Lecture 01

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LECTURE – 01
INTRODUCTION
Money Creation
In economics, money creation is the process by which the money supply of a country is
expanded. There are two principal stages of money creation. First, the central bank of a country
can introduce or issue new money into the economy (termed 'expansionary monetary policy').
A central bank usually injects new money into the economy by purchasing financial assets.
Second, the new money introduced by the central bank is multiplied by commercial
banks through fractional reserve banking, expanding the amount of broad money (i.e. cash
plus demand deposits) in the economy.
The extremely large number of money exchanges that occurs each day all over the earth form a
highly complex web that is very resistant to analysis. However it must be understood that the
basic rules of money creation that govern these exchanges are quite simple, and can be readily
understood by the average layman. How money works is not complex, even though the web of
financial exchanges can become very complex indeed.
How does money work? What values does it reward? Let us first review how it evolved. As we
follow this history we can trace the values that are characteristic of different money systems.
Money evolved from barter, and the limits of barter, as society grew and became anonymous,
so we will start with a short history of this evolutionary process. In barter, two traders trade
equal value of their services or commodities. There are two limitations in barter. First, the two
traders must have, and want to trade, products or services of equal value. Second, as society
grows and becomes anonymous, they must both be ready to make the trade at the same time,
as the trust of the small group no longer exists. Currency and money developed to deal with
these two limitations.
Currency came into use first. It was a simple extension of barter. A commodity was chosen
that could be divided into pieces and held for trading at a later date. Gold and silver have more
recently been the favorite choices for currency, though early on, livestock, grain, pieces of fired
clay, beads, and even humans were used. All these commodities proved difficult to store and
carry. Many deteriorated over time. Even gold and silver proved to be bulky to carry for larger
transactions. Another major limitation of currency was its limited supply. As more or less
trading occurred in a growing economy, there was no convenient way to increase or decrease
the supply of currency.
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Modern money developed from the trade of goldsmithing at the end of the middle ages. At
that time people began storing their excess gold and silver with the local goldsmith for
safekeeping. When gold or silver was put in storage, a receipt was issued by the goldsmith to
the owner, as a record of ownership. The paper receipts were much easier to carry than the
gold or silver, especially for larger transactions, so they began to be used instead of the
precious metal itself.
Then the enterprising goldsmiths figured out that they could loan out the gold they held for
their customers, to third parties. Or better yet, they could issue receipts instead of actually
loaning the gold. The next step was recognizing that they could print more receipts and make
even more loans than they held in gold. In the idea of loaning the value of gold they did not
own, but only held in trust, and the value of gold that did not even exist, was the germ of the
invention of modern money.
As long as not everyone wanted to redeem their receipts and loans for gold at one time, this
system created by the goldsmith/bankers did facilitate trade when there was a shortage of the
commodity, gold, which was used as currency. The fact that the goldsmiths provided an
adequate money supply made possible the industrial revolution. Meanwhile, the
goldsmith/bankers had a good thing going. They were receiving interest by loaning the gold
assets that they were being paid to hold in trust for others, and additional interest from loans
based on gold that did not even exist.
However, the system was not perfect. When economic conditions changed or trust in this shell
game waned, there were bank runs, and people lost their money and their gold as a result. If a
goldsmith could not come up with enough gold to satisfy all claims to redeem receipts for gold
at a given time, the system broke down. Banks are the modern successors to the goldsmiths.
The way they operate is basically the same, although money can no longer be redeemed for
gold; it is now only a token or medium of exchange.
So with this brief history, we will go over the definitions of some basic terms, and then explain
how money is now created and extinguished.
Definitions of basic terms
Here we will not use the terms consumer and producer. Rather we will use the word trader, to
acknowledge the fact that we are all both consumers and producers, (or dependent on
someone who is), and combine these two functions in trade--as traders. Businesses and
governments are group entity traders.
Wealth is anything valued by the economic system. It can be traded by barter, currency or
money. When monetized, wealth becomes assets.
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Currency is a concentrated form of wealth used in trading. Currency is some kind of commodity
that has a sufficiently universal appeal that it can be held and traded later for whatever good or
service its owner chooses.
Money is a purely abstract accounting concept. Pieces of paper or coins may be created to
represent the value of money, but they are only tokens that represent value, not value itself. At
another level, money is simply information, an universal executive information. Money gives its
holder the power to execute whatever plans he or she desires. It is an accounting system that
allows traders to keep track of who has bought and sold how much, and whether each
individual trader has put as much into the system s/he has taken out. Since it is purely abstract,
money can be created in any amount deemed appropriate by its creators. How it is created and
extinguished is one of the issues which need to clarify here. The social values built into its
creation become basic social values of the economy and culture of which it is a part. It is
important to know what these values are.
This set of definitions for money may fly in the face of common knowledge about the way
money works. The following description will show how and why it is in fact valid.
How money is created and extinguished
The matter of money creation is poorly understood. There is a common misconception that
banks or governments create money. Governments only borrow money into existence from
the banks. Banks can and do manage and redistribute money and wealth. Only people and
natural resources represent potential wealth. Only people can, by their labor, produce useful
wealth, which can be traded, either 1) directly by barter, 2) through the use of currency, or 3)
through the creation of money. Remember, all people who buy or sell, i.e. are producers or
consumers, are traders.
Money is created when a trader makes a commitment, by buying goods or services from other
traders, to place goods or services in the marketplace of equal value in the future. In making
purchases, traders borrow against their future production if they do not currently have a
trading surplus. Money is created as evidence of that debt. Putting goods and services back on
the market repays the debt, and extinguishes the money. In other words, money is borrowed
into existence, and is extinguished as the loan is repaid. The effective lender, or guarantor of a
loan is all the traders who trade with the borrower in short the community; the market.
This is how money is created, and extinguished. The stability of a money issue, then, is only
tangentially related to any assets that might guarantee it.
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The stability of a money issue is related solely to the willingness and ability of the vast majority
of the community of traders to put goods or services on the market which have equal value to
what they consume. The stability of an economy is a function of the commitment of traders to
the rules of the system. Trust, that by and large, all members of the market will produce as
much as they consume and be able to trade what they produce for what they want to consume,
is the only ultimate guarantee of any money issue.
The fact that useful wealth/assets are created by people who wish to trade has to be
recognized and acknowledged by the creators and operators of banks and monetary systems,
as well as all the rest of us. While natural resources are sources of wealth, they are not
themselves wealth until they are made useful, and brought into the market as commodities by
the labor of traders. For example, ore in the ground is not of value until it is mined, refined,
and made into a form or object by a person or group of people, that others will trade for in the
market. Even land is not useful in economic terms until it is used in some economic way. The
appropriate function of banks, based on this understanding of how money works, is to act as
clearinghouses --clerks or trustees -- who keep track of the transactions between traders.
In the clearing system, each trader starts with a zero balance in their account. The expectation
is that the balance should stay near zero, though it may vary above or below. All bank income
is based strictly on earned fees for book-keeping services rendered, on a fee for service basis. A
small fee is charged to cover the bookkeeping expense of each transaction.
The money of this system is simply an exchange medium, with no secondary value. The system
is functionally balanced in its operation by the traders. The money supply automatically adjusts
itself to the number and amounts of commitments that members have made to each other.
The bank balance of anyone buying is open knowledge to the seller, who can decide not to sell
to someone who is not pulling their weight; buying more than they are selling (borrowing from
the people with whom they trade by carrying a large negative balance).
If a community using such a system sees that it would benefit from a project that would require
a relatively large sum of money, it can commit itself as a community to one or a group of its
members, giving them a line of credit (permission to temporarily operate with a large negative
balance) to complete the project. This is what banks do now in making loans. The principle of
assuring that all budgets stay balanced (all account balances remain near zero, or return to
zero) must be built into the structure of any monetary system, if it hopes to be stable over
time. It is not built into our present monetary system.
Savings & Investment
Before the understanding about the savings & investment we need to understand the income
for both a company& an individual
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Income is the consumption and savings opportunity gained by an entity within a specified time
frame, which is generally expressed in monetary terms. For households and individuals,
"income is the sum of all the wages, salaries, profits, interest payments, rents and other forms
of earnings received in a given period of time. In brief, individuals earn money through
employment and investments.
Disposable income is total personal income minus personal current taxes. That
means, personal income, minus personal current taxes equal disposable personal income.
Subtracting personal outlay (personal (or, private) consumption expenditure) brings personal
(or, private) savings. In other words, consumption expenditure plus savings equals disposable
income after accounting for transfers such as payments to children in school or elderly parents’
living arrangements.
Discretionary income is money you have after you've paid off all of your bills. That mean
Discretionary income is income after subtracting taxes and normal expenses (such as rent
or mortgage, utilities, insurance, medical, transportation, property maintenance, child support,
inflation, food and sundries, &c.) to maintain a certain standard of living. It is the amount of an
individual's income available for spending after the essentials (such as food, clothing, and
shelter) have been taken care of:
Discretionary income = Gross income - taxes - necessities
Company Income Indicate revenues minus cost of sales, operating expenses, and taxes, over a
given period of time. Income is the reason corporations exist, and are often the single most
important determinant of a stock's price. Income is important to investors because they give an
indication of the company's expected future dividends and its potential for growth and capital
appreciation. That does not necessarily mean that low or negative earnings always indicate a
bad stock; for example, many young companies report negative income as they attempt to
grow quickly enough to capture a new market, at which point they'll be even more profitable
than they otherwise might have been also called earnings.
Saving is income not spent, or deferred consumption. Methods of saving include putting money
aside in a bank or pension plan. Saving also includes reducing expenditures, such as recurring
costs. In terms of personal finance, saving specifies low-risk preservation of money, as in
a deposit account, versus investment, wherein risk is higher. There is some disagreement about
what counts as saving. For example, the part of a person's income that is spent on mortgage
loan repayments is not spent on present consumption and is therefore saving by the above
definition, even though people do not always think of repaying a loan as saving."Saving" differs
from "savings." The former refers to an increase in one's assets, an increase in net worth,
whereas the latter refers to one part of one's assets, usually deposits in savings accounts, or to
all of one's assets. Saving refers to an activity occurring over time, a flow variable, whereas
savings refers to something that exists at any one time, a stock variable.
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Saving is closely related to investment. By not using income to buy consumer goods and
services, it is possible for resources to instead be invested by being used to produce fixed
capital, such as factories and machinery. Saving can therefore be vital to increase the amount of
fixed capital available, which contributes to economic growth. However, increased saving does
not always correspond to increased investment. If savings are stashed in a mattress or
otherwise not deposited into a financial intermediary like a bank there is no chance for those
savings to be recycled as investment by business. This means that saving may increase without
increasing investment, possibly causing a short-fall of demand (a pile-up of inventories, a cut-
back of production, employment, and income, and thus a recession) rather than to economic
growth. In the short term, if saving falls below investment, it can lead to a growth of aggregate
demand and an economic boom. In the long term if saving falls below investment it eventually
reduces investment and detracts from future growth. Future growth is made possible by
foregoing present consumption to increase investment. However savings kept in a mattress
amount to an (interest-free) loan to the government or central bank, which can recycle this
loan.
In a primitive agricultural economy savings might take the form of holding back the best of the
corn harvest as seed corn for the next planting season. If the whole crop were consumed the
economy would deteriorate to hunting and gathering the next season.
Investment is putting money into something with the expectation of profit. More specifically,
investment is the commitment of money or capital to the purchase of financial instruments or
other assets so as to gain profitable returns in the form of interest, income (dividends), or
appreciation (capital gains) of the value of the instrument. It is related to saving or
deferring consumption. Investment is involved in many areas of the economy, such as business
management and finance no matter for households, firms, or governments. An investment
involves the choice by an individual or an organization, such as a pension fund, after some
analysis or thought, to place or lend money in a vehicle, instrument or asset, such
as property, commodity, stock, bond, the foreign asset denominated in foreign currency, that
has certain level of risk and provides the possibility of generating returns over a period of time.
Investment comes with the risk of the loss of the principal sum. The investment that has not
been thoroughly analyzed can be highly risky with respect to the investment owner because the
possibility of losing money is not within the owner's control. The difference
between speculation and investment can be subtle. It depends on the investment owner's mind
whether the purpose is for lending the resource to someone else for economic purpose or not.
In the case of investment, rather than store the good produced or its money equivalent, the
investor chooses to use that good either to create a durable consumer or producer good, or to
lend the original saved good to another in exchange for either interest or a share of the profits.
In the first case, the individual creates durable consumer goods, hoping the services from the
good will make his life better. In the second, the individual becomes an entrepreneur using the
resource to produce goods and services for others in the hope of a profitable sale. The third
case describes a lender, and the fourth describes an investor in a share of the business. In each
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case, the consumer obtains a durable asset or investment, and accounts for that asset by
recording an equivalent liability. As time passes, and both prices and interest rates change, the
value of the asset and liability also change.
An asset is usually purchased, or equivalently a deposit is made in a bank, in hopes of getting a

future return or interest from it. The word originates in the Latin "vestis", meaning garment,
and refers to the act of putting things (money or other claims to resources) into others' pockets.
The basic meaning of the term being an asset held to have some recurring or capital gains. It is
an asset that is expected to give returns without any work on the asset per se. The term
"investment" is used differently in economics and in finance. Economists refer to a real
investment (such as a machine or a house), while financial economists refer to a financial asset,
such as money that is put into a bank or the market, which may then be used to buy a real
asset.
In finance, investment is the commitment of funds by buying securities or other monetary or

paper (financial) assets in the money markets or capital markets, or in fairly liquid real assets,
such as gold or collectibles. Returns on investments will follow the risk-return spectrum.
Types of financial investments include shares, other equity investment, and bonds (including
bonds denominated in foreign currencies). These financial assets are then expected to provide
income or positive future cash flows, and may increase or decrease in value yielding the
investor capital gains or losses.
Investments are often made indirectly through intermediaries, such as banks, mutual
funds, pension funds, insurance companies, collective investment schemes, and investment
clubs. Though their legal and procedural details differ, an intermediary generally makes an
investment using money from many individuals, each of whom receives a claim on the
intermediary.
Within personal finance, money used to purchase shares, put in a collective investment
scheme or used to buy any asset where there is an element of capital risk is deemed
an investment. Saving within personal finance refers to money put aside, normally on a regular
basis. This distinction is important, as investment risk can cause a capital loss when an
investment is sold, unlike saving(s) where the more limited risk is cash devaluing due
to inflation.
In many instances the terms saving and investment are used interchangeably, which confuses
this distinction. For example many deposit accounts are labeled as investment accounts by
banks for marketing purposes. Whether an asset is a saving(s) or an investment depends on
where the money is invested: if it is cash then it is savings, if its value can fluctuate then it is
investment. Before precede more we need to know the importance of Savings & Investment
which already defined.
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Importance of Savings
• Saving ensures that the saver is financially independent in the future and does not rely on
debts (overdrafts, bank or cash loans) or family and friends.
• Savings avails money for special events such as weddings, baptisms, anniversaries, vacations,
etc.
• Savings enables a person to purchase goods and services in cash and thus qualify for cash
discounts.
• Money saved can be used as a collateral or security for loans.
• Savings facilitate the process for establishing and/or expanding business ventures.
Role of Savings in the Economic growth
• Saving which is translated into investment becomes the engine that drives economic growth.
Savings can be used for on-lending to other people who might need the money for production
purposes. The investments would create economic growth and result in job creation.
• Saving can serve as an answer to the lack of investment funds and dependence on foreign
direct investment. Theoretically, when savings are high, investments increase and the economy
grows.
• However, the increase in saving does not always correspond to an increase in investment. If
savings are held under the mattress or otherwise not deposited in a financial intermediary like a
bank, saving will not be channeled into investments by businesses. Saving should thus be
encouraged in order for the funds to be directed to investment.
Investment role in the Economic growth
• Investment generates more facilities to create international Trade through the export &
import.
• Technology transfers can be occur by the investment facilities
• Human capital enhancement easily can be done through more investment in the country.
• The better investment facility creates new companies in the economy which bring
competition and force economic growth.
• By that Enterprise development happens.
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Importance of Investment in personal view point
"The more you sweat in peace time; the less you bleed in the war"
What a quotation! This is applicable for all aspects of your life. If you don't invest your money
and think that there will be no need of money in your contended life, then one day suddenly
you will be in a pathetic situation where you need money for education or medication of your
family member. Then only you will realize the value of money. But dear friend, it will be too late
to do anything and you will be in a deep trouble then. And you will be suffering for not investing
your money in your life sooner or later. So it is better to be late than never.
Following are few of the many advantages of an investment in your life.
Financial Independence
First and the foremost thing is an investment gives you financial freedom. If you invest your
money from the beginning, you need not to worry about the future financial needs. As future is
uncertain, and there may be a situation in your life where you require a large amount of money
to get out of that situation with minimal loss. So to effectively protect yourself from such type
of situation, you must inculcate the habits of saving and investing. It may be because of your
children's education, marriage or medication. Let it be anything which demands lot of money,
you may surpass it if you have invested your money from the beginning itself. Hence,
investment gives you more financial freedom to rely upon.
Increases Wealth
Besides making you financially independent, investment makes you rich also. As you invest
more and more money for a long time, it will definitely make you richer. In the present
generation, it is of utmost importance to be rich as it gives more benefits in each and every
aspect of your life. So investments increase your returns and at the same time make you
wealthy. As you become wealthier, you will have more financial freedom and vice versa.
Fulfilling Personal Goals
If you have a desire for having a luxurious apartment and a luxurious car of your own, then it is
obvious that these desires may be fulfilled by a planned investment and savings. As you invest
more, you tend to become richer. And as you become richer, you may find no difficulty in
achieving your personal goal. Achieving personal goals is the essence of your success in every
aspect of your life.
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Desires of Family members
It is your social responsibility towards your family members to look after them. it also includes
to take care of their personal desires also. And you are the first responsible person to fulfill
their wishes time to time. So if you invest carefully and get good returns and become rich by
that, you may easily fulfill all the desires of yourself as well as your family members also. So
investment plays a vital role in satisfying your family member's wishes.
Increases Knowledge
As investment does not mean mere buying and selling only, and it needs a thorough research in
the various aspects of stock market and the company, it will improve your knowledge. It
develops your knowledge in various fields. Learning more knowledge makes you to err seldom
and which in turn make you a successful investor.
Increases Vision
Vision is not about to see the things happening but it is to see through the future happenings.
For investing, you need a good vision into the future and should be able to interpret the
futuristic phenomenon of a company's prospective. So good vision fetches you more returns
and will contribute to your success at all the fields.
Life Insurance
Life insurance is a contract between the policy owner and the insurer, where the insurer agrees
to pay a designated beneficiary a sum of money upon the occurrence of the insured individual's
or individuals' death or other event, such as terminal illness or critical illness. In return, the
policy owner agrees to pay a stipulated amount (at regular intervals or in lump sums). There
may be designs in some countries where bills and death expenses plus catering for after funeral
expenses should be included in Policy Premium. In the United States, the predominant form
simply specifies a lump sum to be paid on the insured's demise.
The value for the policyholder is derived, not from an actual claim event, rather it is the value
derived from the 'peace of mind' experienced by the policyholder, due to the negating of
adverse financial consequences caused by the death of the Life Assured.
Life policies are legal contracts and the terms of the contract describe the limitations of the
insured events. Specific exclusions are often written into the contract to limit the liability of the
insurer; for example claims relating to suicide, fraud, war, riot and civil commotion.
Life-based contracts tend to fall into two major categories:
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 Protection policies – designed to provide a benefit in the event of specified event,

typically a lump sum payment. A common form of this design is term insurance.
 Investment policies – where the main objective is to facilitate the growth of capital by
regular or single premiums. Common forms (in the US anyway) are whole life, universal
life and variable life policies.
Some policies allow the policyholder to participate in the profits of the insurance company
these are with-profits policies. Other policies have no rights to participate in the profits of the
company, these are non-profit policies.
With-profits policies are used as a form of collective investment to achieve capital growth.
Other policies offer a guaranteed return not dependent on the company's underlying
investment performance; these are often referred to as without-profit policies which may be
construed as a misnomer.
Pensions are a form of life assurance. However, whilst basic life assurance, permanent health
insurance and non-pensions annuity business includes an amount of mortality or morbidity risk
for the insurer, for pensions there is a longevity risk. A pension fund will be built up throughout
a person's working life. When the person retires, the pension will become in payment, and at
some stage the pensioner will buy an annuity contract, which will guarantee a certain pay-out
each month until death.
Alternative Investment
An investment that is not one of the three traditional asset types (stocks, bonds and cash) is
alternative investment. Most alternative investment assets are held by institutional investors
or accredited, high-net-worth individuals because of their complex nature, limited regulations
and relative lack of liquidity. Alternative investments include hedge funds, managed futures,
real estate, commodities and derivatives contracts.
Many alternative investments also have high minimum investments and fee structures
compared to mutual funds and ETFs. While they are subject to less regulation, they also have
less opportunity to publish verifiable performance data and advertise to potential investors.
Alternative investments are favored mainly because their returns have a low correlation with
those of standard asset classes. Because of this, many large institutional funds such as pensions
and private endowments have begun to allocate a small portion (typically less than 10%) of
their portfolios to alternative investments such as hedge funds.
While the small investor may be shut out of some alternative investment opportunities, real
estate and commodities such as precious metals are widely available.
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Alternative investments are sometimes used as a tool to reduce overall investment risk
through diversification.
Some of the characteristics of alternative investments may include:
 Low correlation with traditional financial investments such as stocks and shares
 Alternative investments may be relatively illiquid
 It may be difficult to determine the current market value of the asset
 There may be limited historical risk and return data
 A high degree of investment analysis may be required before buying
 Costs of purchase and sale may be relatively high
Real Assets
Actual, tangible asset (such as valuable antique or art, buildings, coins, commodity, machinery
and equipment, stamp collection) as opposed to financial assets (such as
bonds, debentures, shares). Real assets tend to be most desirable during periods of high
inflation. Currency fluctuations, which refer to changes in the value of currency, demonstrate
that a financial asset is distinctly different from a real asset. The value of a dollar can fall
relative to other types of currency for example, and thus the piece of paper instantly becomes
worthless, even if it is the same physical thing. In Germany following World War I, for example,
individuals were actually burning German currency to keep warm because the financial asset
had such little value in the eyes of the world.
Because a real asset actually has inherent worth, not worth based on society's perception or
assignment of worth, it can never lose 100 percent of its value the way a financial asset can.
While the price of gold or the price of land may change or fluctuate in response to demand, it
will always have some value because it is a physical asset. As such, a real asset is considered to
be a safer investment in times of high inflation; since purchasing power of physical currency is
declining, a real asset which has a more stable and solid inherent value will be in higher
demand.
Gold and other precious metals are often bought during recessions because of these
characteristics of real assets. In addition, some experts believe that owning real estate is a
hedge against inflation. As the value of currency falls, the value of land is not likely to be
reduced, or at least not likely to be reduced by as much.
Private Equity
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Private equity refers to a type of investment aimed at gaining significant, or even complete,
control of a company in the hopes of earning a high return. As the name implies, private equity
funds invest in assets that either are not owned publicly or that are publicly owned but the
private equity buyer plans to take private. Though the money used to fund these investments
comes from private markets, private equity firms invest in both privately and publicly held
companies. Capital for private equity is raised from retail and institutional investors, and can be
used to fund new technologies, expand working capital within an owned company, make
acquisitions, or to strengthen a balance sheet.
The majority of private equity consists of institutional investors and accredited investors who
can commit large sums of money for long periods of time. Private equity investments often
demand long holding periods to allow for a turnaround of a distressed company or a liquidity
event such as an IPO or sale to a public company.
Why private equity?

• Raising Capital
• Increasing Regulation of Public Markets
• Effect on Public Markets
• Financing the Private Equity Boom
Venture capital
Venture capital (VC) is financial capital provided to early-stage, high-potential and

growth startup companies. The venture capital fund makes money by owning equity in the
companies it invests in, which usually have a novel technology or business model in high
technology industries, such as biotechnology, IT, software, etc. The typical venture capital
investment occurs after the seed funding round as growth funding round (also referred
as Series A round) in the interest of generating a return through an eventual realization event,
such as an IPO or trade sale of the company.
In addition to angel investing and other seed funding options, venture capital is attractive for
new companies with limited operating history that are too small to raise capital in the public
markets and have not reached the point where they are able to secure a bank loan or complete
a debt offering. In exchange for the high risk that venture capitalists assume by investing in
smaller and less mature companies, venture capitalists usually get significant control over
company decisions, in addition to a significant portion of the company's ownership (and
consequently value).
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Venture capital is also associated with job creation (accounting for 21% of US GDP), the
knowledge economy, and used as a proxy measure of innovation within an economic sector or
geography. Every year there is nearly 2 million businesses created in the USA, and only 600-800
get venture capital funding. According to the National Venture Capital Association 11% of
private sector jobs come from venture backed companies and venture backed revenue
accounts for 21% of US GDP.
Investment basic in capital market
Why should one invest?
One needs to invest to:

- Earn return on your idle resources
- Generate a specified sum of money for a specific goal in life
- Make a provision for an uncertain future
One of the important reasons why one needs to invest wisely is to meet the cost of Inflation.
Inflation is the rate at which the cost of living increases. The cost of living is simply what it costs
to buy the goods and services you need to live. Inflation causes money to lose value because it
will not buy the same amount of a good or a service in the future as it does now or did in the
past. For example, if there was a 6% inflation rate for the next 20 years, a Tk. 100 purchase
today would cost Tk. 321 in 20 year. This is why it is important to consider inflation as a factor
in any long-term investment strategy. Remember to look at an investment's 'real' rate of
return, which is the return after inflation. The aim of investments should be to provide a return
above the inflation rate to ensure that the investment does not decrease in value. For example,
if the annual inflation rate is 6%, then the investment will need to earn more than 6% to ensure
it increases in value. If the after-tax return on your investment is less than the inflation rate,
then your assets have actually decreased in value; that is, they won't buy as much today as
they did last year.
When to start Investing?
The sooner one starts investing the better. By investing early you allow your investments more
time to grow, whereby the concept of compounding (as we shall see later) increases your
income, by accumulating the principal and the interest or dividend earned on it, year after year.
The three golden rules for all investors are:
- Invest early
- Invest regularly
- Invest for long term and not short term
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What care should one take while investing?
Before making any investment, one must ensure to:

- Obtain written documents explaining the investment
- Read and understand such documents
- Verify the legitimacy of the investment
- Find out the costs and benefits associated with the investment
- Assess the risk-return profile of the investment
- Know the liquidity and safety aspects of the investment
- Ascertain if it is appropriate for your specific goals
- Compare these details with other investment opportunities available
- Examine if it fits in with other investments you are considering or you have
already made
- Deal only through an authorized intermediary
- Seek all clarifications about the intermediary and the investment
- Explore the options available to you if something were to go wrong, and then, if
satisfied, make the investment.
These are called the Twelve Important Steps to Investing.
What is meant by Interest?
When we borrow money, we are expected to pay for using it – this is known as Interest.
Interest is an amount charged to the borrower for the privilege of using the lender’s money.
Interest is usually calculated as a percentage of the principal balance (the amount of money
borrowed). The percentage rate may be fixed for the life of the loan, or it may be variable,
depending on the terms of the loan.
What factors determine interest rates?
When we talk of interest rates, there are different types of interest rates – rates that banks
offer to their depositors, rates that they lend to their borrowers, the rate at which the
Government borrows in the Bond/Government Securities market, rates offered to investors in
small savings schemes rates at which companies issue fixed deposits etc.
The factors which govern these interest rates are mostly economy related and are commonly
referred to as macroeconomic factors. Some of these factors are:
- Demand for money
- Level of Government borrowings
- Supply of money
- Inflation rate
- Bangladesh Bank and the Government policies which determine some of the
variables mentioned above
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What are various options available for investment?
One may invest in:

- Physical assets like real estate, gold/jewellery, commodities etc.
and/or
- Financial assets such as fixed deposits with banks, small saving instruments with
post offices, insurance/provident/pension fund etc. or securities market related
instruments like shares, bonds, debentures etc.
What are various Short-term financial options available for investment?
Broadly speaking, savings bank account, money market/liquid funds and fixed deposits with
banks may be considered as short-term financial investment options:
Savings Bank Account is often the first banking product people use, which offers low interest
(4%-5% p.a.), making them only marginally better than fixed deposits.
Money Market or Liquid Funds are a specialized form of mutual funds that invest in extremely
short-term fixed income instruments and thereby provide easy liquidity. Unlike most mutual
funds, money market funds are primarily oriented towards protecting your capital and then,
aim to maximize returns. Money market funds usually yield better returns than savings
accounts, but lower than bank fixed deposits.
Fixed Deposits with Banks are also referred to as term deposits and minimum investment
period for bank FDs is 30 days. Fixed Deposits with banks are for investors with low risk
appetite, and may be considered for 6-12 months investment period as normally interest on
less than 6 months bank FDs is likely to be lower than money market fund returns.
What are various Long-term financial options available for investment?
Post Office Savings Schemes, Public Provident Fund, Company Fixed Deposits, Bonds and
Debentures, Mutual Funds etc.
Post Office Savings: Post Office Monthly Income Scheme is a low risk saving instrument, which
can be availed through any post office. It provides an interest rate of 8% per annum, which is
paid monthly. Minimum amount, which can be invested, is Tk. 1,000/- and additional
investment in multiples of 1,000/-. Maximum amount is Tk. 3,00,000/- (if Single) or Rs.
6,00,000/- (if held Jointly) during a year. It has a maturity period of 6 years. A bonus of 10% is
paid at the time of maturity. Premature withdrawal is permitted if deposit is more than one
year old. A deduction of 5% is levied from the principal amount if withdrawn prematurely; the
10% bonus is also denied.
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Public Provident Fund: A long term savings instrument with a maturity of 15 years and interest
payable at 8% per annum compounded annually. A PPF account can be opened through a
nationalized bank at anytime during the year and is open all through the year for depositing
money. Tax benefits can be availed for the amount invested and interest accrued is tax-free. A
withdrawal is permissible every year from the seventh financial year of the date of opening of
the account and the amount of withdrawal will be limited to 50% of the balance at credit at the
end of the 4th year immediately preceding the year in which the amount is withdrawn or at the
end of the preceding year whichever is lower the amount of loan if any.
Company Fixed Deposits: These are short-term (six months) to medium-term (three to five
years) borrowings by companies at a fixed rate of interest which is payable monthly, quarterly,
semi annually or annually. They can also be cumulative fixed deposits where the entire principal
along with the interest is paid at the end of the loan period. The rate of interest varies between
6-9% per annum for company FDs. The interest received is after deduction of taxes.
Bonds: It is a fixed income (debt) instrument issued for a period of more than one year with
the purpose of raising capital. The central or state government, corporations and similar
institutions sell bonds. A bond is generally a promise to repay the principal along with a fixed
rate of interest on a specified date, called the Maturity Date.
Mutual Funds: These are funds operated by an investment company which raises money from
the public and invests in a group of assets (shares, debentures etc.), in accordance with a stated
set of objectives. It is a substitute for those who are unable to invest directly in equities or debt
because of resource, time or knowledge constraints. Benefits include professional money
management, buying in small amounts and diversification. Mutual fund units are issued and
redeemed by the Fund Management Company based on the fund's net asset value (NAV),
which is determined at the end of each trading session. NAV is calculated as the value of all the
shares held by the fund, minus expenses, divided by the number of units issued. Mutual Funds
are usually long term investment vehicle though there some categories of mutual funds, such
as money market mutual funds which are short term instruments.
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LECTURE -02
FINANCIAL MARKET AND ITS INSTRUMENTS AND DIFFERENT INDICATORS
Money Market
The money market is better known as a place for large institutions and government to manage
their short-term cash needs. However, individual investors have access to the market through a
variety of different securities. In this tutorial, we'll cover various types of money market
securities and how they can work in your portfolio.
The money market is a subsection of the fixed income market. We generally think of the term
fixed income as being synonymous to bonds. In reality, a bond is just one type of fixed income
security. The difference between the money market and the bond market is that the money
market specializes in very short-term debt securities (debt that matures in less than one year).
Money market investments are also called cash investments because of their short maturities.
Money market securities are essentially IOUs issued by governments, financial institutions and
large corporations. These instruments are very liquid and considered extraordinarily safe.
Because they are extremely conservative, money market securities offer significantly lower
returns than most other securities.
The word “money market” is self explanatory. It’s a market for trading money!!! More precisely
it’s a market where money or its equivalent can be traded. For example whenever a bank
borrows from another bank or financial institutions to overnight to meet the regulatory reserve
requirement we call it a “call money market”. The price they pay for this type of borrowing is
called “call money rate”.
Recently
our money
market has
made a
record
jump of
195% in call
money
rate. 167
Financial institutions and dealers are the main players of money market. Usually institutions
who wish to utilize their fund available for shorter period invest in money market keeping in
mind that the fund may be withdrawn earlier than expected time period. Money market
provides small short term return as well as provides excellent liquidity. Money Market is part of
financial market where instruments with high liquidity and very short term maturities are
traded. Due to highly liquid nature of securities and their short term maturities, money market
is treated as a safe place. Hence, money market is a market where short term obligations such
as treasury bills, commercial papers and bankers acceptances are bought and sold.
Money Market Instruments
Investment in money market is done through money market instruments. Money market
instrument meets short term requirements of the borrowers and provides liquidity to the
lenders. Common Money Market Instruments are as follows:
Treasury Bills (T-Bills)
Treasury Bills, one of the safest money market instruments, are short term borrowing
instruments of the Government of a Country issued through the Central Bank (Bangladesh
Bank). They are (hypothetically) zero risk instruments, and hence the returns are not so
attractive. It is available both in primary market as well as secondary market. It is a promise to
pay a said sum after a specified period. T-bills are short-term securities that mature in one year
or less from their issue date. They are issued maturity (period) of 28 days (or 4 weeks, about a
month), 91 days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6 months), and
364 days (or 52 weeks, about 1 year). Treasury bills are sold by single-price auctions held
weekly. The Government issues T- Bills at a price less than their face value (par value). They are
issued with a promise to pay full face value on maturity. So, when the T-Bills mature, the
government pays the holder its face value. The difference between the purchase price and the
maturity value is the interest income earned by the purchaser of the instrument. T-Bills are
issued through a bidding process at auctions.
Repurchase Agreements
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Repurchase transactions, called Repo or Reverse Repo are transactions or short term loans in
which two parties agree to sell and repurchase the same security. They are usually used for
overnight borrowing. Under repurchase agreement the seller sells specified securities with an
agreement to repurchase the same at a mutually decided future date and price. Similarly, the
buyer purchases the securities with an agreement to resell the same to the seller on an agreed
date at a predetermined price. Such a transaction is called a Repo when viewed from the
perspective of the seller of the securities and Reverse Repo when viewed from the perspective
of the buyer of the securities. Thus, whether a given agreement is termed as a Repo or Reverse
Repo depends on which party initiated the transaction. The lender or buyer in a Repo is entitled
to receive compensation for use of funds provided to the counterparty. Effectively the seller of
the security borrows money for a period of time (Repo period) at a particular rate of interest
mutually agreed with the buyer of the security who has lent the funds to the seller. The rate of
interest agreed upon is called the Repo rate. The Repo rate is negotiated by the counterparties
independently of the coupon rate or rates of the underlying securities and is influenced by
overall money market conditions.
Bangladesh Bank usually conducts Repo and Reverse Repo to control short term money supply
in the market.
Commercial Papers
Commercial paper is a low-cost alternative to bank loans. It is a short term unsecured

promissory note issued by corporate and financial institutions at a discounted value on face
value. They are usually issued with fixed maturity between one to 270 days and for financing of
accounts receivables, inventories and meeting short term liabilities. Say, for example, a
company has receivables of Tk. 1 lac with credit period 6 months. It will not be able to liquidate
its receivables before 6 months. The company is in need of funds. It can issue commercial
papers in form of unsecured promissory notes at discount of 10% on face value of Tk. 1 lac to
be matured after 6 months. Commercial paper being an instrument not backed by any
collateral that’s why usually companies with strong credit rating are capable of issuing such
commercial papers and finds buyers easily. The company is able to liquidate its receivables
immediately and the buyer is able to earn interest of Tk. 10,000 over a period of 6 months.
They yield higher returns as compared to T-Bills as they are less secure in comparison to these
bills; however chances of default are almost negligible but are not zero risk instruments.
Commercial papers are issued by corporations to impart flexibility in raising working capital
resources at market determined rates. Commercial Papers are actively traded in the secondary
market since they are issued in the form of promissory notes and are freely transferable in
demat form. But active trading is not available in Bangladesh.
Certificate of Deposit
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It is a short term borrowing more like a bank term deposit account. It is a promissory note
issued by a bank in form of a certificate entitling the bearer to receive interest. The certificate
bears the maturity date, the fixed rate of interest and the value. It can be issued in any
denomination. They are stamped and transferred by endorsement. Its term generally ranges
from three months to five years and restricts the holders to withdraw funds on demand.
However, on payment of certain penalty the money can be withdrawn on demand also. The
returns on certificate of deposits are higher than T-Bills because it assumes higher level of risk.
While buying Certificate of Deposit, return method should be seen. Returns can be based on
Annual Percentage Yield (APY) or Annual Percentage Rate (APR). In APY, interest earned is
based on compounded interest calculation. However, in APR method, simple interest
calculation is done to generate the return. Accordingly, if the interest is paid annually, equal
return is generated by both APY and APR methods. However, if interest is paid more than once
in a year, it is beneficial to opt APY over APR.
Banker’s Acceptance
It is a short term credit investment created by a non financial firm and guaranteed by a bank to
make payment. It is simply a bill of exchange drawn by a person and accepted by a bank. It is a
buyer’s promise to pay to the seller a certain specified amount at certain date. The same is
guaranteed by the banker of the buyer in exchange for a claim on the goods as collateral. The
person drawing the bill must have a good credit rating otherwise the Banker’s Acceptance will
not be tradable. The most common term for these instruments is 90 days. However, they can
vary from 30 days to180 days. For corporations, it acts as a negotiable time draft for financing
imports, exports and other transactions in goods and is highly useful when the credit
worthiness of the foreign trade party is unknown. The seller need not hold it until maturity and
can sell off the same in secondary market at discount from the face value to liquidate its
receivables.
Capital Market
A capital market is a market for securities (debt or equity), where business enterprises
(companies) and governments can raise long-term funds. It is defined as a market in which
money is provided for periods longer than a year, as the raising of short-term funds takes place
on other markets (e.g., the money market). The capital market includes the stock market
(equity securities) and the bond market (debt).
Capital markets may be classified as primary markets and secondary markets. In primary
markets, new stock or bond issues are sold to investors via a mechanism known as
underwriting. In the secondary markets, existing securities are sold and bought among investors
or traders, usually on a securities exchange, over-the-counter, or elsewhere.
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A market in which individuals and institutions trade financial securities is capital market.
Organizations/institutions in the public and private sectors also often sell securities on the
capital markets in order to raise funds. Thus, this type of market is composed of both
the primary and secondary markets. Both the stock and bond markets are parts of the capital
markets. For example, when a company conducts an IPO, it is tapping the investing public for
capital and is therefore using the capital markets. This is also true when a country's
government issues Treasury bonds in the bond market to fund its spending initiatives.
When referring to a capital market, it is important to note that the term can refer to a rather
broad range of products and services that are associated with finances and investments. To that
end, a capital market will include such components as the stock market, commodities
exchanges, the bond market, and just about any physical or virtual facility or medium where
debt and equity securities can be bought or sold. As a market for securities with a very broad
reach, the capital market is an ideal environment for the creation of strategies that can result in
raising long-term funds for bond issues or even mortgages. At the same time, the capital
market provides the medium for short-term fund strategies as well. Essentially, any type of
financial transaction that is meant to result in the buying and selling of securities and
commodities for profit can rightly be considered part of the capital market.
Institutions are also part of the framework of the capital market. Stock exchanges are one of
the more visible examples of established operations that give form and function to the capital
market. Along with the stock exchanges, support organizations such as brokerage firms also
form part of the capital market. Over the counter markets are also included in the working
definition for a capital market. By providing the mechanisms that make trading possible, these
outward expressions of the capital market make it possible to keep the process ethical and
more easily governed according to local laws and customs. Because of the broad structure of
the capital market, investors of all types have the opportunity to participate in financial
strategies that can strengthen the general economy as well create financial security. Persons
who wish to focus on investment opportunities that are very stable and more or less ensure a
modest return can find plenty of different offerings to choose from. At the same time, investors
who tend to be more adventurous can also find a wide array of investment types that will allow
them to take some additional risk and possibly realize larger returns on their investments.
Primary Market
The primary market is that part of the capital markets that deals with the issuance of new
securities. Companies, governments or public sector institutions can obtain funding through the
sale of a new stock or bond issue. This is typically done through a syndicate of securities
dealers. The process of selling new issues to investors is called underwriting. In the case of a
new stock issue, this sale is an initial public offering (IPO). Dealers earn a commission that is
built into the price of the security offering, though it can be found in the prospectus. Primary
markets create long term instruments through which corporate entities borrow from capital
market.
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Features of primary markets are:
 This is the market for new long term equity capital. The primary market is the market
where the securities are sold for the first time. Therefore it is also called the new issue
market (NIM).
 In a primary issue, the securities are issued by the company directly to investors.
 The company receives the money and issues new security certificates to the investors.
 Primary issues are used by companies for the purpose of setting up new business or for
expanding or modernizing the existing business.
 The primary market performs the crucial function of facilitating capital formation in the
economy.
 The new issue market does not include certain other sources of new long term external
finance, such as loans from financial institutions. Borrowers in the new issue market
may be raising capital for converting private capital into public capital; this is known as
"going public."
 The financial assets sold can only be redeemed by the original holder.
Methods of issuing securities in the primary market are:
 Initial public offering;

 Rights issue (for existing companies);
 Preferential issue.
Secondary Market
The secondary market, also called aftermarket, is the financial market where previously issued
securities and financial instruments such as stock, bonds, options, and futures are bought and
sold. The term "secondary market" is also used to refer to the market for any used goods or
assets, or an alternative use for an existing product or asset where the customer base is the
second market (for example, corn has been traditionally used primarily for food production and
feedstock, but a "second" or "third" market has developed for use in ethanol production).
With primary issuances of securities or financial instruments, or the primary market, investors
purchase these securities directly from issuers such as corporations issuing shares in an IPO or
private placement, or directly from the federal government in the case of treasuries. After the
initial issuance, investors can purchase from other investors in the secondary market.
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The secondary market for a variety of assets can vary from loans to stocks, from fragmented to
centralized, and from illiquid to very liquid. The major stock exchanges are the most visible
example of liquid secondary markets - in this case, for stocks of publicly traded companies.
Most bonds and structured products trade “over the counter,” or by phoning the bond desk of
one’s broker-dealer. Loans sometimes trade online using a Loan Exchange.
Secondary marketing is vital to an efficient and modern capital market. In the secondary
market, securities are sold by and transferred from one investor or speculator to another. It is
therefore important that the secondary market be highly liquid (originally, the only way to
create this liquidity was for investors and speculators to meet at a fixed place regularly; this is
how stock exchanges originated, see History of the Stock Exchange). As general rules, the
greater the number of investors that participate in a given marketplace and the greater the
centralization of that marketplace, the more liquid the market.
Fundamentally, secondary markets mesh the investor's preference for liquidity (i.e., the
investor's desire not to tie up his or her money for a long period of time, in case the investor
needs it to deal with unforeseen circumstances) with the capital user's preference to be able to
use the capital for an extended period of time.
Accurate share price allocates scarce capital more efficiently when new projects are financed
through a new primary market offering, but accuracy may also matter in the secondary market
because: 1) price accuracy can reduce the agency costs of management, and make hostile
takeover a less risky proposition and thus move capital into the hands of better managers, and
2) accurate share price aids the efficient allocation of debt finance whether debt offerings or
institutional borrowing.
The following discussion will be on capital market instruments.
Bond
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt
and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to
repay the principal at a later date, termed maturity. A bond is a formal contract to repay
borrowed money with interest at fixed intervals.
Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender
(creditor), and the coupon is the interest. Bonds provide the borrower with external funds to
finance long-term investments, or, in the case of government bonds, to finance current
expenditure. Certificates of deposit (CDs) or commercial paper are considered to be money
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market instruments and not bonds. Bonds must be repaid at fixed intervals over a period of
time.
Bonds and stocks are both securities, but the major difference between the two is that (capital)
stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders
have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds
usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks
may be outstanding indefinitely.
Issuing Bond
Bonds are issued by public authorities, credit institutions, companies and supranational
institutions in the primary markets. The most common process of issuing bonds is through
underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy
an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the
risk of being unable to sell on the issue to end investors. Primary issuance is arranged by book-
runners who arrange the bond issue, have the direct contact with investors and act as advisors
to the bond issuer in terms of timing and price of the bond issue. The book-runners' willingness
to underwrite must be discussed prior to opening books on a bond issue as there may be
limited appetite to do so.
In the case of government bonds, these are usually issued by auctions, called a public sale,
where both members of the public and banks may bid for bond. Since the coupon is fixed, but
the price is not, the percent return is a function both of the price paid as well as the coupon.
However, because the cost of issuance for a publicly auctioned bond can be cost prohibitive for
a smaller loan, it is also common for smaller bonds to avoid the underwriting and auction
process through the use of a private placement bond. In the case of a private placement bond,
the bond is held by the lender and does not enter the large bond market.
Features of bond
The most important features of a bond are:
 Nominal, principal or face amount — the amount on which the issuer pays interest, and
which, most commonly, has to be repaid at the end of the term. Some structured bonds
can have a redemption amount which is different from the face amount and can be
linked to performance of particular assets such as a stock or commodity index, foreign
exchange rate or a fund. This can result in an investor receiving less or more than his
original investment at maturity.
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 Issue price — the price at which investor buy the bonds when they are first issued,
which will typically be approximately equal to the nominal amount. The net proceeds
that the issuer receives are thus the issue price, less issuance fees.
 Maturity date — the date on which the issuer has to repay the nominal amount. As long
as all payments have been made, the issuer has no more obligations to the bond holders
after the maturity date. The length of time until the maturity date is often referred to as
the term or tenor or maturity of a bond. The maturity can be any length of time,
although debt securities with a term of less than one year are generally designated
money market instruments rather than bonds. Most bonds have a term of up to thirty
years. Some bonds have been issued with maturities of up to one hundred years, and
some even do not mature at all.
 Coupon — the interest rate that the issuer pays to the bond holders. Usually this rate is
fixed throughout the life of the bond. It can also vary with a money market index or it
can be even more exotic. The name coupon originates from the fact that in the past,
physical bonds were issued which had coupons attached to them. On coupon dates the
bond holder would give the coupon to a bank in exchange for the interest payment.
Types of Bond
Perpetual Bond
A bond with no maturity date is Perpetual Bond. Perpetual bonds are not redeemable but pay a
steady stream of interest forever. Since perpetual bond payments are similar to stock dividend
payments - as they both offer some sort of return for an indefinite period of time - it is logical
that they would be priced the same way. The price of a perpetual bond is therefore the fixed
interest payment, or coupon amount, divided by some constant discount rate, which represents
the speed at which money loses value over time (partly because of inflation). The discount rate
denominator reduces the real value of the nominally fixed coupon amounts over time,
eventually making this value equal zero. As such, perpetual bonds, even though they pay
interest forever, can be assigned a finite value, which in turn represents their price.
If a bond promises a fixed annual payment of I, its present intrinsic value V, at the investors
required rate of return for this debt issue is Kd, then,
V= I/ Kd
Thus the present value of perpetual bond is simply the periodic interest payment divided by the
appropriate discount rate per period. Suppose you could buy a bond Tk. 50 a year forever.
Assuming that the required rate of return for this type of bond is 12 percent, so the present
value of the security would be,
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V= 50/.12 = Tk. 416.67
This is the maximum amount that you would be willing to pay for this bond. If the market price
is greater than this amount, however you would not want to buy it and if the market price is
lower than this amount, you would want to buy it.
Non Zero Coupon Bonds
If a bond has a finite maturity, then we must consider not only the interest stream but also the
terminal or maturity value (Face value) in valuing this bond. The valuation equation for such a
bond,
V= I/(1+Kd)1 + I/(1+Kd)2 + … … … + I/(1+Kd)n + MV/(1+Kd)n
Where annual payment is I, its present intrinsic value V, investors required rate of return for
this debt issue is Kd, and MV is the maturity Value of the bond.
We might wish to determine the value of a TK. 1000 per value bond with a 10 percent coupon
and 9 years maturity. The coupon rate compounds an interest rate of Tk. 100 per year. If the
required rate of return is 12 percent then,
V= 100/(1.12)1 + 100/(1.12)2 +… … … + 100/(1.12)9 + 1000/(1.12)9

= 532.80 + 361.00
=TK.893.80
The interest payments have a present value of Tk. 532.80 whereas the principal payment at
maturity has a present value of Tk. 360.
This is the maximum amount that you would be willing to pay for this bond. If the market price
is greater than this amount, however you would not want to buy it and if the market price is
lower than this amount, you would want to buy it.
Zero-coupon bond
A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a
price lower than its face value, with the face value repaid at the time of maturity. It does not
make periodic interest payments, or have so-called "coupons," hence the term zero-coupon
bond. When the bond reaches maturity, its investor receives its par (or face) value.
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In contrast, an investor who has a regular bond receives income from coupon payments, which
are usually made semi-annually. The investor also receives the principal or face value of the
investment when the bond matures.
Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity
dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on
secondary bond markets. Short-term zero coupon bonds generally have maturities of less than
one year and are called bills.
A zero coupon bond makes no periodic interest payments but instead is sold at a deep discount
from its face value. Why buy this bond when it doesn’t pay any interest? The answer lies in the
fact that the buyer of such a bond does receive a return. This return consists of the gradual
increase in the value of the security from its original, below-face-value purchase price until it is
redeemed at face value on its maturity date.
For a zero coupon bond with Maturity Value MV, maturity period of n years, with required rate
of return Kd and the present intrinsic value is V,
V= MV/(1+Kd)n
Suppose a company issued a zero coupon bond having 10 years maturity and Tk. 1000 face
value, if the required rate of return in 12 percent, then,
V= 1000/(1.12)10
=Tk. 322
If someone could purchase this bond for Tk. 322 and redeem it 10 years later for Tk. 1000, the
initial investment would thus provide a 12 percent annual rate of return.
Conversion Option
In finance, a convertible note (or, if it has a maturity of greater than 10 years, a convertible
debenture) is a type of bond that the holder can convert into shares of common stock in the
issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with
debt- and equity-like features. Although it typically has a low coupon rate, the instrument
carries additional value through the option to convert the bond to stock, and thereby
participate in further growth in the company's equity value. The investor receives the potential
upside of conversion into equity while protecting downside with cash flow from the coupon
payments.
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From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a
reduced cash interest payment. The advantage for companies of issuing convertible bonds is
that, if the bonds are converted to stocks, companies' debt vanishes. However, in exchange for
the benefit of reduced interest payments, the value of shareholder's equity is reduced due to
the stock dilution expected when bondholders convert their bonds into new shares.
Like any typical bond, convertible bonds have an issue size, issue date, maturity date, maturity
value, face value and coupon. They also have the following additional features:
 Conversion price: The nominal price per share at which conversion takes place.
 Conversion ratio: The number of shares each convertible bond converts into. It may be
expressed per bond or on a per centum (per 100) basis.
 Parity (Conversion) value: Equity price × Conversion ratio.
 Conversion premium: Represent the divergence of the market value of the CB compared
to that of the parity value.
 Call features: The ability of the issuer (on some bonds) to call a bond early for
redemption, sometimes subject to certain share price performance. The intention is to
encourage investors to convert early into equity (which has now become worth more
than the bond's face value), by threatening repayment in cash for what is now a lower
amount.
Debenture
In law, a debenture is a document that either creates a debt or acknowledges it. In corporate
finance, the term is used for a medium- to long-term debt instrument used by large companies
to borrow money. In some countries the term is used interchangeably with bond, loan stock or
note.
Thus a type of debt instrument that is not secured by physical asset or collateral is
debenture. Debentures are backed only by the general creditworthiness and reputation of the
issuer. Both corporations and governments frequently issue this type of bond in order to secure
capital. Like other types of bonds, debentures are documented in an indenture.
Debentures have no collateral. Bond buyers generally purchase debentures based on the belief
that the bond issuer is unlikely to default on the repayment. An example of a
government debenture would be any government-issued Treasury bond (T-bond) or Treasury
bill (T-bill). T-bonds and T-bills are generally considered risk free because governments, at
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worst, can print off more money or raise taxes to pay these types of debts.
Debentures are generally freely transferable by the debenture holder. Debenture holders have
no rights to vote in the company's general meetings of shareholders, but they may have
separate meetings or votes e.g. on changes to the rights attached to the debentures. The
interest paid to them is a charge against profit in the company's financial statements.
There are two types of debentures:
1. Convertible debentures, which are convertible bonds or bonds that can be converted
into equity shares of the issuing company after a predetermined period of time.
"Convertibility" is a feature that corporations may add to the bonds they issue to make
them more attractive to buyers. In other words, it is a special feature that a corporate
bond may carry. As a result of the advantage a buyer gets from the ability to convert;
convertible bonds typically have lower interest rates than non-convertible corporate
bonds.
2. Non-convertible debentures, which are simply regular debentures, cannot be converted
into equity shares of the liable company. They are debentures without the convertibility
feature attached to them. As a result, they usually carry higher interest rates than their
convertible counterparts.
Government Bond
A bond is a debt investment in which an investor loans a certain amount of money, for a certain
amount of time, with a certain interest rate, to a company or country. A government bond is a
bond issued by a national government denominated in the country's own currency.
Preferred Stock
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a
special equity security that has properties of both equity and a debt instrument and is generally
considered a hybrid instrument. Preferred are senior (i.e., higher ranking) to common stock, but
are subordinate to bonds. Preferred stock usually carries no voting rights, but may carry a
dividend and may have priority over common stock in the payment of dividends and upon
liquidation. Preferred stock may have a convertibility feature into common stock. Terms of the
preferred stock are stated in a "Certificate of Designation".
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Similar to bonds, preferred stocks are rated by the major credit rating companies. The rating for
preferred is generally lower since preferred dividends do not carry the same guarantees as
interest payments from bonds and they are junior to all creditors. The precise detail as to the
structure of preferred stock is specific to each corporation. However, the best way to think
of preferred stock is as a financial instrument that has characteristics of both debt (fixed
dividends) and equity (potential appreciation). Also known as "preferred shares"
There are certainly pros and cons when looking at preferred shares. Preferred shareholders
have priority over common stockholders on earnings and assets in the event of liquidation and
they have a fixed dividend (paid before common stockholders), but investors must weigh these
positives against the negatives, including giving up their voting rights and less potential for
appreciation.
Preferred stock is a special class of shares that may have any combination of features not
possessed by common stock.
The following features are usually associated with preferred stock:
 Preference in dividends.
 Preference in assets in the event of liquidation.
 Convertible into common stock.
 Callable at the option of the corporation.
 Nonvoting.
Common Stock
Common stock is a form of corporate equity ownership, a type of security. It is called

"common" to distinguish it from preferred stock. In the event of bankruptcy, common stock
investors receive their funds after preferred stock holders, bondholders, creditors, etc. That is
In the event of liquidation, common shareholders have rights to a company's assets only after
bondholders, preferred shareholders and other debt holders have been paid in full. On the
other hand, common shares on average perform better than preferred shares or bonds over
time. Common stock is usually voting shares, though not always. Holders of common stock are
able to influence the corporation through votes on establishing corporate objectives and policy,
stock splits, and electing the company's board of directors. Some holders of common stock also
receive preemptive rights, which enable them to retain their proportional ownership in a
company should it issue another stock offering. There is no fixed dividend paid out to common
stock holders and so their returns are uncertain, contingent on earnings, company
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reinvestment, and efficiency of the market to value and sell stock. Additional benefits from
common stock include earning dividends and capital appreciation.
Every share of common stock represents a proportional ownership, or equity, in a company. If a

company has 100,000 shares of common stock and an investor owns one of them, then the
investor owns 1/100,000th of the company, and as such, has an interest in 1/100,000th of the
company’s profits.
Difference between Preferred and Common Stock
Common Stock
The holders of common stock can reap two main benefits from the issuing company: capital
appreciation and dividends. Capital appreciation occurs when a stock's value increases over
the amount initially paid for it. The stockholder makes a profit when he or she sells the stock
at its current market value after capital appreciation.
Dividends, which are taxable payments, are paid to a company's shareholders from its
retained or current earnings. Typically, dividends are paid out to stockholders on a quarterly
basis. These payments are usually made in the form of cash, but other property or stock can
also be given as dividends. Payment of dividends, however, hinges on a company's capacity to
grow — or at least maintain — its current or retained earnings. This means that ongoing
payment of dividends cannot be guaranteed.
Common stock ownership has the additional benefit of enabling its holders to vote on
company issues and in the elections of the organization's leadership team. Usually, one share
of common stock equates to one vote.
Preferred Stock
Preferred stock doesn't offer the same potential for profit as common stock, but it's a more
stable investment vehicle because it guarantees a regular dividend that isn't directly tied to
the market like the price of common stock. This type of stock guarantees dividends, which
common stock does not. The price of preferred stock is tied to interest rate levels, and tends to
go down if interest rates go up and to increase if interest rates fall.
The other advantage of preferred stock is that preferred stockholders get priority when it
comes to the payment of dividends. In the event of a company's liquidation, preferred
stockholders get paid before those who own common stock. In addition, if a company goes
bankrupt, preferred stockholders enjoy priority distribution of the company's assets, while
holders of common stock don't receive corporate assets unless all preferred stockholders have
been compensated (bond investors take priority over both common and preferred
stockholders).
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Like common stock, preferred stock represents ownership in a company. However, owners of
preferred stock do not get voting rights in the business.
Mutual Fund
Mutual Fund is an investment vehicle that is made up of a pool of funds collected from many
investors for the purpose of investing in securities such as stocks, bonds, money
market instruments and similar assets. Mutual funds are operated by money managers, who
invest the fund's capital and attempt to produce capital gains and income for the fund's
investors. A mutual fund's portfolio is structured and maintained to match the investment
objectives stated in its prospectus. One of the main advantages of mutual funds is that they
give small investors access to professionally managed, diversified portfolios of equities, bonds
and other securities, which would be quite difficult (if not impossible) to create with a small
amount of capital. Each shareholder participates proportionally in the gain or loss of the fund.
Mutual fund units, or shares, are issued and can typically be purchased or redeemed as needed
at the fund's current net asset value (NAV) per share, which is sometimes expressed as NAVPS.
Close Ended Mutual Fund
A closed-end fund (or closed-ended fund) is a collective investment scheme with a limited
number of shares. It is called a closed-end fund (CEF) because new shares are rarely issued once
the fund has launched, and because shares are not normally redeemable for cash or securities
until the fund liquidates. Typically an investor can acquire shares in a closed-end fund by buying
shares on a secondary market from a broker, market maker, or other investor as opposed to an
open-end fund where all transactions eventually involve the fund company creating new shares
on the fly (in exchange for either cash or securities) or redeeming shares (for cash or securities).
The price of a share in a closed-end fund is determined partially by the value of the investments
in the fund, and partially by the premium (or discount) placed on it by the market. The total
value of all the securities in the fund divided by the number of shares in the fund is called the
net asset value (NAV) per share. The market price of a fund share is often higher or lower than
the per share NAV: when the fund's share price is higher than per share NAV it is said to be
selling at a premium; when it is lower, at a discount to the per share NAV.
Open Ended Mutual Fund
An open-ended fund is a collective investment scheme which can issue and redeem shares at
any time. An investor will generally purchase shares in the fund directly from the fund itself
rather than from the existing shareholders. It contrasts with a closed-end fund, which typically
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issues all the shares it will issue at the outset, with such shares usually being tradable between
investors thereafter.
Market Indicators
Index
An Index is a statistical indicator providing a representation of the value of the securities which
constitute it. Indices often serve as barometers for a given market or industry and benchmarks against
which financial or economic performance is measured.
A stock market index is a method of measuring a section of the stock market. Many indices are cited by
news or financial services firms and are used as benchmarks, to measure the performance of respective
stock market.
Index Calculation Algorithm for DSE:
Yesterday's Closing Index X Current Market Capitalization

Current Index = -----------------------------------------------------------------------------------------
Opening Market Capitalization
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Yesterday's Closing Index X Closing Market Capitalization

Closing Index = -----------------------------------------------------------------------------------------
Opening Market Capitalization
Current Market Capitalization = ∑ (Last Trading Price X Total no. of indexed shares)
Closing Market Capitalization = ∑ (Closing Price X Total no. of indexed shares)
There are three indices in the DSE as follows:
Sl.No Index Name Base Index Remarks

1 DSI (all shares) 350 (as on 01-11-1993)
DGEN SEC directive regarding index
2 817.63704 (as on 24-11-2001)
(A, B, G & N) was on 17-11-2001
3 DS20 1000 (as on 01-01-2001)
An index graph is drawn by plotting the values of indices over time. The figures of DSI index,
DSE general index and DSE 20 index for 30 days are given below.
Figure 1: DSI Index Graph Last 30 Days
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Figure 2: DSE General Index Graph Last 30 Days
Figure 3: DSE20 Index Graph Last 30 Days
DSE20 is calculated by using the following 20 stocks:
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Figure 4: List of DSE 20 Stocks
The picture below is a graph of index of a specific date. The values of index are calculated in
every five minutes and those values are plotted in the graph. The X-axis contains time and the
Y-axis contains the index value. Anyone can see this graph by visiting DSE website’s homepage.
Figure 5: DSE General Index for a Specific date
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Graph can also be drawn by Index, volume and time. The below figure is an example of such graph:
Figure 6: DSE General Index with Volume for a specific date
Charts
A graphical representation is very much understandable than theoretical explanation. DSE

website provides some charts for every company’s enlisted. One can easily see these graphs by
visiting any companies to DSE site. For example, the below two graphs are the close price graph
and total trade graph of AB Bank.
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Figure 7: Closing Price of AB Bank VS Date for one year
Figure 8: Total Trade of AB Bank VS Date for one year
There are good numbers of charts and graphs with different features.
 Pie Chart
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Figure 9: Pie Chart of Sector wise Market Composition
This Pie chart means the contribution to different sectors in percentage form for consecutive
two days.
 Bar Chart
Bar Chart represents the value in millions to different sectors for consecutive two days.
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Figure 10: Bar Chart of Sector wise Market Composition
COMPANY INDICATOR
Stock Category
A-category companies
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Companies which are regular in holding the current annual general meetings and have declared
dividend at the rate of ten percent or more in the last English calendar year are A Categories
Company, provided that transaction for odd lot (other than market lots or multiple of market
lots) and big lot (single or more certificates containing multiple of market lots in each
certificate) may be kept outside the adjusted due position mechanism for settlement.
B-category companies
Companies which are regular in holding the annual general meetings but have failed to declare
dividend at least at the rate of ten percent in the last English calendar year are B category
share.
G-category companies (Greenfield companies)

No stocks are currently enlisted to this category.
N-category companies
All newly listed companies except Greenfield companies will be placed in this category and their
settlement system would by like B-category companies.
Z-category companies
Companies which have failed to hold the current annual general meetings or have failed to
declare any dividend or which are not in operation continuously for more than six months or
whose accumulated loss after adjustment of revenue reserve, if any, is negative and exceeded
its paid up capital are Z category company.
Credit Rating
Credit rating gives market participants timely access to unbiased, objective, independent,
expert, professional opinion on the quality of securities in a user friendly manner that may be
relied upon for investment decisions. Rating opinion would facilitate the investors to decide
their portfolios by choosing investment options in the market according to their profiles and
preferences. Credit rating would affect significant contribution towards developing the stock
market investor confidence and enhancing the quality and perfection of the securities market,
through provision of credible information for guidance of institutional and individual investors.
Credit ratings are used by investors, issuers, investment banks, broker-dealers, and
governments. For investors, credit rating agencies increase the range of investment alternatives
and provide independent, easy-to-use measurements of relative credit risk; this generally
increases the efficiency of the market, lowering costs for both borrowers and lenders. This in
turn increases the total supply of risk capital in the economy, leading to stronger growth. It also
opens the capital markets to categories of borrower who might otherwise be shut out
altogether: small governments, startup companies, hospitals, and universities.
Here is an example of long term credit rating of Bank as per CRAB (Credit Rating Agency of
Bangladesh)
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LONG-TERM CREDIT RATING of BANK
RATING DEFINITION
AAA Triple A (Extremely Strong Capacity & Commercial Banks rated 'AAA' has extremely strong capacity to meet its financial
Highest Quality) commitments. 'AAA' is the highest issuer credit rating assigned by CRAB. AAA is
judged to be of the highest quality, with minimal credit risk.
AA1, AA2, AA3* Double A (Very Strong Capacity Commercial Banks rated 'AA' has very strong capacity to meet its financial
& Very High Quality) commitments. It differs from the highest-rated Commercial Banks only to a small
degree. AA is judged to be of very high quality and is subject to very low credit risk.
A1, A2, A3 Single A (Strong Capacity & High Commercial Banks rated 'A' has strong capacity to meet its financial commitments
Quality) but is somewhat more susceptible to the adverse effects of changes in circumstances
and economic conditions than Commercial Banks in higher-rated categories. A is
judged to be of high quality and are subject to low credit risk.
BBB1, BBB2, BBB3 Triple B (Adequate Capacity Commercial Banks rated 'BBB' has adequate capacity to meet its financial
& Medium Quality) commitments. However, adverse economic conditions or changing circumstances are
more likely to lead to a weakened capacity of the Commercial Banks to meet its
financial commitments. BBB is subject to moderate credit risk. They are considered
medium-grade and as such may possess certain speculative characteristics.
BB1, BB2, BB3 Double B (Inadequate Capacity & Commercial Banks rated 'BB' is less vulnerable in the near term than other lower-
Substantial Credit Risk) rated Commercial Banks. However, it faces major ongoing uncertainties and
exposure to adverse business, financial, or economic conditions, which could lead to
the Commercial Bank’s inadequate capacity to meet its financial commitments. BB is
judged to have speculative elements and is subject to substantial credit risk.
B1, B2, B3 Single B (Weak Capacity & High Credit Commercial Banks rated 'B' is more vulnerable than the Commercial Banks rated 'BB',
Risk) but the Commercial Banks currently has the capacity to meet its financial
commitments. Adverse business, financial, or economic conditions will likely impair
the Commercial Bank’s capacity or willingness to meet its financial commitments. B is
considered speculative and weak capacity and is subject to high credit risk.
CCC1, CCC2, CCC3 Triple C (Very Weak Capacity Commercial Banks rated 'CCC' is currently vulnerable, and is dependent upon
& Very High Credit Risk) favorable business, financial, and economic conditions to meet its financial
commitments. CCC is judged to be of very weak standing and is subject to very high
credit risk.
CC Double C (Extremely Weak Capacity & Commercial Banks rated 'CC' is currently highly vulnerable. CC is highly speculative
Extremely High Credit Risk) and is likely in, or very near, default, with some prospect of recovery of principal and
interest.
C Single C (Near to Default) A 'C' rating is assigned that is currently highly vulnerable to nonpayment, obligations
that have payment arrearages allowed by the terms of the documents, or obligations
of an issuer that is the subject of a bankruptcy petition or similar action which have
not experienced a payment default. Among others, the 'C' rating may be assigned to
subordinated debt, preferred stock or other obligations on which cash payments
have been suspended in accordance with the instrument's terms. C is typically in
default, with little prospect for recovery of principal or interest.
D (Default) 'D' is in default. The 'D' rating also will be used upon the filing of a bankruptcy
petition or the taking of a similar action if payments on an obligation are jeopardized.
Price Sensitive Disclosures
News that can affect the price of stocks is price sensitive disclosure. News might be given in the
company website, stock exchange website, newspaper or other media. Investors who are
willing to invest stock market are very much concerned about the information that can affect
price. Its market which fixes the price of stocks as per demand supply mechanism. A positive
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disclosure of a certain company definitely increases the demand of stocks and hence price
increases. At the same time a bad disclosure decreases the price of stocks with the decrease of
demand.
For example, if a company is willing to expand its business with big foreign investment, the
investors of this stock will certainly become happy as this information will increase the demand
of the stocks of this company. But it is seen that price sensitive information are not available to
the investors timely. For a stock market to work efficiently and fairly, two principles must apply:
companies need to release relevant information as soon as it is available; and all those who
want to deal in shares should have access to the same information at the same time.
Stock buy/sell declarations by Directors and sponsors
When directors/sponsors want to buy/sell stocks of their company, they have to provide that
news to DSE. The below news is an example of buying of stocks of Bank Asia.
BANKASIANews
Amiran Generations Ltd., one of the corporate Sponsors/Directors of the Bank, has reported its
intention to buy 14,000 shares of the Bank at prevailing market price through Stock Exchange within
next 30 working days.
Post Date:2011-03-14
Expire Date:2011-03-14
Other News
The management of the company provides the news to DSE as per rules and regulations. That news is
published in the stock exchange sites. In DSE website, one can search the News Archive for a specific
company over the years.
LECTURE -04
MARKET TERMINOLOGIES
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How to start?
Open a BO Account and a Trading Account in any merchant bank or any brokerage house.
Deposit money and start transaction. It may be direct, on phone or OMO service.
BO Account:
Beneficiary Owner account is an account which is very similar as traditional account the
accounts of stocks are safely kept. This account is necessary for both primary and secondary
operation. By opening a BO Account to any brokerage house a person can apply to be a
member of CDBL.
To open a BO Account the following system is practiced
For opening a Beneficiary Owner (BO) account, one has to complete the following steps (if you
already have a bank account, otherwise first open an account at a bank) –
 Select a suitable Stockbroker/Brokerage House with whom you would do your business.
Make sure that the Stockbroker you are selecting is a registered member of DSE and
CSE.
 Collect a BO account opening form from the respective Brokerage House and fill it up.
You will need the following documents -
i) Bank CERTIFICATE / National ID Card (or both, depends on the
brokerage house)
ii) Three Copies of Passport Sized Photos
 After filling the form out, pay the brokerage house the account opening fee (it ranges
from Tk. 600 – Tk. 1000, depends on the brokerage house).
 Submit it to them and wait for your account to be opened (from 3 days – 1 month,
depends on the brokerage house).
What are required to open BO Account?
Photocopy of Passport / Social Security Card / Resident Card etc duly attested (if you are
situated in a foreign country then attestation needs to be done the respective Bangladesh
Embassy or High Commission). An FC account with any Bank with branch in Bangladesh
Passport size photographs duly attested A Nominee – beneficiary in case of death of the
investor. His/her signature and photo (duly attested by the investor) on the prescribed form
provided by the brokerage house.
Employment certificate / trade license copy / work permit or Pay slip / tax return document as a
proof of earning status of the NRB. A nominated person with POA (Power of Attorney) who will
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sign trading documents on behalf of the NRB while he is abroad. His/her photo (attested by the
NRB) and signature in a prescribed form by the brokerage house (POA can be any adult person
of legal age residing in Bangladesh). If the broker is a bank then an extra form of KYC (Know
your customer will also have to be filled) Initial fund will have to be a cheque or pay order or
other allowed form drawn from the FC account. It’s easiest if the NRB is in Bangladesh to open
the BO account for investment. All he/she has to do is to visit a proffered brokerage house and
fill some forms and get the Nominee and the POA to sign from then the NRB can go back
abroad and continue applying for IPO’s or continue trading in the secondary market. If you are
abroad and intend to open the BO from there then you need the following steps:
Collect the relevant forms from your proffered brokerage house via mail. Fill it up and get the
introducer part attested by the local Bangladeshi Embassy as a proof of the NRB status by
providing to them the required documents.
Get your photos attested by the local Bangladesh Embassy as well Send the forms back to the
brokerage house with the Nominee and POA part filled in. Send the POA to the brokerage
house.
What is a Trading Account?
The customer account is a number provided by the brokerage house. This number is usually
used for giving the order to buy or sell shares.
Trading account is an account, with the broker, in which the NRB will deposit his/her initial
investment from which the broker will credit or debit fund for buy/sell All earnings from the
investment can be first transferred to a local currency account of the NRB and then to the
trading account through help of the POA Trading account will allow the NRB to allocate fund for
investment in the secondary market Sales proceeds will be issued by Account Payee cheque in
favor of the NRB Investor. As such a local account or a NITA account is needed.
What is a NITA Account?
Non-resident Investment Taka Account (NITA) is an account for channeling foreign currency in
as well as repatriation of earnings from investment All earnings from investments (e.g. Cash
Dividends) are credited to the NITA account An audited statement, certifying that all proper
taxes are already withheld from the earnings Upon issuance of the auditors certificate the
earnings can be repatriated to the NRB in foreign currency If an investors intention is not to
repatriate any foreign currency then NITA account is not mandatory from where should an NRB
open his accounts? Home or Abroad!
Margin and Non-Margin Account:
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Margin Account
(1) A member may extend credit facilities to his approved client for securities
transactions subject to the margin account requirements of these rules.
(2) Margin account arrangements must be evidenced in the form of a written agreement
executed between the member and the client.
(3) Margin accounts are operated according to the rules and regulations of margin
account. For Example:
 Maximum amount of margin loan

 Percentage decrease for force sell
 Eligibility of shares to be bought in margin account i.e. category bindings,
required P/E ratio etc.
 Minimum amount in account for withdrawal.
Who are NRB?
NRB means Non Resident Bangladeshi. In case of a foreign passport holder an endorsement
either from the relevant Bangladeshi embassy or from Bangladesh foreign ministry stating that
“No visa is required” for traveling to Bangladesh – as a proof of dual citizenship
What are the benefits for Investing as NRB?
 10% of all issued IPO are reserved for NRB

 Can trade in the secondary capital market while abroad through Nominee in local
currency.
 As availing custodian services for individuals are difficult and expensive so investment
amount should be transferred either to Nominee or Brokers trading account and then
trade on secondary market either by nominee or personally by phone calls, fax, email
etc. – remember, the buy sale order will have to be faxed in within 24 hours in account
is operated personally.
How to Buy or Sell?
IPO application needs to be filled on a prescribed form. Such forms can be obtained through
mail, website of issuing company, or through broker etc. Trading in secondary market is done
by Buy/Sell order forms. If POA is assigned then the POA need to sign the Buy/Sell order form
within 24 hours of order placement If NRB wishes not to assign a POA then orders can be
placed via phone or email (broker approval required) and then a signed Buy/Sell order form
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needs to be faxed to broker within 24 hours Trading will be carried out within prevailing market
guidelines Shares will be credited or debited to the BO account accordingly
Discretionary Account
(1) Discretionary account means an account in which the client gives a member
discretion which may be complete or within specific limits as to the purchase and
sale of securities including selection, timing and price to be paid or received.
(2) No member shall exercise any discretionary authority with respect to a discretionary
account unless:-
 The client has given prior written authorization to the member to

exercise discretion on the account;
 The member has accepted the discretionary account.
Acceptance of a discretionary account must be evidenced by a document in writing which shall

be available for examination and signed on behalf of a member by authorized person of the
member. The authorization given to the member shall specify the investment objectives of the
client with respect to the particular discretionary account. Each authorization or acceptance
may be terminated by notice in writing by member or the client, as the case may be.
Initial Public Offering (IPO)
A corporation's first offer to sell stock to the public
IPO Processing
The unlisted companies are required to complete certain procedures to get listing at DSE. The
present process/way of listing, in short, may describe as follows:
 Every company intending to enlist its securities to DSE by issuing its securities through
IPO is required to appoint Issue Manager to proceed with the listing process of the
company in the Exchange;
 The Issue Manager prepares the draft prospectus of the company as per Public Issue
Rules of SEC and submit the same to the SEC and the Exchange(s) for necessary
approval;
 The Issuer is also required to make agreement with the Underwriter(s) and Bankers to
the Issue for IPO purpose;
 After receiving the draft prospectus, the Exchange examine and evaluate overall
performance as well as financial features of the company which may have short term
and long term impact on the market;
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 The Exchange send its opinion to SEC within 15 days of receipt of draft prospectus for
SEC's consideration;
 After proper scrutiny, SEC gives it consent for floating IPO as per Public Issue Rule;
 Having consent from SEC, the Issuer is required to file application to the Exchange for
listing its securities within 5 days of issuance of its prospectus;
 On successful subscription, the company is required to complete distribution of
allotment/refund warrants within 42 days of closing of subscription;
 After 100% distribution of shares/refund warrants and compliance of other
requirements, the application for listing of the Issuer is placed to the Exchange's
meeting for necessary decision of the Board of DSE;
 The Board of DSE takes the decision regarding listing/non-listing of the company which
must be completed within 75 days from the closure of the subscription.
Direct listing
Direct Listing is a doorway to list with the Exchange for the company who
 does not require to increase its existing paid up capital but want to list its securities for
prestige, liquidity benefit or any other reasons and
 intent to off load the existing shares of the shareholders for privatization purpose.
1. Eligibility criteria for direct listing: The public limited company having minimum paid up
capital of taka 100(one hundred) million may apply for direct listing to CSE if it is/has
 No accumulated loss
 Regular in holding the AGM
 in commercial operation for at least immediate last five years and
 has profit in three years out of the immediate last five completed accounting/financial
years with steady growth pattern.
2. Application for Listing: The application fee for Listing is Tk. 10,000/-(ten thousand). The
Exchange examines among others the following documents while giving approval to the listing:
 Audited financial statements for the last five years.

 A Credit rating report issued by the credit rating company registered with the
Commission with minimum investment grade of “BBB".
 Due diligence certificate from the directors
 No objection certificate from the lending bank(s) /financial institutions of the company
 Status of loan including information concerning loan default
 ‘Information Document’
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3. Information about the company to the General Public: The company shall prepare an
‘Information Document’ for the purpose of communicating to the general public the
information required to an investor for their investment decision. ‘Information Document’ shall
be published in at least two widely circulated national dailies minimum 7 (seven) days before
commercial trade upon listing by the Exchange.
4. Disposal of Shares The existing shareholders of the concerned company shall sell the shares
through the Exchange upon listing. At least 10% of their shareholdings in the company must be
offered for sell to the public within 30(thirty) working days from the date of listing. However
they are not permitted to sell more than 50% of his existing shareholdings until the company
holds the annual general meeting after completion of one full accounting year of the company
upon listing with the Exchange. Relevant resolution of the shareholders in the general meeting
of the company in this respect is to be submitted to the Exchange while applying for listing.
5. Trading and Settlement procedure: Dematerialization of the securities is a must for direct
listing. Compliance of CSE listing regulations and any other securities law by the listed company
and the procedure of trading and settlement of their securities transactions are same as
applicable to any other listed securities of the Exchange.
Information Document for Direct Listing
 Cover Page of Information Document:

 Table of Contents
 Disposal of shares
 Risk Factors and Management’s Perception about the Risks
 Description of Business
 Description of Property
 Plan of Operation and Discussion of Financial Condition
 Directors and Officers:
 Involvement of Officers and Directors in Certain Legal Proceedings
 Certain Relationships and Related Transactions
 Executive Compensation
 Options granted to Officers, Directors and Employees
 Transaction with Promoters
 Tangible assets per share
 Ownership of the Company’s Securities
 Description of Securities Outstanding or Being Offered
 Debt Securities
 Financial Statement Requirements
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DSE Automated System
Preamble
Globally the developments in information & communication technologies (ICT) have created a
new instance in the securities market operations. DSE introduced Automated Trading System
on 10th August 1998. The recently Upgraded Trading System was started from 21st December,
2008.
Hardware
DSE Automated Trading System (HP NonStop S7806) is running on fault tolerant, high available,
scalable and maintainable Mainframe Server. Previously DSE established the TANDEM NonStop
K204 System on September 1998 and on August 2005 it was replaced with highly scaleable HP
NonStop S7802. DSE upgraded the Trading System again on 21st December, 2008. The existing
HP NonStop S7806 Server is highly fault tolerant to the fact that no single component failure
will halt the system. Its constituent parts are hot swappable, and upward compatible;
components can be added or removed while the system is running and any compatible new
upgraded will work with the system.
All disk drives are mirrored so, if any of the disk crashes the exact copy of the data is available
at online. Moreover the connecting path for every disk whether it is primary or mirror is also
redundant. In every case, minimum two peripheral devices exist. All the components are
working active - active load balancing procedure. To ensure better power quality we have
ensured high end UPS's with long durable backup capability, two instant backup generations
and other electrical devices.
Network (LAN / WAN)
The entire Member (238 members) Server Applications (MSA) are connected with NonStop HP
S-Series Server through either DSE LAN or WAN connectivity. Each member has one or more
Trader Work Station (TWS). The TWSs are being connected to the Trading Server via respective
MSA through LAN and WAN connection. DSE outsourced Metro Net Ltd., DNS Ltd. , X-Net Ltd.,
Dhaka Com Ltd., Ranks ITT, Link-3, Royal Green Online Ltd. etc Network Service Providers (NSP
under WAN Expansion Project).
Now a day member can establish a main office or branch offices to their remote location and
can trade smoothly by using different media ADSL, Optical fiber and Radio Link from Dhaka and
other important cities such as Gazipur, Narayanganj, Comilla, Hobiganj, Chittagong, Sylhet,
Khulna, Barisal, Rajshahi, Bogra at the same time.
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Three DSE branch offices located at Chittagong, Sylhet and Khulna are connected via BTTB's
DDN link. We also used connectivity for redundancy for the DDN link. We have a plan to reach
the DSE branches in same way.
DSE LAN/WAN Expansion within DSE LAN/WAN Expansion outside

Dhaka city Dhaka city
In case of trade interruption due to serious hardware, software, network failure or

telecommunication disruption at the Brokerage houses, there is a provision to allow traders to
trade at DSE Contingency Trading floor.
System Software
The system software is HP Proprietary Non Stop KERNEL and includes the database as part of
the operating system thereby eliminating the layer typically found in most Database
Management Systems (DBMS). The Database functionalities are handled by NONSTOP SQL,
which is simply a different operational session for the operating system. The proprietary nature
of the system software arguably enhances system security.Operating system is HP's proprietary
NonStop KernelDBMS handled by NonStop SQL. The system software treats all its hardware
resources as objects and is thus entirely message driven. This then allows application software
to be deployed using client / server architecture providing shared data processing between the
central server and the user workstation. The central trading system resides in the Stock
Exchange premises, which is running 24 hrs in a day & 365 days in a year.
Application Software
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The application, which runs in DSE for trading, is called TESA (The Electronic Securities
Architecture). TESA has two parts: MSA (Member's Server Application) & TWS (Trader
workstation). MSA is the "Gateway" between the traders and the Stock Exchange, which
manages all the transactions and database operations between the traders and the Trading
Engine. TWS is the Front-end Application closer to investors, where they can submit Buy/Sell
orders for their desired securities TESA (The Electronics Securities Architecture) is the Trading
software (Based on HP proprietary O/S & DBMS) It has developed in view of Distributed
Database system In the client site it is being using SQL as local Database Trading Software is
MSA & TWS In STSD (Signal trader Single Database) system both MSA & TWS are running on a
Windows 2k Professional /XP Professional workstation and for MTSD (Multiple trader Single
Database) MSA install in a Windows 2k Server & the TWSs are in different Windows 2k
Professional /XP Professional workstation-using members in house LAN
TESA architecture
TESA software is built for the global securities markets. It uses fault tolerant computers,
intelligent workstations and client / server design techniques. This provides co-operative
processing, high message integrity, continuous operation and fully automatic recovery. This co-
operative mechanism enables very high speed processing which is essential for today's
electronic markets.
TESA's Application Programmatic Interface (API) is the gateway to the TESA system from the
outside world. All external devices connect through the API. The API provides the translation
between external devices and internal processes. This means that a new process does not need
to be written to support each new device, only the API needs to be modified.
Solution benefits
The TESA application suite derives significant advantages from being implemented on the HP
Non Stop platform. The HP Non Stop customers have benefited from these advantages.
Fault Tolerance: One of the most important automation requirements for any stock exchange
system is continuous system availability. With most systems Fault Tolerance is created at the
application level. Fault Tolerance is a fundamental design feature of the HP Non Stop
architecture.
Data Integrity: Data integrity is an integral feature of HP architecture. TESA employs standard
HP tools to achieve exceptional data integrity.
Scalability: The ability of an exchange to accommodate extraordinary increases in transaction

volumes without loss of its Capital investment in automation is very important. The HP Non
Stop Server is massively scalable due to Parallel processors.
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TESA functional model

An overview of the TESA Functional Model
Client / Server: TESA's Client / Server architecture enables an efficient allocation of computing
resources and provides easily modified user-friendly interfaces. TESA workstations operate
under Windows 2K/ XP professional and can function either as servers on a broker's network or
as workstation. These are used to perform trading and settlement activity by the brokers.
Principal Functions of TESA
 Market Information: Supplying all market information needed to formulate the buy and
sell decisions.
 Order Management: Accept, validate and store orders and quotes from broker
workstations and / or systems.
 Order Execution: Automatically executes orders when buy and sell prices match.
 Trade Reporting: Trade execution reports are provided to each trade participant, to the
settlement system and / or the depository and to the market.
 Index Calculation: Calculates and publishes market indices (DSE General Index &
Weighted Average Index.)
 Market Access: Provide exchange members with efficient affordable GUI-based tools for
accessing the market.
Markets
Four types of market at DSE
 Public Market: In this market instruments are traded in normal volume

 Spot Market: Instruments are traded in normal volumes under corporate action if any
 Odd lot Market: Odd lots of all Instruments are trade in this market
 Block Market: Instruments are traded in bulk volume
Trading sessions
TESA conducts trading in-5-phases.
 Enquiry: In this session Brokers can logon to the system. No order will be submitted in
this session. No trade will be executed. Only previous orders can be withdrew in this
session
 Opening: The Opening is a pure, single-price auction. All buy and all sell orders are
compared and calculate the open-adjust price. No trades will be executed in this session
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 Continuous Trading: During this phase, participants enter orders and immediate
execution or for inclusion in the book. Automatic matching and execution takes place
based on best price/ first in, first out trading rules
 Closing: Closing prices are calculated and disseminated to market participants
Enquiry: Market will be closed in this session & other facilities like the previous enquiry
session.
Market Control
The Market Control Workstation allows the exchange administrative staff to control the
operation of the market, e.g.
Session Control
Opening and closing the market via interactive control or by preset timers.
Validation Parameters
Setting and viewing parameters that control the trading engine validation e.g. tick size, Circuit
Breaker, Circuit Filter, Market lot, Price protection Percentage.
Messaging
Allows the dissemination of company announcement data and general market administrative
massages.
Market information
Market Information is a real-time market data system. It collects, manages, generates and
stores information relating to trade instruments and issuing companies. Market Information is
responsible for,
 Collecting Real-Time Market Information

 Collecting company Information
 Generating Market Statistics
Settlement
The Clearing and Settlement module provides the management of trade from the point of entry
into the Settlement Pool trade database until it has been delivered, settled and removed from
the Settlement Pool. It consists of three major business processes.
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Clearing: participant trade reporting, affirmation, billing and assigning settlement instructions.
Settlement: the process of overseeing that delivery of all instruments to the buyer and payment
of all moneys to the seller has occurred before removing the trade from the settlement pool.
Regulation 4 of the Settlement of Stock Exchange Transactions Regulation 1998 has been given
effect time to time. A new directive was made by SEC dated on 18th March 2003 "Adjusted due
position mechanism for settlement of scrip only as provided by regulation 4(1) of settlement of
Stock Exchange Transaction Regulations, 1998 shall remain suspended from 19th March 2003
until further order".
Here is a complete picture of the settlement system for all of our 427 Instruments in Five (5)
groups in the Four (4) markets. Number of Instruments are 338 (150 + 8D + 22M + 158TB),
Here D for Debentures, M for Mutual funds & TB for Treasury Bonds (Trading in Public, Block &
Odd-lot Market with trade for trade settlement facility for scrip only through DSE Clearing
House on T+1, T+3 basis). "A" and "DA" are marked in BASES columns for Non-Demat & Demat
instrument respectively in our TESA Trading Software.
The above cycle is valid for A, B, G & N category instruments traded in Public, Block &
Odd-lot market. .
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Remarks
 If any instrument declared as Compulsory Spot then Trades of Block and Odd-lot market
of that Instrument will be settled like Spot Market.
 Howla Charge, Laga Charge & Tax are always payable to DSE at Pay-In date for both
Buyer and Seller traded in Public, Block & Odd-lot Market.
 Howla Charge, Laga Charge & Tax are always payable to DSE at T+1 day for both Buyer
and Seller traded in Spot Market.
 Outside-Of-Netted settlement for "A" Group instrument has been withdrawn from 10 th
Dec 2006.
 DVP Trades are Off-Market Settlement (Broker to Broker).
Settlement for different categories instruments
01) For A group Instruments:

Market name Trade for Trade System Settlement & Settlement
Period
Public Trade for Trade * T+1 & T+3
Odd + Block Trade for Trade T+1 & T+3
Spot Trade for Trade T+0 & T+1
02) For B group Instruments:

Period
Spot (Before Book-closer) Trade for Trade T+0 & T+1
03) For G group Instruments:

Period
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04) For N group Instruments:

Period
* As netting system for shares has withdrawn, for A, B, G & N group instrument, member will
have to deposit the full shares at the DSE on T+1 after selling the shares, In case of purchasing
such shares, the buyer will have to deposit the Balanced (Netted) money traded in Public, Block
& Odd-lot market at the DSE on T+1.
05) For Z group Instruments:

Period
** Under the Trade for trade settlement system, member will have to deposit the full money at
the DSE on T+1 after purchasing the shares, In case of selling such shares, the seller will have to
deposit the full shares at the DSE on T+9.
Demate Shares
All selling shares have to transfer (Pay in) to the clearing account of selling Brokers from
concerned BO account within settlement period. Regarding the cash payment the procedure
will remain unchanged as mentioned above.
CDBL function in settlement
The introduction of CDBL does not make any difference to the process of buying and selling
although it does make a difference to the settlement of such trades.
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Where investors have a CDBL account through their broker then the act of giving a sell order to
the broker also authorizes him to move securities from the account to settle the sale. The
broker will move the securities when he enters the order into the market. If the order is
executed then the securities are used to settle the sale. If the order is not executed then the
broker will move the securities back to the investor's account.
Where investors have a CDBL account through a custodian (who is not a broker) then they must
advise their custodian that they have sold as they do for physical securities. However, the
securities must be in a CDBL account before they are sold and the broker may wish to check this
fact with the custodian before executing the order.
On the settlement date of a bought trade the broker will move securities to the account of the
buying investor (provided the investor has paid). Investors may leave the securities in their
account (ready for when they wish to sell or to avoid the need to hold certificates) or they may
request the participant to rematerialise the securities.
Circuit Breaker
Any of a number of procedures implemented by a major stock or commodity exchange when a

certain index falls a predetermined amount in a session, to prevent further losses. Examples
include trading halts and restrictions on program trading.
Pricing
Opening Price
The Range of prices at which the first bids and offers are made or the first transactions is
completed on an exchange is opening price.
Last traded price

The price of the last transaction for a given security at the end of a given trading session.
Closing Price
Closing price also indicates the price of the last transaction for a given security at the end of a
given trading session in most of the stock exchange. But it may differ from last traded price in
Bangladesh because an average weight is taken for determining the closing price.
Days high
The highest price that was paid for a security during a day or certain time period.
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Day’s low
The lowest price a security or commodity reached in a day or certain period of time, usually a
single trading session, opposite of high.
Average price
The average of the prices of a day usually used for some indicators for smoothing.
Change in price
The change of price in a specific period, i.e. day, month.
Days range
The range of a day’s price change, days high – days low = days range.
52 weeks range
The difference between the highest and lowest price of a certain stock within a period of 1 year
or 52 weeks.
Yesterday close
The closing price of previous day may differ from opening price of the following day.
Trading Volume
The number of shares, bonds or contracts traded during a given period, for a security or an
entire exchange. The money amount of trade is trade value while the unit amount is number of
trades. On the other hand Hawla indicates how many times the trade took place, no matter the
quantity or volume.
Premium
The amount by which a bond or stock sells above its par value or the amount by which the first
trading of an IPO exceeds its offering price opposite of discount.
OTC
A security which is not traded on an exchange, usually due to an inability to meet listing
requirements. For such securities, broker/dealers negotiate directly with one another over
computer networks and by phone, and their activities are monitored by the NASD. OTC stocks
are usually very risky since they are the stocks that are not considered large or stable enough to
trade on a major exchange. They also tend to trade infrequently, making the bid-ask spread
larger. Also, research about these stocks is more difficult to obtain.
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Shareholding structure
The combination of different types of shareholders and proportion of their holdings, such as
institutional share holders, sponsor directors, govt. public etc.
Benefits
Dividend
Distribution of earnings to shareholders prorated by the class of security and paid in the form of
money, stock, scrip, or, rarely, company products or property. The amount is decided by the
Board of Directors and is usually paid quarterly. Mutual fund dividends are paid out of income,
usually on a quarterly basis from the fund's investments.
Stock Dividend
Payment of a corporate dividend in the form of stock rather than cash. The stock dividend may
be additional shares in the company, or it may be shares in a subsidiary being spun off to
shareholders. Stock dividends are often used to conserve cash needed to operate the business.
Unlike a cash dividend, stock dividend is not taxed until sold.
What is bonus share and its record date
Bonus shares are free shares issued by the company to its existing share holders. Bonus shares
are issued in a ratio of the shares an investor hold. For example when a company offers 1:5
bonus shares, it means a share holder will get 1 free share for 5 shares. So if an investor holds
100 shares at the time of bonus then they will become 120 shares.
Bonus shares are usually announced by the company with a record date, the date which is
considered for the bonus shares. All the investors holding the shares on the record date are
eligible for bonus shares. Company usually gives bonus shares as a substitute of dividend
payouts. The face value of the share doesn’t get change after bonus. This is unlike stock split.
Bonus shares increases the number of shares in the market which changes the Earning Per
Share EPS (companies net profit / number of shares). As net profit is still remain same and the
numbers of shares are higher, shares EPS goes down after the bonus shares are issued. Ideally it
should reduce the share price but it doesn’t happen in the ratio of shares are offered as bonus
shares thus it usually in the profit of the share holders. This happens because of increase in
liquidity of the share and signal of company’s promise to share its profit with its investors.
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Cash Dividend
Payment of a corporate dividend in the form of cash. Cash dividend are taxable, generally 10%
in Bangladesh. A company pays out cash if there is a risk of free cash flow problem. It is paid on
face value of the share. Example: The market price of BATBC is tk 550 and its face value is tk 10.
If it pays 430% cash dividend then the owner of the stock will get tk 43 per share. 430% cash
dividend 0f tk 10.
Interim Dividend
A dividend which is declared and distributed before the company's annual earnings have been
calculated; often distributed quarterly.
Stock Split
An increase in the number of outstanding shares of a company's stock, such that proportionate
equity of each shareholder remains the same. This requires approval from the board of
directors and shareholders. A corporation whose stock is performing well may choose to split
its shares, distributing additional shares to existing shareholders. The most common stock split
is two-for-one, in which each share becomes two shares. The price per share immediately
adjusts to reflect the stock split, since buyers and sellers of the stock all know about the stock
split (in this example, the share price would be cut in half). Some companies decide to split their
stock if the price of the stock rises significantly and is perceived to be too expensive for small
investors to afford.
Record Date
Date, set by the issuing company, on which an individual must own shares in order to be eligible
to receive a declared dividend, right or capital gains distribution.
Market Lot
Multiple shares held or traded together, usually in units of 100, or 50 or 250 0r 500 etc.
Face Value
The nominal amount assigned to a security by the issuer. For an equity security, face value is
usually a very small amount that bears no relationship to its market price, except for preferred
stock, in which case face value is used to calculate dividend payments. For a debt security, face
value is the amount repaid to the investor when the bond matures (usually, corporate bonds
have a face value of 1000). In the secondary market, a bond's price fluctuates with interest
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rates. If interest rates are higher than the coupon rate on a bond, the bond will be sold below
face value (at a "discount"). If interest rates have fallen, the price will be sold above face value.
Market capitalization
Market capitalization represents the aggregate value of a company or stock. It is obtained by

multiplying the number of shares outstanding by their current price per share. For example, if
XYZ Company has 15,000,000 shares outstanding and a share price of tk20 per share then the
market capitalization is 15,000,000 x 20 = 300,000,000.
Right Issue
New stock (share) issue offered to existing stockholders (shareholders) in proportion to their
current stock/shareholding, for a specified period and at a specified (usually discounted) price.
Its objective is to afford them the opportunity to maintain their percentage of ownership of the
firm.
Ownership
Ultimate and exclusive right (conferred by a lawful claim or title, and subject to certain
restrictions) to enjoy, occupy, possess, rent, sell (fully or partially), use, give away, or even
destroy an item of property. Ownership may be 'corporeal' (title to a tangible object such as a
house) or 'incorporeal' (title to an intangible something, such as a copyright, or a right to
recover debt). Possession (as in tenancy) does not necessarily mean ownership because it does
not automatically transfer title.
Stock buyback
A strategy employed by companies in which they re-purchase their stock on the open market. A
stock buyback can insert upward price pressure on a security because it reduces the supply of
available shares.
EGM
Any formal meeting of shareholders, held between two annual general meetings (AGM), called
by the directors or shareholders cumulatively holding ten-percent or more of the voting rights
AGM
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AGM is an annual meeting of all shareholders of a company, when the company's financial
situation is presented by and discussed with the directors, when the accounts for the past year
are approved and when dividends are declared and audited.
Capital Gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds
or real estate, which exceeds the purchase price. It is the difference between a higher selling
price and a lower purchase price, resulting in a financial gain for the investor. Conversely, a
capital loss arises if the proceeds from the sale of a capital asset are less than the purchase
price.
Capital gains may refer to "investment income" that arises in relation to real assets, such as
property; financial assets, such as shares/stocks or bonds; and intangible assets such as
goodwill.
Many countries impose a tax on capital gains of individuals or corporations, although relief may
be available to exempt capital gains: in relation to holdings in certain assets such as significant
common stock holdings, to provide incentives for entrepreneurship, or to compensate for the
effects of inflation.
Voting Power
The right to exercise vote for decision making in a company is voting power.
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LECTURE – 05
UNDERSTANDING ANNUAL REPORT & FINANCIAL STATEMENTS
To understand the Annual Report we need to know
 Various massage & reports

 Balance Sheet
 Income Statements
 Cash flow
 Owners equity
Massage & Reports
In the beginning of an annual report there are some massage and report from the management
of the company which indicate the future steps from the management team that bring the
future growth of the company. We need to understand those first. Those massage & Report can
be –
 Chairman’s massage
 Directors’ report
 Auditor’s report
Here we illustrate some of those to show the importance, first an example of chairman’s
massage than the director’s report and finally the auditor’s report. We took Tisas gas’s annual
report for the year 2009-2010 to illustrate the massage & report.
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Balance Sheet
A balance sheet summarizes an organization or individual's assets, equity and liabilities at a
specific point in time. Individuals and small businesses tend to have simple balance sheets.
Larger businesses tend to have more complex balance sheets, and these are presented in the
organization's annual report. Large businesses also may prepare balance sheets for segments of
their businesses. A balance sheet is often presented alongside one for a different point in time
(typically the previous year) for comparison.
Components:
Assets
Assets provide probable future economic benefits controlled by an entity as a result of previous
transactions. Assets can be created by operating activities (e.g., generating net income),
investing activities (e.g., purchasing manufacturing equipment), and financing activities (e.g.,
issuing debt).
Common Balance Sheet Asset Accounts
Cash and equivalents
Accounts receivable (trade receivables)
Inventory
Prepaid expenses
Investments
Property, plant, and equipment
Intangible assets
Deferred tax assets
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Pension assets
Liabilities:
Liabilities are obligations owed by an entity from previous transactions that are expected to
result in an outflow of economic benefits in the future. Liabilities are created by financing
activities (e.g., issuing debt) and operating activities (e.g., recognizing expense before payment
is made).
Common Balance Sheet Liability Accounts
Accounts payable (trade payables)
Accrued expenses
Unearned revenue
Notes payable
Bonds payable
Capital (financial) lease obligations
Pension liabilities
Deferred tax liabilities
Stockholders' equity
Stockholders' equity is the residual interest in assets that remains after subtracting a firm's
liabilities. Stockholders' equity is also referred to as "shareholders' equity" and "owners'
equity," or sometimes just "equity" or "net assets." Equity is created by financing activities (e.g.,
issuing capital stock) and by operating activities (e.g., generating net income).
Common Balance Sheet Equity Accounts
Capital stock
Additional paid-in-capital (capital in excess of par)
Treasury stock
Retained earnings
Accumulated other comprehensive income
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Presentation formats:
There is no standardized balance sheet format. However, two common formats are the
Account format and the Report format. Just like the balance sheet equation, an account format
is a layout in which assets are presented on the left hand side of the page and liabilities and
equity are presented on the right hand side. In a report format, the assets, liabilities, and equity
are presented in single column.
A classified balance sheet groups together similar items to arrive at significant Subtotals. For example,
current assets are grouped together and current liabilities are grouped together. Similarly, noncurrent
assets are grouped together, as are noncurrent liabilities.
Assets & Liability Terminology:
Current and Noncurrent Assets:
Current assets include cash and other assets that will likely be converted into cash or used up within one
year or one operating cycle, whichever is greater. The operating cycle is the time it takes to produce or
purchase inventory, sell the product, and collect the cash. Current assets are usually presented in the
order of their liquidity, with cash being the most liquid. Current assets reveal information about the
operating activities of the firm.
Noncurrent assets do not meet the definition of current assets because they will not be converted into
cash or used up within one year or operating cycle. Noncurrent assets provide information about the
firm's investing activities, which form the foundation upon which the firm operates.
Current and Noncurrent Liabilities:
Current liabilities are obligations that will be satisfied within one year or one operating cycle, whichever
is greater. More specifically, a liability that meets any of the following criteria is considered current:
1. Settlement is expected during the normal operating cycle.
2. Settlement is expected within one year.
3. There is not an unconditional right to defer settlement for more than one year.
Current assets minus current liabilities equal working capital. Not enough working capital may indicate
liquidity problems. Too much working capital may be an indication of inefficient use of assets.
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Noncurrent liabilities do not meet the criteria of current liabilities. Noncurrent liabilities
provide information about the firm's long-term financing activities.
Tangible Assets:
Long-term assets with physical substance are known as tangible assets. Tangible assets, such as
plant, equipment, and natural resources, are reported on the balance sheet at historical cost
less accumulated depreciation or depletion. Historical cost includes the original cost of the
asset plus all cost necessary to get the asset ready for use (e.g. freight and installation).
Land is also a tangible asset that is reported at historical cost. However, land is not depreciated.
Tangible assets not used in the operations of the firm should be classified as investment assets.
Intangible Assets:
Intangible assets are long-term assets that lack physical substance. Financial securities are not
considered intangible assets. The value of an identifiable intangible asset is based on the rights
or privileges conveyed to its owner over a finite period. Accordingly, the cost of an identifiable
intangible asset is amortized over its useful life. Examples of identifiable intangibles include
patents, trademarks, and copyrights. Note, however, that the value of internally produced
intangible assets may not be recorded on the balance sheet.
An intangible asset that is unidentifiable cannot be purchased separately and may have an
infinite life. Intangible assets with infinite lives are not amortized, but are tested for impairment
at least annually. The best example of an unidentifiable intangible asset is goodwill.
Owners' equity Terminology:
Contributed capital:
Is the total amount paid in by the common and preferred shareholders. Preferred shareholders
have certain rights and privileges not possessed by the common shareholders. For example,
preferred shareholders are paid dividends at a specified rate, usually expressed as a percentage
of their par values, and have priority over the claims of the common shareholders in the event
of liquidation.
The par value of common stock and preferred stock is a "stated" or "legal" value. Par value has
no relationship to fair value. Some common shares are even issued without a par value. When
par value exists, it is reported separately in stockholders' equity. Also disclosed is the number of
common shares that are authorized, issued, and outstanding. Authorized shares are the
number of shares that may be sold under the firm's articles of incorporation. Issued shares are
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the number of shares that have actually been sold to shareholders. The number of outstanding
shares is equal to the issued shares less shares that have been reacquired by the firm (i.e.,
treasury stock).
Minority interest:
Minority interest (non controlling interest) is the minority shareholders' pro-rata share of the
net assets (equity) of a subsidiary that is not wholly owned by the parent.
Retained earnings:
Are the undistributed earnings (net income) of the firm since inception, the cumulative
earnings that have not been paid out to shareholders as dividends.
Treasury stock:
Is stock that has been reacquired by the issuing firm but not yet retired. Treasury stock reduces
stockholders' equity. It does not represent an investment in the firm. Treasury stock has no
voting rights and does not receive dividends.
Accumulated other comprehensive income:
Includes all changes in stockholders' equity except for transactions recognized in the income
statement (net income) and transactions with shareholders, such as issuing stock, reacquiring
stock, and paying dividends.
Comprehensive income aggregates net income and certain special transactions that are not
reported in the income statement but that affect stockholders' equity. These special
transactions comprise what is known as "other comprehensive income." Comprehensive
income is equal to net income plus other comprehensive income.
It is easy to confuse the two terms "comprehensive income" and "accumulated other
comprehensive income." Comprehensive income is an income measure over a period of time. It
includes net income and other comprehensive income for the period. Accumulated other
comprehensive income does not include net income but is a component of stockholders' equity
at a point in time.
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Specimen of the Balance sheet
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Income Statement
The income statement reports the revenues and expenses of the firm over a period of time. The
income statement is sometimes referred to as the "statement of operations, “the "statement of
earnings," or the "profit and Joss statement." The income statement
Equation is:
Revenues - Expenses = Net income
Investors examine a firm's income statement for valuation purposes while lenders examine the
income statement for information about the firm's ability to make the promised interest and
principal payments on its debt.
Components:
Revenues
are the amounts reported from the sale of goods and services in the normal course of business.
Revenue less adjustments for estimated returns and allowances is known as net revenue.
Expenses
Are the amounts incurred to generate revenue and include cost of goods sold, operating
expenses, interest, and taxes. Expenses are grouped together by their nature or function.
Presenting all depreciation expense from manufacturing and administration together in one
line of the income statement is an example of grouping by nature of the expense. Combining all
costs associated with manufacturing (e.g., raw materials, depreciation, labor. etc.) as cost of
goods sold is an example of grouping by function.
Gains and losses
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Are the amounts which result from incidental transactions outside the firm's primary business
activities. For example a firm might sell surplus equipment used in its manufacturing operation
that is no longer needed. The difference between the sales price and book value is reported as
a gain or loss on the income statement.
Presentation formats
A firm can present its income statement using a single-step or multi-step format. In a single-
step statement, all revenues are grouped together and all expenses are grouped together. A
multi-step format includes subtotals such as gross profit and operating profit.
Example of a multi-step income statement format for the XYZ Company.
XYZ Supply Company

Income Statement(Multi-step)
For the year ended 31 december,200X
Revenue 5579,312
Cost of goods sold (362,520)
Gross profit 216,792
Selling, general. and administrative expense (109,560)
Depreciation expense (69,008)
Operating profit 38,224
Interest expense (2,462)
Income before tax 35,762
Provision for income Taxes (14,305)
Income from continuing operations 21,457
Earnings (losses) from discontinued operation, net of tax 1,106
Net income 22,563
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Example of a single-step income statement format for the XYZ Company.
XYZ Supply Company

Income Statement(Single-step)
Revenues
Landscaping fees 20,075
Finance charge income 100
Total Revenue 20,175
Expenses
Auto expenses 2200
Commission and fees expenses 6000
Dues and subscription expenses 600
Insurance Expenses 250
Total expenses 11,125
Net Income 9050
Gross profit is the amount that remains after the direct cost of producing a product or service is
subtracted from revenue. Subtracting operating expenses, such as selling, general, and
administrative expenses, from gross profit results in another subtotal known as operating profit
or operating income. For nonfinancial firms, operating profit is profit before financing costs and
income taxes are considered and before non-operating items are considered. Subtracting
interest expense (Operating expense for financial firms) and income taxes from operating profit
results in the firm's net income, sometimes referred to as "earnings" or the "bottom line”
If a firm has a controlling interest in a subsidiary. the pro-rata share of the subsidiary's income
for the portion of the subsidiary that the firm does not own is reported in the parent's income
statement as the minority owners' interest. This is subtracted since a controlling interest means
the subsidiary’s entire net income is included in the firm's Income statement.
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Specimen of Income Statement
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Cash Flow Statement

The cash flow statement provides information beyond that available from the income
statement, which is based on accrual, rather than cash, accounting. The cash flow statement
provides the following:
1. Information about a company's cash receipts and cash payments during an accounting
period.
2. Information about a company's operating, investing, and financing activities.
3. An understanding of the impact of accrual accounting events on cash flows.
The cash flow statement provides information to assess the firm's liquidity, solvency, and
financial flexibility. An analyst can use the statement of cash flows to determine whether:
1. Regular operations generate enough cash to sustain the business.

2. Enough cash is generated to pay off existing debts as they mature.
3. The firm is likely to need additional financing.
4. Unexpected obligations can be met.
5. The firm can take advantage of new business opportunities as they arise.
Components:
Items on the cash flow statement come from two sources: (l) income statement items and (2)
changes in balance sheet accounts. A firm's cash receipts and payments are classified on the
cash flow statement as operating, investing, or financing activities.
Cash flow from operating activities (CFO)
Sometimes referred to as "cash flow from operations" or "operating cash flow," consists of the inflows
and outflows of cash resulting from transactions that affect a firm's net income.
Inflows Outflows
Cash collected from customers Cash paid to employees and suppliers
Interest and dividends received Cash paid for other expenses
Sale proceeds from trading securities Acquisition of trading securities
Interest paid
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Taxes paid
Cash flow from investing activities (CFI)
Consists of the inflows and outflows of cash resulting from the acquisition or disposal of long term assets
and certain investments.
Inflows Outflows
Sale proceeds from fixed assets Acquisition of fixed assets
Sale proceeds from debt & equity investments Acquisition of debt & equity investments
Principal received from loans made to others Loans made to others
Cash flow from financing activities (CFF)
Consists of the inflows and outflows of cash resulting from transactions affecting a firm's capital
structure.
Inflows Outflows
Principal amounts of debt issued Principal paid on debt
Proceeds from issuing stock Payments to reacquire stock
Dividends paid to shareholders
Presentation Formats:
There are two methods of presenting the cash flow statement: the direct method and the
indirect method. The difference in the two methods relates to the presentation of cash flow
from operating activities. The presentation of cash flows from investing activities and financing
activities is exactly the same under both methods.
Direct Method
Under the direct method, each line item of the accrual-based income statement is converted
into cash receipts or cash payments. Recall that under the accrual method of accounting, the
timing of revenue and expense recognition may differ from the timing of the related cash flows.
Under cash-basis accounting, revenue and expense recognition occur when cash is received or
paid. Simply stated, the direct method converts an accrual-basis income statement into a cash-
basis income statement.
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Direct Method of Presenting Operating Cash Flow:
XYZ Supply Company

Operating Cash Flow(Direct Method)
Cash collections from customers $429,980
Cash paid to suppliers (265,866)
Cash paid for operating expenses (124,784)
Cash paid for interest (4,326)
Cash paid for taxes (14,956)
Operating cash How $20,048
The direct method begins with cash inflows from customers and then deducts cash outflows for
purchases, operating expenses, interest, and taxes.
Indirect Method
Under the indirect method, net income is converted to operating cash flow by making
adjustments for transactions that affect net income but are not cash transactions, These
adjustments include eliminating noncash expenses (e.g.. depreciation and amortization). non
operating items (e.g. gains and losses). And changes in balance sheet accounts resulting from
accrual accounting events.
Indirect Method of Presenting Operating Cash Flow:
XYZ Supply Company

Operating Cash Flow(Indirect Method)
Net income 518,788
Adjustments to reconcile net income to cash
flow provided by operating activities:
Depreciation and amortization 7,996
Deferred income taxes 416
Increase in accounts receivable (1220)
Increase in inventory (20,544)
Decrease in prepaid expenses 494
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Increase in accounts payable 13,406

Increase in accrued liabili ties 712
Operating cash flow 520,048
Under the indirect method, the starting point is net income, the "bottom line" of the income
statement. Under the direct method the starting point is the top of the income statement,
revenues, adjusted to show cash received from customers. Total cash flow from operating
activities is exactly the same under both methods, only the presentation methods differ.
Specimen of Cash flow statement
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Statement of Owner's Equity

The statement of changes in stockholders' equity summarizes all transactions that increase or
decrease the equity accounts for the period. The statement includes transactions with
shareholders, and a reconciliation of the beginning and ending balance of each equity account,
including capital stock, additional paid-in-capital, retained earnings, and accumulated other
comprehensive income. In addition, the components of accumulated other comprehensive
income are disclosed (i.e., unrealized gains and losses from available-for-sale securities, cash
flow hedging derivatives, foreign currency translation, and adjustments for minimum pension
liability).
Steps to preparation:
1. Determine the ending balance of statement of owner's equity for the last accounting
period. This figure serves as your beginning balance for the current accounting period.
2. Calculate net income by subtracting the amount of money spent on expenses to generate
revenue from organization's operations.
3. Determine how much money was retained by the organization for investment. Capital
investments such as machinery, equipment and the like are all considered assets for the
organization if such investment will be used to generate income.
4. Calculate how much money was withdrawn from the owner's equity account. In general,
the owner's equity account is an owner's claim on profits. Higher balances in owner's
equity accounts may correlate to low debt levels and may be a sign of the good
financial health of an organization. Withdrawals from the owner's equity account for
personal use or as dividend payments may affect the ending equity balance that appears
on the statement of owner's equity at the end of the accounting period.
5. Calculate the ending balance for the statement of owner's equity. Calculate the
difference between investment and withdrawals from the owner's equity account. Take
this figure and add it to income and the beginning equity balance. See the formula
below:
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Ending equity balance =

beginning equity balance + investments – withdrawals + income
Common Accumulated Total

Retained
Stock other
Earnings (in
comprehensive
housands)
Income(loss)
Beginning balance $49,234 $26,664 ($406) $75,492
Net income 6,994 6,994
(40) (40)
Net unrealized loss
on available- for-
sale securities
(56) (56)
Net unrealized loss
on cash flow
hedges
Minimum pension (26) (26)
liability
42 42
Cumulative
translation
adjustment
Comprehensive 6,914
income
Issuance of 1,282 1,282

common stock
Repurchases of (6,200) (6,200)

common stock
Dividends (2,360) (2,360)
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Ending balance $44,316 $31,298 $(486) $75,128
Specimen of Statement of Owner’s equity
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LECTURE – 06
UNDERSTANDING ANNUAL REPORT & FINANCIAL STATEMENT
Ratio Analysis
A tool used by individuals to conduct a quantitative analysis of information in a company's

financial statements. Ratios are calculated from current year numbers and are then compared
to previous years, other companies, the industry, or even the economy to judge the
performance of the company. Ratio analysis is predominately used by proponents of
fundamental analysis.
Ratio Analysis enables the business owner/manager to spot trends in a business and to
compare its performance and condition with the average performance of similar businesses in
the same industry. To do this compare your ratios with the average of businesses similar to
yours and compare your own ratios for several successive years, watching especially for any
unfavorable trends that may be starting. Ratio analysis may provide the all-important early
warning indications that allow you to solve your business problems before your business is
destroyed by them.
A ratio is a mathematical relation between one quantity and another. Suppose you have 200
apples and 100 oranges. The ratio of apples to oranges is 200 / 100, which we can more
conveniently express as 2:1 or 2. A financial ratio is a comparison between one bit of financial
information and another. Consider the ratio of current assets to current liabilities, which we
refer to as the current ratio. This ratio is a comparison between assets that can be readily
turned into cash -- current assets -- and the obligations that are due in the near future -- current
liabilities. A current ratio of 2:1 or 2 means that we have twice as much in current assets as we
need to satisfy obligations due in the near future.
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Ratios can be classified according to the way they are constructed and their general
characteristics. By construction, ratios can be classified as a Activity ratio, a Liquidity ratio, a
Solvency ratio, a Profitability ratio and Valuations ratio:
Financial
Ratio
Activity Liquidity Solvency Profitability Valuations

Ratio Ratio Ratio Ratio Ratio
Receivable Current Ratio Debt to Equity Net profit Earnings per

turnover margin Share (Basic)
Days of sales Quick ratio Gross profit

Debt to capital Earnings per
Outstanding margin share
(Diluted)
Inventory Cash ratio Operating profit

Debt to Assets Price earning
turnover margin
(P/E) ratio
Days of Defensive Pretax Margin

Financial Dividend
inventory on Interval
Leverage payout ratio
hand
Payables Cash Interest Return on Dividend yield

turnover conversion coverage ratio Assets
cycle
Number of
Fixed charge Operating
days of
coverage return on Assets
payables
Total asset Return on Total

Cash flow to
turnover
debt ratio Capital 167
Fixed
Working
asset Return on
turnover
capital common
Equity
equity
turnover
XYZ Company Ltd
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Balance Sheet
XYZ Company Ltd
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Income Statement
167
XYZ Company Ltd
Cash Flow Statement
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Activity ratio
Activity ratios are measures of how well assets are used. Activity ratios -- which are, for the
most part, turnover ratios -- can be used to evaluate the benefits produced by specific assets,
such as inventory or accounts receivable. Or they can be use to evaluate the benefits produced
by all a company's assets collectively.
These measures help us gauge how effectively the company is at putting its investment to work.
A company will invest in assets – e.g., inventory or plant and equipment – and then use these
assets to generate revenues. The greater the turnover, the more effectively the company is at
producing a benefit from its investment in assets. The most common turnover ratios are the
following:
1. Receivable turnover
Accounts receivable turnover is the ratio of net credit sales to accounts receivable. This ratio
indicates how many times in the period credit sales have been created and collected on. it is
considered desirable to have a receivable turnover figure close to the industry norm.
Receivable turnover = Annual Sales/Average receivables
=24,623/ ((798+615)/2)
=34.9 Times
2. Days of sales Outstanding
The inverse of the receivables turnover times 365 is the average collection period, or days of
sales outstanding, which is the average number of days it takes for the company's customers to
pay their bills:
Days of sales Outstanding = 365/ Receivable turnover

=365/34.9
=10.5 Days
It is considered desirable to have a collection period (and receivables turnover) close to the
industry norm. The firm's credit terms are another important benchmark used to interpret this
ratio. A collection period that is too high might mean that customers are too slow in paying
their bills, which means too much capital is tied up in assets. A collection period that is too low
might indicate that the firm's credit policy is too rigorous, which might be hampering sales.
Comments: To deter-mine whether these receivable collection numbers are good or bad, it is
essential that they be related to the firm’s credit policy and to comparable collection figures for
other firms in the industry. The point is, the receivable collection period value varies
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dramatically for different firms (e.g., from 10 to over 60) and it is mainly due to the product and
the industry.
3. Inventory turnover
A measure of a firm's efficiency with respect to its processing and inventory management is
inventory turnover:
Inventory turnover=Cost of goods sold/Average Inventory

=18,049/ ((3482+2831)/2)
= 5.7 Times
This ratio indicates how many times inventory is created and sold during the period. For
inventory turnover, be sure to use cost of goods sold as enumerator not sales.
4. Days of inventory on hand
The inverse of the inventory turnover times 365 is the average inventory processing period, or
days of inventory on hand:
Days of inventory on hand = 365/ Inventory turnover

=365/5.7
=64 Days
Comments: As is the case with accounts receivable, it is considered desirable to have days of
inventory on hand (and inventory turnover) close to the industry norm. A processing period
that is too high might mean that too much capital is tied up in inventory and could mean that
the inventory is obsolete. A processing period that is too low might indicate that the firm has
inadequate stock on hand, which could hurt sales.
5. Payables turnover
A measure of the use of trade credit by the firm is the payables turnover ratio
Payables turnover = Purchases or COGS/Average trade payables

=18,049/ ((1547+1364)/2)
=12.4 Times
6. Number of days of payables
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The inverse of the payables turnover ratio multiplied by 165 is the payables
payment period or number of days of payables, which is the average amount of
times it takes the company to pay its bills
Number of days of payables = 365/ Payables turnover
=365/12.4
=29 Days
Note: We have shown day’s calculation for payables, receivables, and inventory based on
annual turnover and a 365-day a year. If turnover ratios are for a quarter rather than a year, the
number of days in the quarter should be divided by the quarterly turnover ratios in order to get
the "days” from of these ratios.
7. Total asset turnover
The effectiveness of the firm's use of its total assets to create revenue is measured by its total
asset turnover:
Total asset turnover=Revenue/Average total assets
=24,623/ ((8834+7104)/2)
=3.09 Times
Comments: Different types of industries might have considerably different turnover ratios.
Manufacturing businesses that are capital-intensive might have asset turnover ratios near one,
while retail businesses might have turnover ratios near 10. As was the case with the current
asset turnover ratios discussed previously, it is desirable for the total asset turnover ratio to be
close to the industry norm. Low asset turnover ratios might mean that the company has too
much capital tied up in its asset base. A turnover ratio that is too high might imply that the firm
has too few assets for potential sales, or that the asset base is outdated.
8. Fixed asset turnover
The utilization of fixed assets is' measured by the fixed asset turnover ratio
Fixed asset turnover=Revenue/Average net fixed assets
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=24623/ ((4345+3428)/2)
=6.3 Times
Comments: As was the case with the total asset turnover ratio, it is desirable to have a fixed
asset turnover ratio close to the industry norm. Low fixed asset turnover might mean that the
company has too much capital tied up in its asset base or is using the assets it has inefficiently.
A turnover ratio that is too high might imply that the firm has obsolete equipment, or at a
minimum, that the firm will probably have to incur capital expenditures in the near future to
increase capacity to support growing revenues. Since "net" here refers to net of accumulated
depreciation, firms with more recently acquired assets will typically have lower fixed asset
turnover ratios.
9. Working capital turnover
How effectively a company is using its working capital is measured by the working capital
turnover ratio.
Working capital turnover=Revenue/Average working capital
=24623/ ((1292+1246)/2)
=19.40
Comments: Working capital (sometimes called net working capital) is current assets minus
current liabilities. The working capital turnover ratio gives us information about the utilization
of working capital in terms of dollars of sales per dollar of working capital. Some firms may have
very low working capital if outstanding payables equal or exceed inventory and receivables. In
this case the working capital turnover ratio will be very large, may vary significantly from period
to period, and is less informative about changes in the firm's operating efficiency.
Liquidity Ratio
Liquidity ratios provide a measure of a company’s ability to generate cash to meet its
immediate needs. Its ability to turn short-term assets into cash to cover debts is of the utmost
importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators
frequently use the liquidity ratios to determine whether a company will be able to continue as a
going concern. There are three commonly used liquidity ratios.
1. Current Ratio
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The current ratio is the best-known measure of liquidity
Current Ratio=Current Assets/Current Liabilities
=4304/3012
=1.42
Comments: The higher the current ratio, the more likely it is that the company will be able to
pay its short-term bills. A current ratio of less than one means that the company has negative
working capital and is probably facing a liquidity crisis. Working capital equals current assets
minus current liabilities.
2. Quick ratio
The quick ratio is a more stringent measure of liquidity because it does not include inventories
and other assets that might not be very liquid.
Quick ratio= cash + marketable securities + receivables/ current liabilities
= 815/3012
= 0.27
Comments: The higher the quick ratio, the more likely it is that the company will be able to pay
its short-term bills. Marketable securities are short-term debt instruments, typically liquid and
of good credit quality. As before, you should compare these values relative to other firms in the
industry and to the aggregate economy. When possible, you should question management
regarding the reason for these relatively low liquidity ratios (e.g., small receivables due to heavy
cash sales?).
3. Cash ratio
The most conservative liquidity measure is the cash ratio
Cash ratio= cash + marketable securities/ Current Liabilities
= 17/3012
= .01
Comments: The higher the cash ratio, the more likely it is that the company will be able to pay
its short-term bills. The cash ratios during the years have been quite low and they would be
cause for concern except that such cash ratios are typical for a fast-growing retailer with larger
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inventories being financed by accounts payable to its suppliers. In addition, the firm has strong
lines of credit available on short notice at various banks. Still, as an investor, you would want to
confirm how the firm can justify such a low ratio and how it is able to accomplish this.
The current, quick, and cash ratios differ only in the assumed liquidity of the current assets that
the analyst projects will be used to pay off current liabilities.
4. Defensive Interval
The defensive interval ratio is another measure of liquidity that indicates the number of days of
average cash expenditures the firm could pay with its current liquid assets.
Defensive Interval= cash + marketable securities + receivables/ average daily expenditures
Expenditures here include cash expenses for costs of goods, SG&A, and research and
development. If these items are taken from the income statement, noncash charges such as
depreciation should be added back just as in the preparation of a statement of cash flows by
the indirect method.
5. Cash conversion cycle
The cash conversion cycle is the length of time it takes to turn the firm's cash investment in
inventory back into cash, in the form of collections from the sales of that inventory. The cash
conversion cycle is computed from day’s sales outstanding, days of inventory on hand, and
number of days of payables.
Cash conversion cycle = Days of sales outstanding + Days of Inventory on hand - Number of
days of payables
= 10+64-29
= 45 Days
Comments: High cash conversion cycles are considered undesirable. A conversion cycle that is
too high implies that the company has an excessive amount of capital investment in the sales
process. To determine standard cash conversion cycle it should be compared with industry
norm as it varies industry to industry.
Solvency Ratios
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1. Debt to Equity
A measure of the firm's use of fixed-cost financing sources is the debt-to-equity ratio.
Debt to Equity= Total Debt/ Total Share holders’ Equity
= (478+137+6710)/5207
= 140.68%
Comments: Increases and decreases in this ratio suggest a greater or lesser reliance on debt as
a source of financing. Total debt is calculated differently by different analysts and different
providers of financial information. Here, we will define it as long-term debt plus interest-
bearing short-term debt. A lower the percentage means that a company is using less leverage
and has a stronger equity position.
2. Debt to capital
Another way of looking at the usage of debt is the debt-to-capital ratio
Debt to capital= Total debt/ total debt +total shareholders' equity
= 3627/ (3627+5207)
= 41.06%
Comments: Capital equals all long-term debt plus preferred stock and equity. Increases and
decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing.
3. Debt to Assets
A slightly different way of analyzing debt utilization is the debt-to-assets ratio
Debt to Assets= Total debt/Total Assets
= 3627/8834
=41.06%
Comments: Increases and decreases in this ratio suggest a greater or lesser reliance on debt as
a source of financing.
4. Financial Leverage
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Another measure that is used as an indicator of a company's use of debt financing is the
financial leverage ratio (or leverage ratio)
Financial Leverage= Average total assets/Average total liabilities
= 7969/3249
= 2.45%
Comments: Average here means the average of the values at the beginning and at the end of
the period. Greater use of debt financing increases financial leverage and typically, risk to
equity holders and bondholders alike.
5. Interest coverage ratio
The remaining risks ratios help determine the firm's ability to repay its debt obligations. The
first of these is the interest coverage ratio
Interest coverage ratio= earnings before interest and taxes/ Interest payments
= 886+537+ (3+461)/(3+461)
= 4.07 Times
Comments: The lower this ratio, the more likely it is that the firm will have difficulty meeting
its debt payments. When a company's interest coverage ratio is only 1.5 or lower, its ability to
meet interest expenses may be questionable.
6. Fixed charge coverage
A second ratio that is an indicator of a company's ability to meet its obligations is the fixed
charge coverage ratio.
Fixed charge coverage= earnings before interest and taxes + lease payments/ Interest
payments + lease payments
= (1398+461)/ (3+461)
= 4.01 Times
Comments: Here, lease payments are added back co operating earnings in the numerator and
also added to interest payments in the denominator. Significant lease obligations will reduce
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this ratio significantly compared to the interest coverage ratio. Fixed charge coverage is the
more meaningful measure for companies that lease a large portion of their assets, such as
some airlines.
7. Cash flow to debt ratio
This coverage ratio compares a company's operating cash flow to its total debt, which, for
purposes of this ratio, is defined as the sum of short-term borrowings, the current portion of
long-term debt and long-term debt. This ratio provides an indication of a company's ability to
cover total debt with its yearly cash flow from operations.
Cash flow to debt ratio= Operating cash flow/Total debt
= 719/3627
= 19.82%
Comments: The higher the percentage ratio, the better the company's ability to carry its total
debt.
Profitability ratio
Profitability ratios (also referred to as profit margin ratios) compare components of income
with sales. They give us an idea of what makes up a company's income and are usually
expressed as a portion of each dollar of sales. The objective of margin analysis is to detect
consistency or positive/negative trends in a company's earnings. Positive profit margin analysis
translates into positive investment quality. To a large degree, it is the quality, and growth, of a
company's earnings that drive its stock price. The profit margin ratios we discuss here differ
only by the numerator. It's in the numerator that we reflect and thus evaluate performance for
different aspects of the business:
1. Net profit margin
The net profit margin is the ratio of net income to revenue:
Net profit margin=Net income/ revenue
= 886/24623
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= 3.6%
Comments: Analysts should be concerned if this ratio is too low. The net profit margin should
be based on net income from continuing operations, because analysts should be primarily
concerned about future expectations, and "below the line" items such as discontinued
operations will not affect the company in the future.
2. Gross profit margin
The gross profit margin is the ratio of gross profit (sales less cost of goods sold) to sales:
Gross profit margin= gross profit/Revenue
= 6574/24623
= 26.7%
Comments: This ratio indicates the basic cost structure of the firm. An analysis of this ratio over
time relative to a comparable industry figure shows the firm’s relative cost-price position. As
always, it is important to compare these margins and any changes with the industry and strong
competitors. Analyst should be concerned if this ratio is too low.
3. Operating profit margin
The operating profit margin is the ratio of operating profit (gross profit less selling, general, and
administrative expenses) to sales; Operating profit is also referred to as earnings before interest
and taxes (EBIT):
Operating profit margin= Operating income/revenue
or
EBIT/Revenue
= 1398/24623
= 5.7%
Comments: Strictly speaking, EBIT includes some non operating items, such as gains on
investment. The analyst, as with other ratios with various formulations, must be consistent in
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his calculation method and know how published ratios are calculated. Analysis should be
concerned if this ratio is too low. Some analysts prefer to calculate the operating profit margin
by adding back depreciation and any amortization expense to arrive at earnings before interest,
taxes, depreciation, and amortization (EBITDA).
4. Pretax Margin
Sometimes profitability is measured using earnings before tax (EBT), which can be calculated by
subtracting interest from EBIT or from operating earnings. The pretax margin is calculated as:
Pretax margin= EBT/Revenue
= 1422/24623
= 5.78%
5. Return on Assets
Another set of profitability ratios measure profitability relative to funds invested in the
company by common stockholders, preferred stockholders, and suppliers of debt financing.
The first of these measures is the return on assets (ROA). Typically ROA is calculated using net
income
Return on Assets (ROA) = Net Income/Average total Assets
= 886/7969
= 11.12%
Comments: This measure is a bit misleading, however, because interest is excluded from net
income but total assets include debt as well as equity. Adding interest adjusted for tax back to
net income puts the returns to both equity and debt holders in the numerator. This results in an
alternative calculation for ROA:
Return on Assets (ROA) = net income+ Interest expense (1 – tax rate)/ Average total Assets
= 886+3(1-.375)/7969
= 11.13%
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6. Operating return on Assets
A measure of return on assets that includes both taxes and interest in the numerator is the
operating return on Assets.
Operating return on Assets= Operating income/Average total Assets
or
EBIT/ Average total Assets
=1398/7969
= 17.54%
7. Return on Total Capital
The return on total capital (ROTC) is the ratio of net income before interest Expense to total
capital:
Return on total capital= (Net Income+ Gross Interest expense)/Average total capital
= (886+3)/7969
= 11.2%
Comments: Total capital includes short- and long-term debt, preferred equity, and common
equity Analysts should be concerned if this ratio is too low. Total capital is the same as total
assets. The interest expense that should be added back is gross interest expense, not net
interest expense (which is gross interest expense less interest income). An alternative method
for computing ROTC is to include the present value of operating leases on the balance sheet as
a fixed asset and as a long-term liability. This adjustment is especially important for firms that
are dependent on operating leases as a major form of financing
8. Return on Equity
This ratio indicates how profitable a company is by comparing its net income to its average
shareholders' equity. The return on equity ratio (ROE) measures how much the shareholders
earned for their investment in the company. The higher the ratio percentage, the more efficient
management is in utilizing its equity base and the better return is to investors. The return on
equity (ROE) is the ratio of net income to average total equity (Including preferred stock):
Return on equity=Net income/Average total equity
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=886/(5207+4234)/2
=18.77%
Comments: Analysts should be concerned if this ratio is too low. It is sometimes called return
on total equity.
9. Return on common equity
A similar ratio to the return on equity is the return on common equity:
Return on common equity= (net income - preferred dividends)/ average common equity
or
= net income available to common/ average common equity
= 886/79.5
=11.14
Comments: This ratio differs from the return on total equity in that it only measures the
accounting profits available to, and the capital invested by, common stockholders, instead of
common and preferred stockholders. That is why preferred dividends are deducted from net
income in the numerator. Analysts should be concerned if this ratio is too low.
Cross-sectional analysis
When comparing a firm’s financial ratios to industry ratios, you may not feel comfortable using
the average (mean) industry value when there is wide variation among individual firm ratios
within the industry. Alternatively, you may believe that the firm being analyzed is not typical—
that is, it has a unique component. Under these conditions, a cross-sectional analysis may be
appropriate, in which you compare the firm to a subset of firms within the industry that are
comparable in size or characteristics. As an example, if you were interested in Kroger, you
would want to compare its performance to that of other national food chains rather than some
regional chains or specialty food chains.
Another practical problem with comparing a firm’s ratios to an industry average is that many
large firms are multiproduct and multi-industry in nature. Inappropriate comparisons can arise
when a multi-industry firm is evaluated against the ratios from a single industry. Two
approaches can help mitigate this problem. First, you can use a cross-sectional analysis by
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comparing the firm against a rival that operates in many of the same industries. Second, you
can construct composite industry average ratios for the firm. To do this, the firm’s annual
report or 10-K filing is used to identify each industry in which the firm operates and the
proportion of total firm sales derived from each industry. Following this, composite industry
average ratios are constructed by computing weighted average ratios based on the proportion
of firm sales derived from each industry.
Comparison with Peer companies in the same industry:
Ratio ‘XYZ’ ‘ABC’ ‘MNO’ Industry

Average Average Average Average
Receivable turnover 34.9 Times 32.1 Times 33.2 Times 35 Times
Days of sales Outstanding 10.5 Days 8.2 Days 12.1 Days 15 Days
Inventory turnover 5.7 Times 3.3 Times 9 Days 11 Days
Days of inventory on hand 64 Days 70 Days 50 Days 72 Days
Payables turnover 12.4 Times 9 Times 6.5 Times 15 Times
Number of days of payables 29 Days 40 Days 25 Days 30 Days
Total asset turnover 3.09 Times 2.2 Times 4 Times 5 Times
Fixed asset turnover 6.3 Times 7 Times 8 Times 9.2 Times
Working capital turnover 19.40 15.1 13.2 25.3
Current Ratio 1.42 1.5 1.4 2.2
Quick ratio 0.27 .22 .28 .44
Cash ratio .01 .03 .05 .43
Cash conversion cycle 45 Days 60 Days 65 Days 59 Days
Debt to Equity 140.68% 155.3% 145.33% 160.22%
Debt to capital 41.06% 49.5% 55.2% 49.1%
Debt to Assets 41.06% 45.02% 40.12% 34%
Financial Leverage 2.45% 3.1% 1.85% 2.2%
Interest coverage ratio 4.07 Times 4.44% 3.1% 4.43%
Fixed charge coverage 4.01 Times 5.2 Times 3.77 Times 4.4 Times
Cash flow to debt ratio 19.82% 20.3% 15.3% 13%
Net profit margin 3.6% 4.2% 2.78% 5.2%
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Gross profit margin 26.7% 22.9% 27.5% 30%
Operating profit margin 5.7% 4.6% 3.33% 4.9%
Pretax Margin 5.78% 6.8% 5.2% 7.2%
Return on Assets 11.12% 13.6% 8.22% 15.1%
Operating return on Assets 17.54% 18.3% 20.22% 22.3%
Return on Total Capital 11.2% 9.56% 10.2% 14.39%
Return on Equity 18.77% 15.2% 21.34% 23.5%

Return on common equity 11.14 12.6 9.36 14.22
Time-series analysis
Finally, you should examine a firm’s relative performance over time to determine whether it is
progressing or declining. This time-series analysis is helpful when estimating future
performance. For example, some analysts calculate the average of a ratio for a 5- or 10-year
period without considering the trend. This can result in misleading conclusions. For example, an
average rate of return of 10 percent can be based on rates of return that have increased from 5
percent to 15 percent over time, or it can be based on a series that begins at 15 percent and
declines to 5 percent. Obviously, the difference in the trend for these series would have a major
impact on your estimate for the future. Ideally, you want to examine a firm’s time series of
relative financial ratios compared to its industry and the economy.
Time series analysis of XYZ Company Ltd:
Ratio 2001 2000 1999

Receivable turnover 34.9 Times 31.1 Times 29.2 Times
Days of sales Outstanding 10.5 Days 8.2 Days 7.1 Days
Inventory turnover 5.7 Times 4.3 Times 4 Days
Days of inventory on hand 64 Days 59 Days 50 Days
Payables turnover 12.4 Times 9 Times 7 Times

Number of days of payables 29 Days 25 Days 20 Days
Total asset turnover 3.09 Times 2.2 Times 2 Times
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Fixed asset turnover 6.3 Times 7 Times 8 Times
Working capital turnover 19.40 15.1 13.2
Current Ratio 1.42 1.5 1.4
Quick ratio 0.27 .21 .28
Cash ratio .01 .03 .02
Cash conversion cycle 45 Days 60 Days 35 Days
Debt to Equity 140.68% 130.3% 143.33%
Debt to capital 41.06% 49.5% 35.2%
Debt to Assets 41.06% 45.02% 40.12%
Financial Leverage 2.45% 2.1% 1.85%
Interest coverage ratio 4.07 Times 4.44% 3.1%
Fixed charge coverage 4.01 Times 5.2 Times 3.77 Times
Cash flow to debt ratio 19.82% 20.3% 13.3%
Net profit margin 3.6% 3.2% 2.78%
Gross profit margin 26.7% 22.9% 20.5%
Operating profit margin 5.7% 4.6% 3.33%
Pretax Margin 5.78% 6.8% 5.2%
Return on Assets 11.12% 13.6% 9.22%
Operating return on Assets 17.54% 18.3% 15.22%
Return on Total Capital 11.2% 9.56% 9.2%
Return on Equity 18.77% 15.2% 14.34%
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Return on common equity 11.14 10.6 9.36
LECTURE – 07
BASICS OF ANALYSIS
Economic outlook
Forecasted expectations for how well the economy will perform during an upcoming quarter,
year or other time period. An economic outlook could include expectations for
inflation, productivity growth, unemployment and balance of trade. While we cannot predict
the future perfectly, economic indicators help us understand where we are and where we are
going and also that reflect the economic outlook.
An Economic Indicator is simply any economic statistic, such as the unemployment rate, GDP,
or the inflation rate, which indicates how well the economy is doing and how well the economy
is going to do in the future. If a set of economic indicators suggest that the economy is going to
do better or worse in the future than they had previously expected, they may decide to change
their investing strategy. To understand economic indicators, we must understand the ways in
which economic indicators differ. There are following major attributes each economic indicator
has:
Economic Indicators can have one of three different relationships to the economy:
 Pro-cyclic: A pro-cyclic (or pro-cyclical) economic indicator is one that moves in the
same direction as the economy. So if the economy is doing well, this number is
usually increasing, whereas if we're in a recession this indicator is decreasing. The
Gross Domestic Product (GDP) is an example of a pro-cyclic economic indicator.
 Counter cyclic: A counter cyclic (or counter cyclical) economic indicator is one that
moves in the opposite direction as the economy. The unemployment rate gets larger
as the economy gets worse so it is a counter cyclic economic indicator.
 Acyclic: An acyclic economic indicator is one that has no relation to the health of the
economy and is generally of little use. The number of home runs particular product
generally has no relationship to the health of the economy, so we could say it is an
acyclic economic indicator.
Timing
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Economic Indicators can be leading, lagging, or coincident which indicates the timing of their
changes relative to how the economy as a whole changes.
 Leading: Leading economic indicators are indicators which change before the economy
changes. Stock market returns are a leading indicator, as the stock market usually begins
to decline before the economy declines and they improve before the economy begins to
pull out of a recession. Leading economic indicators are the most important type for
investors as they help predict what the economy will be like in the future.
 Lagged: A lagged economic indicator is one that does not change direction until a few
quarters after the economy does. The unemployment rate is a lagged economic
Indicator as unemployment tends to increase for 2 or 3 quarters after the economy
starts to improve.
 Coincident: A coincident economic indicator is one that simply moves at the same time
the economy does. The Gross Domestic Product is a coincident indicator.
After understanding the difference of the indicator, we can now make our understanding more
accurate by knowing the indicators. Many different groups collect and publish economic
indicators, but the most important Bangladeshi indicators published & updated time to time in
Bangladesh Bank & Bureau of Statistics website and are also available for download. The
indicators fall into seven broad categories:
 Total Output, Income, and Spending

 Employment, Unemployment, and Wages
 Production and Business Activity
 Prices
 Money, Credit, and Security Markets
Each of the statistics in these categories helps create a picture of the performance of the
economy and how the economy is likely to do in the future. Those can be describe as follows
Total Output, Income, and Spending
These tend to be the broadest measures of economic performance and include such statistics
as:
 Gross Domestic Product (GDP)
 Real GDP
 Implicit Price Deflator for GDP (Inflation)
 Business Output
 National Income
 Consumption Expenditure
 Corporate Profits
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The Gross Domestic Product is used to measure economic activity and thus is both pro- cyclical
and a coincident economic indicator. The Implicit Price Deflator is a measure of inflation.
Inflation is pro-cyclical as it tends to rise during booms and falls during periods of economic
weakness. Measures of inflation are also coincident indicators. Consumption and consumer
spending are also pro-cyclical and coincident.
Employment, Unemployment, and Wages
These statistics cover how strong the labor market is and they include the following:
 The Unemployment Rate

 Level of Civilian Employment
 Average Weekly Hours, Hourly Earnings, and Weekly Earnings
 Labor Productivity
The unemployment rate is a lagged, counter cyclical statistic. The level of civilian employment
measures how many people are working so it is pro-cyclic. Unlike the unemployment rate it is a
coincident economic indicator.
Production and Business Activity
These statistics cover how much businesses are producing and the level of new construction in
the economy:
 Industrial Production and Capacity Utilization

 New Construction
 New Private Housing and Vacancy Rates
 Business Sales and Inventories
 Manufacturers' Shipments, Inventories, and Orders
Change in business inventories is an important leading economic indicator as they indicate

changes in consumer demand. New construction including new home construction is another
pro-cyclical leading indicator which is watched closely by investors. A slowdown in the housing
market during a boom often indicates that a recession is coming, whereas a rise in the new
housing market during a recession usually means that there are better times ahead.
Prices
This category includes both the prices consumers pay as well as the prices businesses pay for
raw materials and include:
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 Producer Prices
 Consumer Prices
 Prices Received And Paid By Farmers
These measures are all measures of changes in the price level and thus measure inflation.
Inflation is pro-cyclical and a coincident economic indicator.
Money, Credit, and Security Markets
These statistics measure the amount of money in the economy as well as interest rates and
include:
 Money Stock (M1, M2, and M3)

 Bank Credit at All Commercial Banks
 Consumer Credit
 Interest Rates
 Stock Prices and Yields
Nominal interest rates are influenced by inflation, so like inflation they tend to be pro-cyclical
and a coincident economic indicator. Stock market returns are also pro-cyclical but they are a
leading indicator of economic performance. Governments generally try to stimulate the
economy during recessions and to do so they increase spending without raising taxes. This
causes both government spending and government debt to rise during a recession, so they are
countercyclical economic indicators. They tend to be coincident to the business cycle.
International Trade
These are measure of how much the country is exporting and how much they are importing:
 Industrial Production and Consumer Prices of Major Industrial Countries

 Bangladesh International Trade In Goods and Services
 Bangladesh International Transactions
When times are good people tend to spend more money on both domestic and imported
goods. The level of exports tends not to change much during the business cycle. So the balance
of trade (or net exports) is countercyclical as imports outweigh exports during boom periods.
Measures of international trade tend to be coincident economic indicators.
After the understanding about the economy through the indicator, we can acquire a view about
the future where the economy will go and also the present condition where it is now. But for
the further understanding about the economy we have to understand the term country risk.
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Country Risk
Country risk refers to the risk of investing in a country, dependent on changes in the business
environment that may adversely affect operating profits or the value of assets in a specific
country. For example
 Financial factors: currency controls, devaluation or regulatory changes

 Stability factors: mass riots, civil war and other potential events contribute to
companies' operational risks.
This term is also sometimes referred to as political risk, however country risk is a more general
term, which generally only refers to risks affecting all companies operating within a particular
country.
The ICRG (International Country Risk Guide) rating system comprises 22 variables representing
three major components of country risk, namely economic, financial and political. These
variables essentially represent risk-free measures. These are
Economic risk measures a country’s current economic strengths and weaknesses. In general,
when a country’s strengths outweigh its weaknesses it presents a low economic risk, and when
its weaknesses outweigh its strengths the country presents a high economic risk. The 5
economic variables are as follows:
 GDP per Head of Population

 Real Annual GDP Growth
 Annual Inflation Rate
 Budget Balance as a Percentage of GDP
 Current Account Balance as a Percentage of GDP
Financial risk is another measure of a country’s ability to service its financial obligations. This
rating assesses a country’s financial environment based on the following 5 financial variables:
 Foreign Debt as a Percentage of GDP

 Foreign Debt Service as a Percentage of Export in Goods and Services
 Current Account as a Percentage of Export in Goods and Services
 Net Liquidity as Months of Import Cover
 Exchange Rate Stability
Political risk measures the political stability of a country, which affects the country’s ability and
willingness to service its financial obligations. The 12 political risk variables are as follows:
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 Government Stability
 Socio-economic Conditions
 Investment Profile
 Internal Conflict
 External Conflict
 Corruption
 Military in Politics
 Religious Tensions
 Law and Order
 Ethnic Tensions
 Democratic Accountability
 Bureaucracy Quality
Industry Analysis
The term industry loosely refers to any group of businesses that share a particular type of
commercial enterprise. This grouping of firms is also likely to generate profits in a similar
manner, or at least share related activities.
This is intended to assist you with your research as you perform an analysis of your targeted
industry. The following steps should be used as a template to report major findings and
organize your decision. Following factors must be considered as you analyze targeted industry:
Industry environment
First we need to understand the industry by taking its environment under consideration. Which
Include –
 A brief history
 Factors that affect growth
 Government regulations
 Leading businesses in the industry
 Estimated size of the industry – Dollars? Products/Services sold?
 Establish trends in sales over recent years
 Determine current operational/management trends within the industry?
 What types of marketing strategies are prevalent within the industry?
 Is the industry seasonal?
 Is the industry sensitive to economic fluctuations?
Consumer market data
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 Demographics – Population/household size, median income, age, sex, race, ethnicity,

family status, housing status, etc.
 Psychographics – Lifestyle information, tastes, preferences, and buying habits
Industry structure
Industries have specific structures and the investors need to learn and understand the
significance of the structure of the industry. Industry structure includes size measures, e.g.
industry sales, number of firms, and number of employees. Rate of growth and the industry
growth curve are an important element of industry structure as is the extent to which an
industry is unionized. There may be many more elements of industry structure. Industry
structure is one determinant of competition. For example, competition in an industry
comprised solely of union employers will be quite different than in an industry comprised of
both union and non-union firms. Competition is also affected by the extent to which the
government is a large buyer, or perhaps the only buyer, as in the defense industry.
Industry attractiveness
Magnitude and ease of making profit, in comparison with the risks involved, that an industrial
sector offers. It is based on the number of competitors, their relative strength, width
of margins, and rate of growth in demand for its goods or services.
Industry performance
Key success factors (KSF) are areas of critical performance necessary for success in a specific
industry. A firm cannot expect to be competitive in its industry without an understanding of the
industry’s key success factors. Key success factors are a function of both customer needs and
competitive pressures. KSFs are typically identified by completing a list in response to two
questions:
1. What do customers in my industry want?

2. How do successful firms survive the industry’s competitive pressures?
Grocery Store (KSF)

Customer Competition
Cleanliness Bargaining power over suppliers
Freshness Number of local competitors
Selection, including take-out Location relative to competitors
Competitive prices
Location & parking
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Service & pleasant

experience
The entrepreneur must be aware of the key success factors (KSF) in his/her industry. Resources
should be directed to activities that increase competitiveness on KSF and not wasted on
activities that are not critical to KSFs.
Industry Practices
Its include the operation formation of a industry like distribution, pricing, promotion, methods
of selling, service/field support, R&D, legal tactics, reliance on carrying & forwarding agent
(C&A). Through that we can observed the industry practices and take proper view at a glance.
With that we can have an idea of the industry. From now on we will proceed towards the
details of the analysis with the consideration of above points and with the findings of porter’s
five point theory we can easily find an assessment of a particular industry as follows
The economic structure of an industry is not an accident. Its complexities are the result of long-
term social trends and economic forces. But its effects are immediate because it determines the
competitive rules and strategies. Learning about that structure will provide essential insight for
your decision strategy.
Michael Porter has identified five forces that are widely used to assess the structure of any
industry. Porter’s five forces are the:
• Bargaining power of suppliers,

• Bargaining power of buyers,
• Threat of new entrants,
• Threat of substitutes, and
• Rivalry among competitors.
Together, the strength of the five forces determines the profit potential in an industry by
influencing the prices, costs, and required investments of businesses—the elements of return
on investment stronger forces are associated with a more challenging business environment. To
identify the important structural features of your industry research via the five forces, you
conduct an industry analysis that answers the question, “What are the key factors for
competitive success of a targeted company?”
Bargaining Power of Suppliers
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How much power do the suppliers have over the company?
Any business requires inputs—labor, parts, raw materials, and services. The cost of those inputs
can have a significant effect on the company’s profitability. Whether the strength of suppliers
represents a weak or a strong force hinges on the amount of bargaining power they can exert
and, ultimately, on how they can influence the terms and conditions of transactions in their
favor. Suppliers would prefer to sell to the company at the highest price possible or provide you
with no more services than necessary. If the force is weak, then the company may be able to
negotiate a favorable business deal. Conversely, if the force is strong, then company is in a
weak position and may have to pay a higher price or accept a lower level of quality or service.
Factors Affecting the Bargaining Power of Suppliers (Suppliers have the most power when):
 The input(s) you require are available only from a small number of suppliers. For
instance, if company is making computers and need microprocessors, you will have
little or no bargaining power with Intel, the world’s dominant supplier.
 The inputs you require are unique, making it costly to switch suppliers. If company
uses a certain enzyme in a food manufacturing process, changing to another supplier
may require changing company’s entire manufacturing process. This may be very
costly, thus company will have less bargaining power with supplier.
 Company’s input purchases don’t represent a significant portion of the supplier’s
business. If the supplier does not depend on, company will have less power to
negotiate. Of course the opposite is true as well. Wal-Mart has significant
negotiating power over its suppliers because it is such a large percentage of
suppliers’ business.
 Suppliers can sell directly to customers, bypassing the need for the company
business. For example, a manufacturer could open its own retail outlet and compete
against the company.
 It is difficult for company to switch to another supplier. For example, if the company
recently invested in a unique inventory and information management system to
work effectively with supplier, it would be expensive to switch suppliers.
Self Assessment—Bargaining Power of Suppliers

Mark “Yes” or “No” in the space provided. “Yes” indicates a favorable competitive environment
for the business. “No” indicates a negative situation. Use the insight you gain to develop
effective tactics for countering or taking advantage of the situation.
YES Are there a large number of YES Are the products that company needed to
potential input suppliers? The purchase for business ordinary?
greater number of suppliers of Company will have more control when the
Company’s needed inputs, the products which needed are not unique.
NO NO
more control company will have.
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YES Can company easily switch to YE Are the company well informed about
substitute products from other S supplier’s product and market? If the
suppliers? If it is relatively easy to market is complicated or hard to
switch to substitute products more its understand, less bargaining power with
NO power over suppliers increases. suppliers.
YES Do company purchases from suppliers represent a large portion of their business? If company
purchases are a relatively large portion of supplier’s business, company will have more power
NO to lower costs or improve product features.
Bargaining Power of Buyers
How much negotiating power do the company’s buyers have?
The power of buyers describes the effect that customers have on the profitability of company’s
business. The transaction between the seller and the buyer creates value for both parties. But if
buyers (who may be distributors, consumers, or other manufacturers) have more economic
power, company’s ability to capture a high proportion of the value created will decrease, and
company will earn lower profits.
How much power do company’s buyers have over you?
Buyers have the most power when they are large and purchase much of company’s output. If
company sells to a few large buyers, they will have significant leverage to negotiate lower prices
and other favorable terms because the threat of losing an important buyer puts company in a
weak position. Buyers also have power if they can play suppliers against each other. In the
automotive supply industry, the large car manufacturers have significant power. There are only
a few large buyers, and they buy in large quantities. But, when there are many smaller buyers,
company will have greater control because each buyer is a small portion of company’s sales.
Many small customers acting as a group can create a strong force. For instance, because of
their size, health maintenance organizations (HMOs) can purchase health care from hospitals
and doctors at much lower cost than can individual patients. Note that - Not all buyers will
have the same degree of bargaining power with the company or be as sensitive to price,
quantity, or service. For example, apparel makers face significant buyer power when selling to
large retailers like Wal-Mart or department stores, but face a much more favorable situation
when selling to smaller specialty shops.
Factors Influencing the Bargaining Power of Buyers (Buyers have more power when):
 Industry has many small companies supplying the product and buyers are few and
large. For example, company may have little negotiating power if several competing
companies are trying to sell similar products to one large buyer.
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 The products represent a relatively large expense for customers.

 Customers have access to and are able to evaluate market information. Than
company has less room for negotiation if buyers know market demand, prices, and
costs.
 Company’s product is not unique and can be purchased from other suppliers. If
company’s brand is homogenous or similar to all of the others, buyers will base their
decision mainly on price.
 Customers could possibly make company’s product themselves. Anheuser-Busch,
Coors, and Heinz are examples of companies that have integrated back into metal
can manufacture to fill the balance of heir container needs.
 Customers can easily, and with little cost, switch to another product. For example,
IBM customers might switch to Gateway or Dell, but it may be inconvenient for
them to consider Macintosh.
Respond with “Yes” or “No” in the space provided. “Yes” indicates a favorable competitive
environment for business. “No” indicates a negative situation. Use the insight you gain to
develop effective tactics for countering or taking advantage of the situation.
Does company’s product

YE Does Company has enough represent a small expense for
YE
S customers such that losing one S customers? If your product is a
isn’t critical to success? The relatively large expense for
smaller the number of customers, customers, they’ll expend more
the more dependent on each one effort negotiating with you to
NO NO
of them. lower price or improve product
features.
YE Are customers uninformed about YE Is company’s product unique? If

S the company’s product and S company’s product is
market? If company’s market is homogenous or the same as
complicated or hard to competitors’, buyers have more
understand, buyers have less bargaining power.
NO NO
control.
YE Would it be difficult for buyers to integrate backward in the

S supply chain, purchase a competitor providing the products
that company provides, and compete directly with you? The
less likely a customer will enter the industry, the more
NO
bargaining power company has features.
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Threat of New Entrants
How easy is it for businesses to enter company’s market?
Company may have the market cornered with product, but success may inspire others to enter
the business and challenge position. The threat of new entrants is the possibility that new firms
will enter the industry. New entrants bring a desire to gain market share and often have
significant resources. Their presence may force prices down and put pressure on profits.
Analyzing the threat of new entrants involves examining the barriers to entry and the expected
reactions of existing firms to a new competitor. Barriers to entry are the costs and/or legal
requirements needed to enter a market. These barriers protect the companies already in
business by being a hurdle to those trying to enter the market. In addition to up-front barriers,
a new competitor may inspire established companies to react with tactics to deter entry, such
as lowering prices or forming partnerships. The chance of reaction is high in markets where
firms have a history of retaliation, excess cash, are committed to the industry or the industry
has slow growth.
Unique Barriers
Entry barriers are unique for each industry and situation, and can change over time. Most
barriers stem from irreversible resource Commitments Company must make in order to enter a
market. For example, if the existing businesses have well established brand names and fully
differentiated products, as a potential market entrant company will need to undertake an
expensive marketing campaign to introduce your products. Barriers to entry are usually higher
for companies involved in manufacturing than for companies that provide a service because
there is often a significant expense in setting up a production facility.
Another type of entry barrier is regulatory. Overcoming barriers to entry may involve expending
significant resources over an extended period of time. Industries based on patentable
technology may require an especially long-term commitment, with years of research and
testing, before products can be introduced and compete.
Factors Affecting the Threat of New Entrants (The threat of new entrants is greatest when):
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 Processes are not protected by regulations or patents. In contrast, when licenses

and permits are required to do business.
 Customers have little brand loyalty. Without strong brand loyalty, a potential
competitor has to spend little to overcome the advertising and service programs of
existing firms and is more likely to enter the industry.
 Start-up costs are low for new businesses entering the industry. The less
commitment needed in advertising, research and development, and capital assets,
the greater the chance of new entrants to the industry.
 The products provided are not unique. When the products are commodities and the
assets used to produce them are common, firms are more willing to enter an
industry because they know they can easily liquidate their inventory and assets if the
venture fails.
 Switching costs are low. In situations where customers do not face significant one-
time costs from switching suppliers, it is more attractive for new firms to enter the
industry and lure the customers away from their previous suppliers.
 The production process is easily learned. Just as competitors may be scared away
when the learning curve is steep, competitors will be attracted to an industry where
the production process is easily learned.
 Access to inputs is easy. Entry by new firms is easier when established firms do not
have favorable access to raw materials, locations, or government subsidies.
 Access to customers is easy. For instance, it may be easy to rent space to sell
produce at a farmer’s market, but nearly impossible to get shelf space in a grocery
store. You are more likely to find new entrants in the food business using the
farmer’s market distribution system over grocery stores.
 Economies of scale are minimal. If there is little improvement in efficiency as scale
(or size) increases, a firm entering a market won’t be at a disadvantage if it doesn’t
produce the large volume that an existing firm produces.
YE Does Company have a unique YE

Are there high start-up costs for
S process that has been protected? S business? The greater the capital
For example, if company is a requirements, the lower the threat
technology-based company with of new competition lower price or
patent protection enjoys some improve product features.
NO barriers to entry. NO
Are customers loyal to Are the assets needed to run

YE company’s brand? If customers YE
business unique? Others will be
S are loyal to brand, a new S
more reluctant to enter the
product, even if identical, would market if the technology or
face a formidable battle to win equipment cannot be converted
over loyal customers. into other uses if the venture
NO NO
fails.
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Is there a process or procedure Will a new competitor have difficulty

YE YE
critical to company’s business? acquiring/obtaining needed inputs?
S S
The more difficult it is to learn Current distribution channels may
the business, the greater the make it difficult for a new business
entry barrier. to acquire/obtain inputs as readily
NO NO as existing businesses.
Threat of Substitutes
What products could company’s customers buy instead of its own product?
Products from one business can be replaced by products from another. If company produces a
commodity product that is undifferentiated, customers can easily switch away from that
product to a competitor’s product with few consequences. In contrast, there may be a distinct
penalty for switching if company’s product is unique or essential for customer’s business.
Substitute products are those that can fulfill a similar need to the one its product fills. As an
example, a family restaurant may prefer to buy the packaged poultry produced at your plant,
but if given a better deal, they may go to another poultry supplier. If you grow free-range
organically grown chickens, though, and you are selling to upscale restaurants, they may have
few substitutes for the product that you are providing.
Substitutes can come in many forms
Be aware that substitute products can come in many shapes and sizes, and do not always come
from traditional competitors. Pork and chicken can substitute in consumer diets for beef or
lamb. Aluminum beverage cans battle in the market against glass bottles and plastic containers.
Cotton competes with polyester from the petroleum industry. Barnes and Noble retail
bookstores compete with Internet retailer Amazon. Postal services compete with e-mail and fax
machines. It is critical to assess the other options customers have to satisfy their needs. To do
this, look for products that serve the same function as the targeted company. A threat exists if
there are alternative products with lower prices or better performance or both.
How substitutes affect the market place
Substitutes essentially place a price ceiling on products. Market analysts often talk about
“wheat capping corn.” This occurs because wheat and corn are substitutes in animal feed. If
wheat prices are low, corn prices will also be low, because, as corn prices rise, livestock feeders
will quickly shift to wheat to keep ration costs low. This reduces the demand and ultimately the
price of corn. It’s more difficult for a firm to try to raise prices and make greater profits if there
are close substitutes and switching costs are low. But, in some cases, customers may be
reluctant to switch to another product even if it offers an advantage. Customers may consider it
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inconvenient or even risky to change if they are accustomed to using a certain product in a
certain way, or they are used to the way certain services are delivered.
Factors affecting the threat of substitution (Substitutes are a greater threat when):
- Company’s product doesn’t offer any real benefit compared to other products. What
will hold customers if they can get an identical product from company’s competitor?
- It is easy for customers to switch. A grocer can easily switch from paper to plastic bags
for its customers, but a bottler may have to reconfigure its equipment and retrain its
workers if it switches from aluminum cans to plastic bottles.
- Customers have little loyalty. When price is the customer’s primary motivator, the
threat of substitutes is greater
This is a short scorecard to help you assess company position. Read each of the following
questions and respond with “Yes” or “No” in the space provided. “Yes” indicates a favorable
competitive environment. “No” indicates a negative situation. Use the insight you gain to
develop effective tactics for countering or taking advantage of the situation
Does company’s product compare Is it costly for your customers to

YE favorably to possible substitutes? YE switch to another product? When
S If another product offers more S customers experience a loss of
features or benefits to customers, productivity if they switch to
or if their price is lower, another product, the threat of
NO customers may decide that the NO substitutes is weaker.
other product is a better value.
Are customers loyal to existing

YE
products? Even if switching costs are
S
low, customers may have allegiance
to a particular brand. If your
customers have high brand loyalty to
NO your product you enjoy a weak threat
of substitute.
Rivalry among Competitors
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How Intense Is Your Competition?
Competition is the foundation of the free enterprise system, yet with small businesses
even a little competition goes a long way. Because companies in an industry are
mutually dependent, actions by one company usually invite competitive retaliation. An
analysis of rivalry looks at the extent to which the value created in an industry will be
dissipated through head-to-head competition.
Intensity of rivalry among competitors
Rivalry among competitors is often the strongest of the five competitive forces, but can vary
widely among industries. If the competitive force is weak, companies may be able to raise
prices, provide fewer products for the price, and earn more profits. If competition is intense, it
may be necessary to enhance product offerings to keep customers, and prices may fall below
break-even levels. Rivalries can occur on various “playing fields.” In some industries, rivalries
are centered on price competition—especially companies that sell commodities such as paper,
gasoline, or plywood. In other industries, competition may be about offering customers the
most attractive combination of performance features, introducing new products, offering more
after-sale services or warranties, or creating a stronger brand image than competitors. In some
cases the presence of more rivals can actually be a positive—for instance in a shopping area,
where attracting customers may hinge on having enough stores and attractions to make it a
worthwhile stop.
Factors influencing rivalry among competitors (The most intense rivalries occur when):
 One firm or a small number of firms have incentive to try and become the market
leader. In some cases, an industry with two or three dominant firms may experience
intense rivalry when these firms are battling to achieve market leader status. In
other situations, when competitors with diverse strategies and relationships have
different goals and the “rules of the game” are not well established, rivalry will be
more intense.
 The market is growing slowly or shrinking. When the potential to sell products is
stagnant or declining, existing firms are unable to grow their market without taking
market away from competitors. In this situation rivalry is more likely.
 There are high fixed costs of production. When a large percentage of the cost to
produce products is independent of the number of units produced, businesses are
pressured to produce larger volumes. This may tempt companies to drastically cut
prices when there is excess capacity n the industry in order to sell greater volumes
of product.
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 Products are perishable and need to be sold quickly. Sellers are more likely to price
aggressively if they risk losing inventory due to spoilage or if storage costs are high.
 Products are not unique or homogenous. Undifferentiated products (commodities)
compete mainly on price, because consumers receive the same value from the
products of different firms. Because firms do not experience any insulation from
price competition, there is more likely to be active rivalry.
 Customers can easily switch between products. Intense rivalry is likely when
customers in a given industry can easily switch to other suppliers.
 There are high costs for exiting the business. If liquidation would result in a loss,
businesses that invested heavily in their facilities will try hard to pay for them and
may resort to extreme methods of competition.
Company Analysis
As an investor we have to analyze the company for the better investment result. The best way
to do analysis is use the SWOT analysis.
SWOT analysis is a method used to evaluate the Strengths, Weaknesses, Opportunities,

and Threats involved in a company’s position. It involves specifying the objective of the
business venture or project and identifying the internal and external factors that are favorable
and unfavorable to achieve that objective.
In other words the SWOT analysis headings provide a good framework for reviewing strategy,
position and direction of a company or business proposition. A SWOT analysis measures a
business unit, a proposition or idea. A SWOT analysis is a subjective assessment of data which is
organized by the SWOT format into a logical order that helps understanding, presentation,
discussion and decision-making. SWOT analysis can be used for all sorts of decision-making, and
the SWOT template enables proactive thinking, rather than relying on habitual or instinctive
reactions.
A SWOT analysis must first start with defining a desired end state or objective.
 Strengths: characteristics of the business or team that give it an advantage over

others in the industry.
 Weaknesses: are characteristics that place the firm at a disadvantage relative to
others.
 Opportunities: external chances to make greater sales or profits in the
environment.
 Threats: external elements in the environment that could cause trouble for the
business.
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Identification of SWOTs is essential because subsequent steps in the process of planning for
achievement of the selected objective may be derived from the SWOTs. Those points can be
describe as follows
Strengths
 End-user sales control and direction.
weaknesses
 Right products, quality and reliability.
 Customer lists not tested.
 Superior product performance vs
 Some gaps in range for certain sectors.
competitors.
 We would be a small player.
 Better product life and durability.
 No direct marketing experience.
 Spare manufacturing capacity.
 We cannot supply end-users abroad.
 Some staff has experience of end-user
 Need more sales people.
sector.
 Limited budget.
 Have customer lists.
 No pilot or trial done yet.
 Direct delivery capability.
 Don't have a detailed plan yet.
 Product innovations ongoing.
 Delivery-staff need training.
 Can serve from existing sites.
 Customer service staffs need training.
 Products have required accreditations.
 Processes and systems, etc
 Processes and IT should cope.
 Management cover insufficient.
 Management is committed and
confident.
threats
opportunities
 Legislation could impact.
 Could develop new products.
 Environmental effects would favor
 Local competitors have poor products.
larger competitors.
 Profit margins will be good.
 Existing core business distribution risk.
 End-users respond to new ideas.
 Market demand very seasonal.
 Could extend to overseas.
 Retention of key staff critical.
 New specialist applications.
 Could distract from core business.
 Can surprise competitors.
 Possible negative publicity.
 Support core business economies.
 Vulnerable to reactive attack by major
 Could seek better supplier deals.
competitors.
By sorting the SWOT issues one can obtain a system which presents a practical way of
predicting the internal and external information about the business unit, delineating short and
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long term priorities, and allowing an easy way to build a quite knowledge required for the
future investment. This approach captures the collective agreement and commitment of those
who will ultimately want a clear view toward a particular company for further valuation.
For better understanding we need to practice the following practice work.
Valuation
Relative valuation
Valuation ratios are used in analysis for investment in common equity. The most widely used
valuation ratio is the price-to-earning (P/E) ratio, the ratio of the current market price of a share
of stock divided by the company’s earnings per share. Related measures based on price per
share are the price-to-cash flow, the price-to-sales And the price-to-book value ratios.
Earnings per Share (Basic)
Basic EPS is net income available to common divided by the weighted average number of
common shares outstanding.
Earnings per share (EPS) = (Net Income-Preferred dividend)/Weighted average number of

common shares outstanding
For example, assume that a company has a net income of $25 million. If the company pays out
$1 million in preferred dividends and has 10 million shares, the EPS would be $1.92 (24/10).
Comments: The portion of a company's profit allocated to each outstanding share of common
stock. Earnings per share serve as an indicator of a company's profitability.
Calculating Weighted Average number of Share
XYZ company ltd has 10,000 shares on 01-01-2001. On 01-5-2001 it issued 1200 shares. On 01-
07-2001 it again issue 1700 share. What would be its weighted average number of share on 31-
12-2001?
Calculation:
10,000*12 = 120,000 (As the number was outstanding full year)
1200*9 = 10800 (As the number was outstanding only for 9 months)
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1700*5 = 8500 (As the number was outstanding only for 5 months)
139300
Number of share on 31-12-2001 = (139300/12)
= 11609
Earnings per share (Diluted)
Diluted earnings per share are computed assuming that all potentially dilutive securities are
issued. That means we look at a “worst case” scenario in terms of the dilution of earnings from
factors such as executive stock options, convertible bonds, convertible preferred stock,
warrants, bonus share and right share. Suppose a company has convertible securities
outstanding, such as convertible bonds. In calculating diluted earnings per share, we consider
what would happen to both earnings and the number of shares outstanding if these bonds
were converted into common shares.
Diluted EPS= (net income - preferred dividends) + convertible preferred dividend + (convertible
debt interest * (1-t))/( weighted average shares + shares from conversion of convertible
preferred shares + shares from conversion of convertible debt + shares issuable from stock
options)
Example:
Company XYZ has:
 Net income of $2m and 2m weighted average number of shares outstanding for the
accounting period.
 Bonds convertible to common stock worth $50,000: 50 at $1,000, with an interest of
12%. They are convertible to 1,000 shares of common stock.
 A total of 1,000 convertible preferred stock paying a dividend of 10% and convertible to
2,000 shares of common stock, with a par of $100 per preferred stock.
 A total of 2,000 stock options outstanding, 1,000 of which were issued with an exercise
price of $10 and the other 1,000 of which have an exercise price of $50. Each stock
option is convertible to 10 common stocks.
 A tax rate of 40%.
 Stock whose average trading price is $20 per share.
Calculating the fully diluted EPS
Calculation:
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Convertible debt
Assume conversion: If the debt is converted, the company would have to issue an additional
50,000 (50*1,000) common stock. As a result the WASO would increase to 2,050,000. Since the
debt would be converted, no interest would have to be paid. Interest was $6,000 per annum.
The interest expense would flow through to common stockholders but not before the IRS get a
portion of it. So net of taxes the company would have generated an additional $3,600
[(6,000*(1-40%)] in net income.
Adjusted WASO: 2,050,000

Adjusted net income: $2,003,600
Convertible preferred stock
Assume conversion: If the stock is converted the company would have to issue an additional
2,000 shares of common stock. As a result the WASO would increase to 2,052,000. Since the
preferred dividend would no longer be issued the company would not have to pay $1,000
dividends (100*1,000*10%). Since dividends are not tax deductible, there are no tax
implications. So the company would have generated an additional $1,000 in net income
attributable to common stockholders.
Adjusted WASO: 2,050,000
Adjusted net income: $2,003,600
Preferred dividend is reduced to zero
Stock options
If-converted method: Say there are 1,000 stock options in the money (exercise price < market
price of stock). The holders of the stock option can convert their options into stock for a profit
at any point and time. Say 1,000 stock options are out of the money (exercise price > market
price of stock). The holders of the stock option would not convert their options, because it
would be cheaper to purchase the stock on the open market. The out-of-the-money option can
be ignored. The in-the-money options need to be accounted for. Here is how in-the-money
options are accounted for:
 Calculate the amount rose through the exercise of options:

1000 * 10 *$10 = $100,000
 Calculate the number of the common shares that can be repurchased using the amount
raised through the exercise of options (found in step #1):
$100,000 / 20 = 5,000
 Calculate number of common shares created by the exercise of the stock options:
1000 * 10 = 10,000
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 Find the net number by which the number of new common shares, created as result of
the stock options exercised (found in step #3), exceed the number of common shares
repurchased at the market price with proceeds received from the exercise of the
options (found in step #2):
10,000 - 5,000 = 5,000
 Find the total number of shares if the stock options are exercised: add weighted average
number of shares to what you found in step #4:
2,052,000 + 5,000 = 2,057,000
Fully diluted EPS= 2,000,000 + 3,600 - 6,000 + 6,000 = 2,003,600 = 0.974

2,000,000 +50,000 + 2,000 +5,000 2,057,000
P/E
The P/E ratio (price-to-earnings ratio) of a stock (also called its "P/E", or simply "multiple") is a
measure of the price paid for a share relative to the annual net income or profit earned by the
firm per share. P/E is a financial ratio used for valuation: a higher P/E ratio means that investors
are paying more for each unit of net income, so the stock is more expensive compared to one
with lower P/E ratio.
The P/E ratio has units of years, which can be interpreted as "number of years of earnings to
pay back purchase price", ignoring the time value of money. In other words, P/E ratio shows
current investor demand for a company share.
There are various P/E ratios, all defined as:
The price per share in the numerator is the market price of a single share of the stock.
The earnings per share in the denominator depend on the type of P/E:
 An Earnings per share is the net income of the company for the most recent 12 month
period, divided by number of shares outstanding. This is the most common meaning of
"P/E" if no other qualifier is specified. Monthly earning data for individual companies
are not available, so the previous four quarterly earnings reports are used
and earnings are updated quarterly. Note, companies individually choose their financial
year so the schedule of updates will vary.
 "Trailing P/E from continued operations": Instead of net income, uses operating
earnings which exclude earnings from discontinued operations, extraordinary items (e.g.
one-off windfalls and write downs), or accounting changes.
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 "Forward P/E", "P/Ef", or "estimated P/E": Instead of net income, uses estimated net
earnings over next 12 months. Estimates are typically derived as the mean of a select
group of analysts (note, selection criteria is rarely cited). In times of rapid economic
dislocation, such estimates become less relevant as "the situation changes" (e.g. new
economic data is published and/or the basis of their forecasts become obsolete) more
quickly than analysts adjust their forecasts.
The P/E ratio can alternatively be calculated by dividing the company's market capitalization by
its total annual earnings. By comparing price and earnings per share for a company, one can
analyze the market's stock valuation of a company and its shares relative to the income the
company is actually generating. Stocks with higher (and/or more certain) forecast earnings
growth will usually have a higher P/E, and those expected to have lower (and/or riskier)
earnings growth will in most cases have a lower P/E. Investors can use the P/E ratio to compare
the value of stocks: if one stock has a P/E twice that of another stock, all things being equal
(especially the earnings growth rate), it is a less attractive investment. Companies are rarely
equal, however, and comparisons between industries, companies, and time periods may be
misleading.
Dividend payout ratio
The percentage of earnings paid to shareholders in dividends.
Dividend payout ratio=Yearly Dividend per share/Earning per Share
Comments: The payout ratio provides an idea of how well earnings support the dividend
payments. More mature companies tend to have a higher payout ratio
Dividend yield
The dividend yield is the return to shareholders measured in terms of the dividends paid during
the period.
Dividend yield= Dividend per share/Market price per share
Comments: Dividend yield is a way to measure how much cash flow you are getting for each
dollar invested in an equity position. Investors who require a minimum stream of cash flow
from their investment portfolio can secure this cash flow by investing in stocks paying relatively
high, stable dividend yields.
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Price/Book value
The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's book
value to its current market price. Book value is an accounting term denoting the portion of the
company held by the shareholders; in other words, the company's total tangible assets less its
total liabilities.
Calculated as:
A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that
something is fundamentally wrong with the company. As with most ratios, be aware that this
varies by industry. The calculation can be performed in two ways, but the result should be the
same each way.
In the first way, the company's market capitalization can be divided by the company's total
book value from its balance sheet.
The second way, using per-share values, is to divide the company's current share price by the
book value per share (i.e. its book value divided by the number of outstanding shares).
As with most ratios, it varies a fair amount by industry. Industries that require more
infrastructure capital (for each dollar of profit) will usually trade at P/B ratios much lower than
others, for example, P/B ratios are commonly used to compare banks, because most assets and
liabilities of banks are constantly valued at market values. A higher P/B ratio implies that
investors expect management to create more value from a given set of assets, all else equal
(and/or that the market value of the firm's assets is significantly higher than their accounting
value). P/B ratios do not, however, directly provide any information on the ability of the firm to
generate profits or cash for shareholders.
This ratio also gives some idea of whether an investor is paying too much for what would be left
if the company went bankrupt immediately. For companies in distress, the book value is usually
calculated without the intangible assets that would have no resale value. In such cases, P/B
should also be calculated on a "diluted" basis, because stock options may well vest on sale of
the company or change of control or firing of management.
It is also known as the market-to-what-book ratio and the price-to-equity ratio (which should
not be confused with the price-to-earnings ratio), and its inverse is called the book-to-market
ratio.
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Price/Sales
A ratio for valuing a stock relative to its own past performance, other companies or the market
itself. Price to sales is calculated by dividing a stock's current price by its revenue per share for
the trailing 12 months:
The ratio can also be referred to as a stock's "PSR".
The price-to-sales ratio can vary substantially across industries; therefore, it's useful mainly
when comparing similar companies. Because it doesn't take any expenses or debt into account,
the ratio is somewhat limited in the story it tells.
How P/S Is Useful
In a nutshell, this ratio shows how much Wall Street values every dollar of the company's sales.
Coupled with high relative strength in the previous twelve months, a low price-to-sales ratio is
one of the most potent combinations of investment criteria. A low price-to-sales ratio can also
be effective in valuing growth stocks that have suffered a temporary setback.
In a highly cyclical industry such as semiconductors, there are years when only few companies
produce any earnings. This does not mean semiconductor stocks are worthless. In this case,
investors can use price-to-sales instead of the price-earnings ratio (P/E Ratio or PE) to
determine how much they are paying for a dollar of the company's sales rather than a dollar of
its earnings. Price-to-sales is used for spotting recovery situations or for double checking that a
company's growth has not become overvalued. It comes in handy when a company begins to
suffer losses and, as a result, has no earnings (and no PE) with which investors can assess the
shares.
Let's consider how we evaluate a firm that has not made any money in the past year. Unless the
firm is going out of business, the price-to-sales ratio will show whether the firm's shares are
valued at a discount against others in its sector. Say the company has a price-to-sales ratio of
0.7 while its peers have higher ratios of, say, 2. If the company can turn things around, its
shares will enjoy substantial upside as the price-to-sales ratio becomes more closely matched
with those of its peers. Meanwhile, a company that goes into a loss (negative earnings) may
lose also its dividend yield. In this case, price-to-sales represents one of the last remaining
measures for valuing the business. All things being equal, a low price-to-sales ratio is good news
for investors, while a very high price-to-sales ratio can be a warning sign.
Where P/S Fall Short
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That being said, turnover is valuable only if, at some point, it can be translated into earnings.
Consider construction companies. They report very high sales turnover, but, with the exception
of building booms, they rarely make much in the way of profit. By contrast, a software company
can easily generate $4 in net profit for every $10 in sales revenue. What this discrepancy means
is that sales dollars cannot always be treated the same way for every company.
Many people look at sales revenue as a more reliable indicator of a company's growth.
Granted, earnings are a complicated bottom-line number, whose reliability is not always
assured. But, thanks to somewhat hazy accounting rules, the quality of sales revenue figures
can be unreliable too.
Comparing companies' sales on an apples-to-apples basis hardly ever works. Examination of

sales must be coupled with a careful look at profit margins and their trends, as well as with
sector-specific margin.
Debt Is a Critical Factor
A firm with no debt and a low price-to-sales metric is a more attractive investment than a firm
with high debt and the same price-to-sales ratio. At some point, the debt will need to be paid
off, so there is always the possibility that the company will issue additional equity. These new
shares expand market capitalization and drive up the price-to-sales ratio.
Debt-laden companies on the verge of bankruptcy, however, can emerge with low price-to-
sales ratios. This is because their sales have not suffered a drop while their share price and
capitalization collapses.
So how can investors tell the difference? There is an approach that helps to distinguish between
"cheap" sales and less healthy, debt-burdened ones: use enterprise value/sales rather than
market capitalization/sales. By adding the company's long-term debt to the company's market
capitalization and subtracting any cash, one arrives at the company's enterprise value (EV).
Think of EV as the total cost of buying the company, including its debt and leftover cash, which
would offset the cost. EV shows how much more investors pay for the debt. This approach also
helps eliminate the problem of comparing two very different types of companies:
 The kind that relies on debt to enhance sales and

 The kind that has lower sales but does not shoulder debt.
As with all valuation techniques, sales-based metrics are just the beginning. The worst thing
that an investor can do is buy stocks without looking at underlying fundamentals. Low price-to-
sales ratios can indicate unrecognized value potential - so long as other criteria like high profit
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margins, low debt levels and growth prospects are in place. In other cases, price-to-sales can be
a classic value trap.
Price/Cash Flow
A measure of the market's expectations of a firm's future financial health. Because this measure
deals with cash flow, the effects of depreciation and other non-cash factors are
removed. Similar to the price-earnings ratio, this measure provides an indication of relative
value.
Calculated by:
Because accounting laws on depreciation vary across jurisdictions, the price-to-cash-flow ratio
can allow investors to assess foreign companies from the same industry (ex. mining industry)
with a bit more ease.
The price/cash flow ratio is used by investors to evaluate the investment attractiveness, from a
value standpoint, of a company's stock. This metric compares the stock's market price to the
amount of cash flow the company generates on a per-share basis.
This ratio is similar to the price/earnings ratio, except that the price/cash flow ratio (P/CF) is
seen by some as a more reliable basis than earnings per share to evaluate the acceptability, or
lack thereof, of a stock's current pricing. The argument for using cash flow over earnings is that
the former is not easily manipulated, while the same cannot be said for earnings, which, unlike
cash flow, are affected by depreciation and other non-cash factors.
Sometimes free cash flow is used instead of operating cash flow to calculate the cash flow per
share figure.
Just as many financial professionals prefer to focus on a company's cash flow as opposed to its
earnings as a profitability indicator, it's only logical that analysts in this camp presume that the
price/cash flow ratio is a better investment valuation indicator than the P/E ratio.
Investors need to remind themselves that there are a number of non-cash charges in the
income statement that lower reported earnings. Recognizing the primacy of cash flow over
earnings leads some analysts to prefer using the P/CF ratio rather than, or in addition to, the
company's P/E ratio.
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Despite these considerations, there's no question that the P/E measurement is the most widely
used and recognized valuation ratio.
Discounted Cash Flow valuation
It can be hard to understand how stock analysts come up with "fair value" for companies, or
why their target price estimates vary so wildly. The answer often lies in how they use the
valuation method known as discounted cash flow (DCF).
However, you don't have to rely on the word of analysts. With some preparation and the right
tools, you can value a company's stock yourself using this method. We will try to show you
how, taking you step-by-step through a discounted cash flow analysis of a fictional company. In
simple terms, discounted cash flow tries to work out the value of a company today, based on
projections of how much money it's going to make in the future. DCF analysis says that a
company is worth all of the cash that it could make available to investors in the future. It is
described as "discounted" cash flow because cash in the future is worth less than cash today.
For example, let's say someone asked you to choose between receiving $100 today and
receiving $100 in a year. Chances are you would take the money today knowing that you could
invest that $100 now and have more than $100 a year's time. If you turn that thinking on its
head, you are saying that the amount that you'd have in one year is worth $100 dollars today -
or the discounted value is $100. Make the same calculation for all the cash you expect a
company to produce in the future and you have a good measure of the company's value.
DCF analysis requires you to think through the factors that affect a company, such as future
sales growth and profit margins. It also makes you consider the discount rate, which depends
on a risk-free interest rate, the company's costs of capital and the risk its stock faces. All of this
will give you an appreciation for what drives share value, and that means you can put a more
realistic price tag on the company's stock.
To demonstrate how this valuation method works, we will take you step-by-step through a DCF
analysis of a fictional company called The Winner Company. Let's begin by looking at how to
determine the forecast period for your analysis and how to forecast revenue growth.
The Forecast Period & Forecasting Revenue Growth
The Forecast Period
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The first order of business when doing discounted cash flow (DCF) analysis is to determine how
far out into the future we should project cash flows. For the purposes of our example, we'll
assume that The Winner Company is growing faster than the gross domestic product (GDP)
expansion of the economy. During this "excessive return" period, The Winner Company will be
able to earn returns on new investments that are greater than its cost of capital. So, our
discounted cash flow needs to forecast the amount of free cash flow that the company will
produce for this period.
The excess return period tells us how far into the future we should forecast the company's cash
flows. Alas, it's impossible to say exactly how long this period of excess returns will last. The
best we can do is make an educated guess based on the company's competitive and market
position. Sooner or later, all companies settle into maturity and slower growth. (The common
practice with DCF analysis is to make the excess return period the forecast period. But it is
important to note that this valuation method does not restrict your analysis to only excess
return periods - you could estimate the value of a company growing slower than the economy
using DCF analysis too.)
The table below shows good guidelines to use when determining a company's excess return
period/forecast period:
Company Competitive Position Excess Return/Forecast Period

Slow-growing company; operates in highly 1 year
competitive, low margin industry
Solid company; operates with advantage such as 5 years

strong marketing channels, recognizable brand
name, or regulatory advantage
Outstanding growth company; operates with 10 years

very high barriers to entry, dominant market
position or prospects
How far in the future should we forecast The Winner Company’s cash flows?
Let's assume that the company is keeping itself busy meeting the demand for its Winner s.
Thanks to strong marketing channels and upgraded, efficient factories, the company has a
reasonable competitive position. There is enough demand for Winner s to maintain five years of
strong growth, but after that the market will be saturated as new competitors enter the
market. So, we will project cash flows for the next five years of business.
Revenue Growth Rate
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We have decided that we want to estimate the free cash flow that The Winner Company will
produce over the next five years. To arrive at this figure, the standard procedure is to forecast
revenue growth over that time period. Then by breaking down after-tax operating profits,
estimated capital expenditure and working capital needs, we can estimate the cash flow the
company will produce.
Let's start with top line growth. Forecasting a company's revenues is arguably the most
important assumption one can make about its future cash flows. It can also be the most difficult
assumption to make.
We need to think carefully about what the industry and the company could look like as they
evolve in the future. When forecasting revenue growth, we need to consider a wide variety of
factors. These include whether the company's market is expanding or contracting, and how its
market share is performing. We also need to consider whether there are any new products
driving sales or whether pricing changes are imminent. But because that future can never be
certain, it is valuable to consider more than one possible outcome for the company.
First, the upbeat revenue growth scenario: The Winner Company has grown revenues at 20%
for the past two years, and your careful market research suggests that demand for Winner s will
not let up any time soon. Management - always optimistic - argues that the company will keep
growing at 20%.
That being said, there may be reasons to downplay revenue growth expectations. While the
company's revenue growth will stay strong in the first few years, it could slow to a lower rate by
Year 5 as a result of increasing international competition and industry commoditization. We
should err on the side of caution and conservatism and assume that The Winner Company’s top
line growth rate profile will commence at 20% for the first two years, then drop to 15% for the
next two years and finally drop to 10% in Year 5. Posting $100 million of revenue in its latest
annual report, the company is projected to grow its revenues to $209.5 million at the end of
five years (based on realistic, rather than optimistic, growth expectations).
Forecast Revenue Growth Profiles
Current Year 1 Year 2 Year 3 Year 4 Year 5

Year
Optimistic: - 20% 20% 20% 20% 20%
Growth Rate
Revenue $100 M $120 M $144 M $172.8 M $207.4 M $248.9 M
Realistic: - 20% 20% 15% 15% 10%
Growth Rate
Revenue $100 M $120 M $144 M $165.6 M $190.4 M $209.5 M
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Now that we've determined our forecast period and our revenue growth for that period, we
can move on to the next step in our analysis, where we will estimate the free cash flow
produced over the forecast period.
Forecasting Free Cash Flows
Now that we have determined revenue growth for our forecast period of five years, we want to
estimate the free cash flow produced over the forecast period. Free cash flow is the cash that
flows through a company in the course of a quarter or a year once all cash expenses have been
taken out. Free cash flow represents the actual amount of cash that a company has left from its
operations that could be used to pursue opportunities that enhance shareholder value - for
example, developing new products, paying dividends to investors or doing share buybacks.
Calculating Free Cash Flow
We work out free cash flow by looking at what's left over from revenues after deducting
operating costs, taxes, net investment and the working capital requirements (see Figure 1).
Depreciation and amortization are not included since they are non-cash charges.
Figure – 1: How Free Cash Flow is calculated
Future Operating Costs
When doing business, a company incurs expenses - such as salaries, cost of goods sold, selling
and general administrative expenses, and research and development. These are the company's
operating costs. If current operating costs are not explicitly stated on a company's income
statement, you can calculate them by subtracting net operating profits - or earnings before
interest and taxation (EBIT) - from total revenues. A good place to start when forecasting
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operating costs is to look at the company's historic operating cost margins. The operating
margin is operating costs expressed as a proportion of revenues.
For three years running, The Winner Company has generated an average operating cost margin
of 70%. In other words, for every $1 of revenue, the company incurs $0.70 in operating costs.
Management says that its cost cutting program will push those margins down to 60% of
revenues over the next five years.
However, as analysts and investors, we should be concerned that competing Winner factories
might be built, thus squeezing The Winner Company’s profitability. Therefore, as we did when
forecasting revenues, we will err on the side of conservatism and assume that operating costs
will show an increase as a percentage of revenues as the company is forced to lower its prices
to stay competitive over time. Let's say operating costs will hold at 65% of revenues over the
first three projected years, but will increase to 70% in Year 4 and Year 5 (See figure 2)
Taxation
Many companies do not actually pay the official corporate tax rate on their operating profits.
For instance, companies with high capital expenditures receive tax breaks. So, it makes sense to
calculate the tax rate by taking the average annual income tax paid over the past few years
divided by profits before income tax. This information is available on the company's historic
income statements.
Let's assume that for each of the past three years, The Winner Company paid 30% income tax.
We will project that the company will continue to pay that 30% tax rate over the next five years
(see Figure 2).
Net Investment
To underpin growth, companies need to keep investing in capital items such as property, plants
and equipment. You can calculate net investment by taking capital expenditure, disclosed in a
company's statement of cash flows, and subtracting non-cash depreciation charges, found on
the income statement. Let's say The Winner Company spent $10 million last year on capital
expenditures, with depreciation of $3 million, giving net investment of $7 million, or 7% of total
revenues (see Figure 2). But in the two prior years, the company's net investment was much
higher: 10% of revenues. If competition does intensify in the Winner industry, The Winner
Company will almost certainly have to boost capital investment to stay ahead. So, we will
assume that net investment will steadily return to its normal level of 10% of sales over the next
five years, as seen in Figure 2: 7.6% of sales in Year 1, 8.2% in Year 2, 8.8% in Year 3, 9.4% in
Year 4 and 10% in Year 5.
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Figure 2 - Forecasting The Winner Company's operating costs, taxes, net investment and change
in working capital over the five-year forecast period
Change in Working Capital
Working capital refers to the cash a business requires for day-to-day operations or, more
specifically, short-term financing to maintain current assets such as inventory. The faster a
business expands the more cash it will need for working capital and investment.
Working capital is calculated as current assets minus current liabilities. These items are found
on the company's balance sheet, published in its quarterly and annual financial statements. At
year end, The Winner Company’s balance sheet showed current assets of $25 million and
current liabilities of $16 million, giving net working capital of $9 million.
Net change in working capital is the difference in working capital levels from one year to the
next. When more cash is tied up in working capital than the previous year, the increase in
working capital is treated as a cost against free cash flow. Working capital typically increases as
sales revenues grow, so a bigger investment of inventory and receivables will be needed to
match The Winner Company’s revenue growth. In our forecast, we will assume that changes in
working capital are proportional to revenue growth. In other words, if revenues grow by 20% in
the first year, working capital requirements will grow by 20% in the first year, from $9 million to
$10.8 million (see Figure 2). Meanwhile, we will keep a close watch for any signs of a changing
trend.
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Figure 3 - Free cash flow forecast calculation for The Widget Company
As you can see in Figure 3, we've determined our estimated free cash flow for our forecast
period. Now we are one step closer to finding a value for the company.
Calculating the Discount Rate
Having projected the company's free cash flow for the next five years, we want to figure out
what these cash flows are worth today. That means coming up with an appropriate discount
rate which we can use to calculate the net present value (NPV) of the cash flows. So, how do
we figure out the company's discount rate? That's a crucial question, because a difference of
just one or two percentage points in the cost of capital can make a big difference in a
company's fair value. A wide variety of methods can be used to determine discount rates, but
in most cases, these calculations resemble art more than science. Still, it is better to be
generally correct than precisely incorrect, so it is worth your while to use a rigorous method to
estimate the discount rate.
A good strategy is to apply the concepts of the weighted average cost of capital (WACC). The
WACC is essentially a blend of the cost of equity and the after-tax cost of debt. Therefore, we
need to look at how cost of equity and cost of debt are calculated.
Cost of Equity
Unlike debt, which the company must pay at a set rate of interest, equity does not have a
concrete price that the company must pay. But that doesn't mean that there is no cost of
equity. Equity shareholders expect to obtain a certain return on their equity investment in a
company. From the company's perspective, the equity holders' required rate of return is a cost,
because if the company does not deliver this expected return, shareholders will simply sell their
shares, causing the price to drop.
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Therefore, the cost of equity is basically what it costs the company to maintain a share price
that is satisfactory (at least in theory) to investors. The most commonly accepted method for
calculating cost of equity comes from the Nobel Prize-winning capital asset pricing model
(CAPM),
Cost of Equity (Re) = Rf + Beta (Rm-Rf).
Let's explain what the elements of this formula are:
Rf - Risk-Free Rate - This is the amount obtained from investing in securities considered free
from credit risk, such as government bonds from developed countries. The interest rate of U.S.
Treasury bills or the long-term bond rate is frequently used as a proxy for the risk-free rate.
ß - Beta - This measures how much a company's share price moves against the market as a
whole. A beta of one, for instance, indicates that the company moves in line with the market. If
the beta is in excess of one, the share is exaggerating the market's movements; less than one
means the share is more stable. Occasionally, a company may have a negative beta (e.g. a gold
mining company), which means the share price moves in the opposite direction to the broader
market.
(Rm – Rf) = Equity Market Risk Premium - The equity market risk premium (EMRP) represents
the returns investors expect, over and above the risk-free rate, to compensate them for taking
extra risk by investing in the stock market. In other words, it is the difference between the risk-
free rate and the market rate. It is a highly contentious figure. Many commentators argue that
it has gone up due to the notion that holding shares has become riskier.
Once the cost of equity is calculated, adjustments can be made to take account of risk factors
specific to the company, which may increase or decrease the risk profile of the company. Such
factors include the size of the company, pending lawsuits, concentration of customer base and
dependence on key employees. Adjustments are entirely a matter of investor judgment and
they vary from company to company.
Cost of Debt
Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate applied
to determine the cost of debt (Rd) should be the current market rate the company is paying on
its debt. If the company is not paying market rates, an appropriate market rate payable by the
company should be estimated.
As companies benefit from the tax deductions available on interest paid, the net cost of the
debt is actually the interest paid less the tax savings resulting from the tax-deductible interest
payment. Therefore, the after-tax cost of debt is Rd (1 - corporate tax rate).
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Finally, Capital Structure
The WACC is the weighted average of the cost of equity and the cost of debt based on the
proportion of debt and equity in the company's capital structure. The proportion of debt is
represented by D/V, a ratio comparing the company's debt to the company's total value (equity
+ debt). The proportion of equity is represented by E/V, a ratio comparing the company's equity
to the company's total value (equity + debt). The WACC is represented by the following
formula:
WACC = Re x E/V + Rd x (1 - corporate tax rate) x D/V.
A company's WACC is a function of the mix between debt and equity and the cost of that debt
and equity. On the one hand, in the past few years, falling interest rates have reduced the
WACC of companies. On the other hand, corporate disasters like those at Enron and WorldCom
have increased the perceived risk of equity investments.
Be warned: the WACC formula seems easier to calculate than it really is. Rarely will two people
derive the same WACC, and even if two people do reach the same WACC, all the other applied
judgments and valuation methods will likely ensure that each has a different opinion regarding
the components that comprise the company's value.
Winner Company WACC
Returning to our example, let's suppose The Winner Company has a capital structure of 40%
debt and 60% equity, with a tax rate of 30%. The risk-free rate (RF) is 5%, the beta is 1.3 and the
risk premium (RP) is 8%. The WACC comes to 10.64%. So, rounded up to the nearest
percentage, the discount rate for The Winner Company would be 11% (see Figure 1).
WACC for the Winner Company
Cost of Debt Cost of Equity

0.40 [Rd x (1-.30)]+ 0.60 [RF + b(RP)]
0.40 [5.0 x 0.7)] + 0.60 [5.0 + 1.3(8)]
0.40 [3.5] + 0.60 [15.4]
1.40 + 9.24
WACC 10.64%
Rounded WACC 11%
Coming Up With a Fair Value
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Now that we have calculated the discount rate for the Winner Company, it's time to do the final
calculations to generate a fair value for the company's equity.
Calculate the Terminal Value
Having estimated the free cash flow produced over the forecast period, we need to come up
with a reasonable idea of the value of the company's cash flows after that period - when the
company has settled into middle-age and maturity. Remember, if we didn't include the value of
long-term future cash flows, we would have to assume that the company stopped operating at
the end of the five-year projection period.
The trouble is that it gets more difficult to forecast cash flows over time. It's hard enough to
forecast cash flows over just five years, never mind over the entire future life of a company. To
make the task a little easier, we use a "terminal value" approach that involves making some
assumptions about long-term cash flow growth.
Gordon Growth Model
There are several ways to estimate a terminal value of cash flows, but one well-worn method is
to value the company as a perpetuity using the Gordon Growth Model. The model uses this
formula:
Terminal Value = Final Projected Year Cash Flow X (1+Long-Term Cash

Flow Growth Rate) (Discount Rate – Long-Term Cash Flow Growth Rate)
The formula simplifies the practical problem of projecting cash flows far into the future. But
keep in mind that the formula rests on the big assumption that the cash flow of the last
projected year will stabilize and continue at the same rate forever. This is an average of the
growth rates, not one expected to occur every year into perpetuity. Some growth will be higher
or lower, but the expectation is that future growth will average the long-term growth
assumption.
Returning to the Winner Company, let's assume that the company's cash flows will grow in
perpetuity by 4% per year. At first glance, 4% growth rate may seem low. But seen another
way, 4% growth represents roughly double the 2% long-term rate of the U.S. economy into
eternity. Now we will forecast free cash flow of $21.3 million for Year 5, the final or "terminal"
year in our Winner Company projections. You will also recall that we calculated The Winner
Company’s discount rate as 11% (see "Calculating the Discount Rate"). We can now calculate
the terminal value of the company using the Gordon Growth Model:
Winner Company Terminal Value = $21.3M X 1.04/ (11% - 4%) = $316.9M
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Calculating Total Enterprise Value
Now you have the following free cash flow projection for the Winner Company.
Forecast Year 1 Year 2 Year 3 Year 4 Year 5 Terminal Value

Period (Gordon Growth
Model)
Free Cash $18.5M $21.3M $24.1M $19.9M $21.3M $316.9M
To arrive at a total company value, or enterprise value (EV), we simply have to take the present
value of the cash flows, divide them by the Winner Company’s 11% discount rate and, finally,
add up the results.
EV = ($18.5M/1.11) + ($21.3M/(1.11)2) + ($24.1M/(1.11)3) +
($19.9M/(1.11)4) +($21.3M/(1.11)5) +($316.9M/(1.11)5)
EV = $265.3M
Therefore, the total enterprise value for The Winner Company is $265.3 million.
Calculating the Fair Value of Equity
But we are not finished yet - we cannot forget about debt. The Winner Company’s $265.3M
enterprise value includes the company's debt. As equity investors, we are interested in the
value of the company's shares alone. To come up with a fair value of the company's equity, we
must deduct its net debt from the value.
Let's say The Winner Company has $50M in net debt on its balance sheet. We subtract that
$50M from the company's $265.3M enterprise value to get the equity value.
Fair Value of Winner Company Equity = Enterprise Value – Debt

Fair Value of Winner Company = $265.3M - $50M =$215.3M
So, by our calculations, the Winner Company’s equity has a fair value of $215.3 million. That's it
the DCF valuation is complete.
Having finished the DCF valuation, we can judge the merits of buying Winner Company shares.
If we divide the fair value by the number of Winner Company shares outstanding, we get a fair
value for the company's shares. If the shares are trading at a lower value than this, they could
represent a buying opportunity for investors. If they are trading higher than the per share fair
value, shareholders may want to consider selling Winner Company stock.
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You are familiar with the mechanics of DCF analysis and you have seen it applied to a practical
example; now it's time to consider the strengths and weaknesses of this valuation tool. What
makes DCF better than other valuation methods? What are its shortcomings? We answer those
questions in the following section of this tutorial.
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Advantage & Disadvantage of DCF
Having worked our way through the mechanics of discounted cash flow analysis, it is worth our
while to examine the method's strengths and weaknesses. There is a lot to like about the
valuation tool, but there are also reasons to be cautious about it.
Advantages
Arguably the best reason to like DCF is that it produces the closest thing to an intrinsic stock
value. The alternatives to DCF are relative valuation measures, which use multiples to compare
stocks within a sector. While relative valuation metrics such as price-earnings (P/E), EV/EBITDA
and price-to-sales ratios are fairly simple to calculate, they aren't very useful if an entire sector
or market is over or undervalued. A carefully designed DCF, by contrast, should help investors
steer clear of companies that look inexpensive against expensive peers.
Unlike standard valuation tools such as the P/E ratio, DCF relies on free cash flows. For the most
part, free cash flow is a trustworthy measure that cuts through much of the arbitrariness and
"guesstimates" involved in reported earnings. Regardless of whether a cash outlay is counted as
an expense or turned into an asset on the balance sheet, free cash flow tracks the money left
over for investors.
Best of all, you can also apply the DCF model as a sanity check. Instead of trying to come up
with a fair value stock price, you can plug the company's current stock price into the DCF model
and, working backwards, calculate how quickly the company would have to grow its cash flows
to achieve the stock price. DCF analysis can help investors identify where the company's value is
coming from and whether or not its current share price is justified.
Disadvantages
Although DCF analysis certainly has its merits, it also has its share of shortcomings. For starters,
the DCF model is only as good as its input assumptions. Depending on what you believe about
how a company will operate and how the market will unfold, DCF valuations can fluctuate
wildly. If your inputs - free cash flow forecasts, discount rates and perpetuity growth rates - are
wide of the mark, the fair value generated for the company won't be accurate, and it won't be
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useful when assessing stock prices. Following the "garbage in, garbage out" principle, if the
inputs into the model are "garbage", then the output will be similar. DCF works best when
there is a high degree of confidence about future cash flows. But things can get tricky when a
company's operations lack what analysts call "visibility" - that is, when it's difficult to predict
sales and cost trends with much certainty. While forecasting cash flows a few years into the
future is hard enough, pushing results into eternity (which is a necessary input) is nearly
impossible. The investor's ability to make good forward-looking projections is critical - and
that's why DCF is susceptible to error.
Valuations are particularly sensitive to assumptions about the perpetuity growth rates and
discount rates. Our Winner Company model assumed a cash flow perpetuity growth rate of 4%.
Cut that growth to 3%, and the Winner Company’s fair value falls from $215.3 million to $190.2
million; lift the growth to 5% and the value climbs to $248.7 million. Likewise, raising the 11%
discount rate by 1% pushes the valuation down to $182.7 million, while a 1% drop boosts the
Winner Company’s value to $258.9 million.
DCF analysis is a moving target that demands constant vigilance and modification. A DCF model
is never built in stone. If the Winner Company delivers disappointing quarterly results, if its
major customer files for bankruptcy, or if interest rates take a dramatic turn, you will need to
adjust your inputs and assumptions. If any time expectations change, the fair value will change.
That's not the only problem. The model is not suited to short-term investing. DCF focuses on
long-term value. Just because your DCF model produces a fair value of $215.3 million that does
not mean that the company will trade for that any time soon. A well-crafted DCF may help you
avoid buying into a bubble, but it may also make you miss short-term share price run-ups that
can be profitable. Moreover, focusing too much on the DCF may cause you to overlook unusual
opportunities.
DCF is a rigorous valuation approach that can focus your mind on the right issues, help you see
the risk and help you separate winning stocks from losers. But bear in mind that while the DCF
technique we've sketched out can help reduce uncertainty, it won't make it disappear.
What's clear is that investors should be conservative about their inputs and should not resist
changing them when needed. Aggressive assumptions can lead to inflated values and cause you
to pay too much for a stock. The best way forward is to examine valuation from a variety of
perspectives. If the company looks inexpensive from all of them, chances are better that you
have found a bargain.
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LECTURE- 08
RISK AND RETURN
A fundamental idea in finance is the relationship between risk and return. The greater the
amount of risk that an investor is willing to take on, the greater the potential return. The reason
for this is that investors need to be compensated for taking on additional risk.
The chance that an investment's actual return will be different than expected is Risk. Risk
includes the possibility of losing some or all of the original investment. Different versions of
risk are usually measured by calculating the Standard Deviation of the historical returns or
average returns of a specific investment. High standard deviation indicates a high degree of risk.
Many companies now allocate large amounts of money and time in developing risk
management strategies to help manage risks associated with their business and investment
dealings. A key component of the risk management process is risk assessment, which involves
the determination of the risks surrounding a business or investment.
Investors are basically risk averse, meaning that, given a choice between two assets with equal
rates of return, they will select the asset with the lower level of risk. Evidence that most
investors are risk averse is that they purchase various types of insurance, including life
insurance, car insurance, and health insurance. Buying insurance basically involves an outlay of
a given amount to guard against an uncertain, possibly larger outlay in the future. When you
buy insurance, this implies that you are willing to pay the current known cost of the insurance
policy to avoid the uncertainty of a potentially large future cost related to a car accident or a
major illness.
This does not imply that everybody is risk averse or that investors are completely risk averse
regarding all financial commitments. The fact is, not everybody buys insurance for everything.
Some people have no insurance against anything, either by choice or because they cannot
afford it. In addition, some individuals buy insurance related to some risks such as auto
accidents or illness, but they also buy lottery tickets and gamble at race tracks or in casinos,
where it is known that the expected returns are negative, which means that participants are
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willing to pay for the excitement of the risk involved. This combination of risk preference and
risk aversion can be explained by an attitude toward risk that depends on the amount of money
involved. This is the case for people who like to gamble for small amounts (in lotteries or slot
machines) but buy insurance to protect themselves against large potential losses, such as fire or
accidents.
While recognizing this diversity of attitudes, our basic assumption is that most investors
committing large sums of money to developing an investment portfolio are risk averse.
Therefore, we expect a positive relationship between expected return and expected risk.
Notably, this is also what we generally find in terms of long-run historical results—that is, there
is generally a positive relationship between the rates of return on various assets and their
measures of risk. Although there is a difference in the specific definitions of risk and
uncertainty, for our purposes and in most financial literature the two terms are used
interchangeably. Risk is the uncertainty of future outcomes. An alternative definition might be
the probability of an adverse outcome.
Risk — just the thought of it can give investors sleepless nights. However, through careful
planning for your financial future, you can help manage risk. Risk is something encounter every
day. Even crossing a busy street involves some risk. With investments, balancing risk and return
can be a tricky operation. All investors want to maximize their return, while minimizing risk.
Some investments are certainly more "risky" than others, but no investment is risk free. Trying
to avoid risk by not investing at all can be the riskiest move of all. That would be like standing at
the curb, never setting foot into the street. You'll never be able to get to your destination if you
don't accept some risk. In investing, just like crossing that street, you carefully consider the
situation, accept a comfortable level of risk, and proceed to where you're going. Risk can never
be eliminated, but it can be managed. Let's take a look at the different types of risk, how
different asset categories perform, and the ways and means to help manage risk.
Types of Risk
When most people think of "risk" they translate it as loss of principal. However, there are many
kinds of risk. Let's take a look at some of them:
 Capital Risk: Losing your invested money.

 Inflationary Risk: Investment's rate of return doesn't keep pace with inflation rate.
 Interest Rate Risk: A drop in an investment's interest rate.
 Market Risk: Selling an investment at an unfavorable price.
 Liquidity Risk: Limitations on the availability of funds for a specific period of time.
 Legislative Risk: Changes in tax laws may make certain investments less advantageous.
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 Default Risk: The failure of the institution where an investment is made.
How Do Different Assets Perform?
It may seem that there are countless types of investment products to choose from but,
basically, there are three types of core investments: cash (or cash equivalents), bonds, and
stocks.
 Cash
Investments such as bank savings and checking accounts, Certificates of Deposit (CDs), and
Treasury Bills. The prices generally don't fluctuate very much. To investors concerned with
loss of capital risk, cash would appear to be the most secure choice, as principal is guaranteed
and/or insured. Savings and checking accounts are highly liquid, as they can be readily
converted into cash. With CDs, you may face liquidity risk, as they must be held for a
predetermined period of time or may be subject to penalties for premature withdrawal.
Although risk to principal may be minimal, loss of purchasing power, or inflationary risk, must
be taken into consideration. When inflation and taxation are taken into account, returns can
be considerably lower. Hypothetically, let's say in 1981 you earned 14% in an investment. It
sounds astronomical; however, the inflation rate at one point that year soared to 15%. That's
a net loss of value of at least 1% — and that's before taxes take another bite.
 Bonds
commonly called "fixed income investments," they are basically loans or "IOUs." Interest is
earned on the money you lend. The prices of bonds do move up and down, but normally not
as much as stocks. Many people think of bonds as conservative investments, but the returns
can have a high degree of volatility. The fluctuation of interest rates is called interest rate risk,
and a downturn in the bond prices could significantly decrease the overall return of any
particular bond.
 Stocks
Represent equity in, or partial ownership of, a company. An easy way to remember the
difference between stocks and bonds is: "With stocks, you own. With bonds, you loan."
The price of a stock or share can move up or down, sometimes a lot. The returns of
stocks from year to year can be quite volatile, but, as the graph illustrates, the returns
from stocks have significantly outpaced inflation, and topped the returns from cash and
bonds as well, over this twenty-year period.
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Finding Your Comfort Zone
It's possible to achieve higher returns through stocks rather than bonds, and through bonds
rather than through cash, but you can't expect to get higher returns without taking on some
degree of unpredictability. If you seek higher returns, you have to be willing to live with higher
risk. "How much risk is right for me?" The answer will affect your investment decisions.
Although past performance is not a guarantee of what will happen in the future, historical
results over a long period of time can help you make your investment decisions.
The Ways to Manage Risk
There are a number of strategies that can help limit risk while offering the potential of higher
returns.
 Diversification
investing in a variety of investments, or simply following the old adage "Don't put all your
eggs in one basket." With a portfolio spread among several different investments, you
benefit when each type is doing well, and also limit exposure when one or more investment
is performing poorly.
 Asset Allocation
Building upon the diversification concept, with asset allocation you create a customized
portfolio consisting of several asset categories (cash, stocks, bonds) rather than individual
securities. Changing economic conditions affect various types of assets differently;
consequently, each asset category's return may partially offset the others'.
 Cost Averaging
Systematically investing a fixed money amount at regular time intervals means cost
averaging. When this disciplined program is adhered to and market fluctuations are
ignored, it attempts to "smooth out" the ups and downs of the market over the long haul.
Cost averaging, however, cannot guarantee a positive return in a declining market and you
must consider your ability to continue investing on a regular basis under all market
conditions.
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The Means to Manage Risk
Most investors find it difficult to diversify effectively across the full spectrum of cash and
individual stocks and bonds. That is why so many investors have chosen variable products to
apply the strategies previously mentioned. Mutual funds, variable annuities, variable universal
life insurance products offer the potential for maximizing investment performance, investment
flexibility, and convenience. They allow you to allocate investments among several asset
categories to tailor the mix to suit your needs. In addition they offer professional investment
management, and allow you to leave the day-to-day decisions to the "experts." Of course, like
any investment, these products involve risk and you should read a prospectus carefully to see if
they are right for you before investing.
Plant Your Tree Today
An old proverb states, "The best time to plant a tree was yesterday. The second best time to
plant a tree is today." This "power of time" concept applies to personal finance as well. The
sooner you implement your investment plan, the greater the wealth you can potentially
accumulate. In addition, the longer your time horizon, the easier it is to ride out the ups and
downs of your investments. The length of time investors hold onto their portfolios is one of the
crucial factors determining the likelihood of obtaining a positive return. Financial history
indicates that investors are amply rewarded in the long-term for assuming risk. Regrettably
there's no magic potion for eliminating risk. But by carefully creating a long-term, diversified
investment program you can help manage risk. For assistance, contact us to put you together
with a NYLIFE Securities Inc. registered representative — professionally trained and
experienced — who can help you analyze your needs and assist you in putting together an
investment program that fits your needs — at no charge to you.
Measuring Risk
One of the best-known measures of risk is the variance or standard deviation of expected
returns. It is a statistical measure of the dispersion of returns around the expected value
whereby a larger variance or standard deviation indicates greater dispersion. The idea is that
the more disperse the expected returns, the greater the uncertainty of future returns.
Another measure of risk is the range of returns. It is assumed that a larger range of expected
returns, from the lowest to the highest return, means greater uncertainty and risk regarding
future expected returns.
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We consider the variance and standard deviation as one measure of risk because the standard
deviation is the square root of the variance.
Although there are numerous potential measures of risk, we will use the variance or standard
deviation of returns because
(1) This measure is somewhat intuitive,
(2) It is a correct and widely recognized risk measure, and
(3) It has been used in most of the theoretical asset pricing models.
The expected rate of return for an individual investment is computed as,
Exhibit 1:
The expected return for an individual risky asset with the set of potential returns and an
assumption of equal probabilities used in the example would be 11 percent.
The expected rate of return for a portfolio of investments is simply the weighted average of the
expected rates of return for the individual investments in the portfolio. The weights are the
proportion of total value for the investment. The expected rate of return for a hypothetical
portfolio with four risky assets is,
Exhibit 2:
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The expected return for this portfolio of investments would be 11.5 percent. The effect of
adding or dropping any investment from the portfolio would be easy to determine because you
would use the new weights based on value and the expected returns for each of the
investments. This computation of the expected return for the portfolio [E(Rport)] can be
generalized as follows:
where:
Wi = the percent of the portfolio in asset i

E(Ri) = the expected rate of return for asset i
As noted, we will be using the variance or the standard deviation of returns as the measure of
risk (recall that the standard deviation is the square root of the variance). Therefore, at this
point, we will demonstrate how you would compute the standard deviation of returns for an
individual investment. Subsequently, after discussing some other statistical concepts, we will
consider the determination of the standard deviation for a portfolio of investments.
The variance, or standard deviation, is a measure of the variation of possible rates of return,
Ri, from the expected rate of return [E(Ri)] as follows:
Where:
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Pi is the probability of the possible rate of return, Ri
The computation of the variance and standard deviation of the expected rate of return for the
individual risky asset (Exhibit 1) is given below:
Computation of the variance of the expected rate of return for an individual risky asset
Variance (σ2) = .00050

Standard Deviation (σ) = .02236
Therefore, when describing this example, it would contend that for expected return of 11
percent, the standard deviation of your expectations is 2.236 percent.
A Relative Measure of Risk
In some cases, an unadjusted variance or standard deviation can be misleading. If conditions for
two or more investment alternatives are not similar—that is, if there are major differences in
the expected rates of return—it is necessary to use a measure of relative variability to indicate
risk per unit of expected return. A widely used relative measure of risk is the coefficient of
variation (CV), calculated as follows:
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This measure of relative variability and risk is used by financial analysts to compare alternative
investments with widely different rates of return and standard deviations of returns. As an
illustration, consider the following two investments:
Comparing absolute measures of risk, investment B appears to be riskier because it has a

standard deviation of 7 percent versus 5 percent for investment A. In contrast, the CV figures
show that investment B has less relative variability or lower risk per unit of expected return
because it has a substantially higher expected rate of return:
Considering the relative dispersion and the total distribution, most investors would probably
prefer the second investment.
Covariance and Correlation
The covariance statistic provides an absolute measure of how two assets move together over
time. For two assets, i and j, the covariance of rates of return is defined as,
Covariance is affected by the variability of the two individual return series. Obviously, you want
to “standardize” this covariance measure taking into consideration the variability of the two
individual return series, as follows:
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Standardizing the covariance by the individual standard deviations yields the correlation
coefficient (rij), which can vary only in the range –1 to +1. A value of +1 would indicate a perfect
positive linear relationship between Ri and Rj, meaning the returns for the two stocks move
together in a completely linear manner. A value of –1 indicates a perfect negative relationship
between the two return series such that when one stock’s rate of return is above its mean, the
other stock’s rate of return will be below its mean by the comparable amount.
Portfolio Standard Deviation Formula
Now that we have discussed the concepts of covariance and correlation, we can consider the
formula for computing the standard deviation of returns for a portfolio of assets, our measure
of risk for a portfolio. As noted, Harry Markowitz derived the formula for computing the
standard deviation of a portfolio of assets. The expected rate of return of the portfolio was the
weighted average of the expected returns for the individual assets in the portfolio; the weights
were the percentage of value of the portfolio. One might assume it is possible to derive the
standard deviation of the portfolio in the same manner, that is, by computing the weighted
average of the standard deviations for the individual assets. This would be a mistake.
Markowitz derived the general formula for the standard deviation of a portfolio as follows:
This formula indicates that the standard deviation for a portfolio of assets is a function of the
weighted average of the individual variances (where the weights are squared), plus the
weighted covariances between all the assets in the portfolio. The standard deviation for a
portfolio of assets encompasses not only the variances of the individual assets but also includes
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the covariances between pairs of individual assets in the portfolio. Further, it can be shown
that, in a portfolio with a large number of securities, this formula reduces to the sum of the
weighted covariances.
Demonstration of the Portfolio Standard Deviation Calculation
Any asset or portfolio of assets can be described by two characteristics: the expected rate of
return and the expected standard deviation of returns. Therefore, the following demonstrations
can be applied to two individual assets with the indicated return–standard deviation
characteristics and correlation coefficients, two portfolios of assets, or two asset classes with
the indicated return–standard deviation characteristics and correlation coefficients.
Consider the case in which both assets have the same expected return and expected standard
deviation of return. As an example, let us assume
Consider the following examples where the two assets have equal weights in the portfolio (W1 =
0.50; W2 = 0.50). Therefore, the only value that changes in each example is the correlation
between the returns for the two assets. Recall that:
Consider the following alternative correlation coefficients and the covariances they yield. The
covariance term in the equation will be equal to r1,2 (0.10)(0.10) because both standard
deviations are 0.10.
When this general formula is applied to a two-asset portfolio, it is
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Or,
Thus in case ‘a’:
In case ‘b’:
You should be able to confirm through your own calculations that the standard deviations for
Portfolios c and d are as follows:
c. 0.0707
d. 0.05
The final case where the correlation between the two assets is –1.00 indicates the ultimate
benefits of diversification:
Here, the negative covariance term exactly offsets the individual variance terms, leaving an
overall standard deviation of the portfolio of zero. This would be a risk-free portfolio.
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Relationship between risk and return
Under a specified set of assumptions, all rational, profit-maximizing investors want to hold a
completely diversified market portfolio of risky assets, and they borrow or lend to arrive at a
risk level that is consistent with their risk preferences. Under these conditions, the relevant risk
measure for an individual asset is its co-movement with the market portfolio. This co-
movement, which is measured by an asset’s covariance with the market portfolio, is referred to
as an asset’s systematic risk, the portion of an individual asset’s total variance attributable to
the variability of the total market portfolio. In addition, individual assets have variance that is
unrelated to the market portfolio (that is, it is nonmarket variance) that is due to the asset’s
unique features. This nonmarket variance is called unsystematic risk, and it is generally
considered unimportant because it is eliminated in a large, diversified portfolio. Therefore,
under these assumptions, the risk premium for an individual earning asset is a function of the
asset’s systematic risk with the aggregate market portfolio of risky assets. The measure of an
asset’s systematic risk is referred to as its Beta:
Risk Premium = f (Systematic Market Risk)
Some might expect a conflict between the market measure of risk (systematic risk) and the
fundamental determinants of risk (business risk, and so on). A number of studies have
examined the relationship between the market measure of risk (systematic risk) and accounting
variables used to measure the fundamental risk factors, such as business risk, financial risk, and
liquidity risk. The authors of these studies have generally concluded that a significant
relationship exists between the market measure of risk and the fundamental measures of risk.
Therefore, the two measures of risk can be complementary. This consistency seems reasonable
because, in a properly functioning capital market, the market measure of the risk should reflect
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the fundamental risk characteristics of the asset. As an example, you would expect a firm that
has high business risk and financial risk to have an above average beta. At the same time, it is
possible that a firm that has a high level of fundamental risk and a large standard deviation of
return on stock can have a lower level of systematic risk because its variability of earnings and
stock price is not related to the aggregate economy or the aggregate market. Therefore, one
can specify the risk premium for an asset as:
Risk Premium = f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk)
Or
Risk Premium = f (Systematic Market Risk)
The following figure graphs the expected relationship between risk and return. It shows that
investors increase their required rates of return as perceived risk (uncertainty) increases. The
line that reflects the combination of risk and return available on alternative investments is
referred to as the security market line (SML).
The SML reflects the risk-return combinations available for all risky assets in the capital market
at a given time. Investors would select investments that are consistent with their risk
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preferences; some would consider only low-risk investments, whereas others welcome high-risk
investments. Beginning with an initial SML, three changes can occur. First, individual
investments can change positions on the SML because of changes in the perceived risk of the
investments. Second, the slope of the SML can change because of a change in the attitudes of
investors toward risk; that is, investors can change the returns they require per unit of risk.
Third, the SML can experience a parallel shift due to a change in the RRFR or the expected rate
of inflation—that is, a change in the NRFR. Investors place alternative investments somewhere
along the SML based on their perceptions of the risk of the investment. Obviously, if an
investment’s risk changes due to a change in one of its risk sources (business risk, and such), it
will move along the SML. For example, if a firm increases its financial risk by selling a large bond
issue that increases its financial leverage, investors will perceive its common stock as riskier and
the stock will move up the SML to a higher risk position. Investors will then require a higher rate
of return. As the common stock becomes riskier, it changes its position on the SML.
Building Portfolio and its management
There is no single strategy for being successful in the stock market. If we look at the great
investors, Warren Buffet, T. Rowe Price and Peter Lynch, they all had different investment
strategies. However, few people have the natural investment talents and insights that these
men held. Below than is a strategy than can be used by the rest of us to earn high returns while
maintaining minimum risks.
This stock portfolio strategy is based on 3 basic principles:
1. Diversify
2. Buy Quality Stock
3. Pay the Right Price
Here are these principles laid out in detailed steps.
Diversify
Buying several stocks in different industries will prevent wiping out your investments if any one
industry goes down. This should be a minimum of 10 stocks in 10 industries. The more stocks,
the closer your portfolio will mirror the market, but more than 50 stocks is overkill, and become
difficult to maintain. 10 stocks in 10 industries should mirror about 85% of the market, and if
you buy 20 stocks in 20 industries, you will just about have the market mirrored.
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Buy in equal amounts

When building your stock portfolio, buy stocks in equal amounts instead of round lots. In other
words, if you have TK 200000 to invest in 10 stocks, buy TK 20000 worth of each stock. If you
buy an even block, for example 100 shares of a TK 80/share stock, the value in that stock will
total TK 80000 and will make up 40% of your stock holdings instead of 10%. This will go against
our goal in item 1, which is to diversify.
Buy Quality Stock

Quality of the stock is sometime difficult to determine, but here are some general steps you can
take to pick a high quality stock.
A. Large Company
B. A Standard & Poor rating of B+ or higher
C. A leader or one of the leaders in their industry
D. Has been around for many years
E. Has a history of paying dividends
Get good dividends

There are two reasons that you want to go with a company that pays dividends.
A. Dividends increase the total return more than capital gains alone
B. History shows that companies that pay dividend tend to fail less often
Buy when stocks down

Do not buy stock in a company when it is making the front cover of Business Week for it's
success. By this time the stock has already gone up and you will be buying at a peak. Instead
buy when the company is down, but from your other research you know it is a quality company
and will recover.
Have patience
You should sell the stock when the reason you bought the stock is no longer valid. Also consider
selling a stock from a company that is going through a merger. Usually you will be offered a
higher price at the time of the merger and most likely the company will change and not be the
same company you selected.
Management of Portfolio
The art and science of making decisions about investment mix and policy, matching
investments to objectives, asset allocation for individuals and institutions, and balancing risk
against performance. Portfolio management is all about strengths, weaknesses, opportunities
and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and
many other tradeoffs encountered in the attempt to maximize return at a given appetite for
risk. The process of managing an investment portfolio never stops. Once the funds are initially
invested according to the plan, the real work begins in monitoring and updating the status of
the portfolio and the investor’s needs. The first step in the portfolio management process, as
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seen in the following graph, is for the investor, either alone or with the assistance of an
investment advisor, to construct a policy statement. The policy statement is a road map; in it
investors specify the types of risk they are willing to take and their investment goals and
constraints.
All investment decisions are based on the policy statement to ensure they are appropriate for
the investor. Because investor needs change over time, the policy statement must be
periodically reviewed and updated. The process of investing seeks to peer into the future and
determine strategies that offer the best possibility of meeting the policy statement guidelines.
In the second step of the portfolio management process, the manager should study current
financial and economic conditions and forecast future trends. The investor’s needs, as reflected
in the policy statement and financial market expectations will jointly determine investment
strategy. Economies are dynamic; they are affected by numerous industry struggles, politics,
and changing demographics and social attitudes. Thus, the portfolio will require constant
monitoring and updating to reflect changes in financial market expectations. The third step of
the portfolio management process is to construct the portfolio. With the investor’s policy
statement and financial market forecasts as input, the advisors implement the investment
strategy and determine how to allocate available funds across different countries, asset classes,
and securities. This involves constructing a portfolio that will minimize the investor’s risks while
meeting the needs specified in the policy statement. The fourth step in the portfolio
management process is the continual monitoring of the investor’s needs and capital market
conditions and, when necessary, updating the policy statement.
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Based upon all of this, the investment strategy is modified accordingly. A component of the
monitoring process is to evaluate a portfolio’s performance and compare the relative results to
the expectations and the requirements listed in the policy statement.
Overview of management analysis
The Management Analysis is a region of a company in which management discusses numerous

aspects of the company, both past and present. Among other things, Management Analysis
provides an overview of the previous year of operations and how the company fared in that
time period. Management will usually also touch on the upcoming year, outlining future goals
and approaches to new projects. The Management Analysis is a very important section of an
annual report as well, especially for those analyzing the fundamentals, which include
management and management style. Although this section contains useful information,
investors should keep in mind that the section is unaudited.
The concept of company management analysis comes from the fluctuating economic
environment in which businesses operate. Rather than resisting change and settling for
business as usual, business owners, directors and managers can use management analysis to
review operations and enhance their companies' processes.
Company management analysis often starts from the top leadership or management team and
works its way down to the lower levels of the company. Including every portion of the business
in the analysis process provides a well-rounded review of the company. This analysis may
require the use of departmental plans or strategies. In business, management analysis typically
focuses on operations, company culture or financial performance. Operational reviews include
how a company completes tasks and activities, company culture relates to the organization's
business philosophies or practices, and financial reviews are the returns generated from
operations.
Organizations may choose to hire an outside company or individual to help them complete the
company management analysis process. This can help provide an objective opinion of the
company and offer new ideas for managers looking to make changes that will offer significant
company benefits. The income statement, balance sheet, statement of cash flows and
statement of owner's equity provide quantitative information about the company's
performance. The management discussion and analysis, on the other hand, gives qualitative
information about the management's assessment of company performance and its outlook for
the future.
The discussion provided by the management is intended to identify information that potential
investors might not glean from simply reading the numbers in the quantitative financial
statements. A synopsis of the company's recent history is used to present a setting for the
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financial results. A summary of recent mergers or acquisitions and how they affected
performance is important to gaining an understanding of the company's current position.
The overview of the management discussion and analysis includes information about how
economic or government changes have affected or might affect the company. It presents an
assessment of how the company earns income and where it operates, if this information is
relevant to the discussion. The overall focus of the management discussion is on items that
might have a material effect on the company and a fundamental analysis of the company's
results of operations. The management must discuss trends and risks that might affect future
performance. An analysis of the potential positive or negative consequences of certain events
helps potential investors understand the company's situation. The management discussion and
analysis must also disclose any current or possible litigation and how it might have an impact on
the company's financial stability. If there is litigation in process, the management's analysis
should assess whether it believes there is any merit in the legal actions and the expected
outcome of those actions. Any off-balance sheet arrangements, such as letters of credit or
bonds that have been issued to secure business dealings must be disclosed by the
management. It should discuss any derivative instruments, such as hedge contracts, into which
the company has entered in an attempt to reduce the potential risk of price fluctuations or
exchange rate variations. Contractual obligations are detailed, because they influence how the
company conducts business.
The management discussion and analysis looks at the company's level of liquidity, where and
how the company accesses capital, its level of profitability, and the likelihood that the rate of
growth or earnings will continue. If any material capital repayments are due in the near future,
this must be taken into account. The analysis also evaluates any material accounting estimates
that are included in the financial statements and explains how variations in these estimates
could affect operating results. Of necessity, some numbers used in financial statements are
based on estimates, and it is important that the management discloses the degree of certainty
associated with the estimates and the impact on the company if the estimates turn out to be in
error.
How will you evaluate a Company’s Management
Most investors realize that it's important for a company to have a good management team. The
problem is that evaluating management is difficult - so many aspects of the job are intangible.
It's clear that investors can't always be sure of a company by only poring over financial
statements hence the importance of emphasizing the qualitative aspects of a company. There is
no magic formula for evaluating management, but there are factors to which you should pay
attention.
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The job of Management
A strong management is the backbone of any successful company. This is not to say that
employees are not also important, but it is management that ultimately makes the strategic
decisions. You can think of management as the captain of a ship. While not physically driving
the boat, he or she directs others to look after all the factors that ensure a safe trip.
Theoretically, the management of a publicly traded company is in charge of creating value for
shareholders. Management is to have the business smarts to run a company in the interest of
the owners. Of course, it is unrealistic to believe that management only thinks about the
shareholders. Managers are people too and are, like anybody else, looking for personal gain.
Problems arise when the interests of the managers are different from the interests of the
shareholders. The theory behind the tendency for this to occur is called agency theory. It says
that conflict will occur unless the compensation of management is tied together somehow with
the interests of shareholders. Don't be naive by thinking that the board of directors will always
come to the shareholders' rescue. Management must have some actual reason to be beneficial
to shareholders.
Stock Price Isn't Always a Reflection of Good Management
Some say that qualitative factors are pointless because the true value of management will be
reflected in the bottom line and the stock price. There is some truth to this over the long run,
but strong performance in the short run doesn't guarantee good management. The best
example is the downfall of dotcoms. For a period of time, everybody was talking about how the
new entrepreneurs were going to change the rules of business. The stock price was deemed as
a sure indication of success. The market, however, behaves strangely in the short term. Strong
stock performance alone doesn't mean you can assume the management is of high quality.
Length of Tenure
One good indicator is how long the CEO and top management has been serving the company.
One of Buffett's investment criteria is to look for solid stable managements that stick with their
companies for the long term.
Strategy and Goals
Ask yourself, what kind of goals has the management set out for the company? Does the
company have a mission statement? How concise is the mission statement? A good mission
statement creates goals for management, employees, stockholders and even partners. It's a
bad sign when companies lace their mission statement with the latest buzz words and
corporate jargon.
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Insider Buying and Stock Buybacks
If insiders are buying shares in their own companies, it's usually because they know something
that normal investors do not. Insiders buying stock regularly show investors that managers are
willing to put their money where their mouths are. The key here is to pay attention to how long
the management holds shares. Flipping shares to make a quick buck is one thing; investing for
the long term is another. The same can be said for share buybacks. If you ask management of a
company about buybacks, it will likely tell you that a buyback is the logical use of a company's
resources. After all, the goal of a firm's management is to maximize return for shareholders. A
buyback increases shareholder value if the company is truly undervalued.
Compensation
High-level executives pull in six or seven figures per year, and rightly so. Good management
pays for itself time and time again by increasing shareholder value. But knowing what level of
compensation is too high is a difficult thing to determine.
One thing to consider is that managements in different industries take in different amounts.
You have to be suspicious if a manager makes an obscene amount of money while the company
suffers. If a manager really cares about the shareholders in the long term, would this manager
be paying him/herself exorbitant amounts of money during tough times? It all comes down to
the agency problem. If a CEO is making millions of dollars when the company is going bankrupt,
what incentive does he or she have to do a good job?
There is no single template for evaluating a company's management, but we hope the issues
we've discussed in this article will give you some ideas for analyzing a company. Looking at the
financial results each quarter is important, but it doesn't tell the whole story. Spend a little time
investigating the people who fill those financial statements with numbers.
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Definitions of basic terms

How money is created and extinguished

Savings & Investment

An asset is usually purchased, or equivalently a deposit is made in a bank, in hopes of getting a

In finance, investment is the commitment of funds by buying securities or other monetary or

Role of Savings in the Economic growth

Investment role in the Economic growth

Importance of Investment in personal view point

Fulfilling Personal Goals

Desires of Family members

 Protection policies – designed to provide a benefit in the event of specified event,

Some of the characteristics of alternative investments may include:

Why private equity?

Venture capital (VC) is financial capital provided to early-stage, high-potential and

Investment basic in capital market

Why should one invest?

One needs to invest to:

When to start Investing?

What care should one take while investing?

Before making any investment, one must ensure to:

What is meant by Interest?

What factors determine interest rates?

What are various options available for investment?

One may invest in:

What are various Short-term financial options available for investment?

What are various Long-term financial options available for investment?

FINANCIAL MARKET AND ITS INSTRUMENTS AND DIFFERENT INDICATORS

Money Market Instruments

Treasury Bills (T-Bills)

Commercial paper is a low-cost alternative to bank loans. It is a short term unsecured

Features of primary markets are:

Methods of issuing securities in the primary market are:

 Initial public offering;

The following discussion will be on capital market instruments.

The most important features of a bond are:

V= 50/.12 = Tk. 416.67

Non Zero Coupon Bonds

V= I/(1+Kd)1 + I/(1+Kd)2 + … … … + I/(1+Kd)n + MV/(1+Kd)n

V= 100/(1.12)1 + 100/(1.12)2 +… … … + 100/(1.12)9 + 1000/(1.12)9

 Parity (Conversion) value: Equity price × Conversion ratio.

There are two types of debentures:

The following features are usually associated with preferred stock:

 Convertible into common stock.

 Callable at the option of the corporation.

Common stock is a form of corporate equity ownership, a type of security. It is called

Every share of common stock represents a proportional ownership, or equity, in a company. If a

Difference between Preferred and Common Stock

Close Ended Mutual Fund

Open Ended Mutual Fund

Index Calculation Algorithm for DSE:

Yesterday's Closing Index X Current Market Capitalization

Yesterday's Closing Index X Closing Market Capitalization

Closing Market Capitalization = ∑ (Closing Price X Total no. of indexed shares)

There are three indices in the DSE as follows:

Sl.No Index Name Base Index Remarks

Figure 1: DSI Index Graph Last 30 Days

Figure 2: DSE General Index Graph Last 30 Days

Figure 3: DSE20 Index Graph Last 30 Days

DSE20 is calculated by using the following 20 stocks:

Figure 4: List of DSE 20 Stocks

Figure 5: DSE General Index for a Specific date

Figure 6: DSE General Index with Volume for a specific date