CHAPTER ONE - AN OVERVIEW OF FINANTIAL MANAGEMENT

1.1. INTRODUCTION
In the modern world, all the activities are concerned with the economic activities and very
particular to earning profit through any venture or activities. (According to the economics
concept of factors of production, rent given to landlord, wage given to labour, interest given to
capital and profit given to shareholders or proprietors), a business concern needs finance to
meet all the requirements. Hence, finance may be called as capital, investment, fund etc., but
each term is having different meanings and unique characters. Increasing the profit is the main
aim of any kind of economic activity.

To have a good understanding of financial management, you need to understand first what
finance is. In simple language, finance means the money used in day-to-day activities of an
individual or a business for exchange of goods and services. To start any business, we need
capital. Capital is the amount of money required to start a business. The mobilization of finance
is an important task for an entrepreneur. Therefore, finance is one of the significant factors that
determine the nature and size of any enterprise. This is to be noted that identification of sources
of finance from time to time to finance the assets of an enterprise is critical as it avoids the
financial hardships of an enterprise. The finance is required to acquire various fixed assets and
current assets.

1.1.1. MEANING OF FINANCE

According to Khan and Jain, “Finance is the art and science of managing money”. It includes
financial services and financial instruments. Finance also is referred as the provision of money at
the time when it is needed. Finance function is the procurement of funds and their effective
utilization in business concerns.

According to Oxford dictionary, the word ‘finance’ connotes ‘management of money’.

Webster’s Ninth New Collegiate Dictionary defines finance as “the Science on study of the
management of funds’ and the management of fund as the system that includes the circulation of
money, the granting of credit, the making of investments, and the provision of banking facilities.

Finance is a distinct area of study that comprises facts, theories, concepts, principles, techniques
and practices related with raising and utilizing of funds (money) by individuals, businesses, and
governments.
Finance is a very wide and dynamic field of study. It directly affects the decisions of all
individuals and organizations that earn or raise money and spend or invest it. Therefore, finance
is also an area of study that deals with how, where, by whom, why, and through what money is
transferred among and between individuals, businesses, and governments.
 It is concerned with the processes, institutions, markets, and instruments involved in the
transfer of funds.
In addition to principles and techniques, finance requires individual judgment of the person
making the financial decision. Hence, finance can also be defined as the art and science of
managing money.
1.1.2. MAJOR AREAS OF FINANCE

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 a. Investments: This area of finance focuses on the behavior of financial markets and the
pricing of securities. It deals with financial assets like stocks and bonds with respect to:
 Factors that determine the price of financial assets
 The potential risks associated with investing in financial assets
 The best mix of the different types of financial assets
An investment manager’s tasks, for example, may include valuing common stocks, selecting
securities for a pension fund, or measuring a portfolio’s performance.
b. Public Finance: Central, state and local governments handle large sums of money, which
are received from many sources and must be utilized in accordance with detailed policies
and procedures. Governments have the authority to tax and otherwise raise funds, and must
dispense funds according to legislative and other limitations. In addition, government do not
conduct their activities to achieve the same goals as private organizations. Businesses try to
make profits, whereas a government will attempt to accomplish social or economic
objectives. As a result of these and other differences, a specialized field of public finance
has emerged to deal with government financial matters.
c. International Finance: When money crosses international boundaries individuals,
businesses, and governments must deal with special kinds of problems. Each country has its
own national currency; thus, a citizen of foreign country must convert their currency to the
home country currency before being able to purchase goods or services in the home country.
Most governments have imposed restrictions on the exchange of currencies, and these may
affect business transactions. Governments may be facing financial difficulties, such as
balance-of-payments deficits, or may be dealing with economic problems, such as inflation
or high levels of unemployment. In these cases, they may require detailed accounting for the
flows of funds or may allow only certain types of international transactions. The study of
flows of funds between individuals and organizations across national borders and the
development of methods of handling the flows more efficiently are properly within the
scope of international finance.
d. Institutional Finance: A nation's economic structure contains a number of financial
institutions, such as banks, insurance companies, pension funds, credit unions. These
institutions gather money from individual savers and accumulate sufficient amounts for
efficient investment. Without these institutions, funds would not be readily available to
finance business transactions, the purchase of private homes and commercial facilities, and
the variety of other activities that require organizations that perform the financing function
of the economy.
1.1.3. SOURCE OF FINANCE:
The finance required for any organization could be primarily divided into two one is long term
finance to acquire the fixed assets that are useful to the business organization over a period of
time i.e. more than a year, usually we call fixed capital. The other one is short-term finance
which is required to keep running the fixed assets or to make them finance which is required to
keep running the fixed assets or to make them working. This is called the working capital.

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Long-term sources – The important long-term sources are common stock, preference stock
bonds, loans from financial institutions and foreign capital.
Short-term sources – The short-term sources are bank loans, public deposits, trade credits,
provisions and current liabilities.
The requirements of above nature could be financed either through external sources or internal
sources if it is an existing company.
I. External sources – These are the funds drawn from outsiders. Among them the prominent
are discussed below.
a) Share Capital – This is the primary source of finance to a corporate form of
organization. It is the sale of equity or common stock and preference stock to the public
which serves as a permanent capital to an organization. These holders will get dividend in
return for their investment.
b) Common stock – The holders of these shares are owners of the company. They are the
risk takers. They get dividend when the company earns profits, otherwise they do not get
any dividend. Whatever profit is left after meeting all the expenses belongs to them. In
the event of closure of the company they are the last people to get their claim.
c) Preference stock – Preference shares carry two preferential rights one is to get a fixed
dividend at the end of each year irrespective of the profits, other one is to get back the
original investment first when the company goes into liquidation.
d) Change par bonds – Another source of finance to a company is issue of bonds/
debentures. These holders are eligible to get fixed interest at the end of each year. The
holders of these bonds do not wish to take any risk of public deposits. The term is also
mentioned while issuing bonds.
e) Public deposits – This is another mode of finance where the company will advertise and
accept deposits for specified period at a fixed rate of interest.
f) Borrowings – The companies may borrow funds from banks, financial institutions etc for
their requirements at the interest chargeable by the lender institution.
g) Foreign capital – The concept of liberalization is attracting many foreign companies to
participate in the domestic companies. It can be either in the form of direct participation
in the capital or collaboration in a project in the equity of the company and also provide
loans some time.
h) Trade credits – The common means of short-term external finance is trade credits
normally; every company gets its raw material and other supplies on credit basis. This is
known as trade credit. This is an important source of financing.
II. Internal Sources – This is applicable for only those companies which are in existence. By
virtue of their existence, they are in an advantageous position to generate some of the finance
internally.
a. Retained earnings – These are the funds that are retained out of the profits for meeting
future contingencies. It can be either to meet the uncertainty or future growth and
expansion of business. The company would be free to utilize this source. The retained
profits enable a company to withstand seasonal reactions and business fluctuations. The

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 large accumulated savings facilitate a stable dividend policy and enhance the credit
standing of the company. However, the quantum of retained earnings depend on the
volume of the profits made by the company.
b. Provisions – Generally companies, in order to meet the legal and other obligations, create
some funds for future use. These are known as provisions. They include depreciation,
taxation, dividends and various current and non-current liabilities. The amount set apart
in this form would be required to be paid only on certain dates. Till then the company can
use them for its own purpose. For instance, taxes payable to the government are used in
the business until these are paid on due date. Therefore, though for a short-while
provision would serve as a good source of internal finance.

1.2. DEFINITION OF FINANCIAL MANAGEMENT

Financial management is an integral part of overall management. It is concerned with the duties
of the financial managers in the business firm. The term financial management has been defined
by Solomon, “It is concerned with the efficient use of an important economic resource namely,
capital funds”.
The most popular and acceptable definition of financial management as given by S.C.
Kuchal is that “Financial Management deals with procurement of funds and their effective
utilization in the business”.
Howard and Upton: Financial management “as an application of general managerial principles to
the area of financial decision-making.
Weston and Brigham: Financial management “is an area of financial decision-making,
harmonizing individual motives and enterprise goals”.
Joshep and Massie: Financial management “is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for efficient operations.
Thus, Financial Management is mainly concerned with the effective funds management in the
business. In simple words, Financial Management as practiced by business firms can be called as
Corporation Finance or Business Finance.
1.3. SCOPE OF FINANCIAL MANAGEMENT
The scope of financial management refers to the range or extent of matters being dealt with in
financial management.
Traditionally, financial management was viewed as a field of study limited to only raising of
money. Under the traditional approach, the scope and role of financial management was
considered in a very narrow sense of procurement of funds from external sources. The subject of
finance was limited to the discussion of only financial institutions, financial instruments, and the
legal and accounting relationships between a firm and its external sources of funds. Internal
financial decision makings such as cash and credit management, inventory control, capital
budgeting was ignored. Simply stating, the old approach treated financial management in a
narrow sense and the financial manager as a less important person in the overall corporate
management.
However, the modern or contemporary approach views financial management in a broad sense.
Corporate finance is defined much more broadly to include any business decisions made by a

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firm that affect its finance. According to the modern approach, financial management provides a
conceptual and analytical framework for the three-major financial decision-making functions of
a firm. Accordingly, the scope of managerial finance involves the solution to investing,
financing, and dividend policy problems of a firm. Besides, unlike the old approach, here, the
financial manager’s role includes both acquiring of funds from external sources and allocating of
the funds efficiently within the firm thereby making internal decisions. The increased
globalization of business has expanded the scope of financial management.

1.3.1. FUNCTIONS OF FINANCE MANAGER

A financial manager will have to concentrate on the following areas of finance function:
1.  Estimating Financial Requirements: -
The first task of financial manager is to estimate short term and long-term financial requirements
of the business. For this purpose, he will prepare a financial plan for present as well as for future.
The amount required for purchasing fixed assets as well as for working capital will have to be
ascertained.
2.  Deciding on Capital Structure: -
The capital structure refers to the kind and proportion of different securities for raising funds.
After deciding about the quantum of funds required, it should be decided which type of securities
should be raised. It may be wise to finance fixed assets through long-term debts and current
assets through short-term debts.
3.   Selecting a Source of Finance: -
After preparing capital structure, an appropriate source of finance is selected. Various sources
from which finance may be raised include: share capital, debentures, financial institutions,
commercial banks, public deposits etc. If finance is needed for short period then banks, public
deposits and financial institutions may be appropriate. On the other hand, if long-term finance is
required then, share capital, and debentures may be useful.
4.      Selecting a pattern of Investment: -
When funds have been procured then a decision about investment pattern is to be taken. The
selection of an investment pattern is related to the use of funds. A decision will have to be taken
as to which asset is to be purchased. The funds will have to be spent first on fixed assets and then
an appropriate portion will be retained for working capital. The decision-making techniques such
as capital budgeting, opportunity cost analysis etc. may be applied in making decisions about
capital expenditures.

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5.      Proper cash Management: -
Cash management is an important task of finance manager. He has to assess various cash needs
at different times and then make arrangements for arranging cash. The cash management should
be such that neither there is a shortage of it and nor it is idle. Any shortage of cash will damage
the credit worthiness of the enterprise. The idle cash with the business will mean that it is not
properly used. Cash flow statements are used to find out various sources and application of cash.
6.      Implementing Financial Controls: -
 An efficient system of financial management necessitates the use of various control devises.
Financial control devises generally used are budgetary control, break even analysis; cost control,
ratio analysis etc. The use of various techniques by the finance manager will help him in
evaluating the performance in various areas and take corrective measures whenever needed.

1.4. THE FUNCTIONS OF FINANCIAL MANAGEMENT

This refers to the special activities or purposes of financial management. The functions of
financial management are planning for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve goal of the firm.

In general, the functions of financial management include three major decisions a firm must
make. These are:
 Investment decisions
 Financing decisions
 Dividend decisions
1.4.1. Investment Decisions
This deals with allocation of the firm’s scarce financial resources among competing uses. These
decisions are concerned with the management of assets by allocating and utilizing funds within
the firm. Specifically, the investment decisions include:
i) Determining the asset mix or composition: determining the total amount of the
firm’s finance to be invested in current and fixed assets.
ii) Determining the asset type: determining which specific assets to maintain within the
categories of current and fixed assets.
iii) Managing the asset structure, i.e., maintaining the composition of current and fixed
assets and the type of specific assets under each category.
Investment decisions are concerned with the use of funds— the buying, holding, or selling of all
types of assets: Should we buy a new die stamping machine? Should we introduce a new product
line? Sell the old production facility? Buy an existing company? Build a warehouse? Keep our
cash in the bank?

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The investment decisions of a firm also involve working capital management and capital
budgeting decisions. The former refers to those decisions of a firm affecting its current assets and
short – term liabilities. The later, on the other hand, involves long – term investment decisions
like acquisition, modification, and replacement of fixed assets.
Generally, the investment decisions of a firm deal with the left side of the basic accounting
equation: A = L + OE (Assets = Liabilities + Owners’ Equity).

1.4.2. Financing Decisions

The financing decisions deal with the financing of the firm’s investments, i.e., decisions
whether the firm should use equity or debt funds in order to finance its assets. They are also
concerned with determining the most appropriate composition of short – term and long – term
financing. In simple terms, the financing decisions deal with determining the best financing mix
or capital structure of the firm.

The financing decisions of a firm are generally concerned with the right side of the basic
accounting equation. Financing decisions are concerned with the acquisition of funds to be used
for investing and financing day-to-day operations. Should managers use the money raised
through the firms’ revenues? Should they seek money from outside of the business? A
company’s operations and investment can be financed from outside the business by incurring
debts, such as through bank loans and the sale of bonds, or by selling ownership interests.
Because each method of financing obligates the business in different ways, financing decisions
are very important.

1.4.3. Dividend Decisions

The dividend decisions address the question how much of the cash a firm generates from
operations should be distributed to owners in the form of dividends and how much should be
retained by the business for further expansion. There are tradeoffs on the dividend policy of a
firm. On the one hand, paying out more dividends will make the firm to be perceived strong and
healthy by investors; on the other hand, it will affect the future growth of the firm. So the
dividend decision of a firm should be analyzed in relation to its financing decisions.

1.5. THE GOAL OF A FIRM IN FINANCIAL MANAGEMENT

PROFIT MAXIMAZATION AS A DECISION RULE
1.5.1. Meaning of Profit Maximization
Profit maximization is a function of maximizing revenue and /or minimizing costs. If a firm is
able to maximize its revenues for a given level of costs or minimizing costs for a given level of
revenues, it is considered to be efficient.

Profit maximization focuses on the total amount of benefits of any courses of action. This
decision rule as applied to financial management implies that the functions of managerial finance
should be oriented to making of money. Under the profit maximization decision criteria, actions

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that increase profit of a firm should be undertaken; and actions that decrease profit should be
rejected. Similarly, given alternative courses of actions, decisions would be made in favor of the
one with the highest expected profits.
Profit maximization, though widely professed, should not be used as a good goal of a firm in
financial management. This is because it fails to meet many of the characteristics of a good goal.

1.5.2. Limitations of Profit Maximization

1. Ambiguity: The term profit or income is vague and ambiguous concept. It is very illusive and
has no precise connotation. Different people understand profit in different ways. There are many
different economic and accounting definitions of profit, each open to its own set of
interpretations. Even in accounting profit might refer to short-term or long-term profit, total
profit or profit on a per share basis (earnings per share), and before or after-tax profit. Then, the
question or the problem would be which profit is to be maximized? Maximizing one may lead to
minimizing the other.
Furthermore, problems related to inflation and international currency transactions complicate the
issue of profit maximization.
2. Cash flows: The profit a firm has reported does not represent the cash flows to the business.
Firms reporting very high total profit or earnings per share might face difficulty of paying cash
dividends to stockholders. Sometimes, companies might even declare bankruptcy though
reporting a positive income.
3. Timing of Benefits: The profit maximization criterion ignores the differences in the time
pattern of benefits received from investment proposals. This criterion does not consider the
distinction between returns (benefits) received in different time periods and treats all benefits as
equally valuable irrespective of the time pattern differences in benefits. In other words, the profit
maximization ignores the time value of money, i.e., money today is better than money tomorrow.
Also, it does not consider the sooner, the better principle.
To understand this limitation better let us consider the following example.
For example, KK Manufacturing Share Company wants to choose between two projects: project
X and project Y. Both projects cost the same, are equally risky and are expected to provide the
following benefits over three years period.
BENEFITS (PROFITS)
YEAR PROJECT X PROJECT Y
1 Br. 25,000 Br. –0-
2 50,000 50,000
3 –0- 25,000
TOTAL Br. 75,000 Br. 75,000

The profit maximization criterion ranks both projects as being equal. However, project X
provides higher benefits in earlier years and project Y provides larger benefits in later years. The
higher benefits of project X in earlier years could be reinvested to earn even higher profits for

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later years. Profit seeking organizations must consider the timing of cash flows and profits
because money received today has a higher value than money received tomorrow. Cash flows in
early years are valued more highly than equivalent cash flows in later years.

4. Quality of Benefits (Risk of Benefits): Profit maximization assumes that risk or uncertainty
of future benefits is of no concern to stockholders. Risk is defined as the probability that
actual benefit will differ from the expected benefit. Financial decision making involves a
risk-return trade-off. This means that in exchange for taking greater risk, the firm expects a
higher return. The higher the risk, the higher the expected return.

For example, Nyala Merchandising Private Limited Company must choose between two
projects. Both projects cost the same. Project A has a 50% chance that its cash flows would be
actual over the next three years. Project B, on the other hand, has a 90% probability that its cash
flows for the next three years would be realized.
BENEFITS

YEAR PROJECT A PROJECT B

1 Br. 60,000 Br. 45,000
2 65,000 50,000
3 95,000 85,000
TOTAL Br. 220,000 Br. 180,000

Under profit maximization, project A is more attractive because it adds more to Nyala than
project B. However, if we consider the risk of the two projects, the situation would be reversed.

Expected benefit of project A = Br. 220,000 x 50% = Br. 110,000

Expected benefit of project B = Br. 180,000 x 90% = Br. 162,000

In fact, risk can be measured in different ways, and different conclusions about the riskiness of a
course of action can be reached depending on the measure used. In addition to the probability
distribution, illustrated above, risk can also be measured on the basis of the variation of cash
flows.

The more certain the expected cash flow (return), the higher the quality of benefits (i.e., low risk
to investor). Conversely, the more uncertain or fluctuating the expected benefits, the lower the
quality of benefits (i.e., high risk to investors).
1.6. WEALTH MAXIMIZATION AS A DECISION RULE
1.6.1. Meaning of Wealth Maximization

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Wealth maximization means maximization of the value of a firm. Hence, wealth maximization is
also called value maximization or net present value (NPV) maximization.

To understand and appreciate the essence of wealth maximization, we need to consider the
various stakeholders in a given corporation. Stakeholders are all individuals or group of
individuals who have a direct or indirect interest in the firm. They include stockholders, debtors,
managers, employees, customers, governmental agencies and others. But among these, managers
should give priority to stockholders. In fact, the overriding premise of financial management is
that a firm should be managed to enhance the well-being or wealth of its existing common
stockholders. Stockholders’ wellbeing depends on both current and expected dividend payments
and market price of the firm’s common stock.
Wealth maximization as a decision criterion is considered to be an ideal goal of a firm in
financial management. There are several reasons why wealth maximization decision criterion is
superior to other criteria. First, it has an exact measurement unlike profit maximization. It
depends on cash flows (inflows and outflows). Second, wealth maximization as a decision
criterion consider the quality as well as the time pattern of benefits. Third, it emphasizes on the
long-term and sustainable maximization of a firm’s common stock price in the financial market.
Fourth, wealth maximization gives a recognition to the interest of other stakeholders and to the
societal welfare on the long-term basis.

Technically, wealth maximization as a decision rule involves a comparison of value to cost.

Thus, an action that has a discounted value that exceeds its cost can be said to create value and
such action should be undertaken. Whereas an action with less discounted value than cost
reduces wealth and, therefore, should be rejected. The discounted value is a value which takes
risk and timing of benefits into account.
1.6.2. Limitations of Wealth Maximization
The limitations of wealth maximization refer to the potential side costs of wealth maximization if
adopted as a decision criterion.
1. When managers of a corporation are separate from owners, there is a potential for a
conflict of interest between them. This conflict of interest can lead to the maximization of
managers’ interest instead of the welfare of stockholders it is called agency problem.
2. When the goal of a firm is stated in terms of stockholders’ wealth, actions that increase
the wealth of stockholders could be taken as the expense of other stakeholders like debt
holders.
3. Wealth maximization is normally reflected in the firm’s stock price. But if there are
inefficiencies in financial markets, wealth maximization decision rule may lead to
misallocation of scarce resources.
1.7. CLOSLY RELATED FIELD OF FINANCIAL MANAGEMENT
Financial management is one of the important parts of overall management, which is directly
related with various disciplines. The following are mentioned among these disciplines.
1. Financial Management and Economics

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Economic concepts like micro and macroeconomics are directly applied with the financial
management approaches. Investment decisions, micro and macro environmental factors are
closely associated with the functions of financial manager. Financial management also uses the
economic equations like money value discount factor, economic order quantity etc. Financial
economics is one of the emerging area, which provides immense opportunities to finance, and
economical areas.
2. Financial Management and Accounting
Accounting records includes the financial information of the business concern. Hence, we can
easily understand the relationship between the financial management and accounting. In the
olden periods, both financial management and accounting are treated as a same discipline and
then it has been merged as Management Accounting because this part is very much helpful to
finance manager to take decisions. But nowadays financial management and accounting
discipline are separate and interrelated.

3. Financial Management or Mathematics

Modern approaches of the financial management applied large number of mathematical and
statistical tools and techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money, present value of money, cost of capital, capital structure
theories, dividend theories, ratio analysis and working capital analysis are used as mathematical
and statistical tools and techniques in the field of financial management.

4. Financial Management and Production Management

Production management is the operational part of the business concern, which helps to multiple
the money into profit. Profit of the concern depends upon the production performance.
Production performance needs finance, because production department requires raw material,
machinery, wages, operating expenses etc. These expenditures are decided and estimated by the
financial department and the finance manager allocates the appropriate finance to production
department. The financial manager must be aware of the operational process and finance
required for each process of production activities.

5. Financial Management and Marketing

Produced goods are sold in the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements. The financial manager or
finance department is responsible to allocate the adequate finance to the marketing department.
Hence, marketing and financial management are interrelated and depends on each other.

6. Financial Management and Human Resource

Financial management is also related with human resource department, which provides
manpower to all the functional areas of the management. Financial manager should carefully
evaluate the requirement of manpower to each department and allocate the finance to the human
resource department as wages, salary, remuneration, commission, bonus, pension and other
monetary benefits to the human resource department. Hence, financial management is directly
related with human resource management.

1.8. FINANCIAL MARKETS

A Financial Market is a place where the business houses can raise their long and short-term
financial requirements. The development of financial markets indicates the development of

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economic system. For mobilization of savings and for rapid capital formation, healthy growth
and development of these markets are crucial. These markets help promotion of investment
activities; encourage entrepreneurship and development of a country.
1.8.1. Functions of Financial Markets
Generally, financial markets play three important roles in functioning of corporate finance.
1. They assist the capital formation process: Financial markets serve as a way through
which firms can obtain the capital they need for their operations and investment.
2. Financial markets serve as resale markets for financial instruments: They create
continuous liquid markets where firms can obtain the capital they need from individuals
and other businesses easily (serve as a secondary market).
3. They play a role in setting the prices of securities: The price of a financial instrument is
determined through the interaction of demand and supply of the security in the financial
markets.
1.8.2. Classification of Financial Markets
There are many types of financial markets and hence several ways to classify them. For our
purpose, here we shall consider the following two classifications.
1. Classification on the basis of maturity and source of their value
Based on the maturity dates of securities and source of their value, financial markets can be:
i) Money Markets: are financial markets in which securities traded have maturities of one-year
or less. Money market securities are short-term indebtedness. By “short term” we
usually imply an original maturity of one year or less. Money market securities are
backed solely by the issuer’s ability to pay. With money market securities, there is no
collateral; that is, no item of value (such as real estate) is designated by the issuer to
ensure repayment. The investor relies primarily on the reputation and repayment history
of the issuer in expecting that he or she will be repaid.
The most common money market securities are treasury bills, commercial paper, negotiable
certificates of deposit, and bankers’ acceptance.
 Treasury bills (T-bills) are short-term securities issued by the government; they have
original maturities of either four weeks, three months, or six months. Unlike other money
market securities, T-bills carry no stated interest rate. Instead, they are sold on a
discounted basis: Investors obtain a return on their investment by buying these securities
for less than their face value and then receiving the face value at maturity.
 Commercial paper is a promissory note—a written promise to pay—issued by a large,
creditworthy corporation. These securities have original maturities ranging from one day
to 270 days. Most commercial paper is backed by bank lines of credit, which means that a
bank is standing by ready to pay the obligation if the issuer is unable to. Commercial
paper may be either interest bearing or sold on a discounted basis.
 Certificates of deposit (CDs) are written promises by a bank to pay a depositor.
Nowadays they have original maturities from six months to three years.

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 ii) Capital Markets: Capital market is defined as a place where all buyers and sellers of capital
funds as well as the entire mechanism for facilitating and effecting long term funds. It
provides the long-term funds that are needed for investment purpose.
Major securities traded in capital markets include bonds, preferred and common stocks.
2. Classification on the basis of the nature of securities
This is based on whether the securities are new issues or have been outstanding in the market
place. The primary function of a securities market—whether or not it has a physical location—is
to bring together buyers and sellers of securities. Securities markets can be classified by whether
they are involved in original sales or resales of securities, and by whether or not they involve a
physical trading location.
i) Primary Markets: are financial marketers in which firms raise capital by issuing new
securities. When a security is first issued, it is sold in the primary market. This is the
market in which new issues are sold and new capital is raised. So, it is the market whose
sales directly benefit the issuer of the securities.
ii) Secondary Markets: are financial markets in which existing and already outstanding
securities are traded among investors. Here the issuing corporation does not raise new
finance. A secondary market is one in which securities are resold among investors. No
new capital is raised and the issuer of the security does not benefit directly from the
sale. Trading takes place among investors. Investors who buy and sell securities on the
secondary markets may obtain the services of stock brokers, individuals who buy or sell
securities for their clients.
There are two types of secondary markets: exchanges and over-the-counter markets.
i) Exchanges are actual places where buyers and sellers (or their representatives) meet to trade
securities. Examples are the New York Stock Exchange and the Tokyo Stock Exchange.
ii) Over-the-counter (OTC) markets are arrangements in which investors or their
representatives trade securities without sharing a physical location. For the most part,
computer and telephone networks are used for this purpose. These networks are owned and
managed by the market’s members. An example is the Nasdaq system, which is operated by
the National Association of Securities Dealers (NASD).

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