paid by household and
business sector. Besides this, it also receives interests and dividends for the investments made.
Payments

The government sectors make payments to different sectors in the form of transfer payments,
subsidies, grants, etc. It pays to the business sector in return for the goods purchased, makes
transfer payments like pension funds, scholarships, etc. to the household sector. If the
government receipts are greater than the expenses, the surplus goes to capital market. In case
of cash deficit, the government borrows from the capital market to maintain a balance in the
economy.

Business Sector

Receipts

The principle receipts of the business sector constitute of income from the sale of goods and
services, income from exports, subsidies from the government sector, and borrowings from the
capital market.
Payments

Factor payments, import payments, and savings constitute the principal payments from the
business sector to the household sector, government sector, foreign sector and the capital
market.

Foreign Sector

Receipts

The foreign sector receives income from the business sector in return for the goods and services
imported by the latter.

Payments

Foreign sectors need to make payment to the business sector from where imports have been
made.

If exports exceed imports, the economy has a surplus balance of payment. In case exports
exceed imports, the economy faces a deficit balance of payment. Depending on the trade
policies, the economy tries to maintain a balance between imports and exports.

Leakages: The amounts of individual income that are not spent on domestic consumption
arecalled “leakages.” As shown in the model, these leakages consist of taxes, savings, and,
indirectly,imports.
Injections: The amounts of expenditures not for domestic consumption added to the
domesticproduction are called “injections.” As shown in the model, these injections consist of
governmentspending/subsidies, investment expenditures and exports.

Aggregate Demand

Aggregate demand (AD) is the total demand by domestic and foreign households and firms for
an economy’s scarce resources, less the demand by domestic households and firms for
resources from abroad.
The AD curve shows the relationship between AD and the price level. It is assumed that the AD
curve will slope down from left to right. This is because all the components of AD, except
imports, are inversely related to the price level.
For convenience, the AD curve is normally drawn as a straight line, though it can be argued that
it is more likely to be non-linear, many suggesting it has a rectangular hyperbola shape.

It is also claimed that the downward slope of the AD curve reflects ‘normal’ macro-economic
conditions, and that in a deep recession, the AD curve could become vertical.

The equation for aggregate demand adds the amount of consumer spending, private investment,
government spending, and the net of exports and imports. The formula is shown as follows: AD =
C + I + G + (X – M)

Where:

• C = Consumer spending on goods and services

• I = Private investment and corporate spending on non-final capital goods (factories,
equipment, etc.)
• G = Government spending on public goods and social services (infrastructure, Medicare,
etc.)
• X-M = Net exports (exports minus imports)

That is now explained in detail as under:

Consumer Spending—Spending on consumable goods accounts for most of the aggregate
demand in the United States. Personal income and the level of taxes on personal income are the
most important determinants of consumption spending. Personal income less related income
taxes determine individual income available for spending, called “personal disposable income.”
The relationship between consumption spending (CS) and disposable income (DI) is the
consumption function. Graphically, the consumption function can be plotted as a positively
sloped curve.

At the intersection of the CS = DI and CF (Consumption Function) curves on the graph,

consumers are spending all of their disposable income. At other points on the CF curve, spending
is either more or less than disposable income.

Where the CF curve is greater than the CS = DI curve (below DI1), consumer spending exceeds
disposable income. This excess spending over disposable income can occur as a result of
consumers spending accumulated savings or borrowing for current consumption spending.

Where the CF curve is less than the CS = DI curve (above DI1), consumers are not spending all
available disposable income. The excess of disposable income over consumption spending is
ameasure of consumer savings.

Marginal Propensity to Consume

The Marginal Propensity to Consume (MPC) measures the increase in household consumption
from an increase in household income.

To calculate MPC:
MPC = (Change in Consumption)/(Change in Disposable Income)
Average Propensity to Consume (APC)
Average Propensity to Consume measures the proportion of income spent on consumption.

APC = Total Consumption/Total Disposable Income

Marginal Propensity to Save

Marginal Propensity to Save (MPS) measures the increase in savings from a given increase in
household income.

MPS = (Change in Savings)/(Change in Disposable Income)

OR
MPS = 1 - MPC

Average Propensity to Save (APS)

Average Propensity to Save (APS) measures the total proportion of income that is saved.

APS = Total Savings/ Total Income

Investment
In the macroeconomic context, investment includes spending on:
a) Residential construction;
b) Non-residential construction;
c) Business durable equipment; and
d) Business inventory.
The level of spending on these investment goods is influenced by a number of factors, including:
a) Real interest rate (nominal rate less rate of inflation)
b) Demographics (i.e., make-up of the population)
c) Consumer confidence
d) Consumer income and wealth
e) Government actions (tax rates, tax incentives, governmental spending, etc.)
f) Current vacancy rates
g) Level of capacity utilization
h) Technological advances
i) Current and expected sales levels
Over time, the most significant of these factors is the interest rate. Higher interest rates
areassociatedwith lower levels of investment spending, and lower interest rates are associated
with higher levels ofinvestment spending. The graphic representation (an investment demand
[ID] curve) shows the negativerelationship.

Government spending
Government spending or expenditure includes all government consumption, investment, and
transfer payments.[1][2] In national income accounting the acquisition by governments of goods
and services for current use, to directly satisfy the individual or collective needs of the
community, is classed as government final consumption expenditure. Government acquisition of
goods and services intended to create future benefits, such as infrastructure investment or
research spending, is classed as government investment (government gross capital formation).
These two types of government spending, on final consumption and on gross capital formation,
together constitute one of the major components of gross domestic product.
Government spending can be financed by government borrowing, or taxes. Changes in
government spending is a major component of fiscal policy used to stabilize the
macroeconomic business cycle.

Net Exports
Net exports are measured by comparing the value of the goods imported over a specific time
period to the value of similar goods exported during thatperiod. The formula for net exportsis:

Net Exports = Value of Exports - Value of Imports

When net exports are positive (exports greater than imports), aggregate demand is increased
and When net exports are negative (exports less than imports), aggregate demand is
decreased.A number of factors enter into determining a country's level of imports and exports
with othercountries, including:
a. Relative levels of income and wealth—The higher the income and wealth, the greater
thespending, including on imports.
 b. Relative value of currencies—A weaker currency stimulates exports and makes imports
moreexpensive (and vice versa).
c. Relative price levels—The higher the price level, the more costly are goods/services
forforeignbuyers.
d. Import and export restrictions and tariffs—The greater the restrictions and tariffs, the
lower thelevel of imports and/or exports.
e. Relative inflationary rates—The higher the inflation rate, the higher the cost of inputs,
causingoutputs to be more costly and less competitive in the world market.

Aggregate Demand Curve Shift

Aggregate demand typically changesas a result of the following kinds of
occurrences (among others):
1. Personal taxes (e.g., income taxes)
2. Corporate taxes
3. Government spending
4. Exchange rates
5. Consumer confidence
6. Interest rates
7. Technological advances
8. Wealth change etc.

Investment Multiplier

The term investment multiplier refers to the concept that any increase in public or
private investment spending has a more than proportionate positive impact on aggregate
income and the general economy. It is rooted in the economic theories of John Maynard
Keynes.

The multiplier attempted to quantify the additional effects of investment

spending beyond those immediately measurable. The larger an investment’s multiplier,
the more efficient it is in creating and distributing wealth throughout the economy.

The investment multiplier tries to determine the economic impact of public or private
investment. For instance, extra government spending on roads can increase the income
of construction works, as well as the income of materials suppliers. These people may
spend the extra income in the retail, consumer goods, or service industries, boosting the
income of the workers in those sectors.
The formula for calculating the investment multiplier of a project is simply:

1 / (1 - MPC)1/(1−MPC)

AggregateSupply

Aggregate supply, also known as total output, is the total supply of goods and services produced
within an economy at a given overall price in a given period. It is represented by the aggregate
supply curve, which describes the relationship between price levels and the quantity of output
that firms are willing to provide. Typically, there is a positive relationship between aggregate
supply and the price level.
There are 3 theories on aggregate supply, given as under:

Classical Aggregate Supply Curve

This curve is completely vertical, reflecting no relationship between aggregate supply and price
level.This form of supply curve is sometimes associated with the nature of supply in the very
short termwhen factors of production cannot be changed and in the long term when all inputs to
the
production process are fully utilized (including having full employment).

Keynesian Aggregate Supply Curve

This curve is horizontal up to the (assumed) level of output at full employment, and then slopes
upward, reflecting that output is not associated with price level until full employment is reached,
at which point increased output is associated with higher price levels.

Conventional Aggregate Supply Curve

 This curve has a continuously positive slope with a steeper slope beginning at the (assumed)
level of output at full employment, reflecting that at full employment increased output is
associated with proportionately higher increases in price levels.

Factors Affecting Aggregate supply

• Productivity - the level of labour, capital and Multifactor productivity (see the productivity
section for more information). Higher level of productivity means goods and services are being
produced more efficiently, decreasing unit costs of production, increasing aggregate supply

• Labour Wage Costs - higher wage costs mean that an economy produces less goods and
services due to higher costs of production. In Australia, our labour costs are pretty high with a
minimum wage of $17.70 per hour (around $13 USD)
• Taxes and other costs - costs such as regulation and taxation costs can place a burden on the
unit costs of production, lowering the aggregate supply of an economy

• Material Prices - higher material prices and other inputs will increase the unit labour costs of
production and lower aggregate supply. Material prices can also be imported which is affected
by changes in the exchange rate.

• Level of Technology - The potential output of an economy can be increased through the
adaption of new technology, ideas and managerial processes, which can increase the efficiency
of resources, thus increasing long run aggregate supply
 Aggregate (Economy) Equilibrium

In economics, equilibrium is a state where economic forces (supply and demand) are balanced.
Without any external influences, price and quantity will remain at the equilibrium value.
Equilibrium real output (real gross domestic product) would be Q1 and the price level P1. The
effect of a shift in the aggregate demand and/or aggregate supply curve(s) on equilibrium output
and the price level would depend on:
1. Which of the three theoretical supply curves is assumed; and
2. The degree of shift in the curve(s) relative to pre-change equilibrium.

Classical Supply Curve

If the classical supply curve is assumed, an increase in aggregate demand alone results only in
higher price levels. An increase in aggregate supply alone results in more output at alowerprice.

Keynesian Supply Curve

If the Keynesian Supply Curve is assumed, an increase in aggregate demandalone results only
inmore output until output at full employment, at which point output and price leveleach
increase. An increase in supply alone will not affect the price level unless aggregate demand
intersectssupply where it is positively sloped.
Conventional Supply Curve—If the conventional supply curve is assumed, an increase in
aggregate demandalone will increase both the output and the price level. An increase in supply
alone will increase output, butreduce the price level.

National Income & Related concepts

Gross Domestic Product (GDP MP)

Gross domestic product (GDP) is a measure of the market value of all final economic goods and
services, gross of depreciation, produced within the domestic territory of a country during a
given time period. It is the sum total of ‘value added’ by all producing units in the domestic
territory and includes value added by current production by foreign residents or foreign-owned
firms. The term ‘gross’ implies that GDP is measured ‘gross’ of depreciation. ‘Domestic’ means
domestic territory or resident production units. However, GDP excludes transfer payments,
financial transactions and non- reported output generated through illegal transactions such as
narcotics and gambling (these are also known as ‘bads’ as opposed to goods which GDP accounts
for).
While learning about national income, there are a few important points which one needs to bear
in mind:
(i) The value of only final goods and services or only the value added by the production
process would be included in GDP. By ‘value added’ we mean the difference between value of
output and purchase of intermediate goods. Value added represents the contribution of labour
and capital to the production process.
(ii) Intermediate consumption consists of the value of the goods and services consumed as
inputs by a process of production, excluding fixed assets whose consumption is recorded as
consumption of fixed capital. Intermediate goods used to produce other goods rather than being
sold to final purchasers are not counted as it would involve double counting. The intermediate
goods or services may be either transformed or used up by the production process. For example,
the value of flour used in making bread would not be counted as it will be included while bread is
counted. This is because flour is an intermediate good in bread making process. Similarly, if we
include the value of an automobile in GDP, we should not be including the value of the tyres
separately.
(iii) Gross Domestic Product (GDP) is a measure of production activity. GDP covers all
production activities recognized by SNA called the ‘production boundary’. The production
boundary covers production of almost all goods and services classified in the National Industrial
Classification (NIC). Production of agriculture, forestry and fishing which are used for own
consumption of producers is also included in the production boundary. Thus, Gross Domestic
Product (GDP) of any nation represents the sum total of gross value added (GVA) (i.e, without
discounting for capital consumption or depreciation) in all the sectors of that economy during
the said year.
(iv) Economic activities, as distinguished from non-economic activities, include all human
activities which create goods and services that are exchanged in a market and valued at market
price. Non-economic activities are those which produce goods and services, but since these are
not exchanged in a market transaction, they do not command any market value; for e.g. hobbies,
housekeeping and child rearing services of home makers and services of family members that
are done out of love and affection.
(v) National income is a ‘flow’ measure of output per time period—for example, per year—
and includes only those goods and services produced in the current period i.e. produced during
the time interval under consideration. The value of market transactions such as exchange of
goods which already exist or are previously produced, do not enter into the calculation of
national income. Therefore, the value of assets such as stocks and bonds which are exchanged
during the pertinent period are not included in national income as these do not directly involve
current production of goods and services. However, the value of services that accompany the
sale and purchase (e.g. fees paid to real estate agents and lawyers) represent current production
and, therefore, is included in national income.
(vi) An important point to remember is that two types of goods used in the production
process are counted in GDP namely, capital goods (business plant and equipment purchases) and
inventory investment—the net change in inventories of final goods awaiting sale or of materials
used in the production which may be positive or negative. Additions to inventory stocks of final
goods and materials belong to GDP because they are currently produced output.

Gross National Product (GNP)

Gross National Product (GNP) is a measure of the market value of all final economic goods and
services, gross of depreciation, produced within the domestic territory of a country by normal
residents during an accounting year including net factor incomes from abroad. Gross National
Product (GNP) is evaluated at market prices and therefore it is in fact Gross National Product at
market prices (GNP MP).
GNP MP = GDP MP + Net Factor Income from Abroad

NFIA is the difference between the aggregate amount that a country's citizens and companies
earn abroad, and the aggregate amount that foreign citizens and overseas companies earn in
that country.

Net Domestic Product at market prices (NDP MP)

Net domestic product at market prices (NDP MP) is a measure of the market value of all final
economic goods and services, produced within the domestic territory of a country by its normal
residents and non-residents during an accounting year less depreciation. The portion of the
capital stock used up in the process of production or depreciation must be subtracted from final
sales because depreciation represents capital consumption and therefore a cost of production.

NDP MP = GDP MP – Depreciation

NDP MP = NNP MP – Net Factor Income from Abroad

Net National Product at Market Prices (NNP MP)

Net National Product at Market Prices (NNP MP) is a measure of the market value of all final
economic goods and services, produced by normal residents within the domestic territory of a
country including Net Factor Income from Abroad during an accounting year excluding
depreciation.

NNP MP = GNP MP – Depreciation

NNP MP = NDP MP + Net Factor Income from Abroad

NNP MP = GDP MP + Net Factor Income from Abroad – Depreciation

Gross Domestic Product at Factor Cost (GDPFC)

The production and income approach (which we will discuss later in this unit) measure the
domestic product as the cost paid to the factors of production. Therefore, it is known as
‘domestic product at factor cost’. GDP at factor cost is called so because it represents the total
cost of factors viz. labor, capital and entrepreneurship. At this stage, we need to clearly
understand the difference between the concepts: ‘market price’ and ‘factor cost.’
Market Price = Factor Cost + Net IndirectTaxes

= Factor Cost + Indirect Taxes – Subsidies

Net Domestic Product at Factor Cost (NDPFC)

Net Domestic Product at Factor Cost (NDPFC) is defined as the total factor incomes earned by
the factors of production. In other words, it is sum of domestic factor incomes or domestic
income net of depreciation.
As mentioned above, market price includes indirect taxes imposed by government. We have to
deduct indirect taxes and add the subsidies in order to calculate that part of domestic product
which actually accrues to the factors of production. The measure that we obtain so is called Net
Domestic Product at factor cost.

Net National Product at Factor Cost (NNPFC) or National Income

National Income is defined as the factor income accruing to the normal residents of the country
during a year. It is the sum of domestic factor income and net factor income from abroad. In
other words, national income is the value of factor income generated within the country plus
factor income from abroad in an accounting year.
NNPFC = National Income = FID (factor income earned in domestic territory) + NFIA.
If NFIA is positive, then national income will be greater than domestic factor incomes.

Personal Income
While national income is income earned by factors of production, Personal Income is the income
received by the household sector including Non-Profit Institutions Serving Households. Thus,
national income is a measure of income earned and personal income is a measure of actual
current income receipts of persons from all sources which may or may not be earned from
productive activities during a given period of time. In other words, it is the income ‘actually paid
out’ to the household sector, but not necessarily earned. Examples of this include transfer
payments such as social security benefits, unemployment compensation, welfare payments etc.
Individuals alsocontribute income which they do not actually receive; for example, undistributed
corporate profitsand the contribution of employers to social security. Personal income forms the
basis for consumption expenditures and is derived from national income as follows:
PI = NI + income received but not earned – income earned but not received.
An important point to remember is that national income is not the sum of personal incomes
because personal income includes transfer payments ( eg.pension) which are excluded from
national income. Also, not all national income accrues to individuals as their personal income.

Disposable Personal Income (DI)

Disposable personal income is a measure of amount of the money in the hands of the individuals
that is available for their consumption or savings. Disposable personal income is derived from
personal income by subtracting the direct taxes paid by individuals and other compulsory
payments made to the government.
DI = PI - Personal Income Taxes

The Circular Flow of Income

Circular flow of income refers to the continuous circulation of production, income generation
and expenditure involving different sectors of the economy. There are three different interlinked
phases in a circular flow of income, namely: production, distribution and disposition as can be
seen from the following figure.
 Method Data required What is measured

Phase of Output: Value added The sum of net values added Contribution of production
method (Product Method) by all the producing units
enterprises of the country

Phase of income : Income Method Total factor incomes Relative contribution of

generated in the production factor owners
of goods and services

Phase of disposition: Expenditure Sum of expenditures of the Flow of consumption and

method three spending units in the investment expenditures
economy, namely,
government, consumer
households, and producing
enterprises

Income Method
Production is carried out by the combined effort of all factors of production. The factors are paid
factor incomes for the services rendered. In other words, whatever is produced by a producing
unit is distributed among the factors of production for their services.
Under Factor Income Method, also called Factor Payment Method or Distributed Share Method,
national income is calculated by summation of factor incomes paid out by all production units
within the domestic territory of a country as wages and salaries, rent, interest, and profit. By
definition, it includes factor payments to both residents and non- residents.

Expenditure Method
In the expenditure approach, also called Income Disposal Approach, national income is the
aggregate final expenditure in an economy during an accounting year. In the expenditure
approach to measuring GDP, we add up the value of the goods and services purchased by each
type of final user mentioned below.
1. Final Consumption Expenditure
(a) Private Final Consumption Expenditure (PFCE)
(b) Government Final Consumption Expenditure
2. Gross Domestic Capital formation
3. Net Exports
How do we arrive at national income or NNP FC using expenditure method ? We first find the
sum of final consumption expenditure, gross domestic capital formation and net exports. The
resulting figure is gross domestic product at market price ( GDP MP ). To this, we add the net
factor income from abroad and obtain Gross National Product at market price (GNP MP).
Subtracting indirect taxesfrom GNP MP, we get Gross National Product at factor cost (GNP FC).
National income or NNP FC is obtained by subtracting depreciation from Gross national product
at factor cost (GNP FC).

Nominal GDP vs Real GDP: GDP at Current and Constantprices

Since we measure the value of output in terms of market prices, GDP, which is essentially a
quantity measure, is sensitive to changes in the average price level. The same physical output
will correspond to a different GDP level if the average level of market prices changes. That is, if
prices rise, GDP measured at market prices will also rise without any real increase in physical
output. This is misleading because it does not reflect the changes in the actual volume of output.
To correct this i.e. to eliminate the effect of prices, in addition to computing GDP in terms of
current market prices, termed ‘nominal GDP’ or ‘GDP at current prices’, the national income
accountants also calculate ‘real GDP ’or ‘GDP at constant prices’ which is the value of domestic
product in terms of constant prices of a chosen base year. Real GDP changes only when
production changes. As a rule, when prices are changing drastically, nominal GDP and real GDP
diverge substantially. The converse is true when prices are more or less constant.

Gross domestic product (GDP) deflator

The GDP deflator is a comprehensive measure of price levels used to derive real GDP. It relates
the price paid for all new, domestically produced goods and services during a period to prices
paid for goods and services in a prior reference (base) period. The specific goods and services
included change from year to year based on changes in consumption and investment patterns in
the economy. Using the GDP deflator, the calculation of real GDP would be:
Real GDP = (Nominal GDP/GDP Deflator) × 100
If the nominal GDP and the real GDP are known, the formula can be rearranged to determine the
GDP deflator. That formula would be:
GDP Deflator = (Nominal GDP/Real GDP) × 100

Potential Gross Domestic Product (Potential GDP)

Measures the maximum final output that can occur in the domestic economy at a point in time
without creating upward pressure on the general level of prices in the economy. The point of
maximum final output will be a point on the production possibility frontier for the economy.
a. The production-possibility frontier is the (conceptual) maximum amount of various goods
andservices an economy can produce at a given time with available technology and full
utilization ofcurrent economic resources. It is commonly estimated by adjusting GDP for
business cycle andunemployment factors.
b. A production-possibility frontier represented by a curve in a simple two-dimensional
graph(assuming available inputs are totally committed to only two outputs) would be
shown as:

i. Points on the curve represent all input resources (labor, plant capacity, etc.) used to
generatemaximum output. There is no inefficiency in the economy.
ii. At points within the curve actual output (i.e., real GDP) is less than potential output
(potential GDP). The difference (potential GDP − real GDP) is the (negative) GDP gap, a
measure of inefficiency in the economy.
iii. At points outside the curve actual output (i.e., real GDP) exceeds potential output and there
is apositive GDP gap, which will result in price level.
 Unemployment and Employment

In the U.S., official employment/unemployment measures are determined by the Bureau of

LaborStatistics (BLS), a unit of the U.S. Department of Labor. The data the BLS provides comes
primarily from two different surveys, the Current Employment Survey and the Current
Population Survey:
a) Current Employment Survey (CES): A monthly sample survey of 160,000 businesses and
government entities designed to measure employment (only), with industry and
geographical details
b) Current Population Survey (CPS): A monthly sample survey of approximately 60,000
households designed to measure both employment and unemployment, with demographic
details.

In developing measures of employment/unemployment, the population is considered to be

comprised of two major subsets: (1) those in the labor (or work) force, and (2) those not in the
labor force. The labor force is the number of people who are employed plus the unemployed
who are looking for work. The labor pool does not include the jobless who aren't looking for
work.

Unemployment categories include:

Frictional unemployment
the unemployment which exists in any economy due to people being in the process of moving
from one job to another.
Structural unemployment
unemployment resulting from industrial reorganization, typically due to technological change,
rather than fluctuations in supply or demand.
Seasonal unemployment
Seasonal unemployment refers to the time period when the demand for labor or workforce is
lower than normal under certain conditions, however, such a situation is only temporary and
employment reverts to normal thereafter.
Cyclical unemployment
It is unemployment that results when the overall demand for goods and services in an economy
cannot support full employment. It occurs during periods of slow economic growth or during
periods of economic contraction. Let's explore this type of unemployment in a little more detail.

Additional Concepts
a. The official unemployment rate is the percentage of the labor force that is not employed,not
the percentage of the population that is not employed. The calculation would be:
Unemployment Rate = Unemployed (including all categories)/Size of Labor Force
b. The natural rate of unemployment is the percentage of the labor force that is not employed
asa result of frictional, structural and seasonal unemployment. The calculation would be:
Natural Rate of Unemployment = Frictional + Structural + Seasonal Unemployed/Size of Labor
Force
c. Officially, full employment is when there is no cyclical unemployment. Even with
frictional,seasonal, and structural unemployment, officially, full employment can exist. Said
another way,if unemployment is due solely to frictional, structural and seasonal causes (i.e., the
natural rateof unemployment), the economy is in a state of full employment.

Business cycles

The business cycle, also known as the economic cycle or trade cycle, is the downward and
upward movement of gross domestic product (GDP) around its long-term growth trend. The
length of a business cycle is the period of time containing a single boom and contraction in
sequence. These fluctuations typically involve shifts over time between periods of relatively rapid
economic growth (expansions or booms) and periods of relative stagnation or decline
(contractions or recessions)
Components of Business Cycle
The following terms are used to refer to components of the business cycle:
a) Peak—A point in the economic cycle that marks the end of rising aggregate output and
the beginning of a decline in output (the Business Peak in the graph).
b) Trough—A point in the economic cycle that marks the end of a decline in aggregate
output and the beginning of an increase in output (the Recessionary Trough in the graph).
c)Economic Expansion or Expansionary Period—Periods during which aggregate output is
increasing(periods from Trough to Peak in the graph); normally of longer duration than
recessionary periods.
d) Economic Contraction or Recessionary Period—Periods during which aggregate output is
decreasing (periods from Peak to Trough in the graph); normally of shorter duration than
expansionary periods

The different stages of the economy are associated with economic measures and indicators,
such asGDP, unemployment, inflation, interest rates, and inventory-to-sales ratios. These
relationships areoutlined in the following table:

Recession and Depression

Definition of a recession
A recession is characterised as a period of negative economic growth for two consecutive
quarters. In a recession, unemployment will rise, output fall and government borrowing increase.
See more on recessions
Definition of depression
A depression is a recession but much more severe and long lasting. There is no agreed upon
definition of a depression. But, generally a depression would have some of the following
characteristics.

a) Decline in output for a prolonged period e.g. greater than 2 years.

b) A drop in output of 10% or greater.
c) Unemployment rate touching 20% (rather than the 10% rate associated with recessions)

Primary Cause of Business Cycles—While no single theory fully explains the causes and
characteristics of business cycles, a major cause is changes in business investment spending (i.e.,
on plant, equipment, etc.) and consumer spending on durable goods (i.e., on goods used over
multiple periods, like major appliances, automobiles, etc.). The effects of suchdeclines in
spending are shown as follows (assuming the Keynesian supply curve):

Leading and Lagging Indicators of Business Cycles

These measures of economic activity (which change before the aggregate business cycle) are
called “leading indicators” and include measures of:
a. Consumer expectations
b. Initial claims for unemployment
c. Weekly manufacturing hours
d. Stock prices
e. Building permits
f. New orders for consumer goods
g. New order for manufactured capital goods
h. Real money supply

Measures of economic activity associated with changes in the business cycle, but which occur
after changes in the business cycle, are called lagging or trailing indicators. These lagging
indicators are used to confirm elements of business cycle timing and magnitude. Lagging
indicators include measures of:
a) Changes in labor cost per unit of output
b) Ratio of inventories to sales
c) Duration of unemployment
d) Commercial loans outstanding
e) Ratio of consumer instalment credit to personal income

Price Levels and Inflation/Deflation

Price Indexes
Adjustments to squeeze out the effects of changing price levels on economic measures are
accomplished using price indexes (or indices). Mathematically, the price of the referenceperiod
is set equal to 100 (100%), and the price of other periods is measured as a percentage of
thereference (or base) period. Commonly used indexes prepared by the Bureau of Labor
Statistics (BLS) and theBureau of Economic Analysis (BEA) are:

Consumer Price Index (CPI-U)—The Consumer Price Index for All Urban Consumers
(published monthly) relates the prices paid by all urban consumers for a “fixed basket” of goods
and services during a period to the price of the “basket” in a prior reference period. The current
reference period for CPI-U is the 36- month average of prices for 1982 to 1984. The average
prices in that period are taken as 100. Prices in subsequent periods are measured as percentage
changes related to that base period.
Personal Consumption Expenditure Price Index (PECPI)—Relates the average increase
in prices for all domestic personal consumption using a chained index which compares one
quarter's price to the
previous quarter's, instead of choosing a fixed base as is done with the CPI-U (above).
a. The PECPI is benchmarked to a base of 2009 = 100.
b. The PECPI measures spending by and on behalf of the personal sector, which includes both
households and non-profit institutions serving households. (By contrast, the CPI- U measures
out of pocket spending by households only.)
c. The PECPI takes consumer's changing consumption patterns due to changing prices into
account; the CPI-U uses a “fixed” basket of goods.
Purchase Price Index (PPI) (formerly Wholesale Price Index)—Measures the average
change over
time in the selling prices received (i.e., revenue received) by domestic producers for their
output.
a. While the CPI-U includes goods and services purchased for consumption by U.S. households,
thePPI includes a greater set of goods and services spanning the entire range of output by
U.S. producers.
b. The PPI is measured by the revenue (selling price) received by producers; the CPI-U is
measured by consumer expenditures.
c. The prices included in the PPI are from the first commercial transaction of producers for
them domestically produced goods, services, and construction output.
d. The calculations for the PPI are done in essentially the same manner as for the CPI-U index.
e. A primary use of the PPI is to deflate revenue streams in order to measure real growth in
output.

Inflation
A general increase in prices and fall in the purchasing value of money is inflation, while deflation
(or deflation rate) is the annual rate of decrease in the price level.The most common yardstick
used to measure inflation or deflation in the United States is the CPI-U. Although there have
been month-to-month decreases in the CPI-U (i.e., deflation), the United States has experienced
annual inflation since the 1930S.There are two fundamental causes of inflation, one related to
demand, the other related to supply.

Demand-induced (demand-pull) inflation

Demand-pull inflation is the upward pressure on prices that follows a shortage in supply.
Economists describe it as "too many dollars chasing too few goods."

Causes of Demand-Pull Inflation

a) A growing economy. When consumers feel confident, they spend more and take on more
debt. This leads to a steady increase in demand, which means higher prices.
b) Asset inflation. A sudden rise in exports forces an undervaluation of the currencies involved.
c) Government spending. When the government spends more freely, prices go up.
d) Inflation expectations. Companies may increase their prices in expectation of inflation in the
near future.
e) More money in the system. An expansion of the money supply with too few goods to buy
makes prices increase.

Supply-induced (cost-push or supply-push) inflation

Cost-push inflation occurs when overall prices increase (inflation) due to increases in the cost of
wages and raw materials. Higher costs of production can decrease the aggregate supply (the
amount of total production) in the economy. Since the demand for goods hasn't changed, the
price increases from production are passed onto consumers creating cost-push inflation.
Consequences of Inflation.
a) Effects on Distribution of Income and Wealth:
b) Effects on Production
c) Effects on Income and Employment
d) Effects on Business and Trade
e) Effects on the Government Finance
f) Effects on Growth
Deflation
Like inflation, deflation may be caused by changes in aggregate demand and/or aggregate
supply.
a) Demand changes can result in deflation when there is a significant decrease in demand (e.g.,
asmight be caused by a significant drop in consumer confidence about the economy) which
results in awidespread reduction in prices by sellers in an attempt to stimulate sales.
b) Supply changes can result in deflation when there is an increase in aggregate supply (e.g., as
mightbe caused by a significant drop in cost of inputs) that significantlyexceeds an increase in
aggregatedemand. This, too, results in sellers reducing prices in an effort to increase sales.

Consequences of Deflation—the Deflationary Spiral

When prices are falling, consumers have an incentive to delay purchases and businesses have an
incentive to delay investments, both in anticipation of lower prices in the future. These delays
create further decreases in aggregate demand, causing further reductions in prices, increased
idle production capacity, increased unemployment, and reductions in wages, lending and
interest rates. This cycle is called a deflationary spiral. If unchecked, it can have serious adverse
consequence for an economy
 Money, Banking, and Monetary/Fiscal Policy

The money is central to economic activity. In the United States, the Federal Reserve System (the
Fed) manages the money supply and regulates the banking system.

Functions of Money
Money is often defined in terms of the three functions or services that it provides. Money serves
as a medium of exchange, as a store of value, and as a unit of account.
a) Mediumofexchange - Money's most important function is as a medium of exchange to
facilitate transactions. Without money, all transactions would have to be conducted by
barter, which involves direct exchange of one good or service for another. The difficulty with
a barter system is that in order to obtain a particular good or service from a supplier, one has
to possess a good or service of equal value, which the supplier also desires. In other words, in
a barter system, exchange can take place only if there is a double coincidence of wants
between two transacting parties. The likelihood of a double coincidence of wants, however,
is small and makes the exchange of goods and services rather difficult. Money effectively
eliminates the double coincidence of wants problem by serving as a medium of exchange
that is accepted in all transactions, by all parties, regardless of whether they desire each
other’s' goods and services.
b) Storeofvalue -In order to be a medium of exchange, money must hold its value over time;
that is, it must be a store of value. If money could not be stored for some period of time and
still remain valuable in exchange, it would not solve the double coincidence of wants
problem and therefore would not be adopted as a medium of exchange. As a store of value,
money is not unique; many other stores of value exist, such as land, works of art, and even
baseball cards and stamps. Money may not even be the best store of value because it
depreciates with inflation. However, money is more liquid than most other stores of value
because as a medium of exchange, it is readily accepted everywhere. Furthermore, money is
an easily transported store of value that is available in a number of convenient
denominations.
c) Unit of account - Money also functions as a unit of account, providing a common measure
of the value of goods and services being exchanged. Knowing the value or price of a good, in
terms of money, enables both the supplier and the purchaser of the good to make decisions
about how much of the good to supply and how much of the good to purchase.

The Federal Banking System

The United States does not have a central bank but rather a central banking system, the Federal
Reserve System, which consists of:
a. Board of governors—The seven-member policy-making body of the Federal Reserve System
b. Federal open market committee—The 12-MEMBER body responsible for implementing
monetarypolicy through open-market operations to affect the money supply (M1)
c. Federal reserve banks—The 12 district banks, each responsible for a specific geographical
area of the United States. Within their area, each federal bank supervises, regulates, and
examines memberinstitutions; provides currency to and clears checks for those institutions;
and holds reserves andlends to those institutions. The Federal Reserve Banks are owned by
their member institutions, butthey operate under uniform policies of the Federal Reserve
System. Member institutions, whichfunction as financial intermediaries, include:
 i. Commercial banks
ii. Savings and loan associations
iii. Mutual savings banks
iv. Credit unions

Fed Measures of Money Stock

The US Fed provides definitions and measures of money for the U.S. economy, including the
following:
1. M1—Includes paper and coin currency held outside banks and check-writing deposits. This is
thenarrowest definition of money and is based on including instruments used for transactions.

a. U.S. paper currency takes the form of Federal Reserve notes. These notes (“dollar” bills of
variousdenomination) have no intrinsic value in that they do not represent a claim to any
specificcommodity (e.g., gold). Rather, their value derives from the good faith and credit of the
U.S.government.
b. Check-writing deposits are amounts held by banks, savings and loans, and credit unions
forwhich ownership can be transferred by writing a check.

2. M2—Includes M1 items plus savings deposits, money-market deposit accounts, certificates

ofdeposit (less than $100,000), individual-owned money-market mutual funds, and certain
otherdeposits. This measure of money is the primary focus of Fed actions to influence the
economy.

3. M3—Includes M2 items plus certificates of deposit (greater than $100,000), institutional-

owned money market mutual funds and certain other deposits (the FRS no longer provides a
measure of M3).

4. MZM (Money Zero Maturity)—Includes highly liquid items that are readily available for
spending at par value and consists of currency and coins, checking accounts, savings accounts, and
all moneymarket accounts. It is usually computed as M2 less time deposits (e.g., certificates of
deposit) plus institutional-owned money market funds.
 Monetary Policy

Monetary policy, the demand side of economic policy, refers to the actions undertaken by a
nation's central bank to control money supply to achieve macroeconomic goals that promote
sustainable economic growth. The Federal Reserve System can regulate the money supply
(exercise monetary policy) in a number of ways:

a. Reserve-requirement changes—A bank's ability to issue check-writing deposits is limited by

areserve-requirement by the Fed on check-writing deposits. Simply put, loans made by banks
are paidto borrowers by checks drawn on the lending bank. For every dollar of such checks
issued as loans,the bank must have a required amount held as a reserve, either at the bank
or on deposit at aFederal Reserve Bank.
b. open market operations - The most commonly used tool of monetary policy in the U.S.
is open market operations. Open market operations take place when the central bank sells or
buys U.S. Treasury securities in order to influence the quantity of bank reserves and the level
 of interest rates. When the Fed conducts open market operations, it targets the federal
funds rate, since that interest rate reflects credit conditions in financial markets very well.
c. Discount rate—The rate of interest banks pays when they borrow from a Federal Reserve
Bank inorder to maintain reserve requirements is called the “discount rate.” Borrowing from
a Fed bankincreases a bank's reserves with the Fed because the borrowing is credited to the
banks’ reserve withthe Fed, not withdrawn from the Fed bank.
d. Margin requirement—The percentage of the cost of an investment in qualified
(marginable)securities that an investor must pay for with his/her own funds; the percentage
cost of such aninvestment for which the investor cannot use funds borrowed from a broker-
dealer, bank, or otherinstitution to purchase the securities.

Changes in the Money Supply

If other factors are held constant, an increase in the M1 money supply will lower the short- term
interest rate in the market. This can be shown as follows:

Similarly, if the demand for money increases, the interest rate will tend to increase. For
example,large borrowings by the government will increase the demand for money and put
pressure on interest rates to increase.
Velocity of Money
The velocity of money (technically, the income velocity of money) is a measure of the rate at
whichmoney in circulation is used for purchasing new, domestically produced goods and
services. It measures the average rate or frequency at which the money supply “changes hands,”
or turns over in exchange transactions for goods and services during a period.

The classical formula for computing the velocity of money (VM) is:
VM = GDP / MSwhere: GDP = Gross domestic product (nominal)

MS = Money supplyAnd, since GDP can be measured by expenditures, another version of the
equation, called the“equation of exchange” would reflect that:
MS × VM = SpendingThus, MS x VM = P x Q
When expressed in this format, the equality (sometimes called the Fisher equation) expresses
thequantity theory of money. As shown, the Fisher equation says that the price level (P)
multipliedby the quantity of output (Q) (the product of which constitutes nominal GDP) is the
same as(equal to) the money supply (MS) multiplied by the velocity of money (VM). Moreover,
QTM says that quantity of money determines the value of money, it forms the cornerstone
of monetarism.

Fiscal Policy

Fiscal policy is the means by which a government adjusts its spending levels and tax rates to
monitor and influence a nation's economy. It is the sister strategy to monetary policy through
which a central bank influences a nation's money supply. These two policies are used in various
combinations to direct a country's economic goals.An increase in government spending, a
reduction in taxes, or an increase in transferpayments would be initiated to increase aggregate
demand and, thus, stimulate economic activity.Conversely, a decrease in government spending,
an increase in taxes, or a reduction intransfer payments would be initiated to decrease
aggregate demand and, thus, dampen economicactivity.
Thus, government fiscal policy actions are considered to be of three types (or stances):
a. Expansionary—Undertaken to stimulate economic activity and typically involves
governmentspending exceeding taxes collected, resulting in a deficit.
b. Neutral—No change in fiscal policy action because the economy is in equilibrium
withgovernment spending and tax collections in balance.
c. Contractionary—Undertaken to dampen economic activity and typically involves
governmentspending lower than tax collections, resulting in a surplus.

Both Policies together

There are differences in how quickly the alternative forms of policy can be implemented and
how quickly economic activity will be affected. Changes of significant magnitude in fiscal policy
generally require congressional or legislative approval and may be delayed (or never approved) if
there is not agreement by members of Congress or other legislators. However, once approved,
changes in government spending can be implemented quickly and with an almost immediate
impact on demand. Changes in tax rates, once approved, have a less immediate impact and a
less certain magnitude of influence.

Generally, changes in monetary policy can be made more quickly than fiscal policy because
monetary policy is changed by the Federal Reserve Board, not by legislative action. Once
approved, monetary policy has an almost immediate effect on the interest rate, but the full
effect on spending may not occur immediately because of the time lags inherent in ramping-up
(or ramping-down) large-scale projects commonly sensitive to changes in the interest rate.
Of the two approaches, monetary policy has been the primary approach to achieving
economicobjectives. Changes can be approved more quickly to respond to changing economic
circumstancesand monetary policy changes have fewer artificial influences on the economy.
Fiscal policy, on theother hand, causes a redistribution of output and income.

Some Important Interest Rate Concepts

a) Federal funds rate is the target interest rate set by the FOMC at which commercial banks
borrow and lend their excess reserves to each other overnight.
b) Federal discount rate is the interest rate set by central banks—the Federal Reserve in the
U.S.—on loans extended by the central bank to commercial banks or other depository
institutions. The federal discount rate is used as a measure to reduce liquidity problems and
the pressures of reserve requirements.
c) Prime (Interest) Rate—The interest rate commercial banks charge their most
creditworthyborrowers, usually large, financially sound corporations. It is one of the most
widely used marketlagging indicators, is a major benchmark for mortgage and credit card
rates, and is often the basisfor adjustable-rate loans.
d) London Interbank Offer Rate (LIBOR)—The average interest rate participating banks offer
otherbanks for loans on the London market. LIBOR is the world's most widely-used
benchmark for short-term interest rates. In addition, it is used as a benchmark for other
transactions, including derivative instruments and foreign currency transactions.
e) Negative Interest Rates—A negative interest rate is one that is below zero (i.e., < 0.0%).
When policy or instrument terms provide for a negative interest rate, a financial institution
charges depositor to hold their money on deposit rather than paying them interest on those
deposits
 International Economics

Introduction and Reasons for International Activity

The US Economy is an Open economy. Thus, international economic relationships provide
important benefits to, and create challenges not only for the national economy, but also for
entities engaged in international economic activities.

Reasons for International Activity

a) Boosting economic growth. Trade tends to raise GDP by as much as two percent for every
percentage point increase in the ratio of trade-to-GDP, according to Frankel and Romer
(1999).
b) Increasing overall consumer welfare. A 2005 study by Langenfeld and Nieberding estimated
that consumer benefits from imports accounted for nearly six percent of median household
income in 2002.
c) Lowering prices for consumers. Trade lowers domestic prices; improves resource allocation
through specialization; lowers profit margins of domestic producers and increases operating
efficiency of domestic firms through increased competition.
i. A study by the Bank for International Settlements (2008) found that producer prices
decreased by 2.35 percent following a one percent increase in import market share.
ii. An analysis by the CATO Institute (Mad About Trade, Daniel Griswold) found that the
prices of many everyday products tend to rise in the non-tradable and fall in the
tradable sector of the economy.
d) Expanding product variety available to consumers. Trade increases product variety
particularly among trading countries with similar resource endowments and technologies.
Broda and Weinstein (2006) counted 71,420 import varieties in 1972 rising to 259,215 in
2001. Consumers place significant value on variety. Broda and Weinstein found consumers
would have paid 2.6 percent of their income in 2001 to keep the larger number of varieties in
2001 over that in 1972.
e) Benefiting lower-income households. Big box retailers are among the largest import
companies and confer substantial benefits on a wide range of the population [Hausman and
Leibtag (2005) and Furman (2005)].
f) Increasing overall employment. An OECD study in 2011 found that trade liberalization can
increase overall employment in the long run and during recessions, which is not surprising
given that trade enhances economic growth and the damage increasing trade barriers did in
the Great Depression.
i. Adverse employment effects from trade liberalization often are exaggerated. Lower
consumer prices, lower domestic input costs, and increased foreign demand for
domestic products all have employment expanding effects. NAFTA was predicted to
cause huge U.S. job losses, which did not occur, but it created U.S. export related
jobs—paying 18% more on average (Office of Competition and Economic Analysis,
International Trade Administration, U.S. Department of Commerce, July 2010).

Absolute vs. Comparative Advantage: An Overview

The division and specialization of production in the global economy are shaped by two key
principles of capitalism, those of absolute advantage and comparative advantage. While absolute
advantage indicates which nation is best at producing a given good, comparative advantage is an
indication of which nation stands to lose the least by choosing to produce one good versus
another.

Absolute Advantage
A nation or company is said to have an absolute advantage if it requires fewer resources—
generally raw materials, manpower, or time—to produce a given item. For example, assume
France and the United States both produce airplanes. In one month, France can produce 14
planes while the U.S can churn out 45 of comparable quality. This means it takes France 2.14
days to manufacture each plane versus the U.S. rate of 0.67 days.

In the above example, the U.S. has the absolute advantage because its ability to produce high-
quality products at a quicker rate than its competition indicates a more efficient production
model or more available and more talented labour.

Comparative Advantage
Comparative advantage is all about reducing the opportunity cost of a given production strategy.
The opportunity cost of producing a particular item is equal to the potential benefit that could
have been gained by choosing an alternative. It is also what a business or country misses out on
when choosing one option over another.

Assume that, utilizing the same amount of time and resources, China can produce either 30
computers or 45 cellphones. The opportunity cost of manufacturing one computer is 45/30, or
1.5 cellphones. Conversely, the opportunity cost of producing one cell phone is 30/45, or 0.67 of
acomputer.
The comparative advantage comes into play when neighbouring Thailand decides it can also
produce computers or cellphones, but not both. If Thailand's opportunity cost for producing
cellphones is lower than 0.67 of a computers, then it has a comparative advantage for the
production of cellphones. In this case, it is mutually beneficial for Thailand to produce phones
and China to produce computers.

Even if China is more efficient at producing both items, giving it the absolute advantage,
establishing specialized production and arranging an international trade agreement allows both
countries to benefit.

Porter's Four Factors

The Porter Diamond, properly referred to as the Porter Diamond Theory of National Advantage,
is a model that is designed to help understand the competitive advantage that nations or groups
possess due to certain factors available to them, and to explain how governments can act as
catalysts to improve a country's position in a globally competitive economic environment. The
model was created by Michael Porter, a recognized authority on corporate strategy and
economic competition, and founder of the Institute for Strategy and Competitiveness at the
Harvard Business School. It is a proactive economic theory, rather than one that simply
quantifies competitive advantages that a country or region may have. The Porter Diamond is also
referred to as "Porter's Diamond" or the "Diamond Model."

The Porter Diamond suggests that countries can create new factor advantages for themselves,
such as a strong technology industry, skilled labor, and government support of a country's
economy. Most traditional theories of global economics differ by mentioning elements, or
factors, that a country or region inherently possesses, such as land, location, natural resources,
labor, and population size as the primary determinants in a country's competitive economic
advantage. Another application of the Porter Diamond is in corporate strategy, to use as a
framework to analyse the relative merits of investing and operating in various national markets.

The Porter Diamond is visually represented by a diagram that resembles the four points of a
diamond. The four points represent four interrelated determinants that Porter theorizes as the
deciding factors of national comparative economic advantage. These four factors are firm
strategy, structure and rivalry; related supporting industries; demand conditions; and factor
conditions. These can in some ways also be thought of as analogous to the eponymous forces of
Porter's Five Forces model of business strategy.

Firm strategy, structure, and rivalry refer to the basic fact that competition leads to businesses
finding ways to increase production and to the development of technological innovations. The
concentration of market power, degree of competition, and ability of rival firms to enter a
nation's market are influential here. This point is related to the forces of competitors and
barriers to new market entrants in the Five Forces model.

Related supporting industries refer to upstream and downstream industries that facilitate
innovation through exchanging ideas. These can spur innovation depending on the degree of
transparency and knowledge transfer. Related supporting industries in the Diamond model
correspond to the suppliers and customers who can represent either threats or opportunities in
the Five Forces model.

Demand conditions refer to the size and nature of the customer base for products, which also
drives innovation and product improvement. Larger, more dynamic consumer markets will
demand and stimulate a need to differentiate and innovate, as well as simply greater market
scale for businesses.

The final determinant, and the most important one according to Porter's theory, is that of factor
conditions. Factor conditions are those elements that Porter believes a country's economy can
create for itself, such as a large pool of skilled labor, technological innovation, infrastructure, and
capital.

For example, Japan has developed a competitive global economic presence beyond the country's
inherent resources, in part by producing a very high number of engineers that have helped drive
technological innovation by Japanese industries.

Porter argues that the elements of factor conditions are more important in determining a
country's competitive advantage than naturally inherited factors such as land and natural
resources. He further suggests that a primary role of government in driving a nation's economy is
to encourage and challenge businesses within the country to focus on the creation and
development of the elements of factor conditions. One way for the government to accomplish
that goal is to stimulate competition between domestic companies by establishing and enforcing
anti-trust laws.
 Issues at the National Level

While international economic activity benefits the national economy, it also creates issues for
thenational economy.

Dumping Issue
Dumping is when a country's businesses lower the sales price of their exports to unfairly gain
market share. They drop the product's price below what it would sell for at home. They may
even push the price below the actual cost to produce. They raise the price once they've
destroyed the other nation's competition.
Under World Trade Organization (WTO) policy, dumping is not considered illegal
competitionunless the importing country can demonstrate the negative effects on domestic
producers.Importing nations often counter dumping by imposing quotas and/or tariffs on the
dumped product,which has the effect of limiting the quantity or increasing the cost of the
dumped good.

Socio-political Issues
It is often argued that international trade causes or exacerbates certain domestic social and
economic problems, including:
a. Unemployment resulting from the direct or indirect use of “cheap” foreign labor
b. Loss of certain basic manufacturing capabilities
c. Reduction of industries essential to national defense
d. Lack of domestic protection for start-up industries

Political responses to such concerns often result in protectionism in the form of:
a. Import quotas, which restrict the quantity of goods that can be imported
b. Import tariffs, which tax imported goods and thereby increase their cost
c. Embargo, which is a partial or complete ban on trade (imports/exports) or other
commercial activity with one or more other countries
d. Foreign exchange controls, which are government controls on the purchase or sale of
foreign currencies by residents and/or on the purchase or sale of the domestic currency by
non-residents, including:
i. Barring the use of foreign currencies in the country
ii. Barring the possession of foreign currencies by residents
iii. Restricting currency exchange to government-run orgovernment approved
exchanges
 iv. Government imposed fixed exchange rates

Protectionism—Such forms of protectionism benefit some parties while harming others:

a) Parties benefited
i. Domestic producers—Retain market and can charge higher prices
ii. Federal government—Obtains revenue through tariffs
b) Parties harmed
i. Domestic consumers—Pay higher prices and may have less choice of goods
ii. Foreign producers—Loss of market

Such forms of protectionism are generally inappropriate because they are based on economic
misconceptions or because there are more appropriate fiscal and monetary policy responses.

Balance of Payment
The balance of payments is the record of all international trade and financial transactions made
by a country's residents.
The balance of payments has three components. They are the current account, the financial
account, and the capital account. The current account measures international trade, net income
on investments, and direct payments. The financial account describes the change in international
ownership of assets. The capital account includes any other financial transactions that don't
affect the nation's economic output.
The net effects of the amounts reported by the current account, capital account, and
financialaccount can be summarized as:
a. When the sum of earnings and inflows exceeds the sum of spending and outflows, a balance
of payment surplus exists. This surplus would result in an increase in U.S. reserves of foreign
currency or in a decrease in foreign government holdings of U.S. currency.
b. When the sum of spending and outflows exceeds the sum of earnings and inflows, a balance
of payment deficit exits. This deficit would result in a decrease in U.S. holding of foreign
currency reserves or in an increase in foreign government holdings of U.S. currency.

A deficit in the U.S. balance of payments means that U.S. entities have a combined amount of
imports and investments made abroad that exceeds the combined amount of exports and
investments made in the U.S. by foreign entities. Consequently, the U.S. demand for foreign
currencies will exceed the amount of foreign currencies provided by U.S. exports and foreign
investment in the United States and (other things remaining equal) with free-floating exchange
rates, the exchange rates between the dollar and other currencies will rise (i.e., thevalue of the
dollar relative to other currencies will fall).
 i. Such a decline in the dollar would make imports more expensive and exports cheaper
for foreign buyers.
ii. A decrease in imports and an increase in exports would, in turn, move the balance of
payments back toward equilibrium.
iii. Thus, free-floating exchange rates help maintain balance of payment equilibrium.

Exchange Rate Issue (Imports/Exports)

An exchange rate is the price of one unit of a country's currency expressed in units of
anothercountry's currency. Example: $1.20 = 1 euro

Exchange rates are important in determining the level of imports and exports for a country.
a. The lower the cost of a foreign currency in terms of a domestic currency, the cheaper the
foreigngoods and services of that currency in the domestic market.
i. Assume the following alternate exchange rates:
$1.10 = 1 euro (“stronger” dollar than $1.25 = 1 euro)
$1.25 = 1 euro (“weaker” dollar than $1.10 = 1 euro)
ii. When the exchange rate is $1.10 = 1.00 euro, U.S. consumers can buy more
foreign (euro) goods than when the exchange rate is $1.25 = 1.00 euro.
iii. Consequently, imports of euro goods would be higher at the lower exchange rate
(stronger dollar).
b) Conversely, the lower the cost of a foreign currency in terms of a domestic currency, the
higher the cost of domestic goods and services to foreign buyers resulting in lower
exports.Since the exchange rate directly affects the level of imports and exports for both
goods and services,it directly affects the balance of trade of a country.
c) Balance of trade is the difference between the monetary value of imports and exports, which
is apart of a country's current accounting in its balance-of-payments accounts.
i. Trade surplus = Exports > Imports
ii. Trade deficit = Exports < Imports

The next lesson considers the nature and determinants of exchange rates and how
governmentscan influence the level of those rates.

Role of Exchange Rates

Currency is a medium of exchange for goods and services. In short, it's money, in the form of
paper or coins, usually issued by a government and generally accepted at its face value as a
method of payment.
An exchange rate is the value of one nation's currency versus the currency of another nation or
economic zone. For example, how many U.S. dollars does it take to buy one euro? As of Dec. 13,
2019, the exchange rate is 1.10, meaning it takes $1.10 to buy €1.
The currency exchange rate may be expressed as:
a. Direct exchange rate—the domestic price of one unit of a foreign currency. For
example: 1 euro = $1.10.
b. Indirect exchange rate—the foreign price of one domestic unit of currency. For
example: $1.00 = .909 euro ($1.00/$1.10).

A spot exchange rate is the current price level in the market to directly exchange one currency
for another, for delivery on the earliest possible value date. Cash delivery for spot currency
transactions is usually the standard settlement date of two business days after the transaction
date (T+2)

A forward rate is an interest rate applicable to a financial transaction that will take place in the
future. Forward rates are calculated from the spot rate and are adjusted for the cost of carry to
determine the future interest rate that equates the total return of a longer-term investment
with a strategy of rolling over a shorter-term investment.

Exchange rate discount or premium—The difference at a point in time between the spot
exchange rate and the forward exchange rate for two currencies. The discount or premium is
computed as:
[(Forward rate – Spot rate)/Spot rate] × [Months or days in year/Months in forward period]

a. The result is a premium because the forward rate is higher than the spot rate. This
premium indicates that the market assessment is that the value of the dollar relative to the
euro will decline (weaken).
b. If the forward rate is lower than the spot rate, a discount would result. A discount indicates
tha the market believes that the value of the dollar relative to the euro will increase
(strengthen).

Exchange Rate Determination

In 1944, delegates from 45 nations meeting in Bretton Woods, New Hampshire reached
agreement (Bretton Woods Agreement) to establish a post-war international monetary system,
including fixed currency exchange rates. The fixed exchange rate system remained in operation
until 1973, when it was abandoned and replaced by a system of floating exchange rates. The
worldwide exchange system in operation today is not completely free-floating because monetary
authorities in one country can and do intervene in exchange markets of other countries so as to
influence exchange rates. Nevertheless, the current exchange system is largely determined by
aggregate demand and supply for currency.

Factors responsible for determination of exchange rate are as under-

a) Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a lower
inflation rate than another's will see an appreciation in the value of its currency. The prices of
goods and services increase at a slower rate where the inflation is low. A country with a
consistently lower inflation rate exhibits a rising currency value while a country with higher
inflation typically sees depreciation in its currency and is usually accompanied by higher interest
rates

b) Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest
rates, and inflation are all correlated. Increases in interest rates cause a country's currency to
appreciate because higher interest rates provide higher rates to lenders, thereby attracting more
foreign capital, which causes a rise in exchange rates

c) Country’s Current Account / Balance of Payments

A country’s current account reflects balance of trade and earnings on foreign investment. It
consists of total number of transactions including its exports, imports, debt, etc. A deficit in
current account due to spending more of its currency on importing products than it is earning
through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its
domestic currency.

d) Government Debt
Government debt is public debt or national debt owned by the central government. A country
with government debt is less likely to acquire foreign capital, leading to inflation. Foreign
investors will sell their bonds in the open market if the market predicts government debt within
a certain country. As a result, a decrease in the value of its exchange rate will follow.

e) 5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio of export
prices to import prices. A country's terms of trade improves if its exports prices rise at a greater
rate than its imports prices. This results in higher revenue, which causes a higher demand for the
country's currency and an increase in its currency's value. This results in an appreciation of
exchange rate.

f) 6. Political Stability & Performance

A country's political state and economic performance can affect its currency strength. A country
with less risk for political turmoil is more attractive to foreign investors, as a result, drawing
investment away from other countries with more political and economic stability. Increase in
foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country
with sound financial and trade policy does not give any room for uncertainty in value of its
currency. But, a country prone to political confusions may see a depreciation in exchange rates.

g) 7. Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances
to acquire foreign capital. As a result, its currency weakens in comparison to that of other
countries, therefore lowering the exchange rate.

h) Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in
order to make a profit in the near future. As a result, the value of the currency will rise due to
the increase in demand. With this increase in currency value comes a rise in the exchange rate as
well.

Management of currency exchange rates

To the extent a government can influence or determine the demand and supply factors
whichestablish currency exchange rates, it can determine those rates.In the U.S. the Fed can
directly affect interest rates (a demand factor) and the supply of money.
a) To increase the value of the dollar, the Fed could increase the interest rate in the U.S.
Thatresults in added demand for U.S. investment instruments and the dollars needed to
acquirethose investments (increased demand).
b) To increase the value of the dollar (relative to other currencies), the Fed could buy dollars
on the open market using foreign currency reserves. That results in fewer dollars in
circulation (less supply) and more foreign currency in circulation (more supply).
c) To decrease the value of the dollar, the Fed could buy foreign currencies in the
openmarket using dollars. That results in more dollars in circulation (more supply) and
lessforeign currency in circulation (less supply).
d) To decrease the value of the dollar, the Fed could decrease the interest rate in the
U.S.That results in less demand for U.S. investment instruments and the dollars needed
toacquire those investments (decrease demand).

Exchange Rates and Domestic Economy

a) When a currency becomes stronger—or appreciates—the value of a currency has
increasedrelative to another currency; it takes less of that currency to buy another
currency (or more ofanother currency to buy that currency).
 b) When a currency becomes weaker—or depreciates—the value of a currency has
decreased relative to another currency; it takes more of that currency to buy another
currency (or less of another currency to buy that currency).

Consequences of Changing Currency Value

1. When a currency appreciates (becomes stronger):
a. Foreign goods become cheaper, providing consumers access to a wider array of goods
at
lower prices.
b. Domestic producers maintain lower prices, thus encouraging efficiency and putting
downward pressure on inflation (price increases).
c. Domestic producers have more difficulty in competing in both domestic markets and
foreign markets.
2. When a currency depreciates (becomes weaker):
a. Domestic goods become cheaper relative to foreign goods, thus increasing export
demand.
b. Increased export demand increases domestic employment.
c. Imported goods become more expensive, which drives up the cost of imported inputs
(i.e., raw materials, components, etc.).

Issues at Entity Level

While exchange rates create issues for the national economy, for individual entities engaged in
international trade and investment activities, exchange rates are central in determining the
success or failure of their international activities.Businesses that operate internationally or
domestically must deal with various risks when trading in currencies other than their home
currency.

Companies typically generate capital by borrowing debt or issuing equity and then use this to
invest in assets and try to generate a return on the investment. The investment might be in
assets overseas and financed in foreign currencies, or the company's products might be sold to
customers overseas who pay in their local currencies.

Domestic companies that sell only to domestic customers might still face currency risk because
the raw materials they buy are priced in a foreign currency. Companies that do business in just
their home currency can still face currency risk if their competitors operate in a different home
currency. So what are a company's various currency risks? (See also: Currency Exchange: Floating
Rate Vs. Fixed Rate.)

Transaction Risk
Transaction risk arises whenever a company has a committed cash flow to be paid or received in
a foreign currency. The risk often arises when a company sells its products or services on credit
and it receives payment after a delay, such as 90 or 120 days. It is a risk for the company because
in the period between the sale and the receipt of funds, the value of the foreign payment when
it is exchanged for home currency terms could result in a loss for the company. The reduced
home currency value would arise because the exchange rate has moved against the company
during the period of credit granted.

The example below illustrates a transaction risk involving U.S. and Australian dollars:

For the sake of the example, let's say a company called USA Printing has a home currency of U.S.
dollars, and it sells a printing machine to an Australian customer, Koala Corp., which pays in its
home currency of Australian dollars (AU) in the amount of $2 million.

In Scenario A, the sales invoice is paid on delivery of the machine. USA Printing receives AU$2
million, and converts them at the spot rate of 1:2 and so receives $1 million in its home currency.

In Scenario B, the customer is allowed credit by the company, so AU$2 million is paid after 90
days. USA Printing still receives AU$2 million but the spot rate quoted at that time is 1:2.50, so
when USA Printing converts the payment, it is worth only $800,000, a difference of $200,000.

If the USA Printing had intended to make a profit of $200,000 from the sale, this would have
been totally lost in Scenario B due to the depreciation of the AU during the 90-day period.

Eliminating or Mitigating Transaction Risk

An entity can avoid the risk associated with changing exchange rates by engaging only in dollar
denominated transactions. The international nature of business, however, requires that firms of
anysignificant size conduct business with foreign entities, often in terms of a foreign currency.
Therefore, rather than avoid currency risk entirely, firms seek to minimize the degree of risk
associated with such activity.

The risk associated with a change in exchange rates on foreign currency denominated
transactionbalances can be mitigated internally by using:

Matching—Incurring equal amounts of receivables and payable in a foreign currency,

thusresulting in a loss on either of the balances being offset by a concurrent gain on the otherof
the balances.
Leading and lagging- receivables or payables involve collecting receivables and payingobligations
either earlier or later than would normally be required.
a) When a foreign currency is expected to weaken against the domestic currency,
thedomestic entity would seek to collect a receivable early or delay paying a liability.
b) When a foreign currency is expected to strengthen against the domestic currency, the
domestic entity would seek to pay an obligation early or delay collecting a receivable.

The risk associated with a change in exchange rates on foreign currency denominated
transactionbalances can be mitigated with hedging using forward exchange, futures, or option
contracts,currency swaps, and the like.Hedging is a risk management strategy, which involves
using offsetting (or contra) transactions so that a loss on one transaction would be offset (at
least in part) by a gain on another transaction(or vice versa).

Translation Risk
A company that has operations overseas will need to translate the foreign currency values of
each of these assets and liabilities into its home currency. It will then have to consolidate them
with its home currency assets and liabilities before it can publish its consolidated financial
accounts—its balance sheet and profit and loss account. The translation process can result in
unfavourable equivalent home currency values of assets and liabilities. A simple balance sheet
example of a company whose home (and reporting) currency is in British pounds (£) will
illustrate translation risk:
In year one, with an exchange rate of £1:1.50, the company's foreign assets are worth £200 in
home currency terms and total assets and liabilities are each £300. The debt/equity ratio is 2:1.
In year two, the dollar has depreciated and is now trading at the exchange rate of £1:$3. When
year two's assets and liabilities are consolidated, the foreign asset is worth 100 pounds (a 50%
fall in value in pound terms). For the balance sheet to balance, liabilities must equal assets. The
adjustment is made to the value of equity, which must decrease by 100 pounds so liabilities also
total 200 pounds.

The adverse effect of this equity adjustment is that the D/E, or gearing ratio, is now substantially
changed. This would be a serious problem for the company if it had given a covenant (promise)
to keep this ratio below an agreed figure. The consequence for the company might be that the
bank that provided the 200 pounds of debt demands it back or it applies penal terms for a
waiver of the covenant.
Another unpleasant effect caused by translation is that the value of equity is much lower—not a
pleasant situation for shareholders whose investment was worth 100 pounds last year and some
(not seeing the balance sheet when published) might try to sell their shares. This selling might
depress the company's market share price, or make it difficult for the company to attract
additional equity investment.

Some companies would argue that the value of the foreign assets has not changed in local
currency terms; it is still worth $300 and its operations and profitability might also be as valuable
as they were last year. This means that there is no intrinsic deterioration in value to
shareholders. All that has happened is an accounting effect of translating foreign currency. Some
companies, therefore, take a relatively relaxed view of translation risk since there is no actual
cash flow effect. If the company were to sell its assets at the depreciated exchange rate in year
two, this would create a cash flow impact and the translation risk would become transaction risk.

The risk associated with a change in exchange rates on the translation of foreign currency
denominated financial statements can be mitigated in three ways:
a. Reduce the amount of assets and liabilities to be converted using spot (or current)
exchangerates.
b. Since only assets and liabilities converted using a (changing) spot exchange rate results in
gainor loss, minimizing the amount of such assets and liabilities will reduce the recognized
gain or loss.
c. Increase the amount of foreign-based assets likely to appreciate in value (hard currency
assets)and decrease the amount of foreign-based assets likely to depreciate in value (soft-
currencyassets), or vice versa for foreign-based liabilities.
d. Create offsetting assets or liabilities so that a gain or loss on one item will be offset by a loss
or gain on another item.
e. Borrowing in the foreign currency in an amount that approximates the net translation
exposure (net asset) so that a gain or loss on the translation exposure will be offset by a
loss or gain on the borrowing (liability), resulting in a minimum net gain/loss.

Economic Risk
The possible unfavourable impact of changes in currency exchange rates on a firm's future
international earning power; for example, on future costs, prices, and sales. Exchange rate
changes affect the price competitiveness of entities in countries for which the exchange rate
changes.

An economic currency exchange risk occurs when exchange rate changes alter the value of
futurerevenues and costs.
 a. Exchange rate changes may make future foreign revenues convert to fewer units of a
domestic currency (or other currency) or make future costs convert to more units of a
domestic currency (or other currency).
b. These types of changes may reduce the financial viability of future transactions
betweenentities for which the currency exchange rate has changed.
c. The risk associated with changes in exchange rates on future transactions (economic
exposure) can be mitigated by:

Distributing an entity's productive assets in various countries with different currencies and
shifting the sources of revenues and costs to different locations so that the future effects of the
exchange rate changes are minimized.
These changes may involve, among other things:
a. Increasing or decreasing dependency on suppliers in certain foreign countries
b. Establishing or eliminating production facilities in certain foreign countries
c. Increasing or decreasing sales in certain foreign markets
d. Increasing or decreasing the level of debt in certain foreign countries

International Transfer Price Issue

Transfer price is the price at which related parties transact with each other, such as during the
trade of supplies or labor between departments. Transfer prices are used when individual
entities of a larger multi-entity firm are treated and measured as separately run entities. It is
common for multi-entity corporations to be consolidated on a financial reporting basis; however,
they may report each entity separately for tax purposes. Examples
a) Goods from a parent entity to a subsidiary entity (downstream transfer). Goods from a
subsidiary entity to a parent entity (upstream transfer).
b) Goods from one subsidiary entity to another subsidiary entity.
Factors Affecting Transfer Pricing
a) Inflation: the inflation of both countries involved has to be considered when fixing the
transfer price of multinational corporations. Managers and top management would not want
to transfer profits to countries with hyperinflation as doing so may mean exposing the
earnings to unnecessary capital erosion.
b) Exchange rate fluctuations: Exchange rate fluctuations have similar effect on transferring
parties just like inflation.
c) Tax regime of different countries: the relevant tax laws of the countries involved in the
transfer pricing scheme has to be considered and any potential tax implication(s) evaluated
before deciding on what transfer price to set.
d) Goods and services Exchange controls: even though we now live in a borderless economy,
there are still some restrictions when it comes to the movement of certain commodities. For
a transfer price to be effective, management must the impact of goods and services
exchange control.
e) Nature of the transaction: the nature of a transaction is an important variable that must be
carefully considered in order to set a multinational transfer price. Companies can easily fix a
transfer price of their choice for transactions that are unique and Novell.
f) Impact of the transfer on host nation: many companies have in the past been publicly
criticised for not considering the impact of transfer price on their host nation. A competing
company can easily take a jibe on your brand and reputation simply by evoking the moral
implications of the competitors transfer pricing scheme especially when used to move
taxable income abroad – even though it is done legally.
g) Impact on the motivation of participating parties: a serious thought has to be in here. How
will the managers of the transferee company feel about a multinationals transfer pricing
policy when it is likely to affect their appraisal?
h) Import duties: a major decision to make as far as fixing a price at which to transfer goods and
services between countries is the import duties that have to be paid on the transaction. A
cost and benefit analysis has to be carried out in order to ensure that the company will not
be finically worse-off as a result of its actions.
i) Anti-dumping legislations: in a bid to protect economy and jobs, many countries have anti-
dumping legislations in place. This legislation prohibits the transfer of certain goods and
services into their countries. A multinational planning to fix a transfer price must consider
how this will affect the whole process.
j) Competitive pressure and goal congruence implications: this follows on from the
motivational aspect of transfer pricing. Management of a multinational have to ensure that
any price that is fixed will not lead to dysfunctional behaviours. In many
organizations, employee rewards schemes are tied to performance which can be negatively
affected by the price at which the service of a division is transferred to another.

Income Tax Effects of Setting Different Transfer Prices

The following examples illustrate the effects of setting different transfer prices for the same
goods.Assume Company P, located in the U.S., owns controlling interest in Company S, located in
a foreigncountry. The respective tax rates are:
Co. P (U.S.) 50%
Co. S (Foreign) 20%
Company S buys or produces goods for $100. These goods are sold (transferred) to Company
P,which sells the goods to a third-party for $300. Before tax consolidated income is $200 ($300 –
$100), but after tax income depends on the amount of income recognized in each of the two
countries, which is determined by the price at which the goods are transferred from Company S
toCompany P.
a. Example 1—Transfer Price = $200
b. Example 2—Transfer Price = $250

Determining Transfer Price

In the United States, guidance on the appropriate allocation of income between entities under
common control, and therefore appropriate transfer pricing, is provided by the Internal Revenue
Code (Sec. 482).
a) That guidance provides that income should be allocated based on the functions performed
andthe risks assumed by each of the entities involved in arm's-length transactions.
b) Section 482 also gives the IRS the power to audit and adjust international transfer prices, and
toimpose penalties for under payment.
c) Transfer pricing guidelines also are provided by the Organization for Economic Co-operation
andDevelopment (OECD), an international body with representatives from 30-member
nations. TheOECD guidelines embody transfer pricing based on the principle of arm's-length
transactions.

In practice, transfer prices are determined using a variety of methods, including:

Cost-based—Where the transfer price is a function of the cost to the selling unit to produce
agood or provide a service.
a) Cost may be actual or standard cost
b) Based on variable cost, variable and certain fixed cost, or full cost
c) Commonly used when no external market exists for the good or service
Advantages:
i. Relatively simple to use
ii. Less costly to implement than a negotiated price
Disadvantages:
i. i. Requires determining a cost-basis to use
ii. ii. May encourage/facilitate inefficiencies in production of goods or provision of services

Market price–based—Where the transfer price is based on the price of the good or service in
themarket (if available).
a) Commonly used when an external market for the good or service exists
b) Typically a valid “arm's-length” basis for transfer pricing

Advantage:
Avoids using cost-based prices, which may incorporate inefficiencies

Disadvantage:
May be difficult to obtain a market-based price

Negotiated price—Where the transfer price is based on a negotiated agreement between buying
and selling affiliates.
a) Commonly used when no external market exists for the good or service

Advantage:
Preserves each manager's autonomy

Disadvantages:
i. May take excessive time to negotiate a transfer price
ii. May be more costly to implement than a predetermined cost-based transfer price
iii. Performance measures may reflect negotiating ability, not performance
 Globalization

Introduction to Globalization
Globalization is the spread of products, technology, information, and jobs across national
borders and cultures. In economic terms, it describes an interdependence of nations around the
globe fostered through free trade.
On one hand, globalization has created new jobs and economic growth through the cross-border
flow of goods, capital, and labor. On the other hand, this growth and job creation is not
distributed evenly across industries or countries. Specific industries in certain countries, such as
textile manufacturing in the U.S. or corn farming in Mexico, have suffered severe disruption or
outright collapse as a result of increased international competition.

Globalization motives are idealistic, as well as opportunistic, but the development of a global
free market has benefited large corporations based in the Western world. Its impact remains
mixed for workers, cultures, and small businesses around the globe, in both developed and
emerging nations.

The most Factors driving globalization are as under:

a) Global Financial Institutions

The previously mentioned Bretton Woods Agreement, which established an international system
of fixed exchange rates between currencies (which has since been replaced mostly by floating
exchange rates), also established a framework for increased international commerce and
finance, and founded two international institutions intended to oversee the processes of
international economic activity. Those institutions are known today as:

i. The World Bank (formally the International Bank for Reconstruction and Development) is
an international organization dedicated to providing financing, advice, and research to
developing nations to aid their economic advancement. The bank predominantly acts as
an organization that attempts to fight poverty by offering developmental assistance to
middle- and low-income countries.

ii. The International Monetary Fund (IMF) is an international organization that aims to
promote global economic growth and financial stability, encourage international trade,
and reduce poverty. It is with the objective of maintaining order in the international
monetary system, largely by providing funds to economies in financial crises.

b) Reduction in Trade and Investment Barriers

i. Trade Barriers—Biggest declines in trade barriers can be traced to the establishment in

1947 of the General Agreement on Tariffs and Trade (GATT). Later, The World Trade
Organization (WTO) was subsequently established (1995) to encompass GATT and
related international trade bodies. The WTO also serves to “police” the international
trading system.
 ii. Investment Barriers – That have been tackled by means of FDI. Foreign direct investment
(FDI) is direct investment by an entity in facilities to manufacture and/or market goods
and services in a foreign country (i.e., a country other than the investor's home country).\

c) Technological Advances
The development of global infrastructure, has been a key role player here. Among those
developments, advances in two areas have been particularly important.

i. Communications and Information Processing - The basis for most advances has been the
development of the Internet and the World Wide Web (WWW) which enable businesses
to overcome certain constraints of time and location.
ii. Transportation—Developments in transportation have made the movement of people
and products faster and cheaper.

Challenges of Globalizations
One clear result of globalization is that an economic downturn in one country can create a
domino effect through its trade partners. For example, the 2008 financial crisis Globalization
detractors argue that it has created a concentration of wealth and power in the hands of a small
corporate elite which can gobble up smaller competitors around the globe.

Globalization has become a polarizing issue in the U.S. with the disappearance of entire
industries to new locations abroad. It's seen as a major factor in the economic squeeze on the
middle class. The challenges of international business begin by understanding the broad
macroenvironment of a country, including its political, economic, and legal characteristics, and
assessing the risk inherent in each.
Globalization of trade

Trade globalization is a type of economic globalization and a measure (economic indicator) of

economic integration. On a national scale, it loosely represents the proportion of all production
that crosses the boundaries of a country, as well as the number of jobs in that country
dependent upon external trade. On a global scale, it represents the proportion of all world
production that is used for imports and exports between countries. For an individual country,
trade globalization is measured as the proportion of that country's total volume of trade to its
Gross Domestic Product

a) Export: A good or service sold to a buyer in a foreign country.

b) Import: A good or service acquired from a seller in a foreign country

Reasons for and Benefits of International Trade

 a) Increased revenues
One of the top advantages of international trade is that you may be able to increase your
number of potential clients. Each country you add to your list can open up a new pathway to
business growth and increased revenues.
b) Decreased competition
Your product and services may have to compete in a crowded market in the U.S, but you may
find that you have less competition in other countries.
c) Longer product lifespan
Sales can dip for certain products domestically as Americans stop buying them or move to
upgraded versions over time.
d) Easier cash-flow management
Getting paid upfront may be one of the hidden advantages of international trade. When trading
internationally, it may be a general practice to ask for payment upfront, whereas at home you
may have to be more creative in managing cash flow while waiting to be paid. Expanding your
business overseas could help you manage cash flow better.
e) 5. Better risk management
One of the significant advantages of international trade is market diversification. Focusing only
on the domestic market may expose you to increased risk from downturns in the economy,
political factors, environmental events and other risk factors. Becoming less dependent on a
single market may help you mitigate potential risks in your core market.
f) 6. Benefiting from currency exchange
Those who add international trade to their portfolio may also benefit from currency fluctuations.
For example, when the U.S. dollar is down, you may be able to export more as foreign customers
benefit from the favourable currency exchange rate.

Measures of International Trade

a. Worldwide Trade
During the 50-year period 1950 to 2000, the world economy grew 6-fold (six times). During that
same period, global exports (trade) grew 17-FOLD (17 times).

During the period 2000 to 2008, the worldwide economy grew by 30%, while exports (which are
also imports to another country) grew at an average annual rate of 5%; in some years the
increase was close to 20%.

In 2008 and 2009, worldwide economic growth (GDP) slowed considerably, resulting in only a
1.3% increase in 2008 and a 2.6% decrease in 2009. Worldwide merchandise exports increased
by 2.3% in 2008, but decreased by a 12.1% in 2009.

In 2010 and 2011, global output increased by 3.8% and 2.5%, respectively. For the same two
years, global merchandise exports grew by 14% and 4.9%, respectively. Since 2011 both
worldwide imports and exports have continued to grow and have more than recovered the
decreases of the 2008 and 2009 global economic downturn.
b) U.S. Trade
The U.S. has sustained a negative export (net import) position for goods and services since the
MID-1970S.

Aggregate imports/exports
The following graph shows the trend in total U.S. foreign trade (imports and exports) forthe
period 1994 through 2014.

During the period 2000 to 2008, U.S. imports (merchandise and services) grew by 7.0%, while
exports grew by 6.0%.In 2009, as a result of the worldwide economic recession, U.S. imports
declined about 26% and exports declined about 18%.

Between 2009 and the end of 2014, U.S. imports and U.S. exports increased by an average of
approximately 13% annually.

c) Share of GDP
The following table shows the change in the level of imports and exports for the U.S. as a share
of gross domestic product (GDP) for selected years beginning in 1960.
While both U.S. imports and exports as a share of GDP reflect a significant increase since 1960,
the increase in imports as a share of GDP has been greater than that of exports. Between 2011
and 2013, both imports and exports as a share of GDP levelled off at about 17% and 14%,
respectively.

d) World's largest exporters/importers

The United States is the largest import nation by a significant amount, and U.S. imports for 2014
exceeded U.S. exports by more than $792 billion.
China is the second-largest import nation, but when the value of imports by Hong Kong, a special
administrative territory of China (shown separately as number 9), is added with those of
mainland China, their total imports are greater than those of the United States
 e) Composition of imports/exports

Factors Affecting Costs of International Trade

The following are the major factors
a) Transportation Costs
b) Tariff or Other Restrictive Costs
c) Time Costs
d) Transaction Costs
 Globalization of Production
Globalization of production refers to the "sourcing of goods and services from locations around
the globe to take advantage of national differences in the cost and quality of factors of
production like land, labour, and capital"

Sourcing Alternatives—The sourcing of goods and services worldwide may be accomplished

intwo general ways:

A. Outsourcing
Outsourcing is the business practice of hiring a party outside a company to perform services and
create goods that traditionally were performed in-house by the company's own employees and
staff. Outsourcing is a practice usually undertaken by companies as a cost-cutting measure. As
such, it can affect a wide range of jobs, ranging from customer support to manufacturing to the
back office.

Benefits of Outsourcing
a) Get access to skilled expertise.
b) Focus on core activities
c) Better Risk Management
d) Increasing in-house efficiency
e) Run your business 24X7
f) Staffing Flexibility
g) Improve service and delight the customer
h) Cut costs and save BIG

Risks Associated with Outsourcing

a) Loss of Control
Managers often complain about loss of control over their own process technologies and quality
standards when specific processes or services are outsourced. The consequences can be severe.
b) Loss of Innovation
Companies pursuing innovation strategies recognize the need to recruit and hire highly qualified
individuals, provide them with a long-term focus and minimal control, and appraise their
performance for positive long-run impact.
c) Loss of Organizational Trust
For many firms, a significant nonquantifiable risk occurs because outsourcing, especially of
services, can be perceived as a breach in the employer-employee relationship.
 d) Higher-Than-Expected Transaction Costs
Some outsourcing costs and benefits are easily identified and quantified because they are
captured by the accounting system. Other costs and benefits are decision-relevant but not part
of the accounting system. Such factors cannot be ignored simply because they are difficult to
obtain or because they require the use of estimates.

B. Foreign Direct Investment

A foreign direct investment (FDI) is an investment made by a firm or individual in one country
into business interests located in another country. Generally, FDI takes place when an investor
establishes foreign business operations or acquires foreign business assets in a foreign company.
However, FDIs are distinguished from portfolio investments in which an investor merely
purchases equities of foreign-based companies.

Establishing owned or controlled facilities in foreign locations to produce goods or provide

services through the acquisition of property, plant, equipment, and other assets in a foreign
location or locations. Under this approach to sourcing, In a production process involving multiple
stages or multiple components, each stage of production or each component produced could
occur in a different country.

The fundamental intents of establishing foreign production or service facilities may be to:
a) Provision of Finance & Technology
b) Increase in Exports
c) Exchange Rate Stability
d) Lower the overall cost structure and/or improve the quality of the good or service.
e) Expand markets.

Foreign direct investments expose the investing firm to a number of specific risks, including:
a) Political risks
b) Transfer risks
c) Exchange rate risks

Globalization of Capital Markets

Capital markets are venues where savings and investments are channelled between the suppliers
who have capital and those who are in need of capital. The entities that have capital include
retail and institutional investors while those who seek capital are businesses, governments, and
people.

Capital markets are composed of primary and secondary markets. The most common capital
markets are the money market, stock market and the bond market. Capital markets seek to
improve transactional efficiencies. These markets bring those who hold capital and those seeking
capital together and provide a place where entities can exchange securities.

Domestic capital markets traditionally have served as the intermediary between providers and
usersof capital. The use of a strictly domestic capital market, however, has certain limitations
even in thelargest economies.

Global Capital Market is an interconnected set of financial institutions and national markets that
permit the trading of financial securities between and among investor and borrowers
worldwide.While many institutions make up the global capital market, there are two formal
major (mostimportant) international financial markets:
a) Eurodollar market or eurocurrency market (euro-market)
b) Eurodollars are created when a U.S. dollar deposit is made outside the United States and
is maintained in U.S. dollars.
c) Eurodollars provide short-term and intermediate-term loans, less than five years in
maturity, denominated in U.S. dollars.
d) Eurodollars provide an alternative to domestic banks for financing by international firms.

Generally, the cost of borrowing in the Euromarkets will be less than through a domestic bank
because such lending activity is less regulated.
a) International bond market (Eurobonds)

Growth in Capital Markets Flows

The growth in international capital markets in the past 20 years or so has been dramatic.The
following graph shows global trade and capital flows as a percentage of world GDP for theyears
1995 to 2012:
Charles W. L. Hill, international business author, reports that between 1990 and 2006, cross-
borderbank loans increased from $3,600 billion to $17,875 billion and that international equity
offeringsincreased from $18 billion in 1990 to $377 billion in 2006.

U.S. and International Investments

A country's net international investment position shows the difference between a country's
external (foreign) assets and liabilities, including both publicly and privately held assets and debt.
The following chart shows the U.S. net international investment position for the 22 years 1990
through 2012:
Benefits of Global Financial Markets

a) Providing the borrower with funds so as to enable them to carry out their investment plans.
b) Providing the lenders with earning assets so as to enable them to earn wealth by deploying
the assets in production debentures.
c) Providing liquidity in the market so as to facilitate trading of funds.
d) Providing liquidity to commercial bank
e) Facilitating credit creation
f) Promoting savings
g) Promoting investment
h) Facilitating balanced economic growth
i) Improving trading floors

Risks of Global Financial Markets

While global capital markets offer benefits to both investors and borrowers, international capital
activity may be subject to an important risk not encountered in a domestic capital market (i.e.,
foreign currency exchange risk). That risk occurs if an entity engages in a transaction or has a
balance to be settled in a foreign currency, in which case the domestic value of the settlement
will be affected by changes in the currency exchange rate.
 Globalization and Power Shifts

Introduction—Among the most significant effects of the move to a global economy have been
shifts in economic activity and economic importance among nations. These shifts have occurred
in most areas of economic activity, including output (GDP), trade, services, foreign direct
investment, and the home country of multinational entities.

Output Shifts
World output, as measured by real GDP of all countries combined, more than tripled during the
period 1969–2009. As late as the MID-1960S, the U.S. accounted for about 40% of worldwide
economic activity as measured by GDP. By 1969 that share had dropped to slightly less than
30%. Since that time until 2007 nominal GDP of the U.S. remained within the range of 25%– 35%
of worldwide GDP. In 2007, the U.S. accounted for less than 25% of world GDP, but in 2012
accounted for only about 22% of world GDP. The U.S. share of world output is projected to
continue to decline.

The following graph shows the annual share of world nominal GDP for the 10 countries with the
highest nominal GDP in 2013 for the period 1980 through 2013, with projections through 2016.
(The country listing in the upper-right corner is in the same order top to bottom as the country
lines on the graph as of 2015.)

As the graph shows, the major change in the share of world output has occurred with the United
States, Europe (Germany, France, the UK, and Italy), and Japan losing share, and China, India,
and Brazil gaining share. Canada has remained fairly constant at about 3%.

The declines in economies that lost share were not the result of absolute decreases in economic
activity of those countries, but rather the result of greater economic growth in other countries,
notably in China, India, South Korea, Taiwan, and other Southeast Asian countries and in Brazil.

If the current trends continue, the Chinese economy will surpass the U.S. economy as the world's
largest economy.More significantly, however, is the expected dispersion of economic growth
worldwide. The WorldBank estimates that by 2020:
a) What are today considered developing nations will account for 60% of world economic
activity.
b) What are today the major developed nations will account for less than 40%, down from
about 55% in 2010 and about 46% in 2014.
•
Trade Shifts
The following graph shows the share of worldwide exports attributable to six of the largest
export countries over the last 20 years or so (in the order top to bottom on the graph)—China,
the United States, Germany, Japan, France, and the U.K.—for the period 1994 to 2013.

The share of exports attributable to these six countries has remained in the range of 40%–45%
for approximately 25 years. However, the relative share between the countries has changed
significantly.

The United States has steadily lost share of world exports, from as high as 18% (in the 1950S) to
8.39% in 2013; in that year it was the number two export country. In 2013, the U.S. share of
worldwide imports was 12.33%.

Germany gained significantly in the share of world exports from 1950 to about 1980. Between
2002 and 2008, Germany was the number one export country; in 2012, it was the number two
export country, but it has since slipped back into number three behind the U.S.

Since 1985, China has increased its share from about 2% to about 12%, and in 2008, it became
the number one export country.

Service Shifts
Like output and trade, there has been a shift in certain services from being provided domestically
to being provided by foreign-located service providers.
a) In some cases, entities are outsourcing services.
 b) In other cases, entities are directly establishing or acquiring service facilities in foreign
countries.
In 2009, it was estimated that about 70% of all foreign direct investment (FDI) investments were
for service industry capability.

Direct Investment Shifts

Shifts in other economic activities have been paralleled by shifts in foreign direct investment
(FDI).In the 1960S, U.S. firms accounted for more than 60% of worldwide FDI made.

Accumulated Value of FDI

a) In 1980, U.S. firms accounted for almost 40% of the total stock (accumulated value) of
foreign investments made.
b) In 2005, U.S. firms accounted for less that 20% of the total stock of foreign investments
made.
c) During the 31-YEAR period (1980–2011), the share of foreign investments made by
developing economies rose from less than 6.2% to approximately 26.9%. It peaked in 2010 at
31.8%.
d) During the worldwide recession of 2008 and 2009, FDI declined by 12% and 40%,
respectively. In 2010, FDI (investments) increased by about 13%.

During 2010, the three largest FDI investing countries were the United States, Germany, and
France. The largest recipients of FDI investing were the United States, China, and Brazil (Source:
Organization for Economic Cooperation and Development.) In recent years, not only have
developing economies made increased direct foreign investments, those same countries have
been the destination for an increasing share of FDI.

Countries in Southeast Asia (including China and India) and Latin America, notably Mexico and
Brazil, have been major recipients of recent FDI inflows.

Multinational Entities Shift

Multinational Entity (also Multinational Enterprise or Multinational Company): An entity that has
its headquarters in one country, known as the home country, and operates in one or more other
countries, known as host countries.

Multinational firms account for a large share of global production. According to estimates of
UNCTAD in its World Investment Report 2011, multinational firms account for 25 percent of
global GDP and a third of international trade.
a) In 1973, about 50% of the world's largest 260 multinational businesses were U.S. entities.
b) In 2000, 36% of the Fortune Global 500 were headquartered in the United States.
c) In 2009, 28% of the Fortune Global 500 were headquartered in the United States.
 d) By 2015, 25% of the Fortune Global 500 were headquartered in the United States.
e) During the last 40 years or so, the greatest increase in multinationals has occurred in
developing countries, though there have been marginal increases in some developed
nations.
f) The greatest increase in major international firms has been Asian-based, most notably in
China. Between 2001 and 2012 the number of Asian-based companies in the Fortune
Global 500 increased from 116 to 188. China accounted for 98 of the 188 companies.
g) While the historical statistics on the share of multinational enterprises by country are not
entirely comparable, the evidence shows that there has been a relative decline in the role
of U.S. multinational
h) The greatest increase in major international firms has been Asian-based, most notably in
China. Between 2001 and 2012 the number of Asian-based companies in the Fortune
Global 500 increased from 116 to 188. China accounted for 98 of the 188 companies.

While the historical statistics on the share of multinational enterprises by country are not
entirely comparable, the evidence shows that there has been a relative decline in the role of
U.S. multinational entities as the importance of entities from other countries has increased.

Becoming Global

An entity may engage in cross-border economic activity in a number of ways, ranging from
simply buying or selling abroad, to the development of a multinational enterprise with global
operations. These alternatives include:
 A. Importing/exporting
B. Foreign licensing
C. Foreign franchising
D. Forming a foreign joint venture
E. Creating or acquiring a foreign subsidiary
Each of these alternatives is described and the advantages and disadvantages identified below.

A. Importing/Exporting
Exporting—The production of goods or services in a domestic economy (home country) and
selling them in another country
Importing—The purchase of goods or services produced in another country (host country) for
use in the domestic economy (home country)

Advantages of Export:
a) Global Markets can be captured so that country will earn foreign exchange.
b) Exports Generate huge Employment opportunities.
c) Economy of Country will be developed.
d) As no Country can self-sustain by itself Exports and Imports are Necessary for their
functioning and growth.

Disadvantages of Export:
a) Exporting Depleting resources like crude oil, minerals, ores Countries will lose valuable
resources which can never be replenished.
b) Export products are subject to quality standards any bad quality products which are
exported will result in Country reputation and remarks on countries.
c) Low Value Addition Exports will be earning less Foreign exchange

Advantages of Import:
a) Import can help Countries to access best technologies available and best products and
services in the world.
b) Cheap resourcing of products can be possible through Imports by globally Procurement
goods and services.
c) Imports can improve countries Standard of living of people of that country

Disadvantages of Import:
a) Foreign Goods are substituting domestic goods so domestic manufactures may lose their
business and this may cause to total collapse of local industry.
b) Foreign exchange loss to country by importing goods.
c) Import will discourage local manufacturing and inflation may cause.
 d) unemployment may increase.

B. Licensing
A licensing agreement gives a licensee rights to use a product that the licensor already owns.
Numerous items can be part of a licensing agreement, including a trademark, a patent, or even
branding. The rights of the licensee are fully outlined in the agreement for the license, which
may allow them to sell items, use a trademark, or take advantage of a specific brand message.

The licensee is able to keep the profits earn by their use of the licensed items. In return, the
licensor receives an agreed-upon royalty out of those profits for the ongoing use of their items.
Most licensing agreements include a one-time upfront payment for access to the desired items
as well.
There are advantages and disadvantages to licensing for both parties to consider before
finalizing their agreement.

Advantages of Licensing
a) It creates an opportunity for passive income.
b) It creates new business opportunities.
c) It reduces risks for both parties.
d) It creates an easier entry into foreign markets.
e) It creates self-employment opportunities.
f) It offers the freedom to develop a unique marketing approach.

Disadvantages of Licensing
a) It increases opportunities for IP theft.
b) It creates a dependency upon the licensor.
c) It creates added competition in the marketplace.
d) It is offered for a limited time.
e) It could damage the reputation of both parties.
f) It takes time for royalty payments to arrive.
g) It may lead to royalty litigation.

C. Foreign Franchising
A continuing relationship in which a franchisor provides a licensed privilege to the franchisee to
do business and offers assistance in organizing, training, merchandising, marketing and
managing in return for a monetary consideration. Franchising is a form of business by which the
owner (franchisor) of a product, service or method obtains distribution through affiliated dealers
(franchisees).
Advantages:
a) Bankers usually look at successful franchise chains as having a lower risk of repayment
default and are more likely to loan money based on that premise.
b) The corporate image and brand awareness is already recognized. Consumers are generally
more comfortable purchasing items they are familiar with and working with companies
they know and trust.
c) Franchise companies usually provide extensive training and support to their franchisees in
effort to help them succeed.
d) Many times products and services are advertised at a local and national level by the main
franchise companies. This practice helps boost sales for all franchisees, but individual
franchisees don’t absorb the cost.
e) There is a higher likelihood of success since a proven business formula is in place. The
products, services, and business operations have already been established.
Disadvantages:
a) Franchises can be costly to implement. Also, many franchises charge ongoing royalties
cutting into the profits of franchisees.
b) Franchisors usually require franchisees to follow their operations manual to a tee in order
to ensure consistency. This limits any creativity on the part of the franchisee.
c) Franchisees must be very good at following directions in order to maintain the image and
level of service already established. If the franchisee is not capable of running a quality
business or does not have proper funding, this could curtail success.

D. Joint Venturing
A joint venture is an entity that is established and jointly owned by two or more otherwise
unrelated entities. In an international context, at least one of the owners is located in the foreign
country in which the joint venture is established

Advantages of a Joint Venture

a) New insights and expertise
b) Better resources
c) It is only temporary
d) Both parties share the risks and costs

Disadvantages of a Joint Venture

a) Vague objectives
b) Flexibility can be restricted
c) There is no such thing as an equal involvement.
d) Clash of cultures
E. Wholly-Owned Subsidiary
As the title implies, the use of a wholly-owned subsidiary involves the home country entity
owning 100% of a foreign entity over which it has complete control. This may be accomplished in
two ways:
a) Acquiring an entity already established in the foreign country through a legal acquisition
b) Establishing a new entity in the foreign country

Acquiring an Already Existing Entity

a) This approach would involve a business combination in which the home country entity
acquires control of an existing foreign country entity in a legal and accounting acquisition.
b) Both entities would continue to exist and operate as separate legal entities, with the
home country parent having control of the foreign country entity (subsidiary) through its
ownership of the equity of the foreign entity.

Acquisition of a pre-existing foreign entity may have the followingadvantages:

a) It provides a quick entry into the foreign country, without the time-consuming process of
establishing a new entity and developing the capital assets (e.g., property, plant, and
equipment) and presence necessary for operation.
b) There is a known level of operating results and related historic information that is not
available when a new entity is established.
c) When executed in a timely manner, it may serve to “block” or pre-empt competitors
from seeking to enter the same foreign market by establishing a quick presence.

Acquisition of a pre-existing foreign entity may have the following disadvantages:

a) Lack of understanding by the acquiring home parent of the acquired foreign subsidiary's
national values, culture, and business environment may result in conflict.
b) The corporate culture of the acquired foreign entity may be difficult to integrate with
that of the home country parent.
c) Synergies or other benefits expected from the acquisition do not materialize, or they take
longer to achieve than expected.

Establishing a New Entity

This method of obtaining a wholly-owned foreign subsidiary involves establishing a new entity
inthe foreign country. This approach is sometimes referred to as a “greenfield venture.”
 Macroeconomics

Introduction to Macroeconomics
Which of the following is not the macroeconomic measure of study?
a) inflation
b) price levels
c) rate of economic growth
d) None of the above

Which of the following is a leakage in flow cycle?

a) investment expenditures
b) exports
c) Imports
d) None of the above

Which of the following is not a leakage in flow cycle?

a) Taxes
b) subsidies
c) Savings
d) None of the above

Which of the following is not a Injection in flow cycle?

a) Government spending
b) subsidies
c) investment expenditure
 d) None of the above

Which of the following is an Injection in flow cycle?

a) Taxes
b) Imports
c) Savings
d) None of the above

Aggregate Demand
What is the formula for AD ?
a) C - I + G + (X – M)

b) C - I - G + (X – M)

c) C + I + G + (X + M)

d) C + I + G + (X – M)

The excess of disposable income over consumption spending is a measure of?

a) consumer savings

b) consumer borrowings

c) both of the above

d) none of the above

The excess of consumption spending over disposable income is a measure of?

 a) consumer savings

b) consumer borrowings

c) both of the above

d) none of the above

___________ Measures the increase in household consumption from an increase in household

income

a) Marginal Propensity to save

b) Average Propensity to save

c) Average Propensity to Consume

d) Marginal Propensity to Consume

___________ measures the total proportion of income that is saved at a given point of time.

a) increase in household income

b) Marginal Propensity to save

c) Average Propensity to save

d) Average Propensity to Consume

e) Marginal Propensity to Consume

MPC + MPS = ___________

a) 0

b) 1

c) both of the above

d) none of the above

The graphic representation of an investment demand [ID] curve with interest rate shows
_________ relationship.
 a) Positive

b) Negative

c) No relation

d) Cant say

To increase Aggregate demand, Government spending should ______

a) Increase

b) Decrease

c) No Change

d) Cant say

To decrease Aggregate demand, transfer payment should ______

a) Increase

b) Decrease

c) No Change

d) Cant say

The formula for net exports is _________?

a) Quantity of Exports - Quantity of Imports

b) Value of Exports - Value of Imports

c) Quantity of Imports - Quantity ofExports

d) Value of Imports - Value of Exports

On an Increase in personal Taxes, the aggregate demand curve shifts to ________?

a) Right

b) Left
 c) Up

d) Down

Calculate the investment multiplier, if MPC is 0.8.

a) 2

b) 3

c) 4

d) 5

AggregateSupply

Which curve is completely vertical, reflecting no relationship between aggregate supply and
price level?
a) Classical Aggregate Supply Curve
b) Keynesian Aggregate Supply Curve
c) Conventional Aggregate Supply Curve
d) All of the above
Which supply curve is horizontal up to the (assumed) level of output at full employment, and
then slopes upward?
a) Classical Aggregate Supply Curve
b) Keynesian Aggregate Supply Curve
c) Conventional Aggregate Supply Curve
d) All of the above

Which supply curve is reflecting that output is not associated with price level until full
employment is reached?
a) Classical Aggregate Supply Curve
b) Keynesian Aggregate Supply Curve
c) Conventional Aggregate Supply Curve
d) All of the above

Which supply curve has a continuously positive slope with a steeper slope beginning at the
(assumed) level of output at full employment?
a) Classical Aggregate Supply Curve
b) Keynesian Aggregate Supply Curve
c) Conventional Aggregate Supply Curve
d) All of the above.

If labour cost increases, than aggregate supply _________

a) Increase

b) Decrease

c) No Change

d) Cant say

Aggregate (Economy) Equilibrium

___________ is a state where economic forces (supply and demand) are balanced
a) Maximum Production
b) Full employment of resources
 c) Equilibrium
d) Consumption

On a classical supply cure, if AD increases, equilibrium will be at _______ Price

a) Higher
b) Lower
c) Same
d) Can’t say

On a Keynesian supply cure, if AD increases before the full employment level is reached,
equilibrium will be at _______ Price
a) Higher
b) Lower
c) Same
d) Can’t say

On a Conventional supply cure, if AD increases, on new equilibrium there is ________ in AS.

a) Contraction
b) Expansion
c) Increase
d) Decrease

National Income & Related concepts

___________ is a measure of the market value of all final economic goods and services, gross of
depreciation, produced within the domestic territory of a country during a given time period.
 a) GDP
b) NDP
c) GNP
d) NNP

GDP will include only ________.

a) Value of final Goods & Services
b) Value of Intermediate Goods & Services
c) Quantity of final Goods & Services
d) Quantity of intermediate Goods & Services

Value of second hand machinery will be _________ in calculation of GDP

a) Included
b) Ignored
c) Both of the above
d) None of the above

_________ is a measure of the market value of all final economic goods and services, gross of
depreciation, produced within the domestic territory of a country by normal residents during an
accounting year including net factor incomes from abroad.
a) GDP
b) NDP
c) GNP
d) NNP

Which of the following is correct?

a) PI = NI + income received but not earned – income earned but not received.
b) PI = NI - income received but not earned – income earned but not received.
c) PI = NI + income received but not earned + income earned but not received.
d) None of the above

Consumption expense is done by ______ in the economy

a) Household

b) Business

c) Government

d) Both a and c
Investment expense is done by ______ in the economy

a) Household

b) Business

c) Government

d) Both b and c

GDP in terms of current market prices is ________

a) Nominal GDP

b) Real GDP

c) Both of the above

d) None of the above

GDP in terms of constant prices is ________

a) Nominal GDP

b) Real GDP

c) Both of the above

d) None of the above

Find GDP Deflator if, Real GDP is 108 & nominal GDP is 115

a) 1.08

b) 1.15

c) 1.0648

d) 106.48

___________ Measures the maximum final output that can occur in the domestic economy at a
point in time without creating upward pressure on the general level of prices in the economy
a) Indifference curve

b) Market equilibrium curve

c) PPF Curve

d) All of the above

 Unemployment and Employment

Current employment survey is taking survey of _______ businesses and government entities
designed to measure employment
a) 100000
b) 160000
c) 200000
d) 260000
__________ is taking monthly sample survey of approximately 60,000 households designed to
measure both employment and unemployment
a) Current employment survey
b) Current population survey
c) Both of the above
d) None of the above
The unemployment which exists in any economy due to people being in the process of moving
from one job to another is ____________
a) Frictional unemployment
b) Structural unemployment
c) Seasonal unemployment
d) Cyclical unemployment
____________ unemployment resulting from industrial reorganization, typically due to
technological change, rather than fluctuations in supply or demand.
a) Frictional unemployment
b) Structural unemployment
c) Seasonal unemployment
d) Cyclical unemployment
__________ unemployment refers to the time period when the demand for labor or workforce
is lower than normal under certain conditions
a) Frictional unemployment
b) Structural unemployment
c) Seasonal unemployment
d) Cyclical unemployment
__________ is unemployment that results when the overall demand for goods and services in an
economy cannot support full employment
a) Frictional unemployment
b) Structural unemployment
c) Seasonal unemployment
d) Cyclical unemployment
Natural Rate of Unemployment = Frictional + Structural + Seasonal Unemployed/Size of Work
Force
a) Correct
b) Incorrect
c) Can’t Say
 Business cycles

A point in the economic cycle that marks the end of rising aggregate output and the beginning of
a decline in output (the Business Peak in the graph is ________
a) Peak
b) Trough
c) Economic Expansion
d) Economic Contraction
Periods during which aggregate output is decreasing is
a) Peak
b) Trough
c) Economic Expansion
d) Economic Contraction
During boom in economy, interest rates are on its _______
a) Peak
b) Trough
c) Economic Expansion
d) Economic Contraction
_____________ is characterised as a period of negative economic growth for two consecutive
quarters.
a) Deflation
b) Recession
c) Depression
d) All of the ab above
Which of the following are called “leading indicators” to business cycle?
a) Ratio of inventories to sales
b) Duration of unemployment
c) Commercial loans outstanding
d) Stock prices
Which of the following are called “Lagging indicators” to business cycle?
a) New orders for consumer goods
b) New order for manufactured capital goods
c) Changes in labor cost per unit of output
d) Real money supply
 Price Levels and Inflation/Deflation

Price indexes prepared by the Bureau of Labor Statistics (BLS) and theBureau of Economic
Analysis (BEA)dose not include-
a) Consumer Price Index
b) Personal Consumption Expenditure Price Index
c) Purchase Price Index
d) Wholesale Price Index

A general increase in prices and fall in the purchasing value of money is _______
a) Inflation
b) Deflation
c) Recession
d) None of the above

Under which inflation, "too many dollars chasing too few goods."-
a) Demand Pull
b) Cost Push
c) Sagflation
d) Hyper Inflation

What is the base year for CPI?

a) 1980-83
b) 1981-84
c) 1982-84
d) 1983-86

____________ occurs when overall prices increase (inflation) due to increases in the cost of
wages and raw materials
a) Demand Pull
 b) Cost Push
c) Sagflation
d) Hyper Inflation

Money, Banking, and Monetary/Fiscal Policy

Which of the following is function of money?

a) Functions of Money
b) Medium of exchange
c) Store of value
d) All of the above
The Federal open market committee consist of ____ members
a) 10
b) 11
c) 12
d) 15
Does US have a central Bank?
a) Yes
b) No
Which is the Narrowest form of money?
a) M1
b) M2
c) M3
d) MZM
Which measure of money is the primary focus of Fed actions to influence the economy?
a) M1
b) M2
c) M3
d) MZM
Which of the following is not an instrument of monetary policy?
a) Reserve-requirement changes
b) open market operations
c) Margin requirement
d) None of the above
A bank's ability to issue check-writing deposits is limited by a change in __________ by the Fed
on check-writing deposits.
a) Reserve-requirement changes
b) open market operations
 c) Margin requirement
d) None of the above
___________ take place when the central bank sells or buys U.S. Treasury securities in order to
influence the quantity of bank reserves and the level of interest rates
a) Reserve-requirement changes
b) open market operations
c) Margin requirement
d) None of the above
If price is 100 per kg, Total quantity of goods is 1000 kg, velocity is 5, Find the money supply?
a) 10000
b) 20000
c) 25000
d) 100000
The rate set as target interest rate set by the FOMC at which commercial banks borrow and lend
their excess reserves to each other overnight.
a) Federal funds rate
b) Federal discount rate
c) Prime (Interest) Rate
d) None of the above
__________ rate is one that is below zero (i.e., < 0.0%).
a) Federal funds rate
b) Federal discount rate
c) Prime (Interest) Rate
d) Negative interest rate
 International Economics

Which of the following is not a benefit of international activity?

a) Boosting economic growth
b) Increasing overall consumer welfare
c) Lowering prices for consumers
d) None of the above
A nation or company is said to have an _________ if it requires fewer resources—generally raw
materials, manpower, or time—to produce a given item
a) absolute advantage
b) Comparative Advantage
c) Both of the above
d) None of the above
___________ is all about reducing the opportunity cost of a given production strategy
a) absolute advantage
b) Comparative Advantage
c) Both of the above
d) None of the above
Which of the following is not part of poter’s four factor?
a) Firm strategy, structure, and rivalry
b) Related supporting industries
c) Demand conditions
d) None of the above
.

Issues at the National Level

_________ is when a country's businesses lower the sales price of their exports to unfairly gain
market share
a) absolute advantage
b) Comparative Advantage
c) Dumping
d) None of the above
Political responses to dumping concerns often result in protectionism in the form of:
a) Import quotas
b) Import tariffs
c) Embargo
d) All of the above
____________ is the record of all international trade and financial transactions made by a
country's residents.
a) Balance of payment
b) Balance of receipts
c) Budget
d) All of the above

The balance of payments has _______ components.

a) Two
b) Three
c) Four
d) Five

The _________ describes the change in international ownership of assets in balance of payment
a) financial account
b) current account
c) capital account
d) all of the above

When the sum of spending and outflows exceeds the sum of earnings and inflows, a balance of
payment runs with a ________
a) Surplus
b) Deficit
c) Equilibrium
d) None of the above

Which of the following is not a form of exchange rate?

a) Floating rate
b) Fixed rate
c) Both of the above
d) None of the above
The lower the cost of a foreign currency in terms of a domestic currency, the ________ the
foreigngoods and services of that currency in the domestic market.
a) Cheaper
b) Expensive
c) Unchanged
d) None of the above
 Role of Exchange Rates

An exchange rate is the value of one nation's currency versus the currency of another nation or
economic zone.
a) Correct
b) Incorrect

the domestic price of one unit of a foreign currency is ______

a) Direct exchange rate
b) Indirect exchange rate
c) Both
d) None
the forward rate is higher than the spot rate, it is known as ________
a) Discount
b) Primmum
c) Spot rate
d) None

Which of the Factor is not responsible for determination of exchange rate?

a) Inflation Rates
b) Interest Rates
c) Country’s Current Account/Balance of Payments
d) None
To increase the value of the dollar (relative to other currencies), the Fed could ___________
dollars from the open market
a) Buy
b) Sell
c) No action
d) Cant say
When a currency becomes, the value of a currency has decreased relative to another currency; it
takes more of that currency to buy another currency
a) Stronger
b) weaker
c) Unchanged
d) None

Issues at Entity Level

__________ risk arises whenever a company has a committed cash flow to be paid or received in
a foreign currency
a) Transaction risk
b) Translation Risk
c) Economic Risk
d) None
A company sold goods of 1000 ADC Currency, receivable after 2 months. Company is said to
have _______
a) Transaction risk
b) Translation Risk
 c) Economic Risk
d) None
When a foreign currency is expected to become ____________ against the domestic currency,
thedomestic entity would seek to pay an obligation early or delay collecting a receivable.
a) Stronger
b) weaker
c) Unchanged
d) None
Incurring equal amounts of receivables and payable in a foreign currency,, means _________
a) Matching
b) Leading and lagging
c) both
d) None
A company that has operations overseas will need to translate the foreign currency values of
each of these assets and liabilities into its home currency due to ________
a) Transaction risk
b) Translation Risk
c) Economic Risk
d) None
The risk associated with a change in exchange rates on the translation of foreign currency
denominated financial statements can be mitigated through _____?
a) Reduce the amount of assets and liabilities to be converted using spot (or current)
exchange rates.
b) Increase the amount of foreign-based assets likely to appreciate in value (hard currency
assets)
c) Both
d) None
The possible unfavourable impact of changes in currency exchange rates on a firm's future
international earning power is ____________
a) Transaction risk
b) Translation Risk
c) Economic Risk
d) None
The risk associated with changes in exchange rates on future transactions (economic exposure)
can be mitigated by ________
a) Increasing or decreasing dependency on suppliers in certain foreign countries
b) Establishing or eliminating production facilities in certain foreign countries
c) Increasing or decreasing sales in certain foreign markets
d) All of the above
 International Transfer Price Issue

_________is the price at which related parties transact with each other, such as during the trade
of supplies or labor between departments.
a) Department price
b) Company price
c) Transfer price
d) All of the above
Which of the following is not a factor affecting transfer price?
a) Exchange rate fluctuations
b) Tax regime of different countries
c) Goods and services Exchange controls
d) None of the above
Which of the following is not a method of determining transfer pricing?
a) Cost-based
b) Market price–based
c) Negotiated price
d) None of the above
shifting of Income tax liability via transfer pricing is ______
a) Legal
b) Illegal
Which method should be used, Where the transfer price is a function of the cost to the selling
unit to produce agood or provide a service?
a) Cost-based
b) Market price–based
c) Negotiated price
d) None of the above
Which method should be used, Where the transfer price is based on a negotiated agreement
between buying and selling affiliates?
a) Cost-based
b) Market price–based
c) Negotiated price
d) None of the above

Globalization

Introduction to Globalization
.
Which of the following is not a global financial institution, aiming for global growth?
a) International bank for reconstruction and development
b) International monetary fund
c) World bank
d) None of the above

.
What brought a biggest decline in trade barrier in 1947?
a) World Bank
b) IMF
c) GATT
d) None of the above
____________ is called as integrating our economy with the world economy
a) Globalization
b) Privatization
c) Liberalization
d) None of the above

The World Trade Organization (WTO) was subsequently established in ______ to encompass
GATT and related international trade bodies.
a) 1990
b) 1995
c) 1997
d) 2000

Which of the following has played a key role in developing the global trade?
a) Transportation services
b) Communication services
c) Internet facility
d) All of the above

Who was the successor of GATT?

a) IMF
b) WTO
c) Both of the above
d) None of the above
 Globalization of trade

A good or service sold to a buyer in a foreign country is called ________

a) Capital Inflow
b) Capital outflow
c) Output Outflow
d) Export

Which of the following is not a benefit of international trade?

a) Decreased competition
b) Longer product lifespan
c) Increased revenues
d) None of the above

Has the sub-prime crisis of USA in 2008, impacted the global trade?
a) Yes
b) No

During the global economic crisis of 2008, the USA saw a higher decline in _______.
Imports
Exports

In USA since 1960, the increase in ________ as a share of GDP has been greater than that of
_________.
a) Export, Import
b) Imports, Export

In 2014, UK stands _______ on the list of world’s largest exporter

a) 2
b) 3
c) 5
d) 10

In 2014, China stands _______ on the list of world’s largest Importer.

a) 2
b) 3
c) 5
d) 10
Which of the following is not a Factors Affecting Costs of International Trade?
a) Transportation Costs
b) Tariff or Other Restrictive Costs
c) Transaction Costs
d) None of the above
 Globalization of Production

__________refers to the "sourcing of goods and services from locations around the globe to
take advantage of national differences in the cost and quality of factors of production like land,
labour, and capital"
a) Globalization of Trade
b) Globalization of Capital
c) Globalization of production
d) None of the above

The sourcing of goods and services worldwide may be accomplished by _____

a) Outsourcing
b) Foreign direct investment
c) Both of the above
d) None of the above

__________ is the business practice of hiring a party outside a company to perform services for
your company
a) Outsourcing
b) Foreign direct investment
c) Both of the above
d) None of the above

Which of the following is not a risk associated to outsourcing?

a) Loss of Control
b) Loss of Innovation
c) Loss of Organizational Trust
d) None of the above

A _____ is an investment made by a firm or individual in one country into business interests
located in another country
a) Outsourcing
b) Foreign direct investment
c) Both of the above
d) None of the above

Are FDI and FPI alike?

a) Yes
b) No

Which of the following is not a risk associated to FDI?

 a) Political risks
b) Transfer risks
c) Exchange rate risks
d) None of the above

Globalization of Capital Markets

_________ are venues where savings and investments are channelled between the suppliers
who have capital and those who are in need of capital.
a) Bond markets
b) Currency market
c) Capital markets
d) None of the above

Capital markets are composed of _________

a) Primary markets
b) Secondary market
c) Both of the above
d) None of the above

Eurodollarsare created when a U.S. dollar deposit is made outside the United States and is
maintained in U.S. dollars
a) True
b) False

Which of the following is not a benefit of global financial market?

a) Providing the borrower with funds so as to enable them to carry out their investment
plans.
b) Providing the lenders with earning assets so as to enable them to earn wealth by
deploying the assets in production debentures.
c) Providing liquidity in the market so as to facilitate trading of funds
d) None of the above

Net international investment position of USA has ________ over last 22 years.
a) Improved
b) Diminished
c) Same as before
d) None of the above

Globalization and Power Shifts

The U.S. share of world output is projected to continue to ______.
a) Increase
b) Decline
c) Remain Unchanged
d) None of above

The declines in economies that lost share in world trade, were due to the result of absolute
decreases in economic activity of those countries and not because of greater economic growth
in other countries.
a) True
b) False

Who exported the highest in 2008?

Germany
USA
China
None of the above

Who exported the highest in 2012?

a) Germany
b) USA
c) China
d) None of the above

In 1980, U.S. firms accounted for almost ________% of the total stock (accumulated value) of
foreign investments made
a) 30
b) 40
c) 50
d) 60

In 2005, U.S. firms accounted for less than________% of the total stock of foreign investments
made.
a) 20
b) 30
c) 40
d) 50

During 2010, the three largest FDI investing countries were the United States, Germany, and
France
a) True
b) False
In 2009, ________% of the Fortune Global 500 were headquartered in the United States.
a) 25
b) 27
c) 28
d) 30

Becoming Global

Which of the following is the Disadvantage of Export?

a) Exporting Depleting resources like crude oil, minerals, ores Countries will lose valuable
resources which can never be replenished.
b) Export products are subject to quality standards any bad quality products which are
exported will result in Country reputation and remarks on countries.
c) Low Value Addition Exports will be earning less Foreign exchange
d) All of the above

Which of the following is the disadvantage of Import?

a) Import can help Countries to access best technologies available and best products
and services in the world.
b) Cheap resourcing of products can be possible through Imports by globally
Procurement goods and services.
c) . unemployment may increase.
d) Imports can improve countries Standard of living of people of that country

A ________ agreement gives a licensee rights to use a product that the licensor already owns.
a) Licensing
 b) Leasing
c) Both
d) None

___________ is a form of business by which the owner (franchisor) of a product, service or

method obtains distribution through affiliated dealers.
a) Factoring
b) Franchising
c) Both
d) None

A _____ is an entity that is established and jointly owned by two or more otherwise unrelated
entities. In an international context, at least one of the owners is located in the foreign country
where it is established
a) Factoring
b) Franchising
c) Joint Venture
d) None of the above

A _______ involves the home country entity owning 100% of a foreign entity over which it has
complete control.
a) Franchising
b) Joint Venture
c) wholly-owned subsidiary
d) None of the above
 INTRODUCTION TO BUSINESS STRATEGY

Outline of Unit
❑ Define the strategic planning process.

❑ Sequence of procedures which make up the planning process.

❑ Analytical techniques that can be used to facilitate the planning process.

INTRODUCTION
❑ Strategic planning provides purpose and direction for an entity.

❑ It involves an interrelated sequence of procedures, which constitute the

strategic planning process.
Definition
The sequence of interrelated procedures for determining an entity’s
long-term goals and identifying the best approaches for achieving those
goals.
Strategic planning process
❑ Establish the entity’s mission, values, and goals.

❑ Environmental scanning.

❑ Establish objectives.

❑ Formulate strategies.

❑ Implement strategies.

❑ Evaluate and control strategic activities.

Establish the entity’s mission, values, and goals.

Mission statement:-
❑ An expression of the purpose and range of activities of entity.

For example: Apple mission is to bringing the best user experience to its
customer through its innovative hardware, software and services.
Entity values:-
❑ The implicit beliefs that govern the operations of an entity and the
conduct of its relationship with the other parties.

❑ For example: In a memo, management defined Apple values as “the

qualities ,customs , standards and principles that the company as a
whole regards as desirable. They are the basis for what we do and how
we do”.

Goals:-
❑ The desired outcomes or conditions an entity seeks to achieve.

❑ It related to such factors as profitability growth, market share, etc.

 Environmental scanning.
➢ Assessing the entity and the environment in which it operates, which
include three things:-

I. Analyzing the external macro environment

II. Analyzing the industry

III. Analyzing the internal strengths and weaknesses of the entity; external
opportunities and threats.

I. Analyzing the external macro environment in which it

operates

✓ PEST analysis provides a framework for this environmental analysis.

• P-Political factors

• E-Economic factors

• S-Social factors

• T-Technology factors

II. Analyzing the industry in which entity operates.

• The five forces framework was developed by Michael Porter
which is helpful to analyze the industry.
• This is helpful to determine the nature, operating
attractiveness, long run profitability, etc.

III. Analyzing the internal strengths and weaknesses of the

entity; external opportunities and threats

For this SWOT analysis can be done by entity, SWOT stands for;
S-strengths
W-weaknesses
O-opportunities
 T-threats

Establish objectives.
• Establishing objectives is the process of deciding specifically what entity
wants to accomplish in order to achieve its goals.

• Objective should be formulated so that they meet the SMART test ; they
must be

• Specific

• Measurable

• Attainable

• Relevant

• Time bound

Formulate strategies
• Specific strategy formulated will be unique to the entity for which the
strategy is established.

• Three entity-independent generic strategies have been identified by

Michael porter:

✓ Cost leadership

✓ Differentiation

✓ Focus

Implement strategies
• Strategies provide guidelines for determining operating activities but do
not directly determine the specific operating activities to be undertaken
to carry out the strategies.
 • When an entity implements a strategy that other entities are unable to
duplicate, or finds it too costly to imitate, the strategy provides a
competitive advantage.

Evaluate and control strategic activities

I. Determine performance characteristics to evaluate and measure.

II. Establish target values for performance characteristics.

III. Measure performance characteristics.

IV. Compare measured characteristics with target values.

V. Implement changes in activities as needed.

Thank you

Industry analysis

INTRODUCTION
❑ An entity must assess the nature of the competition it faces in its
industry.

❑ Michael porter’s five forces model provides a means of carrying out

such a micro-environmental analysis.

OUTLINE OF UNIT
❑ Understand micro environment analysis which relates to industry.
 ❑ Describe the purpose of industry analysis.

❑ Identify and analyze elements of industry important to entity.

INDUSTRY DEFINITION:-
• An industry may defined as group of entities that produce goods or
provide services which are close substitutes and which compete for the
same customer.

Following are the Five points which have to consider at the time of Industry
analysis.
1) THREAT OF ENTRY INTO THE MARKET BY NEW COMPETITION

❑ The new entrants mostly depends on the barriers to entry into the
industry.

I. Economies of scale.

II. Capital investment required.

III. Access to raw material technology and suppliers.

IV. Access to distribution channels.

V. Customer loyalty and their switching cost.

VI. Respond by existing firms in industry.

VII. Government regulations.

2) THREAT OF SUBSTITUTE GOODS AND SERVICES

❑ The level of threat posed by substitute depends on following factors

a. Availability of substitute

b. Price of substitute

c. Performance of substitute

d. Ease of substitution
 e. Buyer’s loyalty and cost of switching to other supplier

(3)BARGAINING POWER OF BUYERS

❑ Bargaining power of buyers depends on following factors:-

1. Standard product.

2. Number of supplier.

3. Few dominant buyers.

4. Information about goods and services.

5. Cost of switching to other supplier.

(4)BARGAINING POWER OF SUPPLIERS

❑ Bargaining power of supplier depends on following factors:-

i. Substitute inputs.

ii. Number of suppliers.

iii. Power of supplier.

(5)INTENSITY OF RIVALRY
It depends on following factors:-
Structure of competition
Exit barriers
Degree of product differentiation
Customer switching cost
Industry cost structure
Entities strategy
 GENERIC STRATEGY
OUTLINE OF UNIT
• Describe factors that come into play in formulating strategy.

• Identify and describe three generic strategies.

• Characteristics of generic strategy and how each of generic strategies

may be achieved.

INTRODUCTION
❑ After understanding of the characteristics of macro environment and
also industry in which entity operate or may operate, and also the
relationship between an entity and external environment, an entity can
formulate its basic strategy.

❑ Michael porter has identified three industry-independent generic

strategies.

Generic strategies
• Cost leadership strategy

• Differentiation strategy

• Focus strategy

Cost leadership strategy

• Under this strategy, an entity will seek to be the low cost provider in an
industry for a given level of output.

• Entities acquire or maintain cost advantage by:

A. Identifying and avoiding unnecessary costs

B. Improving process efficiency

C. Access to lower cost inputs

D. Using outsourcing
 E. Pursuing vertical integration

Characteristics of cost leadership entities

❑ High level of expertise in manufacturing process.

❑ High level of skill in designing products.

❑ Efficient channels for distribution.

❑ Availability capital to invest in production.

❑ Logistical assets to keep cost low.

TECHNIQUES

❑ LEAN MANUFACTURING

❑ SUPPLY CHAIN MANAGEMENT

❑ PROCESS REENGINEERING

1. LEAN MANUFACTURING

❑ The identification and elimination of waste in production process

❑ Improve product design

❑ Increase production flexibility

❑ Reducing production time

❑ Other defects

2. SUPPLY CHAIN MANAGEMENT

❑ Improving flow of goods

❑ Improving Flow of information

❑ It requires coordination and information sharing among entities in the
entire supply chain.

3. PROCESS REENGINEERING

❑ For improvement in performance and cost reduction major redesign

of exiting process

RISK:-
• The possibility that other entities will be successful in adopting this
strategy.

• The possibility that other entities able produce at even lower cost with
help of new technology.

• The possibility that a number of firms may focus on segments of the

industry and be able to separately achieve lower cost in each those
segments.

DIFFERENTIATION STRATEGY
• This strategy where entity develops products or services that offer
unique features from its competitors in the industry.

• An entity develops a product or services with good and uniqueness will

allow the entity to charge a premium price.

• For maintain differentiation by providing goods or services that have

special or unique:

✓ Features

✓ Function

✓ Durability

✓ Service support
 CHARACTERISTICS OF ENTITIES FOLLOWING DIFFERENTIATION
STRATEGY
• Highly creative and skilled product/services development personnel.

• Leading scientific and market research capabilities.

• Strong marketing and sales personnel.

• A reputation for innovation, quality, and service.

TECHNIQUES
• Market research

• Continuous improvement of its product and processes

• Strict quality control

• Customer oriented services

• New product development

• High level of employee training

RISKS
• Changes in customer preferences or economic status

• Threat of competitors

• The possibility that a number of firms may focus on segments of the

industry and be able to separately achieve greater differentiation cost in
each those segment.

FOCUS STRATEGY
• In this strategy, an entity will focus on a cost advantage or
differentiation.

• The entity may pursue a “quick response approach”

✓ First to bring a product to market.

✓ Providing quick delivery.

• In this strategy, an entity will focus on a cost advantage or

differentiation.

• The entity may pursue a “quick response approach”

✓ First to bring a product to market.

✓ Providing quick delivery.

CHARACTERISTICS OF ENTITIES FOLLOWING DIFFERENTIATION

STRATEGY
• Outstanding market research

• Ability to tailor product or service development strength to the target

subgroup.

• Higher level of customer satisfaction and loyalty.

RISKS
• Typically, smaller size, lower volume and less bargaining power with
suppliers.

• Risk of competitors.

• Changes in targeted customers preference or economic status.

Thank you
 MACRO-ENVIRONMENT ANALYSIS
OUTLINE OF UNIT
❑ Understand macro-environment analysis.

❑ Describe the purpose and characteristics of macro environment.

❑ Identify elements of macro environment important to entity.

INTRODUCTION
❑ An entity will operate in economic system of a particular country and in
a particular market structure.

❑ Within that context, the entity must assess the characteristics of its
macro-environment.

➢ PEST analysis provides a framework for carrying out such an

external macro-environment analysis.

• P-Political factors

• E-Economic factors

• S-Social factors

• T-Technology factors

❖ Its purpose is to provide an understanding of those elements of an

environment typically a country or region, in which a firm operates or is
considering operating.

POLITICAL FACTORS
❑ Political factors-concerned with the nature of political environment and
the ways and the extent which government intervenes in its economy,
including consideration of such things as:

I. Political stability
 II. Labor laws

III. Environment laws

IV. Tax policy

V. Trade restrictions, tariffs, and import quotes

ECONOMIC FACTORS
❑ Economic factors-concerned with the economic characteristics of the
operating environment including consideration of such things as:

I. Economic growth rate

II. Interest rates

III. Inflation rates

IV. Currency exchange rates

SOCIAL FACTORS
❑ Social factors-concerned with the culture and values in operating
environment including consideration of such things as:

I. Population growth rate

II. Age distribution

III. Educational attainment and career attitudes

IV. Health and safety

TECHNOLOGY FACTORS
❑ Technology factors-concerned with the nature and level of technology in
operating environment including consideration of such things as:

I. Level of research and development activity

II. State of automation capability

III. Level of technological “savvy”

IV. Rate of technological change

Variation in basic PEST model PESTEL

• It includes

✓ E –environmental factors

✓ L –legal factors

E-environmental factors which include

✓ Weather

✓ Climate and climate change

✓ Water and air quality

L-legal factors which include

✓ Discrimination law

✓ Consumer law

✓ Employment law

✓ Antitrust law

✓ Health and safety law

STEER another variation

➢ Socio-culture factors
Technological factors
Economic factors
Ecological factors
Regulator factors

IMPORTANCE
❑ The factors assessed will be unique to each analysis.

❑ It helps to establish of operation in anew foreign location

❑ The outcome of PEST analysis provides inputs for SWOT analysis.

Thank you
 Section C
Financial
Management
 Concepts and Tools
Cost Concept
Introduction
Cost is the financial proportion of an asset; it is the cash sum paid or
commitment brought about for goods or services. Costs are bifurcated into
various types and classification in order to take business decisions. Few of
these costs are essentially important for financial management of business.
Different costs are considered while taking long term or short term decision
for the business.
Economic concept or Accounting Concept
Cost and expense are two different things. Cost are resources given up to
achieve an objective. Expenses are costs that have been charged against
revenue in a specific accounting period. “Cost” is an economic concept and
“Expense” is an accounting concept. A Cost need not be an expense, but every
expense was a cost before it became an expense. As described in the FASB
Statement of Concepts No. 6, “ … the value of cash or other resources given up
(or the present value of an obligation incurred) in exchange for a resource
measures the cost of the resource acquired.” Cost is the amount paid for a
resource (or asset), expense is amount of resources that has been used up.
While cost and expense for a resource may occur simultaneously and of same
amount, amount of Cost and expense for the same resource in short term may
be different in cases where resource (or asset) are used in business for more
than one accounting period. In long run Cost and expense will be equal but
amount may be different within a fiscal period. Concept of cost is more
important for most financial management decision than expenses.
Example: Sandra INC has purchased machinery worth $100000 which have
useful life of 4 years. In year 1, cost is $100000 but expense which is
depreciation expense is $25000. Company incurred $10000 for wages. Cost
and expense of wages would be $10000.
Types of Cost
1) Sunk Cost
 Sunk cost are costs that have already been incurred and cannot be
recovered hence they cannot be changed by current or future decisions.
Sunk cost are irrelevant in any decision making process because they
have already been incurred and no present or future decision can
change that fact.
Example: A company entered into an irrevocable lease agreement of 99
years for a property. In this case, for any manager, rent expense would
classify as sunk cost.

2) Opportunity cost
An opportunity cost is a type of implicit cost. “Opportunity Cost” is an
economic term, and opportunity cost is considered an economic cost.
Value of benefits received from next best alternative as a result of
choosing one alternative. As economic resources are limited,
organization has to choose alternative from various opportunities
available. Opportunity cost is revenue or benefit which would have been
derived from the next best alternative not selected, is the cost
associated with the selected alternative. It does not involve actual cash
transaction, but opportunity cost is relevant in current decision making.
Anytime money is invested or used to purchase something, the potential
return from the next best use of that money is lost. Many times lost
income is interest income. If money were not used to invest or purchase
something, it could be invested and interest could be earned.
Example: When company is considering one of the investment proposal
opportunity cost would be if investment proposal is not considered in
that case amount will be either invested or would be used to reduce
debt i.e either it will increase interest income or will reduce interest
expense (If company is having debt)

3) Differential or Incremental cost

When there are two or more proposals, in that case expenses that are
not same in all proposals will be relevant in decision making. All those
cost which are same in all proposals will be irrelevant for decision
making.
Example: while considering replacement of existing machinery in
Capital Budgeting, incremental cost and revenue would be relevant for
the decision making.

Cost of Capital

Various form of Long term sources of funds required in financing the

firm’s assets comprises the firm’s capital structure. Various types of
sources are long term debt, preferred stock and common stock. These
various sources are associated with respective cost using each element
of capital structure.

Cost of Debt
Cost of debt is the interest rate demanded by investors, adjusted for tax.
Adjustment for taxes is made because interest is a tax deductible
expense. This is the rate of return that must be earned in order to
attract and retain lender’s fund. Required rate of return would be
determined by the risk associated with the organization. Various risk
factors include level of interest in the general market, credit risk of firm,
interest rate risk, inflationary rate risk, etc.
From Investor’s point of view, risk and return relationship follows high
risk – high return, low risk – low return. Debt is less risky than equity so
required rate of return on debt is less than common stock and preferred
stock.
Because of the tax deductibility of interest and the lower inherent risk
in bonds than in equity sources, bonds are usually the least expensive
source of financing. While raising funds from debt, a firm must balance
the tax benefit of debt against the cost of financial distress.

Cost of Preferred stock

Preferred stock are considered riskier than debt but less risky than
common equity. It has characteristics of both debt and equity. Rate of
return on preferred stock is higher than debt and lower than equity.
Because preferred dividends are a distribution of income and not an
expense, they are not tax-deductible. Therefore, calculation of the cost
of preferred stock does not include an adjustment for taxes.
Cost of Common stock
Required rate of return on common stock will be calculated based on
certain factors such as expected dividends, price appreciation. Common
stock are considered to be riskier than debt and preferred stock hence
its required rate of return is higher than debt and preferred stock.

Important points to be considered in Cost of capital

1. Opportunity Cost
Opportunity cost is the expected return that the investors could earn
while investing in the next best alternative comparable investment
available. Organization, in order to attract and retain capital from
investors, must earn and be prepared to pay at least expected return
available to investor from the next best comparable investment
elsewhere in the capital markets.

2. Cost of Capital
Cost of capital is calculated for each of the element of capital
structureand these rates are used for analytical purpose however
more commonly average cost of capital is used for organization’s
analytical purpose. As income and cash flow are considered in total
for whole organization, it would be difficult to associate income to
separate element of capital. So weighted average cost of capital
would be considered proper in order to take analytical decisions for
the organization.

Weighted average cost of capital (WACC)

WACC is calculated as sum of cost of capital of each element
weighted with their respective proportion in the total capital.
Example: Consider following information
Particulars Amount ($) Cost of Capital Weight Weighted
(1) (2) (3) (4) cost of capital
(5) = (3) * (4)
Debt 300000 8% 30% 2.4
Preferred 200000 10% 20% 2
equity
Common 500000 12% 50% 6
stock
Total 10,00,000 10.40%
In the above example, we have calculated weight (column – 4) is
calculated as portion of each element divided by total capital of the
firm.
Weight of debt = $300000 / $10,00,000 *100 = 30%
Weight of Preferred equity = $200000 / $10,00,000 *100 = 20%
Weight of Common stock = $500000 / $10,00,000 * 100 = 50%
Hence, weighted average cost of capital = 10.40%

Weighted average cost of capital can be used by firm in

circumstances where overall entity is involved, in situation where
separate business units are involved and these units have different
risk characteristics, or company is involved in separate projects then
in that case weighted average cost of capital of overall entity will not
be much useful but weighted average cost of capital for the units or
separate projects can be considered in such cases.

Cost of capital is the minimum rate of return company is required to

earn in order to fund their lenders or investors. For increasing value
to common shareholders, company must earn more than cost of
capital as cost of capital is the minimum rate of return to be earned
in order to survive. Hence cost of capital is also used as hurdle rate
when analyzing firm’s investment proposals. It can also be used as
discount rate for various finance decisions for the company.
 TIME VALUE OF MONEY
KNOWLEDGE POINTS:

The understanding of interest and related phrases and its calculation

Differentiation between compound and simple interest

The understanding of discounted value and Compounded value

The understanding of recurring, (annuity)

Determination of yields

Determination of CAGR i.e. Compound Annual Growth Rate

Valuation of Security, Capital Expenditure and Leasing and role of present value concept in such valuation

SUMMARY:
 Interest

Effective
Simple Compound Annuity
Rate of
Interest Interest
Interest

Annuity
Applications Sinking Types
of Annuity Funds
Cash Flow in the
Cash flow at
beginning or at
Capital the end of
the start of the
Valuation of
Leasing
Expenditure Period a
Bond (Investment Period
Decision)

Future value Present value

Future value Present value
of the annuity of annuity
of annuity due of annuity due
regular regular

INTRODUCTION:

Individuals earn money to fulfill their routine necessities such as education,

food, clothes, housing, entertainment etc.After fulfilling these necessities,
there are two possibilities. Either individuals may have excess money
resulting into savings or occasionally additional expenditures (such as
marriage function, vehicle purchase or fund requirement in business) have
also to be taken care of. Few individuals are able to put aside fundsto meet
such expected or unexpected additional expenditures. However, most of the
times, one has to borrow money to meet such contingencies. From where one
can borrow money?
Money can be borrowed from financial institutions or relatives. If one can
accommodate a loan fromrelatives it might be interest free but if one borrows
money from financial institutions,one will have to incur some additional cost
periodically for availing money of money lenders or financial institutions. This
additional cost is known as interest.
Now, if we discuss about the alternate scenario, individuals may invest their
savings in bank deposits or debentures or lend to other person. In this way
they can earn interest on their investment.
Interest can be defined as the cost paid by the user of funds(borrower) for the
use of a lender’s money.
WHY IS INTEREST PAID?:

Why lenders charge interest for the use of their funds? There are a various
reasons as per below discussion.

Liquidity
Priorities

Opportunity
Risk Element
Cost

Time value
Inflation
of money

A) Liquidity Priorities: People opt to have their financial resources available

in a form that can easily and immediately be converted into cash rather
than a form which takes time or money to realize.
B) Risk Element: There is an inevitable risk that the borrower will default on
the borrowing or go insolvent. Risk is a considerable factor in deciding of
rate of interest.A lender usually charges higher risk premium (interest
rate) for taking higher risk.
C) Time value of money: Time value of money means that the value of a unit
of money is distinct for distinct time phases. The amount of money
received toady is more valuable than what it will be in future. I.e. the
present worth of money received today is more than money received after
some time. As money received today has more value, a prudent investor
would desire current receipts over future receipts. If one postpones one’s
receipts; one will definitely require some additional money i.e. interest.
D) Inflation: Globally, most of the economies normally demonstrate inflation.
Inflation decreases purchasing power of money. Because of inflation a
 particular amount of money buys fewer goods in the future than it can buy
at present moment. The borrower is required to compensate the lender for
this.
E) Opportunity Cost: The lender has an option between investing his money
in various investments. If he selects one, he sacrifices the return from rest.
It can be said that lender bears an opportunity cost due to the probable
alternative uses of the lent money.

DEFINITION OF INTEREST AND SOME OTHER RELATED TERMS:

A) Principal:Principal is initial amount of borrowing (or lending) of funds. If

you borrow money; the amount of initial borrowing is termed as principal.
Let say, you lend (or borrow) $ 1,00,000 to a person for a year. $ 1,00,000
in this illustration is the ‘Principal.’ Let say, you borrowed $ 2,00,000 from
a financial institution for one year. In this illustration $ 2,00,000 is the
‘Principal’.
B) Rate of Interest (ROI):The rate (generally on yearly basis) at which the
interest is charged for a particular time span for use of principal is called
the ROI. Rate of interest is commonly expressed in terms of percentages.
Let say, you invest $ 10,000 in your bank account for one year with the
interest rate of 12.5% per annum (Per annum means for a year). It means
you would earn $ 12.5 as interest every $ 100 of principal amount in a year.
C) Interest:Interest is the charge paid by a borrower for availing the lender’s
funds.
If one borrows some money from a person for a specifiedtime span;one
would pay extra money than one’s initial borrowing. This additional money
paid can be termed interest. Let say, you borrow $ 1,00,000 for a year and
you pay $ 1,10,000 after one year the difference between initial borrowing
of $ 1,00,000 and end payment $ 1,10,000 i.e. $ 10,000 is the amount of
interest you paid.
If one lends some money to a person for a specified time span;one would
receive extra money than one’s initial lending. This additional money
received can be termed interest. Let say, you lend $ 2,00,000 for a year and
you receive $ 2,20,000 after one year the difference between initial lending
 $ 2,00,000 and receipts $ 2,20,000 i.e. $ 20,000 is the amount of interest
you earned.
D) Accumulated amount (or Balance):

Principal Interest Accumulated

Amount
Amount Earned (Balance)

Accumulated amount is the maturity amount of deposit. It is the sum total

of principal amount and interest earned. It is also known as the balance or
maturity amount of deposit.
Let say, you deposit $ 1,00,000 in your bank for one year with an interest
rate of 10% p.a. you would earn interest of $ 10,000 after one year.
(1,00,000 × 10 %) Method of finding interest will be explained later). After
one year you will get $ 1,10,000 (principal+ interest), $ 1,10,000 is
accumulated amount here.
SIMPLE INTEREST AND COMPOUND INTEREST:

Interest
accrues as

Simple Compounding
Interest or Interest

Simple Interest:

The given topic will help us to learn the concept of simple interest and the
technique tocalculate simple interestand accrued amount for an investment
(principal) with a simple interest rate over a particular time span.
The money that you invest is calledprincipal and the additional money that
you receive for investing your money is calledinterest.
The interest received for investing $ 500 for one year is called the rate
percent per annum. Hence, if amount is invested at the rate of 5% per annum
then the interest received for investing $ 500 for one year is $ 25. The
aggregate of principal and interest is called the amount.
The interest you receive is proportionate to the amount that you invest and
also to the time span for which you invest the amount; the higher the amount
and the time, the higher the interest. Interest is also proportionate to the rate
of interest agreed upon by the investor and the investee. Thus interest
changes in proportion with principal amount, time span and rate of interest.
Simple interest is the interest calculated on the principal for the entire period
of investment. It is computed only on the outstanding principal amount and
not on interest previously earned. It means interest is not received on interest
earned during the tenure of investment.
Simple interest can becalculated byusing following formulas:
I = Pit
A=P+I
= P + Pit
= P(1 + it)
I=A–P
Where,
A = Accumulated amount (final value of an investment)
P = Principal (initial value of aninvestment)
i = Annual interest rate in decimal.
I = Amount of interest
t = Time in years
Following illustrations will help us to observe how exactly these
components are related.
Question 1: How much interest will be earned on $ 1,000 at 5% simple
interest for 3 years?
Answer:I = P × i × t
5
= $ 1,000 × × 3
100

= $ 150
Question 2: Mary deposited $ 10,000 in a bank for 3 years with the interest
rate of 10% p.a. How much interest would she earn?
Answer: I = P × i × t
10
= $ 10,000 × × 3
100

= $ 3,000
Question 3: In Question 2 what will be the final value of investment?
Answer: A = P + I
= $ 10,000 + $ 3,000
= $ 13,000
Question 4:Malcom deposited $ 2,00,000 in his bank for 3 years at simple
interest rate of 10%. How much interest would he earn? How much would be
the final value of deposit?
Answer: (a) required interest amount: I = P × it
10
= $ 2,00,000 × × 3
100

= $ 60,000
(b) Final value of deposit: A = P + I
= $ 2,00,000 + $ 60,000
= $ 2,60,000
Question5: Find the rate of interest if the amount owed after 6 months is $
11,000 borrowed amount being $ 10,000.
Answer: A = P + Pit
i.e. $11,000 = $10,000 + $10,000 × i × 6/12
1,000 = 5,000 i
i = 1/5 = 0.2 i.e 20%
Question6: Ronald invested $ 10,000 in a bank at the rate of 10% p.a. simple
interest rate. He received $ 13,500 after the end of term. Find out the period
for which sum was invested by Ronald.
Answer: A = P (1+it)
 10
$ 13,500 = $ 10,000(1 + × 𝑡)
100
100+10𝑡
$ 13,500 / $ 10,000 =
100
$13,500∗100
– 100 = 10t
$10,000

35 = 10t
t = 3.5∴time = 3.5 years
Question7: Kens deposited some amount in a bank for 5 years at the rate of
10% p.a. simple interest. Kens received $ 1,50,000 at the end of the term.
Compute initial deposit of Kens.
Answer: A = P(1+ it)
10
$ 1,50,000 = P(1 + × 5)
100
50
$ 1,50,000 = P(1 + )
100

$ 1,50,000 = P (1 + 0.5)
$ 1,50,000
P=
1.5

P = $ 1,00,000∴ Initial Deposit of Kens = $ 1,00,000

Question8: A sum of $ 46,875 was lent out at simple interest and at the end of
2 years4 months the total amount was $ 55,625. Find the rate of interest
percent per annum.
Answer: A = P (1 + it)
4
$ 55,625 = $ 46,875(1 + 𝑖 ∗ 2 )
12
7
$ 55,625 / $ 46,875 = 1 + i
3
3
(1.1867 – 1) x = i
7

i = 0.08∴Rate = 8%
Question9: What sum of money will produce $ 1,68,750 as an interest in 6
years and 9 months at 5% p.a. simple interest?
Answer: I = P × it
 5 9
i.e. $ 1,68,750 = P x x6
100 12
5 27
$ 1,68,750 = P x x
100 4
135
$ 1,68,750 = P x
400
400
P = $ 1,68,750 ∗
135

P = $ 5,00,000
∴$ 5,00,000 will produce $ 1,68,750 interest in 6 years and 9 months at 5%
p.a. simple interest.
Question10: In what time will $ 10,000 amount to $ 30,000 at 10 % p.a. ?
Answer: A = P (1 + it)
10
$ 30,000 = $ 10,000 (1 + 𝑡)
100
$ 30,000 100+10𝑡
=
$ 10,000 100

$ 30,000
10t =[ ∗ 100] – 100
$ 10,000
200
t= = 20
10

∴In 20 years $ 10,000 will amount to $ 30,000 at 10% p.a. simple interest rate.
TEST BANK / SELF STUDY QUESTIONS - 1:

Select the correct option.

1. Simple Interest on $ 1,000 for 2 years at 10% per annum is
(a) $ 200 (b) $ 260 (c) $ 160 (d) none of these
2.P = 1,000, R = 10, T = 2½ using I = PRT/100, I will be
(a) $ 375 (b) $ 300 (c) $ 250 (d) none of these
3.If P = 1,000, T = 2, I = $ 100, R will be
(a)4% (b) 5% (c) 6% (d) none of these
4.If P = $ 1,000, A = $ 1,500, than Simple interest i.e. I will be
(a) $ 200 (b) $ 300 (c) $ 500 (d) none of these
5.P = $ 10,000, A = $ 14,500, T = 4.5 years. Rate percent per annum SI will be
(a) 15% (b) 12% (c) 10% (d) none of these
6. P = $ 1,000, I = $ 360, R = 12%, the number of years T will be,
(a) 1 ½ years (b) 2 years (c) 3 years (d) none of these
7.P = $ 10,000, A = $ 15,500, R = 15% SI, t will be.
(a) 3 years8 months (b) 3 yrs. (c) 2.5 years (d) none of these
8.The sum required to earn a monthly interest of $ 1000 at 15% per annum SI
is
(a) $ 50,000 (b) $ 60,000 (c) $ 80,000(d) none of these
9.A sum of money amount to $ 7,315 in 2 years and $ 8,222.5 in 3 years. The
principal and the rate of interest are
(a) $ 5,500, 16.5% (b) $5,500, 16% (c) $ 5,000, 15%(d) none of these
10.A sum of money doubles itself in 5 years. The number of years it would
triple itself is
(a)20 years (b) 15 years(c) 10 years(d) none of these
Compound Interest:

Now we understandthat if the principal remainsidentical for the entire time

span then such interest is known as simple interest.
However,practicallybanks, financial institutions, Insurance corporation and
other deposit taking andmoney lending companies do notcompute interest in
this manner. To understand practicalapproachused by such financial
organizations, we shall study an example.
Suppose you deposit $ 1,00,000 in Citi Bank for 2 years at 10% p.a.
compounded yearly. Interest will be calculated in the following way:
INTEREST FOR FIRST YEAR
I = Pit
10
= $ 1,00,000 x x1
100

= $ 10,000
INTEREST FOR SECOND YEAR
For computing interest for second year principal will not be the original
deposit. Principal for computing interest for second year will be the original
deposit plus interest for the first year. Therefore principal for computing
interest for year two would be:
=$ 1,00,000 + $ 10,000
=$ 1,10,000
10
Interest for the year two = $ 1,10,000 × x1
100

= $ 11,000
Total interest Income = Interest for year one + Interest for year two
= $ 10,000 + $ 11,000= $ 21,000
This interest is $ 1,000higher than the simple interest on $ 1,00,000 for two
years at 10% p.a. It can be observed that this addition in interest is due to the
fact that the principal for the second year was higher than the principal for
first year. The interest computedas per this way is termed compound interest.
So, the compound interest can be defined as the interest that accrues when
earnings for each specified time span plus the principal, so expanding the
principal amount on which future interest is calculated.
Question11: Mr. Cook deposited $ 10,000 in a financial institution for 3 years.
If the rate of interest is 10% p.a., calculate the interest that financial
institution has to pay to Mr. Cook after 3 years if interest is compounded
annually. Also calculate the amount at the end of third year.
Answer: Principal for first year $ 10,000
Interest for first year = Pit
10
= $ 10,000 x x1
100

= $ 1,000
Principal for the second year = Principal for first year + Interest for first year
= $ 10,000 + $ 1,000
= $ 11,000
 10
Interest for second year = $ 11,000 x x1
100

= $ 1,100
Principal for the third year = Principal for second year + Interest for second
year
= $ 11,000 + $ 1,100
= $ 12,100
10
Interest for the third year = $ 12,100 x x1
100

= $ 1,210
Compound interest at the end of third year
= $ 1,000 + $ 1,100 + $ 1,210= $ 3,310
Amount at the end of third year
= Principal (initial deposit) + compound interest
= $ 10,000 + $ 3,310= $ 13,310
Hence, after understanding above concepts, the coredifferentiation between
simple interest and compound interest can now be summarized. The core
differentiation between simple interest and compound interest is that in
simple interest the principal remains invariable throughout whereas in the
case of compound interest principal goes on revising at the end of specified
time span. For a specified principal, rate and time the compound interest is
normallyhigher than the simple interest.
Conversion period:

In the illustrationanalyzed above the interest was compounded annually i.e.

the interestwas computed on yearly basis. However practically, it is not
certain that the interest would be compounded annually in all cases. For
example, in financial institutions the interest is generally compounded
semiannually or half yearly (twice a year) i.e. interest is calculated and added
to the principal after every six months. In some banks interest is compounded
quarterly (four times a year). The period at the end of which the interest is
compounded is known as conversion period. The conversion period is said to
be of six months when the interest is computed and added to the principal
every six months. In this case number of conversion periods per annum would
be two. If the deposit orloan was for three years then the number of
conversion period would be six.Representative conversion periods are given
below:
Conversion Description Number of conversion
period period in a year
12 months Compounding Annually 1
6 months Compounding Semi 2
annually
3 months Compounding Quarterly 4
1 month Compounding Monthly 12
1 day Compounding Daily 365
Formula for compound interest:

Taking P as the principal, i (in decimal) as the rate of interest per conversion
period, n as the number of conversion period,An as the accrued amount after
n payment periods; we have accrued amount at the end of first payment
period:
𝐴1 = P + P i = P (1 + i);
at the end of second payment period
𝐴2 = 𝐴1 + 𝐴1 𝑖 = 𝐴1 (1 + 𝑖)
=P(1+i)(1+i)
= P(1 + 𝑖)2 ;
at the end of third payment period
𝐴3 = 𝐴2 + 𝐴2 𝑖
= 𝐴2 (1 + i)
= P(1 + 𝑖)2 (1 + i)
= P(1 + 𝑖)3
𝐴𝑛 = 𝐴𝑛−1 + 𝐴𝑛−1 𝑖
= 𝐴𝑛−1 (1 + i)
= P(1 + 𝑖)𝑛−1 (1 + i)
= P(1 + 𝑖)𝑛
Thus the accrued amount𝐴𝑛 on a principal P after n conversion periods at i (in
decimal) rate of interest per conversion period is given by
𝐴𝑛 = P(1 + 𝑖)𝑛
Where,
i = Annual Rate of Interest
n = Number of Conversion periods per year
Interest = 𝐴𝑛 − 𝑃 = 𝑃 (1 + 𝑖)𝑛 − 𝑃
= P [(1 + 𝑖)𝑛 − 1]
n is total conversions i.e. t x no. of conversions per year
Note: Calculation of A shall be quite simple with a calculator. However
compound interest table and tables for at various rates per annum with (a)
annual compounding; (b) monthly compounding and (c) daily compounding
are available.
Question 12: $ 20,000 is invested at annual rate of interest of 20%. What is
the amount after two years if compounding is done (a) Annually (b) Semi-
annually (c) Quarterly (d) Monthly?
Answer:
(A) Compounding is done annually
Here principal P = $ 20,000; since the interest is compounded yearly the
number of conversion periods n in 2 years are 2. Also the rate of interest per
conversion period (1 year) i is 0.20
𝐴𝑛 = P(1 + 𝑖)𝑛
𝐴2 = $ 20,000 (1 + 0.20)2
= $ 20,000 (1.2)2
= $ 20,000 x 1.44
= $ 28,800
(B)For semiannual compounding
n = 2 × 2= 4
0.20
i= = 0.10
2

𝐴4 = $ 20,000 (1 + 0.10)4
= $ 20,000 (1.4641)
= $ 29,282
(C)For quarterly compounding
n = 4 × 2= 8
0.20
i= = 0.05
4

𝐴8 = $ 20,000 (1 + 0.05)8
= $ 20,000 (1.4775)
= $ 29,550
(D)For monthly compounding
n = 12 × 2 = 24
0.20
i= = 0.0166
12

𝐴24 = $ 20,000 (1 + 0.0166)24

= $ 20,000 (1.4846)
= $ 29,692
Question13: Determine the compound amount and compound interest on $
10,000 at 12% compounded semi-annually for 8 years. Given that (1 + 𝑖)𝑛 =
2.54035 for i = 6% and n = 16.
0.12
Answer: i = = 0.06; n = 8 x 2 = 16
2

P = $ 10,000
Compound Amount (𝐴12 )= $ 10,000 (1 + 0.06)16
= $ 10,000 (2.54035)
= $ 25,403.5
Compound Interest = $ 25,403.5 - $ 10,000
= $ 15,403.5
Question14: Compute the compound interest on $ 40,000 for 2½ years at
12% per annum compounded half- yearly.
Answer: Here principal P = $ 40,000. Since the interest is compounded half-
yearly the numbers of conversion periods in 2½ years are5. Also the rate of
interest per conversion period (6 months) is 12% x 1/2 = 6% (0.06 in
decimal).
Thus the amount𝐴𝑛 (in $) is given by
𝐴𝑛 = P (1 + 𝑖)𝑛
𝐴5 = $ 40,000 (1 + 0.06)5
= $ 53,529.02
The compound interest is therefore $ 53,529.02 - $ 40,000= $ 13,529.02
To find the Principal / Time / Rate
The formula 𝐴𝑛 = P (1 + 𝑖)𝑛 connects four variables, 𝐴𝑛 ,P, i and n.
Similarly, C.I. (Compound Interest) = P [(1 + 𝑖)𝑛 − 1]connects C.I., P, i, and n.
whenever three out of these four variables are given the fourth can be found
out by simple calculations.
Question15: On what sum will the compound interest at 10% per annum for
two years compounded annually be $ 3,360?
Answer: Here the interest is compounded annually the numbers of
conversion periods in two years are 2. Also the rate of interest per conversion
period (1 year) is 10%.
n = 2 i = 0.10
C.I. = P [(1 + 𝑖)𝑛 − 1]
$ 3,360 = P [(1 + 0.10)2 − 1]
$ 3,360 = P (1.21 – 1)
$ 3,360
P= = $ 16,000
0.21

Hence the required sum is $ 16,000.

Question16: What annual rate of interest compounded annually doubles an
1
investment in 8 years? Given that2 = 1.090508.
8

Answer: If the principal be P then 𝐴𝑛 = 2P.

Since𝐴𝑛 = P (1 + 𝑖)𝑛
2P = P (1 + 𝑖)8
1
28 = (1 + 𝑖)
1.090508 = 1 + i
i = 0.090508∴Required rate of interest = 9.05% per annum
Question17: In what time will $ 80,000 amount to $ 96,800 at 20% per
annum interest compounded half-yearly?
20
Answer: Here interest rate per conversion period (i) = = 10% (0.10 in
2
decimal)
Principal (P) = $ 80,000
Amount (𝐴𝑛 ) = $ 96,800
𝐴𝑛 = P (1 + 𝑖)𝑛
$ 96,800 = $ 80,000 (1 + 0.10)𝑛
$ 96,800
= (1.10)𝑛
$ 80,000

1.21 = (1.10)𝑛
(1.10)2 = (1.10)𝑛
∴n = 2
Hence number of conversion period is 2 and the required time = n/2 = 2/2 = 1
year.
Question18: Find the rate percent per annum if $ 40,000 amount to $
64,420.4 in 2½ year interest being compounded half-yearly.
Answer:Here P = $ 40,000
Number of conversion period (n) = 2½ × 2 = 5
Amount (𝐴5 ) = $ 64,420.4
𝐴5 = P (1 + 𝑖)5
$ 64,420.4 = $ 40,000(1 + 𝑖)5
$ 64,420.4
= (1 + 𝑖)5
$ 40,000

1.61051 = (1 + 𝑖)5
(1.1)5 = (1 + 𝑖)5
i = 0.10
i is the Interest rate per conversion period (six months) = 0.10 = 10% &
Interest rate per annum = 10% × 2 = 20%
Question19:A certain sum invested at 6% per annum compounded semi-
annually amounts to $60,099.985 at the end of one year and six months. Find
the sum.
Answer:Here 𝐴𝑛 = $ 60,099.985
n = 2 × 1.5 = 3
i = 6% × 1/2 = 3% = 0.03
P(in $)=?
We have
𝐴𝑛 = P (1 + 𝑖)𝑛
𝐴3 = P (1 + 0.03)3
$ 60,099.985 = P (1.03)3
 $60,099.985
P= (1.03)3

= $ 55,000
Thus the sum invested is $ 55,000 at the beginning of 1 year and six months.
Question20: $ 32,000 invested at 20% p.a. compounded semi-annually
amounts to $ 46,851.2. Find the time period of investment.
Answer:Here P = $ 32,000
𝐴𝑛 = $ 46,851.2
i = 20 × 1/2 % = 10% = 0.10
n=?
We have 𝐴𝑛 = P (1 + 𝑖)𝑛
$ 46,851.2 = $ 32,000 (1 + 0.10)𝑛
$ 46,851.2
= (1.10)𝑛
$ 32,000

1.4641 = (1.10)𝑛
(1.10)4 = (1.10)𝑛
n = 4. Therefore, time period of investment is 4 half years i.e. 2 years.
Question21:Mr. A opened an account on April, 2019 with a deposit of $ 8,000.
The account paid 8% interest compounded quarterly. On October 1, 2019 he
closed the account and added enough additional money to invest in a 6 month
time-deposit for $ 10,000, earning 8% compounded monthly.
(i) How much additional amount did Mr. A invest on October 1?
(ii) What will the maturity value of his time deposit on April 1 2020?
(iii) How much total interest will be earned?
Given that (1 + 𝑖)𝑛 = 1.0404 for i=2% n = 2 and (1 + 𝑖)𝑛 = 1.04067262 for i =
2
%and n = 6.
3
Answer: (a) The initial investment earned interest for April-June and July-
September quarter
6
I.e. for two quarters. In this case i = 8/4 = 2% = 0.02, n[𝑛 = ∗ 4] = 2
12
and the compounded amount = $ 8,000 (1 + 0.02)2
= $ 8,000 x 1.0404
= $ 8,323.2
The additional amount invested = $ 10,000 - $ 8,323.2= $ 1,676.8
(b)In this case the time-deposit earned interest compounded monthly for six
months.
8 2 6
Here i = = % = 0.0066667n = 6 (𝑖. 𝑒. 12 ∗ 12)andP = $ 10,000
12 3

Maturity value = $ 10,000(1 + 0.006667)6

= $ 10,000×1.04067262
= $ 10,406.73
(c) Total interest earned = $ 323.2 + $ 406.73 = $ 729.93
EFFECTIVE RATE OF INTEREST:

If interest is compounded more than once a year the per annum interest rate
will be lesser thanthe effective interest rate for a year. Let say,Mr. A invests $
1,000 for a year at the rate of 8% per annum compounded semiannually.
Effective interest rate for a year will be greater than 8% per annum since
interest is being compounded more than once in a year. For calculating
effective rate of interest first we have to calculate the interest.
8 6
Interest for first six months = $ 1,000 × × = $ 40
100 12

Principal for computation of interest for next six months:

= Principal for first period + Interest for first period
= $1,000 + $ 40= $ 1,040
8 6
Interest for next six months = $ 1,040 × × = $ 41.6
100 12

Total interest earned during the current year

= Interest for first six months + Interest for next six months
= $ 40 + $ 41.6 = $ 81.6
Interest of $ 81.6 can also be calculated directly from the formula of
compound interest. Effective rate of interest can be calculated by following
formula.
I = PEt
Here I = Amount of interest
E = Effective rate of interest in decimal
t = Time period
P = Principal amount
Putting the values we have
$ 81.6= $1,000 × E × 1
$ 81.6
E=
$ 1,000

= 0.0816 or 8.16%

Frequency of
compounding of
interest rate

more than once in a

year (i.e.
Annually semiannually,
quarterly, monthly
or daily)

Actual Effective
Effective Actual
interest
> = interest >
interest
interest
rate p.a. rate
rate p.a.
Hence, effective interest rate can be defined as the corresponding annual
rate rate
of interest compounded yearly if interest is compounded more than once a
year.
The effective interest rate can be calculated with the help of formula given as
under:
E = (1 + 𝑖)𝑛 - 1
Here E is the effective interest rate
i = actual interest rate in decimal
n = number of conversion period
Question22: $ 1,000 is invested in a Term Deposit that fetches interest 8%
per annum compounded quarterly. What will be the interest after one year?
What is effective rate of interest?
Answer:I = P [(1 + 𝑖)𝑛 − 1]
Here P = $ 1,000
i = 8% p.a. = 0.08 p.a. or 0.02 per quarter
n=4
And I = amount of compound interest
Putting the values we have
I = $ 1,000 [(1 + 0.02)4 − 1]
= $ 1,000 (0.08243216)
= $ 82.43
For effective rate of interest using I = PEt we find
$ 82.43 = $ 1,000 × E × 1.
$ 82.43
E= = 0.0824 or 8.24%
$ 1,000

Note: We may arrive at the same result by using E = (1 + 𝑖)𝑛 - 1

E = (1 + 0.02)4 – 1
= 1.0824 – 1
= .0824 or 8.24%
It is essential to observe that effective rate of interest isrelated to the interest
rate and frequency of compounding the interest and not related to the
amount of principal.
Question23: Find the amount of compound interest and effective rate of
interest if an amount of $ 10,000 is deposited in a bank for one year at the rate
of 6% per annum compounded semiannually.
Answer: I = P [(1 + 𝑖)𝑛 − 1]
HereP = $ 10,000
i = 6% p.a.= 6/2 % semiannually = 0.03
n=2
I = $ 10,000[(1 + 0.03)2 − 1]
= $ 10,000 (0.0609)
= $ 609
Effective rate of interest:
I =PEt
$ 609 = $ 10,000 x E x 1
$ 609
E= = 0.0609 or 6.09%
$ 10,000

We can also calculate Effective rate of interest with the help of following
formula:
E = (1 + 𝑖)𝑛 - 1
= (1 + 0.03)2 – 1
= 0.0609 or 6.09%
Question24: Which is a better investment 6% per year compounded monthly
or 6.4% per year simple interest? Given that (1 + 0.005)12 = 1.06167781.
Answer: i = 6/12 = 0.5% = 0.005
n =12
E = (1 + 𝑖)𝑛 - 1
= (1 + 0.005)12 – 1
= 1.06167781 – 1= 0.0617 or 6.17%
Effective rate of interest (E) being less than 6.4%, the simple interest 6.4% per
year is the better investment.
TEST BANK / SELF STUDY QUESTIONS - 2:
Select the correct option.
1.If P = $ 5,000, R = 10% p.a., n= 6; whatis Amount and C.I.Is
(a)$ 8,857.81, $ 3,857.81 (b) $ 8,875.81, $ 3,857.81 (c) $ 8,857.81 $
3,875.81 (d)none of these
2. $ 500 will become after 10 years at 8% p.a. compound interest amount of
(a) $ 998.62 (b) $ 1097.46 (c) $ 1,079.46 (d)
none of these
3.The effective rate of interest corresponding to a nominal rate 6% p.a.
payable half yearly is
(a) 6.4% p.a. (b) 6.5% p.a. (c) 6.09% p.a. (d)
none of these
4.A machine is depreciated at the rate of 20% on reducing balance. The
original cost of the machine was $ 2,00,000 and its ultimate scrap value was $
60,000. The effective life of the machine is
(a) 4.5 years (appx.) (b) 5.4 years (appx.) (c) 5 years (appx.) (d)
none of these
5.If A = $ 1,500, n = 3 years, R = 8% p.a. compound interest payable half yearly,
thenprincipal (P) is
(a) $ 1,185.5 (b) $1,158.5 (c) $ 1100 (d) none of
these
6.The population of a town increases every year by 2% of the population at
the beginning of that year. The number of years by which the total increase of
population be100% is
(a) 27 years (b) 35 years (app) (c) 17 years (app) (d) none of these
7.The difference between C.I and S.I on a certain sum of money invested for 4
years at 8% p.a. is $ 323.91. The sum is
(a) $ 8,000 (b) $ 3,700 (c) $ 12,000 (d) $ 10,000
8.The useful life of a machine is estimated to be 15 years and cost $ 100,000.
Rate of depreciation is 15% p.a. The scrap value at the end of its life is
(a) $ 8,486.78 (b) $ 8,735.42 (c) $ 8,400 (d) none of
these
9.The effective rate of interest corresponding a nominal rate of 10% p.a.
convertible quarterlyis
(a) 10.83% (b) 10% (c) 10.5% (d) 10.38%
10.The C.I on $ 32,000 for 2½ years at 5% p.a. payable half -yearly is
(a) $ 4,520 (b) $ 4,502 (c) $ 4,205 (d) none of these
11. The C.I on $ 20,000 at 15% p.a. for 2 year when the interest is payable
quarterly is
(a) $ 6,894 (b) $ 6,489 (c) $ 6,849 (d) none of these
12.The difference between the S.I and the C.I on $ 4,800 for 3 years at 10% p.a.
is
(a) $ 144.8 (b) $ 188.4 (c) $ 184.8 (d) $ 148.8
13.The annual birth and death rates per 1,000 are 39.4 and 19.4 respectively.
The number of years in which the population will be doubled assuming there
is no immigration or emigration is
(a) 30 years (b) 35 years (c) 25 years (d) none of these
14. The C.I on $ 8,000 for 6 months at 15% p.a. payable quarterly is
(a) $ 611.25 (b) $ 611 (c) $ 611.52 (d) none of these
ANNUITY:
Meaning:Annuity can be defined as a series of periodic receipts (or
payments) recurrently over a particular time span.
To be termed as an annuity a sequence ofreceipts (or payments) must
haveattributes as mentioned hereunder:
(i) Amount received or (paid) must be consistent over the time span of
annuity and
(ii)Time gapamong two sequentialreceipts (or payments) must be identical.
Examples from practical scenario:
Payment of life insurance premium
Rent of house and
Repayment of housing loan, vehicle loan
Pension income
In all above cases a constant amount of money is paid or received regularly.
Time span between two sequential payments or receipts may be one month,
one quarter or one year.In all such cases annuity comes into the picture. When
a predeterminedsum of money is paid or received recurrently over a
particular time span it is known as annuity.
Perpetuity is nothing but a special kind of annuity. It is one where the
payment or receipt takes place constantly.Since the receipt is persistent,the
future value of perpetuity cannot be calculated. However, the present value of
the perpetuity can be calculated.
Refer following table.Can receipts / payments reflected in the table for 5 years
be termed annuity?
Year Receipts/ Payments($)
Column A Column B Column C
1 15,000 15,000 15,000
2 16,000 15,000 15,000
3 14,000 15,000 –
4 15,000 15,000 15,000
5 17,000 15,000 15,000
Receipts/ Paymentsshown in Column A cannot be called annuity.
Receipts/Payments though have been made at regular intervals but amount
paid are not identical over the period of five years.
Receipts/Payments shownin Column C cannot also be called annuity.
Thoughamounts received/paid are identical in each year but time interval
between different receipts/payments is not equal. It may be noted that time
interval between second and third receipt/payment is two year and time
interval between other consecutive receipts/ payments (first and second third
and fourth and fourth and fifth) is only one year. It may also be noted that for
first two year the receipts/ payments can be called annuity.
Now referColumn B. It may be noted that all receipts/ payments over the
period of 5 years are identical andtime intervalbetweentwo
consecutivereceipts/ payments isalso samei.e.one year. Therefore receipts/
payments as shown in Column B can be termed annuity.
Annuity regular and Annuity due/immediate:
 Annuity

Annuity due or
annuity Annuity regular
immediate

First
First
payment/receipt
payment/receipt
at the end of the
in the first period
period

Annuity may be of two types:

i. Annuity Due or Annuity Immediate: When the first payment or receipt is
made at the beginning of the annuity i.e. today it is known as annuity due or
annuity immediate. Refer following table:
In the beginning of Receipts/
Year Payments($)
1 15,0
00
2 15,0
00
3 15,0
00
4 15,0
00
5 15,0
00

It can be observed that first payment or receipt is made in the beginning of

the first year. This type of annuity is termed annuity due or annuity
immediate.
ii. Annuity regular: In annuity regular first receipt/ payment takes place at the
end of first period. Refer following table:
 Year end Receipts/ Payments($)
1 15,000
2 15,000
3 15,000
4 15,000
5 15,000

It can be observed that first receipts/ paymenttake place at the end of first
year hence it is an annuity regular.
FUTURE VALUE:

The cash value of an investment at some time in the future is known as Future
Value. It is tomorrow’s worth of today’s money compounded at the rate of
interest. Suppose Mr. A invest $ 10,000 in a fixed deposit that pays him9% per
annum as interest. At the end of first year he will have$ 10,900. This
comprises of the original principal of $ 10,000 and the interest earned of $
900. $ 10,900 is the future value of $ 10,000 invested for one year at 9%. It can
be said that $ 10,000 today is worth $ 10,900 in one year’s time if the interest
rate is 9%.
Now suppose Mr. A invested $ 10,000 for two years. How much would he have
at the end of the second year?He had $ 10,900 at the end of the first year. If he
reinvest it he would end up having$ 10,900(1+0.09)= $ 11,881 at the end of
the second year. Thus $ 11,881 is the future value of$ 10,000 invested for two
years at 9%. The future value of a single cash flow can be calculated by
applying the formula of compound interest.
We understand that
𝐴𝑛 = 𝑃(1 + 𝑖)𝑛
Here A = Accumulated amount
n = number of conversion period
i = rate of interest per conversion period in decimal
P = principal
We can calculate Future value of a single cash flow by above formula by
simply replacing A with future value (F) and P with single cash flow (C.F.)
hence,
𝐹 = 𝐶. 𝐹. (1 + 𝑖)𝑛
Question25: You invest $ 6,000 in a two year investment that pays you 8%
per annum. Calculate the future value of the investment.
Answer:𝐹 = 𝐶. 𝐹. (1 + 𝑖)𝑛
Where F = Future value
C.F. = Cash flow = $ 6,000
i = rate of interest = 0.08
n= time period = 2
F=$ 6,000(1 + 0.08)2
=$ 6,000× 1.1664
=$ 6,998.4
Future value of an annuity regular:Let say a uniform sum of $ 1 is deposited
in a savings account at the end of each year for four years at 8% interest. This
implies that $ 1 deposited at the end of the first year will grow for three years,
$ 1 at the end of second year for two years, $ 1 at the end of the third year for
one year and $ 1 at the end of the fourth year will not produce any interest.
Using the concept of compound interest; the future value of annuity can be
calculated. The compound amount (compound value) of $ 1 deposited in the
first year will be

𝐴3 = $ 1 (1 + 0.08)3
= $ 1.191
The compound value of $ 1 deposited in the second year will be
𝐴2 = $ 1 (1 + 0.08)2
= $ 1.124
The compound value of $ 1 deposited in the third year will be
𝐴1 = $ 1 (1 + 0.08)1
= $ 1.06
and the compound value of $ 1 deposited at the end of fourth year will remain
$ 1.
The aggregate compound value of $ 1 deposited at the end of each year for
four years would be:
$ 1.191 + $ 1.124 + $ 1.06 + $ 1= $ 4.375
This is the compound value of an annuity of $ 1 for four years at 8% rate of
interest. We can summarize the above calculation in the following table:
Endofyear Amount Future value at the end of fourth
Deposit ($) year ($)
0 – –
1 1 1 (1 + 0.08)3 = 1.191
2 1 1 (1 + 0.08)2 = 1.124
3 1 1 (1 + 0.08)1 = 1.06
4 1 1 (1 + 0.08)0 = 1
Future Value 4.375

The calculation showninthe tablecanbe expressed as follows:

A (4, i) = A (1 + 𝑖)0 + A (1 + 𝑖)1 + A(1 + 𝑖)2 + A(1 + 𝑖)3
i.e. A (4, i) = A [ 1 + (1 + 𝑖)1 + (1 + 𝑖)2 + (1 + 𝑖)3 ]
Where,
A = annuity
A (4, i) = future value at the end of year four
i = the rate of interest shown in decimal.
Above equation can be extended for n periods and can be rewritten as under:
A (n, i) =A (1 + 𝑖)0 + A (1 + 𝑖)1 +.......................... +A (1 + 𝑖)𝑛−2 + A
(1 + 𝑖)𝑛−1
Here A = Re.1
Therefore
A (n, i) = 1(1 + 𝑖)0 + 1(1 + 𝑖)1 +.......................... + 1(1 + 𝑖)𝑛−2 +
1(1 + 𝑖)𝑖−1
=1 + (1 + 𝑖)1 +.......................... + (1 + 𝑖)𝑖−2 + (1 + 𝑖)𝑖−1
[A geometric series with first term 1 and common ratio (1+ i)]
1.[ 1−(1 + 𝑖)𝑖 ]
=
1− (1+𝑖)

[ 1−(1 + 𝑖)𝑖 ]
=
−𝑖

[(1 + 𝑖)𝑖 −1]

=
𝑖

If A be the periodic payments, the future value of A (n, i) of the annuity is

given by
(1 + 𝑖)𝑖 −1
A (n, i) = A [ ]
𝑖

Question26: Find the future value of an annuity of $ 1,000 made annually for
8 years at interest rate of 12% compounded annually. Given that (1.12)8 =
2.4760.
Answer:Here annual payment
A = $ 1,000
n=8
i=12% = 0.12
Future value of the annuity
(1 + 0.12)8 −1
A (8, 0.12) = $ 1,000 [ ]
0.12
$ 1,000(2.4760 – 1)
=
0.12

= $ 12,300
Question27: $ 400 is invested at the end of each month in an account paying
interest 12% per year compounded monthly. What is the future value of this
annuity after 15th payment? Given that (1.01)15 = 1.1610
Answer:Here A = $ 400
n = 15
i = 12% per annum = 12/12% per month = 0.01
Future value of annuity after 15 months is given by
(1 + 𝑖)𝑖 −1
A (n, i) = A [ ]
𝑖

(1 + 0.01)15 −1
A (15, 0.01) = $ 400 [ ]
0.01
1.1610− 1
= $ 400 [ ]
0.01

= $ 400 X 16.1
= $ 6,440
Future value of Annuity due or Annuity Immediate:As we understand
thatfirst payment or receipt in Annuity due or Annuity immediate ismade
today. However, in Annuity regular, it is assumed that the first payment or the
first receipt is made at the end of first period. The relationship between the
value of an annuity due and an ordinary annuity with reference to future value
is:

Future value of an Annuity due/Annuity immediate = Future value of annuity

regular x (1+i)
Where,
i = the interest rate in decimal.
Computing the future value of the annuity due contains following two steps.

• Compute the future value as though it is an ordinary annuity.

1

• Multiply the outcome by (1+ i)

2

Question28: A invests $ 20,000 every year starting from today for next 8
years. Suppose interest rate is 6% per annum compounded annually. Calculate
future value of the annuity. Given that (1 + 0.06)8 = 1.59384807.
Answer: Step-1: Calculate future value as though it is an ordinary annuity.
Future value of the annuity as if it is an ordinary annuity
(1 + 0.06)8 −1
= $ 20,000 [ ]
0.06

= $ 20,000 x 9.897468
= $ 1,97,949.36
Step-2: Multiply the result by (1 + i)
=$ 1,97,949.36 × (1+0.06)
=$ 2,09,826.32
PRESENT VALUE:

We understand that future value is tomorrow’s worth of today’s money

compounded at some interest rate. It can be said that present value is today’s
value of tomorrow’s money discounted at the interest rate. Present value and
Future value are related to each other in fact they are the reciprocal of each
other. Let’s go back to our fixed deposit example. Mr. A invested $ 10,000 at
9% and get$ 10,900 at the end of the year. If $ 10,900 is the future value of
today’s $ 10,000 at 9% then $ 10,000 is present value of tomorrow’s $ 10,900
at 9%. We have also seen that if we invest $ 10,000 for two years at 9% per
annum we will get $ 11,881 after two years. It means $ 11,881 is the future
value of today’s $ 10,000 at 9% and $ 10,000 is the present value of $ 11,881
where time period is two years and rate of interest is 9% per annum. The
present value of a cash flow (outflow or inflow) can be calculated by applying
compound interest formula.
The present value P of the amount 𝑖𝑖 due at the end of n period at the rate of i
per interest period may be obtained by solving for P the below given equation
𝑖𝑖 = P (1 + 𝑖)𝑖
𝐴
i.e. P = (1+𝑖)
𝑛
𝑛
Calculation of P may be simple if we make use of either the calculator or the
1
present valuetable showing values of(1+𝑖)𝑛 for various time periods/per
annum interest rates.
1
For positive i the factor(1+𝑖)𝑛 is always less than 1 indicating thereby future
amount hassmaller present value.
Question29: What is the present value of $ 10 to be received after three years
compoundedannually at20% interest rate?
Answer: Here 𝐴𝑛 = $10, i = 20% = 0.2, n = 3
𝐴
Required present value=(1+𝑖)
𝑛
𝑛

$ 10
= (1+0.2)3
$ 10
=
1.728

= $ 5.787
Thus $ 5.787 shall grow to $ 10 after 3 years at 20% interest rate
compounded annually.
Question30:Find the present value of $ 20,000 tobe required after 4 years
ifthe interest ratebe 11%. Given that (1.11)4 =1.5181.
Answer: Here I = 0.11 = 11%, n = 4, 𝐴𝑛 = 20,000
𝐴
Required present value = (1+𝑖)
𝑛
𝑛

$ 20,000
= (1+0.11)4
$ 20,000
=
1.5181

= $ 13,174.36
Present value of an Annuity regular: We have understood how compound
interest concept can be used for calculating the future value of an Annuity. We
shall now understand how tocalculate present value of an annuity. Let us take
an illustration, let say your father promise you to give you$ 5,000 on every
31st December for the next five years. Let say today is 1st January. How much
money will you have after five years from now if you invest this gift of the next
five years at 8%? For getting answer we will have to calculate future value of
this annuity.

But you don’t want $ 5,000 to be given to you each year. You instead want a
lump sum figure today. Will you get $ 25,000? The answer is no. The amount
that he will give you today will be less than $ 25,000. For getting the answer
we will have to calculate the present value of this annuity. For getting present
value of this annuity we will calculate the present value of these amounts and
then aggregate them. Refer following table:

Year End Gift Amount Present Value [An/(1 +

($) i)n]
1 5,000 5,000/(1 + 0.08)1 =4,629.63
2 5,000 5,000/(1 + 0.08)2=4,286.69
3 5,000 5,000/(1 + 0.08)3=3,969.16
4 5,000 5,000/(1 + 0.08)4=3,675.15
5 5,000 5,000/(1 + 0.08)5=3,402.92
PRESENT VALUE = 19,963.55

Thus the present value of annuity of $ 5,000 for 5 years at 8% is $ 19,963.55.

It means if you want lump sum payment today instead of $ 5,000 every year
you will get $ 19,963.55.
The above calculation can be written in formula form as under.
The present value (V) of an annuity (A) is the sum of the present values of the
payments.
𝐴 𝐴 𝐴 𝐴 𝐴
∴ V = (1+𝑖)1 + (1+𝑖)2 + (1+𝑖)3
+ (1+𝑖)4
+ (1+𝑖)5

Above equation can be extended for n periods and can be rewritten as under:
𝐴 𝐴 𝐴 𝐴
V = (1+𝑖)1 + (1+𝑖)2
+ ……………+ (1+𝑖)𝑛−1
+ (1+𝑖)𝑛
……….. (1)
 1
Multiplying throughout by we get
1+𝑖
𝑉 𝐴 𝐴 𝐴 𝐴
= (1+𝑖)2 + (1+𝑖)3
+ ……………+ (1+𝑖)𝑛
+ (1+𝑖)𝑛+1
……. (2)
1+𝑖

subtracting (2) from (1) we get

𝑉 𝐴 𝐴
V- = (1+𝑖)1 - (1+𝑖)𝑛+1
1+𝑖
𝐴
Or V (1+i) – V = A - (1+𝑖)𝑛
1
Or 𝑉𝑖 = A [1 − (1+𝑖)𝑛 ]
(1+𝑖)𝑛 −1
∴V = A [ ] = A.P(n,i)
𝑖(1+𝑖)𝑛

(1+𝑖)𝑛 −1
Where,P(n, i) =
𝑖(1+𝑖)𝑛
𝑉
Consequently A = which is useful in problems of amortization.
𝑃(𝑛,𝑖)

A borrowing with fixed rate of interest is said to be repaid if whole principal

and interest are paid over equal time span by way of series of equal payment.
𝑉
A = can be used to calculate the amount of annuity if we have present
𝑃(𝑛,𝑖)
value (V), n thenumber of time period and i the rate of interest in decimal.
Let say your mother purchases a jewelry set for $ 3,30,000. She gets a loan of $
3,00,000 at 18% p.a. from a financial institution and balance $ 30,000 she pays
at the time of purchase. Your mother has to pay whole amount of loan in 15
equal monthly installments with interest starting from the end of first month.
Now we need to calculate how much money has to be paid at the end of every
month. We can calculate equal installment by following formula
𝑉
A=
𝑃(𝑛,𝑖)

Here, V = $ 3,00,000 n = 15
0.18
i= = 0.015
12
(1+𝑖)𝑛 −1
P (n, i) =
𝑖(1+𝑖)𝑛
 (1+0.015)15 −1
P (15, 0.015) =
0.015(1+0.015)15
1.250232− 1
=
0.015(1.250232)
0.250232
=
0.018753

= 13.343572
$ 3,00,000
∴A = = $ 22,482.74
13.343572

Therefore your mother will have to pay 15 monthly installments of $

22,482.74.
Question31:A borrows $ 10,00,000 to buy a house. If he pays equal
installments for 15 years and 8% interest on outstanding balance what will be
the equal annual installment?
𝑉
Answer:A =
𝑃(𝑛,𝑖)

Here, V = $ 10,00,000
n = 15
i = 8 % p.a. = 0.08
𝑉 $ 10,00,000
∴A = =
𝑃(𝑛,𝑖) 𝑃(15,0.08)

$ 10,00,000
= [P (15, 0.08) = 8.559479 from table 2(a)]
8.559479

= $ 1,16,829.5
Question32: $ 10,000 is paid every year for 8 years to pay off a loan. What is
the loan amount if interest rate be 12% per annum compounded annually?
Answer:V = A.P. (n, i)
Here, A = $ 10,000 n = 8
i = 0.12
V = 10,000 × P(8, 0.12)
=10,000 × 4.96764 = $ 49,676.4
Therefore the loan amount is $ 49,676.4
Note: Value of P(8, 0.12) can be seen from table 2(a) or it can be calculated by
formula derived in preceding paragraph.
Question33: Y bought a TV costing $ 26,000 by making a down payment of $
6,000 and agreeing to make equal annual payment for 5 years. How much
would be each payment if the interest on unpaid amount be 12% compounded
annually?
Answer: In the present case we have present value of the annuity i.e. $ 20,
000 ($ 26,000-$ 6,000) and we have to compute equal annual payment over
the period of 5 years.
V = A.P (n, i)
Here, n = 5 and i = 0.12
𝑉
A=
𝑃(𝑛,𝑖)

$ 20,000
=
𝑃(5,0.12)

$ 20,000
= [from table 2(a)]
3.604776

= $ 5,548.19
Therefore each payment would be $ 5,548.19
Present value of annuity due or annuity immediate:Present value of
annuity immediate/ due for n years is the similar as an annuity regular for (n-
1) year plus an initial payment or receipt in beginning of the period.
Computing the present value of annuity due contains two steps.
• Calculate the present value of annuity as if it were annuity regular for one
1 period short.

• Add initial cash receipt/ payment to the step 1 value.

2
 initial
Present annuity payment or
value of regular receipt in
annuity due
or annuity for (n-1) beginning
of the
immediate year period
Question34: Suppose your father decides to gift you $ 15,000 every year
starting from today for the next 6 years. You deposit this amount in a financial
institution as and when you receive and get 8% per annum interest rate
compounded annually. What is the present value of this annuity?
Answer: It is an annuity immediate. For calculating value of the annuity
immediate below mentioned steps will be followed:
Step 1: Present value of the annuity as if it were a regular annuity for one year
less i.e. for 5 years.
= $ 15,000 × P (5, 0.08)
= $ 15,000 × 3.99271= $ 59,890.65

Step 2: Add initial cash deposit to the step 1 value

$ 59,890.65 + $ 15,000 = $ 74,890.65
SINKING FUND:

It is the fund created for a particular purpose by way of series of recurrent

payments over a time span at a given interest rate. Interest is compounded at
the end of each period. Size of the sinking fund deposit is calculated from;
A = P.A (n, i)
Where,
A = amount to be saved,
P = periodic payment,
n = payment period.
Question35: How much amount is required to be invested every year so as to
accumulate$ 5,00,000 at the end of 8 years if interest is compounded annually
at 12%?
Answer:Here, A (n, i) = 5,00,000, n = 8, i = 0.12
We have,
(1+𝑖)𝑛 −1
A (n, i) = A [ ]
𝑖
 (1+0.12)8 −1
$ 5,00,000 = A [ ]
0.12

$ 5,00,000 = A x 12.299693
$ 5,00,000
A= = $ 40,651.42
12.299693

APPLICATIONS:
Leasing:

Permits using the asset for a defined time span

(Lease period)
Owner of the User of the
asset (lessor) Leasing is a financial arrangement under which
asset (lessee)

A consideration (lease rentals) payable over the given

Time span
Leasing is a financial arrangement under which the owner of the asset (lessor)
permits the user of the asset (lessee) to use the asset for a definite time span
(lease period) for a consideration (lease rental) payable over thespecified
time span. It is like taking an asset on rent. The decision as to whether a lease
agreement is advantageous to lessee or lessor can be understood by following
illustrations.
Question36:X Ltd. wants to lease out an asset costing $ 4,50,000 for a 4 year
period. It has fixed a rental of $ 1,50,000 per annum payable annually starting
from the end of first year. Let say rate of interest is 12% per annum
compounded annually on which money can be invested by the company. Is
this agreement favorable to the company?
Answer: First we have to compute the present value of the annuity of $
1,50,000 for 4 years at the interest rate of 12% p.a. compounded annually.
The present value V of the annuity is given by V = A.P (n, i).
= 1,50,000 × P(4, 0.12)
= 1,50,000 × 3.03735 = $ 4,55,602.4
which is higher than the initial cost of the asset and consequently leasing is
favorable to the lessor.
Question37: A company is considering proposal of purchasing a machine
either by making full payment of $ 10,000 or by leasing it for 5 years at an
annual rate of $ 2,500. Which course of action is preferable if the company can
borrow money at 12% compounded annually?
Answer: The present value V of annuityisgiven by V= A.P (n, i).
= 2,500 × P (5, 0.12)
= 2,500 × 3.60478 = $ 9,011.94
which is lower than the purchase price and consequently leasing is preferable.
Capital Expenditure (investment decision):

Capital expenditure means acquiring an asset (which results in outflows of

funds) today in expectation of paybacks (cash inflow) which would flow
through the life of the investment. For taking investment decision the present
value of cash inflow and present value of cash outflows should be compared. If
present value of cash inflows is higher than present value of cash outflows
decision should be in the approval of investment. Let us understand how a
capital expenditure (investment) decision can be taken.
Question38: A machine can be purchased for $ 75,000. Machine will
contribute $ 15,000 per year for the next 8 years. Assume borrowing cost is
12% per annum compounded annually. Determine whether machine should
be purchased or not.
Answer: The present value of annual contribution
V = A.P(n, i)
=15,000 ×P(8, 0.12)
=15,000× 4.96764
= $ 74,514.6
which is less than the initial cost of the machine. Therefore machine must not
be purchased.
Question39: A machine with useful life of 9 years costs $ 22,000 while
another machine with useful life of 6 years costs $ 18,000. The first machine
saves labor expenses of $ 3,800 annually and the second one saves labor
expenses of $ 4,400 annually. Determine the preferred course of action.
Assume cost of borrowing as 12% compounded per annum.
Answer: The present value of annual cost savings for the first machine
= $ 3,800 × P (9, 0.12)
= $ 3,800 × 5.32825
= $ 20,247.35
Cost of machine being $ 22,000 it costs more by $ 1,752.65 than it saves in
terms of labor cost. The present value of annual cost savings of the second
machine
= $ 4,400 × P(6, 0.12)
= $ 4,400 × 4.11141
= $ 18,090.19
Cost of the second machine being $ 18,000 effective savings in labor cost is $
90.19. Hence the second machine is preferable.
Valuation of Bond:

A bond is a debt instrument in which the issuer is indebted to the holder a

debt and is bound to repay the principal and interest. Bonds are ordinarily
sold for a fixed time span longer than a year.
Question40: An investor intends purchasing a 5 year $ 100 par value bond
having nominal interest rate of 8%. At what price the bond may be purchased
now if it matures at par and the investor requires a rate of return of 15%?
Answer: Present value of the bond
8 8 8 8 8 100
= (1+0.15)1 + (1+0.15)2 +(1+0.15)3 + (1+0.15)4 + (1+0.15)5 + (1+0.15)5

= 8 × 0.86957 + 8 × 0.75614 + 8 × 0.65752 + 8 x 0.57175 + 8 x 0.49718 + 100 ×

0.49718
= 6.95656 + 6.04912 + 5.26016 + 4.574 + 3.97744 + 49.718
= $ 76.53528
Thus the purchase value of the bond is $ 76.54.
PERPETUITY:

Perpetuity is a special type of annuity in which the recurrent receipts or

paymentsinitiate on a fixed date and existsperpetually or indefinitely.Leading
examples of perpetuities arefixed coupon payments on irredeemable
(permanently invested) amounts of money.
Two points which are essential to knowfor calculating perpetuity are:
(i)The worth of the perpetuity is predictableas receipts that are anticipated
far in the future have verysmall present value (today’s value of the future cash
flows).
(ii)Moreover, there is no present value for the principalsince the principal is
never repaid.
Hence, the value of perpetuity is basically the interest amount over the yield
or appropriate discount rate.
Calculation of multi period perpetuity:

The formula for calculating the present value of multi-period perpetuity is as

under:
𝑅 𝑅 𝑅 𝑅 𝑅 𝑅
𝑃𝑉𝐴∞ = (1+𝑖)1 + (1+𝑖)2 + (1+𝑖)3 + ………. + (1+𝑖)∞ = ∑∞
𝑛=1 (1+𝑖)𝑛 = 𝑖

Where,
R = the receipt or payment each period
i = the interest rate per receipt or payment period
Question41:Mr. A wants to retire and receive $ 5,000 a month. He wants to
pass this monthly payment to future generations after his death. He can earn
an interest of 10% compounded annually. How much will he need to set aside
to achieve his perpetuity goal?
Answer:R = $ 5,000, i = 0.10/12 or 0.00833
Substituting these values in the above formula, we get
$5,000
PVA =
0.00833

= $ 6,00,000
If he wanted the payments to start today, he must increase the size of the
funds to handle the first payment. This is achieved by depositing $ 6,05,000
(PV of normal perpetuity + perpetuity received in the beginning = $ 6,00,000 +
$ 5,000) which provides the immediate payment of
$ 5,000 and leaves $ 6,00,000 in the fund to provide the future $ 5,000
payments.
Calculation of Growing Perpetuity:

Growing perpetuity means theseries of cash flows grows at a persistent rate

continually.The present value of growing perpetuity can be calculated with
the help of following formula:
𝑅 𝑅 (1+𝑔) 𝑅 (1+𝑔)2 𝑅 (1+𝑔)∞
PVA = (1+𝑖)1 + (1+𝑖)2
+ (1+𝑖)3
+ …….. + (1+𝑖)∞

𝑅 (1+𝑔)𝑛−1 𝑅
∑∞
𝑛=1 (1+𝑖)𝑛
=
𝑖−𝑔

Question42: Assuming that the discount rate is 8% per annum, how much
would you pay to receive $ 100, growing at 6%, annually, forever?
Answer:
𝑅 100
PVA = = = $ 5,000
𝑖−𝑔 0.08−0.06

Computing Rate of Return:

1)Computing the rate of return furnishesvitalstatistics that can be utilized for
forthcoming investments. For instance, if Mr. A invested in a stock that
showed a continual loss, it may be wise to conduct research to find a better-
performing stock. However, if the stock showeda significant gain after several
months of performance, he may chooseto buy more of that stock.
2)Computing the rate of return is that it permits you to measure your
investment and decision- making skills. If yourinvestments are recurrently
generating losses, then you may want to modify your investment plans. A
soundquality of successful business persons is understanding how and when
to make investments, as is understanding when to modify strategies. With a
strongknowledge ofcomputingthe rate of return, your investments can be
monitored and managed at various phases to ascertain the result of the
investments. This leads to a greater level of assurance and the
abilitiesrequired to be anintelligent investor.
Net Present Value Method (NPV): The net present value methodconsiders
the time value of money in assessing capital investments and it is a discounted
cash flow technique. An investment has cash flows throughout its life, and itis
supposed that a rupee of cash flow inthe initial years of an investment hasa
valuehigher than a rupee of cash flow in a subsequent year.
Under Net Present Value Technique, all subsequent net cash inflows after the
initial investment are brought to their present values using a given discount
rate(the time of the initial investment is year 0).
Determining Discount Rate:Theoretically, the rate of return the firm would
have earned by investing the same funds in the best available alternative
investment that has the identical risk is known as the desired rate of return on
an investment or discount rate. However, to decide the finest alternative
opportunity prevailing is difficult in practical terms so rather than using the
true opportunity cost,enterprises often use an alternate measure for the
desired rate of return. An enterprise may determine a minimum rate of return
that all capital projects must meet; this minimum couldbe determined on the
basis ofan industry average or the cost of other investment possibilities. Many
enterprises decide to use the Weighted Average Cost of Capital (WACC) or the
overall cost of capital that an enterprise has incurred in availing funds or
expects to incur in availing the funds requiredforan investment.
The net present value of a project is the amount the investment earns, in
presentworth of rupees after meeting cost of capital in each period.

NET PRESENT VALUE:

Present
Net Total net
Value of
Present initial
Net cash investment
Value inflow

As it might also be possible that some further investment may also be

required during the life of the project then properequation shall be:
 Present
Net Present
Value of
Present Value of
cash
Value cash inflow
outflow

The steps to computing net present value are:-

• Decide the net cash inflow in each year of the investment.
1
• Select the discounting rate or Weighted Average Cost of Capital (WACC) or
2 desired rate of return.

• On the basis of the desired rate of return selected, find the discount factor for
3 each year.

• Determine the present values of the net cash flows by multiplying the cash
4 flows with respective discount factors of respective period.

• Total the values of all PVs of Cash Flows.

5

Now, there are two possibilities:

Decision
Standard

NPV > 0 NPV < 0

Accept the Reject the

project project

Question43: Compute the net present value for a project with a net
investment of$ 2,00,000 and net cash flows year one is $ 1,10,000; for year
two is $ 1,60,000 and for year three is $ 30,000. Further, the company’s cost of
capital is 12%?
[PVIF @ 12% for three years are 0.893, 0.797 and 0.712]
Answer:
Year Net Cash PVIF @ Discounted Cash
Flows 12% Flows
 0 (2,00,000) 1.000 (2,00,000)
1 1,10,000 0.893 98,230
2 1,60,000 0.797 1,27,520
3 30,000 0.712 21,360
Net Present Value 47,110
Recommendation: Since the net present value of the project is positive, the
company should accept the project.
NOMINAL RATE OF RETURN:

The nominal rate is the specified interest rate. If a financial institute pays 8%
annually on a savings account, then 8% is the nominal interest rate. So if you
deposit $ 500 for 1 year, you will receive $ 40 in interest. However, that $ 40
will perhaps be worth less at the end of the year than it wouldhave been at the
beginning. This is because inflation reduces the value of money. As services,
goods and assets, such as real estate, increase in price.
The nominal interest rate is fundamentally the simplest type of interest rate.
Simply presenting,it is the specified interest rate of a given loan or bond. It is
also known as a stated interest rate. This interest operatesas per concept of
simple interest and does not consider the compounding periods.
Real Rate of Return: The real interest rate prescribes the “real” rate thatthe
lender or investor receives after inflation is eliminated and so it is named as
“Real Rate of Return”; that is, the interest rate that exceeds the inflation
rate.Anevaluation of real and nominal interest rates can thus be summed up in
following equation:

Real Nominal
Interest Inflation Interest
Rate Rate

Nominal Real
Rate of Inflation Rate of
Return Return
Effective Rate:
It is the actual correspondingyearly rate of interest at which an investment
grows in price when yield is credited more than once during a year. If interest
is paid m times in a year it can be derived by computing:
𝑖 𝑚
𝐸𝑖 = (1 + ) − 1
𝑚

The mainbenefit to understanding the difference between nominal, real and

effective rates isthat it permitscustomers to take improved decisions about
their investments and borrowings. A borrowingwhich compounds yearlywill
be less expensive than one having recurrent compounding time spans.
A bond that merely pays a 2% real interest rate may not be worth investors’
time if they pursue to increase their assets over time. These rates efficiently
represent the actual cost of a loan for a business or individual and the
actualyield that will be earned by a fixed-income investment.
Effective and nominal interest rates allow financial institutions to usethe
number that appearsbestbeneficial to the customer. When financial
institutions are levying interest, they present the nominal rate, which is lesser
and does not represent how much interest the customer would be indebted
on the balance after a full year of compounding. On the other hand, with
deposit accounts where financial institutions are giving interest, they
normallypresent the effective rate since it is more than the nominal rate.
COMPOUND ANNUAL GROWTH RATE (CAGR):

Compounded Annual Growth Rate (CAGR) is a business and investing

particularword for the smoothed annualized gain of an investment over a
specified time span. It is not an accounting phrase, but remains broadly used,
principally in growth businesses or to compare the growth rates of two
investments; because CAGR reduces the impact of instability of periodic yields
that can render arithmetic means immaterial. CAGR is usually used to portray
the growth over a time span of certaincomponents of the business, for
instanceregistered users,units delivered, incomeetc.
1
𝑉𝑡 𝑡
CAGR (𝑡0 ,𝑡𝑛 ) = (𝑉𝑡𝑛) 𝑛−𝑡0 -1
0
Where V (𝑡0 ) = Beginning Period; V (𝑡𝑛 ) = End Period
Illustration: Suppose the revenues of a company for four years, V(t) in the
above formula, have been

Year 2015 2016 2017 2018

Revenue 200 240 320 420
s
Calculate Compound annual Growth Rate.
Answer:
𝑡𝑛−𝑡0 = 2018 - 2015 =3
The CAGR revenues over the three-year period from the end of 2015 to the
end of 2018 is
1
420 3
CAGR (0, 3) =( ) – 1 = 1.2774 – 1 = 0.2774 or 27.74%
200

Applications:Following are some of the common CAGR applications:

Estimating future values based on the CAGR of a data series.

Computing average yields of investment funds.

Comparing the historical yields of stocks with a savings account or with

bonds.

Evaluating and communicating the performance, over a sequence of years, of

various business components such as market share, customer satisfaction,
costs, performance and sales.

Indicating and comparing the performance of investment advisors.

TEST BANK / SELF STUDY QUESTIONS - 3:

Select the correct option.

1.The present value of an annuity of $ 6,000 for 10 years at 9% p.a. CI is
(a) $ 35,808.95 (b) $ 38,505.95 (c) $ 38,508.59 (d) none of these
2.The amount of an annuity certain of $ 300 for 15 years at 7% p.a. C.I is
(a) $ 7,538.71 (b) $ 7,583.71 (c) $ 7,583.17 (d)
none of these
3.A loan of $ 15,000 is to be paid back in 25 equal installments. The amount of
each installment to cover the principal and at 5% p.a. CI is
(a) $ 1,406.29 (b) $ 1,046.29 (c) $ 1,064.29 (d)
none of these
4.A = $ 1,500 n = 10 years i = 0.10, V = ?
𝐴 1
Using the formulaV = [1 – (1+𝑖)𝑛
] value of V will be
𝑖

(a) $ 9,200 (b) $ 9,261.82 (c) $ 9,126.85 (d) none of

these
5.a = $ 200 n = 20, i = 10% find the FV of annuity
Using the formula FV = a /{(1 + 𝑖)𝑛 − 1}, FV is equal to,
(a) $ 11,455 (b) $ 11,544 (c) $ 11,554 (d) none of
these
6.If the amount of an annuity after 20years at 10%p.a.C.I is$ 5,00,000the
annuitywill be
(a) $ 8,279.82 (b) $ 8,729.82 (c) $ 8,792.82 (d)
none of these
7.Given annuity of $ 500 amounts to $ 23,863.55 at 5% p.a. C. I. Thenumber
ofyears will be
(a) 25 years (appx.) (b) 20 years(appx.) (c)22 years (d) none of
these
8.A company borrows $ 1,00,000 on condition to repay it with compound
interest at 8% p.a. by annual installments of $ 10,000 each. The number of
years by which the debt will be clear is
(a) 20.9 years (appx.) (b) 15 years (c) 23 years (d) none of
these
9.Mr. A borrowed $ 6,000 at 10% p.a. C.I. At the end of 2 years, the money was
repaid along with the interest accrued. The amount of interest paid by him is
(a) $ 1,620 (b) $ 1,260 (c) $ 1,206 (d) none of these
10.Mr. A borrows $ 15,000 on condition to repay it with C.I. at 8% p.a. in
annual installments of $ 2000 each. The number of years for the debt to be
paid off is
(a) 10.8 years (appx.) (b) 13 years (c) 11.9 years (appx.) (d)
None of these
11.A person invests $ 1,000 at the end of each year with a bank which pays
interest at 12%p.a. C.I.annually. The amount standing to his credit one year
after he has made his yearly investment for the 14th time is.
(a) $ 36,279.71 (b) $ 20,000 (c) $ 25,000 (d) none of
the above
12. The present value of annuity of $ 10,000 per annum for 10 years at 5% p.a.
C.I. annually is
(a) $ 92,000 (b) $ 93,000 (c) 30,000 (d) none of
the above
13. A person desires to create a fund to be invested at 8% CI per annum to
provide for a prize of $ 500 every year. Using V =a/I find V and V will be
(a) $ 5,000 (b) $ 6,000 (c) 6,250 (d) none of the above
SUMMARY:
Time value of money: Time value of money means that the value of a unit of
money is distinct for distinct time phases. The amount of money received
toady is more valuable than what it will be in future. I.e. the present worth of
money received today is more than money received after some time.
Interest: Interest is the charge paid/ received by a borrower/ investor for
availing the lender’s funds. If one borrows/ invests some money from a
person/ financial institution for a specified time span; one would pay/ receive
extra money than one’s initial borrowing.
Simple Interest: Simple interest is the interest calculated on the principal for
the entire period of investment.

It can be calculated by using following formulas:

I = Pit
A=P+I
= P + Pit
= P(1 + it)
I =A–P
Where,
A = Accumulated amount (final value of an investment)
P = Principal (initial value of aninvestment)
i = Annual interest rate in decimal.
I = Amount of interest
t = Time in years

Compound Interest: It can be defined as the interest that accrues when

earnings for each specified time span plus the principal, so expanding the
principal amount on which future interest is computed.
Formula for compound interest:
𝐴𝑛 = P(1 + 𝑖)𝑛
Where,
i = Annual Rate of Interest
n = Number of Conversion periods per year
Interest = 𝐴𝑛 − 𝑃 = 𝑃 (1 + 𝑖)𝑛 − 𝑃
= P [(1 + 𝑖)𝑛 − 1]
n is total conversions i.e. t x no. of conversions per year
Effective Rate of Interest: The effective interest rate can be calculated
directly by following formula:
E = (1 + 𝑖)𝑛 - 1
Where E = effective interest rate
i = actual interest rate in decimal
n = number of conversion period
We can calculate Future value of a single cash flow by below formula.

𝐹 = 𝐶. 𝐹. (1 + 𝑖)𝑛
Annuity can be defined as a sequence of periodic receipts (or payments)
recurrently over a specified time span.

Annuity may be of two types:

Annuity Due or Annuity Immediate: When the first payment or receipt is
made at the beginning of the annuity i.e. today it is known as annuity due or
annuity immediate.
Annuity regular: In annuity regular first receipt/ payment takes place at the
end of first period.
If A be the periodic payments, the future value of A (n, i) of the annuity is
given by
(1 + 𝑖)𝑛 −1
A (n, i) = A [ ]
𝑖

Future value of an Annuity due/Annuity immediate = Future value of

annuity regular x (1+i)

Where,
i = the interest rate in decimal.
The present value P of the amount 𝐴𝑛 due at the end of n period at the rate of
i per interest period may be obtained by solving for P the below given
equation

𝐴𝑛 = P (1 + 𝑖)𝑛
𝐴
i.e. P = (1+𝑖)
𝑛
𝑛

Present value of annuity due or annuity immediate:Present value of

annuity immediate/ due for n years is the same as an annuity regular for (n-1)
year plus an initial payment or receipt in beginning of the period. Computing
the present value of annuity due contains two steps.
• Calculate the present value of annuity as if it were annuity regular for one
1 period short.

• Add initial cash receipt/ payment to the step 1 value.

2

Sinking Fund: It is the fund credited for a specified purpose by way of

sequence of periodic payments over a time span at a given interest rate.
Interest is compounded at the end of every period. Size of the sinking fund
deposit is calculated from;

A = P.A (n, i)
Where,
A = amount to be saved,
P = periodic payment,
n = payment period.
Annuity Applications:

Capital expenditure:
• Capital expenditure means acquiring an asset (which results in outflows
of money) today in expectation of paybacks (cash inflow) which would
flow through the life of the investment.

Valuation of Bond:
• A bond is a debt security in which the issuer owes the holder a debt and
is bound to repay the principal and interest. Bonds are ordinarily issued
for a fixed time span longer than a year.

Leasing:
• Leasing is a financial arrangement under which the owner of the asset
(lessor) permits the user of the asset (lessee) to use the asset for a
definite time span (lease period) for a consideration (lease rental)
payable over the specified time span. It is a kind of taking an asset on
rent.
TEST BANK / SELF STUDY QUESTIONS - 4:

Select the correct option.

1.A = $ 12,309, R = 9% p.a., T = 5 years, P will be
(a) $ 7,000 (b) $ 8,000 (c) $ 6,000 (d) none of these
2. If P = 2,000, n = 8years., R = 10% p.a then C. I will be
(a) $ 2,287 (b) $ 2,827 (c) $ 2,872 (d) none of these
3. The time in which a sum of money will be thrice/ treble itselfat 10% p.a C.I
is
(a)10 years (b) 12 years (c) 11.5 years (d) none of
these
4.If A = $ 20,000, n = 15yrs., R = 5% p.a C.I, P will be
(a) $ 8,000 (b) $ 9,000 (c) $ 10,000 (d) none of these
5.The time by which a sum of money would doubleitself at 10% p. a C. I is
(a) 7.28 years (b) 7 years (c) 8 years (d) none of these
6.The present value of an annuity of $ 160 a years for 10 years at 10% p.a. is
(a) $ 983.15 (appx.) (b)$ 900 (c) $ 1,000 (d) none of these
7.A person bought a house paying $ 40,000 cash down and $ 8,000 at the end
of each year for 20 yrs. at 4% p.a. C.I. The cash down price is
(a) $ 1,47,000 (b) $ 1,48,000 (c) $ 1,48,723 (d)
none of these.
8.Mr. A purchased a car valued at $ 3,00,000. He paid $ 2,00,000 at the time of
purchase and agreed to pay the balance with interest at 12% per annum
compounded half yearly in 20 equalhalf yearly installments. If the first
installment is paid after six months from the date of purchase then the
amount of each installment is
[Given log 10.6 = 1.0253 and log 31.19 = 1.494]
(a) $ 8,719.66 (b) $ 8,769.21 (c) $ 7,893.13 (d)
none of these.
PRACTICE QUESTIONS:

1.The difference between compound and simple interest at 8% per annum for
6 years on$ 30,000 is $
(a) 3,620 (b) 3,260 (c) 2,306 (d) 3,206
2.The compound interest on half-yearly rests on $ 5,000 the rate for the first
and second years being9% and for the third year 6%p.a.is $.
(a) 1,500 (b) 1,000 (c) 1,200 (d) None
3.The present value of $ 20,000 due in 3 years at 8% p.a. compound interest
when the interest is paid on yearly basis is $.
(a) 15,876.64 (b) 15,000 (c) 15,900 (d) None
4.The present value of $ 20,000 due in 3 years at 8% p.a. compound interest
when the interest is paid on half-yearlybasis is $.
(a) 16,100 (b) 15,500 (c) 15,806 (d) None
5.Mr. A left $ 1,50,000 with the direction that it should be divided in such a
way that his minor sons B, C and D aged 8, 11 and 14 years should each
receive equally after attaining the age 25 years. The rate of interest being
4.5%, how much each son receives after getting 25 years old?
(a) 60,000 (b) 52,994 (c) 72,000 (d) None
6.In how many years will a sum of money double at 10% p.a. compound
interest?
(a) 6years 3 months (b) 7 years 3 months (c) 8 years 3 months (d) 8
years 2 months
7.In how many years a sum of money trebles at 10% p.a. compound interest
payable on half- yearly basis?
(a)12years 7 months (b) 12 years 6 months(c) 12 years 8 months (d)
11 years 3 months
8.A machine depreciates at 10% of its value at the beginning of a year. The
cost and scrap value realized at the time of sale being $ 46,480 and $ 18,000
respectively. For how many years the machine was put to use?
(a) 7 years (b) 8 years (c) 9 years (d) 10 years
9.A machine worth $ 9,00,000 is depreciated at 18% on its opening value each
year. When its value would reduce to $ 3,00,000?
(a)4years 6 months (b) 4 years 7 months (c) 4 years 5 months (d) 5
years 7 months (appr.)
10.A machine worth $ 9,00,000 is depreciated at 18% of its opening value
each year. When its value would reduce by 85%?
(a)11years 6 months (b) 11 years 7 months (c) 11 years 8 months (d) 9
years 6.7 months (app.)
11.Mr. A borrows $ 12 lakhs Housing Loan at 4% repayable in 15 annual
installments commencing at the end of the first year. How much annual
payment is necessary?
(a) 1,09,729 (b) 1,07,992 (c) 1,07,929 (d)
1,09,792
12.A sinking fund is created for redeeming debentures worth $ 4 lakhs at the
end of 20 years. How much provision needs to be made out of profits each
year provided sinking fund investments can earn interest at 5% p.a.?
(a) 12,097.04 (b) 12,040 (c) 12,039 (d) 12,035
13.A machine costs $ 5,20,000 with an estimated useful life of 25 years. A
sinking fund is created to replace it by a new model at 25% higher costs after
25 years with a salvage value realization of $ 25,000. What amount should be
set aside each year if the sinking fund investments accumulate at 3.5%
compound interest p.a.?
(a) 16,000 (b) 16,500 (c) 16,050 (d) 16,005
14.Mr. A aged 50 wishes his wife Mrs. A to have $ 100 lakhs at his death. If his
expectation of life is another 40 years and he starts making equal annual
investments commencing now at 5% compound interest p.a. how much
should he invest annually?
(a) 82,448 (b) 82,450 (c) 82,449 (d) 82,781.6
15.Mr. A retires at 65 years receiving a pension of $ 14,400 a year paid in half-
yearly installments for rest of his life after reckoning his life expectation to be
13 years and that interest at 4%p.a. is payable half-yearly. What single sum is
equivalent to his pension?
(a) 1,45,000 (b) 1,44,900 (c) 1,44,800 (d)
1,44,700
ANSWER KEYS:
TEST BANK 1:

1. (a) 2. (c) 3. (b) 4. (c) 5. (c) 6. (c)

7. (a) 8. (c) 9. (a) 10. (c)
TEST BANK 2:

1. (a) 2. (c) 3. (c) 4. (b) 5. (a) 6. (b)

7. (a) 8. (b) 9. (d) 10. (c) 11. (c) 12. (d)
13. (b) 14. (a)
TEST BANK 3:

1. (b) 2. (a) 3. (c) 4. (d) 5. (a) 6. (b)

7. (a) 8. (a) 9. (b) 10. (c) 11. (a) 12. (d)
13. (c)
TEST BANK 4:

1. (b) 2. (a) 3. (c) 4. (d) 5. (a) 6. (a)

7. (c) 8. (a)
PRACTICE QUESTIONS:

1. (d) 2. (d) 3. (a) 4. (c) 5. (d) 6. (b)

7. (d) 8. (c) 9. (d) 10. (d) 11. (c) 12. (a)
13. (c) 14. (d) 15. (b)
 Interest rate concept and calculation
Introduction
Interest is the cost incurred for the amount borrowed. Interest is the revenue
earned from the viewpoint of lender for the amount given to borrower while
it is expense incurred from the viewpoint of borrower for the amount
borrowed from lender. It compensates the lender for deferring the use of
resources. Lender accepts various risk while lending the amount as well there
is time value of money which affects amount. So Interest is considered
compensation for the risk bore by lender. Higher the perceived risk, higher
the amount of expected rate of return or interest rate.
Interest Rate expressed in terms of Percentage
Interest rate expressed in terms of percentage rate expressed on per annum
basis is applied to the amount borrowed (Principal) will determine Interest
amount in dollar amount. Borrower and Lender agree upon certain terms and
condition stated in contract. Based on this contract, Interest rate can be fixed,
variable or a combination.
• Fixed Rate: Where Interest rate is fixed during the tenure of the
loan i.e. it will not change during the life of the loan. Example: A
loan of 5 years where fixed interest rate agreed upon between
borrower and lender is 10%. Hence this rate will not change
during 5-year term loan.
• Variable Rate: Where Interest rate is variable during the tenure of
the loan i.e. it will change during the life of the loan. Interest rate
will be determined taking base of economic indicator such as
inflation rate. Example: As per the contract, inflation rate plus 2%
will be the interest rate then, for a year if inflation rate is 10%
then interest rate in that year will be 12%.
• Combination: Where interest rate is combination of both variable
and fixed rate, however not so common, consists of fixed for few
years and variable for another years of tenure of loan or vice
versa. Example: A loan is for 10 years where for first 4 years
Interest rate is variable and afterwards it is fixed.
Market rate of Interest
Based on the demand and supply of the funds in the market, prevailing
interest rate charged on the interest bearing instrument is the market rate of
Interest.
Market rate of Interest also known as prevailing rate of interest is determined
by considering various factors such as economic conditions, expected
inflation, monetary policy, and similar macro-characteristics.
Market rate of interest depends on various economic factors hence it can be
different for different markets and can change over time as economic factors
require changes in interest rate.
For any specific interest bearing instrument within a given market, rate of
interest depends upon various factors which specifies risk associated with
particular interest bearing instrument, credit rating of the issuer, tenure of the
instrument, size of the instrument (amount), marketability of the instrument,
any specific covenant associated with the instrument specified in contractual
terms.

Determinants of Market Interest rate for a Security

Nominal Interest rate is the interest rate with inflation. If inflation subtracted
from nominal interest rate, then real interest rate will be derived. Hence
Nominal interest rate for a security is sum of real risk free rate of Interest,
premiums for market risk, entity risk, security risk, default risk, inflation risk,
tenure of the instrument, amount of the instrument, marketability, special
covenants and feature of instrument, if any.
Nominal Rate of Interest = Real Rate of Interest + Inflation
Nominal rate (quoted rate) = Real Risk Free Rate
+ Inflation Premium
+ Credit Risk Premium
+ Maturity Premium
+ Liquidity Premium
+/- Special premium or discount, if any.
➢ Real Risk Free rate – Interest rate that would occur even if there is no
risk associated with the Instrument. Real Risk free rate are inflation free
rate i.e. it considers inflation as zero and hence it is real rate. Risk free
rate is return on US Treasury securities and it changes as economic
conditions change.
➢ Inflation Premium –It is premium for the adverse effect of expected
inflation on the Instrument. As Inflation is not considered in Real risk
free rate but it affects amount of Instrument hence in order to
compensate for adverse effect of expected Inflation, Premium is added
to real risk free rate. So higher the expected inflation rate , higher will be
nominal interest rate. Premium will be based on average expected
inflation over the tenure of Instrument.
Market price of US Treasury securities will be real risk free rate increase
by inflation risk premium.
Nominal Interest Rate = Real Rate of Interest + Inflation.
➢ Credit Risk Premium – Credit risk also known as default risk is the risk
that the borrower will not be able to repay either interest or principal
or both when due. If perceived credit risk for the instrument is higher
than Interest rate would be higher for the instrument.
➢ Maturity Premium – Longer the tenure of the instrument will be, greater
the perceived risk of the instrument. Value of the long term instrument
varies inversely with the market interest rate commonly known as
Interest rate risk. So longer the time to maturity higher the maturity
premium will be.
➢ Liquidity premium –Liquidity also known as marketability is the ability
to convert instrument into cash without significant discount in short
notice. Higher the liquidity of the instrument, less risky the instrument
will be hence less liquidity premium will be for the instrument.
➢ Special covenants (Such as callability feature, convertibility feature,
collateral, etc.) any attached based on risk associated will affect the
instrument with the related premium/discount.

Interest and Interest rate concepts

 Interest is the cost to borrower and return to lender but all
interest rates are not comparable. Interest rate differ mainly because of
compounding effect. Following are the various types of interest and
interest rate concepts.
1) Stated Interest rate - The annual rate specified in the terms of loan
agreement of the instrument. Example: A loan specified annual rate
of 10% in the terms and agreement of the instrument will make
borrower liable to pay 10% for the amount borrowed.
a. Real Interest Rate: Interest rate to be considered after
removing the effects of Inflation rate on the amount of loan is
real interest rate.
b. Nominal Interest Rate: Real interest rate added by Inflation
effect is Nominal Interest Rate
Nominal Interest rate = Real Interest Rate + Inflation Rate
2) Simple Interest Rate – This is the rate where computation will be
done on the amount of principal borrowed. No compounding effect
will be considered on the same. Hence for every period during the
tenure Interest computed will be same.
I = PRN/100
Where,
I = Interest Amount
P = Principal borrowed
R = Rate of Interest
N = Period
Example = If a person borrows $1000 for 4 Years at 5% pa then
interest for every year will be $50. ($1000 * 5 * 1 /100)
3) Compound Interest Rate – Under this computation, Interest is
calculated on principal as well as on the accumulated Interest still
unpaid. Compound interest is different from simple interest as
compound interest pays interest on interest while simple interest
does not paysinterest on interest.
 Example = If a person borrows $1000 for 4 years at 5% pa then
interest for will be calculated as
1st Year = $1000 * 0.05 = $50
2nd Year = ($1000 + $50) * 0.05 = $52.50
Hence for 2nd Year, under compound Interest $52.50 and for 2 years
total interest is $102.50
This calculation is done using the formula of future value (FV) of
$1.00
FVn = P(1 + R)^n
Where,
P = Principal
R = Rate of Interest
N = Number of Years
Example: If a person borrows $1000 for 4 years at 5% pa
then interest will be calculated as
FVn = $1000(1 + 0.05)^2
FVn = $1000(1.05)^2
FVn = $1000(1.1025)
FVn = $1102.50 = $1000 principal + $102.50
Compound Interest and future value of $1.00 calculations are
performed in same manner.
4) Effective Interest – Effective interest rate is the annual interest rate
implicit to the borrower in the relationship between the net
proceeds from a loan and the dollar cost of the loan.
Example - If a person borrows $1000 for 4 years at 5% pa then
I = $1000 * 0.05 * 4
= $200
EI = $200 / $1000 = 0.20 / 4 = 0.05 = 5%
5) Annual Percentage Rate – Annualized effective interest rate without
compounding on loans that are for a fraction of a year.
 Example - If a person borrows $1000 for 4 years at 5% for 6 months
then
I=P*R*N
= $1000 * 0.05 * 6/12 = $25
Effective interest rate = $25 / $1000
= 0.025 = 2.5%
Annual Percentage rate = 2.5% * 2 = 5%

6) Effective annual percentage rate – Effective annual percentage rate

also called the annual percentage yield, is the annual percentage rate
with compounding on loans that are for a fraction of a year.
EAPR = (1 + I/P)^P – 1
Where,
I = Annual (nominal) interest rate
P = Number of periods in the year
7) Negative Interest Rate – Under traditional interest rate agreement, a
borrower pays a lender interest for the amount borrowed. Under
Negative Interest rate agreement, Owner of the fund pays recipient
to hold the funds i.e. the flow of benefit payment is reversed.

Terms Structure of Interest Rates

Term structure of interest rates refers to the relationship between the time
until the principal balance of the debt instrument is due and how much the
debt instrument pays in interest. Term to maturity is the amount of time,
whereas yield to maturity is the interest rate being paid. This relationship is
often shown graphically with a yield curve.

Upward sloping Yield Curve

In general, yield curves have an upward slope, which means that longer-term
securities have ahigher yield than shorter-term securities. This is a result of
time being a risk factor such that debt instruments whose term to maturity is
more distant have higher risk, or more uncertainty about the future.
Downward sloping Yield Curve
Yield Curve have downward slope, which means that longer- term securities
have a lower yield than shorter term securities. This is the situation which
indicates depression.
Flat Yield Curve
Yield Curve have flat slope, which means that longer term securities have
same yield as of shorter term securities.
Humped Yield Curve
Yield Curve that increases and then decreases reflecting that short term and
long term rates are lower than intermediate rates.
Financial Valuations

INTRODUCTION

What is Valuation?

Valuation is the analytical process of determining the current (or projected)

worth of an asset or a company. There are many techniques used for doing a
valuation. An analyst placing a value on a company looks at the business's
management, the composition of its capital structure, the prospect of future
earnings, and the market value of its assets, among other metrics.

Fundamental analysis is often employed in valuation, although several other

methods may be employed such as the capital asset pricing model (CAPM) or
the dividend discount model (DDM).Any process of assigning worth or value to
something is called valuation.

What is Financial Valuation?

Any process of estimating the fair

value of either of an asset or a
liability (E.g. warranty obligations,
bonds, etc.) or equity (preferred
stock, common stock, etc.) or a
business enterprise.
What is Fair Value?

Fair value is a term with several meanings in the financial world.In investing, it
refers to an asset's sale price agreed upon by a willing buyer and seller,
assuming both parties is knowledgeable and enters the transaction freely. For
example, securities have a fair value that's determined by a market where they
are traded.

In accounting, fair value represents the estimated worth of various assets and
liabilities that must be listed on a company's books.

The consideration derived to sell an asset or paid to transfer a liability in an

orderly transaction between market participants.

While entry price is the price paid when an asset, liability, or other account is
initially recognized. It may or may not be fair value.

For example, the price paid may not be fair value if the transaction is between
related parties. For accounting, fair value is based on an exit price, not an entry
price.

Example of Fair Value

Let's say an investment company has long positions in stocks in its portfolio. By
having long positions, the company anticipates favorable market conditions,
also known as a "bull market." The company is holding onto these stocks with
the expectation they will rise in price over time.

The investment company's original cost of these assets was $6 million.

However, after two negative gross domestic product (GDP) rates, the market
experiences a significant downturn. The company's portfolio falls 40% in value,
to $3.6 million. Therefore, the fair value of the asset is $3.6 million or $6 million -
($6 million x 0.40).

Various Uses of Valuation are as follows:

1. Recognition of Assets and Liabilities

2. Analysis of Investments
3. Capital Budgeting
4. Mergers and Acquisitions
5. Assessment of Closely Held Businesses
6. Tax Determinations
7. Buy/Sell Agreements

Need for Business Valuation

1. To Be Prepared for Unsolicited Offers or Unforeseen Events

Business owners often receive unsolicited offers for their business, and they
may not have a solid grasp of the value of the business. Worse yet, a business
owner may rely on distorted market information related to value that many
times involves vague details related to the terms of the transactions. As a result,
a business owner’s opinion of the value of the business may be formed without
the benefit of reliable market information and without availability to the details
surrounding the transactions.

The death or disability of a business owner may trigger a buy-sell agreement

and the need to redeem or sell partial or full interests in the business. To the
extent a business has obtained a business valuation on a regular basis, the
expectations related to such scenarios are better managed, and consequently
better outcomes are realized.

These two scenarios reinforce the proposition that a business owner is well
served by having a business valuation prepared on a regular basis; the valuation
provides information in the event of unsolicited offers or unforeseen events,
putting the business owner on a level playing field when having to make
important decisions relative to their most important asset.

2. To Be in a Position of Strength When Negotiating a Sale

The sale of the business is frequently the single most important financial
transaction in the business owner’s life. Potential buyers for the business are
typically savvy investment professionals that purchase businesses as a regular
aspect of their line of work. In order to level the playing field, the business
owner must be armed with all relevant factors that impact the value of the
business.

3. To Manage Tax Transactions Efficiently

A well-documented business valuation is frequently an integral component of

effective tax planning strategies related to a private business. For example, the
income tax characterization of incentives to key executives as capital gains
rather than ordinary income may be supported by tax planning structures that
rely on sound valuations. The valuation of business interests on a minority
interest basis is a commonly used technique that provides reduced estate and
gift taxes when minority interests are sold or transferred to family members.

4. To Be Armed to Question a Potential Buyer’s Valuation

A business owner may be offered a high value for the business to grant an
exclusive period during due diligence, thus restricting the owner’s ability to
negotiate with other buyers. In another scenario, the business owner may be
offered an unreasonably high price with the caveat that the transaction is to be
funded primarily with seller financing, leaving the business owner with virtually
all of the risk and no control over the business. Situations such as these illustrate
the fact that the business owner needs to be fully armed with all information
related to the value of the business needed to negotiate favorable price and
terms with a potential buyer.

5. To Aid in the Avoidance of Buy-Sell Disputes

For private businesses that have multiple parties that hold equity, the business
valuation is a powerful tool to use in the establishment and execution of a buy-
sell agreement, minimizing the risk of disputes related to the agreement. During
the establishment of the buy-sell agreement the appraiser can play a critical role
in assisting legal counsel in defining the level of value (e.g., majority interest
basis or minority interest basis), so that the appropriate level of value may be
used given the specific event that triggers the buy-sell agreement. An annual
valuation sets a precedent for the value of the equity, whereas a single valuation
that is prepared at the time a triggering event occurs is more vulnerable to
claims of bias.

6. To Protect the Value of the Business

A well prepared and reported valuation of the business will highlight

weaknesses in the business, providing opportunities for business owners to
mitigate weaknesses and prevent further erosion of value. Similarly, threats to
the business are also identified in the valuation process, providing an
opportunity for the business owner to be proactive in meeting those threats.

7. To Enhance the Performance of the Business

An annual valuation of the business may be used as a benchmark to assess the

performance of the business in its execution of the corporate strategic plan. A
series of annual valuations provides objective information to shareholders so
that they may evaluate management and make appropriate changes. An annual
valuation also provides clear performance metrics and promotes accountability.

8. Third Parties Will Have an Interest in Valuing the Business

Business owners should also be aware that multiple parties will either explicitly
or implicitly value the business, whether or not the business owner chooses to
engage a business appraiser of their own choosing. Therefore, it makes only
good common sense for the business owner to be fully informed as to the value
of the business. Potential buyers will make their own determination of the value
of the business. When a business owner seeks to secure a business loan, the
bank will use its own approach to valuing the business. Finally, whether the
business is sold or is left in a business owner’s estate, the Internal Revenue
Service will have a vested interest in the valuation of the business, most often at
a level that generates additional tax revenue.

9. To Obtain the Best Combination of Price and Terms in the Market

A well prepared valuation assists the business owner in understanding the

strengths, weaknesses, opportunities and threats of the business. This
knowledge provides the business owner the opportunity to accentuate
strengths and opportunities as well as mitigate weaknesses and threats, long
before a sale process for the business commences, affording the business owner
with the foundation to realize the best deal in the market.

10. To Evaluate the Impact of the Business on the Owner’s Personal Balance
Sheet

A key element of personal financial planning is asset allocation. A periodic

business valuation is essential to consider the impact of the business value
within the overall financial portfolio of the business owner. Because the private
business interest is frequently the largest asset on the business owner’s balance
sheet, a business valuation will provide the essential information to implement
prudent asset allocation decisions, alleviating concentration of risk in highly
correlated asset classes.

11. To Determine the Return the Business Owner Realizes

Investment return, or yield, on an investment is determined by two types of

return, return on capital (realized capital gains and unrealized appreciation)
and return of capital (dividends). In order to determine investment return the
value of the investment at the beginning and end of the measurement period is a
fundamental input, as reflected in the following equation:

(Dividends + Realized Capital Gains or Losses + Unrealized

Yield Appreciation)
=
Beginning Investment Value

This equation may be stated in alternative form for the private business
investment, as follows:

(Dividends + Realized Capital Gains or Losses + Change in Business

Yield Value)
=
Beginning Value of the Business

Determining the return on the private business speaks to the concept of

managing the investment in the private business just like marketable securities
are managed. With knowledge on investment return, a business owner may
then implement changes in the business if the investment returns are
inadequate, or consider changes to asset allocations in marketable securities
portfolios.

Yield on the private business is most often the primary driver of the business
owner’s overall return on his or her personal assets. In the end, the business
owner’s personal wealth provides the financial resources to fund retirement as
well as realize other personal financial goals, and the level of financial resources
is largely driven by the return on the business. Therefore, it only makes sense to
have a clear idea of the value of the business and its investment return on a
periodic basis.

12. To Determine the Optimal Use of Financial Leverage for the Business

Investment return is also influenced by the level of debt (or financial leverage)
used in the business to create the return. The use of even modest levels of debt
in the financial management of the business can enhance investment return and
reduce risk for the business owner. A business valuation can be a useful
resource to determine the prudent use of debt capital for the financial
management of the business.

13. To Assist in the Development of Dividend Policy

The earnings of a business may be used in one of three ways: 1) reinvest the
earnings in the business, 2) pay down outstanding debt, or 3) distribute
dividends to owners. As noted previously, dividends have a direct impact on the
yield of the private business interest. As noted previously, the valuation of the
business is a critical input to determine return on the business investment. Once
the return on the business has been determined this information will lead to
prudent decisions on how to best utilize earnings.

Characteristics of Valuation are as follows:

Most valuation has elements of both science (objective characteristics) and art
(subjective characteristics):

As a science, valuation involves the use of quantitative data and techniques, as

well as financial models and other techniques to develop estimates of value.
As an art, valuation incorporates a qualitative dimension and the use of
professional judgment, including an understanding of the purpose and context
of a valuation, the selection of appropriate quantitative techniques and data,
and, ultimately, the assignment of a value.

While for business purposes, value is measured in money.

The determination of value:

• It may be for a separate asset, liability or equity item—A financial

instrument, an operating asset, a bond, or common stock, for example.
• It may be for a group of assets or liabilities—A portfolio of financial
instruments, a capital project, a group of operating assets (e.g., a division
or brand), or an entire business entity as a going concern, for example.
• It takes into account the attributes of the item being valued, including its
condition and location.
• It is as of a particular point in time.
• It depends on the quality of the assumptions and inputs used the
appropriateness of the techniques used for measurement, and the
judgment applied.

Input Characteristics

Generally U.S. GAAP provides a structure for prioritizing the quality of inputs
used in fair value determination. It is divided in three levels:

Level 1—highest level:

Inputs are unadjusted quoted prices in active markets for assets or liabilities
identical to those being valued that the entity can obtain at the measurement
date; all such inputs are observable in a market.

Quoted prices in an active market provide the most reliable evidence of fair
value and should be used when available.

Level 2—Middle level:

Inputs are observable for assets or liabilities, either directly or indirectly, other
than quoted prices described in level 1, above, or include:

• Quoted prices for similar assets or liabilities in active markets

• Quoted prices for identical or similar assets or liabilities in markets that
are not active markets and in which there are few relevant transactions,
prices are not current or vary substantially, or for which little information
is publicly available
• Inputs, other than quoted prices, that are observed for the assets or
liabilities being valued, including, for example, interest rates, yield curves,
credit risks, and default rates
• Inputs derived principally from, or corroborated by, observable market
data by correlations or other means

Depending on the circumstances, these inputs when applied may need to be

adjusted for factors such as condition, location, and the level of activity in the
relevant market.

Level 3— lowest level:

Inputs in this level are unobserved for the assets or liabilities being valued and
should be used to determine fair value only to the extent observable inputs are
not available;

When such unobserved inputs are used, they should reflect the entity's
assumptions about what market participants would assume and should be
developed based on the best information and data available in the
circumstances.
Valuation Approaches

U.S. GAAP describes three broad approaches that can be used to develop a fair
value; these approaches are applicable to financial valuation in general:

1. Market Approach (Sales Comparison Approach) :

The market approach bases the value of the subject business on sales of
comparable businesses or business interests. It’s especially useful when
valuing public companies (or private companies large enough to consider
going public) because data on comparable public businesses is readily
available.

Under this approach, the expert identifies recent, arm’s length

transactions involving similar public or private businesses and then
develops pricing multiples. Several different methods are available,
including the:

Guideline public company method. This technique considers the market

price of comparable (or “guideline”) public company stocks. A pricing
multiple is developed by dividing the comparable stock’s price by an
economic variable (for example, net income or operating cash flow).

Merger and acquisition (M&A) method. Here, the expert calculates pricing
multiples based on real-world transactions involving entire comparable
companies or operating units that have been sold. These pricing multiples
 are then applied to the subject company’s economic variables (for
example, net income or operating cash flow).
Under the market approach, the level of value that’s derived depends on
whether the subject company’s economic variables have been adjusted
for discretionary items (such as expenses paid to related parties). If the
expert makes discretionary adjustments available to only controlling
shareholders, it may preclude the application of a control premium. If not,
the preliminary value may contain an implicit DLOC.

These methods rely on the so-called pricing multiples which determine a

relationship between the business economic performance, such as its
revenues or profits, and its potential selling price.

It generally uses prices and other relevant information generated by

market transactions involving assets or liabilities that are identical or
comparable to those being valued.

It is based on the premise that a market participant will not pay more
than it costs to purchase a similar item.

2. Income Approach:

When reliable market data is hard to find, the business valuation expert
may turn to the income approach. This approach converts future expected
economic benefits — generally, cash flow — into a present value. Because
this approach bases value on the business’s ability to generate future
economic benefits, it’s generally best suited for established, profitable
businesses.

The capitalization of earnings method capitalizes estimated future

economic benefits using an appropriate rate of return. The expert
considers adjustments for such items as discretionary expenses (for
example, for above- or below-market owner’s compensation),
nonrecurring revenue and expenses, unusual tax issues or accounting
methods, and differences in capital structure. This method is most
appropriate for companies with stable earnings or cash flow.

The discounted cash flow (DCF) method also falls under the income
approach. In addition to the factors considered in the capitalization of
 earnings method, the expert accounts for projected cash flows over a
discrete period (say, three or five years) and a terminal value at the end of
the discrete period. All future cash flows (including the terminal value)
are then discounted to present value using a discount rate instead of a
capitalization rate.

As with the market approach, the income approach can generate a

control- or minority-level value, depending on whether discretionary
adjustments are made to the future economic benefits.

The Income approach methods determine the value of a business based on

its ability to generate desired economic benefit for the owners. The key
objective of the income based methods is to determine the business value
as a function of the economic benefit.

It generally uses valuation techniques to convert future amounts of

economic benefits or sacrifices of economic benefits to determine what
those future amounts are worth as of the valuation date.

It converts future cash flows or earnings amounts using models,

including:
a) Discounted cash flows
b) Option pricing models
c) Earnings capitalization models

It is based on the premise that a market participant is willing to pay the

present value of the future economic benefits to acquire an item.

3. Cost Approach:

The cost (or asset-based) approach derives value from the combined fair
market value (FMV) of the business’s net assets. This technique usually
produces a “control level” value, meaning the value to an owner with the
power to sell or liquidate the company’s assets. For that reason, a
discount for lack of control (DLOC) may be appropriate when using the
cost approach to value a minority interest. This approach is particularly
useful when valuing holding companies, asset-intensive companies and
distressed entities that aren’t worth more than their net tangible value.
 The cost approach includes the book value and adjusted net asset
methods. The former calculates value using the data in the company’s
books. Its flaws include the failure to account for unrecorded intangibles
and its reliance on historical costs, rather than current FMV. The adjusted
net asset method converts book values to FMV and accounts for all
intangibles and liabilities (recorded and unrecorded).

It uses valuation techniques to determine the amount required to acquire

or construct a substitute item (replacement cost or reproduction cost).

Use of this approach is more limited than the market approach or the
income approach.Use would be especially appropriate for valuing
specialized types of assets.

General Valuation Techniques

There are various valuation methods, techniques, and models used in finance
and accounting. The most important of those are described here using the U.S.
GAAP hierarchy of inputs as a framework for presentation.
Level 1-Quoted market prices in active markets for identical assets or
liabilities.

These values would consist of prices from exchange-traded markets and

dealer markets for identical assets or liabilities as those being valued.

Such markets include public markets, including stock markets, bond

markets, commodities markets, and currency markets, as well as dealer
markets.

As the quoted market price is for an identical asset or liability,

adjustments to the quoted prices are not appropriate in establishing
value.

Quoted market prices would be appropriate for valuing exchange-traded

investments, futures contracts, actively traded bonds, actively traded
debt, commodities, and the like.

Level 2—Inputs other than those in level 1 that are either directly or
indirectly used for valuing an item, including:

A) Quoted prices for similar assets or liabilities in active markets are used for
valuing an item.

Inputs consist of quoted market prices for assets or liabilities similar to those
being valued.

The market may be any of those identified above as active markets.

Examples:

The valuation of common stock of a public company that is restricted from

sale by SEC requirements but for which there are shares publicly traded in an
active market.

The valuation of a receive-fixed, pay-variable interest rate swap contract

based on a LIBOR swap rate

B) Quoted prices for identical assets or liabilities in markets that

are inactive are used for valuing an item.

These inputs would consist of quoted market prices for assets or liabilities
identical to those being valued, but in a stock, commodities or other market
in which there is little interest shown by potential investors, resulting in few
trades.

The market may be a brokered market for unrestricted securities and may
apply to, for example, such instruments as private label, mortgage-backed
securities, collateralized debt obligations, and certain municipal bonds.

C) Quoted prices for similar assets or liabilities in markets that

are inactive are used for valuing an item.

These inputs consist of quoted market prices for assets or liabilities similar
to those being valued in stock, commodities or other markets in which there
is little interest shown by potential investors, resulting in few trades.

The market may be a brokered market for residential or commercial real

estate and may apply to apartment developments, shopping malls, office
buildings, and the like.

D) Inputs other than quoted prices that are observable are used for valuing
an item.

These inputs consist of observable measures, other than quoted prices, that
are relevant to the assets or liabilities being valued.

These inputs would include interest rates, yield curves, credit risks and
default rates, and may apply to secondary market loans or currency swaps.
 E) Inputs not directly observable, but derived principally from, or
corroborated by, observable market data are used for valuing an item.

These inputs would use market data and be developed by correlation or

other means to be useful in valuing an asset or liability.

The inputs would include the use of multiples of earnings, revenues or

similar performance measures to value a business enterprise.

An example would include the valuation of a building using the price per
square foot from transactions involving comparable buildings in similar
locations.

Level 3-Inputs are unobservable and based on an entity's assumptions.

Estimates are used for valuing an item.

These inputs are based primarily on an entity's assumptions, estimates

and data, and not on external, market-based inputs.

These inputs consist of things like expected cash flows, expected life or
residual value, expected volatility, expected inflation, and the like.

The use of these inputs may be appropriate in valuing, for example, asset
retirement obligations, mortgage servicing rights, capital projects, closely
held businesses, and the like.

Valuation Techniques—CAPM

What is Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is a model that describes the
relationship between the expected return and risk of investing in a security. It
shows that the expected return on a security is equal to the risk-free return plus
a risk premium, which is based on the beta of that security. Below is an
illustration of the CAPM concept.

It is an economic model that derives the relationship between risk and expected
return and uses that measure in valuing securities, portfolios, capital projects
and other assets.It incorporates both the time value of money and the element
of risk. The time value of money is incorporated as the risk-free rate of return.
And the element of risk is incorporated in a risk measure called “beta”.
It recognizes that the expected rate of return on an investment (e.g., stock,
portfolio, capital project, etc.) shall provide for the rate on a risk-free investment
plus a premium for the risk inherent in the investment.

If an investment is expected to provide a rate of return equal to or greater than

the computed rate using CAPM, the investment is economically feasible.

If an investment is expected to provide a rate of return less than that computed

using the CAPM formula, the investment is not economically feasible, and should
not be undertaken.

This model presents a simple theory that delivers a simple result. The theory
says that the only reason an investor should earn more, on average, by investing
in one stock rather than another is that one stock is riskier. Not surprisingly, the
model has come to dominate modern financial theory. But does it really work?

It's not entirely clear. The big sticking point is beta. When professors Eugene
Fama and Kenneth French looked at share returns on the New York Stock
Exchange, the American Stock Exchange, and Nasdaq, they found that
differences in betas over a lengthy period did not explain the performance of
different stocks. The linear relationship between beta and individual stock
returns also breaks down over shorter periods of time. These findings seem to
suggest that CAPM may be wrong.

While some studies raise doubts about CAPM's validity, the model is still widely
used in the investment community. Although it is difficult to predict from beta
how individual stocks might react to particular movements, investors can
probably safely deduce that a portfolio of high-beta stocks will move more than
the market in either direction, and a portfolio of low-beta stocks will move less
than the market.

This is important for investors, especially fund managers, because they may be
unwilling to or prevented from holding cash if they feel that the market is likely
to fall. If so, they can hold low-beta stocks instead. Investors can tailor a
portfolio to their specific risk-return requirements, aiming to hold securities
with betas in excess of 1 while the market is rising, and securities with betas of
less than 1 when the market is falling.

Not surprisingly, CAPM contributed to the rise in the use of indexing–

assembling a portfolio of shares to mimic a particular market or asset class–
by risk-averse investors. This is largely due to CAPM's message that it is only
possible to earn higher returns than those of the market as a whole by taking on
higher risk (beta).
Formula

Example:

Let’s calculate the expected return on a stock, using the Capital Asset Pricing
Model (CAPM) formula. Suppose the following information about a stock is
known:

It trades on the NYSE and its operations are based in the United States

Current yield on a U.S. 10-year treasury is 2.5%

The average excess historical annual return for U.S. stocks is 7.5%

The beta of the stock is 1.25 (meaning it’s average weekly return is 1.25x as
volatile as the S&P500 over the last 2 years)

What is the expected return of the security using the CAPM formula?

• Let’s break down the answer using the formula from above in the article:
 • Expected return = Risk Free Rate + [Beta x Market Return Premium]
• Expected return = 2.5% + [1.25 x 7.5%]
• Expected return = 11.9%

Example

Assume the following:

Then:

Thus, given the assumed facts, the required rate of return for the assumed
investment is 17%.

What is Beta?

It is a measure of the systematic risk as reflected by the volatility of an

investment.
According to CAPM, beta is the only relevant measure of a stock's risk. It
measures a stock's relative volatility–that is, it shows how much the price of a
particular stock jumps up and down compared with how much the entire stock
market jumps up and down. If a share price moves exactly in line with the
market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15% if
the market rose by 10% and fall by 15% if the market fell by 10%.

Beta is found by statistical analysis of individual, daily share price returns in

comparison with the market's daily returns over precisely the same period. In
their classic 1972 study "The Capital Asset Pricing Model: Some Empirical
Tests," financial economists Fischer Black, Michael C. Jensen, and Myron Scholes
confirmed a linear relationship between the financial returns of stock portfolios
and their betas. They studied the price movements of the stocks on the New
York Stock Exchange between 1931 and 1965.

Beta, compared with the equity risk premium, shows the amount of
compensation equity investors need for taking on additional risk. If the stock's
beta is 2.0, the risk-free rate is 3%, and the market rate of return is 7%, the
market's excess return is 4% (7% - 3%). Accordingly, the stock's excess return
is 8% (2 x 4%, multiplying market return by the beta), and the stock's total
required return is 11% (8% + 3%, the stock's excess return plus the risk-free
rate).

What the beta calculation shows is that a riskier investment should earn a
premium over the risk-free rate. The amount over the risk-free rate is calculated
by the equity market premium multiplied by its beta. In other words, it is
possible, by knowing the individual parts of the CAPM, to gauge whether or not
the current price of a stock is consistent with its likely return.

It is computed as:
 Beta (β) = (Standard deviation of an asset [a] / Standard
deviation of asset class benchmark [b]) × Coefficient of
correlation of a and b

Beta (β ) value significance

β = 1, then an investment price (value) moves in line with the asset class
benchmark for that investment; the investment has average systematic risk.

β > 1, then an investment price (value) moves greater than the asset class
benchmark for that investment; the investment has higher systematic risk—the
investment is more volatile than the benchmark for the asset class.

In the above example, above, β = 2 depicts that the assumed asset is more
volatile (more risky) than the benchmark for its asset class; therefore, the
required rate of return (17%) is significantly more than the benchmark rate
(10%).

β< 1, then an investment price (value) moves less than the asset class
benchmark for that investment; the investment has lower systematic risk—the
investment is less volatile than the benchmark for the asset class.

Another example:

Assume:

Risk-free rate = 3%
Benchmark rate = 7%
Excess market = 4% (Market benchmark rate –
return Risk-free rate = Premium)

If β = 1 for an asset, the excess rate of return (premium) for the asset is 4% (1.0
× .04) and its total required rate of return is 7% (3% + 4%).

If β = .80 for an asset, the excess rate of return (premium) for the asset is 3.2%
(.80 × .04) and its total required rate of return is 6.2% (3% + 3.2%).

If β = 2.0 for an asset, the excess rate of return (premium) for the asset is 8%
(2.0 × .04) and its total required rate of return is 11% (3% + 8%).
Plotting of CAPM

The following graph shows the plotted slope of β under three assumptions as to
its value:

When β = 1, a percentage change in an asset class benchmark return (i.e., a

market) produces the same percentage change in an individual asset (e.g., a
stock) of the same asset class.

When β > 1, a percentage change in an asset class benchmark return produces a

greater than equal change in an individual asset of the same asset class.

When β < 1, a percentage change in an asset class benchmark return produces a

less than equal change in an individual asset of the same asset class.

CAPM Assumptions

Some of the most significant assumptions of CAPM are:

1. All investors are assumed to have equal access to all investments and all
investors are assumed to be using a one period time horizon.
2. It is assumed that asset risk is measured solely by its variance from the
asset class benchmark.
3. It is assumed that there are no external cost—commissions, taxes, etc.
 4. It is assumed that there are no restrictions on borrowing or lending at the
risk-free rate of return; all parties are assumed to be able to do so.
5. It is assumed that there is a market for all asset classes and, therefore, a
market benchmark; to the extent there is not a market or a benchmark for
a particular asset class, CAPM cannot be used.
6. It uses historical data, which may not be appropriate in calculating future
expected returns.

Usages of CAPM

CAPM provides a required rate of return (discount rate) that can be used in
determining the value of a variety of assets. It can be used in:

1. Analysis of Securities—establishing a required rate of return for

securities valuation. A key factor in the analysis of securities for
investment purposes is the level of risk associated with the security. The
higher the level of risk, the higher the rate of return required by an
investor.
2. Generally, the required rate of return on an investment can be used as the
discount rate applied to future cash flows for valuation purposes.
3. CAPM uses beta as a measure of the relative risk of an investment
compared to that of a larger market, it can be used to establish a required
rate of return for securities valuation.
4. Specifically, the lower the beta of a security, the lower the risk of that
security when compared with the larger market risk. Thus, when
appropriately used, CAPM provides an easy way to compare risk levels
between securities.
5. Corporate Investment in Capital Projects—establishing hurdle rates (or
discount rates) for capital projects.

In this blow mentioned case, the determination of a discount rate using CAPM
would involve using the following

Company beta or industry beta as surrogate for the project beta = 1.50

The risk-free rate of return = 8%

An asset class benchmark = 16%

Calculation of required discount rate (or hurdle rate):

The 20% would be used as the discount rate in the computation of the net
present value (NPV) of a capital project.

Disadvantages of the CAPM

The CAPM suffers from several disadvantages and limitations that should be
noted in a balanced discussion of this important theoretical model.

Assigning values to CAPM variables

To use the CAPM, values need to be assigned to the risk-free rate of return, the
return on the market, or the equity risk premium (ERP), and the equity beta.

The yield on short-term government debt, which is used as a substitute for the
risk-free rate of return, is not fixed but changes regularly with changing
economic circumstances. A short-term average value can be used to smooth out
this volatility.

Finding a value for the equity risk premium (ERP) is more difficult. The return
on a stock market is the sum of the average capital gain and the average
dividend yield. In the short term, a stock market can provide a negative rather
than a positive return if the effect of falling share prices outweighs the dividend
yield. It is therefore usual to use a long-term average value for the ERP, taken
from empirical research, but it has been found that the ERP is not stable over
time. In the UK, an ERP value of between 3.5% and 4.8% is currently seen as
reasonable. However, uncertainty about the ERP value introduces uncertainty
into the calculated value for the required return.

Beta values are now calculated and published regularly for all stock exchange-
listed companies. The problem here is that uncertainty arises in the value of the
expected return because the value of beta is not constant, but changes over time.
Using the CAPM in investment appraisal

Problems can arise in using the CAPM to calculate a project-specific discount

rate. For example, one common difficulty is finding suitable proxy betas, since
proxy companies very rarely undertake only one business activity. The proxy
beta for a proposed investment project must be disentangled from the
company’s equity beta. One way to do this is to treat the equity beta as a
portfolio beta (βp), an average of the betas of several different areas of proxy
company activity, weighted by the relative share of the proxy company market
value arising from each activity.

βp = (W1β1) + (W2β2)

W1 and W2 are the market value weightings of each business area

β1 and β2 are the equity betas of each business area.

Example

A proxy company, ECG Co, has an equity beta of 1.2. Approximately 75% of the
business operations of ECG Co by market value are in the same business area as
a proposed investment. However, 25% of its business operations by market
value are in a business area unrelated to the proposed investment. These
unrelated business operations are 50% riskier, in systematic risk terms, than
those of the proposed investment. What is proxy equity beta for the proposed
investment?

Solution

Using the portfolio beta formula, βp = (W1β1) + (W2β2):

1.2 = (0.75 x β1) + (0.25 x 1.5 x β1) = (0.75 x β1) + (0.375 x β1) = 1.125 x β1

Proxy equity beta = β1 = 1.2/ 1.125 = 1.067

In this case note that β2 = 1.5 x β1

The information about relative shares of proxy company market value may be
quite difficult to obtain.

A similar difficulty is that ungearing proxy company betas uses capital structure
information that may not be readily available. Some companies have complex
capital structures with many different sources of finance. Other companies may
have untraded debt or use complex sources of finance such as convertible
bonds.

The simplifying assumption that the beta of debt is zero will also lead to
inaccuracy, however small in the calculated value of the project-specific
discount rate.

Another disadvantage in using the CAPM in investment appraisal is that the

assumption of a single-period time horizon is at odds with the multi-period
nature of investment appraisal. While CAPM variables can be assumed constant
in successive future periods, experience indicates that this is not true in the real
world.

Option Pricing

What is Option?

A contract that entitles the owner to buy (call option) or sell (put option) at a
stated price within a specified period. Financial options are a form of derivative
instrument.

Options are financial derivatives that represent a contract by a selling party—or

the option writer—to a buying party—or the option holder. An option gives the
holder the ability to buy or sell a financial asset with a call or put option
respectively. This is done at an agreed price on a specified date or during a
specified time period. Holders of call options seek to profit from an increase in
the price of the underlying asset, while holders of put options generate profits
from a price decline.

Options are versatile and can be used in a multitude of ways. While some
traders use options purely for speculative purposes, other investors, such as
those in hedge funds, often utilize options to limit risks attached to holding
assets.

There are two major types of options: calls and puts.

Call is an option contract that gives you the right but not the obligation to buy
the underlying asset at a predetermined price before or at expiration day.

Put is an option contract that gives you the right but not the obligation to sell the
underlying asset at a predetermined price before at expiration day.

Options may also be classified according to their exercise time:

European style options may be exercised only at the expiration date.

American style options can be exercised anytime between purchase and

expiration date.

The abovementioned classification of options is extremely important because

choosing between European-style or American-style options will affect our
choice for the option pricing model.

There are several options pricing models that use these parameters to
determine the fair market value of an option. Of these, the Black-Scholes model
is the most widely known. In many ways, options are just like any other
investment—you need to understand what determines their price to use them
effectively. Other models are also commonly used such as the binomial
model and trinomial model.

Option Valuation

Valuing an option, including determining it has no value, is based on six factors:

Current stock price relative to the exercise price of the option—the difference
between the current price and the exercise price affects the value of the option.
The impact of the difference depends on whether the option is a call option or a
put option.

Call option: A current price above the exercise (or strike) price increases the
option value; the option is considered “in the money.” The greater the excess,
the greater the option value.
Put option: A current price below the exercise price increases the option value;
the option is considered “in the money.” The lower the current price relative to
the exercise price, the greater the option value.

Expiration of the option: the longer the time to expiration, the greater the option
value (as there is a longer time for the price of the stock to go up).

The risk-free rate of return in the market:the higher the risk-free rate, the
greater the option value.

A measure of risk for the optioned security, such as standard deviation: The
larger the standard deviation, the greater the option value (as the price of the
stock is more volatile; goes up higher and down further than its market
changes).

Exercise price

Dividend payment on the optioned stock: The smaller the dividend payments,
the greater the option value (as more earnings are being retained).There is a
direct relationship between these factors and the fair value of an option.

Black–Scholes Model

It is developed to value options under specific conditions; hence, it is

appropriate for

• European call options, which permit exercise only at the expiration date
• Options for stocks that pay no dividends
• Options for stocks whose price increases in small increments
• Discounting the exercise price using the risk-free rate, which is assumed
to remain constant

As other models used to estimate fair value of an option, the Black–Scholes

method uses the factors mentioned above.

The advantage of the Black–Scholes model is the addition of two elements:

1) Probability factors for:

 • The likelihood that the price of the stock will pay off within the time to
expiration, and
• The likelihood that the option will be exercised.

2) Discounting of the exercise price

Many constraints in the original Black–Scholes model have been overcome by

subsequent modifications, so that modified Black–Scholes models are widely
used in valuing options.

The Black-Scholes model is another commonly used option pricing model. This
model was discovered in 1973 by the economists Fischer Black and Myron
Scholes. Both Black and Scholes received the Nobel Memorial Prize in the
economics for their discovery.

The Black-Scholes model was developed mainly for the pricing European
options on stocks. The model operates under the certain assumptions regarding
the distribution of the stock price and the economic environment. The
assumptions about the stock price distribution include:

Continuously compounded returns on the stock are normally distributed and

independent over time.

• The volatility of continuously compounded returns is known and

constant.
• Future dividends are known (as a dollar amount or as a fixed dividend
yield).
• The assumptions about the economic environment are:
• The risk-free rate is known and constant.
• There are no transaction costs or taxes.
• It is possible to short-sell with no cost and to borrow at the risk-free rate.

Nevertheless, these assumptions can be relaxed and adjusted for special

circumstances if it is necessary. In addition, we could easily use this model to
price options on assets other than stocks (currencies, futures).

The main variables used in the Black-Scholes model include:

Price of underlying asset (S) is a current market price of the asset

Strike price (K) is a price at which an option can be exercised

Volatility (σ) is a measure of how much the security prices will move in the
subsequent periods. Volatility is the trickiest input in the option pricing model
as the historical volatility is not the most reliable input for this model

Time until expiration (T) is a time between calculation and option’s exercise
date

Interest rate (r) is a risk-free interest rate

Dividend yield (δ) was not originally the main input into the model. The
original Black-Scholes model was developed for pricing options on non-paying
dividends stocks.

The underlying theory of the Black–Scholes method and the related

computation can be complex. Therefore, its use is best carried out using
computer applications.

Binomial Option Pricing Model (BOPM)

It is a generalizable numerical method for the valuation of options. It uses a
“tree” to estimate value at a number of time points between the valuation date
and the expiration of the option.

Each time point where the tree “branches” represents a possible price for the
underlying stock at that time.

The simplest method to price the options is to use a binomial option pricing
model. This model uses the assumption of perfectly efficient markets. Under this
assumption, the model can price the option at each point of a specified
timeframe.

Under the binomial model, we consider that the price of the underlying asset
will either go up or down in the period. Given the possible prices of the
underlying asset and the strike price of an option, we can calculate the payoff of
the option under these scenarios, then discount these payoffs and find the value
of that option as of today.

Valuation is performed iteratively, starting at each of the final nodes (those that
may be reached at the time of expiration), and then working backwards through
the tree towards the first node (valuation date).

The value computed at each stage is the value of the option at that point in time,
including the single value at the valuation date.
BOPM Process

The BOPM process consists of three basic steps:

1) Generate a price tree.

2) Calculate the option value at each tree end node.
3) Sequentially calculate the option value at each preceding node.

The process can be illustrated using a simple one-year option:

Assume an option for a share of stock that expires in one year and has an
exercise price of $100. An evaluation estimates that at the end of the year the
underlying stock could have a price as high as $120 and as low as $80.

These facts can be represented graphically as follows:

Probabilities are assigned to each of the possible outcomes to develop an

expected value for the option.

Assume that a .60 probability is assigned to the $120 high value and a .40
probability (1.00 − .60) is assigned to the $80 low value. The entity's cost of
funds is 10%.

Expected Value = [(.60 × $20) + ( .40 × $0)]/1.10

= [$12 + $ 0 ]/1.10

Option Value = $12/1.10 = $10.91

While the one-period model is an extreme simplification of the use of the

binomial option pricing model, it illustrates the approach. In practice the entire
time period of the option would be divided into multiple sub periods, with the
expected outcome of each period being the input for the prior period.

The binomial option pricing model can be used for American-style options,
which allow to exercise any time up to the expiration date, and when the
underlying stock pays dividends, which the original Black–Scholes model does
not accommodate.

Business Entity Valuation

It is the estimation of the economic value of a business entity or portion thereof.

It may be for an entire business entity or for a portion (fractional share) of an
entity.

When an entity is publicly traded in an active market, its value can be

determined by its market capitalization, its total value in the market, which is a
direct measure of its fair value. Thus, the prime concern is the valuation of non-
public entities.

The valuation would be used to determine the cash price that would be received
upon the sale of a business interest or for related purposes, including for:

• Buy-sell agreements
• Business combinations like mergers and acquisitions.
• Estate purposes
• Business Valuation Process
The valuation of a business should be carried out according to a process,
including:

• Establishing standards and premise of the valuation

• Assessment of the economic environment of the business
• Analysis of financial statements
• Formulation of valuation

Standards and Premise of Valuation:

The first element in a business valuation process is to establish the standards

and premise of the value to be developed, which establishes the reasons for and
circumstances surrounding the business valuation.

The standards of value establish the conditions under which the business will be
valued such as:

• Is the valuation legally or otherwise mandated, or

• Is it at the request of a business owner, or
• Is it at the mutual request of a business owner and a prospective buyer, or
• Is it in connection with a business combination?
• The premise of value establishes any assumptions to be used in the
valuation. For example:
Will the business continue in its entirety as a going concern, or
 Will the business be merged into the acquiring firm, or
Will the assets be separately sold?
• Economic Environment Assessment

The broadest issue of concern in establishing the value of a business is the

economic environment in which it operates.The nature of the macro and local
environments and the status of the industry in which the business operates
should be determined as the larger context for valuing a specific business.

Financial Statement Analysis:

Once the implications of the

operating environment and industry
on the valuation process are
understood, the financial statements
of the entity being valued should be
analyzed; that analysis might include:

Common-size analysis

Converting dollar amounts on the financial statements to percentages for

comparison over time and with other entities. Common-size income statement
would show all individual items of revenue, expense, gain and loss as a
percentage of total revenues (or net revenues). Common-size balance sheet
would show all individual items of assets, liabilities, and equity as a percentage
of total assets.

Trend analysis:

Determining the changes over time in

major financial measures, including
revenues, profits/losses, ownership
interest and dividends/withdrawals.

Ratio analysis:

Determining important ratios and other measures to assess changes over time
and to compare with other entities in the industry.
Adjustments:

Making adjustments to the basic financial statements to better reflect normal,

on-going operations or to better facilitate comparisons with other entities; such
adjustments might include, for example:

• The elimination of non-operating assets

• The elimination of non-recurring items
• The elimination of differences in accounting treatments (e.g., accelerated
depreciation versus straight-line depreciation)

Formulation of Valuation

With an understanding of the economic and industry environment and the

outcomes of financial statement and related analysis, alternative methods may
be used to assign a value to the business.

The alternative approaches are:

• Market approach
• Income approach
• Asset approach
• Business Valuation Approaches

Market Approach

It determines the value of an entity by comparing it to other entities with similar

characteristics in the same industry, in the same market(s), of the same size,
with highly similar product lines, similar risks, and other factors.

It is often called the “guideline public company method.”

The market value of a publicly traded entity is used as the basis for establishing
the value of a highly comparable entity that market value, also called market
capitalization, is the total value of a firm's outstanding shares of stock in the
market in which it is traded. It is calculated by multiplying the total number of
outstanding shares by the current market share price. Similar to the comparable
sales method used in real estate appraisals.
The market approach provides a means of valuing an entire entity, but
adjustments may be needed when determining the value of a portion (or
fractional share) of the business ownership or when the business interest may
lack marketability.

Share of business entity: Controlling interest exists when an owner (investor)

has greater than 50% ownership of an entity's voting rights, in which case the
controlling interest can elect the board of directors who, in turn, can control all
aspects of an entity's operation. A greater-than-50% ownership occurs when
there is a business combination.

Minority interest exists when an owner (investor) has less than 50% ownership
of an entity's voting rights, in which case the minority interest is not able to
exercise control over the entity and the value of the ownership should be
discounted relative to the value assigned to the controlling interest (a non-
controlling discount).

Lack of marketability—Marketability is the ability to convert an asset, in this

case an ownership interest in a business, into cash with a high degree of
certainty as to the proceeds.A publicly traded entity is likely to be more
marketable than a privately held entity. As publicly traded entities are more
marketable than privately held entities, they are worth more.

The value of a business ownership interest that lacks marketability must be

discounted from what a comparable publicly traded entity would be worth; the
discount could be substantial.

The appropriate level of discount is a matter of professional judgment; some

statistics show it should be between 30% and 55%.

Disadvantages of market approach

1. Difficulty in identifying publicly traded entities which are highly

comparable to non-publicly traded entities.
2. Nonpublic entity ownership is less liquid than publicly traded shares,
which may make it difficult to determine the liquidity discount necessary.
3. Income Approach (for Business Valuation)
4. This approach determines the fair value of an entity by calculating the net
present value of the benefit stream generated by the entity; the resulting
net present value is the value of the entity.
 5. Net present value is calculated by applying a discount rate or
capitalization rate to the benefit stream provided by the entity.
6. The discount or capitalization rate used is the yield (return) needed to
attract investors, given the risk associated with the investment.

Alternative income approaches:

There are a number of income approaches that are used; four of the most
significant are described below:

1. Discounted cash flows,

2. Capitalization of earnings,
3. Multiples, and
4. Free cash flow.

Discounted cash flows:

Discounted cash flow (DCF) is a valuation method used to estimate the value of
an investment based on its future cash flows. DCF analysis attempts to figure out
the value of a company today, based on projections of how much money it will
generate in the future.

DCF analysis finds the present value of expected future cash flows using
a discount rate. A present value estimate is then used to evaluate a potential
investment. If the value calculated through DCF is higher than the current cost of
the investment, the opportunity should be considered.

It uses discounted future cash flows to get their net present value. Future cash
flows consist of both expected future inflows and outflows. The discount rate
used may be based on:

• The weighted-average cost of capital (WACC)

• The capital asset pricing model (CAPM)

The discounted cash flow method will be used and illustrated in the "Capital
Budgeting" section.
The purpose of DCF analysis is to estimate the money an investor would receive
from an investment, adjusted for the time value of money. The time value of
money assumes that a dollar today is worth more than a dollar tomorrow.

For example, assuming 5% annual interest, $1.00 in a savings account will be

worth $1.05 in a year. Similarly, if a $1 payment is delayed for a year, its present
value is $.95 because it cannot be put in your savings account.

For investors, DCF analysis can be a handy tool that serves as a way to confirm
the fair value prices published by analysts. It requires you to consider many
factors that affect a company, including future sales growth and profit margins.
You’ll also have to think about the discount rate, which is influenced by the risk-
free rate of interest, the company’s cost of capital and potential risks to its share
prices. All of this helps you gain insight into factors that drive share price, so
you’ll be able to put a more accurate price tag on the company’s stock.

A challenge with the DCF model is choosing the cash flows that will be
discounted when the investment is large, complex, or the investor cannot access
the future cash flows. The valuation of a private firm would be largely based on
cash flows that will be available to the new owners. DCF analysis based
on dividends paid to minority shareholders (which are available to the investor)
for publicly traded stocks will almost always indicate that the stock is a poor
value.

However, DCF can be very helpful for evaluating individual investments or

projects that the investor or firm can control and forecast with a reasonable
amount of confidence.
DCF analysis also requires a discount rate that accounts for the time value of
money (risk-free rate) plus a return on the risk they are taking. Depending on
the purpose of the investment, there are different ways to find the correct
discount rate.

Capitalization of earnings

It applies a capitalization rate to the earnings of an entity to determine the value

of the entity.

Capitalization of earnings is a method of determining the value of an

organization by calculating the worth of its anticipated profits based on current
earnings and expected future performance. This method is accomplished by
finding the net present value (NPV) of expected future profits or cash flows, and
dividing them by the capitalization rate (cap rate). This is an income-valuation
approach that determines the value of a business by looking at the current cash
flow, the annual rate of return, and the expected value of the business.

Net income is divided by an assumed or desired rate of return to obtain the

value of the entity that generated the earnings.
Example

This example assumes no future growth and disregards inflation.

An entity expects to earn $100,000 and the rate of return required for the level
of risk is 20%.

Capitalized value = $100,000/.20 = $500,000

The value of the business would be $500,000.

Notice that a $500,000 investment earning at the rate of 20% would provide a
$100,000 return.

Example

It assumes a 4% growth rate and a 3% inflation rate.

An entity expects to earn $100,000 and the rate of return required for the level
of risk is 20%

Capitalized Value = Expected Earnings/[Discount Rate – (Growth Rate +

Inflation Rate)]

Capitalized Value = $100,000/[.20 – (.04 + .03)]

Capitalized Value = $100,000/.13 = $769,231

The value of the business would be $769,231

Drawbacks of Capitalization of Earnings

Evaluating a company based on future earnings has disadvantages. First, the

method in which future earnings are projected may be inaccurate, resulting in
less than expected yields. Extraordinary events can occur, compromising
earnings and therefore affecting the investment's valuation. Also, a startup that
has been in business for one or two years may lack sufficient data for
determining an accurate valuation of the business.

Because the capitalization rate should reflect the buyer’s risk tolerance, market
characteristics, and the company’s expected growth factor, the buyer needs to
know the acceptable risks and the desired ROI. For example, if a buyer is
unaware of a targeted rate, he may pay too much for a company or pass on a
more suitable investment.

Earnings multiples

It applies a multiple factor to the earnings of an entity to determine the value of

the entity.

A multiple attempts to capture many of an entity's operating and financial

characteristics in a single number, which can be multiplied by a measure of
earnings (or other factors) to get an entity's value.The multiple is, in effect, the
same as the rate used above to capitalize earnings.

A capitalization rate of 20% would be the same as a multiple of 5 (100%/20% =

5).

When using the capitalization rate, as shown above, the rate is divided into
earnings to get a value; when using the multiple, the multiple is multiplied by
the earnings to get a value.

Multiples can be developed for a number of financial statement relationships,

some of which are considered enterprise multiples and some of which are
considered equity multiple.
Enterprise multiples provide a value for the entity as a whole, not just the value
of the common shareholders interest. Computing these multiple requires using:

The value of the enterprise (EV) in the numerator; that is, the sum of equity
market value, debt, and other liabilities (the amount of liquid assets may be
subtracted)

The value of enterprise earnings before interest, depreciation, and amortization

(EBITDA) in the denominator

Thus, the equation is: EV/EBITDA

Equity multiples provide a value for the equity holders' interest, not for the
enterprise as a whole. Computing these multiples requires using:

• The market value of the equity in the numerator

• A measure of earnings (or other measure) in the denominator

The most commonly used equity measure is based on the price-to-earnings

ratio (P/E ratio).

The P/E ratio (multiple) is computed as: Market price/Earnings per Share.
Market price is the per share price of a stock in the market.

EPS is provided in the financial statements, but an earnings per share based on
projected earnings usually is more appropriate, as is making adjustments for
non-operating and finance items.

PEG ratio

PEG is a variation of the P/E multiple which provides comparisons when growth
varies across entities.

PEG is computed as (P/E)/EPS growth rate.

It permits easier comparisons between entities in different stages of
development and is especially appropriate for firms in fast growing industries
(e.g., technology). Developing an appropriate earnings-based multiple for
valuation or comparison requires:

• Determining an appropriate group of comparable companies

• Developing forecasts of earnings to use in the calculation; future expected
earnings are a better measure than historic earnings
• Carefully analyzing and adjusting forward-looking earnings to eliminate
non-operating or non-recurring items
• Insuring that the values in the numerator and the denominator are
consistent with each other

A number of other multiples can be developed for an entity and may be

appropriate in certain circumstances, including, for example:

• Book value multiple = Market value/Book value

• Revenue value multiple = Market value/Revenue

The price/earnings to growth ratio (PEG ratio) is a stock's price-to-

earnings (P/E) ratio divided by the growth rate of its earnings for a specified
time period.
The PEG ratio is used to determine a stock's value while also factoring in the
company's expected earnings growth and is thought to provide a more complete
picture than the P/E ratio.

While a low P/E ratio may make a stock look like a good buy, factoring in the
company's growth rate to get the stock's PEG ratio may tell a different story. The
lower the PEG ratio, the more the stock may be undervalued given its future
earnings expectations. Adding a company's expected growth into the ratio helps
to adjust the result for companies that may have a high growth rate and a high
P/E ratio.

The degree to which a PEG ratio result indicates an over or underpriced stock
varies by industry and by company type. As a broad rule of thumb, some
investors feel that a PEG ratio below one is desirable.

According to well-known investor Peter Lynch, a company's P/E and expected

growth should be equal, which denotes a fairly valued company and supports a
PEG ratio of 1.0. When a company's PEG exceeds 1.0, it's considered overvalued
while a stock with a PEG of less than 1.0 is considered undervalued.

Example of How to Use the PEG Ratio

The PEG ratio provides useful information to compare companies and see which
stock might be the better choice for an investor's needs, as follows.

Assume the following data for two hypothetical companies, Company A and
Company B:

Company A:

• Price per share = $46

• EPS this year = $2.09
• EPS last year = $1.74

Company B

• Price per share = $80

• EPS this year = $2.67
• EPS last year = $1.78
Given this information, the following data can be calculated for each company.

Company A

P/E ratio = $46 / $2.09 = 22

Earnings growth rate = ($2.09 / $1.74) - 1 = 20%

PEG ratio = 22 / 20 = 1.1

Company B

P/E ratio = $80 / $2.67 = 30

Earnings growth rate = ($2.67 / $1.78) - 1 = 50%

PEG ratio = 30 / 50 = 0.6

Many investors may look at Company A and find it more attractive since it has a
lower P/E ratio between the two companies. But compared to Company B, it
doesn't have a high enough growth rate to justify its P/E. Company B is trading
at a discount to its growth rate and investors purchasing it are paying less per
unit of earnings growth.

Using the PEG ratio in conjunction with a stock's P/E can tell a very different
story than using P/E alone.

A stock with a very high P/E might be viewed as overvalued and not a good
choice. Calculating the PEG ratio on that same stock, assuming it has good
growth estimates, can actually yield a lower number, indicating that the stock
may still be a good buy.

The opposite holds true as well. If you have a stock with a very low P/E you
might logically assume that it is undervalued. However, if the company does not
have earnings growth projected to increase substantially, you may get a PEG
ratio that is, in fact, high, indicating that you should pass on buying the stock.

The baseline number for an overvalued or undervalued PEG ratio varies from
industry to industry, but investment theory says that, as a rule of thumb, a PEG
of below one is optimal. When a PEG ratio equals one, this means the market's
perceived value of the stock is in equilibrium with its anticipated future
earnings growth.

If a stock had a P/E ratio of 15, and the company projected its earnings to grow
at 15%, for example, this gives it a PEG of one.

When the PEG exceeds one, this tells you that the market expects more growth
than estimates predict, or that increased demand for a stock has caused it to be
overvalued.

A ratio result of less than one says that analysts have either set their consensus
estimates too low or that the market has underestimated the stock's growth
prospects and value.

As you are using the other tools to conduct fundamental analysis, you are
comparing the PEG ratio to the other ratios you have selected. If all of your
chosen tools are showing ratios that indicate undervaluation, you may have
found a stock worth investing in.

As with any analysis, the quality of results changes depending on the input
data. For example, a PEG ratio may be less accurate if calculated with historical
growth rates, as compared to the ratio if a company has projected higher or
upward-trending future growth rates.

Multiples for valuation

Multiples derived from a set of similar or comparable public entities can be used
to estimate the value of a private entity or the ownership interest in such
entity.Highly comparable entities with the same multiples would probably have
the same value.

Therefore, if a set of highly comparable public entities, for example, have a P/E
multiple of 20, and then the comparable private entity would be expected to
have a value 20 times its earnings.By multiplying the multiple by the basis on
which the multiple was developed, the value of an entity can be derived.

Multiple choice and characteristics

The choice of an appropriate multiple for valuation purposes depends on the

nature of the business. Valuing an entity in a capital-intensive industry, for
example, probably would employ a different multiple than would be used in
valuing a consulting firm, which may have little capital investment.

Entities with higher growth, lower risk and higher payout ratios would be
expected to have higher multiples of earnings, book value price to equity, or
book value to revenue than entities with the opposite characteristics.

Due to differences in underlying fundamentals over time and between

countries, multiples computed over time or between countries are less likely to
be reliable measures.

Free Cash Flow

Free cash flow represents the cash a company generates after cash outflows to
support operations and maintain its capital assets. Unlike earnings or net
income, free cash flow is a measure of profitability that excludes the non-cash
expenses of the income statement and includes spending on equipment and
assets as well as changes in working capital.

Interest payments are excluded from the generally accepted definition of free
cash flow. Investment bankers and analysts who need to evaluate a company’s
expected performance with different capital structures will use variations of
free cash flow like free cash flow for the firm and free cash flow to equity, which
are adjusted for interest payments and borrowings.

Free cash flow is cash flow, an entity generates after the cash flow expended or
amortized to maintain or expand its capital asset base. It provides financing that
enables an entity to pursue opportunities, including new product undertakings,
acquisitions, debt reduction etc.

Free cash flow is calculated as:

Net Income
+ Depreciation/Amortization
− Capital Expenditures
± Changes in Working Capital
= Free Cash Flow
The use of free cash flow is a variation on the use of discounted cash flow,
described above, but uses a different measure of cash flow. It may be an
appropriate means of measuring value, especially in the following cases:

• Entities with no dividend history or for which dividends are not reflective
of earnings
• Entities with a number of years of reliable free cash flow

The value of an entity would be determined by computing the present value of

future free cash flow using an appropriate discount rate.

Imagine a company has earnings before depreciation, amortization, interest,

and taxes (EBITDA) of $1,000,000 in a given year. Also, assume that this
company has had no changes in working capital (current assets – current
liabilities) but they bought new equipment worth $800,000 at the end of the
year. The expense of the new equipment will be spread out over time on the
income statement, which evens out the impact on earnings.

However, because FCF accounts for new equipment all at once, the company will
report $200,000 FCF ($1,000,000 EBITDA - $800,000 Equipment) on
$1,000,000 of EBITDA that year. If we assume that everything else remains the
same and there are no further equipment purchases, EBITDA and FCF will be
equal again the next year. In this situation, an investor will have to determine
why FCF dipped so quickly one year only to return to previous levels, and if that
change is likely to continue.

Companies that are capital light, meaning they don't have to make long-term
investments as part of their business, will have very steady free cash flow over
time. Free cash flow for a capital-light business will usually approximate net
income. Companies that do have to make big long-term investments -- building
factories or buying bulldozers, for example -- will have more volatile free cash
flows.

Look at Moody's, a company for which the brainpower of its employees is its
major product. You'll notice that it produces very stable free cash flow over
time, and that its free cash flow roughly approximates its net income from year
to year. This is because it is a very capital-light business. To grow, Moody's
doesn't have to build billion-dollar factories. Rather, it hires more employees
whose salaries are paid as services are produced and sold.

Conversely, Chevron has historically generated volatile free cash flows because
it has to make large, billion-dollar investments in machinery and equipment to
bring oil and gas to the ground. (The fact that oil prices rise and fall certainly
doesn't help reduce the volatility in its free cash flow, either!)

The maturity of a business will also affect free cash flow. Mature businesses
generally produce more consistent free cash flow, because they aren't making
continuously large investments to grow.

Younger companies typically produce little in the way of free cash flow, because
the cash they generate from operations is put back into the business. (As an
example, refer to Wal-Mart's statements of cash flows from 1998 to 2000 and
compare them the statements from 2013 to 2015. You'll see that its slowing
growth has resulted in significantly more free cash flow as a percentage of cash
flow from operations.)

For banks, insurers, and other financial companies, you can essentially throw
out free cash flow altogether. It's simply not useful in the same way it is for non-
financial companies.

Free cash flow in valuation

Many people use free cash flow as a substitution for earnings when valuing
businesses that are mature, capital light, or both. Like price-earnings ratios,
price-to-free-cash-flow ratios can be useful in valuing a business. To calculate a
price-to-free-cash-flow ratio, you can simply divide the price of a share by the
free-cash-flow per share, or the market cap of a company divided by its total
free cash flow.

Ultimately, free cash flow is just another metric, and it doesn't tell you
everything, nor will it be useful for every kind of company. But observing that
there is a very big difference between income and free cash flow will almost
certainly make you a better investor.

Asset Approach for Business Valuation

It determines the fair value of an entity by adding the values of the individual
assets that comprise the business.The underlying principle is that no rational
investor would pay more for an entity than the sum of its component or similar
net assets.

The fair value of each individual asset or liability is determined and the sum of
those values establishes a value for the business entity.Determining the value of
individual assets will require the use of another basic valuation technique, for
example, an income approach, a market approach, or a cost approach.

Under this, the value of certain assets (e.g., intangible assets) may be difficult or
impossible to determine independent of the overall entity.

The use of the asset approach is more appropriate in some circumstances than
in others:

• It is less likely to be appropriate in valuing a going concern.

• It is less likely to be appropriate in valuing a non-controlling fractional
interest in an entity.
• It is more likely to be appropriate when an entity is liquidating (going out
of business).
• It is more likely to be appropriate when an entity has nominal cash flows
and/or earnings.

Business Valuation and Business Combinations

For companies, business valuation is commonly used in with business
combinations. A business combination occurs when an existing or newly formed
business entity either:

• Acquires a group of net assets that constitute a business (e.g., a division or

product line)
• Acquires equity interest in another entity and obtains control of that
entity
• Business combinations may take one of three legal (or statutory) forms:

Merger: When existing entity acquires either a group of assets that constitute a
business or controlling equity interest of another preexisting entity and
“collapses” the acquired assets or entity into the acquiring entity.In this form,
the acquired assets or entity cease to exist separate from the acquiring
entity.Only the acquiring entity remains; the assets and liabilities of the acquired
entity have been merged into the acquiring entity.

Consolidation: When a new entity is formed to consolidate the net assets or the
equity interest of two or more preexisting entities, which cease to exist.In this
form, only the new entity exists after the combination. The assets and liabilities
of the preexisting entities are combined to form the new entity. The preexisting
entities cease to exist as legal entities; only the new entity remains as a legal
entity.

Acquisition: When existing entity acquires controlling equity interest of another

preexisting entity and both entities continue to exist and operate as separate
legal entities. In this form of combination, one entity acquires more than 50% of
the voting stock of another entity but does not “collapse” that entity; it continues
to exist. The acquiring entity becomes the “parent / Holding” of the acquired
“subsidiary.”

In all such cases, consolidated financial statements will be required.

Many present-day corporations operate as a subsidiary of a higher-level parent

corporation.

Why Valuation of Business Combinations?

As most business combinations involve public companies, existing market value
provides a “starting point” for valuing a business combination. For business
combinations that do not involve a publicly traded entity, methods previously
described may be used to develop a base valuation.

Those “starting point” will need to be adjusted to recognize the financial effects
of the reason for the business combination. The reasons for a business
combination and the effect on valuation may include, among others:

1. Expected synergies: The potential is that the performance and value of the
combining of firms will be greater than the firms operating separately,
resulting in financial benefit to the shareholders
2. Economies of scale: The combined companies can operate at a larger scale
and with reduced fixed cost as compared to the sum of the separate
operations resulting into increase profit margins.

3. Reduction in competition: To eliminate a competitor and to acquire

larger market share which enable the acquiring firm to have more control
of the prices of its goods.

4. Diversification: The addition of new goods/services to offerings or the

movement into new geographical areas, either of which may lead to
dampen variations in the acquiring firms revenues and earnings.

5. Supply chain control: The acquisition of a supplier or a customer to gain

control over the supply chain for goods or services and reduce costs and
improve efficiency by such things as better coordination, decreased
transportation expenses.

6. Bargain in purchase: The acquired may be perceived as being

undervalued by the market and, thus, present a bargain investment
opportunity for the acquiring company.

The ultimate objective of all of the above reasons is to improve the financial
performance of the entity.

For accounting purposes, the value of the combination must be allocated to

recording all identifiable assets acquired (including intangible assets), liabilities
assumed and non-controlling interest at fair value as of the date of the
combination. Fair values for individual assets and liabilities may be determined
using the market approach, the income approach, or the cost approach, as
discussed above.

In a case where the purchase price exceeds the net fair value
assigned,anintangible asset “goodwill” is recognized as difference. While when
the purchase price is less than the net fair value assigned to identifiable items,
the difference is recognized as a gain in earnings for the period of the
acquisition.

Hedging and Derivatives

Overview

Hedging is a risk management strategy which involves using offsetting counter

transactions so that a loss on one transaction would be offset against a gain on
another transaction (or vice versa). E.g. One may “hedge a bet” by offsetting a
possible loss from betting on one team to win by also betting on the other team
to win.

Another example: One would hedge against a possible loss in inventory value by
entering into a contract to sell comparable inventory at a fixed price for future
delivery. While hedging is used to reduce risk, it also reduces profit potential.

Hedging is analogous to taking out an insurance policy. If you own a home in a

flood-prone area, you will want to protect that asset from the risk of flooding –
to hedge it, in other words – by taking out flood insurance. In this example, you
cannot prevent a flood, but you can work ahead of time to mitigate the dangers
if and when a flood occurs. There is a risk-reward tradeoff inherent in hedging;
while it reduces potential risk, it also chips away at potential gains. Put simply,
hedging isn't free. In the case of the flood insurance policy example, the monthly
payments add up, and if the flood never comes, the policy holder receives no
payout. Still, most people would choose to take that predictable, circumscribed
loss rather than suddenly lose the roof over their head.

In the investment world, hedging works in the same way. Investors and money
managers use hedging practices to reduce and control their exposure to risks. In
order to appropriately hedge in the investment world, one must use various
instruments in a strategic fashion to offset the risk of adverse price movements
in the market. The best way to do this is to make another investment in a
targeted and controlled way. Of course, the parallels with the insurance example
above are limited: in the case of flood insurance, the policy holder would be
completely compensated for her loss, perhaps less a deductible. In the
investment space, hedging is both more complex and an imperfect science.

The most common way of hedging in the investment world is through

derivatives. Derivatives are securities that move in correspondence to one or
more underlying assets. They include options, swaps, futures and forward
contracts. The underlying assets can be stocks, bonds, commodities, currencies,
indices or interest rates. Derivatives can be effective hedges against their
underlying assets, since the relationship between the two is more or less clearly
defined. It’s possible to use derivatives to set up a trading strategy in which a
loss for one investment is mitigated or offset by a gain in a comparable
derivative.

For example, if Kuton buys 100 shares of Stock at $10 per share, he might hedge
his investment by taking out a $5 American put option with a strike price of $8
expiring in one year. This option gives Kuton the right to sell 100 shares of
STOCK for $8 any time in the next year. If one year later STOCK is trading at $12,
Kuton will not exercise the option and will be out $5. He's unlikely to fret,
though, since his unrealized gain is $200 ($195 including the price of the put). If
STOCK is trading at $0, on the other hand, Kuton will exercise the option and sell
his shares for $8, for a loss of $200 ($205 including the price of the put).
Without the option, he stood to lose his entire investment.

The effectiveness of a derivative hedge is expressed in terms of delta, sometimes

called the "hedge ratio." Delta is the amount the price of a derivative moves per
$1 movement in the price of the underlying asset.
Hedging Elements

It involves two basic elements:

1. Hedged Item: The recognized asset, recognized liability, commitment, or

planned transaction that is at risk of loss. It is the possible loss on the
hedged item that is hedged.
2. Hedging Instrument: The contract or other arrangement that is entered
into to mitigate or eliminate the risk of loss associated with the hedged
item. Derivatives are the primary instrument used for hedging.

Common Hedged Items:The number and kinds of items that can be hedged is
extensive. The most commonly hedged items include:

Inventory/Commodity Prices

Risk that the price of an inventory/a commodity will change and adversely
affect inventory/commodity values and profit margins

Examples

Risk against Future Purchase of Inventory

To hedge the risk that market price changes in inventory will adversely affect
the cost of inventory to be acquired in the future. E.g. if the price of an input to
the production process increased significantly, the firm may not be able to pass
that increase cost to its customers, resulting in a decrease in its profit margins.

Similarly, if a company has a contract to acquire inventory under a purchase

commitment, a decline in the market price of that inventory would result in a
loss. E.g., the value of inventory to be acquired under a firm, fixed-price contract
would be adversely affected if the market price of the inventory decreased
before the delivery date of the inventory.

Risk to Existing Inventory

To hedge the risk that the value of existing inventory will decrease as a result of
changes in market prices. For example, the value of inventory held for future
sale would be adversely affected by a decline in its market value, resulting in a
lower of cost or market write down recognized as a loss in the period of decline.
Foreign Currency Exchange Rates

To hedge risk that the exchange rate between currencies will change such that
the value of revenues, expenses, assets, or liabilities expressed in a foreign
currency will be adversely affected when converted to the domestic currency.

Examples

Transaction Risk

To hedge the risk of exchange rate changes reducing the dollar value of a
receivable denominated to be settled in a foreign currency.

E.g. a receivable denominated in a foreign currency will result in collection of a

fixed number of foreign currency units, but the dollar value of those units will
vary with changes in the exchange rate between that foreign currency and the
dollar.

Translation Risk—Hedge the risk that the dollar value of an investment in a

foreign subsidiary will fluctuate as a result of exchange rate changes.

E.g. translation of accounts on the financial statements of a foreign subsidiary

requires use of changing exchange rates, which subject the account value
carried by the parent in dollars to fluctuate solely as a result of exchange rate
changes.

Interest Rates

To hedge risk that an increase in the market rate of interest will adversely affect
either the value of an existing fixed-rate interest investment or the cost of
interest on variable-rate debt.

Interest rate risk is the risk that arises when the absolute level of interest rates
fluctuate. Interest rate risk directly affects the values of fixed-income securities.
Since interest rates and bond prices are inversely related, the risk associated
with a rise in interest rates causes bond prices to fall, and vice versa. Bond
investors, specifically those who invest in long-term fixed-rate bonds, are more
directly susceptible to interest rate risk.

Suppose an individual purchases a 3% fixed-rate 30-year bond for $10,000. This

bond pays $300 per year through maturity. If during this time, interest rates rise
to 3.5%, new bonds issued pay $350 per year through maturity, assuming a
$10,000 investment. If the 3% bondholder continues to hold his bond through
maturity, he loses out on the opportunity to earn a higher interest rate.
Alternatively, he could sell his 3% bond in the market and buy the bond with the
higher interest rate. However, doing so results in the investor getting a lower
price on his sale of 3% bonds as they are no longer as attractive to investors
since the newly issued 3.5% bonds are also available.

In contrast, changes in interest rates also affect equity investors but less directly
than bond investors. This is because, for example, when interest rates rise, the
corporation's cost of borrowing money also increases. This could result in the
corporation postponing borrowing, which may result in less spending. This
decrease in spending may slow down corporate growth and result in decreased
profit and ultimately lower stock prices for investors.

Examples

Risk to Value of Investment:

Interest rate risk to an investment in fixed-rate debt results from the fact that as
the market rate of interest increases, the value of outstanding fixed-rate debt
instruments decreases. It occurs as with higher interest rates available in the
market, investors will reduce what they are willing to pay for outstanding debt
to a level that provides a return equal to the current market rate of interest.
Such a decline will reduce the value of outstanding investments in fixed-rate
debt.

Risk to cost of debt:

Interest rate risk to outstanding variable-rate debt results from the fact that as
the market rate of interest increases, the cost of debt to the borrower increases
in terms of Interest Burden.

Credit (Default) Risk—Risk that the issuer of debt will default (i.e., fail to make
payments as due), which would result in the investor suffering a loss
Example

Risk of Default by Issuer

To Hedge the risk that an investment in bonds will not be repaid by the issuer of
the bonds, resulting in a loss to the investor of the entire investment.

Common Hedging Instruments

The most common type of instrument used for financial hedging is the
derivative. A derivative is a financial instrument with all three of the following
elements:

1. It has one or more underlying and notional amounts.

2. An underlying is a specified price, rate, or other variable (e.g., a stock
price, a commodity price, an interest rate, a foreign exchange rate, etc.).
3. A notional amount is a specified unit of measure (e.g., shares of stock,
pounds or bushels of a commodity, number of currency units, etc.).

A derivative requires no initial net investment or one that is smaller than would
be required for other types of similar contracts. The terms of a derivative
require or permit a net settlement; the derivative can be settled for cash or an
asset readily convertible to cash in lieu of physical delivery of the subject of the
contract.

The value or settlement amount of a derivative is the amount determined by the

multiplication of the notional amount and the underlying.

Derivative Instruments
The most commonly used derivatives instruments for hedging are as follows:

Futures contracts

A futures contract is a legal agreement to buy or sell a particular commodity or

asset at a predetermined price at a specified time in the future. Futures
contracts are standardized for quality and quantity to facilitate trading on
a futures exchange. The buyer of a futures contract is taking on the obligation to
buy the underlying asset when the futures contract expires. The seller of the
futures contract is taking on the obligation to provide the underlying asset at the
expiration date.

"Futures contract" and "futures" refer to the same thing. For example, you might
hear somebody say they bought oil futures, which means the same thing as an
oil futures contract. When someone says "futures contract," they're typically
referring to a specific type of future, such as oil, gold, bonds or S&P 500 index
futures. The term "futures" is more general, and is often used to refer to the
whole market, such as "They're a futures trader."

Contracts to deliver or receive a commodity, foreign currency, or other asset in

the future at a price set now. They are executed through a clearinghouse. They
are standardized in that the underlying commodity and the commodity's
quality, quantity, and delivery are prespecified in the contract.

Example of Futures Contracts

Futures contracts are used by two categories of market

participants: hedgers and speculators. Producers or purchasers of an underlying
asset hedge or guarantee the price at which the commodity is sold or purchased,
while portfolio managers and traders may also make a bet on the price
movements of an underlying asset using futures.

An oil producer needs to sell their oil. They may use futures contracts do it. This
way they can lock in a price they will sell at, and then deliver the oil to the buyer
when the futures contract expires. Similarly, a manufacturing company may
need oil for making widgets. Since they like to plan ahead and always have oil
coming in each month, they too may use futures contracts. This way they know
in advance the price they will pay for oil (the futures contract price) and they
know they will be taking delivery of the oil once the contract expires.

Futures are available on many different types of assets. There are futures
contracts on stock exchange indexes, commodities, and currencies.

As futures contracts are traded on an exchange, margin requirements, marking

to market, and margin calls apply, and settlement occurs daily.
Mechanism of a Futures Contract
Imagine an oil producer plans to produce one million barrels of oil over the next
year. It will be ready for delivery in 12 months.

Assume the current price is $75 per barrel. The producer could produce the oil,
and then sell it at the current market prices one year from today.

Given the volatility of oil prices, the market price at that time could be very
different than the current price.

If oil producer thinks oil will be higher in one year, they may opt not to lock in a
price now. But, if they think $75 is a good price, they could lock-in a guaranteed
sale price by entering into a futures contract.

A mathematical model is used to price futures, which takes into account the
current spot price, the risk-free rate of return, time to maturity, storage costs,
dividends, dividend yields, and convenience yields. Assume that the one-year oil
futures contracts are priced at $78 per barrel. By entering into this contract, in
one year the producer is obligated to deliver one million barrels of oil and is
guaranteed to receive $78 million. The $78 price per barrel is received
regardless of where spot market prices are at the time.
Contracts are standardized. For example, one oil contract on the Chicago
Mercantile Exchange (CME) is for 1,000 barrels of oil. Therefore, if someone
wanted to lock in a price (selling or buying) on 100,000 barrels of oil, they
would need to buy/sell 100 contracts. To lock in a price on one million barrels of
oil/they would need to buy/sell 1,000 contracts.

Example

A gum farmer may enter into a contract to sell a standard quantity of gum for
delivery in the future at a price set at the time of the contract. The contract
would eliminate the risk that gum prices will fall prior to the delivery date, but it
also limits what the farmer will receive for the gum if prices increase.

Forward contracts

Contracts to deliver or receive a commodity, foreign currency, or other asset in

the future at a price set now. Forward contracts are executed directly between
the contracting parties, not through a clearinghouse/ exchange like futures
contracts. They can be customized to any commodity, amount, and delivery
date. They are settled only at the end of the contract.
Consider the following example of a forward contract. Assume that an
agricultural producer has two million bushels of corn to sell six months from
now and is concerned about a potential decline in the price of corn. It thus
enters into a forward contract with its financial institution to sell two million
bushels of corn at a price of $4.30 per bushel in six months, with settlement on
a cash basis.

In six months, the spot price of corn has three possibilities:

1. It is exactly $4.30 per bushel. In this case, no monies are owed by the
producer or financial institution to each other and the contract is closed.
2. It is higher than the contract price, say $5 per bushel. The producer
owes the institution $1.4 million, or the difference between the current
spot price and the contracted rate of $4.30.
3. It is lower than the contract price, say $3.50 per bushel. The financial
institution will pay the producer $1.6 million, or the difference between
the contracted rate of $4.30 and the current spot price.

Risks with Forward Contracts

The market for forward contracts is huge since many of the world’s biggest
corporations use it to hedge currency and interest rate risks. However, since the
details of forward contracts are restricted to the buyer and seller – and are not
known to the general public – the size of this market is difficult to estimate.

The large size and unregulated nature of the forward contracts market mean
that it may be susceptible to a cascading series of defaults in the worst-case
scenario. While banks and financial corporations mitigate this risk by being very
careful in their choice of counterparty, the possibility of large-scale default does
exist.

Another risk that arises from the non-standard nature of forward contracts is
that they are only settled on the settlement date and are not marked-to-market
like futures. What if the forward rate specified in the contract diverges widely
from the spot rate at the time of settlement?

In this case, the financial institution that originated the forward contract is
exposed to a greater degree of risk in the event of default or non-settlement by
the client than if the contract were marked-to-market regularly.

Example
A user of Rice as an input commodity may enter into a forward contract to buy
Rice for delivery in the future at a price set at the time of the contract. This
would assure the buyer that its cost of Rice at the end of the contract would be
fixed. But it would also preclude buying that Rice at a lower price if the market
price declines by the delivery date.

Option contracts

These are the contracts between a buyer and

seller that give the buyer of the option the
right to buy call option or sell put option, a
particular asset in the future at a strike price.

It gives the buyer the right to buy or sell a

particular asset but do not require the option
holder to do so. Hence, the option holder will
exercise the option only if it is economically
favorable to do so. They are traded either on an exchange (exchange-traded
options) or over the counter as contracts negotiated between parties.

Example

An investor expects the market price of a particular stock to go up over the next
month but is concerned about the possible adverse effects of macroeconomic
conditions on the entire market. The investor may buy an option contract to
purchase the stock at a future date at a price set now. If the price of the stock
increases above the strike price, the investor would exercise the option; if the
price does not increase, the investor would not exercise the option.

Swap contracts

A swap is a derivative contract through which two parties exchange the cash
flows or liabilities from two different financial instruments. Most swaps involve
cash flows based on a notional principal amount such as a loan or bond,
although the instrument can be almost anything. Usually, the principal does not
change hands. Each cash flow comprises one leg of the swap. One cash flow is
generally fixed, while the other is variable and based on a benchmark interest
rate, floating currency exchange rate or index price.

The most common kind of swap is an interest rate swap. Swaps do not trade on
exchanges, and retail investors do not generally engage in swaps. Rather, swaps
are over-the-counter contracts primarily between businesses or financial
institutions that are customized to the needs of both parties.

The Swaps Market

Unlike most standardized options and futures contracts, swaps are not
exchange-traded instruments. Instead, swaps are customized contracts that are
traded in the over-the-counter (OTC) market between private parties. Firms and
financial institutions dominate the swaps market, with few (if any) individuals
ever participating. Because swaps occur on the OTC market, there is always the
risk of a counterparty defaulting on the swap.

The first interest rate swap occurred between IBM and the World Bank in 1981.
However, despite their relative youth, swaps have exploded in popularity. In
1987, the International Swaps and Derivatives Association reported that
the swaps market had a total notional value of $865.6 billion. By mid-2006, this
figure exceeded $250 trillion, according to the Bank for International
Settlements. That's more than 15 times the size of the U.S. public equities
market.
These are the contracts between a buyer and seller by which they agree to
exchange cash flows related to interest, currencies, commodities, or risks. They
are executed directly between the contracting parties, not through a
clearinghouse/exchange. As they are negotiated contracts, swap contracts may
be executed for any amount or length of time.
For cash flow swaps, the parties normally do not exchange the principals
involved, only the cash flows, which are typically associated with interest.

Interest Rate Swaps

In an interest rate swap, the parties exchange cash flows based on a notional
principal amount (this amount is not actually exchanged) in order
to hedge against interest rate risk or to speculate. For example, imagine ABC Co.
has just issued $1 million in five-year bonds with a variable annual interest rate
defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis
points). Also, assume that LIBOR is at 2.5% and ABC management is anxious
about an interest rate rise.

The management team finds another company, XYZ Inc., that is willing to pay
ABC an annual rate of LIBOR plus 1.3% on a notional principal of $1 million for
five years. In other words, XYZ will fund ABC's interest payments on its latest
bond issue. In exchange, ABC pays XYZ a fixed annual rate of 5% on a notional
value of $1 million for five years. ABC benefits from the swap if rates rise
significantly over the next five years. XYZ benefits if rates fall, stay flat or rise
only gradually.

Consider a private mortgage provider that provides first-time home-buyers

with financing. The private mortgage provider gives variable rate mortgage
loans at a 0.25% premium over the existing interest rate, i.e., if the central bank
sets an interest rate of 2%, then the private mortgage provider can give a loan at
2.25%. Clearly, the private mortgage provider’s revenue is linked to the interest
rate set by the central bank.

In order to start operations and provide loans, the private mortgage provider
borrows $2 billion from a large investment bank at a fixed interest rate of 2.1%
for 15 years. The mortgage provider must pay the investment bank $42 million
a year for the next 15 years and also make a lump sum payment of $2 billion at
the end of the loan period. Thus, the mortgage provider’s costs are fixed.
However, its revenues depend on the interest payments it receives from its
customers, which, in turn, is linked to the interest rate set by the central bank.

Thus, the mortgage provider’s revenues are variable. If the central bank lowers
the interest rate to below 1.85%, then the mortgage provider would not be able
to meet its loan obligations. It can use interest rate swaps to swap his fixed
interest rate payments for variable interest rate payments.
Suppose the mortgage provider buys an interest rate swap at a 0.23% premium.
It implies that the party on the other side of the transaction has agreed to pay
the investment bank $42 million a year for the next 15 years, whereas the
mortgage provider has agreed to pay the swap seller the bank rate +0.23% on
$2 billion for the next 15 years. The transaction can only take place if the
mortgage provider and the swap seller have opposing views on whether the
central bank will raise or lower the interest rate over the next 15 years.

Example

A debtor with variable interest rate debt may be concerned that the market rate
of interest will increase and increase its cost of servicing its debt. An interest
rate swap contract would enable the debtor with variable-rate payments to
hedge its interest rate exposure by receiving a variable rate from counterparty
in exchange for paying the counterparty a fixed rate. If the market rate goes up,
the debtor will both pay a higher interest and receive a higher interest, so that
its net cost is the amount of the fixed interest payment.

Hedging Instruments when applied to Hedged Items at risk, hedging

instruments eliminate or mitigate certain risk associated with the hedged item.

Currency Swaps (FX Swaps)

Currency swaps allow their holders to swap financial flows associated with two
different currencies. Consider the example described above: An American
business that borrowed money from a US-based bank (in USD) but wants to do
business in the UK. The business’ revenue and costs are in different currencies.

The business needs to make interest payments in USD, whereas it generates

revenues in GBP. However, it is exposed to risk arising from the fluctuation of
the USD/GBP exchange rate. The business can use a USD/GBP currency swap to
hedge against such a risk. If the business sells £50 million worth of goods in the
UK and the exchange rate falls from £1=$1.23 to £1=$1.22, then the business’s
revenue falls from $61.50 million to $61 million.
In order to protect against such a risk (the USD depreciating against the GBP),
the business can use a USD/GBP swap. The seller of the swap agrees to give the
business $61.5 million for £50 million regardless of what the actual exchange
rate is. The transaction can only take place if the business and the swap seller
have opposing views on whether the USD/GBP exchange rate will appreciate or
depreciate.

Hybrid Swaps (Exotic Products)

Hybrid swaps allow their holders to swap financial flows associated with
different debt instruments that are also denominated in different currencies.
For example, an American variable rate mortgage provider that does business in
the UK can swap a fixed interest rate loan denominated in USD for a variable
interest rate loan denominated in GBP. Other examples of hybrids include
swapping a variable interest rate loan denominated in USD for a variable
interest rate loan denominated in JPY.

Commodity/Inventory Hedges

Risk to firm commitment to buy inventory:

It is to hedge the risk that market price changes will adversely affect the cost of
inventory to be acquired through a firm contract to buy the inventory. E.g. the
value of Iron Rodes inventory to be acquired under a firm, fixed-price contract
would be adversely affected if the market price of the Iron Rodes decreased
before the delivery .In order to protect against the changes in the fair value of
the firm commitment, the company could enter into a futures contract to sell
Iron Rodes. Any loss on the inventory value would be offset by a gain in the
value of the futures contract and vice versa.

Example

Red Star Manufacturing makes silver dinnerware and bases its sales price to
retailers on the price of silver at the time of sale. When the market (spot) price
of silver is $19 per ounce, Red Star enters into a firm commitment contract with
Deep Mine for the purchase of 100,000 ounces of silver for delivery in six
months at $20 per ounce. Red Star is concerned that the market price of silver
will decline below $20 per ounce during the commitment period, which would
result in it recognizing a loss on the purchase. To hedge that possibility, Red Star
enters into a forward contract to sell 100,000 ounces of silver for delivery in six
months at $20 per ounce. At the end of the six-month commitment period, silver
is selling in the spot market for $21 per ounce.

Red Star will recognize a gain on its acquisition of silver from Deep Mine
calculated as 100,000 ounces × ($21 – $20) = $100,000. Red Star will recognize
a loss on its forward contract of $100,000, the 100,000 ounces times the $1 per
ounce excess of its cost ($21) to cover its contract to sell over it sales price
($20).

Though in this example Red Star would have been better off without the
forward contract, the gain and loss exactly offset each other, providing Red Star
certainty as to the cost of its silver inventory.

Risk to existing inventory:

To hedge the risk that the value of inventory accounted for using lower of cost
or market will decrease as a result of changes in market prices. I.e. the value of
inventory held for future sale would be adversely affected by a decline in its
value, resulting in a write-down recognized as a loss in the period of decline. To
hedge the risk of loss due to inventory write-down, the firm could enter into a
forward contract or a put option contract to sell the inventory at a future date.
Any loss on the decline in inventory value would be offset by a gain in the value
of the forward contract or put option.

A forex hedge is a transaction implemented to protect an existing or anticipated

position from an unwanted move in exchange rates. Forex hedges are used by a
broad range of market participants, including investors, traders and businesses.
By using a forex hedge properly, an individual who is long a foreign currency
pair or expecting to be in the future via a transaction can be protected
from downside risk. Alternatively, a trader or investor who is short a foreign
currency pair can protect against upside risk using a forex hedge.

For example, if a U.S. investment bank was scheduled to repatriate some profits
earned in Europe it could hedge some of the expected profits through an option.
Because the scheduled transaction would be to sell euro and buy U.S. dollars, the
investment bank would buy a put option to sell euro. By buying the put option
the company would be locking in an 'at-worst' rate for its upcoming transaction,
which would be the strike price. As in the Japanese company example, if the
currency is above the strike price at expiry then the company would not
exercise the option and simply do the transaction in the open market. The cost
of the hedge is the cost of the put option.

Example

Manisha Inc. acquired inventory at a cost of $100,000 which it expects to sell in

four to six months. To hedge the possibility of a decrease in inventory value
prior to its sale, Manisha enters into a forward contract to sell an equivalent
inventory at the end of three months. Assume that three months later the
inventory has a value of $80,000. Manisha will recognize a $20,000 lower of cost
or market write-down loss on its inventory but will recognize a $20,000 gain on
the value of its forward contract. Specifically, it can acquire the inventory for
$80,000 that it has a forward contract to sell for $100,000.
Foreign Currency Hedges
A receivable denominated in a foreign currency will result in collection of a fixed
number of foreign currency units, but the dollar value of those units will change
with changes in the exchange rate between that foreign currency and the dollar.
A U.S. company could enter into a forward contract now to sell those foreign
currency units when received in the future and thus hedge the receivable.

Example

CANADIAN Providers Inc. sells components to a Japanese manufacturer on

account with terms of net 90. The obligation is denominated (to be settled) in
105,000 yen. CANADIAN Providers will receive a known number of yen
(105,000), but over the three-month credit period, the dollar value of that yen
will rise or fall, depending on changes in the exchange rate between the dollar
and the yen. CANADIAN Providers can lock in the dollar value of the yen it will
receive by entering into forward contract to sell 105,000 yen in three months. If
the dollar strengthens relative to the yen during the three-month period,
CANADIAN Providers will receive fewer dollars for the yen it receives from
collecting the receivable (a dollar loss), but it will recognize an equivalent gain
on its contract to sell yen at the price established three months earlier.

Hedge—translation risk

To hedge the risk that the dollar value of an investment in a foreign subsidiary
will fluctuate as a result of exchange rate changes. For example, translation of
accounts on the financial statements of the foreign subsidiary requires use of
changing exchange rates, which subject the accounts carried on the parent's
books to fluctuate solely as a result of exchange rate changes.
The U.S. parent could

(1) Borrow in the foreign currency of the subsidiary to hedge the effects of
changes in the exchange rate on conversion of the financial statements or

(2) Acquire a foreign currency forward contract to hedge the effects of changes
in the exchange rate on the conversion of the financial statements (a net asset).

Examples

• Fabio Inc. has a foreign operation that is heavily invested in assets. It is

concerned that when it translates the financial statements of its foreign
operation, an appreciation of the dollar against the foreign currency will
result in its asset dollar values being greatly reduced. To hedge that, Fabio
could incur foreign currency liabilities so that its foreign liabilities
approximate its foreign assets. By having an approximate matching of
assets and liabilities, upon translation into dollars, any loss (or gain) on
the value of the translated assets will be offset by a gain (or loss) on the
value of translated liabilities.

• Cozy Inc. has a 100% owned subsidiary, Coco, located in France. Because
of the nature of its business, Coco has a high level of current assets and
 few current liabilities. Coco maintains its accounts in euros, which RWB
translates to dollars for consolidated financial statement purposes. RWB
is concerned that the euro will decline in value against the dollar over the
next few months, resulting in a lower dollar value of the translated net
assets of Coco. RWB decides to hedge this translation risk by entering into
a forward contract. RWB estimates that its net asset exposure as of the
next balance sheet date will be 100,000 euros. Therefore, Cozy enters into
a forward contract to sell 100,000 euros as of the next balance sheet date.
If the euro declines against the dollar, the value of the forward contract
will increase. So, while the decline in the euro versus the dollar would
result in assets being converted to a lower dollar value, that decline would
be offset by the increase in value of the forward contract.

Interest Rate Hedges

Risk to value of investment

Interest rate risk in case of investment in fixed-rate debt results from the fact
that as the market rate of interest increases, the value of outstanding fixed-rate
debt instruments decreases.

It occurs because with higher interest rates available in the market, investors
will reduce what they are willing to pay for outstanding debt to a level that
provides a return equal to the market rate of interest. Such a decline will reduce
the value of outstanding investments in fixed-rate debt.
Example

A firm can hedge its risk of market rate interest increases adversely affecting the
value of its investment by using forward/futures contracts, swap contracts, or
option contracts. If a forward or futures contract is used, a contract to sell the
investment at a price set at the present with delivery in the future could be used.
While if an interest rate swap contract is used, the fixed-rate debt would be
swapped with a counterparty for variable-rate payment.

If an option contract is used, a put option would be acquired, which gives the
investor the right to sell its investment at some future time at a price set now.

Example

Risk to Cost of Borrowing

A company can hedge its cost of borrowing with variable-interest debt by:

1. Using a forward/futures contract—If interest rates increase, the

forward/futures prices will fall. The firm could sell a forward/futures
contract now at the current and buy a forward/futures contract later to
satisfy its sell obligation. The resulting gain will offset the higher interest
expense on the variable-interest debt.

2. Using an interest rate swap—The firm can enter into an interest rate
swap, which would be a contract to exchange a stream of cash flows from
interest. The firm with the variable-interest debt would swap its
potentially variable stream of interest payments for a fixed stream of
interest payments.

3. Credit Risk Hedge—When the issuer of debt will default, which would
result in the investor suffering a loss. A firm can hedge credit risk using a
credit default swap, which involves the transfer of the credit risk on debt
between parties. In return, the seller of the CDS contract assumes the
credit risk that the buyer does not wish to carry. If the issuer of the debt
defaults, the buyer receives compensation for its loss from the seller of
the CDS, very much like buying an insurance policy.

Example
Assume Disman Inc. invests $5,000,000 in the five-year, 8% bonds of Funky Inc.
Because of changes in market conditions (e.g., weak economic performance,
increasing price of oil, etc.), Disman becomes concerned about the possibility of
Funky having to default on it bonds. Disman could buy a credit default swap
(CDS) in the amount of $5,000,000 to cover the potential loss from default.
Assume the fee is 2.0%. Disman would pay $100,000 per year for the CDS
($5,000,000 × .02).

If Funky does not default, the coverage would have cost Disman $500,000 (5
years × $100,000), which would reduce its total income from the investment.

If, Funky defaults, Disman will receive the full $5,000,000 maturity value of the
bonds from the seller of the CDS.

In nutshell, Hedging provides a means of mitigating or eliminating certain risks

associated with assets, liabilities, revenues, expenses, cash flows, and other
items. Typically, hedging is undertaken to either protect against an increase or a
decrease in value of the hedged item. As a general rule:

Hedging an increase in the hedged item is carried out by buying a

futures/forward contract or call option and selling the contract or exercising the
option to derive the hedging benefit of an increased price.

Hedging a decrease in the hedged item is carried out by selling a

futures/forward contract or buying a put option and buying in the future (at a
decreased price) to cover the contract. Hedging generally involves both costs
and risks:

Hedging Costs may include:

• Reduced profit derived from the hedged item as a result of hedging that
turns out to be unnecessary.
• Loss of benefit from a possible favorable change in the price of the hedged
item.
• Difference between spot rates/forward rates and bid/asked prices.
• Fees charged for execution of contracts.
• Internal administrative cost of executing, monitoring and managing
hedging activity.

Hedging Risks may include:

 • Credit risk: It is the counterparty to a contract fails to meet its contractual
obligations. This risk is less likely for contracts executed through an
exchange than for negotiated contracts.
• Market risk: It is the risk of loss from adverse changes in market factors
that affect the hedged item.
• Basis risk: It is the risk of loss from ineffectiveness of the hedge that
results when offsetting investments do not experience price changes in
entirely opposite directions as expected. Basis is the ultimate difference
between the value of the hedged item and the value of the hedging
instrument.

Derivatives and Speculation

Derivatives are major instruments used for hedging; they also can be used for
speculation. Speculation has as its purpose the making of a profit, unlike
hedging, which has as its purpose the offsetting of gains and losses so as to
achieve greater certainty as to value. Investors may use derivatives to speculate
on the direction that a security, commodity, or other item will move.

Example

An investor believes the stock of XYZ Inc. will increase in value. Rather than buy
the stock and hold it, the investor may buy a call option, which gives the investor
the option to buy the stock in the future at a price set now. The cost of the option
is a fraction of the cost of buying the stock. If the stock price increases above the
contracted exercise price during the term of the option, the investor will
exercise the option and recognize a profit as the difference between the strike
price and the higher market price. If the stock price does not increase above the
strike price, the investor will not exercise the option and will lose the cost of
payment for the option.

Hedging vs. Speculation Example

It's important to note that hedging is not the same as portfolio

diversification. Diversification is a portfolio management strategy that investors
use to smooth out specific risk in one investment, while hedging helps to
decrease one's losses by taking an offsetting position. If an investor wants to
reduce his overall risk, the investor shouldn't put all of his money into one
investment. Investors can spread out their money into multiple investments to
reduce risk.
For example, suppose an investor has $500,000 to invest. The investor can
diversify and put money into multiple stocks in various sectors, real estate, and
bonds. This technique helps to diversify unsystematic risk; in other words, it
protects the investor from being affected by any individual event in an
investment.

When an investor is worried about an adverse price decline in their investment,

the investor can hedge their investment with an offsetting position to be
protected. For example, suppose an investor is invested in 100 shares of stock in
oil company XYZ and feels that the recent drop in oil prices will have an adverse
effect on its earnings. The investor does not have enough capital to diversify
their position; instead, the investor decides to hedge their position by buying
options for protection. The investor can purchase one put option to protect
against a drop in the stock price, and pays a small premium for the option. If XYZ
misses its earnings estimates and prices fall, the investor will lose money on
their long position but will make money on the put option, which limits losses.

1) Which of the following U.S. GAAP level of inputs for valuation purposes
are based on observable inputs?

Level Level Level

1 2 3
A Yes Yes Yes

B Yes Yes No

C Yes No No

D No No Yes
2) Which of the following U.S. GAAP approaches is used to determine fair
value converting future amounts to current amounts?

A .Market approach.
B. Sales comparison
approach.
C. Income approach.
D. Cost approach.

3) Which of the following characteristics should be taken into account in

valuing a specific item?

Location Condition
A Yes Yes

B Yes No

C No Yes

D No No

4) Which of the following U.S. GAAP approaches for determining value is

most likely to provide the best evidence of fair value?

A Market approach.

B Income approach.
Correlation
C approach.

D Cost approach.
5) Which of the following levels of the U.S. GAAP hierarchy of inputs is used
for determining fair value can be based on inputs not directly observable
for the item being valued?

Level Level Level

1 2 3
A Yes Yes Yes

B Yes Yes No

C Yes No Yes

D No Yes Yes

6) Which of the following types of investments, if any, could be valued using

level 1 inputs of the U.S. GAAP hierarchy of inputs for determining fair
value?

Equity Debt
Securities Securities
A Yes Yes

B Yes No

C No Yes

D No No
7) In which of the following types of markets could be level 2 inputs in
determining fair value under the U.S. GAAP hierarchy of inputs for fair
value determination?

Active Inactive
Markets Markets
A Yes Yes

B Yes No

C No Yes

D No No

8) Which of the following types of active markets would be considered as

providing level 1 inputs under the U.S. GAAP hierarchy of inputs for fair
value determination?

New York Stock Over-the-Counter

Exchange Market
A Yes Yes

B Yes No

C No Yes

D No No

9) Which of the following level of input in the U.S. GAAP hierarchy of inputs
for fair value determination are likely to be most appropriate for valuing
basic agricultural commodities?
 A Level 1, only.

B Level 2, only.

C Level 3, only.
Level 1 and level
D 3.

10) The variance of an individual

investment captures :

A Only systematic risk.

B Only unsystematic risk.

C Both A and B
Neither systematic nor unsystematic
D risk.

11) Which of the following do investment’s beta measure?

The investment’s systematic

A risk.

The investment’s
B unsystematic risk.

C The investment’s default risk.

The investment’s interest rate
D risk.

12) DOT NET Telecom is considering a project for the coming year that
will cost $50,000,000. DOT NET plans to use the following combination of
debt and equity to finance the investment:
 • Issue $15,000,000 of 20-year bonds at a price of 101,
with a coupon rate

of 8%, and flotation costs of 1.5% of par. The after-

flotation cost yield is 8.08%.
• Use $35,000,000 of funds generated from earnings.
• The equity market is expected to earn 12%. U.S.
Treasury bonds are

currently yielding 5%. The beta coefficient for DOT

NET is estimated to be .60.

DOT NET is subject to an effective corporate income

tax rate of 40%.

The Capital Asset Pricing Model (CAPM) computes the expected return on a
security by adding the risk-free rate of return to the incremental yield of the
expected market return, which is adjusted by the company’s beta. Compute DOT
NET’s expected rate of return on equity.

A 9.2%

B 12.2%

C 7.2%
D 12%
13) Nastle Inc. has the following investment portfolio.

Expected
Investment Beta
return
Investment
15% $100,000 1.2
A
Investment
10% $300,000 −0.5
B
Investment
8% $200,000 1.5
C
Investment
8% $100,000 −1.0
D

If management decided to sell one of the investments, which one should

be selected?

Investment
A A.

Investment
B B.

Investment
C C.

Investment
D D.

14) A market analyst has estimated the equity beta of Housing Homes
Inc. to be 1.4. This beta implies that the company's

Systematic risk is lower than that of the market

A portfolio.
 Systematic risk is higher than that of the market
B portfolio.

Unsystematic risk is higher than that of the market

C portfolio.

Total risk is higher than that of the market

D portfolio.

15) A measure that describes the risk of an investment project relative

to other investments is :

Coefficient of
A variation.

B Beta coefficient

C Standard deviation.

D Expected return.

16) Which of the following describes an option?

A standardized contract to take delivery of a specified quantity of a

A financial instrument in the future.

A contract that allows the holder to purchase a specified quantity of a

B financial instrument at a specified price.

A negotiated contract to purchase a specified quantity of a financial

C instrument in the future.

D An agreement to swap a stream of cash flows.

17) Allen Border was granted options to buy 100 shares of Green
Company stock. The options expire in one year and have an exercise price
of $60.00 per share. An analysis determines that the stock has an 80%
probability of selling for $72.50 at the end of the one-year option period
 and a 20% probability of selling for $65.00 at the end of the year. Green
Company's cost of funds is 10%. Which one of the following is most likely
the current value of the 100 stock options?

A $1,000

B $1,100

C $6,875

D $7,100

18) Which of the following is not a limitation of the basic Black-Scholes

option pricing model?

A It fails to consider the probability that the option will be exercised.

B It assumes the stock does not pay dividends.
It assumes the risk-free rate of return used for discounting remains
C constant during the option period.

D It assumes the option can be exercised only at the expiration date.

19) Which of the following is not a factor routinely considered in

valuing a stock option?

A Time until expiration date.

B Risk-free rate of return.

C Exercise price of the option.

Industry classification of the
D stock.
20) Which of the following options is most likely to have the greatest
value ?

Time to Risk-Free Interest

Option Stock Beta
Expiration Rate
A 3 Yrs. 3.0% 2.00

B 1 Yr. 4.0% 1.00

C 2 Yrs. 2.0% 1.60

D 8 Yrs. 4.5% 4.00

21) Which of the following characteristics is not an advantage of the

Black-Scholes option pricing model?

Incorporates the probability that the price of the stock will pay off
A within the time to expiration.

B Incorporates the probability that the option will be exercised.

C Discounts the exercise price.

Accommodates options when the price of the underlying stock changes

D significantly and rapidly.

22) What does beta measure in the CAPM?

The volatility of a stock relative to its

A competitors

The volatility of a stock relative to the

B market

C The additional return required over the

 risk-free rate

D Unsystematic risk

23) Which of the following categories of risk does an investment's beta

measure?

The investment's systematic

A risk.

The investment's
B unsystematic risk.

C The investment's default risk.

The investment's interest rate
D risk.

24) Assume the following rates exist in the Canada.:

Prime interest rate = 6%

Fed discount rate = 4%
U.S. Treasury Bond rate = 2%
Inflation rate = 1%

Which of the following is most likely the nominal risk-free rate of return ?

A 1%

B 2%

C 4%

D 6%
25) Assume the following values for an investment:

Risk-free rate of return = 2%

Expected rate of return = 9%
Beta = 1.4

Which of the following is the required rate of return for the investment?

A 9.0%

B 9.8%
C 11.8%

D 12.6%

26) Which of the following beta values indicates the least volatility?

A Beta = .5

B Beta = .8
C Beta = 1.0

D Beta = 1.5

27) A graph that plots beta would show the relationship between:

A Asset risk and asset return.

Asset risk and benchmark
B return.
 Benchmark risk and asset
C return.

Asset return and benchmark

D return.

28) Which of the following is not a limitation of the CAPM Model?

It assumes that there are no restrictions on borrowing at the risk-

A free rate of return.

It assumes that no external costs are associated with the

B investment.

C It fails to consider the time value of money.

It fails to consider risk derived from other than variances from the
D asset class benchmark.

29) Boat Company. has $100,000 in bonds payable with a fair market
value of $120,000. It also has 1,000 shares of common stock issued at $50
per share with a fair market value of $80 per share. What amount
represents the corporation's market capitalization?

A $50,000

B $80,000

C $170,000

D $180,000

30) AYGcompany's common stock has a market value of $45. The

company's most recent annual earnings per share is $3.60, and the
company pays an annual dividend of $1.50 per share. What is the
company's price-earnings ratio?
 A 8.82

B 12.08

C 12.50

D 21.43

31) Assume the following abbreviated Balance Sheet of TIJ Co.:

Current Assets $100,000 Current Liabilities $ 30,000

Long-term
Investments 25,000 75,000
Liabilities
Fixed Assets 75,000 Common Stock 70,000
Retained
_________ 25,000
Earnings
Total Assets $200,000 Total L + Equity $200,000

In a common-sized balance sheet, which one of the following percentages

would be shown for current liabilities?

A 15.0%

B 17.6%

C 28.5%

D 30.0%
32) Which one of the following approaches to valuing a business is most
likely to be appropriate when the business has been losing money and is
going to be sold in a distressed sale?

A Asset approach.

B Market approach.
Income approach using capitalized
C earnings.

Income approach using free cash

D flow.

33) The P/E ratio for a share of common stock is computed as:

A Par value/EPS.

B Par value x EPS.

C EPS x Market price.

D Market price/EPS.

34) The land and building that constitute a shopping mall were valued
using the recent sales price of a comparable shopping mall located across
the street. The method of valuation would be an example of the:

A Income approach.

B Market approach.

C Asset approach.

D Cost approach.
35) Which of the following is not a major approach for assigning a value
to an entire going business?

Market
A approach.

Income
B approach.

C Cost approach.

D Asset approach.

36) Assume the following abbreviated Income Statement of BVC Co.:

Revenues $100,000
Cost of Goods Sold 60,000
Gross Profit $ 40,000
Operating Expenses 20,000
Finance Expense 5,000
Net Income $ 15,000
In a common-size income statement, which one of the following
percentages would be shown for Finance Expense?

A 33.33%

B 12.50%

C 8.33%
D 5.00%

37) A company with a net book value of $150,000 has an appropriate

fair value of $120,000. Marvel, one of three owners, has decided to sell his
10% interest in the business. Which one of the following is most likely the
amount at which he can sell his interest?
 A $40,000

B $15,000

C $12,000
<
D $12,000

38) Which one of the following is least likely to be the reason an entity
would seek a valuation of the entity as a going concern?

A In connection with a planned sale of the entity.

B In connection with a property tax determination.

C In connection with developing a buy-sell agreement among the owners.
In connection with developing a settlement with the estate of a recently
D deceased owner.

39) Walter Electronics has subsidiaries in several international

locations and is concerned about its exposure to foreign exchange risk. In
countries where currency values are likely to fall, Walter should
encourage all of the following except

A Granting trade credit wherever possible.

B Investing excess cash in inventory or other real assets.

C Purchasing materials and supplies on a trade credit basis.

Borrowing local currency funds if an appropriate interest rate
D can be obtained.
 40) A derivative security :

A Has no risk of default.

is traded only in the over-the-counter
B market.

has a value based on another security

C or index.

D can be used only for hedging.

41) Which of the following statements regarding forward contracts is

correct?

The buyer of a forward contract gains when prices decrease, and the seller of
A a forward contract loses when prices increase.

The buyer of a forward contract gains when prices increase, and the seller of
B a forward contract loses when prices decrease.

The buyer of a forward contract gains when prices increase, and the seller of
C a forward contract loses when prices increase.

The buyer of a forward contract gains when prices decrease, and the seller of
D a forward contract loses when prices decrease.

42) Which of the following could be used to hedge a net receivable

denominated in British pounds by a U.S. company?

A Purchase a currency put option in British

 pounds.

Purchase a currency call option in British

B pounds.

Purchase a forward contract to buy British

C pounds.

Purchase a forward contract to buy U.S.

D dollars.

43) Which one of the following risks relates to the possibility that a
derivative might not be effective at hedging a particular asset?

A Credit risk.
Default
B risk.

Market
C risk.

D Basis risk.

44) Which one of the following is not a financial derivative?

A Futures
 contract.

B Swap contract.
C Common stock.

D Options.

45) A company has recently purchased inventory of a competitor as

part of a long-term plan to acquire the competitor. However, it is
somewhat concerned that the market price of this stock could decrease
over the short run. The company could hedge against the possible decline
in the stock's market price by

Purchasing a call option on that

A stock.

Purchasing a put option on that

B stock.

C Selling a put option on that stock.

Obtaining a warrant option on that
D stock.

46) Jingle Company has a large amount of variable rate financing due in
one year. Management is concerned about the possibility of increases in
short-term rates. Which of the following would be an effective way of
hedging this risk?
 Buy Treasury notes in the futures
A market.

Sell Treasury notes in the futures

B market.

Buy an option to purchase Treasury

C bonds.

Sell an option to purchase Treasury

D bonds.

47) The foreign currency exchange rate for the immediate delivery of
the currencies being exchanged is the

Historic
A rate.

Forward
B rate.

C Spot rate.

D Prime rate.

48) An importer of English clothing has contracted to pay an amount

fixed in British pounds three months from now. If the importer thinks that
the U.S. dollar may depreciate sharply against the British pound in the
interim, it would be well advised to:

Buy pounds in the forward exchange

A market.

Sell pounds in the forward exchange

B market.

C Buy dollars in the futures market.

 D Sell dollars in the futures market.

49) Which one of the following gives the holder the right to buy an asset
for a specified exercise price on or before a specified expiration date?

A Call option.

B Put option.
Futures
C contract.

Forward
D contract.

50) Which of the following risks can be hedged?

Foreign Interest
Exchange Rate Default
Risk Risk Risk
A. Yes Yes No
B. Yes No Yes
C. Yes Yes Yes
D. No Yes Yes

A Row A

B Row B

C Row C

D Row D
51) A transport company believes that its diesel expenses might rise in
the coming year and wants to create a hedge against it. The current price
of diesel fuel is $3.50/gallon, and the company uses 10,000 gallons per
month. The company purchased a futures contract for 10,000 gallons of
diesel at $3.50/gallon to be delivered in six months. The price of the
contract was $250.00. In six months, the spot price of diesel fuel is
$3.85/gallon. The bus company accepted delivery of the contract
commodity. What was the economic substance of the futures contract?

A The contract produced a cost of $3,750.

There is no economic impact from the
B transaction.

C The contract produced a cost of $250.

D The contract produced savings of $3,250.

CAPITAL BUDGETING

Learning Outcomes

• The objectives of capital investment decisions.

• The importance and purpose of Capital budgeting for a business entity.
• Cash flows in capital budgeting decisions and try to explain the basic
principles for measuring the same.
• Discuss the various capital budgeting techniques like Pay- back, Net
Present Value (NPV), Profitability Index (PI), Internal Rate of Return
(IRR), Modified Internal Rate of Return (MIRR) and Accounting Rate of
Return (ARR).
• Concepts of the various investment evaluation techniques for capital
investment decision making.
• Advantages and disadvantages of the above- mentioned techniques.
Overview

Introduction

Capital budgeting is the process a business undertakes to evaluate potential

major projects or investments. Construction of a new plant or a big
investment in an outside venture are examples of projects that would require
capital budgeting before they are approved or rejected.
As part of capital budgeting, a company might assess a prospective project's
lifetime cash inflows and outflows to determine whether the potential returns
that would be generated meet a sufficient target benchmark. The process is
also known as investment appraisal.

Ideally, businesses would pursue any and all projects and opportunities that
enhance shareholder value. However, because the amount of capital any
business has available for new projects is limited, management uses capital
budgeting techniques to determine which projects will yield the best return
over an applicable period.

Few methods of capital budgeting which companies use to determine which

projects to pursue include throughput analysis, net present value
(NPV), internal rate of return, discounted cash flow, and payback period.

KEY TAKEAWAYS

• Capital budgeting is used by companies to evaluate major projects and

investments, such as new plants or equipment.
• The process involves analyzing a project’s cash inflows and outflows to
determine whether the expected return meets a set benchmark.
• The major methods of capital budgeting include throughput, discounted
cash flow, and payback analyses.

Capital budgeting is a company’s formal process used for evaluating potential

expenditures or investments that are significant in amount. It involves the
decision to invest the current funds for addition, disposition, modification or
replacement of fixed assets. The large expenditures include the purchase of
fixed assets like land and building, new equipments, rebuilding or replacing
existing equipments, research and development, etc. The large amounts spent
for these types of projects are known as capital expenditures. Capital
Budgeting is a tool for maximizing a company’s future profits since most
companies are able to manage only a limited number of large projects at any
one time.

Capital budgeting usually involves calculation of each project’s future

accounting profit by period, the cash flow by period, the present value of cash
flows after considering time value of money, the number of years it takes for a
project’s cash flow to pay back the initial cash investment, an assessment of
risk, and various other factors.

Capital budgets or capital expenditure budgets are a way for a company’s

management to plan fixed asset sales and purchases. Usually these budgets
help management analyze different long-term strategies that the company can
take to achieve its expansion goals. In other words, the management can
decide what assets it might need to sell or buy in order to expand the
company. To make this decision, management typically uses these three main
analyzes in the budgeting process: throughput analysis, discounted cash flows
analysis, and payback analysis.

In simpler terms, Capital Budgeting involves: -

• Identification of investment projects that are strategic to business overall
objectives;
• Estimating and evaluating post-tax incremental cash flows for each
of theinvestment proposals; and
• Selection an investment proposal that maximizes the return to the
investors.

To be successful in a competitive environment, an entity must have a more or

less continuous stream of new undertakings or projects. Identifying and
implementing profitable projects is essential if a firm is to grow and survive in
the long run. This section is concerned with the kinds of decisions involved in
considering new undertakings or projects, including the risk-reward
relationship inherent in new undertakings.

It is the process of measuring, evaluating, and selecting long-term investment

opportunities. These opportunities are typically in the form of projects or
programs being considered by a firm and almost always would involve
significant cost and extend over many periods. Depending on the entity, such
projects may include the routine acquisition of new property, plant, and
equipment, change in a production process, adding new products or services,
establishing new locations, or other similar undertakings. All of the various
kinds of projects and programs undertaken by an entity over time largely
determine its current resources and operations, as well as its ongoing success
or failure. Hence effective capital budgeting is essential to every successful
organization.
Obviously, capital budgeting includes difficult decisions. In most cases buying
fixed assets is expensive and cannot be easily undone. The management has to
decide to spend cash in the bank, take out a loan, or sell existing assets to pay
for the new ones. Each one of these decisions comes with the eternal question:
will they receive the proper return on investment? Because when you think
about it, buying new fixed assets is no different than putting money any other
investment. The company is buying equipment hoping that is will pay off in
the future.

OBJECTIVES OF CAPITAL BUDGETING

1. To find out the profitable capital expenditure.

2. To know whether the replacement of any existing fixed assets gives more
return than earlier.

3. To decide whether a specified project is to be selected or not.

4. To find out the quantum of finance required for the capital expenditure.
5. To assess the various sources of finance for capital expenditure.

6. To evaluate the merits of each proposal to decide which project is best.

FEATURES OF CAPITAL BUDGETING

1. Capital budgeting involves the investment of funds currently for getting

benefits in the future.

2. Generally, the future benefits are spread over several years.

3. The long term investment is fixed.

4. The investments made in the project is determining the financial condition

of business organization in future.

5. Each project involves huge amount of funds.

6. Capital expenditure decisions are irreversible.

7. The profitability of the business concern is based on the quantum of

investments made in the project.
LIMITATIONS OF CAPITAL BUDGETING

1. The economic life of the project and annual cash inflows are only
estimation. The actual economic life of the project is either increased or
decreased. Likewise, the actual annual cash inflows may be either more or less
than the estimation. Hence, control over capital expenditure cannot be
exercised.

2. The application of capital budgeting technique is based on the presumed

cash inflows and cash outflows. Since the future is uncertain, the presumed
cash inflows and cash outflows may not be true. Therefore, the selection of
profitable project may be wrong.

3. Capital budgeting process does not take into consideration of various non-
financial aspects of the projects while they play an important role in
successful and profitable implementation of them. Hence, true profitability of
the project cannot be highlighted.

4. It is also not correct to assume that mathematically exact techniques always

produce highly accurate results.
5. All the techniques of capital budgeting presume that various investment
proposals under consideration are mutually exclusive which may not be
practically true in some particular circumstances.

6. The morale of the employee, goodwill of the company etc. cannot be

quantified accurately. Hence, these can substantially influence capital
budgeting decision.

7. Risk of any project cannot be presumed accurately. The project risk is

varying according to the changes made in the business world.

8. In case of urgency, the capital budgeting technique cannot be applied.

9. Only known factors are considered while applying capital budgeting

decisions. There are so many unknown factors which are also affecting capital
budgeting decisions. The unknown factors cannot be avoided or controlled.

RATIONALE OF CAPITAL BUDGETING DECISIONS

The rationale behind the capital budgeting decisions is efficiency. A company

has to continuously invest in new plant or machinery for expansion of its
operations or replace worn out machinery for maintaining and improving
efficiency. The objective is to maximize profit either by way of increased
revenue or by cost reduction. Broadly, there are two types of capital
budgeting decisions which expand revenue or reduce cost.
1. Investment decisions affecting revenue
It includes all those investment decisions which are expected to bring
additional revenue by raising the size of firm’s total revenue. It is possible
either by expansion of present operations or the development of new product
in line. In both the cases fixed assets are required.

2. Investment decisions reducing costs

It includes all those decisions of the firms which reduces the total cost and
leads to increase in its total earnings i.e. when an asset is worn out or becomes
outdated, the firm has to decide whether to continue with it or replace it by
new machine. For this, the firm evaluates the benefit in the form of reduction
in operating costs and outlays that would be needed to replace old machine by
new one. A firm will replace an asset only when it finds it beneficial to do so.
The above decision could be followed decisions following alternative courses:
i.e., Tactical investment decisions to strategic investment decisions, as
briefly defined below

Tactical investment decisions

It includes those investment decisions which generally involves a small
amount of funds and does not constitute a major departure from what the
firm has been doing in the past.

Strategic investment decisions

Such decisions involve large sum of money and envisage major departure
from what the company has been doing in the past. Acceptance of strategic
investment will involve significant change in the company’s expected profits
and the risk to which these profits will be subject. These changes are likely to
lead stock-holders and creditors to revise their evaluation of the company.
IMPORTANCE OF CAPITAL BUDGETING

1)Long term investments involve risks:

Capital expenditures are long term investments which involve more financial
risks. That is why proper planning through capital budgeting is needed.
2) Huge investments and irreversible ones:
As the investments are huge but the funds are limited, proper planning
through capital expenditure is a pre-requisite. Also, the capital investment
decisions are irreversible in nature, i.e. once a permanent asset is purchased
its disposal shall incur losses.
3) Long run in the business:
Capital budgeting reduces the costs as well as brings changes in the
profitability of the company. It helps avoid over or under investments. Proper
planning and analysis of the projects helps in the long run.
SIGNIFICANCE

• It is an essential tool in financial management

• It provides a wide scope for financial managers to evaluate different
projects in terms of their viability to be taken up for investments
• It helps in exposing the risk and uncertainty of different projects
• It helps in keeping a check on over or under investments
• The management is provided with an effective control on cost of capital
expenditure projects
• Ultimately the fate of a business is decided on how optimally the
available resources are used

Capital Budgeting Process

The process of capital budgeting is as follows:

1. Identifying investment opportunities

An organization needs to identify an investment opportunity. An investment
opportunity can be anything from a new business line to product expansion to
purchasing a new asset. For example, a company finds two new products that
they can add to their product line.

2. Evaluating investment proposals

Once an investment opportunity has been recognized an organization needs

to evaluate its options for investment. That is to say, once it is decided that
new product/products should be added to the product line, the next step
would be deciding on how to acquire these products. There might be multiple
ways of acquiring them. Some of these products could be:

• Manufactured In-house
• Manufactured by Outsourcing manufacturing the process, or
• Purchased from the market

3. Choosing a profitable investment

Once the investment opportunities are identified and all proposals are
evaluated an organization needs to decide the most profitable investment and
select it. While selecting a particular project an organization may have to use
the technique of capital rationing to rank the projects as per returns and
select the best option available.
In our example, the company here has to decide what is more profitable for
them. Manufacturing or purchasing one or both of the products or scrapping
the idea of acquiring both.

4. Capital Budgeting and Apportionment

After the project is selected an organization needs to fund this project. To fund
the project it needs to identify the sources of funds and allocate it accordingly.

The sources of these funds could be reserves, investments, loans or any other
available channel.
5. Performance Review
The last step in the process of capital budgeting is reviewing the investment.
Initially, the organization had selected a particular investment for a predicted
return. So now, they will compare the investments expected performance to
the actual performance.
In our example, when the screening for the most profitable investment
happened, an expected return would have been worked out. Once the
investment is made, the products are released in the market; the profits
earned from its sales should be compared to the set expected returns. This
will help in the performance review.

TYPES OF CAPITAL BUDGETING DECISIONS

Usually capital investment decisions are classified in two ways. One is to

classify them on the basis of firm’s existence. Another is to classify them on
the basis of decision situation.
On the basisoffirm’sexistence

In this, the capital budgeting decisions are taken by both newly incorporated
firms as well as by existing firms. The new firms may be required to take
decision in respect of selection of a plant to be installed. The existing may be
required to take decisions to meet the requirement of new environment or to
face the challenges of competition. These decisions may be classified as
follows:

(i) Replacementdecisions:

The replacement decisions aim at to improve operating efficiency and to

reduce cost. Generally, all types of plant and machinery require replacement
either because of the economic life is over or because it has become
technologically obsolete. The former decision is known as replacement
decisions and latter is known as modernization decisions. Both replacement
and modernization decisions are called cost reduction decisions.
(ii) Expansion decisions:

Existing firms may experience growth in demand of their product line. If such
firms experience shortage or delay in the delivery of their products due to
inadequate production facilities, they may consider proposal to add capacity
to existing product line.

(iii) Diversification decisions:

It requires evaluation of proposals to diversify into new product lines, new

markets etc. for reducing the risk of failure by dealing in different products or
by operating in several markets.
On the basis of decision situation

Usually firms are confronted with three types of capital budgeting decisions.

(i)The accept-reject decisions;

(ii)mutually exclusive decisions;
(iii) Contingent decisions.

1. Accept-reject decisions:

Business firm is confronted with alternative investment proposals. If the

proposal is accepted, the firm incur the investment and not otherwise.
Broadly, all those investment proposals which yield a rate of return greater
than cost of capital are accepted and the others are rejected. Under this
criterion, all the independent proposals are accepted.

In other words, using Net Present Value Method Criterion, an investment

opportunity will be accepted if NPV > 0, or, the same will be rejected if NPV <
0. That is, all independent projects are accepted under this criterion.

It is to be noted that independent projects are those which do not compete

with one another, i.e. the acceptance of one precludes the acceptance of the
other. At the same time, those projects which will satisfy the minimum
investment criterion should be taken into consideration.

2. Mutually exclusive decisions:

It includes all those projects which compete with each other in a way that
acceptance of one precludes the acceptance of other or others. Thus, some
technique has to be used for selecting the best among all and eliminates other
alternatives.

3. Contingent decisions:

These are generally dependable proposals. The investment in one proposal

requires investment in one other proposal. For example, if a company accepts
a proposal to set up a factory in remote area it may have to invest in
infrastructure also.

Hence, capital rationing refers to the situations where the firm has more
acceptable investment requiring greater amount of finance than is available
with the firm. It is concerned with the selection of a group of investment out of
many investment proposals ranked in the descending order of the rate or
return.

In other words, it occurs when a firm has more acceptable proposals than it
can finance. At this point, the firm ranks the projects from highest to lowest
priority and, as such, a cut-off point is considered.

Naturally, those proposals which are above the cut-off will be accepted and
those which are below cut-off point are rejected, i.e., ranking is necessary to
choose the best alternatives.
ESTIMATIONOFPROJECTCASHFLOWS
Capital Budgeting also considers incremental cash flows from an investment
likely to result due to acceptance of any project. Hence, one of the important
tasks in capital budgeting is estimating future cash flows for a project. Though
among various techniques one technique is based on profit. Since timing of
cash flow may not match with period of profit normally firms may be more
interested in cash flows.

For example, Profit and Loss Account may show a sale of $100 mln, but actual
receipt may be lesser. Similarly, for purchase full payment may not have been
made by the company. Further, depreciation is a non-cash item as its outflow
of cash takes place in the beginning at the time of purchase of machinery and
at the end as scrap sale. Thus, due to this time difference it is better to
eliminate decision on the basis of cash flows rather profit. The final decision
we make at the end of the capital budgeting process is no better than the
accuracy of our cash-flow estimates.

The estimation of costs and benefits are made with the help of inputs
provided by Marketing, production, engineering, costing, purchase, taxation,
and other departments.
The project cash flow stream consists of cash outflows and cash inflows. The
costs are denoted as cash outflows whereas the benefits are denoted as cash
inflows.

An investment decision considers the choice of an objective, an appraisal

technique and the project’s life. The objective and technique must be related
to definite period of time. The life of the project may be determined by taking
into consideration the following factors:

(i) Technological obsolescence;

(ii) Physical deterioration; and
(iii) A decline in demand for the output of the project.

No matter how good a company’s maintenance policy, its technological

forecasting ability or its demand forecasting ability, uncertainty will always be
present because of the difficulty in predicting the duration of a project life.

Before, we analyze how cash flow is computed in capital budgeting decision

following items needs consideration:

Depreciation

Depreciation is a non-cash item and itself does not affect the cash flow.
However, we must consider tax shield or benefit from depreciation in our
analysis. Since this benefit reduces cash outflow for taxes it is considered as
cash inflow. To understand how depreciation acts as tax shield let us consider
following example:
Example

ABC Ltd. is manufacturing motors fitted in the Air Conditioners. Its annual
turnover is 30 Million and cash expenses to generate this sale are 25 Million.
Suppose if applicable tax rate is 30% and depreciation is 1.50 crore p.a., then
let us see how depreciation shall act as tax shield from the following table
showing cash flow under two scenarios one with depreciation and another
without depreciation.

NoDepreciat Depreciati
ion onis
isCharg Charg
TotalSales 30.00 ed(Ml 30.0
ed(Ml
Less:CostofGoodsSold 25.00 0
25.0
n) n)
5.00 5.00 0
Less:Depreciation - 1.50
Profitbeforetax 5.00 3.50
Tax@30% 1.50 1.05
ProfitafterTax 3.50 2.45
Add:Depreciation* - 1.50
CashFlow 3.50 3.95
Being non- cash expenditure depreciation has been added back while
calculating the cash flow.

Opportunity Cost:

Opportunity cost can occur both at the time of initial outlay or during the
tenure of the project.
For example, if a company owns a piece of land acquired 10 years ago for 1
Million $ at that time, today it can be sold for 10 Million $. If company uses this
piece of land for a project then its sale value i.e. 10 10 Million $ forms the part
of initial outlay. The cost of acquisition 10 years ago shall be irrelevant for
decision making.

Similarly, alternative cash inflow foregone due to acceptance of any project

should be considered as opportunity cost and should be included in our
analysis.

Sunk Cost:

Sunk cost is an outlay that has already incurred and hence should be excluded
from capital budgeting analysis.
For example, if a company has paid a sum of $ 1,00,000 for consultancy
charges to a firm for the preparation of a Project Report for analysis to decide
whether to take a particular project or not is irrelevant for analysis as sum has
already been paid and shall not affect our decision whether project should be
undertaken or not.

Working Capital

Every project requires working capital as it is must. Hence, while evaluating

the projects initial working capital requirement should be treated as cash
outflow and at the end of the project its release should be treated as cash
inflow.

It is important to note that no depreciation is provided on working capital

though it might be possible that at the time of its release its value might have
been reduced. Further there are also chances that additional working capital
may be required during the life of the project. In such cases the additional
working capital required is treated as cash outflow at that period of time.
Similarly, any reduction in working capital shall be treated as cash inflow.

It may be noted that, if nothing has been specifically mentioned for the release
of working capital it is assumed that full amount has been realized at the end
of the project. However, adjustment on account of increase or decrease in
working capital needs to be considered.
Allocated Overheads:

Allocated overheads are charged on the basis of some rational basis such as
machine hour, labour hour, direct material consumption etc. Since,
expenditures already incurred are allocated to new proposal; they should not
be considered as cash flows. However, it is assumed that overhead cost shall
be increased due to acceptance of any proposal then incremental overhead
cost shall be treated as cash outflow.

Additional Capital Investment:

It is not necessary that capital investment shall be required at the

commencement of the project. It can also be required during the continuance
of the project. In such cases it shall be treated as cash outflows.

Categories of Cash Flows:

(a) Initial Cash Outflow:

The initial cash out flow for a project depends upon the type of capital
investment decision as below:-
(i)If decision is related to investment in a fresh proposal or an expansion then
initial cash outflow shall be calculated as follows:

Amou Amoun
CostofnewAsset(s) nt t
xxx
Add Installation/Set-UpCosts xxx
:
Add InvestmentinWorkingCapital xxx xxx
: InitialCashOutflow xxx
(i) If decision is related to replacement then initial cash outflow
shall be calculated as follows:

Amou Amou
CostofnewAsset(s) nt nt
xxx
Add Add:Installation/Set-UpCosts xxx
:Add Increase (Decrease) in net xxx
/(le Working
Les
ss): NetProceedsfromsaleofoldassets
Capitallevel (xxx
s: (Ifitisareplacementsituation) )
Add/(less): xxx xxx
Taxexpense(saving/loss)duet
osaleofOldAsset
(Ifitisareplacementsituation)
InitialCashOutflow xxx

B) InterimCashFlows:
After initial cash outflow, it is necessary to begin implementing a project; the
firm hopes to get benefit from the future cash inflows generated by the
project. Calculation of cash flows depends on the fact whether analysis is
related to fresh project or modernization of existing facilities or replacement
of existing machined decision.

New Project: If analysis is related to a fresh or completely a new project then

interim cash flow is calculated as follows:-
Similarly interim cash flow in case of replacement decision shall be
calculated as follows:
 Amou Amount
Net increase (decrease) in nt xxx Ter
Add/ Operating Revenue
Net decrease (increase) in operating xxx min
(less): expenses
Net change in income before taxes xxx al-
Net decrease (increase) in taxes xxx
Amount Amount Yea
Add/ Net change
Profit in income
after Tax (PAT) after taxes xxxxxx rIn
(less):
Add/
Add: Net
Non-Cash decrease (increase)(e.g. xxx
Expenses in xxx cre
(less):(less):
Depreciation)
Add/ depreciation charges (increase) in xxx
Net decrease xxx me
Working Capital
Interim net cash
Incremental netfl cash
for the period
flow for xxx xxx nta
the period lNe
tCashFlow:

For the purpose of Terminal Year , first calculate the incremental net cash
flow for the period as calculated in point (b) above and further to it we will
make adjustments in order to arrive at Terminal-Year Incremental Net Cash
flow as follows: -

Amoun Amoun
Finalsalvagevalue(disposalcosts)ofa t t
xxx
Add: sset
InterimCashFlow xxx
Add/(less):Taxsavings(taxexpenses)duetosal xxx
eordisposalofasset(IncludingDepre
Add: ciation)
ReleaseofNetWorking Capital xxx
TerminalYearincrementalnetcashflo xxx
w
BASIC PRINCIPLES FOR MEASURING PROJECT CASH FLOWS

For calculating the projected cash flows the following must be kept in mind:

Block of Assets and Depreciation

Tax shield/ benefit from depreciation is considered while calculating cash

flows from the project. Taxable income is calculated as per the provisions of
Income Tax or similar Act of a country. The treatment of deprecation is based
on the concept of “Block of Assets”, which means a group of assets falling
within a particular class of assets. This class of assets can be building,
machinery, furniture etc. in respect of which depreciation is charged at same
rate. The treatment of tax depends on the fact whether block of asset consist
of one asset or several assets.

Example

Z Ltd. acquired new machinery for $ 100000 depreciable at 20% as per

Written Down Value (WDV) method. The machine has an expected life of 5
years with salvage value of $10000. The treatment of Depreciation/ Short
Term Capital Loss in the 5th year in two cases shall be as follows:

Depreciation for initial 4 years shall be common and WDV at the beginning of
the 5th year shall be computed as follows:

`
PurchasePriceofMachinery 1,00,000
Less:Depreciation@20%for 20,000
year1
WDVattheendofyear1 80,000
Less:Depreciation@20%for 16,000
year2
WDVattheend of year 2 64,000
Less:Depreciation @ 12,800
20%foryear 3
WDVattheend of year 3 51,200
Less:Depreciation @ 10,240
20%foryear 4
WDVattheend of year 4 40,960
(i) Case1:ThereisnootherassetintheBlock:When there is one asset in
the block and block shall cease to exist at the end of 5thyear no deprecation
shall be charged in this year and tax benefit/loss on Short Term Capital Loss/
Gain shall be calculated as follows:
`
WDVatthebeginning 40,960
ofyear5
Less:SalevalueofMachine 10,000
ShortTermCapitalLoss 30,960
TaxBenefitonSTCL@30% 9,288
(ii) Case2:MorethanoneassetexistsintheBlock:When more than one
asset exists in the block and deprecation shall be charged in the terminal year
(last year) in which asset is sold. The WDV on which depreciation be charged
shall be calculated by deducting sale value from the WDV in the beginning of
the year.
Tax benefit on Depreciation shall be calculated as follows:
 `
WDV at the beginning of year 40,960
Less:
5 Sale value of Machine 10,000
WDV 30,960
Depreciation @20% 6,192
Tax Benefit on Depreciation 1,858
@ 30%
If in above two cases sale value of machine is $50000, then no depreciation
shall be provided in case 2 and tax loss on Short Term Capital Gain in Case 1
shall be computed as follows:
`
WDV at the beginning of year 40,960
Less:
5 Sale value of Machine 50,000
Short Term Capital Gain 9,040
Tax Loss on STCG @ 30% 2,712

Exclusion of Financing Costs

When cash flows relating to long-term funds are being defined, financing
costs of long-term funds should be excluded. The weighted average cost of
capital used for evaluating by discounting the cash flows takes into account
the cost of long-term funds.
Or say, the interest and dividend payments are reflected in the weighted
average cost of capital. Hence, if interest on long-term debt and dividend on
equity capital are deducted in defining the cash flows, the cost of long-term
funds will be counted twice.
The exclusion of financing costs principle means that:
(i) The interest on long-term debt is ignored while computing profits
andtaxes and;
(ii) The dividends are deemed irrelevant in cash flow analysis.

While dividends pose no difficulty as they come only from profit after taxes,
interest needs to be handled properly. Since interest is usually deducted in
the process of arriving at profit after tax, an amount equal to ‘Interest (1 -
Tax rate)’ should be added back to the figure of Profit after Tax as shown
below:
Profit before Interest and Tax (1 - Tax rate)
= (Profit before Tax + Interest) (1 - Tax rate)
= (Profit before Tax) (1 - Tax rate) + (Interest) (1 - Tax rate)
= Profit after Tax + Interest (1 - Tax rate)
Example
Suppose ABC Ltd.’s expected profit for the forthcoming 4 years is as follows:

Year Year Year Year

Profit before Interest 1 10,00 2 20,00 340,00 4 50,00
and Tax 0 tax rate
If interest payable is 5,000 and 0 is 30%
0 the profit
0 after tax
excluding financing cost shall be as follows:
Year Year Year Year 4
1 2 3
Profit before Interest 10,00 20,00 40,00 50,000
and Tax
Less: Interest 0
5,000 0
5,000 0
5,000 5,000
5,000 15,00 35,00 45,000
Less: Tax @ 30% 1,500 0 4,500 010,50 13,500
Profit after Tax (PAT) 3,500 10,50 0 24,50 31,500
Add: Interest (1- t) 0
3,500 3,500 0
3,500 3,500
PAT excluding finance 7,00 14,00 28,0 35,000
cost 0 0 00
Alternatively

Year 1 Yea Year Year

r2 3 4
Profit before Interest 10,000 20,00 40,000 50,00
and
Less:Tax
Tax @ 30% 3,000 0
6,000 12,000 0
15,00
PAT excluding finance 7,000 14,0 28,00 0
35,00
cos 00 0 0
t
 ILLUSTRATION
TOVS Ltd is evaluating the option for purchase of a new project with a
depreciable base of1,00,000; expected economic life of 4 years and change
in earnings before taxes and depreciation of 45,000 in year 1, 30,000 in year
2, 25,000 in year 3 and35,000 in year 4. Assume straight-line depreciation
and a 20% tax rate. You are required to compute relevant cash flows.
SOLUTION

Particulars Years
1 2 3 4
Earningsbefore 45,000 30,000 25,00 35,00
tax 0 0
Less:
anddepreciation (25,000 (25,000 (25,00 (25,00
Depreciation
Earningsbefore ) 20,000 ) 5,000 00) 0)
10,00
tax Tax @20%
Less: (4,000 (1,000) 0 0
(2,00
)16,000 4,000 0 0)
8,00
Add: Depre 25,000 25,000 25,00 0
25,00
41,00 29,00 0
25,0 0
33,00
NetCashflow
0 0 00 0

Working Note:
Depreciation = 1,00,000 ÷ 4 = `25,000

CAPITAL BUDGETING TECHNIQUES / METHODS

There are different methods adopted for capital budgeting. The traditional
methods or non-discount methods include: Payback period and Accounting
rate of return method. The discounted cash flow method includes the NPV
method, profitability index method and IRR.

Payback period method:

This method refers to the period in which the proposal will generate cash to
recover the initial investment made. It purely emphasizes on the cash inflows,
economic life of the project and the investment made in the project, with no
consideration to time value of money. Through this method selection of a
proposal is based on the earning capacity of the project. With simple
calculations, selection or rejection of the project can be done, with results that
will help gauge the risks involved. However, as the method is based on thumb
rule, it does not consider the importance of time value of money and so the
relevant dimensions of profitability.
Payback period = Cash outlay (investment) / Annual cash inflow

Advantages:
1. A company can have more favorable short-run effects on earnings per share
by setting up a shorter payback period.
2. The riskiness of the project can be tackled by having a shorter payback
period as it may ensure guarantee against loss.
3. As the emphasis in pay back is on the early recovery of investment, it gives
an insight to the liquidity of the project.

Limitations:
1. It fails to take account of the cash inflows earned after the payback period.
2. It is not an appropriate method of measuring the profitability of an
investment project, as it does not consider the entire cash inflows yielded by
the project.
3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of
cash inflows.
4. Administrative difficulties may be faced in determining the maximum
acceptable payback period.

Example

Project Project
A B
Cost 1,00,000 1,00,000
Expected future
cash flow
Year 1 50,000 1,00,000
Year 2 50,000 5,000
Year 3 1,10,000 5,000
Year 4 None None
TOTAL 2,10,000 1,10,000
Payback 2 years 1 year

Payback period of project B is shorter than A, but project A provides higher

returns. Hence, project A is superior to B.
Example 2
For example, there is an initial investment of ₹1000 in a project and it
generates a cash flow of 300 for the next 5 years.

Therefore the payback period is calculated as below:

Payback period = no. of years – (cumulative cash flow/cash flow)

Payback period = 5- (500/300)

= 3.33 years

Therefore it will take 3.33 years to recover the investment.

Specific Considerations

1. Working capital

Working capital consists of current assets (cash, accounts receivable,

inventory, supplies, etc.) and current liabilities (accounts payable, wages
payable, etc.). Many long-term projects will both require an investment in
working capital (current assets) and derive the benefits of new current
liabilities. The difference between an increase in current assets and the
benefit derived from an increase in current liabilities is the net investment in
working capital for a project.

That net working capital investment is a required cost of a project and should
be recognized as a cash outflow, usually at the beginning, in the analysis of a
project. I.e., in the analysis of a project, in addition to the fixed asset costs
(land, building, furniture/fixtures, etc.), new working capital in the form of
cash (change fund, operating funds, etc.), accounts receivable, inventory and
current payables may be required. The net cost of (amounts tied up in) those
working capital items would be a cash outflow required of the project and
included in the project analysis.

For a project with a limited life, the net working capital investment is
liquidated at the end of the project and should be treated as a cash inflow,
measured at its present value, in the analysis of a project. But, for the payback
period approach to project evaluation, the residual value of a net working
capital investment normally is not considered because that considers cash
flows only until the point at which the initial cost of the project is recovered. If
the project recovers the initial investment within the pre-established
maximum period, any cash flow associated with the working capital residual
value after that maximum period is not relevant.

2. Depreciation
Depreciation does not create a cash flow; it is the yearly (or other period)
allocation of the cash flow that occurred when a project's assets were
acquired. As depreciation expense does not create a cash flow, it is not
considered in the determination of the payback period.

But to the extent depreciation expense is deductible for income tax purposes;
it saves taxes and the cash outflow that would be required to pay those taxes.
That cash outflow savings, called a “tax shield,” is considered in calculating the
payback period.

For example, if $100 of tax deductible depreciation expense occurs during a

year and the firm's tax rate is 30%, the tax shield would be .30 × $100 = $30,
the amount of cash that would be saved as a result of the tax deductibility of
the depreciation expense. That $30 would be recognized as a cash inflow
(savings) for each period it occurred.

3. Residual (salvage) value

The residual value associated with a capital project is not considered in the
payback period approach to project evaluation because that approach
considers cash flows only until the point at which the initial cost of the project
is recovered. If the project recovers the initial investment within the pre-
established maximum period, any cash flow associated with the project
residual value after that maximum period is not relevant.

Payback Reciprocal

It is the reciprocal of payback period. A major drawback of the payback period

method of capital budgeting is that it does not show any cut off period for the
purpose of investment decision. It is, however, argued that the reciprocal of the
payback would be a close approximation of the Internal Rate of Return if the life
of the project is at least twice the payback period and the project generates
equal amount of the annual cash inflows. In practice, the payback reciprocal is a
helpful tool for quickly estimating the rate of return of a project provided its life
is at least twice the payback period.

The payback reciprocal can be calculated as follows:

Averageannualcash inflow
PaybackReciprocal = Initial Investment
Initialinvestment
Example

Suppose a project requires an initial investment of $20,000 and it would give

annual cash inflow of $4000. The useful life of the project is estimated to be 5
years. In this example payback reciprocal will be:

= 4,000 *100 / 20000

= 20%

The above payback reciprocal provides a reasonable approximation of the

internal rate

of return, i.e. 19%.

Accounting rate of return method (ARR)

It helps to overcome the disadvantages of the payback period method. The rate
of return is expressed as a percentage of the earnings of the investment in a
particular project. It works on the criteria that any project having ARR higher
than the minimum rate established by the management will be considered and
those below the specified rate are rejected.
This takes into account the entire economic life of a project providing a better
means of comparison. It also ensures compensation of expected profitability of
projects through the concept of net earnings. However, this method also ignores
time value of money and doesn’t consider the length of life of the projects. Also it
is not consistent with the firm’s objective of maximizing the market value of
shares.
ARR= Average income/Average Investment

Advantages:
1. It is very simple to understand and use.

2. It can be readily calculated using the accounting data.

3. It uses the entire stream of incomes in calculating the accounting rate.

Limitations:
1. It uses accounting, profits, not cash flows in appraising the projects.

2. It ignores the time value of money; profits occurring in different periods are
valued equally.

3. It does not consider the lengths of projects lives.

4. It does not allow for the fact that the profit can be reinvested.

Specific Considerations

Working capital
Working capital consists of current assets (cash, accounts receivable, inventory,
supplies, etc.) and current liabilities (accounts payable, wages payable, etc.).
Many long-term projects will both require an investment in working capital
(current assets) and derive the benefits of new current liabilities. The difference
between an increase in current assets and the benefit derived from an increase
in current liabilities is the net investment in working capital for a project.
A net working capital investment would not enter into the determination of
incremental net income over the life of a project, so it would not affect the ARR
determination.
A net working capital investment would enter into the amount of the
investment, the denominator, used in the ARR determination. A net working
capital investment would increase the amount of the initial investment.
Specifically, the amount of a net investment in working capital would be added
to the investment in fixed assets in determining either the initial investment or
the average investment over the life of the project.
Depreciation
Depreciation is explicitly recognized under the accounting rate of return
approach.
While all of the other methods are based on measuring cash flows, this method
is based on expected accounting revenues and expenses, including depreciation
expense. Thus, the accounting rate of return approach is the only approach that
recognizes depreciation expense.
Because the ARR approach explicitly recognizes depreciation expense, the
choice of depreciation method used by a firm will affect the accounting income
and, therefore, the ARR (i.e., percentage rate).

Income taxes

Income tax expenses are explicitly recognized under the accounting rate of
return approach. Because it is based on expected accounting revenues and
expenses, expected income tax expenses would be taken into account in
computing the net increment in accounting income. Because the full amount of
expected tax expense enters into determining the net increment in accounting
income, the tax effect is taken into account in full; the issue of “tax shield” (a
cash flow concept) is not relevant.
Residual (salvage) value

Conceptually, the residual value associated with a capital project should be

taken into account in determining incremental income to the extent that
residual value is expected to generate an increase in accounting income (from a
gain) or a decrease in accounting income upon disposal. Practically, however, it
is difficult to estimate such an amount at the beginning of a project; therefore, it
is usually ignored in measuring accounting income for a project.
When the average investment in a project is used (the denominator), the
residual value is taken into account in the determination of the average
investment. That average would be determined as:
Average investment = [Initial investment (+ Net working capital, if
any) + Residual value] / 2

Discounted cash flow method:

It calculates the cash inflow and outflow through the life of an asset. These are
then discounted through a discounting factor. The discounted cash inflows and
outflows are then compared. This technique takes into account the interest
factor and the return after the payback period.

Net present Value (NPV) Method:

It is most widely used method for evaluating capital investment proposals. In

this the cash inflow that is expected at different periods of time is discounted at
a particular rate. The present values of the cash inflow are compared to the
original investment. If the difference between them is positive (+) then it is
accepted or otherwise rejected.
It considers the time value of money and is consistent with the objective of
maximizing profits for the owners. However, understanding the concept of cost
of capital is not an easy task.
The equation for the net present value, assuming that all cash outflows are made
in the initial year, will be:
NPV = (Cash flows)/ (1+r) - i

Where,
i- Initial Investment
Cash flows= Cash flows in the time period
r = Discount rate
i = time period

Specific Considerations

Working capital
That net working capital investment is a required cost of a project and should be
recognized as a cash outflow, usually at the beginning of the project, in the
analysis of a project.
For a project with a limited expected life, the net working capital investment is
normally liquidated at the end of the project and should be treated as a cash
inflow, measured at its present value, in the analysis of a project.
For example, in the analysis of a project, in addition to the fixed asset costs
(land, building, furniture/fixtures, etc.), new working capital in the form of cash
(change fund, operating funds, etc.), accounts receivable, inventory, and current
payables may be required. The net investment in those working capital items
would be a cash outflow required of the project and included in the project
analysis. If the project is expected to have a limited life, the working capital
items will be liquidated at the end of the project, which returns their value to the
firm. That future return of working capital should be recognized as a cash
inflow, at its present value, in analysis of the project.

Depreciation
Depreciation does not create a cash flow; it is the allocation of the cash flow that
occurred when a project's assets were acquired. It is not considered in the
determination of the net present value (an approach which is based on cash
flows).
However, to the extent depreciation expense is deductible for income tax
purposes, it saves taxes and the cash outflow to pay those taxes. That cash
outflow savings, called a “tax shield,” is considered in determining the net
present value.

Residual (salvage) value

The residual value associated with a capital project is considered in the net
present value approach. Any residual value expected at the end of the project
life would be discounted to its present value and treated as a positive value in
the determination of net present value. Conversely, if it is expected that an
additional disposal cost would be incurred at the end of the project life, that cost
would be discounted to its present value and treated as a negative value in the
determination of net present value.

Determining Discount Rate

Theoretically, the discount rate or desired rate of return on an investment is the

rate of return the firm would have earned by investing the same funds in the best
available alternative investment that has the same risk. Determining the best
alternative is difficult in practical terms so rather than using the opportunity cost,
organizations often use an alternative measure for the desired rate of return. An
organization may establish a minimum rate of return that all capital projects must
meet; which may be based on an industry average or the cost of other investment
opportunities.
Many organizations choose to use the overall cost of capital or Weighted Average
Cost of Capital (WACC) that an organization has incurred in raising funds or
expects to incur in raising the funds needed for an investment.
Advantages:
1. It recognizes the time value of money
2. It considers all cash flows over the entire life of the project in its calculations.
3. It is consistent with the objective of maximizing the welfare of the owners.
Limitations:
1. It is difficult to use
2. It presupposes that the discount rate which is usually the firm’s cost of capital
is known. But in practice, to understand cost of capital is quite a difficult
concept.
3. It may not give satisfactory answer when the projects being compared involve
different amounts of investment.
Example
Let us see an example to discuss it.
Let us assume the discount rate is 10%

NPV = -1000 + 200/(1+0.1)^1 +

300/(1+0.1)^2+400/(1+0.1)^3+600/(1+0.1)^4+ 700/(1+0.1)^5

= 574.731

We can also calculate it by excel formula.

The discounting rate and the series of cash flows from the 1st year to the last
year is taken as arguments. We should not include the year zero cash flow in the
formula. We should later subtract it.
= NPV (Discount rate, cash flow of 1st year: cash flow of 5th year) + (-Initial
investment)

= NPV (10%, 200:700) – 1000

= 574.731

As NPV is positive, it is recommended to go ahead with the project. But not only
NPV, but IRR is also used for determining the profitability of the project.

ILLUSTRATION

XYZ Ltd is a small company that is currently analyzing capital expenditure

proposals for the purchase of equipment; the company uses the net present value
technique to evaluate projects. The capital budget is limited to 500,000 which
XYZ Ltd believes is the maximum capital it can raise. The initial investment and
projected net cash flows for each project are shown below. The cost of capital of
XYZ Ltd is 12%. Compute the NPV of the different projects.

Project Project Project Project

InitialInvestment 1200,00 2190,00 3250,00 4210,00
ProjectCashInflow 0 0 0 0
sYear1 50,00 40,00 75,00 75,00
2 0
50,00 0
50,00 0
75,00 0
75,00
3 0
50,00 070,00 0
60,00 0
60,00
0 0 0 0
 4 50,00 75,00 80,00 40,00
5 0
50,00 0
75,00 0
100,00 0
20,00
0 0 0 0
SOLUTION
Calculation of net present value:

Period PVfacto Project1 Project2 Project3 Project4

0 r 1.000 (2,00,000 (1,90,00 (2,50,000 (2,10,000
1 0.893 ) 44,650 0) 35,72 ) 66,97 ) 66,97
2 0.797 39,85 39,85
0 59,77
5 559,77
3 0.712 0
35,60 49,84
0 42,72
5 42,72
5
4 0.636 31,80
0 47,70
0 050,88 25,440
0
5 0.567 28,35
0 42,52
0 56,70
0 11,34
NetPresentValue 0
(19,750 5
25,63 0
27,05 0
(3,750
) 5 0 )

Internal Rate of Return (IRR):

It is defined as the rate at which the net present value of the investment is zero.
The discounted cash inflow is equal to the discounted cash outflow. This
considers time value of money. It tries to arrive to a rate of interest at which
funds invested in the project could be repaid out of the cash inflows. However,
computation of IRR is a tedious task.
It is called internal rate because it depends solely on the outlay and proceeds
associated with the project and not any rate determined outside the investment.

It can be determined by solving the following equation:

If IRR > WACC then the project is profitable.

If IRR > k = accept
If IR < k = reject

Example
While calculating, we need to find out the rate at which NPV is zero. This is
usually done by error and trial method else we can use excel for the same.
Let us assume the discount rate to be 10%.
NPV at a 10 % discount is ₹ 574.730.
So we need to increase the discount percentage to make NPV as 0.
So if we increase the discount rate to 26.22 %, the NPV is 0.5 that is almost
zero.
There is in-built excel formula of “IRR” which can be used. The series of cash
flows is taken as arguments.

=IRR (Cash flow from 0 to 5th year)

= 26 %
Therefore in both the ways, we get 26 % as the internal rate of return.

Steps to calculate Internal Rate of Return

A. The calculation of a project's exact internal rate of return is best done

with a financial calculator. In the absence of a financial calculator, the
determination of the internal rate of return will require interpolation and
trial and error.
B. The determination of a project's cash flow, including the treatment of
depreciation and salvage value, is the same as under the NPV approach.
C. Assuming an even cash flow over the life of a project, the determination of
the internal rate of return begins by solving the equation:
 Annual cash inflow (or Savings) × PV factor = Investment cost,
or
PV fac= Investment cost / Annual cash inflow (or Savings)

D. Using the investment cost and expected annual cash inflow, the present
value factor can be determined. Next, the resulting present value factor
would be related to an interest (discount) rate for the time period of the
project. Only by rare coincidence will the exact calculated present value
for the number of periods be found on a present value table. Therefore, it
will be necessary to interpolate to determine the exact internal rate of
return.

Advantages:
1. Like the NPV method, it considers the time value of money.
2. It considers cash flows over the entire life of the project.
3. It satisfies the users in terms of the rate of return on capital.
4. Unlike the NPV method, the calculation of the cost of capital is not a
precondition.
5. It is compatible with the firm’s maximizing owners’ welfare.
Limitations:
1. It involves complicated computation problems.
2. It may not give unique answer in all situations. It may yield negative rate or
multiple rates under certain circumstances.
3. It implies that the intermediate cash inflows generated by the project are
reinvested at the internal rate unlike at the firm’s cost of capital under NPV
method. The latter assumption seems to be more appropriate.

Modified Internal Rate of Return (MIRR)

There are several limitations attached with the concept of the conventional
Internal Rate of Return. The MIRR addresses some of these limitations e.g., it
eliminates multiple IRR rates; it addresses the reinvestment rate issue and
produces results which are consistent with the Net Present Value method. This
is also called Terminal Value method.

Under this method, all cash flows, apart from the initial investment, are brought
to the terminal value using an appropriate discount rate. This results in a single
stream of cash inflow in the terminal year.
The MIRR is obtained by assuming a single outflow in the zeroyear and the
terminal cash inflow as mentioned above. The discount rate which equates the
present value of the terminal cash inflow to the zero year outflow is called the
MIRR.
The decision criterion of MIRR is same as IRR i.e. you accept an investment if
MIRR is larger than required rate of return and reject if it is lower than the
required rate of return.

Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the required rate of
return to the initial cash outflow of the investment. It may be gross or net, net
being simply gross minus one.
The formula to calculate profitability index (PI) is as follows.
PI = PV cash inflows/Initial cash outlay A,
PI = NPV (benefits) / NPV (Costs)
All projects with PI > 1.0 is accepted.
It is mainly used for ranking projects. According to the rank of the project, a
suitable project is chosen for investment.

ILLUSTRATION
Suppose we have three projects involving discounted cash outflow of 5,50,000,
75,000 and 1,00,20,000 respectively Suppose further that the sum of
discounted cash inflows for these projects are 6,50,000, 95,000 and 1,00,30,000
respectively.
Calculate the desirability factors for the three projects.
SOLUTION
The desirability factors for the three projects would be as follows:
1. 650000/ 550000 = 1.18
2. 95000/75000 = 1.27
3. 10030,000/10020000 = 1.001
It would be seen that in absolute terms project 3 gives the highest cash inflows
yet its desirability factor is low. This is because the outflow is also very high. The
Desirability/ ProfitabilityIndex factor helps us in ranking various projects.
Since PI is an extension of NPV it has same advantages and limitation.

Merits of Profitability Index

• It takes into consideration, the Time Value of Money.
• The profits are considered throughout the life of the project.
• This method helps in giving the ranks to the projects.
• It helps in assessing the risk involved in cash inflows through the cost of
capital.
• It also helps in assessing the increase or decrease in the firm’s value due
to the investments.
Demerits of profitability Index
• Unlike the NPV, the Profitability Index may sometimes do not offer the
correct decision with respect to the mutually exclusive projects.
• The cost of capital is must to compute this ratio.
• It is a modernized version of Net Present Value that shows the present
value of future cash inflows over the present value of cash outlay.
Whereas the NPV shows the difference between the present value of
future cash inflows and the present value of cash outlay. Also, the NPV is
an absolute measure, whereas the Profitability Index is a relative
measure.

Equivalent Annual Annuity Approach

The approach provides a means of comparing projects, especially those with

unequal lives.
It calculates the constant annual cash flow generated by a project over its entire
life as if it were an annuity and uses the present value of that cash flow as a basis
for comparing projects.
The EAA is calculated for each project in the following manner:
The NPV for each project is determined.
For each project the annual cash flows that when discounted for the life of the
project exactly equals the NPV of the project is determined; the dollar amount so
determined is the EAA for a project.
The formula used to compute the EAA would be:
Capital Budgeting Risks

Because capital budgeting analysis uses various projections and assumptions,

there is a risk that the actual outcomes may vary from the results of the analysis.
A number of techniques have been developed to incorporate uncertainty and to
measure risks in a project analysis. Those techniques include:

A. Probability Assignment

In this approach, probabilities are assigned to possible outcomes. These

probabilities may be assigned based on past experience, industry-wide
measures, forecasts, simulation, or other bases. Once possible outcomes
have been identified and probabilities have been assigned, an expected
value can be determined.

B. Risk-Adjusted Discount Rates

In this approach to addressing uncertainty in project assessment,

different discount rates are used for projects with different levels of risk.
For a project with higher or lower than normal risk, a higher or lower
discount rate would be used.

C. Time-Adjusted Discount Rates

In this approach, cash flows associated with the later years of a long-term
project are discounted at a higher rate than cash flows of the earlier years.
This use of a higher discount rate for later years reflects the increased
uncertainty in making longer-term projections.

D. Sensitivity Analysis

In this approach, the most likely set of assumptions is used to compute the
most likely outcome. Then one of the assumptions is changed, and the
resulting outcome is determined. This process of changing one
assumption at a time is repeated until the effect of changing each major
assumption separately on the final outcome is known. This process allows
management to consider how sensitive the outcome is to each major
assumption.
 E. Scenario Analysis

In this approach is similar to sensitivity analysis except that rather than

changing one assumption (variable) at a time, multiple related
assumptions are changed simultaneously. This enables management to
determine the range of possible outcomes that might occur.

F. Other Risk Consideration Approaches

In addition to the foregoing approaches for recognizing and measuring

risk inherent in project analysis, firms might also employ:

• Simulation
• Decision-tree analysis

SUMMARY OF DECISION CRITERIA OF CAPITAL BUDGETING TECH

NIQUES

ForMutuallyExclus
Techniques ForIndependentPro iveProjects
ject
PayBack (i) WhenPayback ProjectwithleastPa
periodMaximum ybackperiodshoul
Accepta dbeselected.
Non- blePaybackperiod:A
Discounte ccepted
d Accounti (i)WhenARR
(ii) WhenPaybackperio Projectwiththemax
ngRateof dMaximum Minim imumARRshouldb
Return(A Accepta
umAcceptableRat eselected.
RR) blePaybackperiod:R
eofReturn:Accept
ejected
ed
Discounted NetPrese (i) WhenNPV>O:Accepte Projectwiththehig
ntValue(N (ii)WhenARRMinimum
d hestpositiveNPVsh
PV) AcceptableRateofRe
(ii) WhenNPV<O:Rejecte ouldbeselected.
dturn:Rejected
 Profitabil WhenPI>1:Accepted When Net Present
(i)
ityindex( (ii) WhenPI<1:Rejected Value is same
PI) project with
highest PI should
Internal (i) WhenIRR>K:Accepte be selected.
Projectwiththemax
Rate of d imumIRRshouldbe
Return (ii) WhenIRR<K: selected.
(IRR) Rejected

1) Which of the following is true regarding the payback method?

A. It does not consider the time value of money.

B. It is the time required to recover the investment and earn a
profit.
C. It is a measure of how profitable one investment project is
compared to another.
 D. The salvage value of old equipment is ignored in the event of
equipment replacement.

2) Which of the following is required to calculate the payback period for a

project?

A. Useful life.

B. Minimum desired rate of return.

C. Net present value.

D. Annual cash flow.

3) A project has an initial outflow of $1,000. The projected cash inflows are

Year 1 $200
Year 2 200
Year 3 400
Year 4 400

What is the investment’s payback period?

A. 4 years.
B. 3.5 years
C. 3.4 years.
D. 3 years.

Initial cost $500,000

Life 10 years 4) While evaluating investments, the
release of working capitalat the end of
Annual net cash inflows $200,000
the projects life should be considered
Salvage value $100,000
as,
(a) Cash in flow
(b) Cash out flow
(c) Having no effect upon the capital budgeting decision
(d) None of the above.

5) HBK Co. is evaluating a capital investment proposal for a new machine. The
investment proposal shows the following information:

If acquired, the machine will be depreciated using the straight-line method.

The payback period for this investment is
a) 3.25 years.

b) 2.67 years.

c) 2.5 years.

d) 2 years.
6) Depreciation is included as a cost in which of the following techniques,
A. Accounting rate of return
B. Net present value
 C. Internal rate of return
D. None of the above

7) In considering the payback period for projects, Spice Corp. gathered the
following data about cash flows:

Cash Flows by
Year
Year 1 Year 2 Year 3 Year 4 Year 5
Project $(10,000) $3,000 $3,000 $3,000 $3,000
1
Project (25,000) 15,000 15,000 (10,000) 15,000
2
Project (10,000) 5,000 5,000
3 Which of the
projects will
achieve payback within three years?

A. Projects A, B, and C
B. Projects B and C.
C. Project B only.
D. Projects A and C.

8) A firm wants to know how many years it will take before the accumulated
cash flows from an investment exceed the initial investment, without taking
the time value of money into account. Which of the following financial models
should be used?

a) Payback period.
b) Discounted payback period.
c) Internal rate of return.
 d) Net present value.

9) Which of the following is correct regarding payback method?

A. The payback method considers the time value of money.

B. An advantage is that it indicates if an investment will be profitable.
C. It provides the years needed to recoup the investment in a project.
D. It is calculated by dividing the annual cash inflows by the net
investment.

10) Teammate Co. is negotiating for the purchase of equipment that would
cost $100,000, with the expectation that $20,000 per year could be saved in
after-tax cash costs if the equipment were acquired. The equipment's
estimated useful life is 10 years, with no residual value, and would be
depreciated by the straight-line method.

The payback period is

a) 4.0 years.
b) 4.4 years.
c) 4.5 years.

d) 5.0 years.

11) ABC company purchases an item for $43,000. The salvage value of the
item is $3,000. The cost of capital is 8%. Pertinent information related to this
purchase is as follows:

Net cash Presents value

flows factor at 8%
Year 1 $10,000 0.926
Year 2 15,000 0.857
Year 3 20,000 0.794
Year 4 27,000 0.735

What is the discounted payback period (Years)?

A. 3.10
B. 3.25
C. 2.90
D. 3.14
12) How is the discounted payback method is better than the payback method
in evaluating investment projects?

a) It involves better estimates of cash

flows.
b) It considers the overall profitability
of the investment.
c) It considers the time value of money.
d) It considers the variability of the
return.
13) The Berlin Company is planning to purchase a new machine which it will
depreciate on a straight-line basis over 10-years. A full year’s depreciation
will be taken in the year of acquisition. The machine is expected to produce
cash flow from operations, net of income taxes, of $3,000 in each of the 10
years.; The accounting rate of return is expected to be 10% on the initial
increase in required investment. The cost of the new machine will be

A. $12,000
 B. $13,500
C. $15,000
D. $30,000
14) Which of the following is benefit of the accounting rate of return method
of evaluating investment returns?
a) It considers depreciation.
b) It corresponds to the measure that is often used to evaluate
performance.
c) It considers the time value of money.
d) It considers the risk of the investment.
15) Which of the following changes would result in the highest present value?
A. A $100 decrease in taxes each year for four years.
B. A $100 decrease in the cash outflow each year for three
years.

C. A $100 increase in disposal value at the end of four years.

D. A $100 increase in cash inflow each year for three years.

16) Which of the following techniques consistently gives the best when
evaluating investment projects that are mutually exclusive?
a) The internal rate of return.

b) Net present value.

c) The payback method.
d) The accounting rate of return.

17) The discount rate must be determined in advance for :

A. Internal rate of return method.
 B. Net present value method.
C. Payback period method.

D. Time adjusted rate of return method.

18) Net present value used in decision-making is stated in terms of which of

the following?
a) Net income.
b) Earnings before interest, taxes,
and depreciation.
c) Earnings before interest and
taxes.
d) Cash flow.

19) Management of TIKO has generated the following data about an

investment project that has a five-year life:

Initial investment $100,000

Additional investment in working 5,000

capital
Cash flows before income taxes for 30,000
years 1 through 5
Yearly depreciation for tax purposes 20,000
Terminal value of machine 0
Cost of capital 8%
Present value of $1 received after 5 .681
years discounted at 8%
Present value of an ordinary annuity of 3.993
$1 for 5 years at 8%
Suppose TIKO’s marginal tax rate is 30% and all cash flows come at the end of
the year. In evaluating the decision how is the additional investment in
working capital considered?

A. Ignored because it will be recovered at the end of the

investment.
B. As an adjustment to annual cash flows.
C. As an additional initial investment that will be
recovered at the end of year 5.
D. As a deduction from the cost of the investment.

20) MultipleIRRs are obtained when,

A. Cash flows in the early stages of the project exceed cash flows during
the later stages.
B. Cash flows reverse their signs during the project
C. Cash flows are un even
D. None of the above.

21) BillInc. is considering a number of methods to evaluate investment

projects. Management of Warren is primarily concerned with maximizing
shareholder value. Which of the following would be the best method ?

a) Payback.
b) Net present
value.
c) Discounted
payback.
d) Accounting rate
of return.
22) The calculation of depreciation is used in the determination of the NPV of
an investment for?

A. Decrease in the value of the investment should be

reflected in the determination of net present value.
B. Depreciation adjusts the book value of the investment.
C. Depreciation represents cash outflow that must be
added back to net income.
D. Depreciation increases cash flow by reducing income
taxes.

23) Which of the following is benefit of net present value modeling?

a) It is measured in time, not dollars.

b) It uses accrual basis, not cash basis
accounting for a project.
c) It uses the accounting rate of return.
d) It accounts for compounding of returns.
24) A multiperiod project has a positive net present value. Which of the
following statements is correct for required rate of return?

A. The required rate of return is less than the company’s weighted-average

cost of capital (WACC).
B. The required rate of return is less than the project’s internal rate of
return.
C. The required rate of return is greater than the company’s weighted-
average cost of capital (WACC).
D. The required rate of return is greater than the project’s internal rate of
return.
25) The Mahi Company has decided to introduce a new product. The company
estimates that there is a 30% probability that the product will contribute
$700,000 to profits, a 30% probability that it will contribute $200,000, and a
40% probability that the contribution will be a negative $400,000. The
expected contribution of the new product is

a) $500,000
b) $110,000
c) $166,667
d) $380,000
26) ANY Corporation is evaluating a capital investment that would result in
$30,000 higher contribution margin benefit with increased annual personnel
costs of $20,000. In calculating the net present value of benefits and costs,
income taxes would:

A. Decrease both the amount of the benefits and costs.

B. Has no net effect on either the amount of the benefits
or costs.
C. Decrease the amount of the benefits but increase the
amount of the costs.
D. Increase the amount of the benefits but decrease the
amount of the costs.
27) A depreciation tax shield is

a) An after-tax cash outflow.

b) A reduction in income taxes.
c) The cash provided by
recording depreciation.
d) The expense caused by
depreciation.
28) Assume that Super Industries is considering investing in a project with the
following characteristics:
 Initial investment $500,000
Additional initial investment in
10,000
working capital
Cash flows before income taxes
140,000
for years 1 through 5
Yearly tax depreciation 90,000
Terminal value of initial
50,000
investment
Terminal value of additional
10,000
working capital investment
Cost of capital 10%
Present value of $1 received
.621
after 5 years discounted at 10%
Present value of an ordinary
3.791
annuity of $1 for 5 years at 10%
Marginal tax rate 30%
Investment life 5 years

Assume that all cash flows come at the end of the year. What is the net present
value of the investment?

a) $175,000
b) $ 58,000
c) $ 1,135
d) $ (12,340)
29) Net present value and internal rate of return differ in following:

A. NPV considers reinvestment of project cash flows at the cost of capital

while IRR considers reinvestment of project cash flows at the internal
 rate of return.

B. NPV and IRR make different accept or reject decisions for

independent projects.
C. IRR can be used to rank mutually exclusive investment projects but
not NPV.
D. NPV is expressed as a percentage while IRR is expressed in amount.

30) Which of the following is limitation of the internal rate of return as a

method of evaluating investments?

a) Does not adjust for the time value of money.

b) Does not consider the profitability of the
project.
c) Have limitations when evaluating mutually
exclusive investments.
d) Its results are not intuitive.
31) Which of the following would decrease the internal rate of return of a
proposed asset purchase?

A. Decrease tax credits on the asset.

B. Decrease working capital requirements.

C. Shorten the payback period.

D. Use accelerated, instead of straight-line
depreciation.
32) What is an internal rate of return?

a) A net present value.

 b) An accounting rate of return.

c) A payback period expected from an investment.

d) A time-adjusted rate of return from an investment.

33) Which of the following models equates the initial investment with the
present value of the future cash inflows?

A. Accounting rate of return.

B. Payback period.

C. Internal rate of return.

D. Cost-benefit ratio.

34) Which of the following about investment decision models is true?

a) The discounted payback rate takes into account cash flows for all
periods.
b) The payback rule ignores all cash flows after the end of the payback
period.
c) The net present value model says to accept investment opportunities
when their rates of return exceed the company’s incremental
borrowing rate.
d) The internal rate of return rule is to accept the investment if the
opportunity cost of capital is greater than the internal rate of return.
35) A company is using capital budgeting techniques to compare two
independent projects. It could accept one, both, or neither of the projects.
Which of the following is true about the use of net present value (NPV) and
internal rate of return (IRR) methods for evaluating these two projects?
 A. NPV and IRR criteria will lead to the same accept or reject decision for
two independent projects.
B. If the first project's IRR is more than the organization's cost or capital,
the first project will be accepted but the second project will not.
C. If the NPV criterion leads to accepting or rejecting the first project,
one cannot predict whether the IRR criterion will lead to accepting or
rejecting the first project.
D. If the NPV criterion leads to accepting the first project, the IRR
criterion will never lead to accepting the first project.

36) The internal rate of return is the :

a) Rate of interest that equates the present value of cash outflows and
the present value of cash in-flows.
b) Minimum acceptable rate of return for a proposed investment.
c) Risk-adjusted rate of return.
d) Required rate of return.

37) The profitability index is a variation on which of the following models?

A. Internal rate of return.

B. Economic value-added.

C. Net present value.

D. Discounted payback.
38) A project has a present value of future net cash inflows of $120,000 and an
initial investment of $110,000. Calculate the excess present value index for the
project.

a) $10,000.
b) 109.1%.
c) 91.67%
d) $120,000.

39) Formula for calculating the profitability index of a project is :

A. Subtract actual after-tax net income from the minimum required
return in dollars.
B. Divide the present value of the annual after-tax cash flows by the
original cash invested in the project.
C. Divide the initial investment for the project by the net annual cash
inflow.
D. Multiply net profit margin by asset turnover.

40) Use the following information to answer this question.

Invest Cash outlay Present value of

project cash inflows
1 1,100,000 980,000
2 250,000 600,000
3 1,400,000 1,830,000
4 650,000 790,000

The company has $2,000,000 of financing available for new investment

projects. The investment project with the highest excess profitability index is
 a) Project 1.
b) Project 2.
c) Project 3.
d) Project 4.

41) If an investment project has a profitability index of 1.15 computed using

cash inflows only, then the

A. Project's internal rate of return is 15%.

B. Project's cost of capital is greater than its
internal rate of return.
C. Project's internal rate of return exceeds its net
present value.
D. Net present value of the project is positive.
42) At what stage of the capital budgeting process would management most
likely apply present value techniques?

a) Identification stage.
b) Search stage.
c) Selection stage.
d) Financing stage.

43) All of the following techniques use cash flows as the primary basis for the
calculation except for the

A. Net present value.

B. Payback period.
 C. Discounted payback period.

D. Accounting rate of return.

44) Use the following information to answer this question.

Investment Cash outlay Present value

project of cash
inflows
A $1,100,000 $ 980,000
B 250,000 600,000
C 1,400,000 1,830,000
D 650,000 790,000

The company has $2,000,000 of financing available for new investment

projects. If only one project selected, which should the company undertake to
maximize profitability?

a) Project A.
b) Project B.
c) Project C.
d) Project D.

45) Which of the following techniques considers the incremental accounting

income rather than cash flows:
A. Net present value
B. Internal rate of return
C. Accounting/Simple rate of return
D. Cash payback period
46) Which of the following techniques does not consider the time value of
money?
a) Internal rate of return method
b) Simple cash payback method
c) Net present value method
d) Discounted cash payback method

47) The current worth of money to be received at a future date is called:

A. real value
B. future value
C. present value
D. salvage value

48) If present value of total cash outflow is $15,000 and present value of total
cash inflow is $14,000, what is the net present value of the project?
a) $1,000
b) -$1,000
c) 0
d) 2,000

49) If present value of cash outflow is equal to present value of cash inflow,
the net present value will be:
A. positive
B. negative
C. zero
D. infinite

50) Generally, a project is considered acceptable if its net present value is:
a) negative or zero
b) negative or positive
c) positive or zero
 d) negative

51) Consider the following data on a proposed investment:

Investment required: $160,000
Annual cash inflows: $40,000
Life of the investment: 6 years
Salvage value: 0
Discount rate: 10%
Based on the above data, what is the payback period of the proposed
investment project?
a) 0.25 years
b) 3 years
c) 4 years
d) 5 years

52) An increase in the discount rate will:

A. Reduce the present value of future cash flows.
B. Increase the present value of future cash flows.
C. No effect on net present value.
D. Compensate for reduced risk.

53) Using profitability index, the preference rule for ranking projects is:
a) lower the profitability index, the more desirable the project.
 b) higher the profitability index, the more desirable the project.
c) lower the sunk cost, the more desirable the project.
d) higher the sunk cost, the more desirable the project.

54) The net present value of four projects is given below:

Project A: $25,000
Project B: $10,000
Project C: $22,000
Project D: $15,000
The four projects given above require the same amount of investment. How
would you rank them using net present value (NPV) method?
A. B, D, C, A
B. A, B, C, D
C. A, C, D, B
D. B, C, D, A

55) Capital budgeting is done for :

A. Evaluating short term investment decisions.
B. Evaluating medium term investment decisions.
C. Evaluating long term investment decisions.
D. None of the above

56) If the profitability index of a project is 0.75, it means:

a) the NPV of the project is greater than zero
b) the project's cost is less than the present value of its cash flows
c) the NPV of the project is greater than 1
d) the project returns 75 cents in present value for each dollar invested in
it
57) The comparison of actual costs and benefits of a project with original
estimates is known as:
A. cost-benefit analysis
B. post-completion audit
C. business scorecard report
D. feedback audit

58) A project whose acceptance requires the acceptance of another project is

known as:
a) an independent project
b) a dependent project
c) an essential project
d) a contingent project

59) ABC Ltd. purchases a new equipment. The data is given below:
Cost of equipment: $25,000
Useful life of equipment: 5 years
Tax rate: 30%
If equipment is depreciated using straight line method, what is the
depreciation tax shield associated with the new equipment?
A. $5,000
B. $35,000
C. $1,500
D. $7,500

60) If interest expense of a company is $300,000 and tax rate is 40%, the
after-tax cost of interest is:
a) $120,000
b) $300,000
c) $180,000
 d) $75,000

61) If two alternative investments are compared using incremental cost

approach, the difference between the net present values of two
alternatives will be:
A. greater than the difference obtained using total cost approach
B. less than the difference obtained using total cost approach
C. the same as the difference obtained using total cost approach
D. indeterminable

62) The Willington Company has gathered the following data on a proposed
investment:
Initial investment required: $800,000
Annual incremental revenue: $180,000
Annual incremental expenses: $60,000
Discount rate: 12%
Salvage value: $0

Based on the above, the accounting/simple rate of return is:

a) 22.5%
b) 12%
c) 15%
d) 10.5%

63) In capital budgeting, positive NPV results in:

A. negative economic value added

B. positive economic value added
C. zero economic value added
D. percent economic value added
64) In mutually exclusive projects, project which is selected for comparison
with others must have

A. higher net present value

B. lower net present value
C. zero net present value
D. all of the above

65) In independent projects evaluation, results of IRR and NPV lead to :

A. cash flow decision

B. cost decision
C. same decisions
D. different decisions

66) Set of projects or set of investments to maximize firm value is classified as

A. optimal capital budget

B. minimum capital budget
C. maximum capital budget
D. greater capital budget

67) A point where profile of NPV crosses horizontal axis at plotted graph
indicates project :

A. costs
B. cash flows
C. internal rate of return
D. external rate of return

68) Modified rate of return and modified internal rate of return with exceed
cost of capital if NPV is

A. positive
B. negative
C. zero
D. one

69) Payback period in which expected cash flows are discounted with help of
project cost of capital is classified as :
 A. discounted payback period
B. discounted rate of return
C. discounted cash flows
D. discounted project cost

70) In alternative investments, constant cash flow stream is equal to initial

cash flow stream in approach which is classified as

A. greater annual annuity method

B. equivalent annual annuity
C. lesser annual annuity method
D. zero annual annuity method

71) In capital budgeting, a negative net present value results in

A. zero economic value added

B. percent economic value added
C. negative economic value added
D. positive economic value added

72) Number of years predicted to recover an original investment is classified

as

A. payback period
B. forecasted period
C. original period
D. investment period

73) In capital budgeting, term of bond which has great sensitivity to interest
rates is

A. long-term bonds
B. short-term bonds
C. internal term bonds
D. external term bonds

74) Process in which managers of company identify projects to add value is

classified as

A. capital budgeting
 B. cost budgeting
C. book value budgeting
D. equity budgeting

75) A discount rate which is equal to present value to project cost present
value is classified as

A. negative internal rate of return

B. modified internal rate of return
C. existed internal rate of return
D. relative rate of return

76) An uncovered cost at start of year is $300, full cash flow during recovery
year is $650 and prior years to full recovery is 4 then payback would be

A. 3.46 years
B. 2.46 years
C. 5.46 years
D. 4.46 years

77) Project whose cash flows are sufficient to repay capital invested for rate of
return then net present value will be

A. negative
B. zero
C. positive
D. independent

78) Present value of future cash flows is $2000 and an initial cost is $1100
then profitability index will be

A. 0.55
B. 1.82
C. 0.55
D. 0.0182

79) Profitability index in capital budgeting is used for

A. negative projects
B. relative projects
 C. evaluate projects
D. earned projects

80) Other factors held constant, greater project liquidity is because of

A. less project return

B. greater project return
C. shorter payback period
D. greater payback period

81) In calculation of IRR, an assumption states that received cash flow from
project must

A. be reinvested
B. not be reinvested
C. be earned
D. not be earned

82) In capital budgeting, number of non-normal cash flows having internal

rate of returns are

A. one
B. multiple
C. accepted
D. non-accepted

83) An IRR in capital budgeting can be modified to make it representative of

A. relative outflow
B. relative inflow
C. relative cost
D. relative profitability

84) Whereany firm limits expenditures on capital is classified as

A. optimal rationing
B. capital rationing
C. marginal rationing
D. transaction rationing
85) Initial cost is $5000 and probability index is 3.2 then present values of
cash flows is

A. 8200
B. 16000
C. 0.0064
D. 1562.5

86) A project which has one series of cash inflows and results in one or more
cash outflows is classified as

A. abnormal costs
B. normal cash flows
C. abnormal cash flow
D. normal costs

87) Present value of future cash flows is divided by an initial cost of project to
calculate

A. negative index
B. exchange index
C. project index
D. profitability index

88) If net present value is positive then profitability index wouldbe :

A. greater than two

B. equal to
C. less than one
D. greater than one

89) Cash flows occurring with more than one change in sign of cash flow are
classified as

A. non-normal cash flow

B. normal cash flow
C. normal costs
D. non-normal costs

90) First step in calculation of net present value is to calculate :

 A. present value of equity
B. future value of equity
C. present value cash flow
D. future value of cash flow

91) Situation in which one project is accepted while rejecting another project
in comparison is classified as

A. present value consent

B. mutually exclusive
C. mutual project
D. mutual consent

92) Sum of discounted cash flows is defined as

A. technical equity
B. defined future value
C. project net present value
D. equity net present value

93) Life that maximizes net present value of an asset is classified as

A. minimum life
B. present value life
C. economic life
D. transaction life

94) If two independent projects having hurdle rate then both projects should

A. be accepted
B. not be accepted
C. have capital acceptance
D. have return rate acceptance

95) Cash outflows are costs of project and are represented by

A. negative numbers
B. positive numbers
C. hurdle number
D. relative number
96) In capital budgeting, two projects having cost of capital as 12% is
classified as

A. hurdle rate
B. capital rate
C. return rate
D. budgeting rate

97) In estimating value of cash flows, compounded future value is classified as

:

A. terminal value
B. existed value
C. quit value
D. relative value

98) In capital budgeting, a technique which is based upon discounted cash

flow is classified a

A. net present value method

B. net future value method
C. net capital budgeting method
D. net equity budgeting method

99) An increase in marginal cost of capital and capital rationing are two
arising complications of

A. maximum capital budget

B. greater capital budget
C. optimal capital budget
D. minimum capital budget

100) An initial cost is $6000 and probability index is 5.6 then present value of
cash flows will be

A. 25000
B. 28000
C. 33600
 D. 30000

101) In large expansion programs, increased riskiness and floatation cost

associated with project can cause

A. rise in marginal cost of capital

B. fall in marginal cost of capital
C. rise in transaction cost of capital
D. rise in transaction cost of capital

102) Cash inflows are revenues of project and are represented by

A. hurdle number
B. relative number
C. negative numbers
D. positive numbers

103) Present value of future cash flows is $4150 and an initial cost is $1300
then profitability index will be:

A. 0.0319
B. 3.19
C. 0.31 times
D. 5450

104) Project whose cash flows are lesser than capital invested for required
rate of return then net present value will be

A. negative
B. zero
C. positive
D. independent

105) A type of project whose cash flows do not depend on each other is
classified as

A. project net gain

B. independent projects
C. dependent projects
D. net value projects
106) Net present value, profitability index, payback and discounted payback
are methods to

A. evaluate cash flow

B. evaluate projects
C. evaluate budgeting
D. evaluate equity
WORKING CAPITAL (SHORT-TERM) FINANCING

KNOWLEDGE POINTS:

Meaning of short-term financing.

Recognize key types of short-term financing.

Identification of major current liabilities and assets used for short-term

financing.

KEY CONCEPTS:

Introduction:
Similar to the accounting characterization of current liabilities,
normallythe theory of short-term financing
appliestodebtsthatwillbecomeduewithinayear.Consequently,financial
constituentsthatarerecognized as current liabilities are also considered
types of short-term financing. Further, current assets
usedtoprocurefundswouldalso betypesofshort-termfinancing.Hence, it can
be said that Short-termfinancingisconsisted
ofsourcesthatofferfinanceforaperiodshorter than one year.

Keytypes of short-term financing:

Pledging accounts receivable

Factoring accounts receivable

Short-term notes payable

Trade accounts payable

Accrued accounts payable (e.g. taxes, wages etc.)

Inventory secured borrowings

Commercial paper, Letter of credit, revolving credit and Line of credit

QUESTION BANK

Example 1:Please select correct option with reference to short-term

financing.
i. Accounts receivable can offer short-term finance.
ii. Inventory can offer short-term finance.
iii. Accounts payable can offer short-term finance.
a) i b) i and ii c) i and iii d) i, ii, and iii.

Solution:d) i, ii and iii.

Explanation:All sentences are correct. Accounts payable, accounts receivable
and inventory all can offer short-term finance.

Example 2: For which one of the following time span,Short-term finance is

generally concerned with?
a) Operating cycle b) collection cycle c) One year or less d)
Up to 10 years

Solution:c) One year or less

Explanation:Generally, short-term financing is related with funding for a
period shorter than a year.

Example 3:Of the following, which uses of accounts receivable would be

termed as short-term financing?
a) Either pledgingor factoring b) Both pledging and factoring c) Neither
pledging nor factoring d) None

Solution:b) Both pledging and factoring

Explanation:Factoring the accounts receivable and pledging of accounts
receivable both can be recognized as means of short- term finance. In case of
factoring of accounts receivable, the receivables are disposed of at a discount
for cash to a factor. However, in pledging of accounts receivable, the
receivables are used as security in a funding contract with a lender.
PAYABLES

KNOWLEDGE POINT:

Concept of financing through short-term loans, trade accounts payable and

accrued accounts payable along with relevant advantages and
disadvantages of each of the three

KEY CONCEPTS:

Introduction:

Different payables outstanding arriving maturity within a period shorter than

a year are the common forms of short-term financing.

Short -Term
Financing

Payables

Trade Accrued
Short-Term
Accounts Accounts
Notes Payable
Payable Payable
Short-Term Notes Payable:

Meaning:

If an amount is borrowed from a financial institution repayable within a

period shorter than one year, it will be termed as short term notes payable.
Characteristics:

Normally for a specific motive

A promissory note needs to be served

Bear a rate of interest as per the credit ranking of the borrower

Usually considered unsecured (Even if a lawful executable undertaking to pay (a promissory

note) is essential, unless the borrower's credit score indicates that the lender should
demand pledge, short-term notes are usually considered unsecured.)

Cost of Financing:

Interest Rate:

a
percentage Interest
Prime Rate
rate (or Rate
points)

Normally, the interest rate will be stated as a percentage rate (or points)
above the specified benchmark (say prime rate). For instance, interest rate
may be expressed as “2% over prime.”

Compensating Balance:
It is also possible that a borrower is required to maintain a compensating
balance with the lending financial institution over and above the interest cost
connected with short-term notes. The amount whichis required to be
maintained in a demand deposit account with the lender as a condition of the
borrowing (or for other bank services) is known as a compensating balance.
Such required sum is ordinarilystated as a percentage of the borrowing (or
other element) and escalates the effective cost of the borrowing.

Structured Note:
A “structured note”is aspecial kind of note. A structured note is
generallyconnected withinstruments for long-term or intermediate-term.
However, structured notes for short-term are also possible.When cash flows
(i.e. issuer’s/ borrower’s payment obligation and investor’s/ lender’s yield)
associated with financial instrument (short-term notes) are contingent upon
changes in various factors such as underlying interest rate, stock index,
commodity price; it is known as a structured short-term note.For example: A
petroleum company borrows using a one-year note with the interest rate on
the loandepending on the price of the fuel. As the cash flows are determined
on the basis of the value of an underlying, structured note and other
structured securities are derivatives.

Advantages:
Flexible—amounts and time span (within a year) can be modified as per
requirements

Provides Liquidity/ funds

Unsecured—no assets mortgaged as security

If rate of interest reduces, short maturity allows refinancing at reduced cost

Easy availability for creditworthy organizations

Disadvantages:

Involves settlement in the short-term

If rate of interest escalates, refinancing to be availed at expensive rates

Higher rate of interest and possible requirements for security in case of

poor credit ranking

A requisite compensating balance escalates the cost and decreases actual

funds available

Trade Accounts Payable:

Source (Root cause) of Trade Accounts Payable:
When an enterprise regularly procures goods or services on credit from its
suppliers, the concept of financing through Trade Account Payables arises.

Characteristics:

Generally not secured

Depend on the borrower’s readiness and capacity to pay the debt when
due

Flexible source of short-term funding

Simultaneously with the purchase of the goods or service, level of

financing goes up.

In the carrying out of day-to-day operations, financing happens

automatically (Also known as spontaneous financing)

No assets are mortgaged as a security

Often, a cash discount is offered while extending trade credit for early
payment of an obligation. Such offersare normally expressed as a percentage
of the amount of the obligationand would be extended as part of the credit
terms. For instance, credit terms of “3/12, n/45” offer a 3% discount if the bill
is paid within 12 days, otherwise the full amount is due within 45 days. Other
discount rates and discount periods are common. The annual effective rate of
interest implicit in such cash discount offers shows that effective cash
management would take advantage of most cash discount offers. For instance,
the effective annual percentage rate (APR) of not taking an offer of “3/12,
n/45” is almost 34%, calculated as follows using $1.00 (100%) as the amount
of the obligation:

APR = [(Discount Lost / Principal) × 1] / Time Fraction of Year

APR = [(0.03/0.97) × 1]/(33/360) = 0.0309 × (360/33)
APR = 0.0309 × 10.9091 = 33.71%

Principal is the amount that would have been paid if the discount were taken.
(Even if $1.00 were used as the principal, rather than $0.97, the APR would be
0.03 × 10.9091 = 32.73 %.)
Advantages:

Generally, No Interest charged

Flexible—increases and contracts along with requirements (purchases)

Unsecured—no assets mortgaged as security

for early payment , often discount is offered

Ease of use—less legal documentation necessary

Disadvantage:
 if discounts not availed, effective cost may be higher

Use-specific— only such assets that are acquired through trade accounts
can be financed

Payment required to be made in the short-term

Accrued Accounts Payable:

Source (Root cause) of Accrued Accounts Payable:
When an enterprise receives benefits or cash for the concerned unpaid
obligation, the concept of financing through Accrued Accounts Payable arises.
Hence, with their financing repercussionsthey are similar to that of trade
accounts payable. Some practical examples can be salaries and wages payable,
unpaid taxes, unearned revenue (collected in advance).

benifit or cash
Funds available concerened
is recieved
because of obligation is
(Services of
timing difference satisfied
employees
between these (Salary is paid)
received)
two events
provides
temporary
financing

The funds available because of the timing difference between when the cash
(or benefit) is received and when the connected obligation is satisfied
offersshort-term (temporary) financing to the enterprise. For instance,
generally salary is paid to employees on a monthly basis, i.e. once in a month.
However, employees render their services to enterprise during whole month.
Hence, effectively analyzing, employees are offering one month recurrent
finance to the enterprise, which accrues to the total monthly pay for all
salaried employees. (Technically,the amount would be the average salaries for
the month.) For a bigenterprise, the resulting amount of financing would be
substantial. Also because of taxes payable and revenues collected in advance,
a similar effect arises.
Advantages:

Unsecured—no assets mortgaged (though taxing authorities might have a

particular legal claim)

Ease of use—happens in the ordinary course of business

Flexible—increases and contracts with recurrent transactions

Disadvantages:

use specific sources—only finances benefits acquired through accrued accounts

(e.g., salaries)

Fulfillment to the obligation is essential in the short term

QUESTION BANK

Example 1:If a firm purchases raw materials from its supplier on a 3/15, net
45, cash discount basis, the equivalent annual interest rate (using a 360-day
year) of forgoing the cash discount and making payment on the 45th day is
a) 2% b)18.36% c) 37.11% d)36.72%

Solution:c) 37.11%
Explanation:The buyer is receiving 3% of the face for paying the account 30
days before it is due. The formula to calculate the nominal rate is shown
below.
3% 360 𝑑𝑎𝑦𝑠
Nominal annual cost = × = 37.11%
100 % − 3 % 45 𝑑𝑎𝑦𝑠 − 15 𝑑𝑎𝑦𝑠

Example 2:A company has an outstanding one-year bank loan of $ 10,00,000

at a stated interest rate of 10%. The company is required to maintain a 25%
compensating balance in its checking account. The company would maintain a
zero balance in this account if the requirement did not exist. What is the
effective interest rate of the loan?
a) 8% b) 13.33% c) 20% d) 28%
Solution: b) 13.33%
Explanation:The effective rate is calculated by dividing the interest amount
by the outstanding balance less the compensating balance requirement. The
annual interest amount is equal to $1,00,000 (10%× $10,00,000) and the
compensating balance amount is equal to $2,50,000 (25% × $10,00,000). The
effective interest rate is equal to 13.33% [$ 2,50,000 ÷ ($ 10,00,000 – $
2,50,000)].
Example 3:Which of the following financial instruments generally provides
the largest source of short-term credit for small firms?(CMA adapted)
a) Installment loans b) Trade credit c) Commercial paper d)
Mortgage bonds.
Solution: b)Trade credit
Explanation: For majority of the small enterprises, Trade credit is the largest
source of short-term financing. It happens spontaneously with the
procurement of goods and services.
Example 4:A manufacturing firm wants to obtain a short-term loan and has
approached several lending institutions. All of the potential lenders are
offering the same nominal interest rate, but the terms of the loans vary. Which
of the following combinations of loan terms will be most attractive for the
borrowing firm?(CIA adapted)

a) Simple interest, no compensating balance

b) Discount interest, no compensating balance
c) Simple interest, 20% compensating balance required
d) Discount interest, 20% compensating balance required
Solution: a)Simple interest, no compensating balance
Explanation: From an effective interest basis, simple interest with no
compensating balance is the most advantageous terms.
Example5:Which one of the following would be considered a form of
spontaneous financing?
a) Line of credit b) Accounts payable c) Short-term loan d) Accounts
receivable
Solution: b)Accounts payable
Explanation:Accounts payable are a form of spontaneous financing.
Spontaneous financing happens when financing occurs automatically in the
carrying out of day-to-day operations, as occurs with many common short-
term payables, such as trade accounts payable and accrued accounts payable
(e.g., salaries payable). Spontaneous financing happens in the ordinary course
of business and tends to increase and contract with activity.
Example 6:On March 23, Inco Company received from one of its suppliers a
statement with terms of "3/10, n/30." Because the statement was misfiled, it
was not located for payment until April 5. On which one of the following dates
should the bill be paid?
a) April 5 b) April 6 c) April 22 d) April 28
Solution: c)April 22
Explanation:Since the date for availing the discount has passed, there is no
financial advantage from paying the statement until the final due date, April
22. Payment on that date would assure no penalty for late payment.
Example 7:Which one of the following forms of short-term financing is least
likely to be restricted as to use of proceeds?
a) Short-term notes payable
b) Accrued taxes payable
c) Accrued salaries payable
d)Trade accounts payable

Solution:a)Short-term notes payable

Explanation:As a form of short-term financing, short-term notes
generallyoffer cash which often may be used for several asset and expense
purposes.
Example8:ABC Company borrowed $40,000 from DEF Bank, giving a one-
year note. The terms of the note provided for 8% interest and required a 15%
compensating balance. Which one of the following is the effective rate of
interest on the loan?
a) 4.0% b) 6.0% c) 9.4% d) 10.0%
Solution: c) 9.4%
Explanation:The effective rate of interest on the loan is 9.4% and is
computed as the net proceeds from the loan divided into the cost of the loan.
The cost of the loan is $ 3,200 ($ 40,000 × 0.08 = $ 3,200) and the net
proceeds is $ 34,000 ($ 40,000 − [0.15 × $ 40,000] = $ 34,000); the remaining
$ 6,000 must be maintained as a compensating balance. Thus, the effective
interest is: $ 3,200/$ 34,000 = 9.412%.
Example9:A company wants to approximate the 25% annual interest rate
based on a 365-day year it pays on its working capital loan. Which of the
following terms should the company offer its customers?
a) 2.00%, 10, net 40 b) 1.00%, 10, net 40 c) 0.75%, 15, net 35 d)
0.50%, 15, net 35
Solution: a)2.00%, 10, net 40
Explanation:These terms would provide the desired 25% annual interest
rate.
The interest rate associated with discount terms is computed as:
[Discount Rate/Principal] × [1/(Length of discount period/365)];Where:
Principal = Amount after discount
Length of discount period = Difference between discount date and net date
Using the facts in this Example: [0.02/0.98] × [1/(30/365)] = 0.0204 ×
(365/30) = 0.0204 × 12.17 = 24.83% (or 25% rounded) annual interest rate,
the rightsolution.
(NOTE: An easier and quicker approximation can be made by dividing the
discount period into the days in a year, or 40 – 10 = 30 days; 365/30 = 12.2,
and multiplying that by the discount amount =12.2 × 0.02 = 0.244 (or 25%
rounded), the rightsolution.)
Example10:A company purchased $1,00,000 of merchandise inventory on
January 1. The terms of the purchase were 2/10, net30.The company would
pay what amount on January 9?
a) $70,000 b) $ 98,000 c) $ 99,800 d) $1,00,000
Solution: b)$ 98,000
Explanation:If the company pays on January 9, it would pay $98,000. The
terms offered of 2/10, n/30 provide a 2% discount if the payment is made
within 10 days of the procurement. Since the purchase was on January 1,
January 9 would be within the 10 day period. Therefore, the company would
avail a 2% discount on the purchase amount, or 0.02 × $1,00,000 = $2,000
discount, leaving a balance due of $98,000.
STANDBY CREDIT AND COMMERCIAL PAPER

KNOWLEDGE POINT:

Concept of financing through stand-by credit and commercial paper along with
relevant advantages and disadvantages of the same

KEY CONCEPTS:

Introduction:

Short Term
Financing

Standby Commercial
Credit Paper

Line of Revolving Letter of

Credit Credit Credit

This chapter includes various forms of standby credit, such as line of credit,
revolving credit, and letter of credit. It also includes commercial paper as a
form of funding.

Standby credit facilitates financing from a financier--

 For a particular amount,

Generally for a stated time span and

Often to be available under certain conditions.

Standby Credit:
(A) Line of Credit:
Definition:
An informal agreement between a borrower and a financial institution
whereby the financial institution agrees to a maximum amount of credit that it
will extend to the borrower at any one time.

Explanation:
Usually, the agreement is good only for the prospective borrower's fiscal year
and, even if the agreement is not lawfully binding on the financial institution,
offers the enterprise reasonable assurance that the agreed upon financing will
be available.

Analysis:
Short Term Notes vs. Line of Credit
Particulars Short Term Notes Line of Credit
Essential Resemblances:
Nature of Financing Unsecured Unsecured
Cost of Financing Interest Rate indexed to Interest Rate indexed to
the prime rate and a the prime rate and a
compensating balance compensating balance
Essential Divergences:
Purpose of Financing For a specific motive General use (say to meet
working capital needs)

(B) Revolving Credit Agreement:

Definition:
Like a line of credit, but it is in the context of a legal agreement between the
borrower and the financial institution.
 Explanation:
Borrowings under such agreements have the same maturity,interest and
compensating balance requirements as a line of credit and are normally
unsecured.

(C) Letter of Credit:

Definition:
A conditional commitment by a bank to pay a third party in accordance with
specified terms and commitments.

Explanation:
For example, A Ltd. (domestic company) imports material from B Ltd. (foreign
company). Now, it is possible that payment may be required to be made to a
third party (i.e. B Ltd.) upon submission of evidences that material have been
shipped. Use of a letter of credit provides assurance of finance to the third
party (i.e. B Ltd.) without the borrowing enterprise (i.e. A Ltd.) having to pay
in advance of shipment of goods. Letters of credit are frequently used in
connection with foreign transactions. (example: import of material)

Advantages
Flexible—credit used (debt incurred) only when required

Line of credit and revolving credit provide money for general requirements

Easily available for creditworthy enterprises

Unsecured—no assets mortgaged as security

Disadvantages
 Typically contain a fee

A required compensating balance escalates cost and decreases actual cash

available

The financial institution does not get lawfully obligated by Line of credit

Satisfaction is required to be done in the short term

High interest (and possibly security) required in case of poor credit rating

Commercial Paper:
Definition:
Short-term unsecured promissory notes sold by large, highly creditworthy
firms as a form of short-term financing.

Explanation:
By convention, these notes are for 270 days or less (otherwise, SEC
registration is required), with most being for six months or less. The effective
interest rate is typically less than the cost of borrowing through a commercial
bank.
 Commercial
Paper

Interest Mode of
Rate Issue

Interest
Discounted Directly to Through a
Pay Interest
(deducted up Investor Dealer
front)

Over the
(short) life At maturity
of the note

Advantages:

Provides money for common purpose

Unsecured—no assets are mortgaged as security

Rate of Interest is normally lesser than other short-term sources

Higher amount of funds can be acquired through multiple commercial

paper notes than would be obtainable through a single financial institution

No requirement for compensating balances

Disadvantages:

Lacks flexibility—absence of extension or other arrangements available in bank

borrowings

Available only to most creditworthy enterprises

Satisfaction usually of a large amount is required to be made in the short-term

QUESTION BANK

Example 1:Which one of the following points is not abenefit to

anorganization that uses the commercial paper market for short-term
funding?
a) There are no restrictions as to the type of organization that can enter into
this market.
b) This market offers a broad distribution for borrowing.
c) The expense of maintaining a compensating balance with a commercial
bank can be avoided.
d) This market offers more funds at lesser rates than other methods offer.
Solution: a) There are no restrictions as to the type of organization that can
enter into this market.
Explanation:Commercial papers can be sold only by very creditworthy
organizations.
Example 2:With respect to the use of commercial paper by an industrial firm,
which one of the following statements is most likely to be true?(CMA adapted)
a) The commercial paper issuer is a small company.
b) The commercial paper is secured by the issuer's assets.
c) The commercial paper has a maturity of 60–270 days.
d) The commercial paper is issued through a bank.
Solution: c) The commercial paper has a maturity of 60–270 days.
Explanation:Commercial paper is usuallysold with a short maturity period,
generally 2 to 9 months.
Example3:The maximum time span for which commercial paper may be used
for funding purposes is
a) 365 days b) 270 days c) 180 days d) 30 days
Solution:b) 270 days
Explanation:The maximum time span for which commercial paper (short-
term, unsecured promissory notes) may be used is 270 days. SEC
registrationis required in notes beyond 270 days in maturity and would not
be considered commercial paper.
Example4:A financial instrument used for short-term funding that is
unsecured and available only to the high creditworthy organizations is most
likely a
a) Letter of creditb) Convertiblepreferred stockc) Convertible bond d)
Commercial paper
Solution:d) Commercial paper
Explanation:Commercial paper is a short-term unsecured promissory note
which is issued by large, highly creditworthy organizations as a form of short-
term funding.
Example5:A Inc. has negotiated a $ 5,00,000 revolving credit agreement with
its bank. Under terms of the agreement, A will pay a commitment fee of 2% on
any unused amount of the credit, 8% APR on funds drawn against the credit,
and must maintain a 10% compensating balance from the funds borrowed.
Normally, A would not maintain the amount of the compensating balance with
its bank. At the time of the agreement, A borrows $ 4,00,000, of the $ 5,00,000
credit line, for one year. Which of the following is the closest to the effective
annual interest rate incurred on the borrowing?
a) 10.00% b) 10.50% c) 11.11% d) 9.44%
Solution: d) 9.44%
Explanation:The effective annual interest rate is closest to 9.44%. The
effective annual interest rate is determined as the cost of the borrowing
arrangement divided by the funds available from the borrowing. The cost of
the borrowing consists of the 8% interest rate on the borrowing plus the 2%
commitment fee on the unused portion of funds available. The total cost of
borrowing is:
Borrowed amount = $ 4,00,000 ×0.08 = $ 32,000
Unused portion = $1,00,000 × 0.02=$ 2,000
∴Total cost =$ 34,000
Amount borrowed $ 4,00,000
Less: Compensating balance, 10% $ 40,000
Funds available from borrowing $ 3,60,000
Effective interest rate = Cost $ 34,000/Usable funds $ 3,60,000 = 9.44%, the
rightsolution.
Example6:Which one of the following is a formal lawfulpromise to extend
credit up to some maximum amount to a borrower over a giventime span?
a) Trade creditb) Line of creditc) Revolving credit agreementd)Letterofcredit
Solution:c) Revolving credit agreement
Explanation:Arevolvingcreditagreementisaformallawfulpromise,ge
nerallybyabank,toextendcreditupto
somemaximumamounttoaborroweroveragiventime span.

Example7:Which one of the following would an importer of material from a

new foreign supplier most likely use to assure the supplier of payment?
a) Trade account application b)Commercial paper c)Line of credit d)
Letter of credit
Solution:d) Letter of credit
Explanation:A letter of credit would be used to assure a foreign supplier of
payment. A letter of credit is a conditional promise to pay a third party in
accordance with given terms.

RECEIVABLES AND INVENTORY

KNOWLEDGE POINT:

Concept of financing through pledging and factoring accounts receivable

along with relevant advantages and disadvantages

Concept of use of inventory as security for short-term funding and the

advantages and disadvantages of using inventory secured loans

Understanding different forms of safeguarding inventory as pledge for short-

term funding

KEY CONCEPTS:

Introduction:
 Short
Term
Financing
Non-cash
Current
Assets

Accounts
Inventory
Receivables

Inventory
Realisation Offer as a Realisation
Sell Secured
in Cash security in Cash
Borrowings

Pledging Factoring
Accounts Accounts
Receivables Receivables

Sources of funding for anorganizationcontain certain non-cash current assets.

This chapter explains the ways accounts receivable and inventory can
offerfunding, either by being converted to cash or serving as security for
borrowing.
Pledging Accounts Receivable:
Extent of Financing through Pledging Accounts Receivables:

Terms of
Agreement for
pledging Accounts
Receivables

only specific accounts

all accounts receivable
with known risk, i.e.
are pledged without
receivables that have
regard to or an analysis
been determined to be
of the collectability of
creditworthy are
individual accounts
pledged

a smaller portion a larger portion of

of the face value the face value of
of receivables will receivables will be
be available as available as
funding funding
Current assets-trade accounts receivables can be used as a security for
funding through pledging accounts receivable. Typically, the organization
pledges some or all of its accounts receivable as security for a short-term
borrowing from a financial institution. If the terms of agreement between the
organization and the lender provide that all accounts receivable are offered as
collateral without regard to or an analysis of the collectability of individual
accounts, the lender will lend a smaller portion of the face value of receivables
than if only specific accounts with known risk are offered as collateral. For
instance, a maximum loan of only 60% of receivables may be made when
simply all receivables are pledged, but as much as 85% of face value may be
loaned on receivables that have been identified to be creditworthy.

Cost of Pledging Accounts Receivables:

Interest
Cost of Fees based
Rate ranging
Pledging on face
from 2%
Accounts value of the
above prime
Receivables receivables
rate and up

The rate of interest on advances secured by accounts receivable will usually

range from 2% above prime and up. Moreover, commonly depending upon the
face value of the receivables, a fee is charged.
Advantages:

Flexible—new receivables are available as security concurrently with their

occurrence

Billing and collection services may be assumed by lender

Commonly available

Compensating balances are not required

Offers money for common purpose

Disadvantages:

Cost may be higher than certain other sources of short-term funding

Repayment is required in the short time span

Accounts are committed to lender

Factoring Accounts Receivable:

Meaning:

The sale of accounts receivable to a financial institution (known as a “factor”)

is called Factoring accounts receivable. Actual payment to the organization for
its accounts receivable may take place at various times between the date of
sale and collection of the receivables. The funds realized can then be used for
funding of other assets or used for other purposes. The terms of the sale may
be:

Factoring
Accounts
Receivable -
Terms of Sale

Without
With Recourse
Recourse

the factor has recourse

the factor tolerates the
against the organization
risk related with non-
for some or all of the
collectibility (unless
risk related with non-
fraud is involved)
collectibility
Cost of Factoring Accounts Receivables:
The factor charges a fee depending on:

the creditworthiness of the receivables,

length of maturity of the receivables, and

the degree to which the factor assumes risk of non-collectability.

Advantages:
Flexible—new receivables are available for sale concurrently with their
occurrence

Commonly available

Offers money for common purpose

Normally billing and collection responsibilities are assumed by buyer

Compensating balances are not required

Disadvantages:
Organization may have continuing risk, if sold with recourse

Sale of their accounts may alienate customers

Cost may be higher than certain other sources of short-term funding

Inventory Secured Loans:

With an inventory secured loan anorganizationoffers as security all or part of
its inventory as pledge for a short- term borrowing. The funds can be
borrowed based on the marketability and value of the inventory. Various
arrangements for inventory secured borrowings provide diverse treatment of
the inventory and different levels of security for the lender:
 Floating lien agreement:
• The borrower provides a lien against all of its inventory to the financier.
However, the control of the inventory is retained by the borrower, which
it continuously sells and replaces.

Chattel mortgage agreement:

• The borrower provides a lien against precisely identified inventory. The
control of the inventory is also retained by the borrower. However,
borrower cannot sell it without the financier's consent.

Field warehouse agreement:

• The inventory used as pledge remains at the organization's warehouse,
placed under the control of an independent third-party and held as
collateral.

Terminal warehouse agreement:

• The inventory used as pledge is transferred to a public warehouse where
it is held as collateral.

Cost of Inventory Secure Borrowings:

The cost of funding through inventory secured borrowings will depend on
various factors such as:
the nature of the inventory used as security,

the creditworthiness of the borrower and

the particular type of security contract.

The usual interest rate is 2% above prime and up, and may include other
charges.
Advantages:

Flexible—inventories are available as collateral as soon as they are acquired

Offers money for common purpose

Commonly available for certain inventories (e.g., oil, wheat, etc.)

Compensating balances are not required

Disadvantages:

Cost can be higher than certain other sources of short-term funding

Not possible for certain inventory

Pledged inventory may not be accessible when required

Repayment is required in the short time span

Summary:
In this chapter, wediscussed the most common forms of short-term funding.
As these forms of funding have to be satisfied in the near time span, normally
they are not suitable for funding capital projects. However, they have
asignificantrole to play in the overall financing of anorganization's total assets
and operations.
QUESTION BANK

Example 1:A company enters into an agreement with a firm who will factor
the company's accounts receivable. The factor agrees to buy the company's
receivables, which average $1,00,000 per month and have an average
collection period of 30 days. The factor will advance up to 80% of the face
value of receivables at an annual rate of 10% and charge a fee of 2% on all
receivables purchased. The controller of the company estimates that the
company would save $18,000 in collection expenses over the year. Fees and
interest are not deducted in advance. Assuming a 360-day year, what is the
cost of engaging in this arrangement?(CMA adapted)
a) 17.5% b) 14.0% c) 16.0% d) 11.0%
Solution: a) 17.5%
Explanation:The true percentage cost of the agreement is derivedby dividing
the net cost of the factoring by the net amount received (basically, an effective
interest computation). The total sum paid to the factor would be the annual
rate applied to the sum received or ($1,00,000 × 80%) × 10% =$8,000, plus
the yearly fee or ($1,00,000 × 12) × 2% = $24,000, for a total payment of
$32,000. That would be offset by the cost savings of $18,000, so the net cost
is$32,000 − $18,000 = $14,000. The net proceeds(amount received) is
$1,00,000 × 0.80 = $80,000. Therefore, the yearly interest cost
=$14,000/$80,000 = 17.5%, the rightsolution.
Example2:A Ltd. needs cash for a one-time inventory purchase opportunity.
To obtain that cash, it is considering factoring its accounts receivable. A Ltd.
would factor $ 4,00,000 of its accounts receivable with a 30-day collection
period. A Ltd. has contacted XYZFinancial Consultancy, a major factoring firm,
and has been offered the following factoring terms:
XYZFinancial Consultancy will advance 80% of the face value of the accounts
receivable.XYZFinancial Consultancy will collect and process the factored
receivables for a fee of 2% of the face value of accounts factored payable in
advance.XYZFinancial Consultancy will charge a factoring fee of 5% on the
face value of the accounts receivable due at the end of the 30-day period
covered by the factoring contract.All credits given on the accounts by A Ltd.
for returns and allowances during the period of the contract will be deducted
from the terminal payment.
Assume A Ltd. accepts XYZFinancial Consultancy's terms. If $ 20,000 in return
and allowance credits are issued by A Ltd. during the 30-day period, how
much cash will A Ltd. receive at the initiation of the contract and at the end of
the 30-day period?
Cash Received @ Cash Received @
Option Initiation of Contract Termination of Contract
i $3,20,000 $40,000
ii $3,12,000 $40,000
iii $3,12,000 $42,000
iv $3,12,000 $44,000
a) Optioni b) Optionii c) Optioniii d) Option iv
Solution: b) Option ii
Explanation:A Ltd. will receive $ 3,12,000 at initiation of the contract and
$40,000 at termination of the contract. Those amounts are computed as
follows:
Face value of receivables $ 4,00,000
Advance percentage 0.80
Advance amount $ 3,20,000
Less: 2% processing fee $ 8,000
Payment at initiation $ 3,12,000
Face value of receivables $ 4,00,000
Balance due percentage 0.20
Balance amount $ 80,000
Less: A/R credits issued $ 20,000
Less: 5% factor fee $ 20,000
Payment at termination $ 40,000

Example 3:A Ltd. plans to use its inventory as collateral for a short-term loan.
Which one of the following types of loan agreements with its lender would
provide A Ltd. the most flexibility in the use of the inventory it pledges as
collateral?
a) Chattel mortgage agreement
b) Terminal warehouse agreement
c) Field warehouse agreement
d) Floating lien agreement

Solution:d) Floating lien agreement

Explanation:Under a floating lien agreement,the borrower provides a lien
against its entire inventory to the financier. However, the control of the
inventory is retained by the borrower, which it continuously sells and
replaces.
Example 4:Which one of the following is a form of inventory secured loan in
which the inventory is placed under the control of an independent third
party?
a) Chattel mortgage agreement
b) Terminal warehouse agreement
c) Field warehouse agreement
d) Floating lien agreement

Solution: c)Field warehouse agreement

Explanation:In a field warehouse agreement, the inventory used as pledge
remains at the organization's warehouse, placed under the control of an
independent third-party and held as collateral. (Also, in a terminal warehouse
agreement,the inventory used as pledge is transferred to a public warehouse
where it is held as collateral and placed under the control of an independent
third-party.)
Example5:A Ltd. is considering factoring its accounts receivable. XYZ
Financial Consultancy, a factoring firm has offered the following terms for
accounts receivable due in 30 days:
Value of receivables to be held in reserve for contingencies 20%.
Following costs are deducted at time accounts are factored:
Interest rate on amounts provided before deducting interest (annual rate)
15%. Factor fee on total receivables factored 1%.
If A Ltd. plans to factor $ 4,00,000 of accounts receivable due in 30 days,
which one of the following is the amount it will receive from XYZ Financial
Consultancy at the time the accounts are factored?
a) $3,15,000 b) $3,12,050 c) $3,00,000
d) $3,10,550
Solution: b) $ 3,12,050
Explanation:The amount provided would be $ 4,00,000 accounts receivable -
$ 80,000 reserve - $4,000 factor fee =$3,16,000, for which interest would be
charged for 30 days, or 1.25% (i.e., 1/12 of 15%). Therefore, the correct
amount received would be $ 3,16,000 - ($ 3,16,000 x 0.0125) = $ 3,16,000 - $
3,950 = $ 3,12,050.
Example6:A Ltd. is considering factoring its accounts receivable. XYZ
Financial Consultancy, a factoring firm has offered the following terms for
accounts receivable due in 30 days:

Value of receivables to be held in reserve for contingencies 20%.

Following costs are deducted at time accounts are factored: Interest rate on
amounts provided 15%. Factor fee on total receivables factored 1%.
If A Ltd. factors $ 4,00,000 of its accounts receivable due in 30 days with XYZ
Financial Consultancy and during that 30 days,$ 20,000 of those accounts
receivable are reversed because the related goods were return or allowances
were granted, which one of the following is the amount that A Ltd. will receive
from XYZ Financial Consultancy at the end of the 30 day period?
a) $ -0- (no amount) b) $ 50,000 c) $ 60,000 d) $ 40,000
Solution: c) $ 60,000
Explanation:The amount held in reserve was 0.20 x $ 4,00,000 or $ 80,000.
During the 30-day period of the factor agreement, $ 20,000 of the accounts
receivable factored had to be reversed because of sales returns and
allowances. Therefore, at the end of the 30-day period, XYZ Financial
Consultancy would pay A Ltd. the remaining $ 60,000 ($ 80,000 reserve - $
20,000 reversed = $60,000).

CAPITAL(LONG-TERM) FINANCING
KNOWLEDGE POINTS:
Meaning of long-term financing

Recognize key types of long-term financing

KEY CONCEPTS:
Introduction:
This chapterdiscussesthe concept of long-term financing and recognizes key
types of long-term financing.
Capital
(Long-Term)
Financing

Equity Debt

Financial
Common Preferred Long-term
Bonds (capital)
Stock Stock notes
leases
Long-term financing consists of sources that offer funds for time spanshigher
than a year and contains both equity and debt instruments.
Concept (Understanding) of Long-term Financing:
Occasionally,
Intermediate-term Financing = 1 Year > TENURE < 10 Years

Long-term Financing = TENURE > 10 Years

While differentiating between long-termand intermediate-term financing,

intermediate-term financing is recognized as sources of funding that becomes
dueafter a period of one year but before ten years, and long-term financing is
recognized as sources of funding that becomes dueafter a period of ten years,
including shareholders' equity.
It is possible thatthese two time spansmay be overlapping in case of some
sources, and hence during the current discussion, both classifications have
been treated as long term and a note of the likely tenure of each source has
been made. Moreover, considering all sources of finance that are not short
term as a group is consistent with differentiating those sources, which
represent capital structure (as contrasted with financial structure) of
anorganization.
As major source of funding for most organizations consists of long-term
financing and as the size of obligationlinked with these sources is by definition
for a long time span, anorganization should wiselyanalyze the various sources
of long-term funding and the comparativeshare of each it will employ.
The cost connected with each source and the proportional dollar amount of
each source availed will contribute to the organization's weighted average
cost of capital (WACC) that will determine which projects are financiallyviable
for the organization to consider.
Key types of long-term financing:

Bonds

Common stock

Financial (capital) leases

Long-term notes

Preferred stock
QUESTION BANK

Example 1:The market for outstanding, listed common stock is known as

a) New issue market b) Over-the-counter market c) Secondary market d)
Primary market
Solution: c) Secondary Market
Explanation:Investors trade in outstanding stocks of public companies in the
secondary market. The original issuer does not receive additional fundsdue to
such trades.
Example 2:Long-term funding is generallyconnected with financing for time
span of:
a) Ten-years or more in length
b) One-year or more in length
c) One year to 10 years in length
d) One-year or less in length
Solution: b) One-year or more in length
Explanation:Long-term funding is generally connected with financing for
time span of one year or more.
Example 3:Following would not be considered a source of long-term funding.
Choose correct answer.
a) Trade accounts payable b) Preferred stock c) Financial lease d)
Bonds payable
Solution: a) Trade accounts payable
Explanation:Trade accounts payable (a current liability) is a source of short-
term funding, not long-termfunding.
Example4:Constituents of long-term funding would be part of
a) Neither Capital Structure not Financial Structure
b) Both Capital Structure and Financial Structure
c) Only Capital Structure
d) Only Financial Structure
Solution:b) Both Capital Structure and Financial Structure
Explanation:Financial structure consists of short-term and long-term sources
of financing.Long-term sources of financing consist of components that
contribute to capital structure.(i.e., equityand long-term debt) Therefore,
constituents of long-term funding are part (elements) of both financial
structure and capitalstructure.
Example5:For anorganization,the weighted average cost of capital (WACC) is
decided by its cost of:
a) Neither Short-term Fundingnor Long-term Funding
b) BothShort-term FundingandLong-term Funding
c) OnlyShort-term Funding
d) OnlyLong-term Funding
Solution:d) Only Long-term Funding
Explanation:For anorganization,the weighted average cost of capital (WACC)
is decided by the cost of its long-term funding, not by its short-term funding.
LONG-TERM NOTES AND FINANCIAL LEASES
KNOWLEDGE POINT:

Concept of long-term notes including the common restraining conditions

related with it along with relevant advantages and disadvantages

Concept of financial leases along with relevant advantages and

disadvantages

Assessment of purchase versus leasing alternatives

Lease characteristics including net leases and net-net leases

KEY CONCEPTS:

Long-Term Notes:

Features:
 Tenure:
• Usually, long-term notes are used for borrowings for a period from one
to ten years, but some may be of lengthier time span.

Repayment:
• Generally, these loans are settled up in periodic installments over the life
of the loan.

Security:
• Ordinarily, these loans are secured by a mortgage on land, building or
equipment.

Preventive Conditions:
• Long-term notes normally involve preventive conditions that execute
restraints on the borrower in order to decrease the possibility of default.
Such conditions generally lay limitations on:

• the borrower may be required to furnish

Nature and frequency of periodic financial statements along with
financial information: associated disclosures and also the auditor’s
report.

• Lender’s prior consent may be needed before

Changes in senior
making vital changes in key personnel of
management:
senior management.

• For instance, retaining a minimum working

Retaining working capital at
capital ratio or a minimum dollar amount of
a specified level:
working capital.

• Lender’s prior consent may be needed before incurring

Further incurrence of any further long- term liability, including entering into any
liability: transaction which is a financial leases.

Cost of financing through long-term note:

The cost of financing through a long-term note will be determinedafter taking
into considerationvarious factors such as:
 General level of interest in the market

Credit rating of the borrowing organization and

Value and nature of any security

The cost of a long-term note will be indicated as anexpression of the prime

interest rate. Hence, the interestrate will vary as the prime rate
deviatesduring the time span of the note.
Structured Note:
A “structured note”is aspecial kind of note.When cash flows (i.e. issuer’s/
borrower’s payment obligation and investor’s/ lender’s yield) associated with
financial instrument (short-term notes) are contingent upon changes in
various factors such as underlying interest rate, stock index, commodity price;
it is known as a structured note(or other structured security). For example: A
IT company borrows using a five-year note with the interest rate on the
loandepending on the IT stock index. As the cash flows are determined on the
basis of the value of an underlying, structured note and other structured
securities are derivatives.
Advantages:
Offers funding for long-term, often with periodic settlement (repayment)

Ordinarily available for creditworthy organizations

Disadvantages:
Non-compliance with preventive conditions causes serious repercussions,
including technical default

Higher rate of interest, greater security and more preventive conditions required
in case of poor credit rankings
Financial Leases:
Types of Leases:

Leases

Operating
Financial
Lease (Tax Net - Net
Lease (Capital Net Lease
Oriented Lease
Lease)
Lease)
Financial Lease versus Operating Lease:
Sr. Financial Lease (Capital Operating Lease (Tax
No. Lease) Oriented Lease)
i) The risk and reward The risk and reward associated
associated with ownership with ownership remains
are passed on to the lessee. exclusively with the lessor. I.e.
Lessee generally keeps the ownership for tax and
possession of the asset accounting purpose remains
even after the lease period with the lessor. The lessor is
is completed. also eligible to take back the
possession ofthe asset leased
Lessor only remains the from the lessee.
lawful titleholder of the
asset. The lessee is simply allowed the
use of the asset for a stated
period.
ii) The risk of obsolescence is The risk of obsolescence is
borne by the lessee. borne by the lessor.
iii The lessor does not Generally, the lessor tolerates
) tolerate the cost of cost of maintenance, operations
maintenance, operations or repairs.
or repairs. He enters into
the transaction only as
financier.
iv) The lease is non- The lease is kept cancellable by
cancellable by either party the lessor because the lessor
because the lessor is more does not have any issues in
concerned with his rents leasing the same asset to other
rather than the asset. He ready lessee.
must get his principal back
along with interest.
v) The single lease repays the The lessor anticipates leasing
cost of the asset along with the same asset over and over
the interest. I.e. again to multiple users and
Theleaseisgenerallyfullpay hence the lease is generally non-
out. payout.

Net Lease versus Net – Net Lease:

Leases

Net - net
Net Leases
Leases

Executory Pre established

Costs, i.e. residual value

cost associated
with
ownership
such as

Maintenance,
Taxes and
Insurance

To recognize which costs of the asset are the obligations of the lessee,in
finance, leases are classified as net leases or net-net leases.In a net lease, the
cost connected with ownership is assumed by the lessee during the time span
of the lease. In accounting, these costs are generally known asexecutory costs
and include and insurance,taxes,maintenance. In a net-net lease, the executory
costs as well as pre-established residual value both are assumed by the lessee.
The specific nature of the transaction, i.e. net lease or net-net lease - will affect
the cost of the lease to the lessee and, consequently, the feasibility and
advantages of leasing.
Assessment of Leasing versus Purchase alternatives:
Leasing is asubstituteapproach of funding the procurement of particular
assets. While leasing is an alternative for procuring assets in a capital
budgeting project, appraisal of the project needs to considervarious costs
connected with each alternative for funding the project assets - i.e. buying and
leasing.

Evaluation of the proposed

project to decide it's financial
viablility when asstes are:

purchased
leased
or

Thus, the assessment would need to decide:

Whether the proposal under consideration is financially viable if assets are
purchased; and

Whether the proposal under consideration is financially viable if assets are

leased

Above evaluation may present several possible situations discussed as under:

Possible Situations i.e.
Financial Viability* of the proposed project
under
Traditional Capital Probable Decision
Budgeting Analysis
Leasing
(e.g. NPV using Cost of
Capital)
No No Reject
Yes No Purchase
Yes (more viable) Yes (comparatively less
Purchase
viable)
No Yes Leasing
Yes (comparatively
Yes (more viable) Leasing
less viable)
*No = financially not viable
Yes = financially viable
Factors which
makes Leasing
a better
alternative

Economic Subjective
Factors Factors

Lower cost of Flexibility Convinience

leasing

• the lessor can offer

the asset at a lower
cost than if the lessee
Lower Cost
procured the asset
of leasing
means

• lower interest rate

because the lessor • tax benifits
has efficiencies
that the lessee
does not have;
such as

Advantages:
 Probability of scheduling payments to correspond with cash flows

Fewer (or No) preventive covenants than incurring certain other debt

Probable lesser cost than acquiring, resulting mainly from lessor efficiencies such as
lesser rate of interest, tax advantages, some of which are “passed on” to the lessee

Limited instantaneous cash outflow

The resulting obligation (lease payment) is certain to the sum required

Disadvantages:
Lease funding is asset specific—funds are not available for common purpose

Normally selected for causes other than financial reasoning

The time span of asset usefulness may prove different than Lease tenure

All assets are not generally available for lease

QUESTION BANK

Example 1: What would be the principalcause for anorganization to

settlewith a debt contractrestricting the percentage of its long-term debt?
a) To reduce the risk for existing bondholders
b) To reduce the interest rate on the bonds being sold
c) To cause the price of the organization’s stock to rise
d) To lower the organization’s bond rating
Solution:b) to reduce the interest rate on the bonds being sold
Explanation: Such a condition would lessen the rate of interest on the debt
being sold.
Example 2:Financial and operating leases differ in that the lessor
a) Incurs rent charges which are in fact installment payments consisting of a
payment for both principal and interest only under a financial lease.
b) Finances the project through the leased asset only under a financial lease.
c) Merely acquires use of the asset under a financial lease.
d) Uses the lease as a source of funding only under an operating lease.
Solution: b) Finances the project through the leased asset only under a
financial lease.
Explanation:In a financial lease transaction, the lessee is using the lease as a
source of funding and the lessor is funding the project (offering the capital for
investment) through the leased asset.
Example 3:A Ltd.sold $ 10 million of long-term debt in the present year. What
is a chiefbenefit to A Ltd. with the debt issuance?
a) Due to financial leverage,the reduced earnings per share (EPS) possible.
b) Due to the deduction of interest,the comparatively low post-tax cost.
c) The increased financial risk arising out of the use of the debt.
d) The decrease of A's control over the company.
Solution:Due to the deduction of interest,the comparatively low post-tax cost.
Explanation: The cost of debt is reduced because of tax benefit deduction
available on interest.
Example 4: For the next two years, a lease is estimated to have an operating
net cash inflow of $ 10,000 per annum, before adjusting for $ 6,000per annum
tax basis lease amortization, and a 30% tax rate. The present value of an
ordinary annuity of $1 per year at 10% for two years is 1.74. What is the
lease's after-tax present value using a 10% discount factor?
a) $ 2,610 b) $ 4,350 c) $ 9,570 d) $15,312
Solution: d) $15,312
Explanation:The net present value of a project:
PV
future Inves-
NPV
cash tment
flows
Since this example involves a lease requiring only annual payments there is no
initial investment in this case. Lease amortization must be subtracted from
cash inflows to determine income tax expense.
Annual cash inflow $10,000
Tax basis lease amortization ($ 6,000)
Taxable lease income $4,000
Tax Rate × 30%
Tax expense per year $ 1,200
However, lease amortization is not a cash outflow and is thus excluded from
the calculation of NPV. The after-tax present value of the lease equals:
Annual cash inflow $10,000
Cash outflow for taxes ($ 1,200)
Annual net cash flow $8,800
PV factor for two years at 10% × 1.74
PV of cash flow = lease value $ 15,312

Example5:Select the correct statements regarding the leasing of an asset?

i.In a net-net lease, the lessee is responsible for not only executory costs but
also for residual value of the leased asset.
ii.If the net present value (NPV) of buying an asset is negative, then leasing the
asset should not be considered as a substitute.
a) onlyi b) only ii c) Both i and ii d) Neither i nor ii
Solution: a) only i
Explanation:Statement iis correct. Reason being in a net-net lease, the
executory costs(i.e.taxes,maintenance,insurance etc.) as well as pre-
established residual value both are assumed by the lessee.

However, statement ii is not correct. If the net present value (NPV) of buying
an asset is negative, which demonstrates that it is not financially viable toearn
a positive return byprocuring the asset, it still may be financiallyviable to
lease the asset.
While performing the concludingassessment, the elementary reason for
leasing, rather than purchasing, is that leasing an asset costs less than buying
it.
Hence, while the cost of buying an asset may not result in a positive net
present value (NPV), the cost savings connected with leasing the asset may be
such that it makes leasing the assetfinancially viable.
Example6:A Ltd. will require $ 20,00,000 of new external financing for two
projects it is undertaking. Those projects are:
(a) acquisition of a new long-term asset with a cost of $ 10,00,000 and
(b) a permanent increase in its level of inventory of $ 10,00,000.
The firm is considering two options for financing the two projects.
The first option is to execute a 10-year loan for the full $ 20,00,000.
The second option is to execute a 6-month, $ 20,00,000 loan with the need to
renew the loan at the end of each 6-month period for 10 years.
A restrictive covenant on existing debt requires that the firm maintain a
minimum current ratio of 2.00 or be in default on that loan. The firm currently
has current liabilities of $ 70,00,000 and a current ratio of 2.10, calculated as
current assets/current liabilities.
Which of the alternative financing options for the $ 20,00,000 if any, will
permit the firm to meet the obligation of its existing loan covenant to maintain
a current ratio of at least 2.00?
Option 10-Year Term Loan 6-Month Loans
1 No No
2 No Yes
3 Yes No
4 Yes Yes
a) Option1b) Option2c) Option3d) Option4
Solution: c) Option3
Explanation:The 10-year loan would maintain a current ratio of at least 2.00,
but the 6-month loan option would not result in a current ratio of at least 2.00.
Currently, with $ 70,00,000 in current liabilities and a 2.10 current ratio, A
Ltd. has current assets of$10,500,000, calculated as:
Current Ratio (CR) = Current Assets (CA) /Current Liabilities (CL)
CR 2.10 = CA unknown/ CL $ 70,00,000
CA = CL $ 70,00,000 × CR 2.10
CA = $ 1,47,00,000
For the current ratio calculation, the 10-year term loan would result in an
increase in the current asset Inventory by $ 10,00,000 an increase in long-
term assets by $ 10,00,000 but would not change current liabilities. The note
payable would be recorded as a long-term obligation that does not affect
current liabilities and the $ 10,00,000 for the acquisition of the long-term
asset would not affect current assets. Therefore, neither the increase in long-
term assets nor the 10-year loan would affect the current ratio. Consequently,
under the 10-year term loan arrangement current asset would be
$1,57,00,000 ($1,47,00,000+ $10,00,000), current liabilities would be
unchanged at $ 70,00,000 and the new current ratio would be:
CR = CA $1,57,00,000/ CL $70,00,000 = 2.24 (greater than 2.00)
Under the 6-month loan option the current ratio would be less than the
required 2.00. For the current ratio calculation, the 6-month loan option
would result in an increase in the current asset Inventory by$ 10,00,000, an
increase in long-term assets by $ 10,00,000 and an increase in the current
liability Short-Term Note Payable of $ 20,00,000. The $ 10,00,000 for the
acquisition of the long-term asset would not affect current assets and,
therefore, would not affect the current ratio. Therefore, under the 6-month
loan arrangement current assets would be $ 1,57,00,000 ($ 1,47,00,000 + $
10,00,000), current liabilities would be$ 90,00,000 ($ 70,00,000 + $
20,00,000), and the new current ratio would be:
CR = CA $ 1,57,00,000/ CL $ 90,00,000 = 1.74 (less than 2.00)
Example7:ABC Company entered into a lease contract with DEF Company
effective January 1, 2020 to lease a building that cost DEF $ 15,50,000 to
construct and has a market value of $ 18,00,000. The building has an expected
life of 20 years with an estimated residual value of $ 1,00,000. The lease is for
10 years with annual payments of$ 2,09,244 beginning December 31, 2020,
and is not renewable. ABC's borrowing rate is 10% and its marginal tax rate is
30%.
Present value table factors for 10 years and 20 years are:
10 Years 20 Years
Present value of $1 @ 10% 0.38554 0.14864
Present value of ordinary annuity @ 10% 6.14457 8.51356
Present value of annuity due @ 10% 6.75902 9.36492
In a financial analysis of the lease, which of the following amounts is closest to
the after-tax present value of ABC's lease cost?
a) $1,100,000 b) $880,000 c) $9,00,000 d) $
7,71,080
Solution: c) $ 9,00,000
Explanation:The after-tax present value of ABC's lease cost is closest to
$9,00,000. The correct calculation would be to discount the annual lease
payments ($2,09,244) at 10% for 10 years, and to deduct from that the annual
tax savings (shield) provided by the deductibility of lease payments for tax
purposes ($2,09,244 × 0.30 tax rate), discounted at 10% for 10 years, both
using the present value of an ordinary annuity (since payments are at the end
of each year). Thus, the correct answer is calculated as:
Annual lease payments $2,09,244
PV factor ordinary annuity 10 years @ 10% 6.14457
PV of lease payments $ 12,85,714
Annual lease payments $2,09,244
Tax rate 0.30
Annual tax savings $ 62,773.2
PV factor ordinary annuity 10 years @ 10% 6.14457
PV of tax saving (shield) $ 3,85,714
PV of lease payments $ 12,85,714
Less: PV of tax saving ($ 3,85,714)
Present value of after-tax lease cost $ 9,00,000

Example8:Under which lease terms would the lessee be responsible during

the tenure of the lease for executory costs related with the leased asset?
a) Both Net Lease and Net-Net Lease
b) Neither Net Lease nor Net-Net Lease
c) Only Net Lease
d) Only Net-Net Lease
Solution: a) Both Net Lease and Net-Net Lease
Explanation:In a net lease, the cost connected with ownership is assumed by
the lessee during the time span of the lease. In accounting, these costs are
generally known asexecutory costs and include and
insurance,taxes,maintenance. In a net-net lease, the executory costs as well as
pre-established residual value both are assumed by the lessee.
Example9: What would be the principal reason for anorganization to agree to
a debt conditionrestricting the percentage of its long-term debt?
a) To increase the price of the organization's stock
b) To cause the organization's credit rankingdecrease
c) Reduction in the risk of prevailing debt holders
d) Reduction in the rate of interest on the debt being sold
Solution: d) Reduction in the rate of interest on the debt being sold
Explanation:The key reason for anorganization to agree to a debt condition
restricting the percentage of its long-term debt would be to reduce the risk,
and consequently the rate of interest, on debt being sold. Debt conditionsset
contractual restrictions on actions of the borrower to assistsafeguard the
lender. As such, they lessen the default risk connected with a debt issue and,
consequently, diminish the rate of interest on that debt.
BONDS

KN
OW
Concept of Bonds along with its characteristics LE
DG
Types of bonds depending on the nature of security offered E
POI
Concept of the determination of a bond's issue price and calculation NT:
thereof
Concept of a bond's a) current yield and b) yield to maturity including
computation thereof

Impact of changes in the market interest rate on bond values

The benefits and shortcomings of using bonds for long-term funding

KEY CONCEPTS:
Introduction:Issuance of bonds is one of the most common forms of availing
long-term debt financing for big organizations, which can offer huge amounts
of finance for long time spans.

Debt
Financing

Private Public
Market Market

Private placement
using unregistered Sale of SEC-
Loans from financial instruments typically registered
institutions through insurance instruments (bonds)
companies or pension in the market
funds
 Definition of Bonds:Long-term promissory notes wherein the borrower, in
return for buyers’/lenders’ funds, promises to pay the bondholders a fixed
amount of interest each year and to repay the face value of the note at
maturity.
Characteristics of Bonds:

Agreement: the bond contract

Par value or face value: the “principal” that will be returned at maturity, most
commonly $ 1,000 per bond
Coupon interest rate: the annual rate of interest printed on the bond and
paid on face value
Maturity: the time at which the issuer repays the face value to the holders of
the bond

KeyDissimilarities:

On the
basis of
security
On the
Euro- basis of
bonds Redeem
-ability
Key
Dissimilarities

On the
Floating
basis of
Rate
convert-
Bonds
ability
Zero-
Coupon
Bonds

A) On the basis of security:A key difference in bonds is whether the bond sold is
safeguarded by security.
 On the
basis of
security

Debenture Secured Mortgage

Bonds Bonds Bonds

Definitions:

Debenture Bonds:
• Unsecured; no specific asset is designated as collateral. These bonds are
considered to have more risk and, therefore, must provide a greater
return than secured bonds.

Secured Bonds:
• Have specific assets (e.g., machinery and equipment) designated as
collateral for the bonds.

Mortgage Bonds:
• Secured by a lien on real property (e.g., land and building).

B) On the basis of Redeemability(also called Callability):

On the basis of
Redeemability

Non-
Redeemable/
Redeemable/
Callable Bond
Callable Bond

When the bonds can be bought back (redeemed)by the issuer before maturity,
it is known as Callable bonds.
If the market interest rate reduces significantly below the interest being paid
on the outstanding bonds;callable bonds are most commonly used to allow the
issuing organization to call in outstanding bonds. The organization can lessen
its interest expense by calling in high-interest outstanding bonds and selling
new bonds at the presentlesser rate of interest.
 Generally a higher interest rate is offered by bonds sold with a callable feature
than equivalent bonds without a call feature. The holders of such bonds are
being compensatedby the higher rate of interest for the riskthat the bonds will
be called prior to maturity and the investor will be faced with reinvesting at a
lesserinterest rate.
It mayalso bepossible that a premium (over face or par value) is being offered
by the issuer while calling the bonds in case of bonds sold with a callable
feature.
C) On the basis of convertibility:

On the basis
of
Convertibility

Non-
Convertible
Convertible
Bonds
Bonds
When the holder of the bond has the opportunity of converting the bonds into
a stated number of equity shares (stock) of the sellingorganization, it is known
as convertible bonds. The option to convert will be used by the investors in
convertible bonds if the market price of the stock rises.
Generally a lesserinterest rate is being offered by the bonds sold with a
convertible feature than equivalent bonds without a convertible feature. The
value of the holder's option to convert the bonds into stock is the driving
cause for suchlesser rate of interest.
Convertible bonds also may have a call provision, which would allow the
sellingorganization to redeem the bonds so as to restrict the up-side potential
recognized by the holders of the bond.
D) Zero-Coupon Bonds:

Characteristics of Zero-Coupon Bonds:

 does not pay interest during its life

no (zero) coupons to submit for interest payments

Offer a return to investors by issuing at a deep discount (i.e., amount

less than maturity value) and repaying full par value when redeemed
(bought back) at maturity

The market price is likely to fluctuate more than that of coupon bonds,
since these bonds offer payment only at maturity

E) Floating Rate Bonds:

Rate of a macro
Interest of economic
a spread
Floating benchmark
Rate Bonds rate

For instance,
Quated
0.50%
Rate of Prime rate
(which
Interest for (which
remains
Floating fluctuates)
constant)
Rate Bonds

Characteristics of floating rate bonds:

 Offers an interest rate that fluctuates over the life of the instrument

the interest rate offered is tied to a macroeconomic benchmark rate

such as the prime rate, the U.S. Treasury Bill rate, LIBOR (London
Interbank Offered Rate), the federal funds rate or similar rate, plus a
spread (which is a constant amount)

Since the interest rate offered “floats” (decrease or increase) with

fluctuations in a macroeconomic benchmark, the bonds are likely to
maintain their market value as the market interest rate fluctuates

F) Eurobonds:
Characteristics of Eurobonds:
Issued outside the borrower's country but payable in the borrower's currency

For instance, a U.S. organization (issuer) might sell bonds payable in dollars
but issued in another country. Since the disclosure and registration
requirements are fewer than in the U.S., the bond can be sold at lesser costs
than in the U.S.
Cost of Bond Financing:
The cost of funding with bonds (and other debt) is the rate of interest less the
tax benefits from the tax deductibility of interest expenditure. Accordingly, the
commoncomputation is:
Margi-
Cost of Interest
1.0 nal tax
debt rate
rate
 Bonds issued at

Par Discount Premium

Effective / Market Effective / Market Rate of

Effective / Market Rate of
Rate of Intrest Intrest at the date of
Intrest at the date of issue
issue
= >
<
Coupon / Stated Rate Coupon / Stated Rate of
Coupon / Stated Rate of
of Interest Interest
Interest

Basis for deciding Basis for deciding Basis for deciding

the cost of debt the cost of debt the cost of debt
(bonds) = Coupon / (bonds) = Effective (bonds) = Effective
Stated Interest Rate Rate of Intrest Rate of Intrest

Example:Assume $ 100 par value bonds with a coupon rate of interest of 5%

are issued when the market rate of interest is 9% and that the firm's marginal
tax rate is 30%. The cost of financing with those bonds would be determined
as:
Cost of bond financing = 0.09 × (1.00 − 0.30) = 0.09 × 0.70 = 6.30%
Since the bonds carry a coupon rate of interest less than the market rate of
interest, they would sell at a discount, Specifically, the $ 100 bonds would sell
at $ 55.56 (Approx.) so that the $ 5 interest ($ 100 par × 0.05) would result in
an 9% return (i.e., $ 5/$ 55.56 = 0.09).
As a result of that discount, the effective rate of interest (before tax
consideration) is 9% and 6.30% after the tax deductibility benefit (0.09 ×
0.70). Thus, the cost of financing with those bonds is 6.30%.
Bond Values:

Very hugeamounts can be financed through bond issuessince a very large

number of bonds; each having a face value of (say) $500 can be sold.
Although the face value of each bond may be $500 the cash proceeds received
upon selling the bonds will be based on the connection between the coupon
rateof interest (on the face of the bond) and investors’ required rate of return
when the bonds are sold.
The investors’ required rate of return would dependlargely on the return
offeredby other investment possibilities in the market with equivalent
perceived risk (i.e., the investors’ opportunity cost).

the investors’
required rate i.e.
the market rate

more than the less than the

coupon rate coupon rate

the bonds will the bonds will

sell at less than sell at more than
par i.e. at a par i.e. at a
discount premium

Function of the present value of Bond’s future cash flows:

 Function of the
present value of
Bond’s future
cash flows

determination of
determination of
a bond's market
a bond's selling
value during its
price at issue
life

Cash flows from the bond:

Bonds have two

cash flows

Maturity face
Periodic interest
value

Discounted as Discounted as
the present the present
value of an value of a single
annuity amount
Both the above cash flows would be discounted using the market (investors’)
required rate of return at the time, which reflects the market's evaluation of
the risk integralto the bond issue and rates available through other equivalent
investments.
Example:Assume $ 1,000 in bonds outstanding that pay semiannual interest at
8% coupon rate, maturing in 5 years, and the market rate of interest is
currently 6%.
PV of periodic interest: An annuity of 10 payments (5 years × semiannual) at $
40 per payment ($1,000 × 0.08 × 1/2) discounted at the market rate of
interest 0.03 (0.06 × ½). The table factor for annuity with 10 periods at 0.03 =
8.53. Thus, the present value of interests payments is $ 40 × 8.53 = $ 341.2
 PV of maturity value:A single amount to be received in 10 periods at the
market rate of interest 0.03. The table factor for a single amount with 10
periods at 0.03 = 0.7441. Thus, the present value of the maturity value is
$1,000 × 0.7441 = $ 744.1

The current value of the bonds is $ 341.2 + $ 744.1 = $ 1085.3

Bond Yields:

Bond
Yields

Yield to
Current yield maturity
(CY) (expected rate
of return)

The rate of return

The ratio of annual
interest payments to
the current market
price of the bond
required by investors
as implied by the
current market price of
the bonds is the yield
to maturity

Two measures of rates connected with bonds are notable: current yield and
yield to maturity.
A) Current yield (CY):

Assuming a $ 100, 5% bond currently selling for $90; the current yield (CY)
would be computed as:
CY = Annual coupon interest / Current market price
CY = ($100 × 0.05) / $90 = $ 5 / $90 = 5.56%
Thus, while the coupon rate is 5%, the current yield based on the current
price is 5.56%. As the market price of the bonds changes, so too will the
current yield.
B) Yield to maturity (expected rate of return):

Changes in the rate of return expected on the bond is reflected bychanges in

the market price of an outstanding bond.
Arriving at the yield to maturity is done by:
• Deciding the discount rate that equates the present value of future cash flows
1 from the bond issue with the current price of the bonds

• That discount rate is the rate of return presently expected by holders of the
2 bond

• The process of deciding that rate is similar to the process of determining the
3 internal rate of return on a capital project

• In the absence of a financial calculator or computer, the process is one of trial

4 and error, and interpolation using present value tables

As the bondholders’ present expected rate of return, the yield to maturity is a

vital measure of the organization's present cost of debt capital.
Term Structure of Interest Rates:
Meaning:

• The term st
the current
that have di

Manner of Pr

• The term s
vertical (Y)
horizontal (X

Relationship b
bonds:
• Investors in
market inte
market inter
Goes UP

Market Value of
Goes DOWN

interest bond
rate
Due to a longer holding period, there is a higherprobability that a rise in the
market interestratewill happen and result in a reduction in the value of the
debt and hence, longer-term fixed-rate debt (like bonds) has more risk than
shorter-term debt. Hence, the longer the term of bonds, the more the maturity
premium and consequently, the higher the required rate of return.

Yeild
Curve

Normal Inverted
Flat Yield
Yield Yield
Curve
Curve Curve

The term structure curve If the plotted term structure

(yield curve) is usually
upward sloping from lower
left to upper right,
reflecting that the rate of
return rises as the term
(life) of the debt increases.
curve indicates that short- When the plotted term
term rate of interest is more
structure curve
than long-term rates, it
displays that the rate of displays little or no
return diminishes as the change over time.
term of the debt increases.

Note: Thetermstructureofinterestrateshas
beencoveredindetailinthe“InterestRateConceptsand Calculations”chapter.

Structured Bonds:

Meaning:
When the cash flows associated with the bond (i.e. either the periodic interest
payments or the value at maturity)are contingent upon changes in in one or
more underlying such as specified stock or bond market indexes, commodity
prices, currency exchange rates or other factors; it is known as aStructured
bond.Structured bonds are derivative instruments (i.e. they derive their value
from the value of the underlying)since the value (cash flows) of period
interest payments or the value at maturity depends on change in an
underlying.

Examples of Structured Bonds:

Callable Bonds:

• which give the issuer the ability to redeem the bonds prior to maturity.
Since the call option embedded in the bond may provide for payment of
a call premium based on an underlying.

Convertible Bonds:

• as the holder has the option to convert the bonds to stock, the value of
which may change, thus changing the value at conversion.

Advantages:

Tax advantages on Interest payments

A source of huge amounts of capital

Does not dilute ownership or earnings per share (EPS)

Disadvantages:

Required periodic interest payments and principal repayment at maturity -

default can result in bankruptcy

May impose restrictive conditions and/or require security

QUESTION BANK

Example 1: Bonds payable sold with scheduled maturities at various dates

are known as
a) Serial bonds
b) Term bonds
c) Either Serial bonds or Term bonds
d) BothSerial bonds andTerm bonds
Solution:a) Serial bonds
Explanation:Term bonds are bond issues that mature on a single date.On the
other hand, serial bonds are bond issues that mature in installments (i.e. on
the same date each year over a period of years).
Example 2: Serial bonds are attractive to investors since
a) Investors can select the maturity that suits their financial requirements.
b) The coupon rate on these bonds is adjusted to the maturity date.
c) All bonds in the issue mature on the same date.
d) The yield to maturity is the identical for all bonds in the issue.
Solution: a) Investors can select the maturity that suits their financial
requirements.
Explanation:Serial bonds mature on varying dates permitting an investor to
select a maturity date.
Example 3: Which bond is most expected to maintain a constant market
value?
a) Callable b) Convertible c) Zero-coupon d) Floating-
rate
Solution:d) Floating-rate
Explanation:A bond with a floating rate will normally hold a stable market
value since its value will not vary due to fluctuations in prevalent rate of
interest.
Example 4: A bond backed by fixed assets is a(n)
a) Debenture b) Mortgage bond c) Income bond
d)Subordinated debenture
Solution:b) Mortgage bond
Explanation:A bond secured by property is known as a mortgage bond.
Example 5:The best reason organizationssell Eurobonds rather than
domestic bonds is that
a) Foreign buyers more readily accept the issues of both large and small US
organizations than do domestic investors.
b) Eurobonds do not carry any foreign exchange risk.
c) These bonds are denominated in the currency of the country in which they
are sold.
d) These bonds are generally a less expensive form of funding due to the
nonexistence of government regulation.
Solution:d) These bonds are generally a less expensive form of funding due to
the nonexistence of government regulation.
Explanation:Eurobonds are subject to less strict registration requirements
making them less costly to sell.
Example 6:Select the correct statement with respect to bond funding
alternatives?
a) A call provision is generally considered disadvantageous to the investor.
b) A sinking fund disallows the organization from redeeming a bond issue
before its final maturity
c) A bond with a call provision normally has a lesser yield to maturity than a
comparable bond without a call provision.
d) A convertible bond must be converted to common stock before its maturity.
Solution:a) A call provision is generally considered disadvantageous to the
investor.
Explanation:A call provision permits the organization to call the bond even
though the holder of the bonddoes not want to dispose of the investment.
Example 7:Zero-coupon bonds
a) Are redeemable in measures of a commodity such as ounces of rare metal
(e.g. silver), tons of coal or barrels of oil.
b) Are high-interest-rate, unsecured, high-risk bonds which have been used
broadly for funding leveraged projects.
c) Sell for a minor fraction of their face value since their yield is much lesser
than the market rate.
d) Rise in value each year as they approach maturity, offering the holder with
the total payoff at maturity.
Solution:d) Rise in value each year as they approach maturity, offering the
holder with the total payoff at maturity.
Explanation:This is one of the characteristics that make zero-coupon bonds
attractive to the issuer.
Example 8:A Ltd. has gone bankrupt and will be liquidated. After liquidating
the assets and covering tax liabilities, administration fees, and wage expenses,
the following claims remain:
Notes payable $ 20,000,000
Unsecured bank loans $ 8,000,000
Subordinated debentures $ 12,000,000
There is only $ 20,000,000 available to pay these claims. How much will be
allocated to subordinated debentures?
a) $ 12,000,000 b) $ 8,000,000 c) $ 6,000,000 d) $0
Solutions:d) $0
Explanation:The subordinated debentures are unsecured and subordinated
to other liabilities.
Example 9: The market price of a bond issued at a discount is the present
value of its principal amount at the market (effective) rate of interest
a) Plus the present value of all future interest payments at the market
(effective) rate of interest.
b) Plus the present value of all future interest payments at the rate of interest
stated on the bond.
c) Less the present value of all future interest payments at the market
(effective) rate of interest.
d) Less the present value of all future interest payments at the rate of interest
stated on the bond.
Solution:a) Plus the present value of all future interest payments at the
market (effective) rate of interest.
Explanation:The market price of a bond sold at any amount (par, premium or
discount) is equal to the present value of all of its future cash flows,
discounted at the present market (effective) rate of interest. The market price
of a bond sold at a discount is equal to the present value of both its principal
and periodic future cash interest payments at the given (cash) interestrate,
discounted at the present market (effective) rate.
Example 10: A curve on a graph with the rate of return on the vertical axis
and time on the horizontal axis depicts(CIA adapted)
a) The present value of future returns, discounted at the marginal cost of
capital, minus the present value of the cost.
b) A series of payments of a fixed amount for a specified number of years.
c) The internal rate of return (IRR) on an investment.
d) A yield curve showing the term structure of interest rates.
Solution:d) A yield curve showing the term structure of interest rates.
Explanation:Such a graph demonstrates a yield curve that displays the term
structure of interest rates. The term structure of interest rates denotes how
interest rates differ by time to maturity.
Example 11: Select the bond issues from followingwhich has the highest
interest rate risk, all other things being equal.
a) 20-year, 8% bonds b) 20-year, 5% bonds c) 40-year, 3% bonds d)
10-year, 8% bonds
Solution:c) 40-year, 5% bonds
Explanation:This issue has the lengthiest maturity (with the lowermost
stated rate of interest). Hence, it will have the highest interest rate risk.
Example 12:The market price of a bond sold at a premium is equal to the
present value of its principal amount
a) Only, at the market (effective) rate of interest.
b) Only, at the stated rate of interest.
c) And the present value of all future interest payments, at the market
(effective) rate of interest.
d) And the present value of all future interest payments, at the stated rate of
interest.
Solution:c) And the present value of all future interest payments, at the
market (effective) rate of interest.
Explanation:The market value of a bond, whether issued at par, at a premium
or at a discount, will be the present value of the principal amount plus the
present value of future interest payments, all at the market (effective)
interestrate.
Example13:Select the correct statements regarding debenture bonds and
secured bonds.
i) Comparable secured bondsare likely to have a lesser par value
thanDebenture bonds
ii) Comparable secured bondsare likely to be of shorter duration
thanDebenture bonds.
iii) Comparable secured bondsare more likely to have a lesser coupon rate
thanDebenture bonds.
a) i only b) ii only c) iii only d) i, ii, and iii
Solution:c) iii only
Explanation:Debenture bonds are unsecured bonds. Since they are
unsecured, they are probable to have a higher coupon rate (interest rate) than
comparable secured bonds. And hence, comparable secured bondsare more
likely to have a lesser coupon rate thanDebenture bonds.
Example14:What would be the key reason for anorganization to agree to a
debt condition on new bonds restricting the percentage of the organization's
long-term debt?
a) To decrease the risk for prevailing holders of bond.
b) To diminish the rate of interest on the bonds being issued.
c) To increase the price of the organization's stock.
d) To lessen the organization's bond ranking.
Solution:b) To diminish the rate of interest on the bonds being issued.
Explanation:The key reason anorganization would agree to a debt
conditionrestricting the percentage of its long-term debt would be to diminish
the rate of interest on the bonds being issued. A debt conditionrestricting the
percentage of its long-term debt would give the holders of
bondmoreassurance of repayment and, thus, decrease the risk connected with
the new bond issue. Such reduced risk would lessen the rate of
interestrequired by investors.
Example 15:The best reason organizationssell Eurobonds rather than
domestic bonds is that
a) Foreign buyers more readily accept the issues of both large and small US
organizations than do domestic investors.
b) Eurobonds do not carry any foreign exchange risk.
c) These bonds are denominated in the currency of the country in which they
are sold.
d) These bonds are generally a less expensive form of funding due to the
nonexistence of government regulation.
Solution: d) These bonds are generally a less expensive form of funding due
to the nonexistence of government regulation.
Explanation:Eurobonds are subject to less strict registration requirements
making them less costly to sell.
Example 16: Which bond is most expected to maintain a constant market
value?
a) Callable b) Convertible c) Zero-coupon d)
Floating-rate
Solution: d) Floating-rate
Explanation:A bond with a floating rate will normally hold a stable market
value since its value will not vary due to fluctuations in prevalent rate of
interest.
PREFERRED STOCK
KNOWLEDGE POINT:

Concept of preferred stock along with its characteristics

Concept of (a) current theoretical value of preferred stock (b) expected

rate of return on preferred stock and (c) cost of financing using preferred
stock and calculations thereof

Benefits and drawbacks of using preferred stock for long-term funding

KEY CONCEPTS:
Introduction:

Types of Equity
instruments used
for long term
funding

Common Preferred
Stock Stock

offers "preferences"
to shareholders that
are not provided to
common
shareholders
Preferred Stock:
Definition:
Aclass of ownership in anorganization that has a priority claim on its assets
and earnings before common stock, normally with a dividend that must be
paid out before dividends to common shareholders are paid.
Preferred stock furnish with an ownership interest in anorganization that has
preference claims not granted to common stock shareholders. Ordinarily, a
priority claim to earnings distributions (dividends) and to assets upon
liquidation of the organizationis given to preferred shareholdersdue to such
preference claims.
Features of preferred stock:
Even though preferred stock furnish with an ownership interest in the
organization, oftenit is described as having features of both bonds and
common stock as explained below.
 Preferred
Stock having
features of
both

Common
Bonds; such
Stock; such
as
as

Expected, Limited
Furnish with
and Fixed amount
ownership
of dividend like
interest
interest

Does not Does not

have voting have
rights maturity date

Dividends paid are

not an expense
and are not tax
deductible

Limited liability
to the extent
amount invested

Significant characteristics of preferred stock:

Anorganization can have various classes or types of preferred stock
havingdiverse characteristics along with different preferences.
 Cumulative / Non-Cumulative Feature:
• To differentiate whether dividends not paid in any year accumulate and
require payment prior to payment of common dividends

Participating / Non-Participating Feature:

• To differentiate whether preferred shareholders receive dividends in
excess of the given preference rate

Convertible / Non-Convertible Feature:

• To differentiate whether preferred stock shareholders can exchange
preferred stock for common stock according to a stated exchange ratio

Call Provision:
• The organization’s right to buy back the preferred stock, usually at a
premium

Protective Provision:
• To protect preferred shareholders’ interest. For instance, the right to
vote under certain circumstances or the requirement for a preferred
stock sinking fund

Preferred Stock Values:

For financial valuation and analytical purposespreferred stock is considered
very much like bondssinceit has preference claim to dividends.
Similarities and Dissimilarities in valuation of bonds vis-à-vis preferred stock
can be analyzed as under.

Similarities:

Particulars Bond Preferred Stock

Fundamental Principle Present value of Present value of
for Valuation expected future cash expected future cash
flows gives the value of flows gives the value of
bond. preferred stock.

Dissimilarities:
Particulars Bond Preferred Stock
Forms of future cash Bonds have two forms of Dividends are the only
flows future cash flow i.e. main stream of future
interest and principal at cash flows for preferred
maturity. stocks.
Maturity Time Bonds have a specified Preferred stock may be
maturity time period. outstanding indefinitely.

Components used to forecast the value of preferred stock:

The components used to forecast the value of preferred stock are:

Estimated future annual dividends

Discount rate (i.e. investors’ required rate of return)

An assumption that the dividend stream will exist in perpetuity

Using the anticipatedcomponents, we can compute the theoretical value of a

share of preferred stock (PSV) as:
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
PSV =
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛

For instance, if the annual dividend is $ 5.00 and preferred investors expect
an6% return, the implied value of the preferred stock would be:PSV = $ 5.00 /
0.06 = $ 83.33

Preferred Stock Rate of Return:

Similar toholders of bond, preferred stockholders have an expected rate of
return they want toearn on their investment. That currently expected rate of
return can be computed using two directly determinable components:
 Presently
expected rate
of return can be
computed using

Annual Market
dividend price

Using these components, the expected rate of return (PSER) can be computed
as:
PSER = Annual Dividend / Market Price
Assuming an annual dividend of $ 5.00 and a current market price of $50.00,
the calculation would be:
PSER = $ 5.00 / $50.00 = 0.1 = 10%
Thus, based on the current market price, the currently expected rate of return
on the preferred stock is 10%.
Cost of Financing with Preferred Stock:
 Cost of
Financing with
Preferred
Stock

Outstanding New
Preferred Preferred
Stock Stock

As the annual dividend is “fixed” and the The cost of newly issued
market price will vary to reflect preferred stock is computed
fluctuations in market perceptions of the by dividing the annual
stock, the expected rate of return dividend with the issue price
(computed above) represents the rate (after considering any
investors presently require to invest in the premium or discount).
stock. And such rate is a measure of the
organization's current cost of outstanding
preferred stock capital.

Assume 5,000 shares that pay a $ 10.00 per year dividend (0.10 × $100 par)
are issued for $ 5,12,500 (at a premium). The cost of the newly issued shares
is$ 50,000/$ 5,12,500 = 9.76%(less than the stated rate of 10% because the
proceeds exceed par).
Advantages:
 Does not have a specified maturity date

Voting rights are normally not conferred

Usually a lesser cost of capital than common stock

Does not require any security

Periodic payments are not lawfully required; failure to pay dividends cannot constitute
a default

Disadvantages:
Protective provisions may be onerous; when triggered

Usually, a higher cost of capital than bonds

High expectations for dividend

No tax benefit on dividend payments

QUESTION BANK

Example 1: Preferred and common stock differ in that

a) Preferred stock has a higher preference than common stock with respect to
earnings and assets in the incident of liquidation
b) Tax benefit is available on preferred stock dividends; however such benefit
is not available on common stock dividends
c) Default to pay dividends on preferred stock will force the organization into
insolvencywhile default to pay dividends on common stock will not force the
organization into insolvency
d) Preferred stock dividends are not fixed amounts whilecommon stock
dividends are a fixed amount
Solution:a) Preferred stock has a higher preference than common stock with
respect to earnings and assets in the incident of liquidation
Explanation:Preferred stock has a higher preference than common stockfor
both dividend payment and assets in the event of liquidation.
Example 2:A company issued common stock and preferred stock. Projected
growth rate of the common stock is 10%. The current quarterly dividend on
preferred stock is $2.25. The current market price of the preferred stock is $
90, and the current market price of the common stock is $ 105. What is the
expected rate of return on the preferred stock?
a) 2% b) 7% c) 10%
d) 13%
Solution:c) 10%
Explanation:The expected rate of return on the preferred stock (P/S) is
determined as the annual dividend on the stock divided by the market price of
the stock. This correct answer is computed as: Annual Dividend on P/S $ 9 /
Market Price of P/S $ 90 = 0.1 (or 10%).
Example3: A Ltd., a publicly traded, mid-cap company, wanted to obtain $
100 million in new capital to expand its Iowa plant. Cost of capital was a factor
in making the decision. A Ltd. could either issue new preferred stock or new
debentures. A Ltd.’s underwriter estimated that preferred stock should have
an annual dividend payout of $ 8 and an issue price of $105 per share. The
debentures should have a coupon interest rate of 10% and an issue price of
$103. A Ltd.’s marginal income tax rate was 30%. Which of the following
approaches describes A Ltd.’s best strategy?
a) A Ltd. should issue the debentures since the after-tax cost of debt (6.796%)
would be less than the cost of equity (7.619%).
b) A Ltd. should issue the debentures since the after-tax cost of debt (6.796%)
would be less than the cost of equity (8%).
c) A Ltd. should issue the preferred stock because the cost of equity (8%) is
less than the cost of debt (10%).
d) A Ltd. should issue the preferred stock because the cost of equity (7.619%)
is less than the cost of debt (10%).
Solution:a) A Ltd. should issue the debentures since the after-tax cost of debt
(6.796%) would be less than the cost of equity (7.619%).
Explanation: A Ltd.’s best strategy would be the one that results in the lower
cost of obtaining the $ 100 million in new capital. The cost of debentures is
determined as the annual interest payment divided by proceeds received per
bond issued, reduced by the tax savings resulting from the deductibility of the
bond interest expense. The annual interest payment per bond is: 0.10 × $100
= $ 10.00. The proceeds from each bond are $103.00. Thus, the computed
pretax cost of the bonds is: $ 10.00 / $103.00 = 0.0971. With a tax rate of 30%,
the net of tax cost is: 0.0971 × (1 –0 .30) = 0.0971 × 0.70 = 0.06796 or 6.796%.
The cost of preferred stock is the annual dividend divided by the proceeds
received per share issued. Since dividends are not deductible for tax purposes,
there is no adjustment for tax savings. The annual dividend per share is $ 8.
The proceed from issue of the stock is $105. Thus, the computed cost of the
preferred stock is $ 8.00 /$105.00 = 0.07619 or 7.619%. Therefore, the cost of
issuing bonds (6.796%) is less than the cost of issuing preferred stock
(7.619%) and A Ltd. should issue bonds to obtain its new capital.
Example4:Select the correct statement(s)regarding preferred stock.
i) Furnish with ownership interest
ii) Dividends requiredto be paid
iii) Furnish with voting rights
a) i only b) ii only c) i and ii only d) i, ii and iii
Solution:a) i only
Explanation: Similar to common stock,preferred stock carries an ownership
interest in the organization. Preferred stock does not require the
dividendpayments nor does it ordinarily carry voting rights.
Example 5:What effect will the selling of new preferred stock have on the
following for the selling organization?
Option Long-Term Debt Debt-to-Equity Ratio
a) No Change Decrease
b) No Change Increase
c) Increase Decrease
d) Increase Increase

Solution: a) Long Term Debt – No Change; Debt-to-Equity Ratio - Decrease

Explanation:As preferred stock is not debt, there will be no impact on long-
term debt; however, as preferred stock is equity, the debt-to-equity ratio will
reduce.
Example 6: Select the area in which preferred stock is most likely to differ
from common stock.
a) Tax deductibility of dividends paid b) Voting rights c) Ownership status
d) Maturity date
Solution:b) Voting rights
Explanation:Preferred stock and common stock are most likely to be
dissimilar in area of voting rights; preferred stock normally does not have
voting rights whereas almost all common stock have such voting rights.
Example7:A Ltd. has determined that its pre-tax cost of preferred stock is
10%. If its tax rate is 40%, which one of the following is its post-tax cost of
preferred stock?
a) 15.6% b) 10.0% c) 6% d) 3.6%
Solution:b) 10.0%
Explanation:As tax benefit is not available for dividends on preferred stock,
no adjustment is required to be made to the pre-tax cost. Hence, the post-tax
cost of preferred stock is the equalto the pre-tax cost, 10%.
COMMON STOCK
KNOWLEDGE POINT:

Concept of common stock along with its characteristics

Concept of common stock's current theoretical value & expected rate of

return and calculations thereof

Benefits and shortcomings of using common stock for long-term funding

Concept of crowd funding including major limitations and regulatory

requirements while using crowd funding for issuing equity securities

KEY CONCEPTS:
Concept of common stock:
Introduction and Meaning:
Common stock is the basic form of long-term equity funding for
organizations.The basic ownership interest in anorganization is represented
byCommon stock. Unlike preferred stock, the features of common stock are
fairly identical. Though it is probable in some jurisdictions to have more than
one class of common stock with diverse rights, regulatory and other
requirements almostprevent more than one class of common stock.
Characteristics of Common Stock:
 Residual Claim to Earnings and Assets:
• Claim of Common shareholders to earnings and assets on liquidation
comes subsequent to the claims of creditors and preferred shareholders.

Limited Liability:
• Liability of Common shareholders is limited to their investment.

Preemptive Right:
• The right of first refusal to acquire a proportional share of any new
common stock sold.

Right to Vote:
• For directors, auditors and changes to the corporate charter. A
temporary power of attorney, termed as a proxy, can be used to delegate
such right.

Risks related with Common Stocks:

Risk related
with common
stocks

Risk of Weak
Financial Risk
Earnings

means the risk that common

means the risk that the shareholders are entitled to
common shareholders have all income remaining after
only a residual claim to other capital sources
earnings (and assets on (creditors and preferred
liquidation) shareholders) have received
interest and dividends
As a consequence, thecommon stock capital isgenerally carrying a cost higher
than that of either bonds or preferred stock.
Common Stock Value:
 The value of
common stock
is the present
value of

Expected
Cashflows

stock price
appreciation (a
Expected Dividends consideration usually
not encountered with
preferred stock)

Therefore, if an assumption is made that a share of common stock is to be

purchased and held for only one year,

Present value of Present value of

The expected the expected
present dividends stock market
value of during the one- price at the end
that share year holding of the one-year
period holding period

(Both the above amount discounted at the investor's required rate of return)
Expectations about future dividends, and especially future stock market
prices, become much less certainwhile considering an investment for several
holding periods.An assumption that dividends grow indefinitely at a constant
rate is one way to address that uncertainty in financial analysis. It is assumed
that;dividends distributed and growth in stock value both is incorporated by
the constant growth in dividends. On the basis ofsuch assumption, the current
value of common stock (CSV) can be calculated as:
CSV = Dividend in 1st Year / (Required Rate of Return − Growth Rate)
Example:Assume an expected dividend of $ 4 in the next year, an expected
indefinite dividend growth of 6% annually and a required rate of return of
10%, the resulting value of the common stock would be:CSV = $ 4 / (10% −
6%) = $ 4 / 0.04 = $ 100.00
Common Stock Expected Return/Dividend Growth Model:
On a consideration of an assumption that dividends are anticipated to grow at
a steady rate infinitely into the future (in perpetuity) and that the stock
market price is mirrored by that dividend growth rate, the expected/required
rate of return (CSER) for a prospective present investor (marginal investor)
can be calculated with the dividend growth model as:
Dividend in Next Year
CSER = ( ) + Growth Rate
Market Price

Example:Assuming an expected dividend of $ 4, a growth rate of 6% and a

current market price of$ 100.00, the calculation would be:
CSER = ($ 4 /$ 100.00) + 0.06
CSER = 0.04 + 0.06 = 0.10 = 10%
Thus, the marginal investor with a required rate of return of 10% would be
willing to pay $ 100.00 per share, the current market price of the stock.
Cost of Financing with Common Stock:

The expected return (as computed above) is the current cost of funding
through the use of outstanding(existing) common stock.
Other methods to anticipating the cost of outstanding common stock:

Bond-yield-plus approach

Capital asset pricing model (CAPM)

Arbitrage pricing model

Impact of flotation cost on cost of financing in case of issuance of new

common stock vis-à-vis existing outstanding common stock:
The cost of capital through the issuance of new common stock would be
anticipated to be higher because of flotation costs (i.e.the costs related with
selling the new securities).Proceeds realized aredecreased due toflotation
costsand consequently it increases the cost of funding.
Using the facts in the illustration above and assuming the same $ 100 selling
price, but with a $ 20 per share flotation cost, the calculation would be:
CSER = [$ 4 /($ 100 – $ 20)] + 0.06
CSER = ($ 4 /$ 80) + 0.06
CSER = 0.05 + 0.06 = 0.11 (11%) - the cost of the new issue.
Retained Earnings:
Further, as common stockholders have a residual claim to earnings, and
retained earnings are essentially residual earnings, the expected rate of return
on common stock also represents the implicit cost of internal funding.
Implicit cost of internal funding means the cost of using retained earnings
rather than distributing the same in the form of dividends.

Impact of flotation cost on cost of financing in case of issuance of new

common stock vis-à-vis funding through Retained Earnings:
Since in case of the retained earningsthere are no flotation costs;the cost of
capital for retained earnings would be less than the cost of capital for selling
new common stock due to the flotation costs involvedinselling such new
securities.
Expected Return versus Historic Return:
The historic (ex post) rate of returnis different thanthe expected (ex ante) rate
of return.
The total historic rate of return on common stock (and on other investments)
=
The total dollar return earned since acquisition
Original cost of the investment
For common stock,

Change in
the market
Total dollar Dividends price of the
return Received stock since
it was
acquired

The expected or historic return on a portfolio of common stocks (or other

investment) is the weighted average of the expected/historicreturn on the
investments in the portfolio.
 Advantages:

Does not have a specified maturity date

Does not require any security

Periodic payments are not lawfully required; failure to pay dividends cannot
constitute a default

Disadvantages:

Usually a higher cost of capital than other sources

No tax benefits on dividends payment

Ownership and earnings are diluted because of any additional shares issued

Raising Equity through Crowd funding:

Introduction and Meaning of Crowd Funding:
➢ Crowd funding is the raising of capital for an undertaking (like business
venture, project etc.) by obtaining many small amounts from a large number
of sources, normally accomplished through Internet solicitation.
➢ U.S. securities regulations generally have prohibited the issue (sale) of equity
securities through the use of crowd funding.
➢ In October 2015, the SEC adopted rules, as required by Title III of the 2012
JOBS Act, that alloworganizations to offer and sell equity securities through
crowd funding.

Crowd funding Regulations:

The regulations adopted by the SEC allow the use of crowd funding for the
issue of equity securities subject to certain limits and requirements imposed
on both organizations seeking crowdfunding and investors.
 Crowd Funding
Regulations

Organization Investor
Related Related
Requirenments Requirenments

Organization related requirements:

For organizations seeking crowdfunding, the rules:
➢ Prevent the use of crowd funding by certain entities including;

Non-U.S. organizations

Organizations that plan to merge with or acquire another unspecified organizations

Organizations that have no specific business plan

Organizations that must report under the Exchange Act

Certain investment organizations and

Organizations that fail to comply with SEC reporting requirements

➢ All crowdfunding transactions are requiredto take place only through an SEC-
registered broker- dealer or funding portal

➢ Limit the amount to a maximum of $ 1 million that anorganization may raise

through crowdfunding during any 12-month period

➢ Require certain reporting by the organization including;

 Information about the business

The intended use of funds raised

The security price and the total offering amount

A discussion of the company's financial condition

Disclosure of its financial statements

Information about officers, directors, owners of 20% or more of the

company and

Certain related party transactions

Investor-related requirements:
For investors participating in crowdfunding, the rules:
➢ Limit the maximum amount an investor may invest in all crowd funding
equity offerings during a 12-month period to $ 1,07,000

➢ Usually imposes a one-year holding requirement before the securities may be

resold
 Limit the amount an
individual investor
may invest in
offerings to:

If the investor's
If the investor's
annual income and
annual income or net
net worth both are
worth is less than $
equal to or greater
1,07,000
than $ 1,07,000

10% of the lesser of

their annual income
The Higher of
or net worth, not to
exceed $107,000

5% of their
annual income
$ 2,200 or
or net worth
w.e. less

(Source: SEC, Updated Investor Bulletin: Crowdfunding for Investors, May 10,
2017)
QUESTION BANK

Example 1:Everything else equal,the market value of anorganization’s

outstanding common shares will be higher, when
a) Expected holding periods of investors are longer
b) Expected holding periods of investors are shorter
c) Investors have a lesser required return on equity
d) Investors expect lesser growth in dividend
Solution: c) Investors have a lesser required return on equity
Explanation: The common shares are being valued higherby the investors if
they have a lesser required return because then a lesser discount rate will be
applied by them to the expected future dividend stream of the organization.
Example 2:The cost assigned to retained earnings should be __________
whilecomputing the cost of capital.
a) Greater than the cost of external common equity
b) Lesser than the cost of external common equity
c) The same as the cost of external common equity
d) Zero
Solution: b) Lesser than the cost of external common equity
Explanation: Because of floatation costs involved, the cost of new common
equity is greater than the cost of retained earnings.
Example 3:A Ltd. is determining how to finance some long-term projects. A
Ltd. has decided it prefers the benefits of no fixed charges, no fixed maturity
date, and an increase in the creditworthiness of the organization. Which of the
following would best meet A Ltd.’s funding requirements?
a) Long-term debt b) Short-term debt c) Bonds d) Common stock
Solution: d) Common stock
Explanation: The issuance of common stock contains no fixed charges, no
fixed maturity dates and will improve the creditmerit of the organization.
Example 4:The formula to compute the economic rate of return on common
stock is…
 (Dividends + change in price) (Net income – preferred dividend)
a) b)
beginning price common shares outstanding

Market price per share Dividends per share

c) d)
earnings per share market price per share

(Dividends + change in price)

Solution:a)
beginning price

Explanation: Return on stock is measured by the return to the investor both

in appreciation and in dividends.
Example 5: When calculating the cost of capital, the cost assigned to retained
earnings should be(CIA adapted)
a) Greater than the cost of external common equity
b) Lesser than the cost of external common equity
c) The same as the cost of external common equity
d) Zero
Solution: b) Lesser than the cost of external common equity
Explanation: Because of floatation costs involved, the cost of new common
equity is greater than the cost of retained earnings.
Example6:A stock priced at $ 100 per share is expected to pay $ 10 in
dividends and trade for $ 120 per share in one year. What is the expected
return on this stock?
a) 30% b) 25% c) 20%
d) 10%
Solution: a) 30%
Explanation:The dollar return on stock consists of both the dividends
received ($ 10) and the change in stock price ($ 20). The rate of return on
stock is calculated as the dollar return divided by the dollar amount ofthe
investment on which the return was earned. Thus, the correct calculation is:
($ 10 + $ 20) / $ 100 = $ 30 /$ 100 = 30%.
Example7:Select the correct statement(s)regarding the sale of equity
securities through crowd funding.
i) Crowdfunding must take place only through a SEC-registered broker-dealer
or funding portal.
ii) The amount that can be invested through crowdfunding during a 12-month
period by an investor is limited.
iii) Crowdfunding may be used by any company registered with the SEC.
a) i only b) i and ii only c) i and iii only d) i,
ii, and iii
Solution: b) i and ii only
Explanation:Crowdfunding must take place only through a SEC-registered
broker-dealer or funding portal(statement i) and the amount that can be
invested through crowdfunding during a 12-month period by an investor is
limited to $1,00,000 (statement ii).
Example 8:A start-up company is planning to offer shares of its common
stock through a SEC-registered online funding portal. On an assumption that
the requirements for crowdfundinghave been complied with by the company,
kindly select the maximum amount, if any, the company may raise through
crowdfunding during its first year.
a) There is no limit b) $ 1,00,00,000 c) $10,00,000
d) $1,00,000
Solution: c) $10,00,000
Explanation: The maximum amount that can be raised by an organization
during a 12-month period through crowdfunding is limited to $10,00,000.
Example 9: A Ltd.'s common stock is currently selling for $50 per share and
will pay an $8.00 per share dividend. If A Ltd.'s dividend is expected to grow
indefinitely at 10%, what is the market's required rate of return on a
prospective investment in A Ltd.'s stock?
a) 4% b) 5% c) 26% d) 20%
Solution: c) 26%
Explanation:The market's required rate of return on a prospective
investment in A Ltd.'s stock is 26%. The solution is calculated as: (Current
dividend/Current market price) + Growth rate, or ($ 8 /$ 50) + 10% = 16% +
10% = 26%.
Example 10: Select the correct statements regarding common stock.
i) Furnish with ownership interest
ii) Furnish with voting rights
iii) Dividends are required to be paid
a) ionly b) ii only c) i and ii only d) i, ii and
iii
Solution: c) i and ii only
Explanation:Both an ownership interest and a voting right are granted
bycommon stock. The payments of dividends are not required by common
stock;such dividend payments are at the discretion of the Board of Directors
(BoDs) and need profitable operations.
Example11:The formula to compute the historic economic rate of return on
common stock is…
(Dividends + change in price) (Net income – preferred dividend)
a) b)
beginning price common shares outstanding

Market price per share Dividends per share

c) d)
earnings per share market price per share

(Dividends + change in price)

Solution:a)
beginning price

Explanation:Expected returns are from dividends and stock price

appreciation in case of a common stock. Hence, the rate of return on the
common stock would be (dividends paid during the period + change in the
price of the stock)/stockprice at beginning of the period.
Example12:A Ltd. is determining how to finance some long-term projects. A
Ltd. has decided it prefers the benefits of no fixed charges, no fixed maturity
date, and an increase in the creditworthiness of the organization. Which of the
following would best meet A Ltd.’s funding requirements?
a) Long-term debt b) Short-term debt c) Bonds d) Common stock
Solution: d) Common stock
Explanation:To finance its projects,issuance of common stock would best
meet A Ltd.'s funding strategy. Precisely, issuance of common stock would
(1) Not result in fixed charges, as dividends are at the discretion of the Board
of Directors (BoDs),
(2) Not result in a fixed maturity date, as common stock does not mature and
(3) Likely increase the credit-merit of the organizationsince debt to equity
ratio would be reduced due to increase in the equity resulting from the
issuance of additional common stock.
COST OF CAPITAL AND FINANCIAL STRATEGIES
KNOWLEDGE POINT:
Factors affecting the cost of capital

Concept of Leverage and Business Risk in financing

Guidelines appropriate in developing financial strategies

KEY CONCEPTS:
Cost of Capital - Summary Concepts and Relationships:

Organization's
Capital
Requirements

Long - Term Short - Term

Requirements Requirements

Sources of capital
funding that do
not mature within
one year

Common Stock Variations

Long-Term Financial Preferred
Bonds (including (Hybrids) of
Notes Leases Stock
Retained these kinds of
Earnings) securities

Cost of Capital:
The cost of availing capital from each of the above sources is the rate of return
that each source requires, which depends on the investors’ opportunity
costi.e. thereturns available from other comparable investments in the
market. However, such cost for each sources of capital will be calculated
differently and the cost of each component of capital will be unique for each
organization.
Factors affecting the cost of capital:
Macroeconomic conditions:
• Contains market conditions and expectations concerning economic
elements such as interest rates, tax rates and inflation/deflation rates.
Increasing interest rates, tax rates and inflation or expectation thereof
will cause a higher cost of capital.
Organization’s past performance:
• Represents operating and financial decisions taken by management and
the riskiness related with those decisions. The more the inferred risk
inherent in past performance, the greater the risk premium required and
consequently the cost of capital.
Funding amount:
• Identifies that the higher the absolute amount of funding sought, the
higher the cost of capital.
Relative level of debt funding:
• Identifies that at some level of debt funding; increasing funding sought
through debt will increase the cost of marginal debt and cause a higher
the cost of capital.
Maturity of Debt:
• Identifies that the lengthier the maturity of debt, the greater the cost of
capital. The longer the debt, the more the risk of interest rate variations
thus, a maturity premium for that risk is charged by financiers.
Security of Debt:
• Identifies that the more the value of security comparative to the amount
of debt, the lesser the rate of interest or cost of capital.

Historic Rates of Return:

To gain an insight into the comparative average cost of each component of
capital over long time span;rates of return earned historically by investors on
various forms of investment needs to be analyzed. For instance, one study
(Ibbotson &Sinquefield) shows the following long-run annual rates of return:
Security Type Annual Rate of Return
Long – Term Corporate Bonds 5.9%
Common Stock 12.3%
Common Stock – Small Firms 17.6% (Others have shown as low as
12.7%)
 The rate of return on preferred stock reasonably could be expected to be
greater than that of bonds, but less than that of common stockbecause
preferred stock has combined features of bonds and common stockboth.
Financing, Leverage and Business Risk:
Notonly the cost of capital but also the business risk of the organizationis
affected by the mix of capital funding.
Concept of Leverage:
In a business environment, the use of borrowing, cost structure, or other
arrangement to increase the potential benefit derived from an undertaking,
operation or position is known as leverage. In financial management,two
types of leverage are common:

Leverage

Operating Financial
Leverage Leverage
A) Operating Leverage:
➢ Measures the degree to which anorganization incurs fixed cost in its
operations.
➢ With a higher fixed cost, operating results can get affected dramatically due to
a substantialreduction in sales. Thus, all other things equal, the more
anorganization's fixed cost, the higher its business risk.
➢ On the other hand, there will be a higher increase in return on equity, if sales
increase for anorganization with a high degree of operating leverage.
➢ To calculate the degree of operating leverage (DOL) the following formula is
used:
% change in operating income
DOL =
% change in unit volume

➢ Here, it is noteworthy that the operating income is used in numerator, which

does not take into account financing expense.

B) Financial Leverage:
➢ Financial leverage is a measure of risk as the level of debt funding
increases.Financial Leverage measures the extent to which an organization
uses debt funding.
➢ Normally, debt is a less costly form of fundingas compared to equity; thus,
anorganization would like to use as much debt funding as is reasonable so as
to offergreater returns to shareholders.
➢ However, the risk connected with debt increases as more and more debt is
issued. Therefore, the cost i.e. rate of interest on additional debt needs to be
higherto compensate financiers for the increased risk. The risk to
shareholders that the interest payments and/or principal repayment cannot
be metalso increases.
➢ To calculate the degree of financial leverage (DFL) the following formula is
used:
% change in EPS
DFL =
% change in EBIT
Where; EPS = Earnings per share
EBIT = Earnings Before Interest and Taxes
Financing Strategies:
At any point in time,
 An organization's
historic funding
strategy is evident
from its Balance
Sheet

Liabilities and
Assets Shareholder's
Equity

Results of the
organization's How the organization's
accumulated investment undertakings have been
in projects and other financed
undertakings

For any new project, the organizationusually will have various alternative
ways of funding it. Even though the best funding alternative will be based on
all the facts and circumstances existing at the time, certain guidelines for
appropriate funding strategy exist.
Guidelines for appropriate financing strategy:

Guidelines for
appropriate
financing
strategy

Hedging Optimum Tax rate

Business risk
principle of capital structure advantage
constraint
financing objective effect

The below mentioned guidelines should be consideredwhile deciding the

nature and weightage (proportion) of resources used by an organization in
funding its operations and projects.
A) Hedging principle of financing:
➢ This guideline (also termed as the principle of self-liquidating debt) provides
that short-term needs should be financed with short-term sources of funding
and permanent or long-terminvestments in assets should be financed with
permanent or long-term sources of capital. The objective of this principle is to
match cash flows from assets with the cash requirements need to satisfy the
associated funding.
➢ Accordingly, equity or long-term debt shall be considered to finance long-term
assets (e.g. property, plant and equipment among others) andpermanent
amounts of current assets (e.g. level of accounts receivable and inventory
normally on hand). On the other hand, temporary sources of financing shall be
considered to finance temporary investments in assets (e.g. a temporary
increase in inventory to meet seasonal demand).

B) Optimum capital structure objective:

➢ This guideline provides to minimize anorganization's aggregate cost of
permanent (long-term) capital funding by using an optimum (or satisfying)
mix of equity and debtelements. The objective in forming the organization's
capital structure is to determine the set or sets of capital sources that offers
the lowermost composite cost of capital (i.e. weighted average cost of capital)
for the organization.
➢ As anorganization will have common stock, a keyconcern is how much debt
funding it should use comparative to its equity funding.
➢ As noted above, basic long-term debt funding is less costly than common stock
funding. (This is quite logical, because the tax benefitarising from debt
expense – interest - is tax deductible, while the cost of common stock –
dividends - is not.)
➢ Therefore, as discussed in the concept of financial leverage, organizations will
be interested to use more amounts of long-term debt for funding. Still, at some
level of comparative debt, the increased risk of nonpaymentconnected with
the debt will require debt investors to demand such a high return (default
premium) that the cost of debt may be more than the cost of common stock.

C) Business risk constraint:

➢ This guideline provides that anorganization with greatervariability in its
operating results should limit the extent to which it uses debt funding (i.e.
 financial leverage). Organizations with a higher level of business risk should
use less debt funding than an organization with stable operating results
because such organizations (i.e. organizations with a higher level of business
risk) have a greater possibility that operating results may cause default on
fixed obligations.
➢ The uncertainty inherent in the nature of the operations of the business can
be considered as a driving element for business risk. Such business risk would
be affected by factors such as macroeconomic conditions, degree of
competition, size, diversification and operating leverage etc.
➢ Business risk is measured in terms of the variability of anorganization's
expected operating earnings (i.e. earnings before interest and taxes(EBIT)).
Higher variation indicatesgreater risk.

D) Tax rate advantage effect:

➢ This guideline provides that other things being equal, the benefit of debt
funding would be higher if the tax rate of anorganization is higher. Because
the cost of debt – i.e. interest - is tax deductible, it produces a tax advantage to
the organization. Consequently, the higher amount of tax savings could be
possible from the use of debt funding rather than using equity funding; the
higher the tax rate relevant to anorganization.

Summary:
The key alternatives available to an organization for funding its financial needs

The nature of an organization's capital and financial structure

Financial needs reated to its capital projects and ongoing operations

Various sources of long - term and short - term funding

Cost of such different sources of funding and

The benefits and drawbacks of each such sources

To conclude, guidelines for an effective funding strategy have been explained

and discussed.
QUESTION BANK

Example1: A company has $ 30,00,000 of outstanding debt and $ 20,00,000 of

outstanding common equity. Management plans to maintain the same
proportions of financing from each source if additional projects are
undertaken. If the company expects to have $ 1,20,000 of retained earnings
available for reinvestment in new projects in the coming year, what dollar
amount of new investments can be undertaken without issuing new equity?
a) $0 b) $ 24,000 c) $ 90,000 d) $
3,00,000
Solution: d) $ 3,00,000
Explanation:The proportion of equity in the financial structure of the
organization is the value of outstanding equity divided by the total value of all
financing sources.
Value of Equity $ 20,00,000
= = 0.4
Value of Debt + Value of Equity $ 30,00,000 + $ 20,00,000

Since the Example states that the organization will maintain the same weight
of each financing source, each dollar invested is composed of 40 cents of
equity and 60 cents of debt. The first $ 1,20,000 of equity used in financing
new projects is sourced from retained earnings. This source of equity is
exhausted when the firm reaches an investment level of:
$ 1,20,000
= $ 3,00,000
0.4

When the level of investment exceeds this amount, equity financing must be
raised externally.
Example2: A company has $ 13,00,000 of 12% debt outstanding and $
10,00,000 of equity financing. The required return of the equity holders is
14% and there are no retained earnings currently available for investment
purposes. If new outside equity is raised, it will cost the firm 18%. New debt
would have before-tax cost of 10%, and the corporate tax rate is 40%.When
calculating the marginal cost of capital, the company should assign a cost of
[List I] to equity capital and [List II] to the after-tax cost of debt financing.
 Option List I List II
a 14% 7.2%
b 14% 6%
c 18% 6%
d 18% 7.2%

Solution: c) List I – 18%; List II – 6%

Explanation:The marginal cost of equity financing is 18% and the after-tax
cost of new debt financing is 10% × (1 − 0.4) or 6%.
Example3: The theory underlying the cost of capital is mainlyrelated with the
cost of_______.
a) Any mix of old or new, short-term or long-term funds
b) Long-term funds and new funds
c) Short-term funds and new funds
d) Long-term funds and old funds
Solution: b) Long-term funds and new funds
Explanation:The theory underlying cost of capital is associated to existing
long-term fundingand availing fresh long-term funding.
Example 4: The capital structure of anorganization contains bonds with a
coupon rate of 10% and an effective interest rate is 12%. The corporate tax
rate is 40%. What is the firm’s net cost of debt?
a) 10% b) 7.2% c) 6%
d) 12%
Solution: b) 7.2%
Explanation: The cost of debt is equal to the effective rate less the tax benefit
or 7.2% [12% × (1–0.4)].
Example5:A Ltd. is considering a project for the coming year that will cost $
10,00,00,000. A Ltd. plans to use the following combination of debt and equity
to finance the investment:
➢ Issue $ 3,00,00,000 of 10-year bonds at a price of 102, with a coupon rate of
9%, and flotation costs of 2% of par. The after-flotation cost yield is 9.09%.
➢ Use $ 7,00,00,000 of funds generated from earnings.
➢ The equity market is expected to earn 14%. US Treasury bonds are currently
yielding 6%. The beta coefficient for A Ltd. is estimated to be 0.70. A Ltd. is
subject to an effective corporate income tax rate of 30%.
The before-tax cost of A Ltd.’s planned debt financing, net of flotation costs, in
the first year is
a) 9.09% b) 10% c) 7.92% d)
8%
Solution: a) 9.09%
Explanation:The cost of debt before tax is the bond yield to maturity, 9.09%.
Example6:A Ltd. is considering a project for the coming year that will cost $
10,00,00,000. A Ltd. plans to use the following combination of debt and equity
to finance the investment:
➢ Issue $ 3,00,00,000 of 10-year bonds at a price of 102, with a coupon rate of
9%, and flotation costs of 2% of par. The after-flotation cost yield is 9.09%.
➢ Use $ 7,00,00,000 of funds generated from earnings.
➢ The equity market is expected to earn 14%. US Treasury bonds are currently
yielding 6%. The beta coefficient for A Ltd. is estimated to be 0.70. A Ltd. is
subject to an effective corporate income tax rate of 30%.

Assume that the after-tax cost of debt is 9% and the cost of equity is 15%.
Determine the weighted-average cost of capital.
a) 13.2% b) 8.5% c) 9.5% d)
6.3%
Solution: a) 13.2%
Explanation:The cost of debt and equity is weighted in proportion to its
percentage of the total financing. $ 30 million or 30% of the financing is
coming from debt and $ 70 million or 70% is coming from equity. Therefore,
the weighted-average cost of capital is 13.2% = (30% × 9%) + (70% × 15%).
Example7:Select the factor that might cause anorganization to increase the
debt in its financial structure.
a) A rise in the price-earnings ratio (P/E Ratio)
b) A rise in the federal funds rate
c) Greater economic uncertainty
d) Arise in the corporate income tax rate
Solution: d) Arise in the corporate income tax rate
Explanation:Tax advantage is available on interest. Hence, a rise in income
tax rate would decrease the post-tax cost of debt as a form of funding.
Example8:Select the situation in which the benefits of debt funding over
equity funding are likely to be highest.
a) Many noninterest tax advantages and low marginal tax rates
b) Many noninterest tax advantages and high marginal tax rates
c) Few noninterest tax advantages and low marginal tax rates
d) Few noninterest tax advantages and high marginal tax rates
Solution: d) Few noninterest tax advantages and high marginal tax rates
Explanation: When the marginal tax rate is high and the organization has few
noninterest tax advantages, the deduction for interest on debt is maximized.
Example9: Anorganization’s target or optimal capital structure is consistent
with which one of the following?
a) Least weighted-average cost of capital (WACC)
b) Least cost of equity
c) Least cost of debt
d) Maximum earnings per share (EPS)
Solution: a) Least weighted-average cost of capital (WACC)
Explanation:Optimal capital structure results in the minimum weighted-
average cost of capital (WACC).
Example10: The degree of operating leverage (DOL) is
a) Lesser if the degree of total leverage is greater, other things held constant
b) A measure of the change in operating income ensuing from a given change
in sales
c) A measure of the change in earnings available to common stockholders
related with a given change in operating earnings (i.e. EBIT)
d) Identical at all levels of sales
Solution: b) A measure of the change in operating income ensuing from a
given change in sales
Explanation:The degree of operating leverage (DOL) is a measure of the
change in earnings available to common stockholders related with a given
change in sales volume. It is computed, for a specified level of sales, as
% change in operating income
DOL =
% change in unit volume

Example11: When anorganization finances each asset with a financial

instrument of the same approximate maturity as the life of the asset, it is
applying: (CMA adapted)
a) A hedging approach
b) Financial leverage
c) Return maximization
d) Working capital management
Solution: a) A hedging approach
Explanation:The approach of matching asset and liability maturities is known
as a hedging approach. The approach helps ensure that funds are produced
from the assets when the connected obligations are due.
Example12: Assume that nominal rate of interest just increased significantly
but that the expected future dividends for anorganization over the long run
were not affected. As a result of the rise in nominal rate of interest, the
organization’s stock price should ___________.
a) Change, but in no obvious direction b) Stay constant c) Decrease
d) Increase
Solution: c) Decrease
Explanation: If market (nominal) rate of interest raise significantly, the yield
available through interest paying investments will rise. That will lead
investors, including those with investments in stock, to take the advantage of
greater interest yields into account while making or appraising investments. If
to continue to provide a competitive return;anorganization's stock does not
offer higher dividends, then the stock price will decline. The lesser stock price,
along with the same level of dividends, will make a stock competitive with
alternative investments in the market due to resulting enhancedrate of return
on the stock.
Example13:Most commonly,the cost of debt is measured as:
a) Actual rate of interest - tax benefits
b) Actual rateof interest + a risk premium
c) Actual rateof interest adjusted for inflation
d) Actual rate of interest
Solution: a) Actual rate of interest - tax benefits
Explanation: Most commonly,the cost of debt is measured as the actual rate
of interest less the tax advantage. The tax benefit result because the interest
expense is deductible for tax purposes and the ensuing tax advantage
decrease the effective cost (and rate) of debt funding. For instance, if the
(stated)actual rate of interest is 20% and the rate of tax is 30%, the effective
rate of interest (actual rate of interest less tax benefit) will be 20% x (1.00 -
0.30) or 20% x 0.70 = 14% effective cost of debt.
Example14:Select the correct statement(s)regarding the use of short-term
funding by an organization.
i) Short-term funding normally has a lesser risk of illiquidity than long-term
funding.
ii) Short-term funding normally provides more financial flexibility than long-
term funding.
iii) Short-term funding normally has a lesser rate of interest than long-term
funding.
a) i only b) i and ii c) ii and iii d) i, ii and
iii
Solution: c) ii and iii
Explanation: Statementi is not correct since short-term funding normally has
a greater (not lesser) risk of illiquidity than does long-term funding.
By its nature, short-term borrowing must be repaid or refinanced in the near
term and, on an on-going basis, more often than long-term debt.It might be
impossible for the organization to either repay or refinance the debt due
tochanges in the economic environment or changes within the entity. In that
case, the organization would be technically bankrupt.

Usually, more financial flexibilityis offered to anorganizationby the short-term

fundingrather than long-term funding.
With changes in the requirement for funds, the level of borrowing can be more
readily contractedor expanded with short-term funding.With changes in
requirements for funds,the level of borrowing cannot be freely adjustedwith
long-term funding, especially when there is a reduction in the requirement for
debt.

Short-term funding is normallyinexpensive than long-term funding.

For a given borrower at a specific point of time, generally, rate of interest on
short-term borrowings are lesser than rate of interest on long-term
borrowings.
Example15: A Ltd. sold $ 40 million of long-term debt in the current year.
What is a major benefit to A Ltd. with the debt issuance?
a) The decrease of A Ltd.'s control over the organization
b) The greater financial risk ensuing from the use of the debt
c) The comparatively low post-tax cost due to the interest deduction
d) The decreased earnings per share (EPS) possible through financial leverage
Solution:c) The comparatively low post-tax cost due to the interest deduction
Explanation:The interest expenseresulting as a consequence of issuance of
debt is deductible for tax purposes. Consequently, the effective cost of debt is
lesser than its specified rate of interest by the amount of taxbenefits
receiveddue to such interest deduction. The effective cost of debt is its interest
cost x (1 –rate of tax).
Example16: According to the hedging principle (or the principle of self-
liquidating debt), in making decisions regarding the maturity structure of an
organization's funding, kindly select the most appropriateguidelines.
a) Finance a project that will profit fornine years with a short-term note
b) Finance an expansion, other than temporary, in accounts receivable by
selling long-term bonds
c) Finance a project with short-term paybacks by selling common stock
d) Finance a seasonal expansion in inventory by selling bonds
Solution:b) Finance an expansion, other than temporary, in trade receivable
by selling long-term bonds
Explanation:The hedging principle provides that the maturity structure of an
organization's funding should be consistent with the cash flow generated by
the asset being funded. Projects or assets that offer short-term paybacks
should be funded with short-term financing and projects or assets of long-
term time span or advantage should be funded with permanentor long-term
financing.
Hence, an expansion, other than temporary (i.e. permanent), in trade
receivable, which will necessitate a permanent increase in funding, should be
financed by selling long-term bonds (or, if the alternative is made available,
common stock issuance).
Example17:Select the corporate characteristic that would favor debt funding
versus equity funding.
a) Low aversion to risk b) Below-average stock
issuing costs
c) A high tax rate d) A high debt-to-equity ratio
Solution:c) A high tax rate
Explanation:The cost of debt (i.e. interest expense) is tax deductible and
consequentlypresents a tax benefit.Other things being equal, the greater
benefit from debt financing will occur to an organization withhigher rate of
tax.Hence, the nominal cost of the debtis being offset by such tax benefit. Since
interest is not paid on dividends to equity holders and as dividends are not tax
deductible, there are no similarbenefitsconnected to equity funding.
Example18:Select the correct option that would motivate anorganization to
use short-term loans to retire its 15-year fixed-rate callable bonds that have
five years until maturity?
a) The organization is facing cash flow difficulties
b) Rate of Interest have dropped over the previousten years
c) Rate of Interest have increased over the previousten years
d) The organizationanticipatesrate of interest to increase over the subsequent
five years
Solution:b) Rate of Interest have dropped over the previous ten years
Explanation:If rate of interest have dropped over the previous ten years, an
organization can presently borrow at a lesser rate of interest than that on the
earlier, fixed-rate debt. Therefore, anorganization would be motivated to
swap the outstanding fixed-rate bonds with short-term borrowings with a
lesser interest cost.
Example19:A company has $ 13,00,000 of 12% debt outstanding and $
10,00,000 of equity financing. The required return of the equity holders is
14% and there are no retained earnings currently available for investment
purposes. If new outside equity is raised, it will cost the firm 18%. New debt
would have before-tax cost of 10%, and the corporate tax rate is 40%.When
calculating the marginal cost of capital, what cost should the company assign
to equity capital and to the after-tax cost of debt financing?
Option Cost of Equity After-Tax Cost of Debt
a 14% 7.2%
b 14% 6%
c 18% 6%
d 18% 7.2%

Solution: c) Cost of Equity – 18%; After-Tax Cost of Debt – 6%

Explanation:The marginal cost of equity financing is 18% and the after-tax
cost of new debt financing is 10% × (1 − 0.4) or 6%.
Working Capital management

INTRODUCTION

Working Capital is the difference between a firm's current assets and its current
liabilities.It represents a company's ability to pay its current liabilities with its
current assets. Working capital is an important measure of financial health
since creditors can measure a company's ability to pay off its debts within a
year.

Formula: Working capital = Current assets − Current liabilities

It is the difference between a firm’s current assets and current liabilities. The
challenge is to determine the proper category for the vast array of assets and
liabilities on a corporate balance sheet and deciding the overall health of a firm
in meeting its short-term commitments.

It is an indicator of the short-term financial position of an organization and is

also a measure of its overall efficiency. Working capital ratio indicates whether
the company possesses sufficient assets to cover its short-term debt. It also
shows the liquidity levels of companies for managing day-to-day expenses and
covers inventory, cash, accounts payable, accounts receivable and short-term
debt that is due. It is derived from various company operations such as debt and
inventory management, supplier payments and collection of revenues.
Explanation on Current Assets and Current Liabilities

The above elements are short-term balance sheet elements, defined as follows:

Current Assets:

Generally resources expected to be converted to cash, sold, or consumed within

one year which a company currently owns (tangible and intangible both) that it
can easily turn into cash within one year or one business cycle, whichever is
less. Further categories include Current and savings accounts; highly liquid
marketable securities like stocks, bonds and ETFs; money market
Accounts; cash and cash equivalents, accounts receivable, stock, and other
shorter-term prepaid expenses. Generally current assets do not include long-
term or illiquid investments such as long term hedge funds, real estate, or
collectibles.

Current Liabilities:

It generally includes obligations due to be settled within one year.It also

includes all the debts and expenses the firm expects to pay within a year or one
business cycle, whichever is lesswhich includes all the normal costs of running
the business such as rent, utilities, materials and supplies; interest or principal
payments on debt; accounts payable; accrued liabilities; and accrued
income taxes. Other current liabilities generally include dividendsand long-term
debt that is due within a year.
Naturally a working capital ratio does change over a period of time as a
company's current liabilities and current assets are based on a 12-month
period.

As such working capital figure can change every day and every time, depending
on the nature of a company's debt. What was once a long-term liability, such as a
5-year loan, becomes a current liability in the ninth year when the repayment
deadline is within a year. Similarly, what was once a long-term asset, such as
real estate or equipment, suddenly becomes a current asset when a buyer is
there and company intends to sell.

It fully depends on company's cash flows whether a company is able to pay its
liabilities when due. The working-capital formula assumes that a company
really would liquidate its current assets to pay current liabilities, which is not
always realistic considering some cash is always needed to
meet payroll obligations and maintain operations. Further, the working-capital
formula assumes that accounts receivable are readily available for collection,
which may not be the case for each company.

There are some other aspects to be considered also important to understand

like the timing of asset purchases, payment and collection policies, likelihood
that a company will write off some past-due receivables and even capital-raising
efforts which can generate different working capital needs for similar
companies. It is also important to note that working capital needs vary from
industry to industry, considering how different industries depend on expensive
equipment, use different revenue accounting methods, and approach other
industry-specific matters.

To keep working capital stable is difficult task for manufacturers and other
companies that require a lot of up-front costs. Hence, comparison of working
capital is generally most meaningful among companies within the same industry
and "high" or "low" ratio should be made within this context.

It is also to be noted that working capital cannot be depreciated the way fixed
assets are. Components of working capital, such as inventory and accounts
receivable, may lose value or even be written off, but it does not follow
depreciation rules. It can only be expensed immediately to match the revenue
they help to generate.

Working capital can be devalued when market values of some assets are
measured. It happens when asset's price is below its original cost. Generally it
happens in case of inventory and accounts receivable.

Sometimes Inventory obsolescence can be a real issue. It does happen when, the
market for the inventory has priced it lower than the inventory's initial
purchase value as recorded in the accounting books. To reflect current market
conditions and use the lower of cost and market method, a company marks the
inventory down, resulting in a loss of value in working capital.

At the same time, few receivables may become not collectible at some point of
time and have to be written off, which is another loss of value in working capital.
As such losses in current assets reduce working capital below its expected level
it may have to be infused through longer-term funds or assets, but a costly way
to finance additional working capital.
Good or ugly to have a large amount of working capital?

If one includes a company's contingent reserve cash in its assets within the
working capital formula , then a large amount of working capital is a good
indicator that the company will be financially able to repay its payables and
other short-term debt even if business were to suddenly dry up.

But, if one is using only a company's cash needed for "day-to-day" operations in
the current assets part of the working capital formula, then a large amount of
working capital with a relatively small amount of cash could mean potential
issues. It could mean the company may face trouble to move its inventory,
collecting its receivables from customers too slowly, paying its vendor's
payables too quickly. If the company has little cash available and it's unable to
do well in those three categories, the company could run into problems paying
its bills and vendors.

Is a negative working capital amount always a bad?

While a negative working capital amount typically warns that a company has
more short-term debt than it has in cash and other assets, it sometimes results
in to the smart use of cash resources depending on the company's business
model.

In Dell's , for example, the company was able to assemble its personal
computers and sell them directly to customers more than 30 days before the PC
maker needed to pay its suppliers.

But it gave Dell large accounts payable balances (a negative working capital
balance), the company was able to make and sell computers by essentially using
its suppliers' money without ever having to dip into its own cash reserves!
Objectives of Working Capital Management:

It is most important to set business goals and management strategies,

techniques and methods to manage working capital of business. Few important
objectives of working capital management are listed below:

1. To optimize of Working Capital Cycle:

Generally, working capital cycle commences from the day raw materials are
acquired and ends when the finished products are sold. One of the major
objectives of working capital management is to ensure that there is no
hindrance in above mentioned process. It includes collecting and processing of
raw materials and other initial investment in time, placing all the essentials for
production, selling finished products as soon as possible, collecting account
receivables on time and clearing all the account payable’s in time.

2. To balance Working Capital:

The good net working capital is required to stay in a stable equilibrium. The
ratio of current assets and current liabilities should be optimized. As the lower
value of this ratio implies that company is not financially stable to clear its debts,
higher value is also not an indication of prosperity, it may suggest like that the
company has too many inventory piled up and they are not investing in excess
cash.

3. To minimize Cost of Capital:

It focuses on minimizing cost of capital, rate of interest. It is only when the cost
of capital will be lesser than revenue, one can earn profit. Utilization of long-
term funds is one way of minimizing capital cost. The principle states that long
term sources should finance fixed assets and permanent assets. Also, the short-
term or temporary assets should be financed by short-term sources of finance.

4. To assist the Business to avoid excess-borrowing:

Excess-borrowing is among the quickest way towards business growth as well

as business failure. Excess-borrowing leads to mismanagement of finance as
well as assets. Their business goes far beyond their financial goals which lead
towards financial failure. A proper working capital management will definitely
reflect warning sign where you can put your control towards business
expansion.

5. To facilitate to earn Optimal Return:

The return on the investment infused on short term basis must exceed the
average cost of capital to ensure wealth maximization. Say the rate of return
earned from the investment in short term assets should exceed the rate of
interest or cost of capital. Working capital management aims to extract
maximum from an investment in current assets to ensure higher profitability.

6. To facilitate expansion of Company’s Investment:

Saved money from working capital management is being an inexpensive source

of finance that can be used for your business expansion, funds for existing
projects or company’s investment toward expansion of their idea and vision
towards growth of an organization.
7. To establish healthy Relation with Suppliers:

When a business has defined objectives of working capital and engaging its best
management concerning its working capital along with other financial
indicators. Then lenders or suppliers will be more interested in carrying a
business with you. Their understanding of the business, management setup will
definitely boost confidence within the business.

Factors Governing Working Capital

1. Type of Business:

A trading Company requires large working capital while industrial concerns

may require relatively lower working capital. A banking company, of course
requires maximum amount of working capital. Public utilities, businesses
dealing in staple products, e.g., necessaries, require low working capital as they
have a steady demand and continuous cash-inflow enough for current liabilities.

2. Size of the Unit:

The amount of working capital depends directly upon the volume of business.
The greater the size of a business unit, the larger will be the requirements of
working capital.

3. Terms of Purchase and Sale:

Use of trade credit may lead to lower working capital, while cash purchases will
demand large working capital. Similarly, credit sales will require larger working
capital, while cash sales will require lower working capital.
4. Inventory Turnover:

If inventories are large and their turn-over is slow, it requires larger capital but
if inventories are small and their turnover is quick it requires lower working
capital.

5. Process of Manufacture:

Long period, complex and round about process of production will require larger
working capital, while simple, short period process of production will require
lower working capital.

6. Importance of Labour:

Capital intensive industries, i.e., mechanized industries, will require lower

working capital, while labour intensive industries such as small-scale and
cottage industries will require larger working capital.

7. Proportion of Raw Material in Costs:

If raw materials are costly, larger working capital base is required and if raw
materials are cheaper and constitute a small part of the total cost of production
it requires lower working capital.

8. Cash Requirement:

In case of a demand for larger cash needs, company shall have larger working
capital, e.g., at the time of dividend payment, taxation, interest charges, wages
and salaries, it requires enough cash. If a company has shortage of working
capital, it may have to skip payment of cash dividends or reduce the dividend
rate or issue stock dividends.

9. Seasonal Variations:

During pick season, a business requires larger working capital while during the
slack season a company requires lower working capital. E.g. in sugar industry
the season is in monsoon; while in the woolen industry the season is the winter.
Usually the seasonal need of working capital is financed by temporary
borrowing.
10. Banking

If the corporation has good banking relations and credit facilities, it may have
minimum margin of regular working capital. But in the absence of it, it should
have relatively larger amount of net working capital.

11. Growth and Expansion:

For normal rate of expansion in the volume of business, a company may have
greater proportion of retained earnings to provide for more working capital but
for fast-growing concerns, we shall require larger and larger amount of working
capital. A plan of working capital should be formulated to the future as well as
present needs of a corporation. Permanent working capital must be secured on
a long-term basis.

Management of Net Working Capital

Sufficient net working capital is required to avoid the risk of interrupting

operations and the ability to meet current obligations, but excess net working
capital reduces the rewards, which could be recognized by the firm through
investment with higher returns.

Itis the measure of a company’s liquidity and its ability to meet short-term
obligations, to fund operations of the business. To have more current assets
than current liabilities and thus having a positive net working capital balance is
ideal scenario.

The working capital management includes the management of the major

elements of working capital including:

• Cash
 • Marketable securities
• Accounts receivable
• Inventories
• Current liabilities

Cash Management

Introduction

Cash is also essential for financial stability while also usually considered as part
of a total wealth portfolio. It is the process of collecting and managing cash
flows. It can be important for both individuals and companies. It is a key
component of a company's financial stability.

Generally businesses have a wide range of offerings available across the

financial marketplace to help with all types of cash management requirements.
Banks are typically a primary financial service provider for the same. Different
cash management solutions are also available for individuals and businesses to
obtain the best return on cash assets or the most efficient use of cash
comprehensively.

Cash is the primary current asset that companies use to pay their obligations on
a regular basis. In business, companies have cash inflows and outflows that
must be prudently managed in order to meet payment obligations, plan for
future payments, and maintain adequate business stability.

It is also often known as treasury management. Business managers, corporate

treasurers, and chief financial officers are typically the main individuals
responsible for overall cash management strategies, cash related
responsibilities, and stability analysis. Many companies may outsource part or
all of their cash management responsibilities to different service providers.
There are several key metrics being monitored and analyzed by cash
management executives on periodical basis.

The cash flow statement is a central component of corporate cash flow

management. It is often reported to stakeholders on a quarterly basis, parts of it
are usually maintained and tracked internally on a daily basis. The cash flow
statement comprehensively records all of a business’s cash flows. It includes
cash received from accounts receivable, cash paid for accounts payable, cash
paid for investing, and cash paid for financing. The bottom line of the cash flow
statement reports how much cash a company has readily available.

Importance of cash management

No cash situation in our lives can be a nightmare and for a business it can be
devastating and for small businesses, it can lead to a point of no return. It affects
the credibility of the business and can lead to them shutting down. Hence, the
most important task for business managers is to manage cash.

Business Management needs to assure that there is adequate cash to meet the
current obligations and there are no idle funds as well. It is also important as
businesses depend on the recovery of receivables. If a debt turns into bad or no
recoverable, it can hamper the cash flow and business operations. Hence, cash
management is also about being cautious and making enough provision for
contingencies like bad debts, slowdown, etc.

Functions of cash management

Ideally an organization should be able to match its cash inflows to its cash
outflows. Cash inflows majorly include recovery from account receivables and
cash outflows majorly include account payables.
While cash outflows like payment to suppliers, operational expenses, payment
to regulators are more or less certain, cash inflows can be tricky. So the
functions of cash management can be explained as follows:

Cash Budgets

Base for determining a firm's cash requirements is its cash budget, which
presentsbudgeted cash receipts and disbursements for each budget period. If
the projected cash balance is higher than the required, management can plan to
make investments or pay down existing debt. On the other hand, if a cash
shortage is projected, management can either reduce cash requirements, make
plans to borrow, or otherwise plan for the shortfall. To monitor these cash
balances, large firms prepare daily cash reports so that excess cash can be
invested and cash shortages provided for. As management projections of the
amount and timing of cash inflows and outflows may go wrong, companies must
invest in some amount of cash to hedge that uncertainty.

Cash flows

With reference to targeted cash balance, firms will seek to accelerate cash
inflows and defer cash outflows to have cash available for a longer period so
that it can be invested in higher return projects or undertakings. For example,
the claim to cash reflected by accounts receivable do not provide the return to
the firm that would result from collecting the account and investing the cash in
inventory or a capital undertaking.

Ideal cash management system is that prevents the insolvency and reduces the
days in account receivables, increases the collection rates, choose the suitable
investment vehicles that improve the overall financial position of the firm.

Sometimes the cash inflows are more than the outflows, or vice versa.Hence, a
firm has to manage cash affairs in a way, such that the cash balance is
maintained at its minimum level while the surplus cash is invested in the
profitable opportunities.

Controlling Cash Inflows

The interval between when a firm claims cash due to providing goods or
services and when that cash is actually available to the firm to reinvest should
be the shortest a. The long interval does not provide a return to the firm.
Therefore, the firm should establish policies and procedures to reduce this time
period, and to simultaneously provide security of the cash.

Companies are more concerned with reducing the time from when a customer
initiates payment until the cash is available for use. It is a time period commonly
referred to as incoming float.

This period of float may be reduced by following mechanism:

Lockbox system

It is an arrangement of several lockboxes that are strategically placed near

geographic locations of customers, so that aggregate time from the customers to
the lockboxes is minimized. It ishighly encouraged by banks, which earn a fixed
monthly fee for each box, as well as service charge for each payment processed.

For example, a company in Washington may elect to have lockboxes in Chicago,

Los Angeles, New York to reduce the incoming mail float for payments made
from customers located near these cities.

Banks provide a periodic review service to match the addresses from which
customers are issuing their payments to lockbox to see if the lockbox
configuration is well optimized. If not, they are shifted to more customer-centric
locations, and customers are notified to alter their remittances to new locations.
At the same time frequent shifting of lockbox locations is not recommended as it
annoys the accounts payable employees of customers, which must be kept
updated the pay-to addresses in their computer systems.

It is an excellent way to reduce mail float for a larger company that has a
worldwideor across the country customer base. It is not a requirement for a
smaller company with a local customer base to use more than a single lockbox,
as any reduction in mail float is more than offset by the related bank fees.

Lockbox Operations
Under this system, the post office boxes are leased by a company in areas where
it has a high volume of payments through the mail. Customers do payment to
those post office locked boxes. The firm's bank collects the remittances from the
boxes and processes and deposits the checks directly to company's account. The
bank then notifies the firm and amounts collected so that the firm can update its
cash and receivables accounts. A lockbox arrangement may reduce the incoming
float from a week to couple of days which provide following benefits:

• Cash is available for use sooner than later.

• The efforts spent for handling collections drops considerably, resulting in
less cost and greater security.
• It helps to reduce likelihood of dishonored checks.

The Advantages and Disadvantages of Lockbox Banking

With this payment processing services, there are both pros and cons to lockbox
banking. It provides companies with a very efficient way of depositing customer
payments. This is especially beneficial when a company is unable to deposit
checks on a timely basis or if it is constantly receiving customer payments
through the mail.
On the other hand, it can also be very risky. E.g. Bank employees who have
access to lockboxes are rarely checked which may cause the situation to
potential fraud. It occurs in the form of check counterfeiting as the checks that
are in the lockboxes provide all the information needed to make counterfeits.

Preauthorized checks

Checks are preauthorized by a payerand written either by the payee or by payee

's bank and then deposited in the payee's bank account.

As the title implies, under this arrangement cash is collected through checks
that are authorized in advance. Such an arrangement would be especially
appropriate for a firm to consider when its customers pay a fixed amount each
period for many periods.
Process:

1. First Customer's authorization and indemnification agreement with the

firm's bank is executed.
2. Firm builds database with needed information as required.
3. Each period the firm prepares an electronic file and deposit slip and sends
them to the bank for further processing.
4. The bank prints checks, deposits funds, and processes checks through the
clearing system.
5. In automated process, the bank would process the electronic file through
the Automated Clearing House network which would reduce the paying
party's bank account and credit the receiving party's account within same
day.

Advantages

• Cash is available for use instantly.

• The firm's follow up of collection is reduced considerably, resulting in less
time and cost and higher security.
• Customers may appreciate not having to deal with periodic bills.

Preauthorized debit/credit card

When one makes a purchase through credit or debit card, banking institution
sets aside, or holds money to verify
whether the cost of the service is
available in account. It is the process
by which they approve sufficient
funds to cover the cost of transaction.
It’s a verification of funds for the merchant’s credit card processor.

Through debit card transactions, holds are released and balance are corrected
instantly after the transaction occurred. Holds on credit card accounts can be in
place for as long as a month, depending on your bank. Under a preauthorized
debit or credit arrangements, cash is collected by a charge to a debit or credit
card that has been authorized in advance. The use of preauthorized debit/credit
cards has the same advantages as use of preauthorized checks.

Process:

• Customer provides information and authorization for transactions.

• Company charges debit/credit card as provided by authorization
• Company provides customer with receipt.
• Company's card processor submits charge through debit/credit card
interchange system to:
• Bank to recognize amount in Company's account
• Customer's card issuer to charge customer's account
• Charged amount shows up on Company's bank statement as deposit and
on customer's debit/credit card statement.

Remote deposit

It is the ability of a bank customer in the United States and Canada to deposit
a check into a bank account from a remote location from office or home, without
having to physically deliver the check to the bank. It is typically accomplished
by scanning a digital image of a check into a computer, then transmitting that
image to the bank. The practice became legal in the United States in 2004 when
the Check Clearing for the 21st Century Act (or Check 21 Act) took effect. This
service is typically used by businesses, though a remote deposit application and
has begun to be implemented by many banks.
Check 21 Act is intended in part to keep the country's financial services
operational in the event of a rapid long-distance transportation is impossible,
like the September 11, 2001, attacks. The Check 21 Act makes the digital image
of a check legally acceptable for payment purposes, just like a traditional
physical check.

With remote deposit, the entity receiving a check uses a special scanner to
develop a digital image of the checks called as “check truncation,” as the
processing of the physical paper check stops at that point and electronically
sends the images to its bank where they are processed as a deposit.

Advantages:

• Elimination of physical paper checks deposit at Banks.

• It generally allows clear faster resulting in funds deposited more quickly
and bad checks are detected instantly.
• Process can be integrated with the firm's accounting system.
• Digital images of processed checks and deposits are available as evidence
without the need for duplicate copies.

Concentration banking

Concentration banking is the practice of diverting the funds in a set of bank

accounts into an investment account, from which the funds can be more
efficiently invested. It usually requires that an organization keep all of its bank
accounts with a single bank. By doing so, the bank can shift the funds in
individual accounts into an investment account with a simple entry. When cash
is being concentrated from accounts managed by other banks, the concentration
process is more involved and more expensive.

Process of Concentration Banking

1. The places are identified first where company’s major customers are
located and then the local bank accounts are opened at each location.
2. After accounts are being opened, the local collection center or the bank
branch is identified where all the checks are collected from the customers.
3. The remittances from the customers can be collected either in person or
through the post. Once the checks are collected, they are deposited in the
local banks for the clearance.
4. The funds are transferred to the concentration Bank account through any
telegraphic/electronic transfer schemes.

It is to be noted that Concentration banking is needed when a business has a

number of subsidiaries or locations, each with its own accounts. When cash is
widely distributed in this manner, local managers are more likely to make non-
optimal cash investment decisions, resulting in a low or nonexistent return on
investments. By using concentration banking, an organization can hire an
investment manager who is responsible for investing all of the funds that have
been shifted into a centralized location.

The use of concentration banking can present legal problems, since the funds
are being taken away from subsidiaries that are legal entities, and whose
financial positions may suffer as a result of the cash withdrawal. To remedy this
problem, the cash transfers are recorded as loans from the subsidiaries to the
corporate parent. By doing so, the parent now has an obligation to eventually
return the funds to each subsidiary, along with the interest payable on each
loan.

It is used to accelerate the flow of cash to a firm's principal bank account. That
flow is achieved by having customers remit payment and company making
deposits to banks close to their locations. The funds collected in the multiple
local bank accounts are transferred regularly, and often automatically, to the
firm's account in its concentration bank.

For example, a company that has multiple chain stores across the country, with
each store depositing its cash into local banks. The company may establish that
these funds are concentrated or deposited into one account, usually called
a concentration account.

A concentration Bank account is a central deposit account that aggregates funds

from several locations into one centralized account. Banks may use
concentration accounts for fund transfers, private banking transactions, trust
and custody accounts, and international transactions. It allows for quick and
easy account management as it is easy to transfer from and deposit money into
a single account as opposed to having multiple accounts.

On flip side, Legal authorities heavily scrutinize concentration accounts as they

can be misused for money laundering. It will be more difficult to follow a money
trail if funds from disparate sources are combined in one central location.
For example, a bank employee can deposit customer funds along with
investment funds in one country and withdraw the same amount in another
country.As the funds are in pool, there is no way to know where the source or
destination of those funds.

Recently, The USA Patriot Act required banks to establish clearer policies for
detecting and reporting suspicious transactions and prohibited customers from
moving their own funds into, out of, or through the concentration accounts.

The benefits of concentration banking include:

• Cash available for use sooner than later.

 • For better controlling and usage, excess cash from multiple locations is
flowed to a single account.

• Arrangements can be made with the concentration bank to automatically

to invest cash in excess of needed amounts.

• “sweeping” facility takes excess funds from accounts, even within the
same bank, at the end of each work day and either invests those funds for
very short periods of time in short term instruments, or uses them to pay
down lines of credit.

Example

Suppose Arnold Ltd. is a multinational corporation with subsidiaries in ten

geographical locations within the United States. Initially, each subsidiary is
responsible for managing its own finances. However, this practice produces
wide imbalances in accounting. This is primarily because the performance of
each subsidiary varies based on market conditions and team. Fund transfers
between each of these branches are also a costly affair.

To streamline operations, ARNOLD LTD. sets up a concentration banking system

in which branches transfer a certain portion of their earnings into a central
bank. An investment manager, at the headquarters, is responsible for making
investment decisions related to funds in this account. Fund transfers from
subsidiaries to the parent institution are recorded as loans in accounting and
returned, along with interest earned, by the parent entity to the subsidiary.

Depository transfer checks/official bank checks

This system is used by a designated collection bank to deposit the daily receipts
of a corporation from multiple locations. Depository transfer checks are a way
to ensure better cash management for companies which have multiple cash
collection locations.
Data is transferred by a third-party information service from each location, from
which DTCs are created for each deposit location. This information is then
entered into the check-processing system at the destination bank for deposit.

They are used by companies to collect revenue from multiple locations, which
are then deposited in one lump sum accountin a bank.

The third-party information service is used to transfer the data through a

concentration bank. A concentration bank is the primary financial institution
where it conducts the majority of its financial transactions. The concentration
bank then creates DTCs for each deposit location, which is entered into the
system.

A depository transfer check looks like a personal check, except that "Depository
Transfer Check" is written across the top center of the face of the check. These
instruments are non-negotiable and do not bear a signature.

Businesses are given a key for a secured dropbox. Deposits, which are placed in
a bag with deposit slips, are dropped off in this dropbox after business hours.
The bank opens the drop box in the morning and deposits the overnight deposit
into the business' checking account.

Depository transfer checks are used to transfer funds between a firm'sinter

accounts. Depository transfer checks are generally unsigned, non-negotiable,
and payable only to an account of the firm.
For example, in a manual system, at the time of cheque deposit at a local bank, it
also prepares and sends a depository transfer check to its principal bank. The
receiving bank deposits the funds to the firm's account and processes the
depository check back to the local bank where funds were deposited by the
firm's unit.

As an alternative to traditional processing, an automated system exists which

transmits the deposit information electronically to the principal bank where the
actual check is prepared and processed, and the funds deposited to the firm's
account. Under either the traditional or the automated process, funds normally
are not available for the firm to use until the depository transfer check actually
clears the local bank.

DTC is an efficient way of transferring funds between a firm's banks when an

automated transfer system is used. Depository transfer checks may be used in
conjunction with a lockbox or concentration banking.

DTC-based systems have also slowly been replaced by Automatic Clearing

House (ACH). ACH systems are electronic funds-transfer systems that deal with
payroll, direct deposit, tax refunds, consumer bills, and other payment systems
in the United States.

Wire transfer

A wire transfer is an electronic transfer of funds across a network administered

by hundreds of banks or transfer service agencies around the world.
Wire transfers allow for the individualized transmission of funds from single
individuals or entities to others while still maintaining the efficiencies
associated with the fast and secure movement of money. It allows people in
different geographic locations to safely transfer money to financial institutions
around the globe.

These transfers are considered remittance transfers under U.S. law. However,
the term has represents any electronic transfer of money from one person to
another.

No physical money is transferred between banks when conducting a wire

transfer. Instead, information is passed between banking institutions about the
recipient, the bank receiving account number, and the amount transferred.

The Federal Reserve Bank Wire System and a private wire service operate in the
United States. As it is a relatively expensive method of transferring funds, wire
transfers should be used only for large transfers, for example, as a means of
moving large sums in a concentration banking arrangement.

Process

1. The sender of a wire transfer first pays for the transaction upfront at his
bank.

2. The recipient's bank receives all the necessary information from the
initiating bank and deposits its own reserve funds into the correct
account.

3. Both banks then settle the payment on the back end, after the money has
been deposited. This is why no physical transfer is made during a wire
transfer.

Nonbank wire transfers do not require bank account numbers. It is usually the
case with transfers by companies like Western Union, whose international
money transfer service is available in more than 200 countries.

Cash outflows Control

While cash inflows are all about receiving money into your business, cash
outflows are all about money going from your business.

Examples of cash outflows include payment of expenses, purchasing property or

equipment, or paying back loans.

The key to improve your cash out flow is to defer all outflows of cash as long as
it can while still meeting all obligations on time. Delaying cash outflows makes it
possible to maximize the benefits of each dollar in your own cash flow.

The sound management of cash outflows requires managing business liabilities.

It also requires followthe slogan that ‘Pay your bills on time, but never before
they are due.’

Following key areas should have been focused:

Trade credit

It allows deferring cash payments to suppliers until a later date, without calling
credit card interest and limits.
Trade discounts

It requires paying bills quickly to take advantage of a discount.

The central objective of deferring cash outflows is to make cash available for a
longer period and control cash disbursements for which following methods are
identified:

Purchases/Payments Management

It considers that certain things can be done to conserve cash both before and
after obligations are incurred.

These include:

• To establish and use charge accounts instead of cash. It includes the use of
credit cards, which can be limited in amount and types of purchases
permitted.
• To prefer suppliers that provides generous deferred payment terms.
• Not to pay bills before they are dueconsidering advantage of discounts
offered.
• Stretch payments which involve making payments after the established
due date.
Remote Disbursing Method

Remote disbursing is done to increase the float on checks used to pay

obligations. By increasing the float, cash is available longer time to pay for
obligations. It is accomplished by establishing checking accounts in remote
locations and paying bills with checks drawn on those accounts.

Hence, even when the entity being paid receives the payment in a timely
manner, it takes longer for the check to clear the account. Thus, it has use of the
funds for a longer period of time. In practical world, electronic processing
requirements have much eliminated the usefulness of remote banking for
delaying account reduction for any significant period of time.

Zero Balance Accounts Mechanism

It is based on an agreement between the firm and a bank under which the firm
has accounts with no balance. Under one arrangement, checks are written on
these accounts are processed as usual, resulting in to overdrawn accounts, but
by agreement with the bank these overdrafts are covered automatically at the
end of each day, by transfers from a master account. Thus, at the end of each
day, these accounts have no balance.

Under a different application of zero balance accounts, after a firm determines

an amount to be paid from an account, exact amount is deposited into the
account. Therefore, the account has no real balance at the end as any
outstanding checks are exactly equal to the account balance.

The benefits include:

• Near elimination of excess cash balances in those accounts

• Very little administration required, e.g., monitoring and reconciling
accounts
• Possible increase in payment float through use of zero balance accounts in
remote banks

Draft
A draft is an order to pay. Unlike a check which is drawn on an account of the
writer, a draft is drawn on an account of a bank. In essence, a draft is a form of
check that is guaranteed by the bank on which it is drawn.

Common forms of draft:

Bank draft

An order to pay drawn by a bank on itself or on other bank with which the
issuing bank has an account. Mostly used by banks dealing with other banks and
are “sold” by banks to customers. When purchased, the customer pays the bank
the amount of the draft and a fee and the bank issues the customer a draft
drawn on itself or its account with another bank. Thus, the customer has a check
that is guaranteed to be paid when presented.

It can be issued on an:

1. Individual basis—A single draft for a specified amount

2. Automatic basis—Recurring drafts for a fixed amount issued periodically

Cashier's check
It is an order to pay drawn by a bank's cashier on an account of the bank.
Functions the same way as a bank draft except cashier's checks are drawn only
on the bank that issues the check and are done only on an individual basis.

Certified check

An order to pay in the form of a customer's check, “certified” as having the funds
by the bank. When a bank certifies a check, it immediately withholds the amount
of the check from the writer's account and the check becomes the bank's
obligation to pay.

Money order

An order to pay a sum of money sold by NBFCs. Functions the same as a

cashier's check, but usually has a limited dollar amount.
Benefits of draft:

• It provides assurance to the payee that the instrument will be honored for
its stated value.
• Drafts do not disclose bank/checking account information to the recipient
and, in fact, do not require a checking account.
• Automation of bank drafts facilitates the payment of recurring obligations
of a fixed amount.

Disadvantage

• It involves a fee that may make their use relatively expensive compared to
payment by check.

Positive Pay System

It is an automated cash-management service to determine check fraud. Banks

use it to match the checks a company issues with those it presents for payment.
Any check considered suspected is sent back to the issuer for further
examination. It acts as a form of insurance for a company against fraud, losses,
and other liabilities. There is generally a charge incurred for using it, although
some banks now offer the service for free.
To protect against forged, altered, and counterfeit checks, itmatches the check
number, amount, and account number of each check against a list provided by
the company. If these do not match, the bank will not process the check. When
security checks are not put in place, identity thieves and fraudsters can create
counterfeit checks that may end up being processed.

When the information does not match the check, the bank notifies through an
exception report, withholding payment until the company advises the bank to
accept or reject the check. The bank can flag it, notify a representative at the
company, and seek permission to clear the check.

If the company finds only a minor error or other minor problem, it can choose to
request the bank to clear the check. If the company forgets to send a list to the
bank, all checks presented included may be rejected.

How does Positive Pay work?

It requires the company to transmit a file of issued

checks to the bank each day checks are written. When
those checks are presented for payment at the bank,
they are compared electronically against the list of
transmitted checks.

The check-issue file sent to the bank contains the check number, account
number, issue date, and dollar amount. Sometimes the payee name is included,
but is not part of the matching service.

When a check is presented that does not match in the file, it becomes an
"exception item". The bank sends a fax or an image of the exception item to the
client. The client reviews the image and instructs the bank to pay or return the
check.

A fee is also charged by the bank for Positive Pay, although some banks now
offer the service for free. The fee may be considered an "insurance premium" to
help avoid check fraud losses and liability.

These systems are offered by banks as a means of fraud detection for an entity's
checking accounts.
 1. An entity electronically transmits to its bank a file for the checks it has
issued. That file contains the entity's account number, check issue dates,
check numbers and check amounts for all checks written.
2. When the entity's checks are presented at the bank for payment, they are
compared electronically against the list provided by the entity.
3. If the elements of a check do not exactly match the file presented by the
issuing entity, the bank treats the check as an exception item that is held
until the issuing firm is contacted.
4. The bank provides the issuing entity, either electronically or by fax,
information about the exception item.
5. The issuing entity can then either approve payment of the item or return
the check through the banking system.

Issues with Positive Pay

1. If the company forgets to issue a file to the bank, all checks that should
have been included in that file may be rejected by the bank.
2. The file should contain all miscellaneous check transactions, such as
manual checks, so that the bank will know what to do when these items
are presented for payment.
3. A check that is cut and taken straight to the bank may arrive at the bank
teller before the associated file is sent to the bank at the end of the day,
possibly resulting in a rejected check.
4. It essentially protects banks from liability, and yet they charge companies
for this service.

Electronic Funds Transfers (EFTs)

Electronic Funds Transfer (EFT) is a system of transferring money from one

bank account directly to another without any paper money changing hands. One
of the most widely-used EFT programs is direct deposit; through which payroll
is deposited straight into an employee's bank account. However, EFT refers to
any transfer of funds initiated through an electronic terminal, including credit
card, ATM, Fedwire and point-of-sale (POS) transactions. It is used for both
credit transfers, such as payroll payments, and for debit transfers, such as
mortgage payments.
It is an electronic means of transferring funds similar to wire transfer, but used
in a broader context. Rather than payments occurring through the use of checks
or drafts, payments are initiated and processed based on the transfer of
computer files between entities.

Types of EFTs

The most common types of EFTs include:

Direct deposit:

Enables businesses to pay employees. During

the employee onboarding process, new
employees typically specify the financial
institution to receive the direct deposit
payments.

Wire transfers: Used for non-regular payments, such as the down payment on
a house.

Automated Teller Machines (ATMs):

Allows cash withdrawals and deposits, fund transfers and checking of account
balances at multiple locations, such as branch locations, retail stores, shopping
malls and airports.

Debit cards:

Allows users to pay for transactions and have those funds

deducted from the account linked to the card.

Pay-by-phone systems: Allows users to pay bills or transfer money over the
phone.

Online banking: Available via personal computer, tablet or smartphone. Using

online banking, users can access accounts to make payments, transfer funds and
check balances.
EFTs usually settles on the next business day, but can take longer during bank
holidays. International transactions (IATs) and high-value transactions above
$25,000 are not eligible for same-day processing. E.g. a company prepares a file
of payments to vendors with all information and transmits the file electronically
to its bank. The bank then reduces the firm's account and forwards the
payments electronically through the Automated Clearing House (ACH) system,
which makes payments electronically to the accounts of vendors, employees,
etc.

The advantages:

• Float reduction so firms can defer payments until they are due and still
ensure payments are received when due.
• Administration can be routine and integrated with a firm's larger
accounting and information system, thus reducing cost and errors.
• Low transaction fee costs, especially when compared to traditional check
writing and mailing.

Short-Term Securities Management

Short-term investments or temporary investments are those which can easily be

converted to cash typically within 1 year. Many short-term investments are sold
or converted to cash after a period of only 3-12 months. Few common examples
of short term investments include CDs, money market accounts, high-yield
savings accounts, government bonds and Treasury bills. Usually, these
investments are high-quality and highly liquid assets or investment vehicles.

Short-term investments may also refer specifically to financial assets of a similar

kind, but with a few additional requirements that are owned by a company.
Recorded in a separate account,
and listed in the current assets section of the corporate balance sheet, these are
investments that a company has made that are expected to be converted into
cash within one year.

The goal of a short-term investmentis to protect capital while also generating a

return similar to a Treasury bill index fund or another similar benchmark.
Companies in a strong cash position will have a short-term investments account
on their balance sheet. So the company can afford to invest excess cash in stocks,
bonds, or cash equivalents to earn higher interest than what would be earned
from a normal savings account.

There are two basic requirements for a company to classify an investment as

short-term. First, it must be liquid, like a stock listed on a major exchange that
trades frequently or U.S. Treasury bonds. Second, the management must intend
to sell the security within a relatively short period, such as 12 months.
Marketable debt securities, aka "short-term paper," that mature within a year or
less, such as U.S. Treasury bills and commercial paper, also count as short-term
investments.

Marketable equity securities include investments in common and preferred

stock while Marketable debt securities can include corporate bonds that is,
bonds issued by another company but they also need to have short maturity
dates and should be actively traded to be considered liquid.

When a firm experiences temporary excess cash, it should invest those funds so
as to earn a return greater than would be provided by idle cash.As the funds so
invested will be needed in the near term to satisfy obligations or to invest in
planned undertakings, management must be prudent in the use of such
investments.
The following are major concerns in selecting short-term investments:

Safety of Principal

Investments should have little risk of default by the issuer. Default risk is a
measure of the likelihood that the issuer will not be able to make future interest
and/or principal payments to a security holder. Temporary investments should
be in securities with a low risk of default, U.S. Treasury issues, for example.

Price Stability:

Investments in debt instruments have interest rate risk, the risk that derives
from the relationship between the rate of interest paid by a security and the
changing rate of interest in the market. Specifically, the market value of an
existing debt instrument varies inversely with changes in the market rate of
interest.

Hence, the interest rate risk is that the market rate of interest will increase,
resulting in a decrease in the market value of an investment. If sold, that
investment would incur a loss and, as a result, less cash would be available.
Investing in securities that mature in a short period mitigates this risk.

Liquidity

Investments should be in instruments that have a ready market for converting

securities to cash without incurring undue cost. Hence, thinly traded closely
held securities, or those with a high cost of premature conversion should be
avoided.

Other Factors—

Taxability—whetherthe investment income is taxable.

Diversification—Possibility of risk reduction having multiple investments that

are not highly correlated with each other so that the positive performance of
some investments will offset the negative performance of other investments

Admin Cost—the cost incurred to make and maintain investments which

includes brokerage fees, management fees, and custodial fees
There is a variety of opportunities available for short-term investments referred
to as the money market.

The primary investments in the money market include:

U.S. Treasury Bills

It is considered virtually risk-free with maturities of 3 months (91 days), 6

months (182 days), and 1 year (365 days), they are periodically available
directly through Federal Reserve Banks and they are continuously available in
the secondary market.

It provides:

I. Safety of principal
II. Price stability if held to (short) maturity
III. Marketability/liquidity

Federal Agency Securities

These securities are obligations of a federal government agency like Federal

Home Loan Bank, Federal Land Bank, and others that are the responsibility of
the agency; these securities are not backed by the good faith and credit of the
federal government. As a consequence, these securities are perceived as having
risky than Treasury obligations.
They are also not as marketable as Treasury obligations. Hence, the securities of
these agencies have slightly higher yields to compensate for the higher default
risk and lower marketability. These securities are offered in various
denominations and with a wide range of maturities. The secondary market for
these securities is good.

Negotiable Certificates of Deposit

These are issued by banks in return for a fixed time deposit with the bank. The
securities pay a fixed rate of interest and are available in a variety of
denominations and maturities. Unlike conventional certificates of deposit,
negotiable certificates of deposit can be bought and sold in a secondary market.
So if a holder needs cash before maturity instead of incurring an interest penalty
by “cashing in” the certificate, it can be sold in the secondary market at little or
no penalty. These securities offer a high safety of principal and relatively short-
term stability, but less marketability than Treasury or federal agency
obligations.

Bankers’ Acceptances

It is a draft drawn on a specific bank by a firm that has an account with the bank.
If the bank accepts the draft, it becomes a negotiable debt instrument of the
bank and is available for investment. The primary use of it is in the financing of
foreign transactions. Bankers’ acceptances are issued in denominations that
relate to the value of the transaction for which the acceptance was made.
Maturities typically are from 30 days to 180 days. As acceptances have a higher
risk and less marketability than Treasury or Federal agency obligations, they
have a higher yield than those securities.

Commercial Paper
It consists of short-term unsecured promissory notes issued by large,
established firms with high credit ratings. It is available in a variety of
denominations, either directly from the issuing firm or dealersand can be
purchased with maturities from a few days up to 270 days. The secondary
market for commercial paper is very limited and is usually restricted to dealers
in the paper. The lack of marketability, commercial paper provides a yield
greater than other short-term instruments with comparable risk, but usually
still less than the prime rate of interest.

Repurchase Agreements

In a repurchase agreement, the firm makes an investment and simultaneously

enters into a commitment to resell the security at the original contract price
plus an agreed interest income for the holding period. These agreements are
usually for large denominations and have maturities specified in each
agreement. The yield available is less than available on Treasury bills, but may
offer advantages of liquidity and very short maturity.

The major benefits are:

 • The time of the agreement can be adjusted to any length, including as
short as one day.
• As the agreement provides for resale of the investment at the original
price, the risk of market price declines is avoided.

The above make repurchase agreements a viable investment option, especially

for very short-term uses of excess cash.

Investment Assessment

A firm has a variety of options available for short-term investment

opportunities. In selecting, the firm will consider such factors as safety of
principal, price stability and liquidity of the various investments. The objective
is to minimize the risk associated with the investment, while seeking to earn a
competitive rate of return. Hence, the making of short-term investments
illustrates the risk-reward trade-off discussed earlier for capital project
investments.

The risk-reward relationship reflects that the greater the perceived risk
inherent in an opportunity, the greater the reward expected from an
investment.

In making short-term investments of temporary excess cash, a firm will give

priority to avoiding risk, rather than maximizing return of particular concern
will be the market value at risk.

Coefficient of Variation

It is a measure used to assess the risk-reward relationship for either short-term

or long-term investments. It is a measure of the relative variability of return
values around the mean return; it can be thought of as a measure of the total
risk per unit of return.
The coefficient of variation ratio is computed as:

Example

The common stock of ABC Company has a 10% average return with a standard
deviation of 30%. What is the coefficient of variation (CV) for ABC's common
stock?

CV = .30/.10

= 3.0

Lower the investment's coefficient of variation, the better its total risk-return
trade off. If the AR is zero or negative, the resulting ratio will not be valid and
the CV cannot be used to assess risk for that investment.
Sharpe Ratio

The measure used to assess the risk-reward relationship is the Sharpe ratio.

It measures how well the average return on an investment compensates for the
risk of the investment; it can be thought of as a measure of the excess return
(reward) per unit of risk.

The ratio is computed as:

Example

The common stock of ABC Company has a 10% average return with a
standard deviation of 20%. The current risk-free rate measured by the return
on T-Bills is 2%. What is the Sharpe ratio for ABC's common stock?

= (.10 − .02)/.20

= .08/.20

= .40

The greater the ratio, the better its risk-adjusted performance. A negative one
indicates that an investment with no risk would perform better than the
investment being analyzed.

When it is used to compare securities or portfolios in the same macroeconomic

environment and for the same time period, the risk-free rate is often ignored
and only the average return used as the numerator in the calculation.
In using the Sharpe ratio for a portfolio of securities, the average return would
be measured using weighted average return for the portfolio and the standard
deviation of the excess portfolio returns.

In using the Sharpe ratio to analyze security or portfolio returns over a long
period of time, the geometric mean of the returns should be used instead of a
weighted average.

Accounts Receivable Management

Every company wants to buy low and sell high. But they can lose everything
with poor receivables management during the last phase of the sales process.
Over half of all bankruptcies can be attributed to poor receivables management,
which demonstrates its importance. Receivables management involves much
more than reminding customers to pay. It is also about identifying the reason
for non-payment. Perhaps a product or service was not delivered Or there was
an administrative error in the invoice?
Good receivables management is a comprehensive process consisting of:

• Determining the customer’s credit rating in advance

• Frequently scanning and monitoring customers for credit risks
• Maintaining customer relations
• Detecting late payments in due time
• Detecting complaints in due time
• Reducing the total balance outstanding (DSO)
• Preventing any bad debt in receivables outstanding

The word receivable stands for the amount of payment not received. This means
the company has extended credit facility to its customers.

Accounts receivable is the money that a business has a right to receive after a
certain period of time when the business has sold goods or services on credit.
For example, the accounts receivable is the record of fact that a company has
done some work for customer X and that customer X owes money to the
company. Generally, the credit period is short ranging from a month or two to a
year.

The process involved in the Accounts receivable management

An Account receivable management process involves the following:
a. Credit rating i.e the paying ability of the customers shall be reviewed before
agreeing to any terms and conditions
b. Continuously monitoring any risk of non-payment or delay in receiving the
payments
c. Customer relations should be maintained and thus to reduce the bad debts
d. Addressing the complaints of the customers
e. After receiving the payments, the balances in the particular account receivable
should be reduced
f. Preventing any bad debts of the receivables outstanding during a particular
period.

For many businesses, accounts receivable account for a significant portion of

current assetsof total assets. For these, effective management of accounts
receivable is essential not only for profitability, but also for viability. For any
firm that sells goods or services on account, how it manages its credit and
collection process plays a role in the firm's success or failure.

Preparing good receivables management

In principle, good receivables management involves two steps. Firstly, you

determine your strategy and then you specify the appropriate procedures.

Step 1. Determine the strategy

• Which customers do you accept and under which conditions?

• Which customers do you monitor?
• Who should no longer be accepted, and when is the exit?
Step 2. Prepare appropriate procedures

• What is your invoicing process like?

• What is your invoice like?
• When do you remind a customer by phone?
• When do you remind a customer in writing?
• What does the reminder look like?
• When do you engage a debt collection agency?
• When will you start legal proceedings?
• What is the role of your employees in this respect?

Which systems will you require?

Companies use different applications and systems to limit the risks and update
the data. These can help you set up and design your receivables management.

• Acceptance system. Based on credit information, you determine whether

a new customer is accepted or not. This may be a manual or automated
process.
• Monitoring system. This system checks the entire portfolio for
continuous insight into existing customers and suppliers. This is essential,
particularly with regard to chain parties.
• Invoicing system. Invoices may be sent manually or automated
(sometimes as a digital invoice) and reminders must be logically aligned.
• Bookkeeping system. All receivables and payables are booked in this
system, which provides insight into the cash flow and receivables risk.
• CRM system. The Customer Relationship Management (CRM) system lists
information relating to agreements, contact and contracts with customers.
Complaints can also be processed in this system to improve insight into
the background of non-payment.

Accounts receivable management is concerned with the conditions leading to

the recognition of receivables and the process those results in eliminating the
receivables. Therefore, this lesson will consider:

I. Establishing general terms of credit

II. Determining customer creditworthiness and setting credit limits
III. Collecting accounts receivable
Establishing General Terms of Credit

If sales are on credit, the firm must establish the general terms under which
such sales will be made. To a certain extent, for competitive reasons the terms of
sale adopted by a firm will need to be in line with industry terms which may
include:

Total Credit Period

Establishes the maximum period for which credit is extended. Typical industry
practice reflects that the length of the credit period relates to the “durability” of
goods sold.

For example, firms that sell perishable goods have a shorter credit period than
that sell durable goods. This length of time the firm is expected to finance its
sales on credit and for which it must, in turn, have financing.

Discount

The discount rate and period must be decidedif a discount is to be offered for
early payment of accounts.The combination of the discount rate and period will
determine the effective interest rate associated with the discount offered which,
in turn, will determine the effectiveness of the discount policy.

The rate and period offered depends on the margin realized on its sales and its
cost of financing its accounts receivable. Practically, the rate and period will
need to be competitive with other firms in the industry.

Penalty for Late Payment

It mentions the penalty to be assessed if customers don't pay by the due date.
The penalty should at least cover the cost of financing the accounts receivable
for the overdue period.

Credit Sales Documentation

It determines the form of documentation to be required from customers at the

time they purchase on account. The most common arrangement is to sell on an
open account, that is, an implicit contract documented only by a receipt signed
by the buyer.

If the amount being charged is very large or if the buyer's credit is suspect, a
firm will likely require more formal documentationlike a commercial draft. If
foreign sales are to be made, appropriate processes will have to be decided
upon.

Customer Creditworthiness and Setting Credit Limits

The decisions are to be made whether a customer can buy on account and, if so,
what maximum amount can be charged. It is critical to recognize that the
objective is to maximize profits, not to minimize credit losses. Too stringent
policy will result in a failure to make sales that would be paid, resulting in lower
losses on accounts receivable, but also resulting in lost revenues.

When a customer is considered for credit, there are two major approaches to
determining whether to grant credit and at what level:

Credit-rating service

A number of analysts are in the business of assessing the creditworthiness of

businesses, Independent reports from these agencies provide considerable
information about a potential credit customer, including credit score that shows
relative creditworthiness. Such scores can be used in both making the credit
decision and in establishing a credit limit. Other sources of information about
prospective credit customers include trade associations, banks, and chambers of
commerce, among others.
Financial analysis

A firm may undertake its own analysis of a prospective credit customer. Since
this can be an expensive undertaking, it is typically done only by large firms and
in special circumstances where the seller wants a more direct understanding of
the prospective credit customer. It would rely on information from outside
sourcesand incorporate the firm's own analysis, including financial ratios based
on financial information. As the consideration is whether to extend short-term
credit, the focus will be on the prospect's short-term debt-paying ability.

Collecting Accounts Receivable

The most faced issue in selling on credit is that a sale will be executed, but may
not be collected. Even with the best of filtering processes, a business that sells
on account can expect some loss due to non-collection from customers. The
objective is to keep that post-sale loss to a minimum. To fulfill this, accounts
receivable must be monitored and action should be taken where appropriate
requirement arises.

Monitoring accounts receivable

Collection management needs to monitor accounts receivable in the aggregate

and also individually.

Assessment of total accounts receivable is done with averages and ratios which
include:

• Average collection period

• Day's sales in accounts receivable
• Accounts receivable turnover
• Accounts receivable to current or total assets
• Bad debt to sales

Individual accounts receivable can also be assessed through an ageing of

accounts receivable schedule. Such a schedule shows the amount owed by how
long the amount has been due from each customer.
A typical schedule would be prepared / generated based on the following
categories of customers:

1) Not Due
2) 30 Days Dues
3) 60 Days Dues
4) 90 Days Dues
5) 180 Days Dues
6) 360 Days Dues
7) Total

As the probability of not collecting increases with the age of an amount due,
overdue accounts need to be pursued instantly through various reminders of
demands or if needed then it may go for appointing collection agency.

These actions are not without a financial and, probably, a goodwill cost.
Therefore, each case may need to be decided based on the amount involved and
other considerations.

International Receivables

Sales receivables from foreign customers can present special collection issues
due to various international differences in law, culture and customs and
uncertainty as to the timing and/or collectability of amounts due. It calls for
special consideration when making sales or incurring accounts receivable from
foreign customers.

Advance Collection

Advance collection is not a reasonable expectation when making sales to foreign

customers. Often, such customers are not comfortable with prepaying for goods
or services not yet received. In addition, prepayment may not be feasible from a
cash flow perspective. So, purchases on-account is a common and expected
option for foreign customers.

Open-Account Sales

While sales on account (accounts receivable) are common and generally secure
from abuse within certain countries, and especially in the U.S., when used for
international sales they can present special collection problems. If payment is
not made by a foreign buyer, the domestic seller may face the following issues:

• Follow up for collection in a foreign country, which may be quite difficult

and costly
• Facing a foreign legal system that may have different standards for such
matters
• Possibilityof absence of documentation and other support needed to
successfully pursue a claim.

How to deal with Foreign Collection Problems

Usage of documentary letters of credit or documentary drafts which protect

both the seller and the buyer. In this payment is to be made based on
presentation of documents conveying title, and that specific procedures have
been followed.

A letter of credit shows a bank's promise to pay the exporter to that of the
foreign buyer based on the exporter complying with the terms and conditions of
the letter of credit.

A documentary draft is handled like a check from a foreign buyer, except that
title does not transfer to that buyer until the draft is paid.

One of the biggest barriers to proper cash flow and a source of anxiety for many
business owners are overdue accounts receivable. Getting a customer is a big
win but getting that customer to pay in a timely manner is essential for your
company’s financial health.

Following are the steps to effectively manage accounts receivable:

• Contract and Check Credit.

With the guidance of legal team, develop a binding engagement letter that
sets forth your payment terms. Run a credit check on prospective clients
to see if they have a history of late payments or bankruptcies and other
financial troubles.

• Accounts Receivable Tracker

 A key part of this process is to effectively track accounts receivable.
Reports should be run to highlight payment trends and which customers
are frequently remain unpaid. One can also set up alerts that will tell
when a customer is overdue or soon to be overdue in their payments to
allow for more effective follow-up.

• Make Payment Easier.

There are multiple payment gateways available in this world by adoption

of technological changes. The efforts should include providing various
options for payment to the customers so that they pay outstanding
quickly. Like accepting credit cards, Debit Cards or direct transfers of
payments.

Depending on business, mobile payment solution could also be a good fit.

Many of these modes require a cut of the transaction total due to nominal
charges, but if overdue payments are hampering business, it is worth to
invest.

• Regular Invoicing.

A delayed invoice will lead to delayed payment. Make sure invoices are
sent out in time.

• Billing Approach.

If billing is causing issues, payment terms need to be reassessed. Ask

clients to pay you in installments throughout the engagement and require
a deposit before work begins. At least one can start with simply
shortening your payment terms.

Inventory Management
It is the process of ordering, storing, and using a company's inventory which
include the management of raw materials, components, and finished products,
as well as warehousing and processing such items.

A company's inventory is one of its most valuable assets. In retail,

manufacturing, food service, and other inventory-intensive sectors, a company's
inputs and finished products is the core of its business. A shortage of inventory
when and where it's needed can be extremely detrimental.

At the same time, inventory can be thought of as a liability as non-accounting

angle. A large inventory carries the risk of spoilage, theft, damage, or shifts in
demand. Inventory must be insured, and if it is not sold in time it may have to be
disposed of at through away prices—or to be destroyed.

Hence, inventory management is important for businesses of any size. Knowing

when to restock items, what to purchase or produce, and at what price—as well
as when to sell and at what price—can easily become complex decisions. Small
businesses will often keep track of stock manually and determine the reorder
points and quantities. While larger businesses will use specialized ERP software
as a service (SaaS) applications.

Appropriate inventory management strategies differ depending on the industry.

E.g. An oil depot is able to store large amounts of inventory for extended periods
of time, allowing it to wait for demand to pick up. While storing oil is expensive
and risky—a fire led to millions of pounds in damage and fine, here is no risk
that the inventory will spoil or go out of style.
For businesses dealing in perishable goods or products for which demand is
extremely time-sensitive or fast-fashion items, sitting on inventory is not an
option, and misjudging the timing or quantities of orders can be costly.

Hence, the core issue in inventory management is to determine and maintain an

optimum investment in all inventories. For a manufacturing firm, that includes
raw materials, work-in-process, and finished goods; and for a retail firm, it is
goods for resale. As with other aspects of financial management, inventory
management involves a risk-reward trade-off. In this case, the trade-off is
between overinvesting in inventory to avoid shortages and incurring excessive
cost, and underinvesting in inventory to save cost, but incurring the risk of
shortages.
For companies with complex supply chains and production processes, balancing
the risks of inventory gluts and shortages is always challenging. To achieve it,
two major methods for inventory management have been developed in USA:

1) Just-in-time and
2) Materials requirement planning

A) Materials Requirement Planning (MRP)

The materials requirement planning (MRP) inventory management method is

sales-forecast dependent, meaning that manufacturers must have accurate sales
records to enable accurate planning of inventory needs and to communicate
those needs with materials suppliers in a timely manner.

For example, manufacturer using an MRP inventory system might ensure that
materials such as plastic, fiberglass, wood, and aluminum are in stock based on
forecasted orders. Inability to accurately forecast sales and plan inventory
acquisitions results in a manufacturer's inability to fulfill orders.
MRP is a system for calculating the materials and components needed to
manufacture a product. It consists of three primary steps:

1. Taking inventory of the materials and components on hand,

2. Identifying which additional ones are needed and then
3. Scheduling their production or purchase.

MRP is one of the most widely used systems for harnessing computer power to
automate the manufacturing process.

MRP uses information from the bill of materials (a list of all the materials,
subassemblies and other components needed to make a product, along with
their quantities), inventory data and the master production schedule to
calculate the required materials and when they will be needed during the
manufacturing process.

MRP is useful in both discrete manufacturing, in which the final products are
distinct items that can be counted -- such as bolts, subassemblies or automobiles
-- and process manufacturing, which results in bulk products -- such as
chemicals, soft drinks and detergent -- that can't be separately counted or
broken down into their constituent parts.

The next generation of MRP, manufacturing resources planning (MRP II), also
incorporated marketing, finance, accounting, engineering, and human resources
aspects into the planning process. A related concept that expands on MRP
is enterprise resources planning (ERP), which uses computer technology to link
the various functional areas across an entire business enterprise. As data
analysis and technology became more sophisticated, more comprehensive
systems were developed to integrate MRP with other aspects of the
manufacturing process.

This approach has been widely used in the U.S. since many decades.

Characteristics of MRP System

Relationships with Supplier

They are impersonal with purchases made through bids accepted from many
suppliers. The low bid is usually accepted, regardless of the supplier's location.
Purchases are normally made in large lots, which may be greater than what is
immediately needed.

Quality

Quality is set at an acceptable level, allowing for a certain level of defects.

Supply Push

Goods are produced in anticipation of a demand for the goods. So, the
characteristics of the products available to the end user have already been
decided—colors, features, sizes, etc.

Accounting

It involves complex cost accumulation and allocations, including setting

standards, allocating costs, variance analysis and reporting.

Inventory Level

As production is in anticipation of sales, inventories are maintained at every

level in the process as buffers against unexpected increased demand. If demand
is less, finished goods inventory accumulates.

Production

MRP is based on long set-up times and long production runs; it is not flexible. It
uses specialized labor and function-specific equipment.

Just-in-Time Inventory (JIT) Inventory System

This concept was originated in Japan in the 1960s and 1970s; Toyota Motor
Corp. (TM) contributed the most to its origin. It allows companies to save
significant amounts of money and reduce waste by keeping only the inventory
they need to produce and sell products. This approach reduces storage and
insurance costs, as well as the cost of liquidating or discarding excess inventory.
It can be risky. If demand unexpectedly increases, the manufacturer may not be
able to source the inventory to meet that demand, damaging its reputation with
customers and driving business toward competitors. Even the smallest delays
can be problematic; if a key input does not arrive "just in time," a bottleneck can
result.
Advantages:

• Production runs are short which means that manufacturers can quickly
move from one product to another.
• It reduces costs by minimizing storage needs.
• Companies also spend less money on raw materials as they buy sufficient
resources to make the ordered products and no more.

Dis Advantages:

It involves potential disruptions in the supply chain.

If a vendor cannot deliver the ordered goods in a time, it could hamper the
entire production process. A sudden unexpected order for goods may delay the
delivery of finished products to end clients.
Elements
Continuous improvement:

• Attacking fundamental problems and anything that does not add value to
the product.
• Devising systems to identify production and allied problems.

Simplicity

Simple systems are simple & easy to understand, easily manageable and the
chances of going wrong are very low.

A product

Oriented layout for less time spent on materials and parts movement.

Quality control at source to ensure every worker is solely responsible for the
quality of their own produced output.

Eliminating waste:

There are seven types of waste:

1. Waste from product defects.

2. Waste of time.
3. Transportation waste.
4. Inventory waste.
5. Waste from overproduction.
6. Processing waste.

Waste minimization is one of the primary objectives of Just In Time system. This
needs effective inventory management throughout the whole supply chain.
Initially, a manufacturing entity will seek to reduce inventory and enhance
operations within its own organization. In an attempt to reduce waste
attributed to ineffective inventory management, SIX principles in relation to JIT
have been stated and they are:
1. Reduce buffer inventory.
2. Try for zero inventory.
3. Search for reliable suppliers.
4. Reduce lot size and increase the frequency of orders.
5. Reduce purchasing cost.
6. Improve material handling.
7.

Successful Examples

JIT inventory management is used today by businesses in industries ranging

from retail to fast food to tech. Toyota is one of the most famous examples of
Just in Time manufacturing simply because it was one of the first to implement
this strategy effectively. Here are some other examples of JIT in action:

Apple

Itmaintains as little inventory on hand as possible. By lowering the amount of

stock on hand, Apple carries a lower risk of overstocking and chalking up dead
stock in its warehouses. As explained by Tim Cook, CEO of Apple, “Inventory is
fundamentally evil. You kind of want to manage it like you’re in the dairy
business. If it gets past its freshness date, you have a problem.”

Xiaomi

Itmanages a small inventory by releasing limited quantities of its mobile phones

per week. The drawback to this strategy is that eager consumers have to wait
for the items to hit the stores – resulting in potential lost sales. Still, Xiaomi still
benefits from keeping costs down and eliminating wastage.

Characteristics of JIT System

Inventory

The demand pulls inventory through the production process in that each stage
produces only what is needed by the next one and outside purchases are made
only as required. So, excess raw materials, work-in-process and, ideally, finished
goods inventories are greatly reduced or eliminated.

Demand

Goods are produced only when there is an end-user demand. Goods are
produced with the characteristics desired by the customer and in the quantity
demanded.

Accounting

It eliminates or combines inventory accounts as inventory is reduced or

eliminated. Other accounts are considered direct cost, thereby reducing
amounts allocated on a somewhat arbitrary basis. The accounting focuses more
on total measures, including days of stock on hand, return on assets, lead-time,
and others.

Production
Production occurs like full set of operations to produce a product are carried
out. Workers are trained to operate multiple equipments and robots are used
where feasible. Each work center functions like a small factory.

Suppliers

Close relationships are developed with a limited number of suppliers to help

operating interrelationships and to help assure timely delivery of quality inputs.
The physical distance between source of supply and production facilities is
minimized. Goods are purchased only in the quantity needed to meet
production demand and entered directly in the production process.

Quality

As inventory is eliminated of every stage of the production process, inputs to the

process must be high quality; otherwise a defective input would stop
production. So, there must be total control of quality of inputs. This is
accomplished by working closely with suppliers to insure quality in their
production process, as well as implementing quality practices within its own
processes.

Advantages of JIT System

• Reduction in time in replenishing product inputs

• Reduction in cost of defects
• Simplified and relevant accounting and performance measures
• Reduced investment in stock
• Lower cost of inventory related transportation, warehousing, insurance,
taxes, and other costs

The concepts and practices of JIT cannot be used by every firm and will not be
appropriate also for all processes of some kind of corporates. Companiesusing a
traditional materials requirement planning system or similar large lot
production systems will be more concerned with the economic order quantity
(EOQ) system.

Economic Order Quantity

This model is used in inventory management by calculating the number of units
a company should add to its inventory with each order to reduce the total costs
of its inventory assuming constant demand.

The costs of inventory in the model include holding and setup costs.

The EOQ model seeks to ensure that the right amount of inventory is ordered
per batch so a company does not have to make orders too frequently and there
is not an excess of inventory sitting on theother hand. It assumes that there is a
trade-off between inventory holding costs and inventory setup costs, and total
inventory costs are minimized when both setup costs and holding costs are
minimized.

The objective is to identify the optimal number of product units for ordering. If
achieved, a company can minimize its costs for buying, delivery, and storing
units. The EOQ can be modified to determine different production levels or
order intervals, and corporations with large supply chains and high variable
costs use an algorithm in their computer software to determine EOQ.

EOQ is cash flow tool which can be used by a company to control the amount of
cash tied up in the inventory balance. For many companies, inventory is its
largest asset other than its human resources, and these businesses must carry
sufficient stock to meet the needs of customers. If EOQ can help minimize the
level of inventory, the cash savings can be used for some other business purpose
or investment.

The EOQ formula determines a company's inventory reorder point. When

inventory falls to a certain level, the EOQ, if applied to business processes,
triggers the need to place an order for more units. By determining a reorder
point, the business avoids running out of inventory and can continue to fill
customer orders. If the company runs out of inventory, there is a shortage cost,
which is the revenue lost as the company has insufficient inventory to fill an
order. An inventory shortage may also mean the company loses the customer or
the client will order less in the future.

EOQ Assumptions

• Demand is constant.
• Unit cost and carrying cost are constant.
• Delivery is instant.

Reorder Point

A reorder point is the unit quantity on hand that triggers the purchase of a
predetermined amount of replenishment inventory. If the purchasing process
and supplier fulfillment work as planned, the reorder point should result in the
replenishment inventory arriving just as the last of the on-hand inventory is
used up. The result is no interruption in production and fulfillment activities,
while minimizing the total amount of inventory on hand.
It can be different for every item of inventory, since every item may have a
different usage rate, and may require differing amounts of time to receive a
replenishment delivery from a supplier. For example, a company can elect to
buy the same part from two different suppliers; if one supplier requires one day
delivering an order and the other supplier requires three days, then the
company's reorder point for the first supplier would be when there is one day's
supply left on hand, or three days' supply for the second supplier.

The basic formula for the reorder point is to multiply the average daily usage
rate for an inventory item by the lead time in days to replenish it.

For example, SV Inc. uses an average of 25 units of its green widget every day,
and the number of days it takes for the supplier to replenish inventory is four
days. Therefore, SV should set the reorder point for the green widget at 100
units. When the inventory balance declines to 100 units, SV places an order, and
the new units should arrive four days later, just as the last of the on-hand
widgets are being used up.

However, this formula for the reorder point is only based on average usage; in
reality, demand may spike above or decline below the average level, so there
may still be some inventory on hand when the replenishment order arrives, or
there may have been a stockout condition for several days that has interfered
with production or sales. To guard against the latter condition, a company may
alter the reorder formula to add a safety stock, so that the formula becomes:

(Average daily usage rate x Lead time) + Safety stock

This formula alteration means that replenishment stock will be ordered sooner,
which greatly reduces the risk that there will be a stockout condition. However,
it also means that a company will have a larger investment in its on-hand
inventory, so there is a trade-off between always having available inventory and
funding a larger inventory asset.

It is concerned with determining the inventory quantity at which goods should

be reordered. At some remaining quantity new inputs must be ordered so as to
be available before the current inventory runs out; that quantity is the reorder
point.

The quantity at which inventory is reordered must be sufficient to continue

production until the new order is delivered—the delivery time stock. In
addition, a safety stock is usually maintained to hedge against unforeseen events
(e.g., unexpected usage or unusual defects). Therefore, the reorder point can be
expressed as:

ReorderPoint=DeliveryTimeStock+SafetyStock

Supply Chain Management

Supply chain management (SCM) is the active management of supply chain

activities to maximize customer value and achieve a sustainable competitive
advantage. It represents a conscious effort by the supply chain firms to develop
and run supply chains in the most effective & efficient ways possible. Supply
chain activities cover everything from product development, sourcing,
production, and logistics, as well as the information systems needed to
coordinate these activities.

It is the entire sequence of processes ranging from sourcing, production, and

distribution of a good. Every entity that contributes in any way to the final good
is part of the supply chain.
The concept of Supply Chain Management (SCM) is mainly based on two
concepts:

I. The first is that practically every product that reaches to user represents
the cumulative effort of multiple organizations. These organizations are
referred to collectively as the supply chain.
II. The second is that while supply chains have existed for a long time, most
organizations have only paid attention to what was happening within
their “four walls.” Few businesses understood, much less managed, the
entire chain of activities that ultimately delivered products to the final
customer.

It is mainly concerned with managing the flow of goods, services, information

related to a particular product from the raw material stage through the delivery
of the final output to the user. It involves coordinating and integrating these
flows both within and among entities. The primary objective is to meet end-user
demand with the most efficient resource usage. It is often used in the efficient
management of inventory.

A key aspect of supply chain management is the sharing of information through

the supply chain so that all relevant parties are aware of the needs of each
subsequent party in the supply chain. The intent of such sharing is to improve
processes so as to reduce inventory, time, defects, and costs all along the supply
chain.

How Supply Chain Management Works?

SCM centrally controls the production, shipment, and distribution of a product.
By managing the supply chain, companies are able to cut excess costs and
deliver products to the consumer faster. It is done by keeping tighter control of
internal inventories, internal production, distribution, sales, and
the inventories of company vendors.

It is based on the idea that nearly every product that comes to market results
from the efforts of various organizations that make up a supply chain. Although
supply chains have existed for ages, most companies have only recently paid
attention to them as a value-add to their operations.

In SCM, the supply chain manager coordinates the logistics of all aspects of the
supply chain which consists of five parts:

• The plan or strategy

• The source (of raw materials or services)
• Manufacturing (focused on productivity and efficiency)
• Delivery and logistics
• The return system (for defective or unwanted products)

Management of Current Liabilities

Current liabilities are generally settled through available current assets, which
are used up within one year. Current assets include cash or accounts
receivables, which is money owed by customers for sales. The ratio of current
assets to current liabilities is an importantto determine a company's ongoing
ability to pay its debts as they are due.

It is typically one of the largest current liability accounts on a company's

financial statements, and it represents unpaid invoices. Companies try to match
payment dates so that their accounts receivables are collected before the
accounts payables are due.

For example, a company might have 60-day terms for money owed to their
supplier, which results in requiring their customers to pay within a 30-day term.
Over and above, Current liabilities can also be settled by creating a new current
liability like a new short-term debt obligation.

Few Financial Terms for Understanding:

Short-term liabilities

They are incurred in connection with assets which will generate cash in the
short term to repay the liability. It is the essence of the principle of self-
liquidating debt.

Permanent amount of financing

Few portion of current liabilityinvolves a permanent amount of financing. For
example, to the extent a minimum balance always remains in trade accounts
payable, this minimum amount is a form of permanent financing.

Short-term borrowing

It does not require collateral and does not impose restrictive conditions.

Early payment

Generally discounts are being offered for early payment of trade payables, many
with an effective annual interest rate of over 30%, and should be taken if
possible.

Effective cost of debt:

If current liabilities require maintaining a minimum balance, the effective cost of

debt is greater than the stated cost.

Standby finance

A line of credit provides an effective means of arranging “standby” financing.

The credit is available and can be used when required, reducing the cost
associated with excess borrowings.

1. Which one of the following risks is likely to increase when minimizing the
investment in current assets?
 Increase in Accounts receivable
A defaults.

B Increase in Inventory spoilage.

C Increase in Inventory shortages.

D Increase in Inventory obsolescence.

2. Company X utilizes more debt financing and less equity financing than does
Company Y. Which of the following statements is likely to be true?

A Company X has more net earnings variability than Company Y.

Company X has more operating earnings variability than
B Company Y.

Company X has less operating earnings variability than

C Company Y.

D Company X has less financial leverage than CompanyY.

3. If a company increases its cash balance by issueof additional shares of

common stock, impact on working capital would be:

It increases and the current ratio remains

A unchanged.

It remains unchanged and the current ratio

B remains unchanged.

C It increases and the current ratio decreases.

D It increases and the current ratio increases.

4. Appropriate level of working capital requires by:

A Making changes in the capital structure and dividend policy of the firm.

Evaluation of the risks associated with different levels of fixed assets and the
B types of debt used to finance these assets.

Maintaining short-term debt at the lowest possible level because it is generally

C more expensive than long-term debt.

Adjusting the benefit of current assets and current liabilities against the
D possible technical insolvency.

5. Net working capital is the gap between

Current assets and current

A liabilities.

Fixed assets and fixed

B liabilities.

Total assets and total

C liabilities.

Shareholders’ investment and

D cash.

6. Which of the following statements related to working capital management

is/are correct?

A. Company may be over invested in net working capital.

B. A company can be under invested in net working capital.

A None of the above.

B A only.

C B only.
D Both.

7. Can a company do over investment and/or under investment in net

working capital?

Over Under
Investment Investment
Yes Yes
Yes No

No Yes

No No

Which one of the following not to be considered as an element in working

capital management?

A Accounts receivable.
B Accounts Payable.
Property, plant, and
C equipment.

D Inventory.

8. Snowman has received several proposals to establish a lockbox system

to expedite its receipts. Snowman receives an average of 700 checks per
 day averaging $1,800 each, and its cost of short-term funds is 7% per
year.

Assuming all proposals will produce equivalent processing results and

using a 360-day year, which one of the following is ideal proposal?

A A $0.50 fee per check.

B A flat fee of $125,000 per year.

A fee of 0.03% of the amount
C collected.

A compensating balance of
D $1,750,000.

9. A company has daily cash receipts of $100,000 and collection time of 4

days. A bank has offered to reduce the collection time by 2 days at fee of
$500 / month. If money market rates are expected to be at 6% p.a., the
net annual profit/lossdue to this service would be :

A $ 3,000

B $12,000

C $0

D $ 6,000

10. What is the major benefit of a zero-balance account system?

A Toensure that cash is available for contingencies.

B To maximize the amount of interest earned on
 demand deposits.

To maximize the float involved in cash

C disbursements.

D To maximize the float involved in cash receipts.

11. A compensating balance is generally used in:

To compensate a financial institution for services rendered by providing it

A with deposits of funds.

B To compensate for possible losses on a marketable securities portfolio.

It is a level of inventory held to compensate for variations in usage rate and
C lead time.

D It is the prepaid interest on a loan.

12. The banker’s acceptance is an instrument used to:

Call for immediate payment upon delivery of the shipping

A documents to the bank’s customer and acceptance of goods
by the bank.

Involves a method where an invoice being signed by the

banker upon receipt of goods, after which both the banker
B and the seller record the transaction on their respective
books.

It is a draft payable on a specified date and guaranteed by

C the bank.

It is a method of sales financing in which the bank retains

D title to the goods until the buyer has completed the
payment.
13. Which of the following is likely to provide the greatest safety of
principal?

A Commercial paper.
Bankers'
B acceptance.

C Promissory Notes.

D U.S. Treasury bills.

14. Which of the benefit would a lockbox likely to provide for

receivables management?

Minimized collection
A float.

Maximized collection
B float.

Minimized disbursement
C float.

Maximized disbursement
D float.

15. Apple is a newly established firm, and the owner is evaluating

type of Bank account to open. Apple is planning to keep a $500
minimum balance in the account for emergencies and plans to write
appx. 80 checks monthly. The bank would levy $10 per month plus
$0.10 per check with no minimum balance.

Firm also has the option of a premium business account that requires a
$2,500 minimum balance without any monthly fees or other charges.

If Apple’s cost of funds is 10%, which option should Apple choose?

 Standard account, because the savings is $34
A per year.

Premium account, because the savings is $34

B per year.

Standard account, because the savings is $16

C per year.

Premium account, because the savings is $16

D per year.

16. Which one of the following techniques of Cash Management

focuses on cash disbursements?

A Lock-box system.

B Zero-balance account.

C Pre-authorized checks.
Depository transfer
D checks.

17. A minimum balance that a firm must maintain with a commercial bank is :

Transaction
A balance.

Compensating
B balance.

Precautionary
C balance.
D Speculative balance.

18. Which of the following would be the appropriate form of investment for a
firm's temporary excess cash balance?

A Common stock
Commercial
B paper

Corporate
C bonds

Municipal
D bonds

19. Which of the following investment in securities would be expected to have

the highest returns?

A U.S. Treasury bills

B Municipal bonds
Federal agency
C securities

D Corporate bonds

20..Ideally Collection float is described as the :

Time between when a firm receives a check and when the funds are available
A for use by the firm.

Time between when a customer mails a check and when the funds are available
B for use by the firm.

C Time between when a customer mails a check and when the check is received
 by the firm.

Time between when a firm deposits a check and when the funds are available
D for use by the firm.

21. Whiledoing short-term investments, which of the following is the risk

associated with the ability to sell an investment in a shorterspan of time
without having to make significant price discounts?

Purchasing power
A risk.

B Interest rate risk.

C Default risk.

D Liquidity risk.

22. An institution is looking for to assess its investment portfolio's exposure to

price changes would use which one of the following techniques?

Market value at risk

A analysis.

Cash flow at risk

B analysis.

C Earnings at risk analysis.

D Back testing analysis

23. The expected rate of return for the stock of CAG Enterprise is 20%, with a
standard deviation of 15%. The expected rate of return for the stock of BAGS
Associates is 10%, with a standard deviation of 9%. The riskier one is as
follows:
A CAG because its return is higher.
CAG because its standard deviation is
B higher.

BAGS because its standard deviation is

C higher.

BAGS because its coefficient of variation is

D higher.

24. A company uses portfolio management to develop its investment portfolio.

If the company wishes to obtain optimal risk reduction, it should make its
future investment in one of the followingpatters:

An investment that correlates negatively to the current

A portfolio holdings.

An investment that is uncorrelated to the current portfolio

B holdings.

An investment that is highly correlated to the current

C portfolio holdings.

An investment that is perfectly correlated to the current

D portfolio holdings.

25. A corporate treasurer,when managing cash and short-term investments, is

primarily concerned with

A Maximizing rate of return.

B Minimizing taxes.
Investing in Treasury bonds since they have no
C default risk.

D Liquidity and safety.

26. If an investment is expected to be held for a long span of time, the
preferred method for calculating the expected return is :

Arithmetic
A average.

B Median.
Geometric
C average.

Subjective
D estimate.

27. Claris has the following investment portfolio.

Expected
Investment Beta
return
Investment 1 15% $100,000 1.2
Investment 2 10% $300,000 −0.5
Investment 3 8% $200,000 1.5
Investment 4 8% $100,000 −1.0

Calculate the expected return of the portfolio?

A 10.25%
B 9.86%
C 12.5%
11.35%

28. The expected return of a portfolio is measured by thefollowing :

A Variance.
Weighted
B average.

Standard
C deviation.

D Beta.

29. For ensuring payment of its accounts receivables, which of the following
procedures are adopted by the firm:

Discount
A policy.

B Credit policy.
Collection
C policy.

Payables
D policy.

30. Which of the following shows a firm's credit criteria?

The span of time a buyer is given to pay for his/her

A purchases.

The percentage of discount allowed for early

B payment.
C The diligence to collect slow-paying accounts.
The required financial strength of acceptable
D customers.

31. An omanian company has credit sales of $20,000 in April, $30,000 in May,
and $50,000 in June. It collects 75% in the month of sale and 25% in the
following month. The balance in accounts receivable on January 1 was
$25,000. What are the accounts receivable at 30th June?

A $7,500

B $12,500

C $37,500

D $45,000

32. Accounts receivable management is related with:

A. Policies for recognition of accounts receivable.

B. Policies related to the collection of accounts receivable.

A Both.

B A only.

C B only.

D None.
33. A firm is offered credit terms of 2/10, net 30 on its purchases. Sound cash
management practices would mean that the firm would pay the account on
which day?

Day 2 and
A 30.

Day 2 and
B 10.

C Day 10.

D Day 30.

34. The objective of accounts receivable management is to:

A Maximize sales.
B Minimize credit losses.

C Maximize profits.
Minimize uncollectible
D accounts.

35. Calculations to determine the inventory reorder point would include :

A Ordering cost.

B Carrying cost.

C Average daily usage.

Economic order
D quantity.
36. An increase in the following would cause management to reduce the
average inventory?

A The cost of placing an order.

B The cost of carrying inventory.

The annual demand for the
C product.

The lead time needed to acquire

D inventory.

37. Luis Company relaxed its credit policy by lengthening its discount period
from 10 to 15 days. Which of the following is likely reason for the same?

a. To show a higher average age of accounts on its accounts

receivable aging schedule.
b. To meet terms offered by competitors.
c. To seek to stimulate sales.

A A only.
B B only.

C C only.

D B and C.

38. Which of the following approaches related to Inventory Management

orders at the point where carrying costs is nearest to restocking costs to
minimize total inventory cost?

A Economic order quantity.

B Just-in-time.
 Materials requirements
C planning.

Activity-based costing
D (ABC).

39. In computing the reorder point for an item of inventory, which of the
following is used?

A. Cost

B. DailyUsage

C. Lead time

A A and B.

B B and C.

C A and C.
D All.

40. The amount of inventory that a company would tend to stock would
increase as the:

Sales fall to a permanently lower

A level.

B Cost of carrying stock decreases.

C Variation in sales decreases.
Cost of running out of stock
D decreases.
41. Which of the following assumptions is related toEOQ?

The carrying cost per unit will vary with ordered

A quantity.

The cost of placing an order will vary with quantity

B ordered.

C Periodic demand is known.

The purchase cost per unit will vary based on
D quantity discounts.

42. A Toy company sells 1,500 units of a each year and orders the items in
equal quantities of 500 units at a price of $5 per unit. No safety stocks. If the
company has a cost of capital of 12%, its annual cost of carrying inventory is :

A $150
B $180

C $300

D $900

43. All following are characteristics of just-in-time (JIT) systems except

A Reduction of inventories to zero.

B Instant inspection of materials to eliminate defective parts.

Simplified production activities by eliminating non-value-added
C activities.

D Sales forecasts being shared with vendors.

44. A temporary increase in inventory to meet a seasonal demand should

ideally be financed by:
 An increase in current
A liabilities.

B Issuing bonds.

C Issuing preferred stock.

D Issuing common stock.

45. Following the hedging principle, short-term liabilities would be used to

finance which one of the following?

A The acquisition of plant machinery.

B Repayment of bond principal at maturity.

C Procurement at a bargain price.

D The acquisition of a patent.

46. In working capital management, one tries to follow the hedging principle
of finance. Which of the following is too aggressive to be consistent with that
principle?

A Financing short-term needs with long-term funds.

B Financing long-term needs with short-term funds.

C Financing seasonal needs with short-term funds.

Financing a permanent build-up in inventory with
D long-term debt.
47. On March 1, 2019, Estes Company purchased goods totaling $1,000 from
one of its suppliers with terms of 2/15, n/45. If Estes pays the invoice on April
10, 2019, which one of the following is the amount Estes would pay?

A $1,020
B $1,000

C $980

D $850

48. Sharpe, Inc. is evaluating option ofa short-term loan of $100,000. Bank has
offered a 180-day loan at the rate of 7.00% p.a., with the requirement that it
maintains a $10,000 balance in its account during loan period. If Sharpe
accepts such loan terms, using a 360-day year, which one of the following
most closely approximates the annual interest rate on the loan?

A 3.89%
B 7.00%

C 7.78%

D 15.56%
Financial Analysis and Planning - Ratio Analysis

LEABRNINGOUTCOMES

• Sources of financialdata for Analysis.

• Financial ratios and its Types.
• Use of financialratios to analyze the financial statement.
• Analyze the ratios from the perspective of investors, lenders, suppliers,
managers etc. to evaluate the profitability and financial position of an
entity.
• Users and objective of Financial Analysis: - A Birds Eye View.
• Advantages of ratio analysis.
• Limitations of Ratio Analysis.

It is to state that once the financial statements of an organization are prepared

they later need to be analyzed. One such tool to analyze and asses the financial
situation of a firm is Ratio Analysis which allows the stakeholder to make better
sense of the accounts and better understand the current fiscal scenario of an
entity. Let us take an in-detail look at ratio analysis.

The base of financial analysis, planning and decision making is financial

statements which mainly consist of Balance Sheet and Profit and Loss
Account. The profit & loss account shows the operating activities and the
balance sheet reflects the balances of the acquired assets and of liabilities at a
particular point of time.

However, the above do not disclose all of the necessary and relevant
information. For the purpose of obtaining the material and relevant
information necessary for ascertaining the financial strengths and weaknesses
of an enterprise, it is required to analyze the data depicted in the financial
statement.

There are certain analytical tools which help in financial analysis and
planning. The important tools are Ratio Analysis and Cash Flow Analysis.

Meaning of Ratio

A ratio is a relationship between two

numbers indicating how many times the
first number contains the second. For
example, if a bowl of fruit contains eight
oranges and six lemons, then the ratio of
oranges to lemons is eight to six (that is,
8:6, which is equivalent to the ratio 4:3).
It is the indicated quotient of two mathematical expressions and as the
relationship between two or more things.But hereratio means financial ratio
or say accounting ratio which is a mathematical expression of the relationship
between two accounting figures.

Meaning of Ratio Analysis

Ratio analysis refers to the analysis and interpretation of the figures appearing
in the financial statements (i.e., Profit and Loss Account, Balance Sheet and Fund
Flow statement etc.).

It is a process of comparison of one

figure against another. It enables the
users like shareholders, investors,
creditors, Government, and analysts
etc. to get better understanding of financial statements.

Khan and Jain define the term ratio analysis as “the systematic use of ratios to
interpret the financial statements so that the strengths and weaknesses of a firm
as well as its historical performance and current financial conditions can be
determined.”

It is a very powerful analytical tool useful for measuring performance of an

organization. Accounting ratios may just be used as symptom like blood
pressure, pulse rate, body temperature etc. The physician analyses these
information to know the causes of illness. Similarly, the financial analyst should
also analyze the accounting ratios to diagnose the financial health of an
enterprise.

The term financial ratio can be explained by :

i) defining how it is calculated and

ii) Whatis the objective of this calculation?

A) Based on Calculations :

A relationship expressed in mathematical terms; between two individual figures

or group of figures; Connected in some logical manner; and Selected from
financial statements of the concern.

B) Objective for financial ratios is that all stakeholders (owners,

investors, lenders, employees etc.) can draw conclusions
It shows Performance, Strengths & weaknesses of a firm based on which
decisions in relation to the firm can be taken.
Ratio analysis also proves that a single accounting figure by itself may not
communicate any meaningful information but when expressed as a relative to
some other figure, it may definitely provide some significant information.
It is not just the comparison of different numbers from the balance sheet,
income statement, and cash flow statement. It also includes comparison of
numbers against previous years, other companies, the industry, or even the
economy in general for the purpose of financial analysis.

Following are the sourcesofFinancialDataforRatio Analysis :

(i) AnnualReports
(ii) Interimfinancialstatements
(iii) NotestoAccounts
(iv) Statementofcashflows
(v) Business periodicals.
(vi) Creditandinvestmentadvisoryservices

Generally, ratio analysis involves following four steps:

1) Collection of relevant accounting data from financial statements.

2) Constructing ratios of related accounting figures.

3) Comparing the ratios with the standard ratios

4) Interpretation of ratios to arrive at valid conclusions

Example

The income for the year from operations is let us say 1,00,000/- for a given year.
The Purchases and other direct expenses cost around 75,000/-. So the Gross
Profit f the year is 25,000/-. Now it can be said that the Gross Profit is 25% of
the Operations Revenue. We calculate this as
G.P. Ratio = GPSales/Revenue ×100

G.P.Ratio = 25,0001,00,000 ×100

G.P. Ratio = 25%

One factor to be kept in mind is that ratio analysis is used only to compare
numbers that make sense and give us a better understanding of the financial
statement. Comparing random financial accounts should be avoided.

When investors and analysts talk about fundamental or quantitative analysis,

they are usually referring to ratio analysis. Ratio analysis involves evaluating the
performance and financial health of a company by using data from the current
and historical financial statements. The data retrieved from the statements is
used to compare a company's performance over time to assess whether the
company is improving or deteriorating; compare a company's financial standing
with the industry average; or compare a company to one or more other
companies operating in its sector to see how the company stacks up.

Most investors are familiar with a few key ratios, particularly the ones that are
relatively easy to calculate. Some of these ratios include

• the current ratio, return on equity (ROE),

• the debt-equity (D/E) ratio,
• the dividend payout ratio,
• the price/earnings (P/E) ratio.
While there are numerous financial ratios, ratio analysis can be categorized into
six main groups:

1. Liquidity Ratios:

Liquidity ratios measure a company's ability to pay off its short-term debts as
they come due using the company's current or quick assets. Liquidity ratios
include current ratio, quick ratio, and working capital ratio.
The terms 'liquidity' and 'short-term solvency' are used synonymously.
Liquidity means ability of the business to pay its short-term liabilities. Inability
to pay-off short-term liabilities affects its credibility as well as its credit rating.
Continuous default on the part of the business leads to commercial bankruptcy.
Eventually such commercial bankruptcy may lead to its sickness and
dissolution. Short-term lenders and creditors of a business are very much
interested to know its state of liquidity because of their financial stake.
VariousLiquidityRatiosare:
A. Current Ratio
B. Quick Ratio or Acid test Ratio
C. Cash Ratio or Absolute Liquidity Ratio
D. Basic Defense Interval or Interval Measure Ratios
E. Net Working Capital Ratio

A.Current Ratio

The current ratio is a liquidity ratio that measures a company's ability to pay
short-term obligations or those due within one year. It tells investors and
analysts how a company can maximize the current assets on its balance sheet to
satisfy its current debt and other payables.
The current ratio compares all of a company’s current assets to its current
liabilities. These are usually defined as assets that are cash or will be turned into
cash in a year or less, and liabilities that will be paid in a year or less.
The current ratio is sometimes referred to as the “working capital” ratio and
helps investors understand more about a company’s ability to cover its short-
term debt with its current assets.
Weaknesses of the current ratio include the difficulty of comparing the measure
across industry groups, overgeneralization of the specific asset and liability
balances, and the lack of trending information.
The main question this ratio addresses is: "Does your business have enough
current assets to meet the payment schedule of its current debts with a margin
of safety for possible losses in current assets?"
To calculate the ratio, analysts compare a company's current assets to its
current liabilities. Current assets listed on a company's balance sheet include
cash, accounts receivable, inventory and other assets that are expected to be
liquidated or turned into cash in less than one year. Current liabilities include
accounts payable, wages, taxes payable, and the current portion of long-term
debt.

Formula
The current ratio is calculated by dividing current assets by current liabilities.
This ratio is stated in numeric format rather than in decimal format. Here is the
calculation:

Where,
Current Assets = Inventories + Sundry Debtors + Cash and Bank
 Balances
+ Receivables/ Accruals + Loans and Advances +
Disposable Investments + Any other current
assets.

Current Liabilities = Creditors for goods and services + Short-

term Loans +
Bank Overdraft + Cash Credit + Outstanding
Expenses + Provision for Taxation + Proposed
Dividend + Unclaimed Dividend + Any other
current liabilities.

A current ratio that is in line with the industry average or slightly higher is
generally considered acceptable. A current ratio that is lower than the industry
average may indicate a higher risk of distress or default. Similarly, if a company
has a very high current ratio compared to their peer group, it indicates that
management may not be using their assets efficiently.

Current Ratio and Debt

A company with a current ratio less than one does not, in many cases, have the
capital on hand to meet its short-term obligations if they were all due at once,
while a current ratio greater than one indicates the company has the financial
resources to remain solvent in the short-term. However, because the current
ratio at any one time is just a snapshot, it is usually not a complete
representation of a company’s liquidity or solvency.
For example, a company may have a very high current ratio, but its accounts
receivable may be very aged, perhaps because its customers pay very slowly,
which may be hidden in the current ratio. Analysts must also consider the
quality of a company’s other assets versus its obligations as well. If the
inventory is unable to be sold, the current ratio may still look acceptable at one
point in time, but the company may be headed for default.A current ratio of less
than one may seem alarming.
Calculating the current ratio at just one point in time could indicate the
company can’t cover all its current debts, but it doesn’t mean it won’t be able to
once the payments are received.
Additionally, some companies, especially larger retailers such as Wal-Mart, have
been able to negotiate much longer-than-average payment terms with their
suppliers. If a retailer doesn't offer credit to its customers, this can show on its
balance sheet as a high payables balance relative to its receivables balance.
Large retailers can also minimize their inventory volume through an efficient
supply chain, which makes their current assets shrink against current liabilities,
resulting in a lower current ratio.
The current ratio can be a useful measure of a company’s short-term solvency
when it is placed in the context of what has been historically normal for the
company and its peer group. It also offers more insight when calculated
repeatedly over several periods.
The current ratio helps investors and creditors understand the liquidity of a
company and how easily that company will be able to pay off its current
liabilities. This ratio expresses a firm’s current debt in terms of current assets.
So a current ratio of 4 would mean that the company has 4 times more current
assets than current liabilities.
A higher current ratio is always more favorable than a lower current ratio
because it shows the company can more easily make current debt payments.
If a company has to sell of fixed assets to pay for its current liabilities, this
usually means the company isnot making enough from operations to support
activities. In other words, the company is losing money. Sometimes this is the
result of poor collections of accounts receivable.
The current ratio also sheds light on the overall debt burden of the company. If a
company is weighted down with a current debt, its cash flow will suffer.

Example
Carlos’s Shop sells ice-skating equipment to local hockey teams. Carlos is
applying for loans to help fund his dream of building an indoor skate rink.
Carlos’s bank asks for his balance sheet so they can analysis his current debt
levels. According to Carlos’s balance sheet he reported $100,000 of current
liabilities and only $25,000 of current assets. Carlos’s current ratio would be
calculated like this:
As you can see, Carlos only has enough current assets to pay off 25 percent of
his current liabilities. This shows that Carlos is highly leveraged and highly
risky. Generally Banks would prefer a current ratio of at least 1 or 2, so that all
the current liabilities would be covered by the current assets. Since Carlos’s
ratio is so low, it is unlikely that he will get approved for his loan.

B.Quick / Acid Test / Liquid Ratio

The quick ratio is an indicator of a company’s short-term liquidity position and

measures a company’s ability to meet its short-term obligations with its most
liquid assets.
Since it indicates the company’s ability to instantly use its near-cash assets (that
is, assets that can be converted quickly to cash) to pay down its current
liabilities. An acid test is a quick test designed to produce instant results—
hence, the name.
Short-term investments include trading securities and available for sale
securities that can easily be converted into cash within stipulated time period.
Marketable securities are traded on an open market with a known price and
readily available buyers. Any stock on the New York Stock Exchange would be
considered a marketable security because they can easily be sold to any investor
when the market is open.
The Quick Ratio is a much more conservative measure of short-term liquidity
than the Current Ratio. It helps answer the question: "If all sales revenues
should disappear, could my business meet its current obligations with the
readily convertible quick funds on hand?"
The quick ratio is often called the acid test ratio in reference to the historical use
of acid to test metals for gold by the early miners. If the metal passed the acid
test, it was pure gold. If metal failed the acid test by corroding from the acid, it
was a base metal and of no value.
The acid test of finance shows how well a company can quickly convert
its assets into cash in order to pay off its current liabilities. It also shows the
level of quick assets to current liabilities.

Formula
The quick ratio is calculated by adding cash, cash equivalents, short-term
investments, and current receivables together then dividing them by current
liabilities.

Sometimes company financial statements donot give a breakdown of quick

assets on the balance sheet. In this case, you can still calculate the quick ratio
even if some of the quick asset totals are unknown. Simply subtract inventory
and any current prepaid assets from the current asset total for the numerator.

The acid test ratio measures the liquidity of a company by showing its ability to
pay off its current liabilities with quick assets. If a firm has enough quick assets
to cover its total current liabilities, the firm will be able to pay off its obligations
without having to sell off any long-term or capital assets.
Since most businesses use their long-term assets to generate revenues, selling
off these capital assets will not only hurt the company it will also show investors
that current operations arenot making enough profits to pay off current
liabilities.
An acid-test of 1:1 is considered satisfactory unless the majority of "quick
assets" are in accounts receivable, and the pattern of accounts receivable
collection lags behind the schedule for paying current liabilities.
Higher quick ratios are more favorable for companies because it shows there
are more quick assets than current liabilities. A company with a quick ratio of 1
indicates that quick assets equal current liabilities. This also shows that the
company could pay off its current liabilities without selling any long-term
assets. An acid ratio of 2 shows that the company has twice as many quick assets
than current liabilities.
Obviously, as the ratio increases so does the liquidity of the company. More
assets will be easily converted into cash if need be. This is a good sign for
investors, but an even better sign to creditors because creditors want to know
they will be paid back on time.

Example
Let’s assume Carlos’s Clothing Store is applying for a loan to remodel the
storefront. The bank asks Carlos for a detailed balance sheet, so it can compute
the quick ratio. Carlos’s balance sheet included the following accounts:
Cash: $10,000
Accounts Receivable: $5,000
Inventory: $5,000
Stock Investments: $1,000
Prepaid taxes: $500
Current Liabilities: $15,000
The bank can compute Carlos’s quick ratio like this.

Carlos’s quick ratio is 1.07. This means that Carlos can pay off all of its current
liabilities with quick assets and still have some quick assets left over.

C.Cash Ratio

Cash ratio is a liquidity ratio that measures a firm’s ability to pay off its current
liabilities with only cash and cash equivalents. The cash ratio is much more
restrictive than the current or quick ratio because no other current assets can be
used to pay off current debt–only cashand cash equivalents.
This is why many creditors look at the cash ratio. They want to see if a company
maintains adequate cash balances to pay off all of their current debts as they
come due. Creditors also like the fact that inventory and accounts receivable are
left out of the equation because both of these accounts are not guaranteed to be
available for debt servicing. Inventory could take months or years to sell and
receivables could take weeks to collect. Cash is guaranteed to be available for
creditors.

Formula

The cash coverage ratio is calculated by adding cash and cash equivalents and
dividing by the total current liabilities of a company.

The cash ratio shows how well a company can pay off its current liabilities with
only cash and cash equivalents.

A ratio of 1 means that the company has the same amount of cash and
equivalents as it has current debt. In other words, in order to pay off its current
debt, the company would have to use all of its cash and equivalents. A ratio
above 1 means that all the current liabilities can be paid with cash and
equivalents. A ratio below 1 means that the company needs more than just its
cash reserves to pay off its current debt.

As with most liquidity ratios, a higher cash coverage ratio means that the
company is more liquid and can more easily fund its debt. Creditors are
particularly interested in this ratio because they want to make sure their loans
will be repaid. Any ratio above 1 is considered to be a good liquidity measure.

Example
Supan’s Palace is a restaurant that is looking to remodel its dining room. Supan
is asking her bank for a loan of $100,000. Supan’s balance sheet lists these
items:

Cash: $10,000
Cash Equivalents: $2,000
Accounts Payable: $5,000
Current Taxes Payable: $1,000
Current Liabilities: $10,000
Supan’s cash ratio is calculated like this:

As you can see, Supan’s ratio is .75. This means that Supan only has enough cash
and equivalents to pay off 75 percent of her current liabilities. Depending about
Bank Policy, loan will be given to the company.

D.Defense Ratio / Cash Interval Ratio

This ratio is a useful ratio to measure the liquidity risk of a company. The use of
defensive assets ensures that the ratio measures the most conservative but
realistic situation of a company’s liquidity. The ability of the company to survive
on liquid assets signals towards a strong company, which doesn’t need external
support to run its operations. Hence a higher defense is considered good,
however, it needs to be looked at more holistically.

A company can monitor this ratio regularly across the business cycle to
understand the liquidity situation during different periods. Many businesses are
cyclical across a year or over an economic cycle.
If for some reason all the company's revenues were to suddenly cease, the Basic
Defense Interval would help determine the number of days the company can
cover its cash expenses without the aid of additional financing.

For example in the tourism industry customers book their holiday early in the
year, but they take the trip only during the holiday season. In the booking
season the company receives a lot of cash but it is still contingent on customers
actually making the trip. Hence during the off season, the revenues are very low
and they need to manage operations via internal sources. However, this trend
changes during the holiday season, when the company starts recognizing
revenue for the bookings. It is very important for the company to measure the
liquidity situation through the period and compare it with previous years.

Formula

Cash and Bank Balance + Marketable Securities

Annual Operating Expenses / Number of Days in a year

Where Daily Operating Expenses =

Cost of Goods Sold + Selling Administration and other General expenses -

Depreciation and other non-cash expenditure / Number of days in a year

Defensive Interval Ratio Formula Components

Defensive assets = cash + marketable securities + Cash Equivalent

Daily operational expenses = (annual operating expenses – noncash charges) /

365
Analyst can check the financial statements and notes to accounts for details of
all the items in the formula. It is important to identify the underlying defensive
assets and daily expenses accurately.

Defensive Assets is the sum of cash, marketable securities.

Daily Operational expenses refers to the per day operating expense (Cost of
Sales, Operating expenses) but excluding non-cash items such as depreciation.

Analysts consider DIR to be a more useful liquidity ratio than quick ratio or
current ratio due to the fact that it compares assets to expenses rather than
comparing assets to liabilities.

Analysis and Interpretation

There is no perfect answer to the number of days over which existing assets will
provide sufficient funds to support company operations. Instead, analysts need
to review the ratio over time to see if the defensive interval is reducing; this may
indicate that the company’s buffer of liquid assets is gradually declining in
proportion to its immediate payment liabilities.

Generally, a higher DIR is better as it provides more liquidity for the company.
However, sometimes too much liquid assets could be negative as it could imply
that the company is not employing capital efficiently to generate higher returns.
Analyst need to look at this ratio from the industry in which the company
operates. In capital intensive industries, the company might have deployed its
capital in large scale projects, which can be long-term value creative. Further, in
certain industries it might be a common practice to avail short-term loans to
manage operations (like working capital loans) as it might be cheaply available.
Analyst need to be aware about all these dynamics before commenting on the
DbIR of a company.

Lenders also look at this ratio on a regular interval. There may not be a direct
covenant attached to this ratio (although it could be possible especially for
short-term loans), but it provides a good proxy of the operating condition of a
company.
E.Net Working Capital

Net working capital is a liquidity calculation that measures a company’s ability

to pay off its current liabilities with current assets. This measurement is
important to management, vendors, and general creditors because it shows the
firm’s short-term liquidity as well as management’s ability to use its assets
efficiently.

Much like the working capital formula focuses on current liabilities like trade
debts, accounts payable, and vendor notes that must be repaid in the current
year. It only makes sense the vendors and creditors would like to see how much
current assets, assets that are expected to be converted into cash in the one
year, are available to pay for the liabilities that will become due in the coming 12
months.

Bankers look at Net Working Capital over time to determine a company's ability
to meet payments in financial crises. Loans are often tied to minimum working
capital requirements.

If a company can not meet its current obligations with current assets, it will be
forced to use its long-term assets. This can lead decreased operations, sales, and
may even be an indicator of more severe organizational and financial problems.

Formula
The net working capital formula is calculated by subtracting the current
liabilities from the current assets. Here is what the basic equation looks like.

Typical current assets that are included in the net working capital calculation
are cash, accounts receivable, inventory, and short-term investments. The
current liabilities section typically includes accounts payable, accrued
expenses and taxes, customer deposits, and other trade debt.
Some people also choice to include the current portion of long-term debt in the
liabilities section. This makes sense because although it is from a long-term
obligation, the current portion will have to be repaid in the current year. Thus,
it’s appropriate to include it in with the other obligations that must be met in the
next 12 months.

Example
Let’s look at Paul’s Retail store as an example. Paul owns and operates a
women’s clothing and apparel store that has the following current assets and
liabilities:

Cash: $10,000
Accounts Receivable: $5,000
Inventory: $15,000
Accounts Payable: $7,500
Accrued Expenses: $2,500
Other Trade Debt: $5,000

Paul would can use a net working capital calculator to compute the
measurement like this:

Since Paula’s current assets exceed current liabilities, so the WC is positive. This
means that Paul can pay all of her current liabilities using only current assets. In
other words, the store is very liquid and financially sound in the short-term. It
can use this extra liquidity to grow the business.

If Paul’s current liabilities exceeded current assets, WC would be negative

indicating that short-term liquidity isnot as high as it could be.

Analysis

Obviously, a positive net WC is better than a negative one. A positive calculation

shows creditors and investors that the company is able to generate enough from
operations to pay for its current obligations with current assets. A large positive
measurement could also mean that the business has available capital to expand
rapidly without taking on new, additional debt or investors. It can fund its own
expansion through its current growing operations.

What is Negative Net Working Capital?

A negative net working capital, on the other hand, shows creditors and investors
that the operations of the business arenot producing enough to support the
business’ current debts. If this negative number continues over time, the
business might be required to sell some of its long-term, income producing
assets to pay for current obligations. Expanding without taking on new debt or
investors would be out of the question and if the negative trend continues, net
WC could lead to a company declaring bankruptcy.

It is to be kept in mind that a negative number is worse than a positive one, but
it doesn’t necessarily mean that the company is going to go under. It’s just a sign
that the short-term liquidity of the business isn’t that good. There are many
factors in what creates a healthy, sustainable business. For example, a positive
WC might not really mean much if the company can’t convert its inventory or
receivables to cash in a short period of time. Technically, it might have more
current assets than current liabilities, but it can’t pay its creditors off in
inventory, so it doesn’t matter. Conversely, a negative WC might not mean the
company is in poor shape if it has access to large amounts of financing to meet
short-term obligations such as a line of credit.

What is a more telling indicator of a company’s short-term liquidity is an

increasing or decreasing trend in their net WC. A company with a negative net
WC that has continual improvement year over year could be viewed as a more
stable business than one with a positive net WC and a downward trend year
over year.

Change in Net Working Capital

There are three main ways the liquidity of the company can be improved year
over year. First, the company can decrease its accounts receivable collection
time. Second, it can reduce the amount of carrying inventory by sending back
unmarketable goods to suppliers. Third, the company can negotiate with
vendors and suppliers for longer accounts payable payment terms. Each one of
these steps will help improve the short-term liquidity of the company and
positively impact the analysis of net working capital.

2. Solvency Ratios:

It is also called financial leverage ratios, solvency ratios compare a company's

debt levels with its assets, equity, and earnings to evaluate whether a company
can stay afloat in the long-term by paying its long-term debt and interest on the
debt.

Examples of solvency ratios include debt-equity ratio, debt-assets ratio,

and interest coverage ratio.

Leverageratios / Solvency Ratiosareoftwotypes:

1. CapitalStructureRatios
(a) EquityRatio
(b) DebtRatio
(c) DebttoEquityRatio
 (d) DebttoTotalAssetsRatio
(e) CapitalGearingRatio
(f) ProprietaryRatio
2. CoverageRatios
(a) Debt-ServiceCoverageRatio(DSCR)
(b) InterestCoverageRatio
(c) PreferenceDividendCoverageRatio
(d) FixedChargesCoverageRatio

What is Capital Structure?

The capital structure is how a firm finances its overall operations and growth by
using different sources of funds. Debt comes in the form of bond issues or long-
term notes payable, while equity is classified as common stock, preferred
stock or retained earnings.

Capital structure can be a mixture of a firm's long-term debt, common equity

and preferred equity. A company's proportion of long-term debt is considered
when analyzing capital structure. When analysts refer to capital structure, they
are most likely referring to a firm's debt-to-equity (D/E) ratio, which provides
insight into how risky a company is. Usually, a company that is heavily financed
by debt has a more aggressive capital structure and therefore poses greater risk
to investors. This risk, however, may be the primary source of the firm's growth.

A.Equity Ratio

The equity ratio is an investment leverage or solvency ratio that measures the
amount of assets that are financed by owners’ investments by comparing the
total equity in the company to the total assets.

The equity ratio highlights two important financial concepts of a solvent and
sustainable business. The first component shows how much of the total
company assets are owned outright by the investors. In other words, after all of
the liabilities are paid off, the investors will end up with the remaining assets.
The second component inversely shows how leveraged the company is with
debt. The equity ratio measures how much of a firm’s assets were financed by
investors. In other words, this is the investors’ stake in the company. This is
what they are on the look for. The inverse of this calculation shows the amount
of assets that were financed by debt. Companies with higher equity ratios show
new investors and creditors that investors believe in the company and are
willing to finance it with their investments.

Formula
The equity ratio is calculated by dividing total equity by total assets. Both of
these numbers truly include all of the accounts in that category. In other words,
all of the assets and equity reported on the balance sheet are included in the
equity ratio calculation.

Analysis
In general, higher equity ratios are typically favorable for companies. This is
usually the case for several reasons. Higher investment levels by shareholders
shows potential shareholders that the company is worth investing in since so
many investors are willing to finance the company. A higher ratio also shows
potential creditors that the company is more sustainable and less risky to lend
future loans.

Companies with higher equity ratios will have more debt financing and more
debt service costs than companies with lower ratios.

As with all ratios, they are contingent on the industry. Exact ratio performance
depends on industry standards and benchmarks.

Example
Steve’s Tech Company is a new startup with a number of different investors.
Steve is looking for additional financing to help grow the company, so he talks to
his business partners about financing options. Steve’s total assets are reported
at $150,000 and his total liabilities are $50,000. Based on the accounting
equation, we can assume the total equityis $100,000. Here is Steve’s equity ratio.

As you can see, Steve’s ratio is .67. This means that investors rather than debt
are currently funding more assets. 67 percent of the company’s assets are
owned by shareholders and not creditors. Depending on the industry, this is a
healthy ratio.

B.Debt Ratio

Debt ratio is a solvency ratio that measures a firm’s total liabilities as a

percentage of its total assets. In a sense, the debt ratio shows portion of
company’s liability to its assets. In other words, this shows how many assets the
company must sell in order to pay off all of its liabilities.

This ratio measures the financial leverage of a company. Companies with higher
levels of liabilities compared with assets are considered highly leveraged and
more risky for lenders.

This helps investors and creditors analysis the overall debt burden on the
company as well as the firm’s ability to pay off the debt in future, uncertain
economic times.

Formula
The debt ratio is calculated by dividing total liabilities by total assets. Both of
these numbers can easily be found the balance sheet. Here is the calculation:
Analysis
The debt ratio is shown in decimal format because it calculates total liabilities as
a percentage of total assets. As with many solvency ratios, a lower ratios is more
favorable than a higher ratio.

A lower debt ratio usually implies a more stable business with the potential of
longevity because a company with lower ratio also has lower overall debt. Each
industry has its own benchmarks for debt.

For example, a debt ratio of 0.50 is often considered to be less risky. This means
that the company has twice as many assets as liabilities, Or said a different way,
this company’s liabilities are only 50 percent of its total assets. Essentially, only
its creditors own half of the company’s assets and the shareholders own the
remainder of the assets.

The debt ratio is a fundamental solvency ratio because creditors are always
concerned about being repaid. When companies borrow more money, their
ratio increases creditors will no longer loan them funds. Companies with higher
debt ratios are better off looking to equity financing to grow their operations.

Example
Dave’s Guitar Shop is thinking about building an addition onto the back of its
existing building for more storage. Dave consults with his banker about applying
for a new loan. The bank asks for Dave’s balance to examine his
overall debt levels.

The banker discovers that Dave has total assets of $100,000 and total liabilities
of $25,000. Dave’s debt ratio would be calculated like this:
As you can see, Dave only has a debt ratio of .25. In other words, Dave has 4
times as many assets as he has liabilities. This is a relatively low ratio and
implies that Dave will be able to pay back his loan. Dave shouldn’t have a
problem getting approved for his loan.

C. Debt to Equity Ratio

The debt to equity ratio is a financial, liquidity ratio that compares a company’s
total debt to total equity. The debt to equity ratio shows the percentage of
company financing that comes from creditors and outsiders. A higher debt to
equity ratio indicates that more outsider’s financing (bank loans) is used than
own financing.

Formula
The debt to equity ratio is calculated by dividing total liabilities by total equity.
The debt to equity ratio is considered a balance sheet ratio because all of the
elements are reported on the balance sheet.

Analysis
Each industry has different debt to equity ratio benchmarks, as some industries
tend to use more debt financing than others. A debt ratio of 0.50 means that
there are half as many liabilities as there is equity. In other words, the assets of
the company are funded 2-to-1 by investors to creditors. This means that
investors own 66.6 cents of every dollar of company assets while creditors only
own 33.3 cents on the dollar.

A debt to equity ratio of 1 would mean that investors and creditors have an
equal stake in the business assets.
A high debt to equities ratio here means less protection for creditors, a low ratio,
on the other hand, indicates a wider safety cushion. This ratio indicates the
proportion of debt fund in relation to equity. This ratio is very often referred in
capital structure decision as well as in the legislation dealing with the capital
structure decisions (i.e. issue of shares and debentures). Lenders are also very
keen to know this ratio since it shows relative weights of debt and equity. Debt
equity ratio is the indicator of firm's financial leverage.

A lower debt to equity ratio usually implies a more financially stable business.
Companies with a higher debt to equity ratio are considered more risky to
creditors and investors than companies with a lower ratio. Unlike equity
financing, debt must be repaid to the lender. Since debt financing also requires
debt servicing or regular interest payments. Companies leveraging large
amounts of debt might not be able to make the payments.

Creditors view a higher debt to equity ratio as risky because it shows that the
investors haven’t funded the operations as much as creditors have. In other
words, investors don’t have as much skin in the game as the creditors do. This
could mean that investors don’t want to fund the business operations because
the company isn’t performing well. Lack of performance might also be the
reason why the company is seeking out extra debt financing.

Example
Assume ABC Company has $100,000 of bank lines of credit and a $500,000
mortgage on its property. The shareholders of the company have invested $1.2
million. Here is how you calculate the debt to equity ratio.

D.Capital Gearing Ratio

Capital Gearing Ratio is a great tool for investors. By analyzing the capital
gearing ratio you get to know the exact proportion of out sider’s financing in
capital structure. Through capital gearing ratio, the investors can understand
how geared the capital of the firm is. The firm’s capital can either be low geared
or high geared. When a firm’s capital is composed of more common stocks
rather than other fixed interest or dividend bearing funds, it’s said to have been
low geared. On the other hand, when the firm’s capital consists of less common
stocks and more of interest or dividend bearing funds, it’s said to be high
geared.

Now why it matters to know whether the firm’s capital is high geared or low
geared? Here’s why. Companies which are low geared tend to pay less interests
or dividends. On the other hands, high geared companies need to give more
interest increasing the risk of investors. For this reason, banks and financial
institutions don’t want to lend money to the companies which are already high
geared.

A company is said to be low geared if the larger portion of the capital is

composed of common stockholders’ equity. On the other hand, the company is
said to be highly geared if the larger portion of the capital is composed of fixed
interest/dividend bearing funds.

Formula:

= Preference Share Capital + Debentures + Loan / Equity Share Capital +

Reserves and Surplus

In the above formula, the denominator consists of common stockholders’ equity

that is equal to total stockholders’ equity less preferred stock and the numerator
consists of fixed interest or dividend bearing funds that usually include long
term loans, bonds, debentures and preferred stock etc.

Example:

The following information have been taken from the balance sheet of ABC
limited:

Year 20X1:

Common stockholders’ equity: $3,000,000

Preferred stock – 9%: $1,900,000
Bonds payable – 6%: $1,600,000

Year 20X2:

Common stockholders’ equity: $3,200,000

Preferred stock – 9%: $1,800,000
Bonds payable – 6%: $1,000,000
We can compute the capital gearing ratio for the years 20X1 and 20X2 from the
above information as follows:

For the year 20X1:

Capital gearing ratio = 3,500,000 / 3,000,000

= 7: 6 (Highly geared)

For the year 20X2:

Capital gearing ratio = 2,800,000 / 3,200,000

= 7: 8 (Low geared)

E.Proprietary Ratio

It shows the proportion of total assets of a company which are financed by

proprietors’ funds. The proprietary ratio is also known as equity ratio. It helps
to determine the financial strength of a company and is useful for creditors to
assess the ratio of shareholders’ funds employed out of total assets of the
company.
The word “Proprietors” is a synonym for “owners of a business”, proprietors’
fund, in this case, would only be the funds which belong to the
owners/shareholders of the business. Proprietors’ funds are also known
as Owners’ funds, Shareholders’ funds, Net Worth, etc.

Formula:

Proprietors’ funds or Shareholders’ funds

= Equity Share Capital + Preference Share Capital + Reserves and Surplus

Total Assets = Includes total assets as per the balance sheet

Example:

From the balance sheet of Unreal Corporation calculate its proprietary ratio
Liabilities Amount Assets Amount
Share Capital 10,00,000 Tangible Assets 10,00,000
Reserves & Surplus 2,00,000 Long-Term Investments 5,00,000
Short-Term Borrowings 40,000 Stock 70,000
Trade Payable 4,00,000 Trade Receivable 70,000

Total 16,40,000 Total 16,40,000

Shareholders’ Funds/Total Assets

S/H Funds = 10,00,000 + 2,00,000

Total Assets = 16,40,000

12,00,000/16,40,000

Proprietary ratio = 0.73

A proprietary ratio of 0.73 shows that the company has 0.73 units of
shareholders’ funds for each unit of total asset or in other words 73% of total
assets of the company are financed by proprietors’ funds.

High & Low Proprietary Ratio

High – This ratio indicates the relative proportions of capital contribution by

shareholders in comparison to the total assets of a company. It is used as a
screening device for financial analysis, a higher ratio, say more than 75% means
sufficient comfort for creditors since it points towards lesser dependence on
external sources.

Low – Whereas, a lower ratio, say less than 60% means discomfort for creditors
since it shows more dependence on external sources, a lower ratio can be seen
as a threat and may increase unwillingness of creditors to extend credit to the
company. A company should mix and balance its external and internal sources
in a way that none of them is too high in comparison to the other.

Coverage Ratios
A Coverage Ratio is any one of a group of financial ratios used to measure a
company’s ability to pay its financial obligations. A higher ratio indicates a
greater ability of the company to meet its financial obligations while a lower
ratio indicates a lesser ability. Coverage ratios are commonly used by creditors
and lenders to determine the financial standing of a prospective borrower.
The most common coverage ratios are:

A. Interest coverage ratio: The ability of a company to pay the interest

expense (only) on its debt

B. Debt service coverage ratio: The ability of a company to pay all debt
obligations, including repayment of principal and interest

C. Cash coverage ratio: The ability of a company to pay interest expense

with its cash balance.

D. Preference Dividend Coverage Ratio :- It measures ability of the company

to make payment of Preference Dividend.

#1 Interest Coverage Ratio

The interest coverage ratio (ICR), also called the “times interest earned”,
evaluates the number of times a company is able to pay the interest expenses on
its debt with its operating income. This ration must be exceeding 1. A low ICR
signals default risk and the refusal of lenders to lend more money to the
company.

Formula

The interest coverage ratio formula is calculated by dividing the EBIT (Earnings
before interest and taxes) by the interest expense. Here is what the interest
coverage equation looks like.
As you can see, the equation uses EBIT instead of net income. Earnings before
interest and taxes is essentially net income with the interest and tax expenses
added back in. The reason we use EBIT instead of net income in the calculation
is because we want a true representation of how much the company can afford
to pay in interest. If we used net income, the calculation would be screwed
because interest expense would be counted twice and tax expense would
change based on the interest being deducted. To avoid this problem, we just use
the earnings or revenues before interest and taxes are paid.

Further note that that this formula can be used to measure any interest period.
For example, monthly or partial year numbers can be calculated by dividing the
EBIT and interest expense by the number of months you want to compute.

Example
Caroline’s Jam Company is a jelly and jam jarring business that cans
preservatives and ships them across the country. Caroline wants to expand her
operations, but she doesn’t have the funds to purchase the canning machines
she needs. Thus, she goes to several banks with her financial statements to try to
get the funding she wants. Caroline’s earnings before interest and taxes is
$50,000 and her interest and taxes are $15,000 and $5,000 respectively. The
bank would compute Caroline’s interest coverage ratio like this:

As you can see, Caroline has a ratio of 3.33. This means that has makes 3.33
times more earnings than her current interest payments. She can well afford to
pay the interest on her current debt. This is a good sign because it shows her
company risk is low and her operations are producing enough earning to pay
her interest.
For example, a company reports an operating income of $500,000. The company
is liable for interest payments of $60,000.

Interest coverage = $500,000 / $60,000 = 8.3x

Therefore, the company would be able to pay its interest payment 8.3x over
with its operating income.

Analysis

Analyzing a coverage ratio can be tricky because it depends largely on how

much risk the creditor or investor is willing to take. Depending on the desired
risk limits, a bank might be more comfortable with a number than another. The
basics of this measurement don’t change, however.
If the computation is less than 1, it means the company isn’t making enough
money to pay its interest payments. Forget paying back the principal payments
on the debt. A company with a calculation less than 1 can’t even pay the interest
on its debt. This type of company is beyond risky and probably would never get
bank financing.

If the coverage equation equals 1, it means the company makes just enough
money to pay its interest. This situation isn’t much better than the last one
because the company still can’t afford to make the principle payments. It can
only cover the interest on the current debt when it comes due.

If the coverage measurement is above 1, it means that the company is making

more than enough money to pay its interest obligations with some extra
earnings left over to make the principal repayments.

Going back to our example above, Sarah’s coverage ratio is 3.33. She is making
enough money from her current operations to pay her current interest rates
3.33 times over. Her company is extremely liquid and shouldn’t have problem
getting a loan to expand.

#2 Debt Service Coverage Ratio

The debt service coverage ratio (DSCR) evaluates a company’s ability to use
funds available to it to repay its debt obligations including interest. The DSCR is
often calculated when a company takes a loan from a bank, financial institution,
or other loan provider. A DSCR of less than 1 suggests an inability to serve the
company’s debt.

For example, a DSCR of 0.9 means that there is only enough funds available to
cover 90% of annual debt and interest payments. This ratio must be greater
than 1.

The debt service coverage ratio is important to both lenders and investors, but
lenders most often analyze it. Since this ratio measures a firm’s ability to make
its current debt obligations, current and future creditors are particularly
interest in it.

Lendersnot only want to know the cash position and cash flow of a company,
they also want to know how much debt it currently owes and the available cash
to pay the current and future debt.
In this way, the DSCR is more telling of a company’s ability to pay its debt.

Formula

The debt service coverage ratio formula is calculated as under.

= Funds available for debt servicing / Interest and Principal repayment.

= P A T + Depreciation + Interest + Any other non cash item / Interest and

Principal repayment.

Total debt service refers to all costs related to servicing a company’s debt. This
often includes interest payments, principle payments. The debt service amount
is rarely given in a set of financial statements. Many times this is mentioned in
the financial statement notes, however.
Example

Batoo’s Shoe Store is looking to remodel its storefront, but it doesn’t have
enough cash to pay for the remodel itself. Thus, Batoo is talking with several
banks in order to get a loan. Batoo is a little worried that he won’t get a loan
because he already has several loans.

According to his financial statements and documents, Batoo’s had the following:

Funds Available for Debt

$150,000
Servicing

Interest Expense $55,000

Principle Payments $35,000

Redemption of Debentures $25,000

Here is Batoo’s debt service coverage calculation:

As you can see, Burton has a ratio of 1.3. This means that Batoo makes enough in
operating profits to pay his current debt service costs and be left with 30
percent of his profits.
#3 Cash Coverage Ratio

This is one more additional ratio, known as the cash coverage ratio, which is
used to compare the company’s cash balance to its annual interest expense.
This is a very conservative metric, as it compares only cash on hand (no other
assets) to the interest expense the company has relative to its debt.
Formula

Cash coverage ratio = Total cash and bank balance / Total interest expense

Example

Consider a company with the following information:

Cash balance: $50 million
Short-term debt: $12 million
Long-term debt: $25 million
Interest expense: $2.5 million
Cash coverage = $50 million / $2.5 million = 20.0x
This means the company can cover its interest expense for twenty times.

# 4 Preferred Dividend Coverage Ratio

The preferred dividend coverage ratio is a financial measure that calculates a

corporation’s ability to pay the preference dividend owed to its preferred
shareholders based on its earnings after taxes. In other words, it shows
investors and shareholders how well the company is doing by comparing profits
to preferred dividends. If the company has sufficient profits to pay the
dividends, it’s deemed to be doing well.

This coverage ratio, also called times preferred dividend earned ratio, looks at
the company’s net income to see if it is sufficient to meet the fixed dividend
amount payable on its outstanding preferred shares. Thus, it is useful to all
current and potential shareholders, as well as debt holders, as an important
component in evaluating a company’s financial health.

Banks and other creditors will use this ratio to evaluate how much additional
debt the company can handle. Even common stock shareholders should be
aware of this coverage ratio, as it could have an effect on common stock
dividends.

Ideally, the company will have much more profits than it needs to cover this
dividend payment, but this isn’t always the case. A coverage ratio of 1 signifies
the company will be able to meet its preferred dividend obligation, while a
number less than 1 means it cannot and is a serious problem.

There are three important pieces of information needed to calculate the

preferred dividend coverage ratio: net income, the fixed dividend rate
on preferred shares and par value of the preferred shares. Each of these can be
obtained from company financial statements, such as the annual report and the
prospectus.

Now, let’s look at how to calculate the preferred dividend coverage ratio
equation.

Formula
The preferred dividend coverage ratio formula is calculated by dividing the net
income (Earning After Taxes) for the year by the preferred dividend amount for
that year.

Preferred Dividend Coverage Ratio = Net Income / Annual Preferred Dividend

Amount

Before we can calculate this preferred dividend coverage ratio equation, we

compute the preferred dividends for the year. We can do this by multiplying the
annual dividend rate by the par value of the shares. Both of these factors can be
found in the preferred stock issue’s prospectus. Now, you can divide the net
income, by this number to find the coverage ratio.

Example

XYZ, Inc. is an established cloud storage solution provider with a track record
among investors for paying the highest preferred dividend in the sector. Larry is
a money manager looking for opportunities in his high-income portfolio. He is
trying to determine if adding XYZ, Inc. to his portfolio is a good long-term
position. One of the tools Larry uses in his search for such investments is the
PDC ratio. It gives him an idea of how stable the company is and assures him if
the dividend can be expected to last for his investors.

Larry pulls XYZ, Inc.’s annual report to find the company’s net income was $20
million. Then, he looks at the preferred issue’s prospectus to find it was issued
for a total par value of $10,000,000 at 5%.

Seeing that XYZ, Inc. could cover 40 times their annual preferred dividend
obligation with their annual profits proves to Larry that there is a very good
chance the dividend will be paid. It also illustrates that XYZ, Inc. is in great
financial shape.

A. Gross Profit

Gross profit margin is a profitability ratio that calculates the percentage of sales
that exceed the cost of goods sold. In other words, it measures how efficiently a
company uses its materials and labor to produce and sell products profitably.
You can think of it as the amount of money from product sales left over after all
of the direct costs associated with manufacturing the product have been
considered. These direct costs are typically called cost of goods sold or COGS.

The gross profit ratio is important because it shows management and investors
how profitable the core business activities are without taking into consideration
the indirect costs. In other words, it shows how efficiently a company can
produce and sell its products. This gives investors a key insight into how healthy
the company actually is.

That is why it is almost always listed on front page of the income statement in
one form or another. Let’s take a look at how to calculate gross profit and what
it’s used for.

Formula
The gross profit formula is calculated by subtracting total cost of goods sold
from total sales.

Both the total sales and cost of goods sold are found on the income statement.
This equation looks at the pure dollar amount of GP for the company, but many
times it’s helpful to calculate the gross profit rate or margin as a percentage.

The gross profit percentage formula is calculated by subtracting cost of goods

sold from total revenues and dividing the difference by total revenues. Usually a
gross profit calculator would rephrase this equation and simply divide the total
GP dollar amount we used above by the total revenues. Both equations get the
result.

Example
Miami owns a clothing business that designs and manufactures high-end
clothing for children. She has several different lines of clothing and has proven
to be one of the most successful brands in her space. Here’s what appears on
Miami’s income statement at the end of the year.

Total sales : $1,000,000

COGS : $350,000
Rent : $100,000
Utilities : $10,000
Office expenses : $2,500

Miami has an upcoming meeting with investors and wants to know how to find
gross profit and what method to use. First, we can calculate Miami’s overall
dollar amount of GP by subtracting the $350,000 of COGS from the $1,000,000
of total sales like this:

As you can see, Miami has a GP of $650,000. This means the goods that she sold
for $1M only cost her $350,000 to produce. Now she has $650,000 that can be
used to pay for other bills like rent and utilities.

B. Net Profit

Net profit ratio (NP ratio) is a popular profitability ratio that shows
relationship between net profit after tax and sales. It is computed by dividing
the net profit after tax by sales.

Formula:

Example:
The following data has been extracted from income statement of Albari
corporation.

Sales : $200,000
Net profit before tax : $50,000
Income tax : 10%

Required: Compute net profit ratio of Albari Corporation using above

information.

Solution:

= ($45,000* / 200,000)

= 0.225 or 22.5%

*Net profit after tax:

= $50,000 – ($50,000 × 0.1)

= $45,000

Significance and Interpretation:

Net profit (NP) ratio is a useful tool to measure the overall profitability of the
business. A high ratio indicates the efficient management of the affairs of
business.

There is no norm to interpret this ratio. To see whether the business is

constantly improving its profitability or not, the analyst should compare the
ratio with the previous years’ ratio, the industry’s average and the budgeted net
profit ratio.

The use of net profit ratio in conjunction with the assets turnover ratio helps in
ascertaining how profitably the assets have been used during the period.

C. Operating Profit Ratio

Operating profit ratio establishes a relationship between operating Profit

earned and revenue generated from operations (net sales). Operating profit
ratio is a type of profitability ratio which is expressed as a percentage.
Sales include both Cash and Credit Sales, on the other hand, Operating Profit is
the net operating profit. Operating Profit ratio helps to find out Operating
Profit earned in comparison to revenue earned from operations.

Formula

= Operating Profit / Sales

Operating Profit = Net profit before taxes + Non-operating expenses – Non-

operating incomes

or

Operating Profit = Gross profit + Other Operating Income – Other operating

expenses

Revenue from Operations = Cash sales + Credit sales

Example

Ques. Calculate Operating profit ratio from the below information

Sales 5,00,000

Operating Profit 1,00,000

Operating Profit Ratio = (Operating Profit/Net Sales)*100

(1,00,000/5,00,000)*100

= 20%

This means that for every 1 unit of sales the company earns 20% as operating
profit.
Alternatively, the company has an Operating profit margin of 20%, i.e. 0.20 unit
of operating profit for every 1 unit of revenue generated from operations.

High and Low Operating Profit Ratio

This ratio helps to analyze a firm’s operational efficiency; a trend analysis can be
done between two different accounting periods to assess improvement or
deterioration of operational capability.

High – A high ratio may indicate better management of resources i.e. a higher
operational efficiency leading to higher operating profits in the company.

Low – A low ratio may indicate operational flaws and improper management of
resources, it is an indicator that the profit generated from operations are not
enough as compared to the total revenue generated from sales.

Profitability Ratios based on Return

A. Return on Assets Ratio

The return on assets ratio, is a profitability ratio that measures the income
produced by total assets during a period by comparing net income to the
average total assets. In other words, the return on assets ratio or ROA measures
how efficiently a company can manage its assets to produce profits during a
period.

Since company assets’ sole purpose is to generate revenues and produce profits,
this ratio helps both management and investors see how well the company can
convert its investments in assets into profits. In short, this ratio measures how
profitable a company’s assets are.

Formula
The return on assets ratio formula is calculated by dividing income by average
total assets.
When using the first formula, average total assets are usually used because asset
totals can vary throughout the year. Simply add the beginning and ending assets
together on the balance sheet and divide by two to calculate the average assets
for the year.

Analysis
The return on assets ratio measures how effectively a company can earn a
return on its investment in assets. In other words, ROA shows how efficiently a
company can convert the money used to purchase assets into income or profits.

It only makes sense that a higher ratio is more favorable to investors because it
shows that the company is more effectively managing its assets to produce
greater amounts of net income. A positive ROA ratio usually indicates an
upward profit trend as well. ROA is most useful for comparing companies in the
same industry as different industries use assets differently. For instance,
construction companies use large, expensive equipment while software
companies use computers and servers.

Example

Carlos’s Construction Company is a growing construction business that has a

few contracts to build storefronts in downtown Chicago. Carlos’s balance sheet
shows beginning assets of $1,000,000 and an ending balance of $2,000,000 of
assets. During the current year, Carlos’s company had income of $20,000,000.
Carlos’s return on assets ratio looks like this.

As you can see, Carlos’s ratio is 133.33 percent. In other words, every dollar that
Carlos invested in assets during the year produced $1.33 of income. Depending
on the economy, this can be a healthy return rate no matter what the investment
is.

Investors would have to compare Carlos’s return with other construction

companies in his industry to get a true understanding of how well Carlos is
managing his assets.

B. Return on Capital Employed

Return on capital employed or ROCE is a profitability ratio that measures how

efficiently a company can generate profits from its capital employed by
comparing operating profit to capital employed. In other words, return on
capital employed shows investors how many dollars in profits each dollar of
capital employed generates.

ROCE is a long-term profitability ratio because it shows how effectively assets

are performing while taking into consideration long-term financing.

This ratio is based on two important calculations: operating profit and capital
employed. Operating profit is often called EBIT (Earnings before interest and
taxes). EBIT is often reported on the income statement because it shows the
company profits generated from operations.

Most often capital employed refers to the total assets of a company less all
current liabilities. This could also be looked at as stockholders’ equity plus long-
term liabilities. Both equal the same figure.

Formula

Return on capital employed formula is calculated by dividing Operating profit or

EBIT by the employed capital.

If employed capital is not given in a problem or in the financial statement notes,

you can calculate it by subtracting current liabilities from total assets. In this
case the ROCE formula would look like this:
Analysis
The return on capital employed ratio shows how much profit each dollar of
employed capital generates. Obviously, a higher ratio would be more favorable
because it means that more dollars of profits are generated by each dollar of
capital employed.

For instance, a return of 0.20 indicates that for every dollar invested in capital
employed, the company made 20 cents of profits.

Investors are interested in the ratio to see how efficiently a company uses its
capital employed as well as its long-term financing strategies. Companies’
returns should always be high than the rate at which they are borrowing to fund
the assets. If companies borrow at 10 percent and can only achieve a return of 5
percent, they are losing money.

Just like the return on assets ratio, a company’s amount of assets can either
hinder or help them achieve a high return. In other words, a company that has a
small dollar amount of assets but a large amount of profits will have a higher
return.

Example

Sitaraman’s Auto Body Shop customizes cars for celebrities and movie sets.
During the year, Sitaraman had anOperating profit of $100,000. Sitaraman
reported $100,000 of average total assets and $25,000 of average current
liabilities on his balance sheet for the year.

Accordingly, Sitaraman’s return on capital employed would be calculated like

this:
As you can see, Sitaraman has a return of 1.33. In other words, every dollar
invested in employed capital, Sitaraman earns $1.33. Sitaraman’s return might
be so high because he maintains low assets level.
Companies with large cash reserves usually skew this ratio because cash is
included in the employed capital computation even though it isn’t technically
employed yet.

C. Return on Equity (ROE) Ratio

The return on equity ratio or ROE is a profitability ratio that measures the
ability of a firm to generate profits from its shareholders in the company. In
other words, the return on equity ratio shows how much profit each dollar of
common stockholders’ equity generates.

So a return on 0.20 means that every dollar of common stockholders’ equity

generates 20 cents dollar of net income. This is an important measurement for
potential investors because they want to see how efficiently a company will use
their money to generate net income.

ROE is also an indicator of how effective management is at using equity

financing to fund operations and grow the company.

Formula

The return on equity ratio formula is calculated by dividing net income by

Average shareholder’s equity.

Most of the time, ROE is computed for common shareholders. In this case,
preferred dividends are not included in the calculation because these profits are
not available to common stockholders. Preferred dividends are then taken out
of net income for the calculation.
Also, average common stockholder’s equity is usually used, so an average of
beginning and ending equity is calculated.

Analysis
Return on equity measures how efficiently a firm can use the money from
shareholders to generate profits and grow the company. Unlike other return on
investment ratios, ROE is a profitability ratio from the investor’s point of view—
not the company. In other words, this ratio calculates how much money is made
based on the investors’ investment in the company, not the company’s
investment in assets or something else.

That being said, investors want to see a high return on equity ratio because this
indicates that the company is using its investors’ funds effectively. Higher ratios
are almost always better than lower ratios, but have to be compared to other
companies’ ratios in the industry. Since every industry has different levels of
investors and income, ROE can’t be used to compare companies outside of their
industries very effectively.

Example

Tamil’s Tool Company is a retail store that sells tools to construction companies
across the country. Tamil reported Earning After Taxes of $22,000 and is
required to pay preferred dividends of $10,000 during the year. Tamil also had
10,000, $5 par common shares outstanding during the year. Tamil would
calculate her return on common equity like this:

= (Net Income – Preference Dividend) / Equity Share Capital

= (22,000 – 10,000) / 50,000

= 12,000 / 50,000

= 0.24 i.e. 24 %

As you can see, after preferred dividends are removed from net income Tamil’s
ROE is 24 %. This means that every dollar of common
shareholder’s equity earned about $ 0.24 this year. Tamil’s ratio is most likely
considered high for her industry. This could indicate that Tamil’s is a growing
company.

An average of 5 to 10 years of ROE ratios will give investors a better picture of

the growth of this company.

Profitability Ratios required for Analysis

A. Earnings per Share (EPS)

Earnings per share (EPS), also called net income per share, is a market prospect
ratio that measures the amount of net income earned per share of common
stock outstanding. In other words, this is the amount of money each share of
common stock would receive if all of the profits were distributed to the
outstanding shares at the end of the year.

Earnings per share are also a calculation that shows how profitable a company
is on a shareholder basis. So a larger company’s profits per share can be
compared to smaller company’s profits per share. Obviously, this calculation is
heavily influenced on how many shares are outstanding. Thus, a larger company
will have to split its earning amongst many more shares of stock compared to a
smaller company.

Formula

Earnings per share or basic earnings per share is calculated by subtracting

preferred dividends from net income and dividing by the weighted average
common shares outstanding. The earnings per share formula looks like this.

Most of the time earning per share is calculated for year-end financial
statements. Since companies often issue new stock and buy back treasury stock
throughout the year, the weighted average common shares are used in the
calculation. The weighted average common shares outstanding is can be
simplified by adding the beginning and ending outstanding shares and dividing
by two.
Analysis

Earnings per share are the same as any profitability or market prospect ratio.
Higher earnings per share are always better than a lower ratio because this
means the company is more profitable and the company has more profits to
distribute to its shareholders.

Although many investors don’t pay much attention to the EPS, a higher earnings
per share ratio often makes the stock price of a company rise. Since so many
things can manipulate this ratio, investors tend to look at it but don’t let it
influence their decisions drastically.

Example

Queen Co. has net income during the year of $50,000. Since it is a small
company, there are no preferred shares outstanding. Queen Co. had 5,000
weighted average shares outstanding during the year. Queen’s EPS is calculated
like this.

As you can see, Queen’s EPS for the year is $10. This means that if Queen
distributed every dollar of income to its shareholders, each share would receive
10 dollars.

B. Dividend per Share

Dividend per Share (DPS) is the total amount of dividend attributed to each
share outstanding of a company. Calculating the dividend per share allows an
investor to determine how much income from the company he or she will
receive on a per share basis. Dividends are usually a cash payment paid to the
investors in a company, although there are other types of payment that can be
received.
Formula

The formula for calculating dividend per share has two variations:

Dividend per Share = Total Dividends Paid / Shares Outstanding

or

Dividend Per Share = Earnings Per Share x Dividend Payout Ratio

Example
Company B announced a total dividend of $500,000 paid to shareholders in the
upcoming quarter. Currently, there are 1 million shares outstanding.

The dividend per share would simply be the total dividend divided by the shares
outstanding. In this case, it is $500,000 / 1,000,000 = $0.5 dividend per share.

C. Dividend Payout Ratio

The dividend payout ratio measures the percentage of earning available to

equity shareholders (EATESH) that is distributed to shareholders in the form of
dividends during the year. In other words, this ratio shows the portion of profits
the company decides to keep to fund operations and the portion of profits that is
given to its shareholders.

Investors are particularly interested in the dividend payout ratio because they
want to know if companies are paying out a reasonable portion of net income to
investors. For instance, most startup companies and tech companies rarely give
dividends at all. In fact, Apple, a company formed in the 1970s, just gave its first
dividend to shareholders in 2012.

Conversely, some companies want to investors’ interest so much that they are
willing to pay out unreasonably high dividend percentages. Inventors can see
that these dividend rates can’t be sustained very long because the company will
eventually need money for its operations.

Formula
The dividend payout formula is calculated by dividing total dividend by the
earning available to equity shareholders of the company.

= Equity dividend / Earning available to equity shareholders

This calculation will give you the overall dividend payout ratio. Both the total
dividends and the earning available to equity shareholders will be reported on
the financial statements.

You can also calculate the dividend payout ratio on a share basis by dividing the
dividends per share by the earnings per share.

Obviously, this calculation requires a little more work because you must figure
out the earnings per share as well as divide the dividends by each outstanding
share. Both of these formulas will arrive at the same answer however.

Analysis
Since investors want to see a steady stream of sustainable dividends from a
company, the dividend payout ratio analysis is important. A consistent trend in
this ratio is usually more important than a high or low ratio.

Since it is for companies to declare dividends and increase their ratio for one
year, a single high ratio does not mean that much. Investors are mainly
concerned with sustainable trends. For instance, investors can assume that a
company that has a payout ratio of 20 percent for the last ten years will
continue giving 20 percent of its profit to the shareholders.

Generally, more mature and stable companies tend to have a higher ratio than
newer startup companies.

Example

John’s Kitchen is a restaurant chain that has several shareholders. John reported
$10,000 of earning available to equity shareholders on income statement for the
year. John’s issued $3,000 of dividends to its shareholders during the year. Here
is John’s dividend payout ratio calculation.
As you can see, John is paying out 30 percent of his net income to his
shareholders. Depending on John’s debt levels and operating expenses, this
could be a sustainable rate since the earnings appear to support a 30 percent
ratio.

Done up to this on 23nd Nov. 2019 in lecture of 10 to 1.30 pm Saturday

Profitability Ratios
related to Market

A. Price Earnings
{P/E Ratio}

The price earnings ratio, often called the P/E ratio or price to earnings ratio, is a
market prospect ratio that calculates the market value of a common stock
relative to its earnings by comparing the market price per share by the earnings
per share. In other words, the price earnings ratio shows what the market is
willing to pay for a stock based on its earnings.

Investors often use this ratio to evaluate what a stock’s fair market value should
be by predicting future earnings per share. Companies with higher future
earnings are usually expected to issue higher dividends or have appreciating
stock in the future.

Obviously, fair market value of a stock is based on more than just predicted
future earnings.Investor speculation and demand also help increase a share’s
price over time.

The PE ratio helps investors analyze how much they should pay for a stock
based on its current earnings. This is why the price to earnings ratio is often
called a price multiple or earnings multiple. Investors use this ratio to decide
what multiple of earnings a share is worth. In other words, how many times
earnings they are willing to pay.

Formula
The price earnings ratio formula is calculated by dividing the market value price
per share by the earnings per share.

P / E Ratio = MPS / EPS

The earnings per share ratio is also calculated at the end of the period for each
share outstanding. A trailing PE ratio occurs when the earnings per share is
based on previous period. A leading PE ratio occurs when the EPS calculation is
based on future predicted numbers. A justified PE ratio is calculated by using
the dividend discount analysis.
Analysis

The price to earnings ratio indicates the expected price of a share based on its
earnings. As a company’s earnings per share being to rise, so does their market
value per share. A company with a high P/E ratio usually indicated positive
future performance and investors are willing to pay more for this company’s
shares.

A company with a lower ratio, on the other hand, is usually an indication of poor
current and future performance. This could prove to be a poor investment.

In general a higher ratio means that investors anticipate higher performance

and growth in the future.

An important thing to remember is that this ratio is only useful in comparing

like companies in the same industry. Since this ratio is based on the earnings per
share calculation, management can easily manipulate it with specific accounting
techniques.

Example

The Island Corporation stock is currently trading at $50 a share and its earnings
per share for the year are 5 dollars. Island’s P/E ratio would be calculated like
this:

= MPS / EPS

= 50 / 5

= 10 Times

As you can see, the Island’s ratio is 10 times. This means that investors are
willing to pay 10 dollars for every dollar of earnings. In other words, this stock is
trading at a multiple of ten.
Since the current EPS was used in this calculation, this ratio would be
considered a trailing price earnings ratio. If a future predicted EPS was used, it
would be considered a leading price to earnings ratios.

B. Dividend Yield Ratio

The dividend yield is a financial ratio that measures the amount of cash
dividends distributed to common shareholders relative to the market value per
equity share. The dividend yield is used by investors to show how their
investment in stock is generating either cash flows in the form of dividends.

Investors invest their money in stocks to earn a return. Investor is able to earn a
return either by dividends or stock appreciation. Some companies choose to pay
dividends on a regular basis to increase investors’ interest. These shares are
often called income stocks. Other companies choose not to issue dividends and
instead reinvest this money in the business. These shares are often called
growth stocks. In this case, price of equity share is influenced with retained
earnings.

Investors can use the dividend yield formula to help analyze their return on
investment in stocks.

Formula

The dividend yield formula is calculated by dividing the cash dividends per
share by the market value per share.

=DPS/MPS

DPS = Dividend Share MPS=Market Price Share

Cash dividends per share are often reported on the financial statements, but
they are also reported as gross dividends distributed.

The shares’ market value is usually calculated by looking at the open stock
exchange price as of the last day of the year or period.
Analysis
Investors use the dividend yield formula to compute the cash flow they are
getting from their investment in stocks. In other words, investors want to know
how much dividends they are getting for every dollar that the stock is worth.

A company with a high dividend yield pays its investors a large dividend
compared to the fair market value of the stock. This means the investors are
getting highly compensated for their investments compared with lower
dividend yielding stocks.

A high or low dividend yield is relative to the industry of the company. As

mentioned above, tech companies rarely give dividends at all. So even a small
dividend might produce a higher dividend yield ratio for the tech industry.
Generally, investors want to see a yield as high as possible.

Example

Starch’s Bakery is an upscale bakery that sells cupcakes and baked goods in
Beverly Hills. Starch’s is listed on a smaller stock exchange and the current
market price per equity share is $150. As of last year, Starch paid $15,000 in
dividends with 1,000 shares outstanding. Starch’s yield is computed like this.

Dividend Yield = DPS / MPS

= $ 15 / $ 150

= 0.10 i.e. 10 %

As you can see, Starch’s dividend yield is 10 %. This means that Starch’s
investors receive 10 dollar in dividends for every 100 dollar they have invested
in the company. In other words, the investors are getting a 10 percent return on
their investment.
 C. Price to Book Ratio

The price to book ratio, also called the P/B or market to book ratio, is a financial
valuation tool used to evaluate whether the stock of the company is over or
undervalued by comparing the price of all outstanding shares with the net
assets of the company. In other words, it is a calculation that measures the
difference between the book value and the share price of the company.

This comparison demonstrates the difference between the market value of

equity share and book value of equity shares. The market value equals the
current stock price of all outstanding shares. This is the price that the market
thinks the company is worth. The book value, on the other hand, comes from the
balance sheet. It equals the net assets of the company.

Investors and analysts use this comparison to differentiate between the true
value of a publicly traded company and investor speculation. For example, a
company with no assets and a visionary plan is able to create hype. With this
ratio, we will be able to identify correct situation.

Formula

The Price-to-Book ratio formula is calculated by dividing the Market Price Per
Share by Book Value Per Share.

= MPS / BVPS

MPS = Market Price Share

BVPS = Book Value Per Share

The market price per share is simply the current stock price that the company is
being traded at on the open market. For book value per share, we first subtract
the total liabilities from the total assets and divide the difference by the total
number of shares outstanding on that date.

Many investors rephrase this equation to form the book to market ratio formula
by dividing the total book value of the firm by the total market value of the
company.
= BVPS / MPS

MPS = Market Price Share

BVPS = Book Value Per Share

Unlike the PB ratio, the MB formula compares values on a company-wide basis.

Analysis

Investors use both of these formats to help determine whether a company is

overpriced or underpriced. For example, a P/B ratio above 1 indicates that the
investors are willing to pay more for the company than its net assets are worth.
This could indicate that the company has healthy future profit projections and
the investors are willing to pay a premium for that possibility.

If the market book ratio is less than 1, on the other hand, the company’s stock
price is selling for less than their assets are actually worth. This company is
undervalued for some reason. Investors could theoretically buy all of the
outstanding shares of the company, liquidate the assets, and earn a profit
because the assets are worth more than the stock price. Although in reality, this
strategy probably wouldn’t work.

This valuation method is only one that investors use to see if an investment is
overpriced. Keep in mind that this method doesn’t take dividends into
consideration. Investors are almost always willing to pay more for shares that
will regularly and reliability issue a dividend. There are many other factors like
this that this basic calculation doesn’t take into account. The real purpose of it is
to give investors a rough idea as to whether the sale price is close to what it
should be.

Example

Tim wants to invest in Bob’s Furniture Company, a publicly traded company.

Bob has 50,000 shares outstanding that are trading at $2 per share. The
furniture business reported $50,000 of net assets on their balance sheet this
year. Tim would calculate Bob’s price book ratio like this:
Calculation of BVPS

= Net Assets / Number of Shares

= $ 50,000 / 50,000

= $ 1 Per Share

Price to Book Ratio

= MPS / BVPS

=$2/$1

= 2Times

As you can see, the market price of the company is twice that of the book value.
This means that Bob’s stock costs twice as much as the net assets reported on
the balance sheet. All else equal, this company would be considered over valued
because investors are willing to pay more for the assets than they are worth, but
they might have a good reason for this. Bob might have a big expansion in the
works that could double the size of the business.

This metric has its limitations, but generally works well for businesses like
Bob’s. It doesn’t however work well for valuing company with high levels of
intangible assets and low fixed assets like tech companies.

Profitability Ratios:
It shows how well a company can generate profits from its operations. Profit
margin, return on assets, return on equity, return on capital employed, and
gross margin ratio are examples of profitability ratios.

The profitability ratios measure the profitability or the operational efficiency of

the firm. These ratios reflect the final results of business operations. They are
some of the most closely watched and widely quoted ratios. Management
attempts to maximize these ratios to maximize firm value.
Profitability Ratios are as follows:

Profitability Ratios based on Sales

A. Gross Profit Ratio
B. Net Profit Ratio
C. Operating Profit Ratio
D. Expenses Ratio

ProfitabilityRatiosrelatedtoOverallReturnonAssets/Investment
s
• ReturnonInvestments(ROI)
• Return on Assets (ROA)
• Return of Capital Employed (ROCE)
• Return on Equity (ROE)

ProfitabilityRatiosrequiredforAnalysisfromOwner'sPointofVie
w
• Earnings per Share (EPS)
• Dividend per Share (DPS)
• Dividend Payout Ratio (DP)

ProfitabilityRatiosrelatedtoMarket/Valuation/Investors
• Price Earnings (P/E) Ratio
• Dividend and Earning Yield
• Market Value/ Book Value per Share (MV/BV)

4. Efficiency Ratios:
It is also called activity ratios, efficiencyratios evaluate how well a company uses
its assets to generate sales and maximize profits. Key efficiency ratios are the
asset turnover ratio, inventory turnover, and days' sales in inventory.

These ratios are employed to evaluate the efficiency with which the firm
manages and utilizes its assets. For this reason, they are often called 'Asset
management ratios'. These ratios usually indicate the frequency of sales with
respect to its assets. These assets may be capital assets or working capital or
average inventory.

Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio:

• Assets Turnover Ratio

• Fixed Assets Turnover Ratio

• Capital Turnover Ratio

• Current Assets Turnover Ratio

• Working Capital Turnover Ratio

• Inventory/ Stock Turnover Ratio

• Receivables (Debtors) Turnover Ratio

• Payables (Creditors) Turnover Ratio.

These ratios are usually calculated with reference to Sales/ Cost of goods
sold/ Purchase and are expressed in terms of rate or times.

Asset Turnover Ratio

The asset turnover ratio is an efficiency ratio that measures a company’s ability
to generate sales from its assets by comparing net sales with average total
assets. In other words, this ratio shows how efficiently a company can use its
assets to generate sales.

The total asset turnover ratio calculates net sales as a percentage of assets to
show how many sales are generated from each dollar of company assets. For
instance, a ratio of 5 means that each $ of assets generates $ 5 sales.

Formula

The asset turnover ratio is calculated by dividing net sales by average total
assets.

Total Assets Turnover Ratio

= Net Sales / Avg. Total Assets

Net sales, found on the income statement, are used to calculate this ratio returns
and refunds must be backed out of total sales to measure the truly measure the
firm’s assets’ ability to generate sales.

Average total assets are usually calculated by adding the beginning and ending
total asset balances together and dividing by two. This is just a simple average
based on a two-year balance sheet.

Analysis
This ratio measures how efficiently a firm uses its assets to generate sales, so a
higher ratio is always more favorable. Higher turnover ratios mean the company
is using its assets more efficiently. Lower ratios mean that the company isnot
using its assets efficiently and most likely have management or production
problems.

For instance, a ratio of 1 means that the net sales of a company equal the
average total assets for the year. In other words, the company is generating 1 $
of sales for every $ invested in assets.

Like with most ratios, the asset turnover ratio is based on industry standards.
Some industries use assets more efficiently than others. To get a true sense of
how well a company’s assets are being used, it must be compared to other
companies in its industry.

The total asset turnover ratio is a general efficiency ratio that measures how
efficiently a company uses all of its assets. This gives investors and creditors an
idea of how a company is managed and uses its assets to produce products and
sales.

Sometimes investors also want to see how companies use more specific assets
like fixed assets and current assets. The fixed asset turnover ratio and the
working capital ratio are turnover ratios similar to the asset turnover ratios that
are often used to calculate the efficiency of these asset classes.

Example
Salt’s Tech Company is a tech startup company that manufactures a new tablet
computer. Salt is currently looking for new investors and has a meeting with an
angel investor. The investor wants to know how well Salt uses its assets to
produce sales, so he asks for the financial statements.

Here is what the financial statements reported:

Beginning Assets: $50,000

Ending Assets: $1,00,000

Net Sales: $ 7,50,000

The total asset turnover ratio is calculated like this:

Average Net Assets = (Beginning Assets + Year End Assets ) / 2

= (50,000 +1,00,000) / 2

= 75,000

= Net Sales / Average Total Assets

= 7,50,000 / 75,000
= 10 Times

As you can see, Salt’s ratio is 10. This means that for every dollar in assets, Salt
generates sale of $ 10.

Fixed Assets Turnover Ratio

The fixed asset turnover ratio is an efficiency ratio that measures a

company’sefficiency of generating sales for their investment in property, plant,
and equipment by comparing net sales with average fixed assets. In other
words, it calculates how efficiently a company is producing sales with its
machines and equipment.

Investors and creditors use this formula to understand how well the company is
utilizing their equipment to generate sales. This concept is important to
investors because they will be able to measure an approximate return on their
investment. This is particularly true in the manufacturing industry where
companies have large and expensive equipment purchases. Creditors, on the
other hand, want to make sure that the company can produce enough revenues
from a new piece of equipment to pay back the loan they used to purchase it.

A high fixed assets turnover ratio indicates efficient utilization of fixed assets in
generating sales. A firm whose plant and machinery are old may show a higher
fixed assets turnover ratio than the firm which has purchased them recently.

Formula

The fixed asset turnover ratio formula is calculated by dividing net sales by the
average fixed assets.

Fixed Assets Turnover Ratio

= Net Sales / Avg. Fixed Assets

As you can see, it’s a pretty simple equation. Since using the gross equipment
values would be misleading, we always use the net asset value that’s reported
on the balance sheet by subtracting the accumulated depreciation from the
gross.

Businesses often purchase and sell equipment throughout the year, so it’s
common for investors and creditors to use an average net asset figure for the
denominator by adding the beginning balance to the ending balance and
dividing by two.

Average Net Fixed Assets = (Beginning Fixed Assets + Year End Fixed Assets ) /
2

= Net Sales / Average Net Fixed Assets

Analysis
A high turnover indicates that assets are being utilized efficiently and large
amount of sales are generated using a small amount of Fixed assets. It could also
mean that the company has sold off its equipment and started to outsource its
operations. Outsourcing would maintain the same amount of sales and decrease
the investment in equipment at the same time.

A low turnover, on the other hand, indicates that the company isn’t using its
Fixed assets to their fullest extent. This could be due to a variety of factors. For
example, sale of the company is low. Also, they might have overestimated the
demand for their product and overinvested in machines to produce the
products. It might also be low because of manufacturing problems like
a bottleneck in the value chain that held up production during the year and
resulted in fewer than anticipated sales.

Keep in mind that a few outside factors that can also contribute to this
measurement.

What is Fixed Asset Turnover Used For?

Accelerated depreciation is one of the main factors. Remember we always use

the net assets by subtracting the depreciation from gross assets. If a company
uses an accelerated depreciation method like double declining depreciation,
the book value of their equipment will be artificially low making their
performance look a lot better than it actually is.

Similarly, if a company doesn’t keep reinvesting in new equipment, this metric

will continue to rise year over year, with the same sales, because the
accumulated depreciation balance keeps increasing and reducing the
denominator. Investors and creditors have to be conscious of this fact when
evaluating how well the company is actually performing.

Example

John’s Car Restoration is a custom car shop that builds custom hotrods and
restores old cars to their former glory. John is applying for a loan to build a new
facility and expand his operations. His sales for the year are $250,000 using
average fixed assets $100,000 for.

How is the Fixed Assets Turnover Ratio Calculated?

Here’s how the bank would calculate John’s turn over.

= Net Sales / Average Net Fixed Assets

= 2,50,000 / 1,00,000

= 2.50 Times

As you can see, John generates 2.50 times more sales than the net book value of
assets. The bank should compare this metric with other companies similar to
John’s in his industry. A 2.50 X metric might be good for the architecture
industry, but it might be not good for the automotive industry that is dependent
on heavy equipment.

It’s always important to compare ratios with other companies’ in the industry.
 Capital turnover Ratio

Capital turnover compares the annual sales of a business to the average total
amount of capital. The intent is to measure the proportion of revenue that a
company can generate with a given amount of capital. It is also a general
measure of the level of capital investment needed in a specific industry in order
to generate sales. For example, capital turnover is very high in most services
industries and much lower in the more asset-intensive oil refining industry. As
an example of the calculation, if a company has $20 million of sales and $2
million of average capital, then its capital turnover is 10 X.

There are a number of problems with the capital turnover concept that limit its
use. These issues are:

• Leverage. A company may incur an excessive amount of debt to fund additional

sales, rather than acquiring more equity. The result is high capital turnover, but
at an increased risk level.
• Profits. The ratio ignores whether a company is generating a profit,
concentrating instead on the generation of sales.
• Cash flow. The ratio ignores whether a company is generated any cash flow.

Given these issues, valid usage of the capital turnover concept is certainly
limited. At best, it can be employed to examine asset investment levels across an
entire industry, to gain a general idea of which competitors appear to be making
better use of their capital.

Formula

Capital turnover ratio =

Net sales / Avg.Capital employed

Where
Net sales = Gross sales – sales return

Capital = Share capital + reserves

Current Asset Turnover Ratio

It is an activity ratio measuring firm’s ability of generating sales through its

current assets (cash, inventory,accounts receivable, etc.). It can be calculated by
dividing the firm's net sales by its average current assets, and it shows the
number of turns made by the current assets of the enterprise.

The values may vary between businesses and industries. Higher current assets
turnover comparing to competitors would indicate a high intensity of the
current assets usage. The increasing trend of this ratio is a good sign because
this means that the company is working on the consistent improvement of its
policies in inventory, accounts receivable, cash and other current assets
management. In fact, increasing current asset turnover leads to the decrease of
the financial resources amount, needed for the company's operations
maintenance. This means that bigger part of the financial resources can be used
for current operations intensification or making investments. The decrease of
the current assets turnover indicates the firm's increasing need of sources of
finance.

Formula:

Current Asset Turnover = Net Sales ÷ Average Current Assets

Inventory Turnover Ratio

The inventory turnover ratio is an efficiency ratio that shows how effectively
inventory is managed by comparing cost of goods sold with average inventory
for a period. This measures how many times average inventory is “turned” or
sold during a period. In other words, it measures how many times a company
sold its average inventory dollar amount during the year. A company with
$1,50,000 of average inventory and cost of goods sold of $7,50,000 effectively
sold its 5 times over.

This ratio is important because turnover depends on two main components of

performance. The first component is stock purchasing. If larger amounts of
inventory are purchased during the period, the company will have to sell
greater amounts of inventory to improve its turnover. If the company can’t sell
these greater amounts of inventory, it will incur storage costs and other holding
costs.

The second component is sales. Sales have to match inventory purchases

otherwise the inventory will not turn effectively. That’s why the purchasing and
sales departments must be in tune with each other.

Formula

The inventory turnover ratio is calculated by dividing the cost of goods sold for
a period by the average inventory for that period.

Average Inventory (Avg. Stock) = (Opening Inventory + Closing Inventory) / 2

Cost of Goods Sold (COGS) = Opening Stock + Purchases – Closing Stock

Inventory Turn over Ratio =

COGS / Avg. Stock

Analysis
Inventory turnover is a measure of how efficiently a company can control its
merchandise, so it is important to have a high turn. This shows the company
does not overspend by buying too much inventory and wastes resources by
storing non-saleble inventory. It also shows that the company can effectively sell
the inventory it buys.

This measurement also shows investors how liquid a company’s inventory is.
Inventory is one of the biggest assets a retailer reports on its balance sheet. If
this inventory cannot be sold, it creates financial crisis for the company. This
measurement shows how easily a company can turn its inventory into cash.
Creditors are particularly interested in this because inventory is often put up as
collateral for loans. Banks want to know that this inventory will be easy to sell.

Inventory turnoverratio varies with industry. For instance, the apparel industry
will have higher turns than the exotic car industry.

Example
Jonny’s Furniture Company sells industrial furniture for office buildings. During
the current year, Jonny reported cost of goods sold on its income statement of
$1,000,000. Jonny’s beginning inventory was $200,000 and its ending inventory
was $300,000. Jonny’s turnover is calculated like this:

Average Inventory

= (Opening Inventory + Closing Inventory) / 2

= (2,00,000 + 3,00,000) / 2

= 5,00,000 / 2

= $ 2,50,000

Inventory Turn over Ratio

= COGS / Avg. Stock

= 10,00,000 / 2,50,000

= 4 Times

As you can see, Jonny’s turnover is 4. This means that Jonny sold roughly 4 times
of its inventory during the year. It also implies that it would take Jonny
approximately 3 Months (12 Months / 4 times) to sell its average entire
inventory or complete one turn.

Video recording done till this on 1st Jan. 2020 at 6 p.m.

Recording started on 29th Jan. 10 to 1.30 p.m.

Accounts Receivable Turnover Ratio

Accounts receivable turnover is an efficiency ratio or activity ratio that

measures how many times a business can turn its accounts receivable into cash
during a period. In other words, the accounts receivable turnover ratio
measures how many times a business can collect its average accounts receivable
during a period.

A turn refers to each time a company collects its average receivables. If a

company had $ 10,000 of average receivables during the year and credit sales is
$40,000. The company would have turned its accounts receivable four times
because it collected four times.

This ratio shows how efficient a company is at collecting its credit sales from
customers. Some companies collect their receivables from customers in 3
months, while other takes up to 6 months to collect from customers.

In some ways the receivables turnover ratio can be viewed as a liquidity ratio as
well. Companies are more liquid the faster they can convert their receivables
into cash.

Formula
Accounts receivable turnover is calculated by dividing net credit sales by the
average accounts receivable for that period.

= Net Credit Sales / Average Debtors

The reason net credit sales are used instead of net sales is that cash sales donot
create receivables. Only credit sales establish a receivable, so the cash sales are
left out of the calculation. Net sales simply refer to sales minus returns and
refunded sales.
The net credit sales can usually be found on the company’s income
statement for the year. Average receivables is calculated by adding the
beginning and ending receivables for the year and dividing by two.

Analysis
Since the receivables turnover ratio measures a business’ ability to efficiently
collect its receivables, it only makes sense that a higher ratio would be more
favorable. Higher ratios mean that companies are collecting their receivables
more frequently throughout the year. For instance, ratio 4 means that the
company collects its average receivables four times during the year. In other
words, this company is collecting is money from customers every three months
(12 Months / four times).

In case firm sells goods on credit, the realization of sales revenue is delayed and
the receivables are created. The cash is realized from these receivables later on.

The speed with which these receivables are collected affects the liquidity
position of the firm. The debtor's turnover ratio throws light on the collection
and credit policies of the firm. It measures the efficiency with which
management is managing its accounts receivables.

Higher efficiency is favorable from a cash flow standpoint as well. If a company

can collect cash from customers sooner, it will be able to use that cash to pay
bills and other obligations sooner.

Accounts receivable turnover also is an indication of the quality of credit sales

and receivables. A company with a higher ratio shows that credit sales are more
likely to be collected than a company with a lower ratio. Since accounts
receivable are often posted as collateral for loans, quality of receivables is
important.

Example
Sill’s Ski Shop is a retail store that sells outdoor skiing equipment. Sill offers
credit to all of his main customers. At the end of the year, Sill’s balance sheet
shows $20,000 in accounts receivable, $75,000 of gross credit sales, and
$30,000 of returns. Last year’s balance sheet showed $10,000 of accounts
receivable.
The first thing we need to do in order to calculate Sill’s turnover is to calculate
net credit sales and average accounts receivable.

Net credit sales equals gross credit sales minus returns (75,000 – 30,000 =
45,000).

Average accounts receivable can be calculated by averaging beginning and

ending accounts receivable balances ((10,000 + 20,000) / 2 = 15,000).

Finally, Sill’s accounts receivable turnover ratio for the year can be like this.

= Net Credit Sales / Average Debtors

= 45,000 / 15,000

= 3 times

As you can see, Sill’s turnover is 3. This means that Sill collects his receivables
about 3 times a year or once every 4 months (12 Months / 3 times). In other
words, when Sill makes a credit sale, it will take him 4 months to collect the cash
from that sale.

Accounts Payable Turnover Ratio

The accounts payable turnover ratio is a liquidity ratio that shows a company’s
ability to pay off its accounts payable by comparing net credit purchases to the
average accounts payable during a period. In other words, the accounts payable
turnover ratio is how many times a company can pay off its average accounts
payable balance during the course of a period.

This ratio helps creditors to analyze the liquidity of a company by gauging how
easily a company can pay off its current suppliers and vendors. Companies that
can pay off supplies frequently throughout the year indicate to creditor that
they will be able to make regular payments.
Vendors also use this ratio when they consider establishing a new line of credit
or floor plan for a new customer. For instance, car dealerships and music stores
often pay for their inventory with floor plan financing from their vendors.
Vendors want to make sure they will be paid on time, so they often analyze the
company’s payable turnover ratio.

Formula

The accounts payable turnover formula is calculated by dividing the total

purchases by the average accounts payable for the year.

The total purchases number is usually not readily available on any general
purpose financial statement. Instead, total purchases will have to be calculated
by adding the ending inventory to the cost of goods sold and subtracting the
beginning inventory. Most companies will have a record of supplier purchases,
so this calculation may not need to be made.

The average payables is used because accounts payable can vary throughout the
year. The ending balance might be representative of the total year, so an average
is used. To find the average accounts payable, simply add the beginning and
ending accounts payable together and divide by two.

Analysis
Since the accounts payable turnover ratio indicates how quickly a company pays
off its vendors, it is used by supplies and creditors to help decide whether or not
to grant credit to a business. As with most liquidity ratios, a higher ratio is
almost always more favorable than a lower ratio.

A higher ratio shows suppliers and creditors that the company pays its bills
frequently and regularly. It also implies that new vendors will get paid back
quickly. A high turnover ratio can be used to negotiate favorable credit terms in
the future.
As with all ratios, the accounts payable turnover is specific to different
industries. Every industry has a slightly different standard. This ratio is best
used to compare similar companies in the same industry.

Example

Kob’s Building Suppliers buys constructions equipment and materials from

wholesalers and resells this inventory to the general public in its retail store.
During the current year Kob purchased $1,000,000 worth of construction
materials from his vendors. According to Kob’s balance sheet, his beginning
accounts payable was $55,000 and his ending accounts payable was $958,000.

Here is how Kob’s vendors would calculate his payable turnover ratio:

As you can see, Kob’s average accounts payable for the year was $506,500
(beginning plus ending divided by 2). Based on this formula Kob’s turnover ratio
is 1.97. This means that Kob pays his vendors back on average once every six
months of twice a year. This is not a high turnover ratio, but it should be
compared to others in Kob’s industry.

Use by Analysts

Ratio analysis can provide an early warning signal of a potential improvement

or deterioration in a company’s financial situation or performance. Analysts
engage in extensive number-crunching of the financial data in a company’s
quarterly financial reports for any such hints. Successful companies generally
have solid ratios in all areas, and any hints of weakness in one area may spark a
significant sell-off in the stock.

Certain ratios are closely scrutinized because of their relevance to a certain

sector, as for instance inventory turnover for the retail sector and days sales
outstanding (DSOs) for technology companies.
Of course, using any ratio in any of the categories listed above should only be
considered as a starting point. Furthermore ratios and qualitative analysis
should be incorporated to effectively analyze a company's financial position.

Ratios are usually only comparable across companies in the same sector, since
an acceptable ratio in one industry may be regarded as too high in another.

For example, companies in sectors such as utilities typically have a high debt-
equity ratio, but a similar ratio for a technology company may be regarded as
unsustainably high.

Putting Ratio Analysis in to Practice

Ratios can be used to determine a number of things about a performance of

corporations. Analyzing these ratios can be an excellent place for choosing
stocks and other investments. In fact, not knowing certain ratios, such as price-
earnings ratio (P/E), before making an investment decision would be
considered unwise sometimes.

The purpose of Financial Statement Analysis (Ratio Analysis) is to evaluate

management performance in Profitability, Efficiency and Risk.

Although financial statement information is historical, it is used to project future

performance

Financial Statement Analysis (Ratio analysis) can be done using Three

Methods –
Vertical Analysis:

It is also called as Common Size Statements Analysis which compares the each
item of to the base case of the financial statements. All income statement items
are expressed as percentage of Sales. Balance Sheet Items are expressed as a
percentage of Total Assets or Total Liabilities.

Horizontal Analysis

It compares the two financial statements (income statement, balance sheet) to

determine the absolute change as well as percentage changes.
Ratio analysis of financial statement is another tool that helps identify changes
in a company’s financial situation. A single ratio is not sufficient to adequately
judge the financial situation of the company. Several ratios must be analyzed
together and compared with prior-year ratios, or even with other companies in
the same industry. This comparative aspect of ratio analysis is extremely
important in financial analysis. It is important to note that ratios are parameters
and not precise or absolute measurements. Thus, ratios must be interpreted
cautiously to avoid erroneous conclusions. An analyst should attempt to get
behind the numbers, place them in their proper perspective and, if necessary,
ask the right questions for further types of ratio analysis.

RECORDING COMPLETED UPTO THIS ON 29TH JANUARY, 2020

SOLVENCY RATIO ANALYSIS:-
Solvency Ratio Analysis type is primarily sub-categorized into two parts –

1) Liquidity Ratio Analysis and

2) Turnover Ratio Analysis of financial statement.

They are further sub-divided into 10 ratios as seen in the diagram below.
Objectives of Ratio Analysis

Interpreting the financial statements and other financial data is essential for all
stakeholders of an entity. Ratio Analysis hence becomes a vital tool for financial
analysis and financial management.
Let us take a look at some objectives of ratio analysis:

1. Measure of Profitability

2. Evaluation of Operational Efficiency

3. Ensure Liquidity

4. Overall Financial Strength

5. Comparison

1] Measure of Profitability

Profit is very essential to keep organization surviving. So if I say that ABC firm
earned a profit of $ 5 lakhs last year, how will you determine if that is a good or
bad figure? Context is required to measure profitability, which is provided by
ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense ratio etc provide a
measure of profitability of a firm. The management can use such ratios to find
out problem areas and improve upon them.

2] Evaluation of Operational Efficiency

Certain ratios highlight the degree of efficiency of a company in the management

of its assets and other resources. It is important that assets and financial
resources be allocated and used efficiently to avoid unnecessary expenses.
Turnover Ratios and Efficiency Ratios will point out any mismanagement of
assets.

3] Ensure Liquidity

Every firm has to ensure that some of its assets are liquid, in case it requires
cash immediately. So the liquidity of a firm is measured by ratios such as
Current ratio and Quick Ratio. These help a firm maintain the required level of
short-term solvency.

4] Overall Financial Strength

There are some ratios that help determine the firm’s long-term solvency. They
help determine if there is a strain on the assets of a firm or if the firm is over-
leveraged. The management will need to quickly rectify the situation to avoid
liquidation in the future. Examples of such ratios are Debt-Equity Ratio,
Leverage ratios etc.

5] Comparison

The organizations’ ratios must be compared to the industry standards to get a

better understanding of its financial health and fiscal position. The management
can take corrective action if the standards of the market are not met by the
company. The ratios can also be compared to the previous years’ ratio’s to see
the progress of the company. This is known as trend analysis.

The objective of financial statements is to provide information about the

financial position, performance and changes in financial position of an
enterprise that is useful to a wide range of users in making economic decisions.

User of Financial Statements

1. Managers

2. Shareholders
 3. Prospective investors

4. Financial Institutions

5. Suppliers

6. Customers

7. Employees

8. Competitors

9. General Public

10. Governments

Managers require Financial Statements to manage the affairs of the company

by assessing its financial performance and position and taking important
business decisions.

Shareholders use Financial Statements to assess the risk and return of their
investment in the company and take investment decisions based on their
analysis.

Prospective Investors need Financial Statements to assess the viability of

investing in a company. Investors may predict future dividends based on the
profits disclosed in the Financial Statements. Furthermore, risks associated with
the investment may be gauged from the Financial Statements. For instance,
fluctuating profits indicate higher risk. Therefore, Financial Statements provide
a basis for the investment decisions of potential investors.

Financial Institutions (e.g. banks) use Financial Statements to decide whether

to grant a loan or credit to a business. Financial institutions assess the financial
health of a business to determine the probability of a bad loan. Any decision to
lend must be supported by a sufficient asset base and liquidity.

Suppliers need Financial Statements to assess the credit worthiness of a

business and ascertain whether to supply goods on credit. Suppliers need to
know if they will be repaid. Terms of credit are set according to the assessment
of their customers' financial health.

Customers use Financial Statements to assess whether a supplier has the

resources to ensure the steady supply of goods in the future. This is especially
vital where a customer is dependant on a supplier for a specialized component.

Employees use Financial Statements for assessing the company's profitability

and its consequence on their future remuneration and job security.

Competitors compare their performance with rival companies to learn and

develop strategies to improve their competitiveness.

General Public may be interested in the effects of a company on the economy,

environment and the local community.

Governments require Financial Statements to determine the correctness of tax

declared in the tax returns. Government also keeps track of economic progress
through analysis of Financial Statements of businesses from different sectors of
the economy.

Investors
Investors, who have invested their money in the firm’s shares, are interested in
the firm’s earnings and future profitability. Financial statement analysis helps
them in predicting the bankruptcy and failure probability of business
enterprises. After being aware of the probable failure, investors can take
preventive measures to avoid/minimize losses.

Advantages of Ratio Analysis

When applied correctly, ratio analysis throws light on many problems of the
firm and also highlights some positives. Ratios are essentially whistleblowers
which draw the management’s attention towards issues needing attention.

Ratio analysis is widely used as a powerful tool of financial statement analysis. It

establishes the numerical or quantitative relationship between two figures of a
financial statement to ascertain strengths and weaknesses of a firm as well as its
current financial position and historical performance.

It helps various interested parties to make an evaluation of certain aspect of a

firm’s performance.

Let us take a look at some advantages of ratio analysis:

1. Forecasting and Planning:

2. Budgeting:

3. Measurement of Operating Efficiency:

4. Communication:

5. Control of Performance and Cost:

6. Inter-firm Comparison:

7. Indication of Liquidity Position:

8. Indication of Long-term Solvency Position:

9. Indication of Overall Profitability:

10. Signal of Corporate Sickness:

11. Aid to Decision-making:

12. Simplification of Financial Statements:

13. Assistance in Investment Decisions:

14. Issues Identification:

1. Forecasting and Planning:

The trend in costs, sales, profits and other facts can be known by computing
ratios of relevant accounting figures of last few years. This trend analysis
with the help of ratios may be useful for forecasting and planning future
business activities.
2. Budgeting:

Budget is an estimate of future activities on the basis of past experience.

Accounting ratios help to estimate budgeted figures. For example, sales
budget may be prepared with the help of analysis of past sales.

3. Measurement of Operating Efficiency:

Ratio analysis indicates the degree of efficiency in the management and

utilisation of its assets. Different activity ratios indicate the operational
efficiency. In fact, solvency of a firm depends upon the sales revenues
generated by utilizing its assets.

4. Communication:

Ratios are effective means of communication and play a vital role in

informing the position of and progress made by the business concern to the
owners or other parties.

5. Control of Performance and Cost:

Ratios may also be used for control of performances of the different

divisions or departments of an undertaking as well as control of costs.

6. Inter-firm Comparison:

Comparison of performance of two or more firms reveals efficient and

inefficient firms, thereby enabling the inefficient firms to adopt suitable
measures for improving their efficiency. The best way of inter-firm
comparison is to compare the relevant ratios of the organization with the
average ratios of the industry.

7. Indication of Liquidity Position:

Ratio analysis helps to assess the liquidity position i.e., short-term debt
paying ability of a firm. Liquidity ratios indicate the ability of the firm to pay
and help in credit analysis by banks, creditors and other suppliers of short-
term loans.
8. Indication of Long-term Solvency Position:

Ratio analysis is also used to assess the long-term debt-paying capacity of a

firm. Long-term solvency position of a borrower is a prime concern to the
long-term creditors, security analysts and the present and potential owners
of a business. It is measured by the leverage/capital structure and
profitability ratios which indicate the earning power and operating
efficiency. Ratio analysis shows the strength and weakness of a firm in this
respect.

9. Indication of Overall Profitability:

The management is always concerned with the overall profitability of the

firm. They want to know whether the firm has the ability to meet its short-
term as well as long-term obligations to its creditors, to ensure a reasonable
return to its owners and secure optimum utilization of the assets of the firm.
This is possible if all the ratios are considered together.

10. Signal of Corporate Sickness:

A company is sick when it fails to generate profit on a continuous basis and

suffers a severe liquidity crisis. Proper ratio analysis can give signal of
corporate sickness in advance so that timely measures can be taken to
prevent the occurrence of such sickness.

11. Aid to Decision-making:

Ratio analysis helps to take decisions like whether to supply goods on credit
to a firm, whether bank loans will be made available etc.

12. Simplification of Financial Statements:

Ratio analysis makes it easy to grasp the relationship between various items
and helps in understanding the financial statements.

13. Assistance in Investment Decisions:

Ratio analysis will help validate or disprove the financing, investment and
operating decisions of the firm. They summarize the financial statement into
comparative figures, thus helping the management to compare and evaluate
the financial position of the firm and the results of their decisions.
14. Issues Identification:

Ratio analysis helps to identify problem areas and bring the attention of the
management to such areas. Some of the information is lost in the complex
accounting statements, and ratios will help pinpoint such problems.

The technique of ratio analysis is a very useful device for making a study of
the financial health of a firm. But it has some limitations which must not be
lost sight of before undertaking such analysis.

1. Window Dressing.

2. Ratios ignore the price level changes due to inflation.

3. Ignorance of Qualitative Aspects.

4. No Standard Definition:-

5. Solution:-

Window Dressing:-

The firm can make some year-end changes to their financial statements, to
improve their ratios. Then the ratios end up being nothing but window
dressing.
Ratios ignore the price level changes due to inflation.

Many ratios are calculated using historical costs, and they overlook the
changes in price level between the periods. This does not reflect the correct
financial situation.

Ignorance of Qualitative Aspects:-

Accounting ratios completely ignore the qualitative aspects of the firm. They
only take into consideration the monetary aspects (quantitative)

No Standard Definition:-

There are no standard definitions of the ratios. So firms may be using

different formulas for the ratios. One such example is Current Ratio, where
some firms take into consideration all current liabilities but others ignore
bank overdrafts from current liabilities while calculating current ratio

Solution:-

And finally, accounting ratios do not resolve any financial problems of the
company. They are a means to the end, not the actual solution.
RECORDING / SHOOTING DONE UP TO THIS POINT ON 13.02.2020

RECORDING / SHOOTING STARTED ON 14.02.2020

Additional limitation of ratio analysis

1. Limitations of Financial Statements:

2. Historical Information:
3. Different Accounting Policies:
4. Lack of Standard of Comparison:
5. Quantitative Analysis:
6. Window-Dressing:
7. Changes in Price Level:
8. Causal Relationship Must:
9. Ratios Account for one Variable:
10. Seasonal Factors Affect Financial Data:
11. Ignorance of Future:
12. Interpretation:
13. Judgments and Estimates in Accounts:
14. Contribution of Minor Factors:
15. Meaningful Correlation:
16. External Factors:

1. Limitations of Financial Statements:

Ratios are calculated from the information recorded in the financial

statements. But financial statements suffer from a number of limitations and
may, therefore, affect the quality of ratio analysis.

2. Historical Information:

Financial statements provide historical information. They do not reflect

current conditions. Hence, it is not useful in predicting the future.
3. Different Accounting Policies:

Different accounting policies regarding valuation of inventories, charging

depreciation etc. make the accounting data and accounting ratios of two
firms non-comparable.

4. Lack of Standard of Comparison:

No fixed standards can be laid down for ideal ratios. For example, current
ratio is said to be ideal if current assets are twice the current liabilities. But
this conclusion may not be justifiable in case of those concerns which have
adequate arrangements with their bankers for providing funds when they
require, it may be perfectly ideal if current assets are equal to or slightly
more than current liabilities.

5. Quantitative Analysis:

Ratios are tools of quantitative analysis only and qualitative factors are
ignored while computing the ratios. For example, a high current ratio may
not necessarily mean sound liquid position when current assets include a
large inventory consisting of mostly obsolete items.

6. Window-Dressing:

The term ‘window-dressing’ means presenting the financial statements in

such a way to show a better position than what it actually is. If, for instance,
low rate of depreciation is charged, an item of revenue expense is treated as
capital expenditure etc. the position of the concern may be made to appear
in the balance sheet much better than what it is. Ratios computed from such
balance sheet cannot be used for scanning the financial position of the
business.

7. Changes in Price Level:

Fixed assets show the position statement at cost only. Hence, it does not
reflect the changes in price level. Thus, it makes comparison difficult.

8. Causal Relationship Must:

Proper care should be taken to study only such figures as have a cause-and-
effect relationship; otherwise ratios will only be misleading.
9. Ratios Account for one Variable:

Since ratios account for only one variable, they cannot always give correct
picture since several other variables such Government policy, economic
conditions, availability of resources etc. should be kept in mind while
interpreting ratios.

10. Seasonal Factors Affect Financial Data:

Proper care must be taken when interpreting accounting ratios calculated

for seasonal business. For example, an umbrella company maintains high
inventory during rainy season and for the rest of year its inventory level
becomes 25% of the seasonal inventory level. Hence, liquidity ratios and
inventory turnover ratio will give biased picture.

11. Ignorance of Future:

The goal of financial analysis is to make predictions about how a company

will do in the future. In contrast, ratio analysis is performed on historical
data and may have little to do with what is going on currently at the
company. In addition to the historical information, current information such
as news releases from the company must be included in the analysis.

12. Interpretation:
A ratio itself is not significant. It must be interpreted in comparison with prior
periods' ratios, predetermined benchmarks, or ratios of competitors.
The ability of using of ratios is dependent upon the analyst's ability to adjust the
reported numbers before calculating the ratios and then to interpret the results.

13. Judgments and Estimates in Accounts:

Accounting and the preparation of financial statements require judgments as
well as making assumptions and estimates. The more frequent publishing of
financial statements, the more frequent will be the need to make these
estimates, and the greater will be the uncertainty inherent in the financial
statements and thus the ratios calculated from them, because many transactions
require several quarters or several years for completion to happen.
The longer the time it takes for completion of a transaction, the more tentative
will be the estimates relating to it which affect the financial statements. The
short-term incentives, agendas, and personal interests of those who prepare
them may affect estimates relating to long-term events.

14. Contribution of Minor Factors:

A company may have poor operating results as caused by several different,
small factors. If an analyst focuses on trying to find one major problem, then he
may miss the confluence of many other factors.

15. Meaningful Correlation:

To be meaningful, a ratio must measure a meaningful relationship. E.g. the
relationship between sales and accounts receivable is meaningful, so the ratios
that relate those items are significant. However, there is no meaningful
relationship between freight cost and the average balance of total long-term
debt, so a ratio relating those items to one another would be useless for any kind
of interpretations..

16. External Factors:

In interpreting firm's financial ratios, an analyst must consider external factors
like economic or political conditions that may have affected performance of all
firms or all firms in the firm's specific industry.
MULTIPLE CHOICE QUESTIONS

(1) Iftheassetturnoverandprofitmarginofacompanyare1.85and0.35respec
tively,thereturnon investment is :
(a) 0.65 (b) 0.35 (c) 1.50 (d)5.29

(2) Thebudgetedannualsalesofafirmis80,000
and25%ofthesameiscashsales.Iftheaverageamountof
debtorsofthefirmis5,000,theaveragecollectionperiodofcreditsalesmo
nths.
(a) 1.50 (b) 1.00 (c) 0.50
 (d)1.75

(3) The current liabilities of Akash Ltd. are $ 30,000. If its current ratio is
3:1 and Quick ratio is 1:1, the value ofstock-in-tradewillbe
(a) $ 20,000. (b) $ 30,000(c) $ 60,000(d) Insufficientinformation
(4) Thecostofgoodssoldwas $
2,40,000.Beginningandendinginventorybalanceswere$ 20,000and $
30,000, respectively.Whatwastheinventoryturnoverratio?
(a) 8.0times (b) 12.0times (c) 7.0times (d) 9.6times
(5) If,Grossprofit= $
40,000GPMargin=20%ofsalesWhatwillbethevalueofcostofgo
odssold?
(a) $ 160,000 (b) $ 120,000 (c) $ 40,000 (d) $ 90,000

(6) NetIncomebeforeInterestandtaxisalsocalled:
(a) Operating Income / Profit (b) Gross Profit (c) Marginal Income(d)
 Other Income

(7) Costofgoodssold $ 30,000,openingInventory $

9,000,Closinginventory $ 7,800.Whatwastheinventory turnoverratio?
(a) 3.57times (b) 3.67times (c) 3.85times (d) 5.36times

(8) Inventoryturnoverratiocanbecalculatedasfollow?
(a) Costofgoodssold/Averageinventory

(b) Grossprofit/Averageinventory

(c) Costofgoodssold/sale
(d) Costofgoodssold/Grossprofit

(9) The Inventory Turnover ratio is 5 times and numbers of days in a

year is 365. Inventory holding period indayswouldbe
(a) 100days (b) 73days (c)50days (d) 10days
(10) Inventoryof$96,000waspurchasedduringtheyear.Thecostofgoodssold
was$90,000andtheending
inventorywas$18,000.Whatwastheinventoryturnoverratiofortheyear
?
(a) 5.0 (b) 5.3 (c) 6.0 (d)
6.4
(11) Whichofthefollowingratiosexpressedthathowmanytimestheinventoryi
sturningovertowardsthecostof goodssold?
(a) Netprofitratio (b) Gross profitratio
(c) Inventoryturnoverratio (d)
Inventory holdingperiod

(12) IfCostofgoodssold=$40,000;GPM
argin=20%ofsales
CalculatetheGrossprofitmargin.
(a) $32,000 (b) $48,000 (c) $8,000 (d)
$10,000
(13) Ratioswhichmaybeusedforcomparinglabourcostovertimeincludethefoll
owingexcept:
(a) Gross profit ratio (b)Efficiencyratio
(c) Illness ratio (d) Absenteeism ratio

(14) Whichofthefollowingisnotincludedintheliquidityratios?
(a) Currentratio (b) liquidratio (c) debt-equityratio (d)
Quickratio

(15) Whichofthefollowingformulaistobeusedforcalculatingthereturnonequi
tyshareholders’funds?
(a) Net profit- Pref. dividend

Eq. share capital + free reserves

(b) = net profit + pref. dividend

Eq. share capital + free reserves

(c) = net profit + pref. dividend

Eq. share capital - free reserves

(d) = net profit-pref. dividend

Eq. share capital - free reserves

(16) Whichofthefollowingstatements is
notcorrectinlimitationsofratioanalysis?

(a) Theutilityofratioscomputedfromthefinancialstatementsofoneyearo
nlyisobviouslylimited.

(b) Whilecomparingratiosofpastseveralyearsitshouldberemembere
dthatchangeinpricelevelmay makesuchcomparisonuseful.

(c) Thereispracticallynostandardratioagainstwhichtheactualperforma
ncecanbecompared.

(d) Oneratiousedwithoutreferencetootherratiosmaybemisleading

(17) ThefollowingbalancesaretakenfromthebooksofAltd.Attheendoftheyea
r.Calculatenetprofitratio from the given information:
Grossprofit 67,500
Costofgoodssold 1,01,250
Netprofit 33,750

(a) 10% (b) 66% (c) 20% (d)40%

(18) DebtorsofAmarLtd.areof$60,000andbillsreceivableareof$4,000.Iftotal
salesis$7,30,000inwhich 4/5thiscreditsales.Findout average collection
period.(workingdaysintheyearare365).
(a) 40days (b) 32days (c) 27days (D)30days

(19) SaleofALtd.Duringtheyearis$8,50,000,grossprofitis$40,000.Closingsto
ckis$2,10,000,opening stockis$1,30,000.Calculatestockturnover.
(A) 5times (B)4.76times (C)6.53times
(D) 5.23times
 SHOOTING ON 02-06-2020

(20) FollowingbalancesareavailablefromthebooksofXltd.Attheendofaccount
ingyear:

$
Equity share capital 40,00,000
General reserve 7,00,000
Fixed assets 85,00,000
Current assets 15,00,000
Fictitious assets 7,00,000
Calculate, Fixed Assets to Current Assets Ratio
 (A) 5.67 (B) 0.1765 (C) 2.9233 (D) 0.3421

(21) TheinformationgivenbelowistakenfromABCLtd.
$

Share capital 10,00,000

Reserves 3,00,000
Fictitious assets 1,00,000
8% debentures 5,00,000
Current liabilities 1,00,000

Calculate total Long term debt-equityrati

(A) 41.66% (B)60%(C) 26% (D) 50 %

(22) The company has cash on hand $10,000, bank balance $ 45,000 and
readily marketable securities $25,000 and liquid liabilities are
$1,20,000.
Find out acid-test ratio.
 (A) 0.67:1 (B)0.45:1 (C)0.58:1
(D)0.29:1
(23) Its sale is $20,00,000. If operating expenses are $1,00,000, find out
cost of goods sold. Expenses are 80 % of sales.

(A) $13,40,000 (B)$14,40,000 (C)$12,40,000

(D)$15,00,000
(24) Currentratioofafirmis2:1,whileitscurrentassetsincludingstockare$12,
00,000.Atthattimeitsliquid ratiois 1.50:1,Findthevalueofstock.

(A) Stock $3,00,000

(B) Stock $6,00,000

(C) Stock $18,00,000

(D) Stock $12,00,000

(25) Acompanyhasissueddebenturesof$20,000.Itspreferencesharecapitalis
$30,000andequitysharecapitalis$2,00,000,thecapitalgearingratiowillb
easunder

(A) 15% (B) 25% (C)10%

(D)5%
(26) Thecurrentratioofacompanyis2:1,whichofthefollowingsuggestionswou
ldimprovetheratio?
 (A) Topayacurrentliability
(B) Toborrowmoneyforashorttimeonaninterestbearingpromissorynote

(C) Topurchasestockforcash

(D) Togiveaninterestbearingpromissorynotetoacreditortowhommoney
waspayable.
(27) Towhomratioanalysisismostuseful?
(A) Government (B)Shareholders (C)Creditors (D)All
of the above
(28) Whilecalculatingliquidratio,whichassetswillbeexcludedfromcurrentas
sets?
(A) Bankoverdraft (B) Stockintrade (C) debtors (D)
Billsreceivable
(29) Fromthefollowing,whichtyperatioisacidtestratio?
(A) Liquidityratio (B) Profitabilityratio
(C)Leverage Ratio (D) Activityratio
(30) Whichofthefollowingratios,showstherelationshipbetweenoneitemtak
enfrombalancesheetandanother
takenfromtradingorprofitandlossaccount?
(A) Operatingratio (B) Profitabilityratio (C)
Gearingratio (D) Debtorsratio
(31) Profitabilityratioisrelatedto
(A) Sale (B)Creditors (C) Debtors
(D)Assets
(32) Tofindtheexpenseratio,expensesaregenerallydividedby?
(A) Capitalemployed (B) Sales (C)
Profit (D)Assets
(33) Whichassetsisnotincludedwhilecalculatingtherateofreturnoninvestme
nt?
(A) fixed (B) current (C) fictitious (D)
Trade Investment
(34) Fromthefollowing,incalculationofwhichratio,preferencedividendisdedu
ctedfromnetprofit?
 (A) returnon capitalemployed (B)
returnon shareholders’ funds
(C) returnonequityshareholdersfund
(D) net profitratio
(35) Whichassetscannotbeincludedincurrentassetswhilecalculatingthecurr
entratio?
(A) Fixed Assets (B) Stockintrade (C) Prepaid
Expenses (D) Debtors
(36) Ifproprietaryratiois100%itmeansthat
(A) Businessdoesnotuseanyoutsidefunds
(B) Businesstotallydependsonoutsidefunds

(C) Theproportionbetweenownedandoutsidefundsis1:1
(D) It ishardtosaybecauseoflackofinformation

(37) Fromthefollowing,whichratioisnotprofitabilityratio?
(A) Proprietaryratio (B)Net Profit Ratio (C)
Earnings per share (D) Expenseratio
(38) Acompanyhasissueddebenturesof$3,00,000,itspreferencesharecapital
is$2,00,000andequityshare
capitalis$20,00,000,thenthecapitalgearingratiowillbeasunder:

(A) 20%or1:5 (B) 25%or1:4 (C) 10%or1:10

(D) 50% or 1 : 2
(39) Ifstockturnoveris5times,openingstockis$10,000lessthantheclosingsto
ckandaveragestockis$40,000. Find outpurchases.

(A) $2,00,000 (B)$1,35,000 (C)$2,40,000

(D) $2,10,000
(40) Currentliabilitiesareequalto
(a) Workingcapital+currentassets (b) Working capital –currentassets
(c) Currentassets – workingcapital
(d)Current assets + working capital
(41) ThecurrentratioofBMLtd.Is2:1,whilequickratiois1.8:1.Ifthecurrent
liabilities are $40,000, the value of stock will be
(a) $6,400 (b) $8,000 (c) $10,000
(d)$12,000
(42) Currentratio-1.75,Liquidratio—1.25,Stock—$1,00,000.
Currentliabilities=?, Currentassets=?
(a) $2,50,000,3,00,000 (b) $ 2,00,000,3,50,000
(c) $3,00,000,3,50,000
(d)$3,50,000,5,00,000

(43) Objectiveofratioanalysisis/are
(a) Toallowsinterestedpartieslikeshareholdersinvestors,creditors,gov
ernmentandanalysistomake an
evaluationofcertainaspectsofafirm’sperformance.
(b) Toshowthefirmsrelativestrengthsandweakness.
(c) Todeterminethefinancialconditionandperformanceofthefirm.
(d) Alloftheabove

(54) Capital turnover ratio are equal to ________

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
(a)
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
(b)
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
(c)
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
(d) None of the above

(55) Total Assets Turnover Ratio are equal to ________

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
(a)
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
(b)
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
(c)
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
(d) None of the above

(56) Stock turnover ratio are equal to:

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑠𝑜𝑙𝑑
(a)
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
(b)
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑠𝑜𝑙𝑑
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
(c)
𝑆𝑎𝑙𝑒𝑠
(d) None of the above
(57) Creditors Turnover Ratio is
𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑢𝑟𝑐ℎ𝑠𝑒
(a)
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
(b)
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑠𝑜𝑙𝑑
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
(c)
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
(d) None of the above
(58) Current Ratio is
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
(a)
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
(b)
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑠𝑜𝑙𝑑
(c)
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
(d) None of the above

(59) Liquid Ratio is

𝐿𝑖𝑞𝑢𝑖𝑑 𝑅𝑎𝑡𝑖𝑜
(a)
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
(b)
𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
(c)
𝐿𝑜𝑛𝑔−𝑡𝑒𝑟𝑚 𝐹𝑢𝑛𝑑𝑠
(d) None of the above
(60) Debt - Equity Ratio is
𝐷𝑒𝑏𝑡𝑠
(a)
𝐸𝑞𝑢𝑖𝑡𝑦
𝐸𝑞𝑢𝑖𝑡𝑦
(b)
𝐷𝑒𝑏𝑡𝑠
 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑒𝑒𝑡𝑠
(c)
𝐿𝑖𝑞𝑢𝑖𝑑 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
(d) None of the above

(61) Proprietary Ratio is

𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐹𝑢𝑛𝑑𝑠
(a)
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
(b)
𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
(c)
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐹𝑢𝑛𝑑𝑠
(d) None of the above

(62) Debt Service Ratio is

𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥
(a)
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶ℎ𝑎𝑟𝑔𝑒𝑠
𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
(b)
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
(c)
𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
(d) None of the above

(63) Capital Gearing Ratio is

𝐹𝑖𝑥𝑒𝑑 financial charges 𝐵𝑒𝑎𝑟𝑖𝑛𝑔 𝐹𝑢𝑛𝑑𝑠
(a)
𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐹𝑢𝑛𝑑𝑠
𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐹𝑢𝑛𝑑𝑠
(b)
𝐹𝑖𝑥𝑒𝑑 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐵𝑒𝑎𝑟𝑖𝑛𝑔 𝐹𝑢𝑛𝑑𝑠
𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝐹𝑢𝑛𝑑𝑠
(c)
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
(d) None of the above

(64) Earnings Per Share (EPS) is

Earning Avaliable to Equity Share Holders
(a)
𝑁𝑜.𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠
𝑁𝑜.𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠
(b)
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝐹𝑢𝑛𝑑𝑠
(c)
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
(d) None of the above

(65) Price Earnings Ratio is

 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒
(a)
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
(b)
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒
𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝐹𝑢𝑛𝑑𝑠
(c)
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
(d) None of the above

(66) Pay - out ratio is

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒
(a)
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
(b)
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒
𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝐹𝑢𝑛𝑑𝑠
(c)
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
(d) None of the above

(67) Lenders are interested in __________ to judge the firm’s ability to pay of
current interest and installments
a. Debt Ratio b. Debt Service Coverage Ratio
c. Debt-Equity Ratio d. None of the above

(68) Activity Ratios are also called as –

a. Coverage Ratios b. Leverage Ratios

c. Liquidity Ratios d. Turnover Ratios

(69). ______ ratio indicates the firm’s ability of generating sales per rupee of long
term investment

a. Capital Turnover Ratio b. Fixed Assets Turnover Ratio

c. Inventory Turnover Ratio d. Interest Coverage Ratio

(70). The relationship between Sales & Capital Assets is expressed as __________
a. Working Capital Turnover Ratio b. Inventory Turnover Ratio
c. Fixed Assets Turnover Ratio d. Capital Turnover Ratio

(71). Quick ratio is also known as –

 a. Absolute liquidity ratio b. Acid Test Ratio
c. Cash Ratio d. None of the above

(72). _______ ratio is also known as Stock Turnover Ratio

a. Working Capital Turnover Ratio b. Inventory Turnover Ratio
c. Fixed Assets Turnover Ratio d. Capital Turnover Ratio

(73). Working Capital =

a. Current Assets – Quick Liabilities b. Quick Assets –
Quick Liabilities
c. Current Assets – Current Liabilities d. Quick Assets –
Current Liabilities

74.Northern Corp. has a debt-to-equity ratio of 1.75, and total assets of $275
million. Southern is considering issuing another $20 million of debt and
another $20 million of equity. What will be Northern's debt-to-equity ratio
after the issuance?

a. 1.46 b. 1.75
c. 1.63 d. 1.95
75. Titles of ratios frequently include the terms "on" and "to." When used in
ratio titles, these imply the use of which one of the following
mathematical functions?
A Subtraction.
B
Multiplication.
C Division.
D Squaring.

76. XYZ company sells 10,000 boards a year at $66 each. All sales are on
credit, with terms of 3/10, net 30, which mean 3% discount if payment is
made within 10 days; otherwise full payment is due at the end of 30 days.
One half of the customers are expected to take advantage of the discount
and pay on day 10. The other half are expected to pay on day 30. Sales
 are expected to be uniform throughout the year for both types of
customers.
Assume that the average collection period is 25 days. After the credit
policy is well established, what is the expected average accounts
receivable balance for the company at any point in time, assuming a 365-
day year?

A $684.93
B $1,808.22
C $27,123.30
D $45,205.48

77. Kamanwala Company is a manufacturer of industrial products and

employs a calendar year for financial reporting purposes. Assume that
Kamanwala’s total quick assets exceeded total current liabilities both
before and after the transaction. Further assume that Kamanwala has
positive profits during the year and a credit balance throughout the year
in its retained earnings account. Payment of a trade account payable of
$64,500 would:
 Increase the current ratio but the quick ratio would not be
A affected.

Increase the quick ratio but the current ratio would not be
B affected.

C Increase both the current and quick ratios.

D Decrease both the current and quick ratios.

SHOOTING COMPLETED TILL 02-06-2020

SHOOTING STARTED ON 03-06-2020

78. Information related to a firm's solvency is used primarily to assess a

firm's ability to
A Convert assets to cash.
B Pay its debts.
C Generate profits.
D Collect its receivables in a timely manner.

79. A company has profit after tax of $5.4 million, interest expense of
$1 million for the year, depreciation expense of $1 million, and a
40% tax rate. What is the company's times-interest-earned ratio?
A 5.4
B 6.4
C 7.4
D 10.0
Illustration 1:
The following is the Balance Sheet of a company as on 31st March:
Illustration 2:

From the following Balance Sheet and additional information, you are required
to calculate:

(i) Return on Total Assets

(ii) Return on Capital Employed
(iii) Return on Shareholders’ Fund
Illustration 3:

ABC Company has capital of Rs. 10, 00,000; its turnover is 3 times the capital
and the margin on sales is 6%. What is the return on investment?
Illustration 4:

Shyam & Company supplies you the following information regarding the year
ended 31st December:
Illustration 5:

The Capital of a Company is as follows:

Illustration 6:

With the following ratios and further information given below, prepare a
Trading, Profit and Loss Account and Balance Sheet:
Illustration 7:

The balance sheet of ABC Company is given below:

Financial Decisions :Leverages

Learning Outcomes

• To understand the concept of business risk and financial risk.

• To discuss and interpret the types of leverages.
• To discuss the relationship between operating leverage and Break even
analysis.
• To discuss positive and negative Leverage.
• To discuss financial leverage as 'Trading on equity
• To discuss financial leverage as 'Double edged sword'.
Overview

Analysis of Leverage

* Business and Financial Risk

* Types of Leverage :
1)Operating Leverage
2)Financial Leverage
3) Combined Leverage

Introduction

A company can finance its operations through common and preference shares,
with retained earnings, or with debt. Generally a firm uses a combination of these
financing instruments. Capital structure refers to a firm's debt-to-equity ratio,
which provides insight into how risky a company is Capital structure decisions by
firms will have an effect on the expected profitability of the firm, the risks faced
by debt holders and shareholders, the probability of failure, the cost of capital and
the market value of the firm.

Business Risk and Financial Risk

Financial risk and business risk are two different types of warning signs that
investors must investigate when considering making an investment. Financial
risk refers to a company's ability to manage its debt and financial leverage,
while business risk refers to the company's ability to generate sufficient revenue
to cover its operational expenses.

An alternate way of viewing the difference is to see financial risk as the risk that
a company may default on its debt payments and business risk as the risk that
the company will be unable to function as a profitable enterprise.

Financial Risk

A company's financial risk is related to the company's use of financial leverage

and debt financing, rather than the operational risk of making the company a
profitable enterprise.

Financial risk is concerned with a company's ability to generate sufficient cash

flow to be able to make interest payments on financing or meet other debt-
related obligations. A company with a relatively higher level of debt financing
carries a higher level of financial risk since there is a greater possibility of the
company not being able to meet its financial obligations and becoming
insolvent.

Some of the factors that may affect a company's financial risk are interest
rate changes and the overall percentage of its debt financing. Companies with
greater amounts of equity financing are in a better position to handle their debt
burden. One of the primary financial risk ratios that analysts and investors
consider to determine a company's financial soundness is the debt/equity ratio,
which measures the relative percentage of debt and equity financing.

Debt/Equity Ratio = Total Liabilities / Shareholders' Equity

Foreign currency exchange rate risk is a part of the overall financial risk for
companies that do a substantial amount of business in foreign countries.

Moreover, financial risk does not end up here as it is a myriad of risks which are
given as under:

• Market Risk: Risk arising due to the fluctuations in the financial assets.
• Exchange Rate Risk: The risk arising out of the variations in the currency
rates.
• Credit Risk: The risk emerging because of non-payment of debt by a
borrower.
 • Liquidity Risk: The risk originating as a result of a financial instrument is
not traded quickly in the market.

Business Risk

Business risk refers to the basic viability of a business—the question of whether

a company will be able to make sufficient sales and generate sufficient revenues
to cover its operational expenses and turn a profit. While financial risk is
concerned with the costs of financing, business risk is concerned with all the
other expenses a business must cover to remain operational and functioning.
These expenses include salaries, production costs, facility rent, and office and
administrative expenses.

Special Considerations

Business risk is often categorized into systematic risk and unsystematic risk.
Systematic risk refers to the general level of risk associated with any business
enterprise, the basic risk resulting from fluctuating economic, political, and
market conditions. Systematic risk is an inherent business risk that companies
usually have little control over, other than their ability to anticipate and react to
changing conditions.

Unsystematic risk, however, refers to the risks related to the specific business in
which a company is engaged. A company can reduce its level of unsystematic
risk through good management decisions regarding costs, expenses,
investments, and marketing. Operating leverage and free cash flow are metrics
that investors use to assess a company's operational efficiency and management
of financial resources.

Every business organization operates in an economic environment. The

economic environment includes both micro and macro environment. The
changes in the factors of the two environments directly influence the business,
and the risk arises. Some of those factors changes in customer tastes and
preferences, inflation, change in the policies of the government, natural
calamities, strikes, etc. The business risk is divided into various categories:

• Compliance Risk: The risk arising due to the change in government laws.
• Operational Risk: The risk originating due to the machinery break down,
process failure, lockouts by workers, etc.
 • Reputation Risk: The risk emerging as a result of any misleading
advertisement, lawsuit, criticism of bad products or services, etc.
• Financial Risk: The risk arising due to the use of debt capital.
• Strategic Risk: Every business organization works on a strategy, but due
to the failure of strategy the risk arises.

KEY POINTS
• Financial risk refers to a company's ability to manage its debt and
financial leverage.
• Business risk refers to the company's ability to generate sufficient
revenue to cover its operational expenses.
• With financial risk, there is a concern that a company may default on its
debt payments.
• With business risk, the concern is that the company will be unable to
function as a)

The basis for

Comparison between
Business Risk Financial Risk
Financial Risk vs.
Business Risk

Business risk is the risk of

Financial risk is the risk of not
not being able to make the
being able to pay off the debt
1. Meaning operations profitable so that
that the company has taken to
the company can meet its
get the financial leverage.
expenses easily.

Business risk is purelyFinancial risk is related to the

2. What it’s?
operational. payment of debt.

Yes. If the firm doesn’t take

3. Avoidable? No. debt, there would be no
financial risk.

4. Duration Business risk will be there asFinancial risk would be there

long as the companyuntil the equity financing is
 operates. increased drastically.

Every business wants toTo generate better returns and

perpetuate and expand; andto tap into the lure of financial
5. Why?
with continuation comes theleverage, company gets into
risk of not being able to do it. debt and takes the financial risk.

By systemizing the process

of production and operationBy reducing debt financing and
6. How to handle it?
and by minimizing cost ofby increasing equity financing.
production/operation.

We can look at the debt-asset

When there’s variability in
7. Measurement ratio, and financial leverage
EBIT.
multiplier.

Risk and Return are closely related as one must have heard many times that if
you do not bear the risk; you will not get any profit. Business Risk is a
comparatively bigger term than Financial Risk; even financial risk is a part of the
business risk. Financial Risk can be ignored, but Business Risk cannot be
avoided. The former is easily reflected in EBIT while the latter can be shown in
EPS of the company.

Debt Financing vs. Equity Financing: An Overview

When financing a company, "cost" is the measurable cost of obtaining capital.

With debt, this is the interest expense a company pays on its debt. With equity,
the cost of capital refers to the claim on earnings provided to shareholders for
their ownership stake in the business.

KEY POINTS

• When financing a company, "cost" is the measurable cost of obtaining

capital.
 • With equity, the cost of capital refers to the claim on earnings provided to
shareholders for their ownership stake in the business.
• Provided a company is expected to perform well, debt financing can
usually be obtained at a lower effective cost.

DEBT FINANCING
When a firm raises money for capital by selling debt instruments to investors, it
is known as debt financing. In return for lending the money, the individuals or
institutions become creditors and receive a promise that the principal and
interest on the debt will be repaid on a regular schedule.

The advantages of debt financing are numerous. First, the lender has no control
over your business. Once you pay the loan back, your relationship with the
financier ends. Next, the interest you pay is tax deductible. Finally, it is easy to
forecast expenses because loan payments do not fluctuate.

What if your company hits hard times or the economy, once again, experiences a
meltdown? What if your business does not grow as fast or as well as you
expected? Debt is an expense and you have to pay expenses on a regular
schedule. This could put a damper on your company's ability to grow.

Pros of debt financing:

• Can be used by almost any kind and size of business.

• Retain ownership of business, which means need not to share profits
long-term.
• Repayment schedule is known.
• There are a range of options like loans, credit cards, lines of credit, etc.
• Interest on the debt can be deducted from the tax return.
• Interest rates on loans are usually lower than the return on equity
investments.

Cons of debt financing:

• Requires repayment of both principal and interest whether business is

good or bad.
 • Debt is an expense and expenses prevent you from reinvesting your
revenue in the business.
• There’s always a risk. Defaulting will cost you the assets (or personal
guarantee) you pledged as collateral.
• Lenders may restrict what you use the money for or whether you can look
for more financing elsewhere.
• With some analysis and information, one should be able to discern
whether debt vs equity funding will most benefit your business.

EQUITY FINANCING
Equity financing is the process of raising capital through the sale of shares in a
company. With equity financing comes an ownership interest for shareholders.
Equity financing may range from a few thousand dollars raised by an
entrepreneur from a private investor to an initial public offering (IPO) on a
stock exchange running into the billions.

Equity financing places no additional financial burden on the company. Since

there are no required monthly payments associated with equity financing, the
company has more capital available to invest in growing the business. But that
doesn't mean there's no downside to equity financing.

In fact, the downside is quite large. In order to gain funding, you will have to give
the investor a percentage of your company. You will have to share your profits
and consult with your new partners any time you make decisions affecting the
company. The only way to remove investors is to buy them out, but that will
likely be more expensive than the money they originally gave you.

Pros of equity financing:

• For new businesses with no revenue or those which are yet to attain
profitability, equity financing can be your best if not only option.
• Investors take on almost all the risk; they receive their returns only if the
business succeeds
• No percentage of your revenues will be diverted to pay loans.

Cons of equity financing:

• Give up a percentage of your business.

 • Investors may have control over key decisions and influence the culture of
the company.
• Landing investment can be a full-time effort, and reporting to investors
regularly can take precious man-hours.
• Investors or “equity partners” usually do not expect a return on their
investment for 3-5 years, but they often exit after 5-7 years.

Advantages of Debt Compared to Equity

• Because the lender does not have a claim to equity in the business, debt
does not dilute the owner's ownership interest in the company.

• A lender is entitled only to repayment of the agreed-upon principal of

the loan plus interest, and has no direct claim on future profits of the
business. If the company is successful, the owners reap a larger portion of
the rewards than they would if they had sold stock in the company to
investors in order to finance the growth.

• Except in the case of variable rate loans, principal and interest obligations
are known amounts which can be forecasted and planned for.

• Interest on the debt can be deducted on the company's tax return,

lowering the actual cost of the loan to the company.

• Raising debt capital is less complicated because the company is not

required to comply with state and federal securities laws and regulations.

• The company is not required to send periodic mailings to large numbers

of investors, hold periodic meetings of shareholders, and seek the vote of
shareholders before taking certain actions.

Disadvantages of Debt Compared to Equity

• Unlike equity, debt must at some point be repaid.

• Interest is a fixed cost which raises the company's break-even point. High
interest costs during difficult financial periods can increase the risk of
 insolvency. Companies that are too highly leveraged (that have large
amounts of debt as compared to equity) often find it difficult to grow
because of the high cost of servicing the debt.

• Cash flow is required for both principal and interest payments and must
be budgeted for. Most loans are not repayable in varying amounts over
time based on the business cycles of the company.

• Debt instruments often contain restrictions on the company's activities,

preventing management from pursuing alternative financing options and
non-core business opportunities.

• The larger a company's debt-equity ratio, the more risky the company is
considered by lenders and investors. Accordingly, a business is limited as
to the amount of debt it can carry.

• The company is usually required to pledge assets of the company to the

lender as collateral, and owners of the company are in some cases
required to personally guarantee repayment of the loan.

Example
If you run a small business and need $40,000 of financing, you can either take
out a $40,000 bank loan at a 10 percent interest rate, or you can sell a 25
percent stake in your business to your neighbor for $40,000.

Suppose your business earns a $20,000 profit during the next year. If you took
the bank loan, your interest expense (cost of debt financing) would be $4,000,
leaving you with $16,000 in profit.

Conversely, had you used equity financing, you would have zero debt (and as a
result, no interest expense), but would keep only 75 percent of your profit (the
other 25 percent being owned by your neighbor). Therefore, your personal
profit would only be $15,000, or (75% x $20,000).

From this example, you can see how it is less expensive for you, as the original
shareholder of your company, to issue debt as opposed to equity. Taxes make
the situation even better if you had debt since interest expense is deducted from
earnings before income taxes are levied, thus acting as a tax shield (although we
have ignored taxes in this example for the sake of simplicity).

Of course, the advantage of the fixed-interest nature of debt can also be a

disadvantage. It presents a fixed expense, thus increasing a company's risk.
Going back to our example, suppose your company only earned $5,000 during
the next year. With debt financing, you would still have the same $4,000 of
interest to pay, so you would be left with only $1,000 of profit ($5,000 - $4,000).
With equity, you again have no interest expense, but only keep 75 percent of
your profits, thus leaving you with $3,750 of profits (75% x $5,000).

However, if a company fails to generate enough cash, the fixed-cost nature of

debt can prove too burdensome. This basic idea represents the risk associated
with debt financing.

What Is a Leverage Ratio?

A leverage ratio is any one of several financial metrics that look at how much
capital comes in the form of debt (loans) or assesses the ability of a company to
meet its financial obligations. The leverage ratio category is very crucialas
companies rely on a mixture of equity and debt to finance their operations and
knowing the amount of debt held by a company is useful in evaluating whether
it can pay its debts off as they come due.

Understanding the Leverage Ratio

Too much debt is dangerous for a company and its investors / shareholders.
However, if a company's operations can generate a higher rate of return than
the interest rate on its loans, then the debt is helping to add growth in profits.
However, uncontrolled debt levels can lead to credit downgrades or worse. On
the other hand, too few debts can also raise questions. A reluctance or inability
to borrow may be a sign that operating margins are simply too tight.

There are several different specific ratios which may be categorized as a

leverage ratio, but the main factors are debt, equity, assets, and interest
expenses.

A leverage ratio can be also used to measure a company's mix of operating

expenses to get an idea of how changes in output will affect operating income.
Fixed and variable costs are the two types of operating costsand depending on
the company and the industry, the mix will differ.

While the consumer leverage ratio refers to the level of consumer debt as
compared to disposable income and is used in economic analysis and by
policymakers.

TypesofLeverage

There are three commonly used measures of leverage in financial analysis.

These are:

• Operating Leverage

• Financial Leverage

• Combined Leverage

DegreeofOperatingLeverage(DOL)
The degree of operating leverage (DOL) is a multiple that evaluates how much
operating income of a company will change in response to a change in sales.
Companies with a large proportion of fixed costs to variable costs have higher
levels of operating leverage.

The DOL ratio assists analysts in determining the impact of any change in sales
on company earnings.
Formula for Degree of Operating Leverage
The degree of operating leverage can be calculated in several different ways.
First, we can use the formula from the definition of the ratio:

Since the operating leverage ratio is closely related to the company’s cost
structure, we can calculate it using its contribution margin. The contribution
margin is the difference between total sales and total variable costs.
Finally, if there is available information about the cost structure of a company,
we can use the following formula:

Where:

• Q – the number of units

• P – the price per unit
• V – the variable cost per unit
• F – the fixed costs

What Does the Degree of Operating Leverage Tells?

The higher the DOL, the more sensitive a company’s earnings before interest
and taxes (EBIT) are with respect to changes in sales assuming other variables
constant. The ratio helps analysts determine what the impact of any change in
sales will be on the company’s earnings.

Operating leverage measures a company’s fixed costs as a percentage of its total

costs. It is used to evaluate a business’ breakeven point which shows where
sales are high enough to pay for all costs and the profit is zero.

A company with high operating leverage has a large proportion of fixed costs
that means a huge increase in sales can lead to outsized changes in profits. A
company with low operating leverage has a large proportion of variable cost that
means that it earns a smaller profit on each sale, but does not have to increase
sales as much to cover its lower fixed costs.
Key Takeaways

• The DOL is a multiple that measures how much the operating income of a
company will change in response to a change in sales.
• The DOL ratio helps analysts in determining the impact of any change in
sales on company earnings.
• A company with high operating leverage has a large proportion of fixed
costs, which means that a big increase in sales can lead to outsized changes
in profits.

Break-EvenAnalysisandLeverage

Break-even analysis is a generally used method to study the Cost Volume Profit
analysis. This technique can be explained in two ways:

It is concerned with computing the break-even point. At this point of production

level and sales there will be no profit and loss i.e. total cost is equal to total sales
revenue.

This technique is used to determine the possible profit/loss at any given level of
production or sales

. . . FixedCost
Brea k-evenpointinunits=--------
Contributionperunit
Example1:
Company X has $500,000 in sales in year one and $600,000 in sales in year two.
In year one, the company's operating expenses were $150,000, while in year
two, the operating expenses were $175,000.

Year one EBIT = $500,000 - $150,000 = $350,000

Year two EBIT = $600,000 - $175,000 = $425,000

Next, the percentage change in the EBIT values and the percentage change in the
sales figures are calculated as:

% change in EBIT = $425,000 / $350,000 - 1 = 21.43%

% change in sales = $600,000 / $500,000 -1 = 20%

Lastly, the DOL ratio is calculated as:

DOL = % change in operating income/% change in sales = 21.43% / 20% =

1.0714

Since businesses with higher operating leverage do not proportionately increase

expenses as they increase sales, they may bring in more operating income than
others. However, those businesses with high operating leverage are also
affected more by poor management decisions and other factors that can cause
losses in business income.

A company with low operating leverage has a large proportion of variable costs
that means that it earns a smaller profit on each sale but does not have to
increase sales as much to cover its lower fixed costs.

However, so long as a business earns a substantial profit on each sale and

sustains adequate sales volume, fixed costs are covered and profits are earned.

Example 2:

The main formula can be used to calculate the degree of operating leverage
divides the percent change in EBIT by the percent change in sales. For example,
Company ABC's EBIT increased by 8.58 percent from 2017 to 2018, and its sales
increased by 6.04 percent during the same period. The degree of operating
leverage is shown in the following table:

COMPANY ABC (IN MILLIONS)

2018 2017 % Change

EBIT 14,358 13,224 8.58%
Sales 55,632 52,465 6.04%
Degree of Operating Leverage 1.4206

Example 3:

The degree of operating leverage can also be calculated by subtracting the

variable costs of sales and dividing that number by sales minus variable costs
and fixed costs. For example, for the fiscal year ended 2018, Company A had
sales of $55.63 billion, fixed costs of $11.28 billion, and variable costs of $30
billion. Company B had sales of $29.32 billion, fixed costs of $5.47 billion, and
variable costs of $16.38 billion.

Company A's degree of operating leverage is ($55.63 billion - $30 billion) /

($55.63 billion - $30 billion - $11.28 billion) = 1.78. Company B's degree of
operating leverage is ($29.32 billion - $16.38 billion) / ($29.32 billion - $16.38
billion - $5.47 billion) = 1.73. If both companies experience a 20 percent
increase in sales, Company A's profits rise by 35.6% and Company B's profits
rise by 34.6%.

Company A (millions Company B (millions

$) $)
Sales 55,632 29,318
Variable Costs (VC) 29,993 16,376
Fixed Costs (FC) 11,281 5,473
Sales - VC 25,639 12,942
Sales - VC - FC 14,358 7,469
Degree of Operating
1.785694 1.732762
Leverage

Example 4:

The management of BBC Corp. wants to determine the company’s current

degree of operating leverage. The company sells 10,000 product units at an
average price of $50. The variable cost per unit is $12 while the total fixed costs
are $100,000.

The company’s DOL is:

Therefore, every 1% change in the company’s sales will change the company’s
operating income by 1.38%.

Example 5:

The following information pertains to last week's operations of CBC Company.

The company sold 2,500 units at $25 each. Variable cost per unit is $15.

Sales Revenue $62,500

Less: Variable Costs 37,500
Contribution Margin $25,000
Less: Fixed Costs 15,000
Operating Income $10,000

The degree of operating leverage is:

Contribution
DOL=
margin
Operating income
 = $25,000
$10,000

DOL= 2.5 times

Analysis: If sales revenue changes by a certain percentage, operating income

will change by 2.5 times the percentage change in sales. A 10% increase in sales
will result in a 25% increase in operating income.

Old New
Sales Revenue ($25/unit) $62,500 $68,750
Less: Variable Costs ($10/unit)37,500 41,250
Contribution Margin $25,000 $27,500
Less: Fixed Costs 15,000 15,000
Operating Income $10,000 $12,500

In the table above, sales revenue increased by 10% ($62,500 to $68,750).

However, it resulted in a 25% increase in operating income ($10,000 to
$12,500).

This is actually caused by the amplifying effect of using fixed costs. Even if sales
increase, fixed costs do not change hence causing an amplified increase in
operating income.

Example 6:

Calculate degree of operating leverage in the following cases and predict the
increase in operating income subject to 15% increase in sales.

Company X: operating income increases by 15% if sales increase by 10%.

Company Y: sales are $2,000,000, contribution margin ratio is 40% and fixed
costs are $400,000

Solution
Company X:
Degree of operating leverage = % change in operating income/% change in sales
= 15%/10% = 1.5
In response to a 15% increase sales, operating income will increase by 22.5%
[=1.5 × 15%]

Company Y:
Operating margin = ($2,000,000 × 0.4 − $400,000) ÷ $2,000,000 = 20%
Degree of operating leverage = contribution margin percentage/operating
margin = $40% ÷ 20% = 2%

Increase in operating income in response to 15% increase in sales = 2 × 15% =

30%

Example 7:

Let us now calculate Amazon’s DOL.

Below is the snapshot of Amazon’s Income Statement for 2014, 2015 and 2016.
Source: Amazon SEC Filings

DOL formula = % change in EBIT / % change in Sales

DOL OF AMAZON – 2016

% change in EBIT (2016) = (4,186-2,233)/2,233 = 87%

% change in Sales (2016) = (135,987 – 107,006)/107,006 = 27%

Amazon’s DOL (2016) = 87% / 27% = 3.27x

DOL OF AMAZON – 2015

% change in EBIT (2015) = (2,233- 178)/174 = 1154%

% change in Sales (2015) = (107,006 – 88,988)/88,988 = 20%

Amazon’s DOL (2015) = 1154% / 20% = 57.02x

REASONS FOR HIGHER DOL:

• Higher Fixed Costs

• Lower Variable Costs

Analysis and Interpretation

The DOL can show the impact of operating leverage on the firm’s EBIT. Also, the
DOL is crucial to assess the effect of fixed costs and variable costs of the core
operations of business.

A high degree of operating leverage shows an indication that the company has a
high proportion of fixed operating costs compared to its variable operating
costs. This means that it uses more fixed assets to support its core business. It
also means that the company can make more money from each additional sale
while keeping its fixed costs intact. So, the company has a high DOL by making
fewer sales with high margins. As a result, fixed assets, such as property, plant,
and equipment, acquire a higher value without incurring higher costs. At the
end of the day, the firm’s profit margin can expand with earnings increasing at a
faster rate than sales revenues.

On the other hand, a low DOL suggests that the company has a low proportion of
fixed operating costs as compared to its variable costs which means that it uses
less fixed assets to support its core business while sustaining a lower gross
margin.

It is important to understand that controlling fixed costs can lead to a higher

DOL because they are independent of sales volume. The percentage change in
profits as a result of changes in the sales volume is higher than the percentage
change in sales. This means that a change of 4% is sales can generate a change
greater of 4% in operating profits.

Practical Usage Explanation: Cautions and Limitations

At the end of the day, operating leverage can tell to stakeholders how risky a
company may be. Although a high DOL can be beneficial to the firm, often, firms
with high DOL can be vulnerable to business cyclicality and changing
macroeconomic conditions.

When the economy is booming, a high DOL may boost a firm’s profitability.
However, companies that need to spend a lot of money on property, plant,
machinery, and distribution channels, cannot easily control consumer demand.
So, in the case of an economic downturn, their earnings may plummet because
of their high fixed costs and low sales.

What is Financial Leverage?

Financial leverage is the usage of borrowed money (debt) to finance the
purchase of assets with the expectation that the income or capital gain from the
new asset will certainly exceed the cost of borrowing.
In most of the cases, the provider of the debt will put a limit on how much risk it
is ready to take and shows a limit on the extent of the leverage it will allow. In
the case of asset-backed lending, the financial provider uses the assets
as collateral until the borrower repays the loan. While in case of a cash flow
loan, the general creditworthiness of the company is used to back the loan.

Financial leverage is the usage of debt to increase earnings. Interest is the cost of
using debt to finance operations. Interest is a fixed charge because unlike
dividends, interest must be paid whether or not the firm is profitable. The use of
financing that carries a fixed charge is called financial leverage.

Financial leverage is also a part of solvency analysis. Financial leverage

magnifies the effect of both managerial success and managerial failure in terms
of Profit or losses. When financial leverage is being used, an increase in EBIT
will cause an even greater proportionate increase in net income, and a decrease
in EBIT will cause an even greater proportionate decrease in net income.

Financial leverage ratios measure a company's use of debt to finance its assets
and operations. Financial leverage can also be defined as the percentage of fixed
cost financing in a firm's overall capital structure, because the increased amount
of debt causes the company's financial costs (interest expense) to increase.

Higher financial leverage shows that shareholders are accepting greater risk
because the higher the leverage, the more fixed interest costs the company will
be required to pay. On the other hand, if the company generates more net
income from its investment of the borrowed funds than is required to service its
debt costs for the borrowed funds, they will benefit from the high financial
leverage because profits will increase.

Financial leverage magnifies both profit and loss and therefore requires careful
consideration by a financial manager.

How Financial Leverage works?

When purchasing assets, three options are available to the company for
obtaining financing like equity, debt, and leases. Apart from equity, the rest of
the options involve fixed costs that are lower than the income that the company
expects to earn from the asset. In this case, we assume that the company uses
debt to finance the asset acquisition.

Example

Assume that Company ABC wants to acquire an asset that costs $100,000. The
company can either use equity or debt financing. If the company opts for the
first option, it will own 100% of the asset, and there will be no interest
payments. If the asset appreciates in value by 30%, the asset’s value will
increase to $130,000 and the company will earn a profit of $30,000. Similarly, if
the asset depreciates by 30%, the asset will be valued at $70,000 and the
company will incur a loss of $30,000.

Alternatively, the company may go with the second option and finance the asset
using 50% common stock and 50% debt. If the asset appreciates by 30%, the
asset will be valued at $130,000. It means that if the company pays back the
debt of $50,000, it will remain with $80,000, which translates into a profit of
$30,000. Similarly, if the asset depreciates by 30%, the asset will be valued at
$70,000. It means that after the paying the debt of $50,000, the company will
remain with $20,000 which translates to a loss of $30,000 ($50,000 – $20,000).

Advantages:
 • If financial leverage is used properly, the interest expense paid on the
debt capital will be less than the return earned from investing it, and the
excess return will benefit the equity investors.
• Interest paid on debt is tax-deductible which effectively reduces interest
as an expense.

Limitations:

• The financial leverage may be used improperly, and the return earned
from investing the debt capital will be less than the interest expense paid
on it, which will hurt the value of the equity investors' investments.
• Too much financial leverage causes the cost of all of the company's capital
to increase because investors will perceive greater risk and will require a
greater return on their investment.

The financial leverage ratio represents the amount of debt a firm is using to
finance its assets. The more debt the company has, the higher its financial
leverage ratio will be. As a company increases its debt, it is incurring more fixed
charges of interest that must be paid. The more fixed charges in interest
thecompany has, the less income it will have available for distribution. If a
company has a high financial leverage ratio in combination with high volatility
of sales or operating profit, the risk is higher that thecompany may not be able
to service its debt and will make default on it.

Borrowing money to finance assets will cause total assets to increase while total
equity remains same. Since the financial leverage ratio is calculated as total
assets divided by total equity, the company's financial leverage ratio will
increase as more money is borrowed to finance additional assets.

While on the other hand, issuing equity to finance assets will cause total assets
and total equity to increase by the same amount. Since beginning total assets are
greater than beginning total equity, the proportional increase in total assets will
be less than the proportional increase in total equity. Since the numerator of the
financial leverage ratio will increase less, proportionately, than the denominator
will, the result will be a decrease in the financial leverage ratio.
A company with financial leverage is called as "trading on the equity." "Trading
on the equity" is simply a term that means the company is using financial
leverage (debt) to achieve increased returns. Trading on the equity, or financial
leverage, may or may not be successful.

Remember that "trading on the equity" is a term used to mean that a company is
borrowing money to invest in assets. The company is borrowing to invest
because it expects the investment to earn a greater return than the company
will pay in interest so the company's profits will increase as a result of its
borrowing to invest. In fact, by borrowing a portion of the funds it invests, a
company can greatly increase its rate of return on the amount of its own funds
that it has invested.

However, trading on the equity may not always be helpful as the borrowed
principal must be repaid along with interest; the company assumes risk by
borrowing. The company is required to repay the obligation whether or not the
expected return materializes. If the actual return is lower than expected, the
repayment of the principal and interest will need to come from cash flow
generated by other projects.

Comparing the company's return on assets with after-tax cost of debt can give
some insight into whether or not the company’s management is using financial
leverage successfully.

Financial leverage which is also known as leverage or trading on equity, refers to

the use of debt to acquire additional assets.

The use of financial leverage to control a greater amount of assets (by

borrowing money) will cause the returns on the owner's cash investment to be
amplified. That is, with financial leverage:

an increase in the value of the assets will result in a larger gain on the owner's
cash, when the loan interest rate is less than the rate of increase in the asset's
value

a decrease in the value of the assets will result in a larger loss on the owner's cash

Example of Financial Leverage

Mary uses $500,000 of her cash to purchase 40 acres of land with a total cost of
$500,000. Mary is not using financial leverage.

Sue uses $500,000 of her cash and borrows $1,000,000 to purchase 120 acres of
land having a total cost of $1,500,000. Sue is using financial leverage to
own/control $1,500,000 of property with only $500,000 of her own money.
Let's also assume that the interest on Sue's loan is $50,000 per year and it is
paid at the beginning of each year.

Trading on Equity in Financial Leverage

The basic assumption relating to financial leverage is that the firm can earn
more on assets acquired by the borrowed funds. Since borrowed funds require a
fixed payment in the form of interest the difference between the earnings from
the assets and interest on the use of the funds goes to the equity shareholders.

Hence use of fixed interest bearing funds provide increased return on equity
investment without additional requirement of funds from the shareholders.
Trading on equity refers to the utilization of non-equity sources of funds in the
capital structure of an enterprise.

The use of borrowings for the purpose of financial advantage for residual
stockholders is called trading on equity. Hence trading on equity may be based
upon bonds, non-participating preferred stock and/or limited rental leases.
When a corporation earns more on its borrowed capital than the interest it has
to pay on bonds, trading on equity is profitable.
So financial leverage is also called trading on equity. However there is the
possibility of adverse result if the return is not adequate. Hence trading on
equity is of double-edged. It may be defined as the increase in profit/return
resulting from borrowing capital at a low rate and employing it in a business
yielding a higher rate.

According to Kulkarni and Satyaprasad ‘trading on equity refers to the

pyramiding of corporate layers so that a successful smaller amount of stock
makes it possible for a company to gain control of the subsidiaries’.

The use of the fixed-charge sources of funds, such as debt and preference capital
along with the owner’s equity in the capital structure is described as financial
leverage or gearing or trading on equity. Trading on equity is calculated by
relating the rate of return on equity capital under the existing capital structure
inclusive of debt capital to the rate of return on equity capital under an all-
equity capital structure, i.e. the equivalent amount of equity share capital be
raised in place of borrowed funds.

Financial leverage explains the impact on EPS and trading on equity shows the
impact of return on equity capital. The use of fixed charge or return bearing
securities like debentures, bonds, preference share capital, term loan, etc., to
increase the earnings available to equity shareholders is termed as trading on
equity.

FinancialLeverageasa'DoubleedgedSword'
On one hand when cost of 'fixed cost fund' is less than the return on investment
financial leverage will help to increase return on equity and EPS. The firm will
also benefit from the saving of tax on interest on debts etc. However, when cost
of debt will be more than the return it will affect return of equity and EPS
unfavorably and as a result firm can be under financial distress. This is why
financial leverage is known as "double edged sword".

EffectonEPSandROE:
• When, ROI > Interest - Favourable - Advantage
• When, ROI < Interest - Unfavourable - Disadvantage
• When, ROI = Interest - Neutral - Neither advantage nor disadvantage.

DegreeofFinancialLeverage(DFL)

A degree of financial leverage (DFL) is a leverage ratio that measures the

sensitivity of a company’s earnings per share (EPS) with respect to fluctuations
in its operating income, as a result of changes in its capital structure. It measures
the percentage change in EPS for a unit change in operating income, also known
as earnings before interest and taxes (EBIT).

This ratio indicates that the higher the degree of financial leverage, the more
volatile earnings will be. Since interest is usually a fixed expense, leverage
glorifies returns and EPS. This is good when operating income is rising, but it
can be an issue when operating income is under pressure.

What Does Degree of Financial Leverage Tell?

DFL is invaluable in helping a company to evaluate the amount of debt or
financial leverage it should opt for in its capital structure. If operating income is
relatively stable, then earnings and EPS would also be stable as well, and the
company can afford to take on a significant amount of debt. However, if the
company operates in a sector where operating income is quite volatile, it may be
prudent to limit debt to easily manageable levels.

The use of financial leverage varies largely by industry and by the business
sector. There are many industry sectors in which companies operate with a
high degree of financial leverage. Retail stores, airlines, grocery stores, utility
companies, and banking institutions are classic examples of the same.
Unfortunately, the excessive use of financial leverage by many companies in
these sectors has played aimportant role in forcing a lot of them to file
for bankruptcy.

E.g. R.H. Macy (1992), Trans World Airlines (2001), Great Atlantic & Pacific Tea
Co (A&P) (2010) and Midwest Generation (2012).

Moreover, excessive use of financial leverage was the primary culprit which led
to the U.S. financial crisis between 2007 and 2009. The demise of Lehman
Brothers (2008) and a host of other highly levered financial institutions are
prime examples that are associated with the use of highly levered capital
structures.

Key Takeaways

• The degree of financial leverage (DFL) is a leverage ratio that measures the
sensitivity of a company’s EPS to fluctuations in its operating income, as a
result of changes in its capital structure.
• This ratio indicates that the higher the degree of financial leverage, the
more volatile earnings will be.
• The use of financial leverage varies greatly by industry and by sector.

Example :1

XYZ Company earned $500,000 in Year 1. It had no debt, so its EBIT and EBIT –
Interest are the same. The DFL ratio is 1. Now assume XYZ is considering
expanding its manufacturing facility, at a cost of $1 million. If XYZ borrows the
money, it will incur $60,000 in interest expenses. The decision to borrow is
based on the amount XYZ’s managers think revenue will increase because of the
expansion. Assume it is estimated that XYZ’s revenue for Year 2 will increase to
$600,000 as a result of the expanded business. Now XYZ’s DFL is: Year 2 DFL =
$600,000/($600,000 - $60,000) = 1.11 This means that for every change in
earnings before taxes, there is a 1.11x change in EBIT. If this, in fact, does
happen, then management’s decision to borrow the money paid off, because the
increase in revenue more than covered the debt incurred to fund the expansion.

Formula for Degree of Financial Leverage

There are several ways to calculate the

degree of financial leverage. The choice of
the calculation method depends on the
goals and context. For example, a
company’s management often wants to
decide whether it should or should not
issue more debt. In such a case, net
income would be an appropriate measure
of the company’s profitability:

But, if an investor wants to determine the effects of the company’s decision to

incur additional leverage, the earnings per share (EPS) is a more appropriate
figure because of the metric’s strong relationship with the company’s share
price.

Finally, there is also a formula that allows calculating the degree of financial
leverage in a particular time period:
Example: 2

DELL Corp. is preparing to launch a new project that will require substantial
external financing. The company’s management wants to determine whether it
can safely issue a significant amount of debt to finance the new project.
Currently, the company’s EBIT is $500,000, and interest payments are $100,000.

In order to make the decision, the company’s management wants to examine the
degree of financial leverage ratio:

It shows that a 1% change in the company’s leverage will change the company’s
operating income by 1.25%.

Example: 3

Two companies have the same EBIT of $3,000,000 but different capital
structure. Company Y is mostly focused on equity financing using both common
and preferred equity. Its preferred dividend payment is $150,000, and the
interest payment is $250,000. By contrast, Company Z tends to use debt
financing and has only common equity. Its interest payment is $1,250,000. The
tax rate for both companies is 30%.

The degree of financial leverage of Company Y is 1.18 and 1.71 for Company Z.

EBIT $3,000,000
DFL of Company Y = = = 1.18
D $150,000
EBIT - I - $3,000,000 - $250,000 -
1-T 1 - 0.30

EBIT $3,000,000
DFL of Company Z = = = 1.71
EBIT - I $3,000,000 - $1,250,000

Hence, Company Z is more sensitive to fluctuations in EBIT than Company Y. If

EBIT of both companies rises by 5%, the EPS of Company Y will increase by
5.9% (5 × 1.18), and the EPS of Company Z will increase by 8.55% (5 × 1.71). In
contrast, the drop in EBIT by 10% will lead to a decrease in the EPS of Company
Y by 11.8% and by 17.1% for Company Z.

DegreeofCombinedLeverage(DCL)

A degree of combined leverage (DCL) is a leverage ratio that summarizes the

combined effect that the degree of operating leverage (DOL) and the degree of
financial leverage have on earnings per share (EPS), given a change in sales. This
ratio can be used to determine the most optimal level of financial and operating
leverage to use in any firm.

What Does the DCL Tell?

It summarizes the effects of combining financial and operating leverage, and

what effect this combination, or variations of this combination, has on the
corporation's earnings. Not all companies use both operating and financial
leverage, but this formula can be used if they do.

A firm with a high level of combined leverage is seen as riskier than a firm with
less combined leverage because high leverage means more fixed costs to the
firm.

Key Takeaways
 • The DCL summarizes the effects that the combined degree of operating
leverage and degree of financial leverage have on a company's earnings per
share, based on a given change in shares.
• It helps a company discern its best possible levels of operational and
financial leverage.
• It helps companies understand how the combined leverage affects the
company's total earnings.

Low vs. high combined leverage

It summarizes the effect of fixed operating costs and fixed financial costs on a
company’s earnings per share (EPS). It is a measure of the total risk of a
business because it includes both operating risk and financial risk.

A high value DCL ratio means that a large proportion of a company’s total costs
are fixed, and incremental sales will result in a higher incremental EPS. Other
things being equal such companies have to generate more sales to cover their
total fixed costs.

A smaller proportion of fixed operating and financial costs will result in a lower
DCL ratio, which shows lower incremental EPS on incremental sales and lower
sensitivity to the slippage in sales.

Formula for Degree of Combined Leverage (DCL)

The formula used for deriving the Degree of Combined Leverage is:

DCL = %Change in EPS / %Change in Sales = DOL * DFL

This ratio is very useful to a company or firm to understand the effects of

combining financial and operating leverage on the total earnings of the
company. A high level of combined leverage shows the risk involved in the
company as there are more fixed costs in the company, while a low combined
leverage would mean better for the company.

Measuring Degree of Combined Leverage

As the degree of combined leverage is calculated by combining both the
operational leverage and the financial leverage, it assists in ascertaining the
total risk involved in the business. Operating Leverage measures the operating
risk or business risk of the company while Financial Leverage measures the
financial risk of the company. Together, both the financial leverage ratio and the
operating leverage ratio can provide an idea of how much risk per share are
involved.

Operating leverage is determined by the percentage change in earning before

tax or interest is due and similarly financial leverage is determined by the
percentage change in the gross before the tax and interest per share is due.

It is on the company to maintain the degree of combined leverage so as to

minimize the risks involved in the business. Maintaining the risk and not
increasing it, the business should try to lower or minimize the financial leverage
in order to balance the operating leverage and by minimizing the operating
leverage when the financial leverage is to be balances. The balanced degree of
combined leverage (DCL) provides with an increase in the earnings per share of
the equity holders which is why it is important to calculate the Degree of
CombinedLeverage (DCL) for better understanding of the position of the
company and minimizing the risks of the company.

SUMMARY

Operating leverage exists when a firm has a fixed cost that must be defrayed
regardless of volume of business. It can be defined as the firm's ability to use
fixed operating costs to magnify the effects of changes in sales on its earnings
before interest and taxes.
Financial leverage involves the use fixed cost of financing and refers to mix of
debt and equity in the capitalization of a firm. Financial leverage is a
superstructure built on the operating leverage. It results from the presence of
fixed financial charges in the firm's income stream.

Combined leveragecan be defined as the potential use of fixed costs, both

operating and financial, which magnifies the effect of sales volume change on
the earning per share of the firm. Degree of combined leverage (DCL) is the ratio
of percentage change in earning per share to the percentage change in sales. It
indicates the effect the sales changes will have on EPS.

Example 1:

Calculate the degree of operating leverage, degree of financial leverage and the
degree of combined leverage for the following firms and interpret the result:

Solution:
Interpretation and Comments:
From the above statements, the DOL reveals that if there is a variation in sales
by 1%, there is a corresponding variation in EBIT by 2.4%, 2.14% and 1 6% in
the case of firm B, Q and R respectively On the other hand, the DFL shows that if
EBIT varies by 1% there will be a corresponding variation in EPS by 1.11%,
1.07% and 1% in the case of the firms B. O and R.

Similarly, DCL prove that if sales vary by 1%, there will be a corresponding
variation in EBT by 2.67, 2.29 and 1.60 in the case of firm B, O and R
respectively.

It is also found from the above table that firm B possess all the three highest
leverage followed by Q and R. Moreover the DFL is lower than DOL in all the
cases. Combined leverage measures the total risk of the firm. Thus, if the two
leverages are high, no doubt, it is a very risky one.

Thus, if a firm enjoys low financial leverage and high operating leverage the
same partly adjust the high operating leverage which has been found in the
present problem. Because, we know that a low operating leverage presents
lower fixed cost and higher variable cost.

A high financial leverage shows that the firm has increased its ROE after
applying debt-financing in its capital structure. So is concluded that a firm
should always have a high financial leverage corresponding to a low operating
leverage. If this is taken into consideration none of the said three firms have
faithfully followed the norms.

Example 2:
Key performance indicators of the JBC Company for the accounting year are as
follows.

* The liabilities are formed as a result of bonds issue with a fixed interest rate of
17%.

** Income tax rate is 30%.

Thus, the degree of operating leverage for the JBC Company is 1.889.

DOL=($15,000-$6,500)/($15,000-$6,500-$4,000)=1.889
This means that change in sales by 1% will lead to change in EBIT by 1.889%.

Since the JBC Company has outstanding debts, it uses financial leverage, the
degree of which is 1.128.

DFL=$4,500/($4,500-$510)=1.128

Thus, the change in EBIT by 1% will lead to the change in earnings per share
(EPS) by 1.128%.

Now we can calculate the degree of combined leverage of the JBC Company.

DCL=1.889*1.128=2.131

These results indicate that change in sales by 1% will lead to change in earnings
per share by 2.131%.

Example 3:

A firm selling price of its product is $100 per unit. The variable cost per
unit is $50 and the fixed operating costs are $50,000 per year. The fixed interest
expenses (non-operating) are $25,000 and the firm has 10,000 shares
outstanding. Let us evaluate the combined leverage resulting from sale of 1)
2000 units & 2) 3000 units. Tax rate = 35%.
 A combined leverage (total risk) of 4 depicts that for every $1 change in
sales, there would be a $4 change in the Earnings per share in either direction.

Example 4:

Two firms X and Y are in a similar business. Find out the total risk.

Particulars Firm X Firm Y

Sales @ Rs.20 3,50,000 2,80,000
each
Fixed Cost 40,000 40,000
Variable cost 1,70,000 1,10,000
Tax 40% 40%

Particulars Firm X Firm Y

Debt @ 10% 3,00,000 2,00,000
Equity Rs.100 5,00,000 6,00,000
each
Preference 1,00,000 1,00,000
share@7%

Solution:

Particulars Amount (Rs.) X Amount (Rs.) Y

Sales 3,50,000 2,80,000
Less: Variable 1,70,000 1,10,000
Cost
Contribution 1,80,000 1,70,000
margin
Less: Fixed Cost 40,000 40,000
EBIT 1,40,000 1,30,000
Less: Interest 30,000 20,000
EBT 1,10,000 1,10,000
Less: Tax 44,000 44,000
Profit 66,000 66,000
Less: Dividend 7,000 7000
on preference
shareholders
Shareholders 59,000 59,000
Profit
Number of 5000 6000
shares
Earnings per 11.8 9.83
share
Degree of 1,80,000/1,40,000 1,70,000/1,30,000
operating = 1.28 =1.30
leverage =
Contribution
Margin / EBIT
Degree of 1,40,000/1,10,000 1,30,000/1,10,000
Financial =1.27 = 1.18
leverage =
Contribution/
EBT

Combined Leverage = DOL*DFL

Firm X:
=1.28*1.27
= 1.62
Interpretation: If 1% increase in sales then 1.62% increase in EPS.

Firm Y:
= 1.30*1.18
= 1.53
Interpretation: If 1% increases in sales then there is 1.53% increase in EPS.
So, the firm X has opportunity to give higher EPS in comparison to firm Y.

Example 5:

Find out the combined leverage with the help of given information of
following Companies :

Particulars Company A Company B Company C Company D

Sales 2, 00,000 1, 50, 200 4, 50, 000 4, 10,000
Variable 20, 000 ---- 50, 000 25, 600
cost
Fixed cost 10, 200 30, 000 10, 000 15, 000
Degree of 1.32 1.13 1.10 1.20
financial
leverage

Solution:
Particulars Company A Company B Company C Company D
Sales 2, 00,000 1, 50, 200 4, 50, 000 4, 10,000
Less: 20, 000 ---- 50, 000 25, 600
Variable
cost
Contribution 1, 80,000 1, 50,200 4, 00,000 3, 84,400
margin (A)
Less: Fixed 10, 200 30, 000 10, 000 15, 000
cost
Earnings 1, 69, 800 1, 20,200 3, 90,000 3, 69,400
before tax
(B)
Degree of 1.06 1.25 1.03 1.04
Operating
leverage(C =
A/B)
Degree of 1.32 1.13 1.10 1.20
financial
leverage
(given)(D)
Degree of 1.40 1.41 1.13 1.25
combined
leverage
(C*D)

Illustration 6:

A simplified income statement of Zoysa Ltd. is given below. Calculate and

interpret its degree of operating leverage, degree of financial leverage and
degree of combined leverage.

Income Statement of Zoysa Ltd. for the year ended 31st March 2005:
Solution:

Illustration 7:

The following figures relate to two companies:

You are required to:

(i) Calculate the operating, financial and combined leverages for the two
companies; and

(ii) Comment on the relative risk position of them.

Solution:

(ii) Comments on the Relative Risk Position:

(a) Operating Leverage:

As the operating leverage for Q Ltd. is higher than that of P. Ltd; Q Ltd. has a
higher degree of operating risk. The tendency of operating profit to vary
disproportionately with sales is higher for Q Ltd. as compared to P. Ltd.

(b) Financial Leverage:

Since finance leverage for the two companies is the same, both the companies
have the same degree of financial risk, i.e. the tendency of net
disproportionately is the same for P. Ltd. and Q Ltd.

(c) Combined Leverage:

As the combined leverage for Q Ltd. is higher than P Ltd; Q Ltd. has overall
higher risk as compared to P Ltd.

Illustration 8:

A firm has sales of Rs. 20,00,000, variable cost of Rs. 14,00,000 and fixed costs
of Rs. 4,00,000 and debt of Rs. 10,00,000 at 10% rate of interest. What are the
operating, financial and combined leverages? If the firm wants to double its
Earnings before Interest and Tax (EBIT), how much of a rise in sales would be
needed on a percentage basis?

Solution:

Rise in Sales Needed to Double its EBIT:

As the operating leverage is 3, when sales increase by 100% operating profit
will increase by 300%. Thus, 33⅓% rise in sales volume will increase the
operating profit by 100%), i.e., double the earnings before interest and tax.

Verification:

Illustration 9:

From the following, prepare Income Statement of company A, B and C:

Solution:
Section

D
 Study Tips
1. Study even when you don’t want to.
2. Read for at least thrice, for one reading is never enough
a. First Read : Basic understanding
b. Second Read : Conceptual Learning
c. Third Read : Remembering the concepts
3. Don’t skip anything; learn everything with a mindset that this concept
will be asked in exams.
4. Don’t read practicals, solve them instead.
5. Be serious with your study time.
6. Read and Highlight the key words.
7. Make notes
8. After every 40 minutes, take a small break of 10 minutes. This helps to
continue study for longer and is better than study at a stretch.
9. Use a planner. Divide book into units, units into chapters, chapters
into topics and then plan how many topics you should cover in day.
Rome was not built in a day as they say.
10.Evaluate your day against the plan.
11.Find a quiet spot to study.
12.How to study practical aspects
a. Understand the topics
b. Understand an example related to that topic
c. Take a practical
d. Solve on your own without seeing the answer
13.How to remember
a. Question yourself once you studied something
b. Visualize the topics that you studied
c. Connect them to something
d. Create a cue
14.Eat healthy and stay fit
15.You can never finish it until you start.
 Paper pattern

The exam consists of multiple-choice questions, task-based simulations, and

written communication tasks. Specifically, the four-hour BEC exam is structured
as follows:

Testlet 1: Thirty-one multiple-choice questions

Testlet 2: Thirty-one multiple-choice questions
Testlet 3: Two task-based simulations
Testlet 4: Two task-based simulations
Testlet 5: Three written communication tasks