Unit I Role of Financial Institution 3-4 Valuation of the Firm 4 Dividend Valuation Model 4-15 Dividend Policies 4-15 Walter Model 16-18 Gordon Model 18-21 Payment Ration divided as a residual payment M.M. Irrelevance Doctrine. 21-24 Unit II Investment Decision Investment Analysis Risk Analysis Probability Approach. Business Failures, Mergers, Consolidations and liquidation. Unit III Capital Markets 47-60 Fiscal Policies, Government Regulations affecting Capital Market 55 Role of SEBI 60-65 Stock Markets 65-76 Unit IV Lease Financing, Mutual Funds. Venture Capital, Derivatives – Futures and Options Inflation and Financial Decisions. Unit V Foreign Collaboration Business Ventures Abroad. Multinational Corporations International Financial Institutions

24 24-25 25-38 38-41 42-46

76-90 90-98 98-115 115-123 123-129

130-144 144-145

1.1 What is corporate finance? Corporate finance is the study of the decisions that every firm has to make. Corporate finance covers all decisions made by business that affect their finances, ultimately then marketing, strategic, and advertising decisions are all corporate finance decisions.

In decision making, there is only one objective in corporate finance – to maximize firm value. To achieve this objective, three core corporate financial principles must be observed.

 

The investment principle specifies that firm should not invest in assets that earn less than a minimum acceptable hurdle rate. Where the hurdle rate will reflect the risk of the investment and the mix of debt and equity used by the firm. The financing principle, posts that firms should use a mix of debt and equity that maximizes their value. The dividend principle, Argues that firms that do not have enough investments that earn the hurdle rate return the cash to the owners of the business. Every decision that a business makes has financial implications, and any decision which affects the finances of a business is a corporate finance decision.

Financial System Financial System: These are the five main parts that together make up financial system:
   

Money: To pay for purchases and store wealth. Financial Instruments: To transfer wealth from savers to investors and to transfer risk to those best equipped to bear it. Financial Markets: Buy and sell financial instruments. Financial Institutions: Provide access to financial markets (a finical intermediary) “A financial institution is an institution that provides

financial services for its clients or members.” Financial institutions are often regulated be Government bodies. Central Banks: Monitor financial Institutions and stabilize the Economy.

Financial Institutions: Financial institutions act as financial intermediaries that gather the savings of many individuals and reinvest them in the financial markets. For example, banks raise money by taking deposits and by selling debt and common stock to investors. They then lend the money to companies and individuals. Of course banks must charge sufficient interest to cover their costs and to compensate depositors and other investors. Financial Institutions are one important pillar of the financial system.  “A financial institution is an institution that provides financial services for its clients or members.”  Act as financial intermediaries. Their main functions include (Role of Financial Institution):  Reduce transactions cost by specializing in the issuance of standardized securities  Reduce information costs of screening and monitoring borrowers.  Issue short term liabilities and purchase long-term loans. Banks and their immediate relatives, such as savings and loan companies, are the most familiar intermediaries. But there are many others, such as insurance companies and mutual funds. In the United States insurance companies are more important than banks for the long-term financing of business. They are massive investors in corporate stocks and bonds, and they often make long-term loans directly to corporations. Most of the money for these loans comes from the sale of insurance policies. Say you buy a fire insurance policy on your home. You pay cash to the insurance company, which it invests in the financial markets. In exchange you get a financial asset (the insurance policy). You receive no interest on this asset, but if a fire does strike, the company is obliged to cover the damages up to the policy limit. This is the return on your investment. Of course, the company will issue not just one policy but thousands. Normally the incidence of fires averages out, leaving the company with a predictable obligation to its policyholders as a group. Financial intermediaries contribute in the smooth functioning of the economy. Some examples. The Payment Mechanism Think how inconvenient life would be if all payments had to be made in cash. Fortunately, checking accounts, credit cards, and electronic transfers

allow individuals and firms to send and receive payments quickly and safely over long distances. Banks are the obvious providers of payments services, but they are not alone. For example, if you buy shares in a money-market mutual fund, your money is pooled with that of other investors and is used to buy safe, short-term securities. You can then write checks on this mutual fund investment, just as if you had a bank deposit. Borrowing and Lending Almost all financial institutions are involved in channeling savings toward those who can best use them. Thus, if Ms. Jones has more money now than she needs and wishes to save for a rainy day, she can put the money in a bank savings deposit. If Mr. Smith wants to buy a car now and pay for it later, he can borrow money from the bank. Both the lender and borrower are happier than if they were forced to spend cash as it arrived. Of course, individuals are not alone in needing to raise cash. Companies with profitable investment opportunities may also wish to borrow from the bank, or they may raise the finance by selling new shares or bonds. Governments also often run at a deficit, which they fund by issuing large quantities of debt. Pooling Risk Financial markets and institutions allow firms and individuals to pool their risks. For instance, insurance companies make it possible to share the risk of an automobile accident or a household fire. Here is another example. Suppose that you have only a small sum to invest. You could buy the stock of a single company, but then you would be wiped out if that company went belly-up. It’s generally better to buy shares in a mutual fund that invests in a diversified portfolio of common stocks or other securities. In this case you are exposed only to the risk that security prices as a whole will fall.

The value of the firm is obtained by discounting expected cash flows to the firm, i.e., the residual cash flows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions.

Where, CF to Firmt = Expected Cash flow to Firm in period t WACC = Weighted Average Cost of Capital In the adjusted present value approach, the value of the firm is written as the sum of the value of the firm without debt (the unlevered firm) and the effect of debt on firm value.


Firm Value = Unlevered Firm Value + (Tax Benefits of Debt – Expected Bankruptcy Cost from the Debt) The optimal dollar debt level is the one that maximizes firm value

Dividend: Dividend refers to the corporate net profits distributed among shareholders. Dividends can be both preference dividends and equity dividends. Preference dividends are fixed dividends paid as a percentage every year to the preference shareholders if net earnings are positive. After the payment of preference dividends, the remaining net profits are paid or retained or both depending upon the decision taken by the management. Kinds of Dividend:  Cash Dividend  Stock Dividend or Bonus Shares  Interim Dividend  Extra Dividend  Property Dividend  Scrip Dividend  Bond Dividend  Composite Dividend Steps to the Dividend Decision

Measures of Dividend Policy Dividend Payout = Dividends/ Net Income

• Measures the percentage of earnings that the company pays in dividends • If the net income is negative, the payout ratio cannot be computed. Dividend Yield = Dividends per share/ Stock price • Measures the return that an investor can make from dividends alone • Becomes part of the expected return on the investment. Two bad reasons for paying dividends 1. The bird in the hand fallacy 2. We have excess cash this year… Three “good” reasons for paying dividends 1. Clientele Effect: The investors in your company like dividends. 2. The Signaling Story: Dividends can be signals to the market that you believe that you have good cash flow prospects in the future. 3. The Wealth Appropriation Story: Dividends are one way of transferring wealth from lenders to equity investors (this is good for equity investors but Bad for lenders) A Dividend Matrix

A Practical Framework for Analyzing Dividend Policy


Different Types of Dividends The distribution of excess cash to shareholders can take two forms: dividends and/or share repurchase. Different Types of Dividends: 1. Cash dividends: Usually paid four times a year in cash.
2. Stock dividends: Stock dividends simply amount to distribution of

additional shares to existing shareholders. They represent nothing more than recapitalization of earnings of the company. (That is, the amount of the stock dividend is transferred from the R/E account to the common share account. Because of the capital impairment rule stock dividends reduce the firm’s ability to pay dividends in the future. e.g. 10% stock dividend.  Distribution of stock does not affect the value of the firm or the wealth of the shareholder.  Increase shares outstanding. Implications a. reduction in the R/E account b. reduced capacity to pay future dividends c. proportionate share ownership remains unchanged d. shareholder’s wealth (theoretically) is unaffected Effect on the Company a. conserves cash b. serves to lower the market value of firm’s stock

c. promotes wider distribution of shares to the extent that current owners divest themselves of shares...because they have more d. adjusts the capital accounts e. dilutes EPS Effect on Shareholders a. proportion of ownership remains unchanged b. total value of holdings remains unchanged c. if former DPS is maintained, this really represents an increased dividend payout. 3. Stock split: Although there is no theoretical proof, there is widespread belief that an optimal price range exists for a company’s common shares. It is generally felt that there is greater demand for shares of companies that are traded in the $40 - $80 dollar range. The purpose of a stock split is to decrease share price. Similar to a stock dividend. The NYSE requires share distributions of less than 25% to be treated as stock dividends. Usually expressed in ratios. E.g. 2:1 means that investors get one new share for each share that they own (so the total number of shares outstanding doubles). The result is:  increase in the number of share outstanding  theoretically, no change in shareholder wealth Reasons for use:  better share price trading range  psychological appeal (signaling theory) Example:  The XYZ Company is considering using a stock split to put its shares into a better trading range. Currently, the company’s shares are trading for $150 and the company’s shareholders equity accounts are as follows: • Commons shares (100,000 outstanding) $1,500,000 • Retained earnings 15,000,000 • Net Worth $16,500,000  A 2 for 1 Stock Split: • New Share Price = P0[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00 • The firm’s equity accounts: 1. Commons shares (200,000 outstanding) $1,500,000 2. Retained earnings 15,000,000 3. Net Worth $16,500,000  A 4 for 3 Stock Split: • New Share Price = P0[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50 • The firm’s equity accounts: 1. Commons shares (133,333 outstanding) $1,500,000

2. Retained earnings 15,000,000

3. Net Worth $16,500,000 A 3 for 4 Reverse Stock Split: • New Share Price = P0[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00 • The firm’s equity accounts: 1. Commons shares (75,000 outstanding) $1,500,000 2. Retained earnings 15,000,000 3. Net Worth $16,500,000

Share repurchases (buybacks):  The companies buy back its own shares from stockholders.  Can be either an open market repurchase (the firm buys on an exchange like any other investor) or a tender offer (the firm announces to all of its shareholders that it is willing to buy a fixed number of shares at a specified price).  Allowed under the OBCA and CBCA. Reasons for use: • to go “private” • as a substitute for cash dividends • for control purposes • as a defensive measure when the firm suspects a takeover bid. Method of Repurchase:  Tender offer: This is a formal offer to purchase a given number of shares at a given price over current market price. open market purchase: • The purchase of shares through an investment dealer like any other investor • This is not designed for large block purchases.

private negotiation with major shareholders

In any repurchase program, the securities commission requires disclosure of the event as well as all other material information through a prospectus. Repurchase Example: Current EPS = [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00 Current P/E ratio = $20 / $4 = 5X EPS after repurchase of 100,000 shares = $4.4 m / 1.0 = $4.40 Expected market price after repurchase: = [p/e][EPSnew] = [5][$4.40] = $22.00 per share

Effects of A Repurchase:  EPS should increase  A higher market price per outstanding share of common stock should result  Stockholders not selling their shares back to the firm will enjoy a capital gain if the repurchase increases the stock price. Advantages of Repurchases:  signal positive information about the firm’s future cash flows  used to effect a large-scale change in the firm’s capital structure  increase investor’s return without creating an expectation of higher future cash dividends  reduce future cash dividend requirements or increase cash dividends per share on the remaining shares, without creating a continuing incremental cash drain  capital gains treated more favorably than cash dividends for tax purposes Disadvantages of Repurchases:  signal negative information about the firm’s future growth and investment opportunities  the provincial securities commission may raise questions about the intention  share repurchase may not qualify the investor for a capital gain Stock Dividends vs. Stock Splits 1. Lowers stock price slightly lowers stock price a lot 2. Little psychological appeal much stronger psychological appeal 3. Recapitalization of earnings no recapitalization 4. No change in proportional same Ownership 5. Odd lot problems rarely will this be a problem 6. Theoretically, no value to same The investor Four dates associated with dividends Declaration date: The day the dividend is announced. Record date: Dividend is paid to the shareholders of record on this date. Ex-dividend date: The date on and after which the sellers of the stock, not the buyers, will receive the current dividend - two business days before the record date. Prior to the stock going ex-dividend, it is said to be selling cum-dividend. Payment date: Cheque mailed or account credited.

  


The announcement, record and payment dates are set by the board of directors and the ex-dividend date is set by the stock exchanges. Dividend Declaration Process   cash dividends are normally paid quarterly declaration date • This is the date on which the Board of Directors meet and declare the dividend. In their resolution the Board will set the date of record, the date of payment and the amount of the dividend for each share class. • When CARRIED this resolution makes the dividend a current liability for the firm. Date of record is the date on which the shareholders register is closed and all those who are listed will receive the dividend. ex dividend date is the date that the value of the firm’s common shares will reflect the dividend payment (i.e. fall in value) Date of payment is the date the cheques for the dividend are mailed out to the shareholders.

  

Settlement Cycle  In June 1995 the settlement cycle for all non-money-market Canadian and U.S. securities was reduced from five business days (T + 5) to three business days (T + 3).  The rationale for the change stems from the 1987 stock market crash when it was realized that a securities market failure could result in a credit market failure. The gridlock created in 1990 by the bankruptcy of Drexel Burnham Lambert, a large U.S. broker, increased the need to minimize the risks involved in the clearing and settlement of securities.  The shortened settlement cycle requires that the payment of funds and the delivery of securities take place on the third business day after the trade date. This will reduce credit, market and liquidity risks by decreasing post-trade settlement exposure.

Dividend Declaration Process


Dividend Policy: Dividend Policy means that decision of the management through which it is determined how much of net profits are to be distributed as dividend among the shareholders and how much to be retained in the firm, if the firm reinvests capital now, it will grow and can pay higher dividends in the future. The two main ways that firms distribute cash to equity investors are dividends and share repurchases. Significance: Determination of dividend policy of the firm is one of the important financial decisions of the management. Three main decisions are taken in the financial management. These are: I) Investment Decisions ii) Financing Decision iii) Dividend Decisions Factors Determining Dividend Policy:  Financial Needs of the Company  Stability of Dividends  Legal Requirements  Liquidity  Growth Prospects  Availability of Funds Earnings Stability Control Taxes Investment Opportunities Effects on Earnings per Share Age of Company Inflation Types of Dividend Policy:

   

Steady Dividends at the Present Level Policy Steady Dividends at a Lower Level Policy Steady Dividends at Higher Level Policy Dividends Fluctuating with Earnings Policy Low Regular Dividends Plus Extra Dividend Policy of Eliminating the Dividend Entirely

Determinants of Dividend Policy The main determinants of dividend policy of a firm can be classified into:
      1. Dividend payout ratio Stability of dividends Legal, contractual and internal constraints and restrictions Owner's considerations Capital market considerations and Inflation.

Dividend payout ratio Dividend payout ratio refers to the percentage share of the net earnings distributed to the shareholders as dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the firm. The retained earnings constitute a source of finance. The optimum dividend policy should strike a balance between current dividends and future growth which maximizes the price of the firm's shares. The dividend payout ratio of a firm should be determined with reference to two basic objectives – maximizing the wealth of the firm’s owners and providing sufficient funds to finance growth. These objectives are interrelated. Dividend stability refers to the payment of a certain minimum amount of dividend regularly. The stability of dividends can take any of the following three forms:    constant dividend per share constant dividend payout ratio or constant dividend per share plus extra dividend

2. Stability of dividends

3. Legal, contractual and internal constraints and restrictions

Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid. Such conditions pertain to capital impairment, net profits and insolvency. Important contractual restrictions may be accepted by the company regarding payment of dividends when the company obtains external funds. These restrictions may cause the firm to restrict the payment of cash dividends until a certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of earnings. Internal constraints are unique to a firm and include liquid assets, growth prospects, and financial requirements, availability of funds, earnings stability and control.

4. Owner's considerations

The dividend policy is also likely to be affected by the owner's considerations of the tax status of the shareholders, their opportunities of investment and the dilution of ownership.
5. Capital market considerations

The extent to which the firm has access to the capital markets, also affects the dividend policy. In case the firm has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access to capital markets, it is likely to adopt a low dividend payout ratio. Such companies rely on retained earnings as a major source of financing for future growth.
6. Inflation

With rising prices due to inflation, the funds generated from depreciation may not be sufficient to replace obsolete equipments and machinery. So, they may have to rely upon retained earnings as a source of fund to replace those assets. Thus, inflation affects dividend payout ratio in the negative side. Bonus shares and stock splits Bonus share is referred to as stock dividend. They involve payment to existing owners of dividend in the form of shares. It is an integral part of dividend policy of a firm to use bonus shares and stock splits. A stock split is a method commonly used to lower the market price of shares by increasing the number of shares belonging to each shareholder. Bonus shares may be issued to satisfy the existing shareholders in a situation where cash position has to be maintained. Alternative Dividend Policies Alternate Dividend Policies:  Residual payout.  Constant payout ratio.  Stable dollar dividend policy.  Stable dollar dividend per share.  Stable dollar dividend per share plus extras. 1. Residual Dividend Policy: Dividends are paid only after the optimal capital budget is financed. This implies the following process:
 

Determine optimal capital structure. Using the marginal cost of capital, solve for the firm’s optimal capital budget (IOS and MCC schedules). Use internal equity necessary to maintain the optimal capital structure and finance the optimal capital budget.

Any residual funds are declared as cash dividends.

Positive aspects of this approach:
 

You use lower cost sources of financing first. You distribute funds to shareholders on which you can’t earn a rate of return greater than MCC/WACC. You will acquire external equity (incur underwriting costs) only if the rate of return on your marginal projects exceeds the cost of external financing. This approach, in a perfect world, should maximize the value of the firm...and maximize shareholders wealth.

Negative aspects:

Because the number of good capital projects will vary from year to year,....and because the amount of internal equity capital will vary from year to year (profits vary each year), the resulting stream of dividends over time will be highly dividends one year, high dividends the next. The uncertainty around the dividend stream does not meet the needs of shareholders for ‘resolution of uncertainty.’

2. Constant Payout Ratio: Pay a constant percentage of earnings per share out in the form of dividends per share. Advantages:  A decision-rule makes the dividend decision easy for members of the board. Disadvantages:  DPS will be as volatile (uncertain) over time as EPS.  At times the firm will have to access external other times (when there are few good investment opportunities) the firm will find itself with excess cash....idle cash...which lowers the firm’s return on assets employed. 3. Stable Dollar Dividend Policy: Pay the same dollar dividend each year....revising it only if there is a longterm change in earnings. Advantages: Results in a stable dividend stream over time...meeting the needs of shareholders who require resolution of uncertainty. Disadvantages:

There may be times when the firm will need to access external sources of capital (when the number of good investment projects exceeds the financial resources available.) There may be times when the firm will have excess cash on hand... (fewer good investment opportunities than the available internal funds.) DPS will tend to fall over time if there is a dividend reinvestment plan...or stock options being exercised...etc.

4. Stable Dollar Dividend per Share: The board of directors seeks to hold dividends per share constant over time, increasing or decreasing DPS only if the board feels there is expectation for a new level of EPS in the future. Advantages:  Meets the needs of shareholders for a stable stream of dividends per share over time.  Addresses the signaling issue.  Addresses the dilution of DPS that can happen as a result of dividend reinvestment plans and stock options. Disadvantages:  May leave the firm with excess cash at times, or may force the firm to external markets when there are many good investment projects available. 5. Stable Dollar DPS + Extras: DPS are held stable. When the firm experiences times of cash surplus (when there are few good investment projects available) the surplus funds are distributed through a ‘special’ dividend that is called an ‘extra.’ Advantages:  Addresses the issues of resolution of uncertainty and signaling.  The ‘extra’ allows the firm to distribute funds that it can’t make good use of ...without having the market think that the increase in DPS is permanent. Disadvantages:  There still may be some times when the firm will have to go to external equity markets when it faces a great need for equity capital because of many good projects.  If the firm declares too many extras in a row...the market may come to expect them. Dividend theories or Dividend based equity models Relevance theories Which consider dividend decision to be relevant as it affect the value of the firm.

Irrelevance Theories Which consider dividend decision to be irrelevant as it does not affects the value of the firm. Dividend-based equity models    Walter Approach Gordon growth model Modigliani and Miller approach

Walter’s Valuation Model Prof. James E Walter argued that in the long-run the share prices reflect only the present value of expected dividends. Retentions influence stock price only through their effect on future dividends. Walter has formulated this and used the dividend to optimize the wealth of the equity shareholders. Assumptions of this model: 1. Retained earnings are the only source of finance. This means that the company does not rely upon external funds like debt or new equity capital. 2. The firm's business risk does not change with additional investments undertaken. It implies that r(internal rate of return) and k(cost of capital) are constant. 3. The firm has an infinite life and is a going concern. 4. All earnings are either distributed as dividends or invested internally immediately. 5. There is no change in the key variables, namely, beginning earnings per share (E), and dividends per share (D). The values of D and E may be changed in the model to determine results, but any given value of E and D are assumed to remain constant in determining a given value.


Formula: Walter's model P = D Ke – g

Where: P = Price of equity shares D = Initial dividend Ke = Cost of equity capital g = Growth rate expected After accounting for retained earnings, the model would be: P = D Ke – rb

Where: r = Expected rate of return on firm’s investments b = Retention rate (E - D)/E Equation showing the value of a share (as present value of all dividends plus the present value of all capital gains) – Walter's model: P = D+ r/ke (E D) ke

Where: D = Dividend per share and E = Earnings per share Example: A company has the following facts: Cost of capital (ke) = 0.10 Earnings per share (E) = $10 Rate of return on investments ( r) = 8% Dividend payout ratio: Case A: 50% Case B: 25% Show the effect of the dividend policy on the market price of the shares. Solution: Case A: D/P ratio = 50% When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5 5 + [0.08 / 0.10] [10 - 5] P = 0.10 => $90

Case B: D/P ratio = 25% When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5 2.5 + [0.08 / 0.10] [10 - 2.5] P = 0.10 => $85

Conclusions of Walter's model:
1. When r > ke, the value of shares is inversely related to the D/P ratio.

As the D/P ratio increases, the market value of shares decline. Its value is the highest when D/P ratio is 0. So, if the firm retains its earnings entirely, it will maximize the market value of the shares. The optimum payout ratio is zero. 2. When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P ratio increases, the market price of the shares also increases. The optimum payout ratio is 100%. 3. When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this case, there is no optimum D/P ratio. Limitations of this model: 1. Walter's model assumes that the firm's investments are purely financed by retained earnings. So this model would be applicable only to all-equity firms. 2. The assumption of r as constant is not realistic. 3. The assumption of a constant ke ignores the effect of risk on the value of the firm.

Gordon’s model of dividend policy According to Prof. Gordon, Dividend Policy always affects the value of the firm. He showed how dividend policy can be used to maximize the wealth of the shareholders. The main proposition of the model is that the value of a share reflects the value of the future dividends accruing to that share. Hence, the dividend payment and its growth are relevant in valuation of shares. The model holds that the share’s market price is equal to the sum of share’s discounted future dividend payment. It assumes that the company issues a dividend that has a current value of D that grows at a constant rate g. It also assumes that the required rate of return for the stock remains constant at k which is equal to the cost of equity for that company. It involves summing the infinite series which gives the value of price current P.


Summing the infinite series we get

In practice this P is then adjusted by various factors e.g. the size of the company

K denotes expected return = yield + expected growth. It is common to use the next value of D given by: D1 = D0 (1 + g), thus the Gordon’s model can be stated as

Assumptions of this model:
1. The firm is an all equity firm. No external financing is used and



6. 7. 8.

investments programmed are financed exclusively by retained earnings. Return on investment(r) and Cost of equity (Ke) are constant. The firm has perpetual life. The company has perpetual life and the streams of earnings are perpetual. A corporate tax does not exist. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also constant. Growth rate of the firm is the product of retention ratio and its rate of return. Ke > br Therefore, the growth rate g=br, is also constant forever.

Arguments of this model: 1. Dividend policy of the firm is relevant and that investors put a positive premium on current incomes/dividends. 2. This model assumes that investors are risk averse and they put a premium on a certain return and discount uncertain returns. 3. Investors are rational and want to avoid risk. 4. The rational investors can reasonably be expected to prefer current dividend. They would discount future dividends. The retained earnings are evaluated by the investors as a risky promise. In case the earnings are retained, the market price of the shares would be adversely affected. In case the earnings are retained, the market price of the shares would be adversely affected.

5. Investors would be inclined to pay a higher price for shares on which current dividends are paid and they would discount the value of shares of a firm which postpones dividends. 6. The omission of dividends or payment of low dividends would lower the value of the shares.

Derivation: We want to find out the value of: Pn as:




Since We get


If: g < k, then: a < 1 and
Thus, we get


Dividend Capitalization model: According to Gordon, the market value of a share is equal to the present value of the future streams of dividends.

E(1 - b) Ke - br Where: P = E = b = 1-b = Ke = P =

Price of a share Earnings per share Retention ratio Dividend payout ratio Cost of capital or the capitalization rate Growth rate (rate or return on investment of an br - g = all-equity firm)

Example: Determination of value of shares, given the following data: D/P Ratio Retention Ratio Cost of capital r EPS Case A 40 60 17% 12% $20 Case B 30 70 18% 12% $20

$20 (1 0.60) = $81.63 P = 0.17 – (0.60 x > (Case A) 0.12) $20 (1 0.70) = $62.50 P = 0.18 – (0.70 x > (Case B) 0.12) Gordon's model thus asserts that the dividend decision has a bearing on the market price of the shares and that the market price of the share is favorably affected with more dividends.

Modigliani & Miller’s Irrelevance Model According to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant as it does not affect the value of the firm. They argue that the value of the firm depends on the firm’s earnings and firm’s earnings are influenced by its investment policy and not by the dividend policy. Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on the market price of the shares, according to this model. Assumptions of MM model

1. Existence of perfect capital markets and all investors in it are rational. Information is available to all free of cost, there are no transactions costs, securities are infinitely divisible, no investor is large enough to influence the market price of securities and there are no floatation costs. 2. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends. 3. A firm has a given investment policy which does not change. It implies that the financing of new investments out of retained earnings will not change the business risk complexion of the firm and thus there would be no change in the required rate of return. 4. Investors know for certain the future investments and profits of the firm (but this assumption has been dropped by MM later). Argument of this Model 1. By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally. The effect of dividend payment would be offset by the effect of raising additional funds. 2. MM model argues that when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever is gained by the investors as a result of increased dividends will be neutralized completely by the reduction in the market value of the shares. 3. The cost of capital is independent of leverage and the real cost of debt is the same as the real cost of equity, according to this model. 4. Those investors are indifferent between dividend and retained earnings imply that the dividend decision is irrelevant. With dividends being irrelevant, a firm’s cost of capital would be independent of its dividendpayout ratio. 5. Arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be irrelevant.

MM Model: Market price of the share in the beginning of the period = Present value of dividends paid at the end of the period + Market price of share at the end of the period.

P0 = 1/ (1 + ke) x (D1 + P1) = (D1 + P1) / (1 + ke). Wher Prevailing market price of a P0 = e: share ke =cost of equity capital D Dividend to be received at the = end of period 1 and 1 Market price of a share at the P1 = end of period 1. Value of the firm, nP0 Where n : ∆ n I E = = (n + ∆ n) P1 – I+E (1 + ke)

number of shares outstanding at the beginning of the period Change in the number of shares outstanding during the = period/ additional shares issued. = Total amount required for investment = Earnings of the firm during the period.

Example: A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at $100 each. The firm is expecting to pay a dividend of $5 per share at the end of the current financial year. The company's expected net earnings are $250,000 and the new proposed investment requires $500,000. Prove that using MM model, the payment of dividend does not affect the value of the firm. Solution:
1. Value of the firm when dividends are paid: i.

Price per share at the end of year 1: P0 = 1/(1 + ke) x (D1 + P1) $100 = 1/(1 + 0.10) x ($5 + P1) P1 = $105 Amount required to be raised from the issue of new shares: ∆ n P1 = I – (E – nD1) => $500,000 – ($250,000 - $125,000) => $375,000 Number of additional shares to be issued: ∆n = $375,000 / 105 => 3571.42857 shares (unrounded) Value of the firm: => (25,000 + 3571.42857) (105) $500,000 + $250,000 (1 + 0.10) => $2,500,000




2. Value of the firm when dividends are not paid: i.

Price per share at the end of year 1: P0 = 1/(1 + ke) x (D1 + P1) $100 = 1/(1 + 0.10) x ($0 + P1) P1 = $110 Amount required to be raised from the issue of new shares: => $500,000 – ($250,000 -0) = $250,000 Number of additional shares to be issued: => $250,000/$110 = 2272.7273 shares (unrounded) Value of the firm: => (25,000 + 2272.7273) (110) $500,000 + $250,000 (1 + 0.10) => $2,500,000

ii. iii. iv.

Thus, according to MM model, the value of the firm remains the same whether dividends are paid or not. This example proves that the shareholders are indifferent between the retention of profits and the payment of dividend. Limitations of MM model: 1. The assumption of perfect capital market is unrealistic. Practically, there are taxes, floatation costs and transaction costs. 2. Investors cannot be indifferent between dividend and retained earnings under conditions of uncertainty. This can be proved at least with the aspects of i) near Vs distant dividends, ii) informational content of dividends, iii) preference for current income and iv) sale of stock at uncertain price.

The functions of finance involve three major decisions a company must make: 1. The investment decision 2. The financing decision 3. The dividend/share repurchases decision. The investment decision is the most important of the three decisions when it comes to the creation of value. Capital investment is the allocation of capital to investment proposals whose benefits are to be realized in the future. Because the future benefits are not known with certainty, investment proposals necessarily involve risk. Consequently, they should be evaluated in relation to their expected return and risk. The investment decision is the decision to reallocate capital when an asset no longer

economically justifies the capital committed to it. The investment decision, then, determines the total amount of assets held by the firm, the composition of these assets, and the business-risk complexion of the firm as perceived by suppliers of capital. Using an appropriate acceptance criterion, or required rate of return, is fundamental to the investment decision. In selecting new investments, a company must manage existing assets efficiently. Financial managers have varying degrees of operating responsibility for existing assets. They are more concerned with the management of current assets than with fixed assets. Determining a proper level of liquidity is very much a part of this management, and its determination should be in keeping with the company's overall valuation. Although financial managers have little or no operating responsibility for fixed assets and inventories, they are instrumental in allocating capital to these assets by virtue of their involvement in capital investment.

“Investment analysis is the study of financial securities for the purpose of successful investing.” A security can be defined as: “A legal contract representing the right to receive future benefits under a stated set of conditions.” Investment analysis is the study of how an investment is likely to perform and how suitable it is for a given investor. Investment analysis is key to any sound portfolio-management strategy. Investors not comfortable doing their own investment analysis can seek professional advice from a financial advisor. An analysis of past investment decisions. An investment analysis is a look back at previous investment decisions and the thought process of making the investment decision. Key factors should include entry price, expected time horizon, and reasons for making the decision at the time. For example, in conducting an investment analysis of a mutual fund, the investor would look at factors such as how the fund has performed compared to its benchmark. The investor could also compare performed to similar funds, its expense ratio, management stability, sector weighting, style and asset allocation. Investment goals should always be considered when analyzing an investment; one size does not always fit all, and highest returns regardless of risk are not always the goal. For any beginner investor, investment analysis is essential. Looking back at past decisions and analyzing the mistakes and successes will help fine-tune strategies. Many investors don't even document why they made an investment let alone analyze why they were wrong or right. You could make a proper decision, extraordinary events could lose you money, and if you didn't analyze it, you would shy away from making the same decision.


Investment process:

Risk analysis examines the uncertainty of income flows for the total firm and for the individual sources of capital (that is, debt, preferred stock, and common stock). This involves examining the major factors that cause a firm’s income flows to vary. More volatile income flows mean greater risk (uncertainty) facing the investor. The total risk of the firm has two internal components: business risk and financial risk. Definition to risk analysis: A procedure to identify threats & vulnerabilities, analyze them to ascertain the exposures, and highlight how the impact can be eliminated or reduced. A process to determine what security is appropriate for a system or environment. Risk analysis is a process for managing risk, which is compromised of three distinct but interactive components: risk assessment, risk management and risk communication.



In a PRA, risk is characterized by two quantities: The magnitude consequence(s), and







The likelihood (probability) of occurrence of each consequence.

Consequences are expressed numerically (e.g., the number of people potentially hurt or killed) and their likelihoods of occurrence are expressed as probabilities or frequencies (i.e., the number of occurrences or the probability of occurrence per unit time). The total risk is the expected loss: the sum of the products of the consequences multiplied by their probabilities. The spectrum of risks across classes of events are also of concern, and are usually controlled in licensing processes – it would be of concern if rare but high consequence events were found to dominate the overall risk, particularly as these risk assessment is very sensitive to assumptions (how rare is a high consequence event?). Probabilistic Risk Assessment usually answers three basic questions:

1. What can go wrong with the studied technological entity, or what are the initiators or initiating events (undesirable starting events) that lead to adverse consequence(s)? 2. What and how severe are the potential detriments, or the adverse consequences that the technological entity may be eventually subjected to as a result of the occurrence of the initiator? 3. How likely to occur are these undesirable consequences, or what are their probabilities or frequencies? Two common methods of answering this last question are Event Tree Analysis and Fault Tree Analysis . In addition to the above methods, PRA studies require special but often very important analysis tools like human reliability analysis (HRA) and commoncause-failure analysis (CCF). HRA deals with methods for modeling human error while CCF deals with methods for evaluating the effect of inter-system and intra-system dependencies which tend to cause simultaneous failures and thus significant increases in overall risk. PRA studies have been successfully performed for complex technological systems at all phases of the life cycle from concept definition and predesign through safe removal from operation. For example, the Nuclear Regulatory Commission required that each nuclear power plant in the US perform an Individual Plant Examination (IPE) [1] to identify and quantify plant vulnerabilities to hardware failures and human faults in design and operation. Although no method was specified for performing such an evaluation, the NRC requirements for the analysis could be met only by applying PRA methods. In general, a PRA is conducted in three stages: Risk identification, risk quantification and risk evaluation and acceptance. Stage 1 Risk Identification 2 Risk Quantification Question What can go wrong? What is the likelihood it would go wrong? What are the consequences? What can be done? What are the options And trade-offs?

3 Risk Evaluation and Acceptance

Identify risk source Assess probabilities subjective, or objective Model causal relationships and their impacts Create policy options Trade-off analysis of risk and cost/benefits of

mitigation Short answers: Risk Uncertainty of the performance of a system (the world), quantified by probabilities of observable quantities. When risk is quantified in a risk analysis, this definition is in line with the ISO standard definition: «combination of the probability of an event and its consequence». Risk Acceptance A decision to accept a risk. Risk acceptance depends on risk criteria. Risk Acceptance Criterion A reference by which risk is assessed to be acceptable or unacceptable. This definition is not included in the ISO standard. It is an example of a risk criterion. Risk Analysis Systematic use of information to identify sources and assign risk values. Risk analysis provides a basis for risk evaluation, risk treatment and risk acceptance. Information can include historical data, theoretical analysis, informed opinions, and concerns of stakeholders. Risk Assessment Overall process of risk analysis and risk evaluation. Risk Avoidance Decision not to become involved in, or action to withdraw from a risk situation. The decision may be taken based on the result of risk evaluation. Risk Communication Exchange or sharing of information about risk between the decision-maker and other stakeholders. The information may relate to the existence, nature, form, probability, severity, acceptability, treatment or other aspects of risk. Risk Control Actions implementing risk management decisions. Risk control may involve monitoring, re-evaluation, and compliance with decisions. Risk Criteria Terms of reference by which the significance of risk is assessed. Risk criteria may include associated cost and benefits, legal and statutory requirements, socio-economic and environmental aspects, concerns of stakeholders, priorities and other inputs to the assessment. Risk Evaluation


Process of comparing risk against given risk criteria to determine the significance of the risk. Risk evaluation may be used to assist the decisionmaking process. Risk Financing Provision of funds to meet the cost of implementing risk treatment and related costs. Risk Identification Process to find, list and characterize elements of risk. Elements may include source, event, consequence, probability. Risk identification may also identify stakeholder concerns. Risk Management Coordinated activities to direct and control an organization with regard to risk. Risk management typically includes risk assessment, risk treatment, risk acceptance and risk communication. Risk Management System Set of elements of an organization’s management system concerned with managing risk. Management system elements may include strategic planning, decision-making, and other processes for dealing with risk. Risk Optimization Process, related to a risk, to minimize the negative and to maximize the positive consequences and their respective probabilities. In a safety context risk optimization is focused on reducing the risk. Risk Perception Set of values or concerns with which a stakeholder views risk. Risk perception depends on the stakeholder’s needs, issues and knowledge. Risk Transfer Share with another party the benefit of gain or burden of loss for a risk. Risk transfer may be affected through insurance or other agreements. Risk transfer may create new risks or modify existing risk. Legal or statutory requirements may limit, prohibit or mandate the transfer of certain risk. Risk Treatment Process of selection and implementation of measures to modify risk. The term risk treatment is sometimes used for the measures themselves. Risk treatment measures may include avoiding, optimizing, transferring or retaining risk. Unavailability The probability that the component or system is unavailable at any given time. Uncertainty

Lack of knowledge about the performance of a system, and observable quantities in particular. Unreliability The probability of one or more failures over a specified time period. The number of expected system failures provides a good approximation for system unreliability for cases where expected system failures are less than 1. Risk Analysis Methodologies

Qualitative Methodologies o Preliminary Risk Analysis o Hazard and Operability studies(HAZOP) o Failure Mode and Effects Analysis(FMEA/FMECA) o Discussion and Conclusion Tree Based Techniques o Fault tree analysis o Event tree analysis o Cause-Consequence Analysis o Management Oversight Risk Tree o Safety Management Organization Review Technique o Discussion and Conclusion Techniques for Dynamic system o Go Method o Digraph/Fault Graph o Markov Modeling o Dynamic Event Logic Analytical Methodology o Dynamic Event Tree Analysis Method o Discussion and Conclusion

1. Qualitative risk analysis methodologies In the this section, we will deal with the qualitative methods used in risk analysis namely preliminary risk analysis(PHA), hazard and operability study(HAZOP), and failure mode and effects analysis (FMEA/FMECA). 1.1 Preliminary Risk Analysis

Preliminary Risk Analysis Preliminary risk analysis or hazard analysis [1, 2, 3, 4, 5] is a qualitative technique which involves a disciplined analysis of the event sequences which could transform a potential hazard into an accident [1]. In this technique, the possible undesirable events are identified first and then analyzed separately. For each undesirable events or hazards, possible improvements, or preventive measures are then formulated. The result from this methodology provides a basis for determining which categories of hazard should be looked into more closely and which analysis methods are most suitable. Such an analysis also proved valuable in the

working environment to which activities lacking safety measures can be readily identified. With the aid of a frequency/ consequence diagram, the identified hazards can then be ranked according to risk, allowing measures to be prioritized to prevent accidents. 1.2 Hazard and Operability studies (HAZOP)

The HAZOP technique was developed in the early 1970s [7] by Imperial Chemical Industries Ltd [1]. HAZOP[1, 2, 7, 8, 17] can be defined as the application of a formal systematic critical examination of the process and engineering intentions of new or existing facilities to assess the hazard potential that arise from deviation in design specifications and the consequential effects on the facilities as a whole. This technique is usually performed using a set of guidewords: NO/NOT, MORE OR/LESS OF, AS WELL AS, PART OF REVERSE, AND OTHER THAN. From these guidewords, a scenario that may result in a hazard or an operational problem is identified. Consider the possible flow problems in a process line, the guide word MORE OF will correspond to high flow rate, while that for LESS THAN, low flow rate. The consequences of the hazard and measures to reduce the frequency with which the hazard will occur are then discussed. This technique had gained wide acceptance in the process industries as an effective tool for plant safety and operability improvements. Detailed procedures on how to perform the technique are available in literature [7, 17]. 1.3 Failure Mode and Effects Analysis (FMEA/FMECA)

This method was developed in the 1950s by reliability engineers to determine problems that could arise from malfunctions of military system. Failure mode and effects analysis [1, 2, 3, 5, 6, 7, 8, 9, 17, 25, 26, 27, 28, 29, 30, 31, and 58] is a procedure by which each potential failure mode in a system is analyzed to determine its effect on the system and to classify it according to its severity [1]. When the FMEA is extended by a criticality analysis, the technique is then called failure mode and effects criticality analysis (FMECA). Failure mode and effects analysis has gained wide acceptance by the aerospace and the military industries [7]. In fact, the technique has adapted itself in other form such as misuse mode and effects analysis [15]. Detail procedures on how to carry out an FMEA and its various applications in the different industries have been documented in [16]. On the other hand, the way to evaluate the criticality index is available in [1] and [3]. The use of knowledge base system for the automation of FMEA process

have been discussed in [25, 26, 27], whereas the use of causal reasoning model for FMEA is documented in [28]. An improved FMEA methodology which uses a single matrix to model the entire system and a set of indices derived from probabilistic combination to reflect the importance of an event relating to the indenture under consideration and to the entire system is presented in [29, 30]. A similar approach was made in literature [31] to model the entire system using fuzzy cognitive map. 1.4 Discussion and Conclusion

The three techniques outlined above require only the employment of hardware familiar personnel. However, FMEA tends to be more labor intensive, as failure of each individual component in the system has to be considered. A point to note is that these qualitative techniques can be used in the design as well as operational stage of a system. All the techniques mentioned above have seen wide usage in the nuclear power plant and chemical processing plant. In fact, FMEA, one of the most documented, has been used by Intel [52] and National Semiconductor [53] to improve the reliability of their product. For the case of preliminary risk analysis, it has seen application in safety analysis [2] as well as offshore platform [1]. HAZOP, on the other hand, has been widely used in the chemical industries [3] for detailed failure and effect study on the piping and instrumentation layout. 2. Tree based techniques In this section, fault-tree analysis (FTA), event-tree analysis(ETA), causeconsequence analysis(CCA), management oversight risk tree(MORT) and safety management organization review technique (SMORT) will be discussed. 2.1 Fault tree analysis

The concept of fault tree analysis (FTA)[1, 2, 3, 4, 5, 6, 7, 8, 10, 11, 17, 23] was originated by Bell Telephone Laboratories in 1962 as a technique with which to perform a safety evaluation of the Minutemen Intercontinental Ballistic Missile Launch Control System[23]. A fault tree is a logical diagram which shows the relation between system failure, i.e. a specific undesirable event in the system, and failures of the components of the system[2]. It is a technique based on deductive logic. An undesirable event is first defined and causal relationships of the failures leading to that event are then identified.


Figure 1 out".


A fault tree depicting the event "Fire breaks

Fault tree can be used in qualitative or quantitative risk analysis. The difference in them is that the qualitative fault tree is looser in structure and does not require use of the same rigorous logic as the formal fault tree [7]. Figure 1 shows a fault tree with top event "Fire breaks out". This method is used in a wide range of industries and there is extensive support in the form of published literature and software packages, such as CARA [2]. An application of fault tree analysis on causal relations for large vehicle accidents is documented in [11]. On the other hand, detailed descriptions on how to carry out fault tree analysis are given in literature [1, 3, and 7]. 2.2 Event tree analysis

Event tree analysis [3, 5, 6, 7, 8, 10, and 17] is a method for illustrating the sequence of outcomes which may arise after the occurrence of a selected initial event. This technique, unlike fault tree uses inductive logic. It is mainly used in consequence analysis for pre-incident and post-incident application. The left side connects with the initiator, the right side with plant damage state; the top defines the systems; nodes (dots) call for branching probabilities obtained from the system analysis. If the path goes up at the node, the system succeeded, if down, it failed. ETA has seen application in the nuclear industries for operability analysis of nuclear power plant as well as accident sequence in the Three Mile Island-2 reactor’s accident [6]. 2.3 Cause-Consequence Analysis

Cause-consequence analysis (CCA) [2, 3, 5, 8, and 17] is a blend of fault tree and event tree analysis [17]. This technique combines cause analysis

(described by fault trees) and consequence analysis (described by event trees), and hence deductive and inductive analysis is used. The purpose of CCA is to identify chains of events that can result in undesirable consequences. With the probabilities of the various events in the CCA diagram, the probabilities of the various consequences can be calculated, thus establishing the risk level of the system. Figure 2 below shows a typical CCA.

Figure 2 : A typical Cause-Consequence Analysis This technique was invented by RISO Laboratories in Denmark to be used in risk analysis of nuclear power stations [2]. However, it can also be adapted by the other industries in the estimation of the safety of a protective or other system [2]. Details on how to carry out cause consequence analysis as well as the benefits and restrictions of it are documented in literature [2, 17]. 2.4 Management Oversight Risk Tree

Management oversight risk tree (MORT) was developed in the early 1970s [2] for the U.S. Energy Research and Development Administration as safety analysis method that would be compatible with complex, goal-oriented management systems [17]. MORT [2, 8, 12, 17, 21, 22, 23] is a diagram which arranges safety program elements in an orderly and logical manner. Its analysis is carried out by means of fault tree, where the top event is “Damage, destruction, other costs, lost production or reduced credibility of the enterprise in the eyes of society” [2]. The tree gives an overview of the


causes of the top event from management oversights and omissions or from assumed risks or both. The MORT tree has more than 1500 possible basic events inputted to 100 generic events which have being increasing identified in the fields of accident prevention, administration and management. A generic MORT diagram is included at the end of this report. MORT is used in the analysis or investigation of accidents and events, and evaluation of safety programs. Its usefulness was revealed in literature [17], “Normal investigations revealed an average of 18 problems (and recommendations). Complementary investigations with MORT analysis revealed additional 20 contributions per case”. 2.5 Safety Management Organization Review Technique

Safety management organization review technique (SMORT) [2, 17] is a simplified modification of MORT developed in Scandinavia [17]. This technique is structured by means of analysis levels with associated checklists, while MORT is based on a comprehensive tree structure. Owing to its structured analytical process, SMORT is classified as one of the tree based methodologies. The SMORT analysis includes data collection based on the checklists and their associated questions, in addition to evaluation of results. The information can be collected from interviews, studies of documents and investigations. This technique can be used to perform detailed investigation of accidents and near misses. It also served well as a method for safety audits and planning of safety measures [2]. 2.6 Discussion and Conclusion

The tree-based methods are mainly used to find cut-sets leading to the undesired events. In fact, event tree and fault tree have been widely used to quantify the probabilities of occurrence of accidents and other undesired events leading to the loss of life or economic losses in probabilistic risk assessment. However, the usage of fault tree and event tree are confined to static, logic modeling of accident scenarios [13]. In giving the same treatment to hardware failures and human errors in fault tree and event tree analysis, the conditions affecting human behavior can not be modeled explicitly. This affects the assessed level of dependency between events. No doubt, there exists techniques such as human cognitive reliability [5, 12] to reconcile such deficiencies in the fault tree analysis; new methodologies that model such responses have emerged. 3. Methodologies for analysis of dynamic system

In this section, GO method, digraph/fault graph, event sequence diagrams, Markov modeling, dynamic event logic analytical methodology and dynamic event tree analysis method will be discussed. 3.1 GO method

The GO method [5, 13] is a success-oriented system analysis that uses seventeen operators to aid in model construction [5]. It was developed by Kaman Sciences Corporation during the 1960s for reliability analysis of electronics for the Department of Defense in U.S The GO model can be constructed from engineering drawings by replacing system elements with one or more GO operators. Such operators are of three basic types: (1) independent, (2) dependent, and (3) logic. Independent operators are used to model components requiring no input and the independent operators, require at least one input in order to have an output. Logic operators, on the other hand, combine the operators into the success logic of the system being modeled. With the probability data for each independent and dependent operator, the probability of successful operation can then be calculated. The GO method is used in practical application where the boundary conditions for the system to be modeled are well defined by a system schematic or other design documents. However, the failure modes are implicitly modeled, making it unsuitable for detailed analysis of failure modes beyond the level of component events shown in the system drawing. Furthermore, it does not treat common cause failures nor provide structural information (i.e. the minimum cut sets) regarding the system. A brief description of GO flow, which is based on GO method, is documented in literature [13]. 3.2 Digraph/Fault Graph

The fault graph method/digraph matrix analysis[5, 13] uses the mathematics and language of graph theory such as “path set” (a set of models traveled on a path) and “reachability” (the complete set of all possible paths between any two nodes)[5]. This method is similar to a GO chart but uses AND and OR gates instead. The connectivity matrix, derived from adjacency matrix for the system, shows whether a fault node will lead to the top event. These matrices are then computer analyzed to give singletons (single components that can cause system failure) or doubletons (pairs of components that can cause system failure). Digraph method allows cycles and feedback loops which


make it attractive for dynamic system. Figure 3 shows a success oriented system digraph of simplified emergency core cooling system.

Figure 3 : Success oriented system digraph of simplified emergency core cooling system in a nuclear power plant (Ralph R. Full wood & Robert E. Hall) 3.3 Markov Modeling

Markov modeling [1, 3, 5, 7, 8, 14, 18] is a classical modeling technique used for assessing the time-dependent behavior of many dynamic systems[13]. In a ‘Markov chain’ processes, transitions between states are assumed to occur only at discrete points in time. On the other hand, in a ‘discrete Markov process’, transitions between states are allowed to occur at any point in time. For process system, the discrete system states can be defined in terms of ranges of process variables as well as component status. This methodology also incorporates time explicitly, and can be extended to cover situations where problem parameters are time independent. The state probabilities of the system P(t) in a continuous Markov system analysis are obtained by the solution of a coupled set of first order, constant coefficient differential equations : dP/dt = M.P(t), where M is the matrix of coefficients whose off-diagonal elements are the transition rate and whose diagonal elements are such that the matrix columns sum to zero. An application of Markov modeling to a hold-up tank problem is discussed in literature [13], while Pate-Cornell (1993) used the


technique to study the fire propagation for a subsystem on board a offshore platform in [14]. 3.4 Dynamic Event Logic Analytical Methodology

The dynamic event logic analytical methodology (DYLAM)[13, 18, 19] provides an integrated framework to explicitly treat time, process variables and system behavior[13]. A DYLAM will usually comprise of the following procedures: (a) component modeling, (b) system equation resolution algorithms, (c) setting of TOP conditions and (d) event sequence generation and analysis. DYLAM is useful for the description of dynamic incident scenarios and for reliability assessment of systems whose mission is defined in terms of values of process variables to be kept within certain limits in time [19]. This technique can also be used for identification of system behavior and thus, as a design tool for implementing protections and operator procedures [19]. It is important to note that system specific DYLAM simulator must be created to analyze each particular problem. Furthermore, input data such as probabilities of a component being in certain state at transient initiation, independency of such probabilities, transition rates between different states, and conditional probability matrices for dependencies among states and process variables need to be provided to run the DYLAM package. An application of DYLAM on a reservoir problem is given in literature [18]. 3.5 Dynamic Event Tree Analysis Method

Dynamic event tree analysis method (DETAM)[13, 20] is an approach that treats time-dependent evolution of plant hardware states, process variable values, and operator states over the course of a scenario[20]. In general, a dynamic event tree is an event tree in which branching are allowed at different points in time. This approach is defined by five characteristics set: (a) branching set, (b) set of variables defining the system state, (c) branching rules, (d) sequence expansion rule and (e) quantification tools. The branching set refers to the set of variables that determine the space of possible branches at any node in the tree. Branching rules, on the other hand, refer to rules used to determine when a branching should take place (a constant time step). The sequence expansion rules are used to limit the number of sequences. This approach can be used to represent a wide variety of operator behaviors, model the consequences of operator actions and also served as a framework for the analyst to employ a causal model for errors of commission. Thus it allows the testing of emergency procedures and

identify where and how changes can be made to improve their effectiveness. An analysis of the accident sequence for a steam generator tube rupture is presented in literature [20]. 3.6 Discussion and Conclusion

The techniques discussed above address the deficiencies found in fault/event tree methodologies when analyzing dynamic scenarios. However, there is also limitation to their usage. The digraph and GO techniques model the system behavior and deal, in limited extends, with changes in model structure over time. On the other hand, Markov modeling requires the explicit identification of possible system states and the transitions between these states. This is a problem as it is difficult to envision the entire set of possible states prior to scenario development. DYLAM and DETAM can solve the problem through the use of implicit statetransition definition. The drawbacks to these implicit techniques are implementation- oriented [13]. With the large tree-structure generated through the DYLAM and DETAM approaches, large computer resources are required. The second problem is that the implicit methodologies may require a considerable amount of analyst effort in data gathering and model construction.

A Business Failure is an unfortunate circumstance. The majority of firms that fail do so within the first year or two of life, other firms grow, mature, & fail much later. The failure of a business can be viewed a number of ways & can result from one or more causes. Types of Business Failure: 1.Technical Insolvency: Business Failure that occurs when a firm is unable to pay its liabilities as they come due. 2. Bankruptcy: Business Failure that occurs when a firm’s liabilities exceed the fair market value of assets. Major Causes of Business Failure 1. Mismanagement • The primary causes of Business Failure are mismanagement, which accounts about 50% of all cases. • Numerous specific managerial faults can cause the firm to fail. Over expansion, poor financial action, an ineffective sales force, & high production costs can all singly or in combination cause the ultimate failure of the firm. • Poor financial actions include bad capital budgeting decisions, poor financial evaluations of the firm’s strategic plan prior to making

financial commitments, nonexistent or inadequate cash flow planning, and failure to control receivables or inventories. 2. Economic Activity especially economic downturns – can contribute to the failure of a firm. • If the economy goes into recession , sales decrease • In 1990s, a number of major Business Failures such as Olympia & York (Real Estate), America West Air Lines, resulted from over expansion & the recessionary economy. 3. Corporate Maturity: A final cause of Business Failure is corporate maturity. Firms, like individual do not have infinite lives. Like a product, a firm goes through the stages of birth, growth, maturity, & eventual decline. Seven failures to business growth 1. Failure to anticipate: Most companies react to the changes that are taking place right now. They react to customers, react to the economy, and react to government legislation. Instead of merely reacting, you need to anticipate future changes and plan for them. 2. Failure to communicate: There is a big difference between informing and communicating. Informing is one-way, static and seldom leads to action. Communicating is two-way, dynamic and usually leads to action. Ironically, we have all these fantastic communication age tools, but we’re using them in an information age way. Realize that the information age is not our friend; it’s our enemy in disguise. When you focus on maximizing two-way communications, you can create a communication-age organization and cause positive change much faster. 3. Failure to collaborate: The majority of people tend to cooperate, which is very different from collaborating. Even though we often use the word “collaborate,” we’re really just cooperating, which is a lower level function Remember that today’s technologies allow us to collaborate in new and amazing ways. Make sure you’re using them properly. 4. Failure to innovate: When asked when the last time they did something innovative was, most companies have to go back five or ten years to cite something meaningful. Why? Because the majority of companies innovate once, come up with a great product or service, form a company around it, and then they let it ride. They don’t continue to innovate and create new products and services. The more time you devote to innovation, the more profitable and efficient you’ll ultimately be. 5. Failure to pre-solve problems:


Some people say that a problem is an opportunity in disguise. Nonsense! A problem is a problem. A problem is only an opportunity before you have it. You can base your product development on your customer’s future problems and deliver the product or service right when the problem is starting to hit. 6. Failure to de-commoditize: Any product or service can be de-commoditized. Unfortunately, many companies tend to come up with something new, and then that’s their main product. Other people copy the product. Margins get thin. Sales slowdown. And they end up competing on price. The key is to take your product and put a service wrapper around it. Look at your product or service and think of ways that you can wrap a service around it to add value. But don’t stop there. Keep adding value to it every year so you never become a commodity again. 7. Failure to differentiate: Too many companies become just like everyone else. They don’t continue to stand out. Even though they do strategic planning, realize that you can infinitely differentiate your company if you’re only bold enough to try. Have the courage to do the things your competition isn’t doing. Causes of Business Failure The following are some possible causes of business failure. • Cash flow problems • Poor business planning • Fall in demand for the product • Rise in costs or a lack of control of costs Cash Flow problems For many small and newly formed businesses, this is often the single most important reason for business failure. The problem arises when the money coming into the company from sales is not enough to cover the costs of production. It is important to remember that it is a case of having the money to be able to pay debts when the debts are due, not simply generating enough revenue during a year to cover costs. Poor Business planning Many new businesses will have to put together a business plan to present to the bank before it receives loans or financial help. The time and effort put into these plans is crucial for success. Bad planning or poor information on which the plan is based is likely to lead to difficulties for the firm. For example, if the firm plans to sell 2,000 units per month in the first year because it used only limited market research and ends up only selling 500 per month, it will soon be in serious danger of collapse. Fall in demand for the product There are a number of reasons why demand might fall. Some of these might be to do with the business taking their eye off the ball and not paying

sufficient attention to their customers' needs - perhaps the product is not up to scratch, perhaps the quality is poor, maybe the price is too high most of these things are within the businesses control. Falling sales might be a sign that there might be something wrong with the product or the price or some other aspect of the marketing mix. Sometimes the fall in sales might be as a result of the competition providing a better product or service – in part the business can do something about this they have to recognise it in the first place. Rise in costs or a lack of control of costs Costs of production can rise for a number of reasons. There may have been wage rises, raw material prices might have increased (for example the price of oil or gas), the business might have had to spend money on meeting some new legislation or standard and so on. In many cases, a firm can plan for such changes and is able take them into account but if the costs rise unexpectedly, this can catch a firm off guard and tip them into insolvency. Visible Problems in Business

Lacking Feedback:– In new business when feed back or communication does not exist between the various parties of a unit than there will be a hurdle in entrepreneurship. Absence of Internal control: – Control over the business comes from the internal side of the business specially for a new entrepreneur. So less internal control always be a problem. Team Building:– A new business depends on the coordination and team efforts .lacking with team building always be a problem for entrepreneur. Career risk:— loss of employment security can be a problem for starting a new business because if entrepreneur don’t get success than he also loosing an employment opportunity for himself. Reason for Business Failure


Interna l

Externa l

External Causes The external causes are beyond the control of the industry & usually affect the industry group as a whole. • Non-availability of raw-material • Unfavorable change in govt. • Industrial strikes, etc. • Irregular supply of vital inputs such as power, water, etc • Fiscal irregularities Internal Causes The internal causes are within the control of the industry. • Shortage of working capital • Lack of Industry Experience • Poor Business Planning • Lack of Entrepreneurial Skill • Extending too much credit and poor credit control • Lack of control on key areas like management, finance, inventory, etc. • An improper demand forecast for the products to be sold. • Wrong choice of technology, wrong location etc. • Poor pricing strategies




Merger: Merger is defined as combination of two or more companies into a single company where one survives and the others lose their corporate existence. The survivor acquires all the assets as well as liabilities of the merged company or companies. Generally, the surviving company is the buyer, which retains its identity, and the extinguished company is the seller. Types of     Merger: Horizontal Vertical Circular Conglomerate

 Vertical combination: A company would like to take over another company or seek its merger with that company to expand espousing backward integration to assimilate the resources of supply and forward integration towards market outlets. The acquiring company through merger of another unit attempts on reduction of inventories of raw material and finished goods, implements its production plans as per the objectives and economizes on working capital investments. In other words, in vertical combinations, the merging undertaking would be either a supplier or a buyer using its product as intermediary material for final production.


The following main benefits accrue from the vertical combination to the acquirer company: It gains a strong position because of imperfect market of the intermediary products, scarcity of resources and purchased products; Has control over products specifications.  Horizontal combination: It is a merger of two competing firms which are at the same stage of industrial process. The Acquiring firm belongs to the same industry as the target company. The mail purpose of such mergers is to obtain economies of scale in production by eliminating duplication of facilities and the operations and broadening the product line, reduction in investment in working capital, elimination in competition concentration in product, reduction in advertising costs, increase in market segments and exercise better control on market.  Circular combination: Companies producing distinct products seek amalgamation to share common distribution and research facilities to obtain economies by elimination of cost on duplication and promoting market enlargement. The acquiring company obtains benefits in the form of economies of resource sharing and diversification.  Conglomerate combination: It is amalgamation of two companies engaged in unrelated industries like DCM and Modi Industries. The basic purpose of such amalgamations remains utilization of financial resources and enlarges debt capacity through re-organizing their financial structure so as to Service the shareholders by increased leveraging and EPS, lowering average cost of capital And thereby raising present worth of the outstanding shares. Merger enhances the overall Stability of the acquirer company and creates balance in the company’s total portfolio of Diverse products and production processes. Acquisitions: Acquisition in general sense is acquiring the ownership in the property. In the context of business combinations, an acquisition is the purchase by one company of a controlling interest in the share capital of another existing company. Merger Vs Acquisitions: Merger 1. A transaction where two firms agree to integrate their operations because they have resources and capabilities that together may create Acquisition 1. When one company takes over another and clearly established itself as the new owner, the purchase is called an acquisition.


stronger competitive advantage. 2.
Merger refers to combination of two entities through mutual negotiation to form a third company also known as a Merger of Equals.


Acquisition refers to acquiring of a target company's controlling interest or asset. The target company can dissolve and operate under the acquirer name.

3. When two firms merge, stocks of both are surrendered and new stocks in the name of new company are issued.

3. Unlike the merger, stocks of the acquired firm are not surrendered, but bought by the public prior to the acquisition, and continue to be traded in the stock market.

Amalgamation: Merger is also defined as amalgamation. Merger is the fusion of two or more existing companies. All assets, liabilities and the stock of one company stand transferred to Transferee. Company in consideration of payment in the form of: Equity shares in the transferee company, Debentures in the transferee company, Cash or A mix of the above modes. Takeover: A ‘takeover’ is acquisition and both the terms are used interchangeably. Takeover differs from merger in approach to business combinations i.e. the process of takeover, transaction involved in takeover, determination of share exchange or cash price and the fulfillment of goals of combination all are different in takeovers than in mergers. Purpose of Mergers and Acquisitions The basic purpose of merger or business combination is to achieve faster growth of the corporate business. Faster growth may be had through product improvement and competitive position. 1) Procurement of supplies: To safeguard the source of supplies of raw materials or intermediary product 2) Revamping production facilities: To achieve economies of scale by amalgamating production facilities through more intensive utilization of plant and resources; 3) Market expansion and strategy: To eliminate competition and protect existing market; 4) Financial strength: To improve liquidity and have direct access to cash resource; 5) Strategic purpose: The Acquirer Company views the merger to achieve strategic objectives through alternative type of combinations which may be horizontal, vertical, product expansion, market extensional or other specified unrelated objectives depending upon the corporate strategies. 6) Desired level of integration: Mergers and acquisition are pursued to obtain the desired Level of integration between the two combining business houses. Such integration could be

Operational or financial. Advantages of mergers:    A merger does not require cash. A merger may be accomplished tax-free for both parties. A merger lets the target (in effect, the seller) realize the appreciation potential of the merged entity, instead of being limited to sales proceeds. A merger allows the shareholders of smaller entities to own a smaller piece of a larger pie, increasing their overall net worth. A merger of a privately held company into a publicly held company allows the target company shareholders to receive a public company's stock, despite the liquidity restrictions of SEC Rule 144a. A merger allows the acquirer to avoid many of the costly and timeconsuming aspects of asset purchases, such as the assignment of leases and bulk-sales notifications. Of considerable importance when there are minority stockholders is the fact that upon obtaining the required number of votes in support of the merger, the transaction becomes effective and dissenting shareholders are obliged to go along.

 

The disadvantages of mergers and acquisitions are:     Diseconomies of scale if business become too large, which leads to higher unit costs. Clashes of culture between different types of businesses can occur, reducing the effectiveness of the integration. May need to make some workers redundant, especially at management levels - this may have an effect on motivation. May be a conflict of objectives between different businesses, meaning decisions are more difficult to make and causing disruption in the running of the business. companies merge? Market dominance Channel control Cost cutting Leadership Survival Adopt technologies

Why      

  

Financial gain and personal power Gaining Core competency Acquiring talent, knowledge, technology

Phases in Acquisition:  Scouting and opportunity identification  Opportunity Evaluation  Due Diligence  Bid  Negotiation  Agreement  Integration  Post Acquisition learning Forward triangular merger : A type of merger that occurs when the subsidiary of the acquiring corporation merges with the target firm. In a forward triangular merger, the subsidiary's equity merges with the target firm's stock. As a result of the merger, the target becomes a part of the original subsidiary of the acquirer. This form of acquisition is often used for regulatory reasons. Reverse Triangular Merger: When the subsidiary of the acquiring corporation merges with the target firm. In this case, the subsidiary's equity merges with the target firm's stock. As a result of the merger, the target would become a wholly-owned subsidiary of the acquirer and shareholders of the target would get shares of the acquirer. This form of acquisition is often used for regulatory reasons. Merger securities: A non-cash asset paid to the shareholders of a corporation that is being acquired or is the target of a merger. These securities generally consist of bonds, options, preferred stock and warrants, among others. Merger securities can become undervalued when large investment firms are required to sell them as a result of their strict investment requirements. For example, a large mutual fund may receive stock options from an acquiring company when one of the companies held in its portfolio is purchased. If the fund has a policy against holding options, it may be required to sell them, which can then cause the price of the options to fall to very low levels. Merger deficit: An accounting term used to describe the situation when the total value of the share capital used to purchase another company is less than the total value of the equity purchased. The merger does not necessarily have to be an all-stock acquisition.

In other words, a merger deficit arises when a company uses funds it raised in new stock issues to purchase the stock of another company. The stock purchased must be worth more than the share capital used to purchase it in order for the deference to be classified as a merger deficit. Acquisition fee: Charges and commissions paid out for the selection or purchase of property. Some examples include real estate commission, acquisition expense and development/construction fees. An acquisition fee represents all the costs associated with an acquisition. Acquisition Premium: The difference between the actual costs for acquiring a target firm versus the estimate made of its value before the acquisition. During a merger and acquisition, companies will first estimate the cost that they wish to pay for a target firm. As the entire M&A process takes many weeks, the price paid for the target firm may in fact be higher or lower than its market price at the time of completion because of economic fluctuations. Consolidation: In technical analysis, the movement of an asset's price within a well-defined pattern or barrier of trading levels. Consolidation is generally regarded as a period of indecision, which ends when the price of the asset breaks beyond the restrictive barriers. Periods of consolidation can be found in charts covering any time interval (i.e. hours, days, etc.), and these periods can last for minutes, days, months or even years. Lengthy periods of consolidation are often known as a base. Types of business consolidations There are three forms of business combinations:

Statutory Merger: a business combination that results in the liquidation of the acquired company’s assets and the survival of the purchasing company. Statutory Consolidation: a business combination that creates a new company in which none of the previous companies survive. Stock Acquisition: a business combination in which the purchasing company acquires the majority, more than 50%, of the Common stock of the acquired company and both companies survive. Amalgamation: Means an existing Company which is taken over by another existing company. In such course of amalgamation, the


consideration may be paid in "cash" or in "kind", and the purchasing company survives in this process. Liquidation: Liquidation is the process by which a company (or part of a company) is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as windingup or dissolution, although dissolution technically refers to the last stage of liquidation. The process of liquidation also arises when customs, an authority or agency in a country responsible for collecting and safeguarding customs duties, determines the final computation or ascertainment of the duties or drawback accruing on an entry. Consolidation Phase A stage in the life of a company or an industry in which components in the company or industry start to merge to form fewer components. These components can include product lines at the company level or companies themselves at the industry level. The consolidation of companies differs from mergers in that consolidations create new entities while mergers do not. Let's say the video game industry is starting to mature, and its companies start to acquire other companies and join together to form larger entities; this would be an example of a consolidation phase for the industry. Different types of consolidation loans Consolidation loans are used to pay off other loans, but they don't eliminate debt. People can use consolidation loans to roll their debt into one loan with an easier monthly payment. Different lenders have different requirements for approving consolidation loans. 1. Private Consolidation Private lenders (such as banks and credit unions) offer private consolidation loans, but they require that you pass a credit check. In case of bad credit, you may still get a consolation loan by getting someone to co-sign. 2. Federal Consolidation There is no need for a credit check or a co-signer for federal consolidation loans, but they can only be used to consolidate other federal loans. 3. Mortgage A mortgage is a type of consolation loan because you can use it to make payments on credit cards, medical bills or student loans. 4. Home Equity Line of Credit You can also take out a second mortgage on the valuables inside your house. This is called a home equity line of credit. 5. Credit Cards

A credit card is also a type of consolidation loan because you can use it to make payments on other credit cards. The downside is that the more credit card debt you incur, the lower your credit rating gets, which makes it harder to get new credit cards.

A capital market is a market where both government and companies raise long term funds to trade securities on the bond and the stock market. It consists of both the primary market where new issues are distributed among investors, and the secondary markets where already existent securities are traded. The stock market forms a major portion of the capital market. In the capital market, mortgages, bonds, equities and other such investment funds are traded. The capital market also facilitates the procedure whereby investors with excess funds can channel them to investors in deficit. The capital market provides both overnight and long term funds and uses financial instruments with long maturity periods. The following financial instruments are traded in this market:  Foreign exchange instruments  Equity instruments  Insurance instruments  Credit market instruments  Derivative instruments  Hybrid instruments The following are some of the main capital market regulatory authorities:
      

U.S. Securities and Exchange Commission Securities and Exchange Board of India(SEBI) Australian Securities and Investments Commission Authority of Financial Markets (France) Canadian Securities Administrators Securities and Exchange Surveillance Commission (Japan) Role of the Capital Market

The primary role of the capital market is to raise long-term funds for governments, banks, and corporations while providing a platform for the trading of securities. This fundraising is regulated by the

performance of the stock and bond markets within the capital market. The member organizations of the capital market may issue stocks and bonds in order to raise funds. Investors can then invest in the capital market by purchasing those stocks and bonds. The capital market, however, is not without risk. It is important for investors to understand market trends before fully investing in the capital market. To that end, there are various market indices available to investors that reflect the present performance of the market. 1. Regulation of the Capital Market Every capital market in the world is monitored by financial regulators and their respective governance organization. The purpose of such regulation is to protect investors from fraud and deception. Financial regulatory bodies are also charged with minimizing financial losses, issuing licenses to financial service providers, and enforcing applicable laws. 2. The Capital Market’s Influence on International Trade Capital market investment is no longer confined to the boundaries of a single nation. Today’s corporations and individuals are able, under some regulation, to invest in the capital market of any country in the world. Investment in foreign capital markets has caused substantial enhancement to the business of international trade. 3. The Primary and Secondary Markets The capital market is also dependent on two submarkets – the primary market and the secondary market. The primary market deals with newly issued securities and is responsible for generating new long-term capital. The secondary market handles the trading of previously-issued securities, and must remain highly liquid in nature because most of the securities are sold by investors. A capital market with high liquidity and high transparency is predicated upon a secondary market with the same qualities. Capital Market Analyst The Capital Market Analyst is required to have extensive knowledge of finances, risk management products and financial markets . The capital market analyst should have strong analytical and presentation skill. He should also be capable of negotiating. The following is the list of functions by the capital market analyst:


     

  

The capital market analyst is supposed to assist his clients in the different capital market transactions and financing structures. The capital market analyst is also responsible for assessing the structures and the financial products. The capital market analyst analyzes financing and the financial risk management proposals. The capital market analyst negotiates the finance related agreements. The capital market analyst manages the bank relationship. The capital market analyst analyzes the financial risk management products which includes the derivatives and thereby keeps the financial market under close watch. The capital market analyst assists in projects and prepares presentations. The capital market analyst should be skilled in collecting and documenting the business requirements. The capital market analyst should be skilled in creating process and data flow maps and diagrams.

The capital market analyst should possess knowledge in the following areas of the global capital market:
       

Trading Settlements Custody Compliance Risk OTC derivatives Finance Prime Brokerage

The role of the capital market analyst is also to develop capital market reports and recommendations on particular kinds of stocks. They study the company information’s and based on them they formulate financial models. Such models are used to forecast the future trends. On the basis of such trend the capital market analyst decide on whether the specified stock should be bought or sold. The recommendations of the capital market analysts differ across the different firms. The analyst sometimes is caught between the employing company and the company whose stock they are studying. The capital market analyst is also responsible for issuing the earnings estimates for companies. The earnings estimate is basically the estimate of the earnings per share. The earnings estimate has gained prominence in Wall Street. The companies that overshoot their estimates experience rising stock prices whereas in the reverse case the stock prices are seen to be taking a downturn.


The reports and the earnings estimates have conflicting objectives. The analysts are instructed by the companies to keep their earnings estimate lower than the figure that the company actually desires to report. Hence in most times overshoot their expectations which signal the less knowledgeable investors to buy. These are known as the earnings whispers. The earnings whispers are created using a number of methods. Capital Market Theory Capital Market Theory tries to explain and predict the progression of capital (and sometimes financial) markets over time on the basis of the one or the other mathematical model. Capital market theory is a generic term for the analysis of securities. In terms of trade off between the returns sought by investors and the inherent risks involved, the capital market theory is a model that seeks to price assets, most commonly, shares. In general, whenever someone tries to formulate a financial, investment, or retirement plan, he or she (consciously or unconsciously) employs a theory such as arbitrage pricing theory, capital asset pricing model, coherent market hypothesis, efficient market hypothesis, fractal market hypothesis, or modern portfolio theory. The most talked about model in Capital Market Theory is the Capital Asset Pricing Model. In studying the capital market theory we deal with issues like the role of the capital markets, the major capital markets in the US, the initial public offerings and the role of the venture capital in capital markets, financial innovation and markets in derivative instruments, the role of securities and the exchange commission, the role of the federal reserve system, role of the US Treasury and the regulatory requirements on the capital market. The Capital Market Theory deals with the following issues:          Importance of venture capital in the capital market Initial public offerings Role of capital market Major capital markets worldwide Markets and financial innovations in derivative instruments Role of Federal Reserve System Role of securities Capital market regulatory requirements Role of the government treasury


Assumptions of Capital Market Theory: The capital market theory builds upon the Markowitz portfolio model. The main assumptions of the capital market theory are as follows: All Investors are Efficient Investors: Investors follow Markowitz idea of the efficient frontier and choose to invest in portfolios along the frontier. Investors Borrow/Lend Money at the Risk-Free Rate: This rate remains static for any amount of money. The Time Horizon is equal for All Investors: When choosing investments, investors have equal time horizons for the chosen investments. All Assets are Infinitely Divisible: This indicates that fractional shares can be purchased and the stocks can be infinitely divisible. No Taxes and Transaction Costs: It is assumed that investor’s results are not affected by taxes and transaction costs. All Investors Have the Same Probability for Outcomes: When determining the expected return, assume that all investors have the same probability for outcomes. No Inflation Exists: Returns are not affected by the inflation rate in a capital market as none exists in capital market theory. There is No Mispricing within the Capital Markets: It is assumed that the markets are efficient and that no mispricing within the markets exists. Mortgages, equities, bonds, and other investments are traded in the capital market. The financial instruments in this market have long maturity periods. Capital market theory states that federal funds, federal agency securities, treasury bills, commercial papers, negotiable certificates of deposits, repurchase agreements, Eurocurrency loans and deposits, options and futures are merchandised in the capital market. When one has to put a price on a security, one has to determine the risk and return of the security both for single assets, as well as a portfolio of assets. The uncertainty and variability of returns on assets and the possibilities of losses can be defined as risks.


The theory of capital market defines returns in the following manner: K = Pt + Ct - Pt-1 / Pt-1 Where the time of purchase of the asset of price Pt-1 is t-1. If this be the case, then the return (K) from the time period t-1 to t is the above mentioned formula. Ct is the cash gotten from assets between t-1 and t. Pt is the price of the asset at time t. for practitioners of the capital market theory, it has not lost its significance. It is still as important for retirement, financial, and investment plans. Capital Market Report The Capital Market Report is prepared by the capital market analysts and are of various types. They are the financial statements of a company's performance in the capital market. They are four different kinds of capital market reports. They are 10-K Reports, 10-Q Reports, Form 8-K Reports and the Proxy Statements. Each of these reports may be discussed in detail under the following heads: 1. 10-K Reports The companies that are publicly traded are supposed to maintain the 10-K report each year. This is a kind of annual report of the company that contains information of the company’s business, finances and management. The types of capital market report also inform about the bylaws of the company, other legal documents and the lawsuits that the company may have a hand in. If one is keen on learning about anything about the company that is not mentioned in the annual report may find them in the 10-K Reports. 2.10-Q Capital Market Reports or the Quarterly Reports The quarterly reports are nothing but the abridged forms of the annual reports. They are issued at an interval of three months. They consist of financial statements and list the material events that have occurred in the company. By material event we mean any stock split or acquisition. 3. Form 8 -K The companies that are publicly traded are required to maintain the Form 8-K where they record any material event that might have affected the financial status of the company. The material events that occur

include stock splits, mergers and acquisitions, management changes and the secondary stock offerings. Although such in formations would be finally filed in the 10-K Report, even then the 8-K is easier to access when one needs to know about these events. 4. Proxy Statements Each year the publicly traded companies call a meeting where they discuss the issues like company business situation. The shareholders nominate the Board of Directors by way of votes. Before such a meeting is conducted the company distributes a proxy statement to the shareholders. This proxy statement consists of business issues that need to be discussed in the meeting and a ballot for voting for the purpose of forming the new Board of directors. The Proxy Statement also gives authority to someone in the management team to vote on his behalf. Capital market instruments: Capital market instruments are responsible for generating funds for companies, corporations, and sometimes national governments. These are used by the investors to make a profit out of their respective markets. There are a number of capital market instruments used for market trade, including  Stocks  Bonds  Debentures  Treasury-bills  Foreign Exchange  Fixed deposits, and others Money Market Vs Capital Market Money market Capital market 1. It is for short term 1. It is for long term. 2. Each single instrument is of large amount 3. Central bank and Commercial banks
are major.

2. Each single instrument is of small amount. 3. Development bank and insurance
companies are major.

4. Instruments are T-bill, CM, etc 5. Supplies funds for WC. 6. These instruments do not have secondary market. 7. Transactions are on over phone and no formal place.

4. Instruments are shares, debentures,
etc. 5. Supplies funds for fixed capital requirement.

6. These instruments have secondary market. 7. Transactions are at formal place. Eg stock market.

8. Transaction without the help of broker.

8. Transaction has to be conducted with the help of broker.

FACTORS AFFECTING CAPITAL MARKET IN INDIA:The capital market is affected by a range of factors. Some of the factors which influence capital market are as follows:A) Performance of domestic companies:The performance of the companies’ or rather corporate earnings is one of the factors which have direct impact or effect on capital market in a country. Weak corporate earnings indicate that the demand for goods and services in the economy is less due to slow growth in per capita income of people. Because of slow growth in demand there is slow growth in employment which means slow growth in demand in the near future. Thus weak corporate earnings indicate average or not so good prospects for the economy as a whole in the near term. In such a scenario the investors (both domestic as well as foreign) would be wary to invest in the capital market and thus there is bear market like situation. The opposite case of it would be robust corporate earnings and its positive impact on the capital market. The corporate earnings for the April – June quarter for the current fiscal has been good. The companies like TCS, Infosys,Maruti Suzuki, Bharti Airtel, ACC, ITC, Wipro,HDFC,Binani cement, IDEA, Marico Canara Bank, Primal Health, India cements , Ultra Tech, L&T, Coca- Cola, Yes Bank, Dr. Reddy’s Laboratories, Oriental Bank of Commerce, Ranbaxy, Fortis, Shree Cement ,etc have registered growth in net profit compared to the corresponding quarter a year ago. Thus we see companies from Infrastructure sector, Financial Services, Pharmaceutical sector, IT Sector, Automobile sector, etc. doing well. This across the sector growth indicates that the Indian economy is on the path of recovery which has been positively reflected in the stock market (rise in sensex & nifty) in the last two weeks. (July 13-July 24). B) Environmental Factors:Environmental Factor in India’s context primarily means- Monsoon. In India around 60 % of agricultural production is dependent on monsoon. Thus there is heavy dependence on monsoon. The major chunk of agricultural production comes from the states of Punjab, Haryana & Uttar Pradesh. Thus deficient or delayed monsoon in this part of the country would directly affect the agricultural output in the country. Apart from monsoon other natural calamities like Floods, tsunami, drought, earthquake, etc. also have an impact on the capital market of a country. The Indian Met Department (IMD) on 24th June stated that India would receive only 93 % rainfall of Long Period Average (LPA). This piece of news directly had an impact on Indian capital market with BSE Sensex falling by 0.5 % on the 25th June. The major losers were automakers and consumer goods firms since the below normal monsoon forecast triggered concerns that demand in the crucial rural heartland would take a hit. This is because

a deficient monsoon could seriously squeeze rural incomes, reduce the demand for everything from motorbikes to soaps and worsen a slowing economy. C) Macro Economic Numbers:The macroeconomic numbers also influence the capital market. It includes Index of Industrial Production (IIP) which is released every month, annual Inflation number indicated by Wholesale Price Index (WPI) which is released every week, Export – Import numbers which are declared every month, Core Industries growth rate ( It includes Six Core infrastructure industries – Coal, Crude oil, refining, power, cement and finished steel) which comes out every month, etc. This macro –economic indicators indicate the state of the economy and the direction in which the economy is headed and therefore impacts the capital market in India. A case in the point was declaration of core industries growth figure. The six Core Infrastructure Industries – Coal, Crude oil, refining, finished steel, power & cement – grew 6.5% in June; the figure came on the 23 rd of July and had a positive impact on the capital market with the sensex and nifty rising by 388 points & 125 points respectively. D) Global Cues:In this world of globalization various economies are interdependent and interconnected. An event in one part of the world is bound to affect other parts of the world , however the magnitude and intensity of impact would vary. Thus capital market in India is also affected by developments in other parts of the world i.e. U.S. , Europe, Japan , etc. Global cues includes corporate earnings of MNC’s, consumer confidence index in developed countries, jobless claims in developed countries, global growth outlook given by various agencies like IMF, economic growth of major economies, price of crude –oil, credit rating of various economies given by Moody’s, S & P, etc. An obvious example at this point in time would be that of subprime crisis & recession. Recession started in U.S. and some parts of the Europe in early 2008 .Since then it has impacted all the countries of the world- developed, developing, and less- developed and even emerging economies.

For any economy to achieve and sustain growth it has to have political stability and pro- growth government policies. This is because when there is political stability there is stability and consistency in government’s attitude which is communicated through various government policies. The viceversa is the case when there is no political stability .So capital market also


reacts to the nature of government, attitude of government, and various policies of the government. The above statement can be substantiated by the fact the when the mandate came in UPA government’s favor ( Without the baggage of left party) on May 16 2009, the stock markets on Monday , 18th May had a bullish rally with sensex closing 800 point higher over the previous day’s close. The reason was political stability. Also without the baggage of left party government can go ahead with reforms. F) Growth prospectus of an economy:When the national income of the country increases and per capita income of people increases it is said that the economy is growing. Higher income also means higher expenditure and higher savings. This augurs well for the economy as higher expenditure means higher demand and higher savings means higher investment. Thus when an economy is growing at a good pace capital market of the country attracts more money from investors, both from within and outside the country and vice -versa. So we can say that growth prospects of an economy do have an impact on capital markets. G) Investor Sentiment and risk appetite :Another factor which influences capital market is investor sentiment and their risk appetite .Even if the investors have the money to invest but if they are not confident about the returns from their investment, they may stay away from investment for some time. At the same time if the investors have low risk appetite, which they were having in global and Indian capital market some four to five months back due to global financial meltdown and recessionary situation in U.S. & some parts of Europe, they may stay away from investment and wait for the right time to come. Short answers Capital market:      Capital markets facilitate the transfer of capital (i.e. financial) assets from one owner to another. They provide liquidity. Liquidity refers to how easily an asset can be transferred without loss of value. A side benefit of capital markets is that the transaction price provides a measure of the value of the asset. The capital market is the market for securities, where companies and the government can raise long-term funds. The capital market includes the stock market and the bond market. Financial regulators, such as the U.S. Securities and Exchange Commission and Securities and Exchange Board of India (SEBI)-India, oversee the capital markets in their designated countries to ensure that investors are protected against fraud.


The capital markets consist of the primary market, where new issues are distributed to investors, and the secondary market, where existing securities are traded. 1. Role of capital markets:        Mobilization of Savings & acceleration of Capital Formation Promotion of Industrial Growth Raising of long term Capital Ready & Continuous Markets Proper Channelization of Funds Provision of a variety of Services

2. Why Capital Markets Exist: Capital markets facilitate the transfer of capital (i.e. financial) assets from one owner to another.  They provide liquidity. • Liquidity refers to how easily an asset can be transferred without loss of value.  A side benefit of capital markets is that the transaction price provides a measure of the value of the asset. 3. Factors contributing to growth of Indian Capital Market

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Establishment of Development banks & Industrial financial institution. Legislative measures Growing public confidence Increasing awareness of investment opportunities Growth of underwriting business Setting up of SEBI Mutual Funds Credit Rating Agencies

4. Functions of a capital market
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Disseminate information efficiently Enable quick valuation of financial instruments –both equity and debt Provide insurance against market risk or price risk Enable wider participation Provide operational efficiency through -simplified transaction procedure -lowering settlement timings and -lowering transaction costs Develop integration among -real sector and financial sector -equity and debt instruments

-long term and short term funds -Private sector and government sector and -Domestic funds and external funds  Direct the flow of funds into efficient channels through -investment -disinvestment -reinvestment

5. Indian Capital Market deficiencies  Lack of transparency  Physical settlement  Variety of manipulative practices  Institutional deficiencies  Insider trading 6. Pension Fund A pension fund is a pool of assets forming an independent legal entity that are bought with the contributions to a pension plan for the exclusive purpose of financing pension plan benefits. 7. Mutual fund A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors and invests it in stocks, bonds, short-term money market instruments, and/or other securities. The mutual fund will have a fund manager that trades the pooled money on a regular basis. The net proceeds or losses are then typically distributed to the investors annually. 8. Financial Institution A financial institution is an institution that provides financial services for its clients or members. Probably the most important financial service provided by financial institutions is acting as financial intermediaries. Most financial institutions are highly regulated by government bodies. Broadly speaking, there are three major types of financial institution:1) Deposit -taking institutions that accept and manage deposits and make loans (this category includes banks, credit unions, trust companies, and mortgage loan companies); 2) Insurance companies and pension funds; and 3) Brokers, underwriters and investment funds. 9. Who are the participants in the capital market? The following are the market participants in the capital market:(a) Foreign institutional Investors (b) Non- Resident Indians (c) Persons of Indian Origin (d) Retail investors (e) Venture capital funds

(f) Mutual Funds (g) Private Equity (h) High Net worth Individuals (HNIs) (i)Financial Institutions (j)Insurance companies 10. What is price – earnings ratio ( P/E ratio) ? PE Ratio is a short form for Price to Earnings Ratio. This is the ratio of the market price of a stock and its EPS. It is used to judge the valuation of a company. This ratio shows how much the investors are willing to pay for a company for each rupee of profit. Price Earnings ratio = Market price per share -----------------------------Earnings per Share 11. What is the criteria for selecting top 30 and 50 stocks in case of BSE & NSE respectively? The following are the criteria for selecting the top 30 and 50 Stocks for BSE & NSE respectively:(a) Market capitalization: -The company should have a market capitalization in the Top 100 market capitalization’s of the BSE. Also the market capitalization of each company should be more than 0.5% of the total market capitalization of the Index. (b)Trading frequency: -The Company to be included should have been traded on each and every trading day for the last one year. Exceptions can be made for extreme reasons like share suspension etc. (c) Number of trades: -The scrip should be among the top 150 companies listed by average number of trades per day for the last one year. (d)Industry representation: -The companies should be leaders in their industry group. (e)Listed history:- The companies should have a listing history of at least one year on BSE. (f)Track record:- In the opinion of the index committee, the company should have an acceptable track record. 12. How to calculate the value of sensex at a particular point? The following are the steps to calculate sensex at a particular point of time:First: Find out the “free-float market cap” of all the 30 companies that make up the Sensex. Second: Add all the “free-float market caps” of all the 30 companies. Third: Make all this relative to the Sensex base. The value you get is the Sensex value. To understand the third step let us take an example.


Example:-Suppose, the free float market cap of all the 30 companies was Rs. 100,000,000 at the end of one trading day and the value of sensex is 12500. The market cap at the end of next trading day becomes Rs.120,000,000, then the sensex value at the end of that day is – Sensex value = 120,000,000 x12500 = 15000 100,000,000 Thus the sensex value at the end of next trading day is 15000. Please note that every time one of the 30 companies has a “stock split” or a "bonus" etc. appropriate changes are made in the “market cap” calculations. 13. Capital: Capital is something owned which provides ongoing services. In the national accounts, or to firms, capital is made up of durable investment goods, normally summed in units of money. Broadly: land plus physical structures plus equipment. The idea is used in models and in the national accounts. 14. Capital ratio The capital ratio is a measure of a bank's capital strength used by U.S. regulatory agencies. 15. Capital Consumption:
In national accounts, capital consumption is the amount by which gross investment exceeds net investment. It is the same as replacement investment.

16. Capital intensity Capital intensity is the amount of capital per unit of labor input 17. Equity Capital Market – ECM A market that exists between companies and financial institutions that is used to raise equity capital for the companies. Some activities that companies operate in the equity capital markets include: overall marketing, distribution and allocation of new issues; initial public offerings, special warrants, and private placements. Along with stocks, the equity capital markets deal with derivative instruments such as futures, options and swaps.

Securities and Exchange Board of India (SEBI): The Government of India set up a body called Securities and Exchange Board of India in April 1988.However, the real beginning of SEBI started in 1992, when the SEBI Act, 1992 was passed and assented by the President of India. The basic objectives of the Board were identified as:
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to protect the interests of investors in securities; to promote the development of Securities Market; to regulate the securities market and

For matters connected therewith or incidental thereto.

SEBI has introduced the comprehensive regulatory measures, prescribed registration norms, the eligibility criteria, the code of obligations and the code of conduct for different intermediaries like, bankers to issue, merchant bankers, brokers and sub-brokers, registrars, portfolio managers, credit rating agencies, underwriters and others. It has framed bye-laws, risk identification and risk management systems for Clearing houses of stock exchanges, surveillance system etc. which has made dealing in securities both safe and transparent to the end-investor. Another significant event is the approval of trading in stock indices (like S&P CNX Nifty & Sensex) in 2000. A market Index is a convenient and effective product because of the following reasons:
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It acts as a barometer for market behavior; It is used to benchmark portfolio performance; It is used in derivative instruments like index futures and index options; It can be used for passive fund management as in case of Index Funds.

Two broad approaches of SEBI is to integrate the securities market at the national level, and also to diversify the trading products, so that there is an increase in number of traders including banks, financial institutions, insurance companies, mutual funds, primary dealers etc. to transact through the Exchanges. In this context the introduction of derivatives trading through Indian Stock Exchanges permitted by SEBI in 2000 AD is a real landmark. FUNCTIONS OF SEBI     

Regulates Capital Market. Checks Trading of securities. Checks the malpractices in securities market. It enhances investor's knowledge on market by providing education. It regulates the stockbrokers and sub-brokers. To promote Research and Investigation.

OBJECTIVES OF SEBI  It tries to develop the securities market.

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Promotes Investors Interest. Makes rules and regulations for the securities market. ROLE AND FUNCTIONS OF SEBI

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Protection of Investors’ Interest. Promoting the development of securities market Regulating the securities market Guidelines on Capital Issues. Regulates Working of Mutual Funds. Regulates Merchant Banking Services. Regulates Stock Brokers Activities. Portfolio Management. Restrictions on Insider Trading. Regulates Take-over, and Mergers. Research and Publicity. Dematerialization of Shares. ROLE OF SEBI IN THE PROCESS OF IPO

SEBI regulates the IPO process and issued detailed Guidelines under section 11 of the SEBI Act, 1992 in the name of SEBI (Disclosure and Investors Protection) Guidelines, 2002 generally known as DIP Guidelines. It is also noted that under the provisions sections 55 of the Companies Act, 1956. the matters pertaining to issue and transfer of securities and nonpayment of dividend in case of listed companies, the companies intend to get listed are being administered by SEBI. ROLE OF SEBI IN THE DEVELOPMENT OF STOCK AND CAPITAL MARKETS SEBI and the Primary Market  It is no longer necessary for companies to obtain prior permission for raising of capital from the market.  SEBI has issued guidelines for all companies for disclosure of information and protection of investor’s interest.  For issues above Rs.100 Core book building requirement has been introduced.  Bankers to the Issue and portfolio managers have to be registered with SEBI. SEBI and the Secondary Market  The governing bodies of Stock Exchange have been recognized, restructured and broad based.


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SEBI has drawn up a comprehensive plan of inspecting all Stock Exchanges to determine the extent of compliance with SEBI guidelines. Computerized screen based trading has been introduced on all major stock exchanges. All Stock Exchanges (SEs) have been directed to set up a clearing house or cleaning corporation. SEBI has accepted the Dave Committee recommendations on improving the working of OTCEI. The Bombay Stock Exchange (BSE) has been asked to reduce trading period from 14 days to 7 days for B group shares. The BSE has been allowed to introduce a revised Carry Forward System. Brokers, sub-brokers have been brought under the regulatory framework of SEBI. Penal action is taken by SEBI against any member for violation of SEBI Act. Registers to Issues and Share Transfer Agents have been brought under SEBI. Merchant Banking activity has been statutory brought under SEBI. SEBI has issued guidelines pertaining to buy-back of shares.

SEBI and Investor Protection SEBI has taken various steps to strengthen investor confidence and interest in the Secondary Market. This includes rationalization and refinement of margin system such as mark to market margin, volatility margin etc. SEBI and Mutual Funds All Mutual Funds have to be registered with the SEBI. UTI has also been brought under SEBI. SEBI has issued guidelines to provide for portfolio disclosure, standardization of accounting policies, valuation norms for determining net asset value and pricing. SEBI has been entrusted with a challenging, difficult and complex job. SEBI in Capital Market      

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New SEBI guidelines were issued. Guidelines for First Issue of New Company. Guidelines for the New issues made by the Private Limited Company. Guidelines for Issue to the public by existing Company. The terms & conditions of the New Instruments. Disclose the arrangement of the amount received by issuing of Shares. Public issue by the existing listed companies & the calculation of NAV & Market price. Credit rating is compulsory in case of convertible debentures. Minimum Interval criteria. Bonus issues.

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Debenture maturity period and redemption. Disclosure of application amount raised through issue of shares. Issues to Promoters, Shareholders & Employees. ROLE IN DEBT MARKETS

It is mandatory for the issuer of the debt instrument to obtain a rating from a credit agency and disclose it in the offer document, ratings obtained in the last three years also need to be disclosed. FCD’s with conversion period over 3 years are allowed provided the conversion is optional with “call” & “put” option. In case of NCD/PCD, the premium to be paid, redemption amount, period of maturity shall be indicated in the prospectus. The issuer can choose to roll over the debentures with or without change in interest rate. In such cases exit option is mandatory for existing debenture holders. It is mandatory for the issuer to obtain a fresh credit rating from an agency within six months prior to date of redemption. This rating has to be communicated to the holders. It is mandatory that the above communication be vetted by SEBI with respect to the credit rating. The disclosures contain the long term equity to debt ratio, servicing behavior with respect to the existing holders. It is also mandatory to obtain a certificate from a financial institution about their no objection to a pari passu charge being created in favour of the trustee to proposed debenture issue. ROLE IN DERIVATIVES MARKETS

SEBI has mandated the following conditions for a stock to be included in derivatives:  Stock shall be amongst the top 500 in terms of average daily market capitalization. The market wide position limit in the stock shall not be less than Rs.50 crores. It is mandatory for the clearing house to provide guarantee for settlement of trades.

Clearing Corporation will monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both. Establishment of electronic funds transfer is mandatory.

SEBI has made the following rules for protection of investors:  Trading Member is required to provide every investor with a risk disclosure document so that investors can take a conscious decision to trade in derivatives. Investor can demand the trade confirmation slip with his ID in support of the contract note. Money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/Clearing Corporation. In the event of default of the Trading/Clearing Member the amounts paid by the client towards margins are not utilized towards the default of the member. Losses suffered by the Investor, if any, on settled / closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges.

Effects Of Measures Taken:  The above measures have resulted in some discipline in the workings of the markets and provision of protection of safeguards to investors. This has resulted in control of malpractices in the capital market operations such as rigging of prices, delays in finalizing allotments, manipulation of prices before listing, diversion of funds, delays in delivery of shares, have started to yield some dividends. Duties, powers & functions exercised by SEBI  Subject to the provisions of this Act, it shall be the duty of the Board to protect the interests of investors in securities and to promote the development of, and to regulate the securities market, by such measures as it thinks fit Regulating the business in stock exchanges and any other securities markets


Registering and regulating the working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers and such other intermediaries who may be associated with securities markets in any manner Registering and regulating the working of the depositories, depository participants, custodians of securities, foreign institutional investors, credit rating agencies and such other intermediaries as the Board may, by notification, specify in this behalf. Registering and regulating the working of venture capital funds and collective investment schemes, including mutual funds. Prohibiting fraudulent and unfair trade practices relating to securities markets . Prohibiting insider trading in securities Regulating companies substantial acquisition of shares and take-over of

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Calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges, mutual funds, other persons associated with the securities market intermediaries Suspend the trading of any security in a recognized stock exchange Restrain persons from accessing the securities market and prohibit any person associated with securities market to buy, sell or deal in securities. SEBI Powers

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Call periodical Returns. Call for any information from Stock Exchanges. Direct enquiries of the affairs of Stock Exchanges. Power to grant approval to the bye-laws of recognized Stock Exchange. Power to make or amend the bye-laws. Power to compel listing of Securities by Public Companies. Power to control & regulate Stock Exchanges. Power to grant registration to market intermediaries. Power to levy fees or other charges. Power to regulate FII etc., Future Challenges

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Speculative Trading & Distribution of Turnover. Market Abuses.

A "stock market" is nothing more than a market, or "exchange", where stocks are bought, sold, or traded. There is no physical "stock market" - in fact, there are a variety of stock exchanges around the world (e.g. the New York Stock Exchange (NYSE), NASDAQ, the London Stock Exchange (LSE)), any of which could accurately be referred to as a stock market. Stocks exchanges can be "listed" (meaning they have a physical place) or "virtual" (meaning that all trading is done virtually). The market in which shares are issued and traded either through exchanges or over-the-counter markets. Also known as the equity market, it is one of the most vital areas of a market economy as it provides companies with access to capital and investors with a slice of ownership in the company and the potential of gains based on the company's future performance. This market can be split into two main sections: the primary and secondary market. The primary market is where new issues are first offered, with any subsequent trading going on in the secondary market. Function and purpose

The stock market is one of the most important sources for companies to raise money. This allows businesses to go public, or raise additional capital for expansion. The liquidity that an exchange provides affords investors the ability to quickly and easily sell securities. This is an attractive feature of investing in stocks, compared to other less liquid investments such as real estate. History has shown that the price of shares and other assets is an important part of the dynamics of economic activity, and can influence or be an indicator of social mood. Rising share prices, for instance, tend to be associated with increased business investment and vice versa. Share prices also affect the wealth of households and their consumption. Therefore, central banks tend to keep an eye on the control and behavior of the stock market and, in general, on the smooth operation of financial system functions. Financial stability is the raison d'être of central banks Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee payment to the seller of a security. This eliminates the risk to an

individual buyer or seller that the counterparty could default on the transaction.  The smooth functioning of all these activities facilitates economic growth in that lower costs and enterprise risks promote the production of goods and services as well as employment. In this way the financial system contributes to increased prosperity. The behavior of the stock market Investors may temporarily pull financial prices away from their long term trend level. Over-reactions may occur— so that excessive optimism (euphoria) may drive prices unduly high or excessive pessimism may drive prices unduly low. New theoretical and empirical arguments have been put forward against the notion that financial markets are efficient. Stock market index The movements of the prices in a market or section of a market are captured in price indices called stock market indices, of which there are many, e.g. BSE SENSE indices. Such indices are usually market capitalization (the total market value of floating capital of the company) weighted, with the weights reflecting the contribution of the stock to the index. The constituents of the index are reviewed frequently to include/exclude stocks in order to reflect the changing business environment. Common stock

A share (also referred to as equity shares) of stock represents a share of ownership in a corporation. Types of stock Stock typically takes the form of shares of common stock. As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions. Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders. Convertible preferred stock is preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually anytime after a predetermined date. Shares of such stock are called "convertible preferred shares" (or "convertible preference shares" in the United Kingdom). Steps to Start Investing in the Stock Market:

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As a newcomer to the world of stock buying and selling, it is very important to research and then tread the sensitive fiscal ground. Research and education on the way the stock market operates enables you to integrate faster with the existent investors. The market is no different from any other. Here too, stocks are bought at a price and withheld till a profitable fluctuation takes place. The stock market also has rules to abide by and marketing to follow. It is never easy at the beginning and takes a while for a newcomer to integrate within the system. The following are some simple steps to get started on the right footing:

Research and get educated on stocks and the market. There are a number of seminars and symposiums organized regularly. Many existent investors and brokers have also offered free counseling. They review financial sites and offer advice on how to optimize investments via online chat rooms. Set a realistic goal for your investment purpose. The goal and financial planning should be such that they offer you the space to err and correct. Your financial goals should be in sync with stock picking strategies and market trends. Never lose an opportunity to understand the annual reports and quarterly reports. There are a number of dedicated documents that the stock exchange makes available to you as an investor. You need to take time off to read through and understand the facts and figures, to make your own predictions. It pays well to check out the holdings of the successful mutual companies. Their winnings could be yours! Keep your gut-instinct secret and pay heed to it. You should always invest only in what you are confident about. As a beginner, it is good to consider the stocks of local companies or ones that you are familiar with or know investors in the same. However, at the same time, invest in stocks that you can hold at least for five years. Never give in to the temptation of selling out the moment there is a price drop. The market builds its potential to serve you better with time. Back up your financial goal by diversifying your investments. You should avoid investing all the funds in hand in any one or two stocks or industries only. As a newcomer, you have the added advantage of learning from trial and error before the investment multiplies and there is more at stake. Save on commissions by identifying discount brokerage to buy stocks. Once you apply the basics successfully and make additional investments in the stock market, you could use the gained confidence and investment skills to develop your own money making ideas. Never invest in stocks or mutual funds if you are already running a bad debt, credit card debt or any other. At least not as an escape route. It is not that you have to be completely debt-free, but as a newcomer, it is important that you set your priorities right and use the

stock market investments to steer you clear of other financial obligations. As a fresher, you should avoid looking up to the stock market as a source for funds to take care of basic living expenses. The market will take time to churn out the expected turn over. Keeping the financial goals in mind all the time, you should never lose an opportunity even outside of the stock market to maximize your contributions and diversifying investments. How to start investing in the Stock Market

Assimilate information: The stock market is just like any other trading arena. It is unique in application and hence, it is very important to get yourself educated on the basics and the terms and abbreviations used. You should use every resource to get acquainted with the roles of other players on the field and understand how one enriches the other. Set time aside to read and research about stocks, stock exchange and market trends. Inquire about seminars, symposiums and online resources. Set financial goals: Like everything else in life, stock investing too can lead to 'aimless wandering' if there is no short and long term financial goal in place. You could look up any of the stock-picking strategies like options trading that are easily accessible to set your own goals. Invest in market-specific knowledge: Indulge in preliminary reading of annual and quarterly reports. Look up dedicated documents accessible from the Securities and Exchange Commission. Once you get acquainted with the lingo and analysis, you will be better equipped to meet the market challenges. Invest small and on familiar turf: It is very important to invest small in the beginning. Like any other fiscal arena, don't put all the eggs in one basket. Buy stocks to diversify. Invest primarily, in those companies that you are familiar with. This will add to your level of confidence while interacting within the 'ring'. Compare and analyze research: It is important to conduct stock research and assimilate and analyze the performance of successful companies dealing in mutualfunds and stock. The profits could be yours if you follow similar trends and identify their success strategy. Study the charts: Compare and study the charts relevant to your investment in the stock market. This enables you to home your investment skills by identifying upscale industries and major foreign investments.


Focus on the long term financial goal: Achieve short term, but don't let the long term financial goal out of sight. In order to achieve both, it is important to indulge in goal setting and be patient with stocks that are slow in making it to the charts and save on commissions. The latter can be achieved by making optimum use of discount brokerages. The stock market can be a roller-coaster ride if you don't tread with caution. Use the three R's - Research, Review and Revise, for success on this turf. Understanding the Stock Market The stock market is huge. It beats even the entire world economy by at least ten or twelve times! The value of the stocks cannot be directly compared to any fixed income security. Traditionally, the latter relates to a fixed value. In the case of company stock, the value of the security changes in time. The change is naturally a higher value if the company is profitable in transactions and productivity, and lower if the company incurs a loss. The stock market deals with relatively liquid securities that are influenced by actual market price. Understanding the stock market involves knowing how to identify the stocks that are listed and traded on stock exchanges. The stock exchange is an entity that banks on corporation or mutual organization. The basic business of a stock exchange is to generate a network of buyers and sellers of various companies, as well as a list of stocks and securities. There are many national, as well as, regional exchanges all over the world. Components of the Stock Market The people who are part and parcel of this fiscal market are the primary stock investors, fund traders, brokers and agents and professionals at the stock exchange, who execute the orders and differences. While some exchanges are physical locations, where traders enter verbal bids and offers at the same time, the others are virtual and function via computer networking. In the latter, the online trading opportunities are handled electronically. Purpose of a Stock Exchange In the stock market, the actual trade is based on an auction paradigm. The potential investor bids a price for a stock, while a potential seller makes a specific value claim. When you buy stocks or sell 'at market' it means that you accept the ask price quoted. In the stock market, just like in other trading arenas, most sales take place on the first-come-first-served basis, especially if there are multiple bidders or sellers at a given price. The purpose of the market is to facilitate stock investing via exchange of securities. The stock market is also responsible for providing real-time trading information and facilitating price enhancement. There are specialists who handle the trade in a physical exchange. They ensure that

only the stocks listed with the exchange are traded. The specialist matches 'buy' and 'sell' orders and even uses his own money or stock to close the difference after a particular predetermined span of time. The trade details are reported to the brokerage firms and subsequently the investors. Today, computers play a very important role in program trading. How to Optimize Investments in the Stock Market Today, all over the world, new and experienced investors are conducting stock research and tapping the potential of the stock market from the comfort of home or office. There are many virtual listed exchanges like the National Association of Securities Dealers Automated Quotation or NASDAQ if the physical ones like the New York Stock Exchange or NYSE do not fit into your hectic schedule. Stock trading can be completely handled on specially designed computer network now. The buyers and sellers are electronically matched, while bids are provided along with 'ask price'. The purchasing and selling of stock takes place through a systematic, electronic stock exchange. The fully automated order matching process makes it very easy to indulge in profiting stock exchange, once you have understood how the market works and the terms and abbreviations that market specific. There are a number of dedicated resources that help investors to identify and get over the temporary pull of prices, changes in fundamental factors like profits or dividends, market hypothesis and even the tendency of the stock market to trend over longer time periods for stock trading. What Makes Stock Prices Rise and fall If the company earns profits, it gives back the profits to its stockholders by means of dividends. The authority of a person in the company policies and decision-making is proportional to the number of stocks he/she owns. Thus, this means a person who own 100% stocks of a particular company is the owner of that company. People who own a sizable amount of stocks in the company are allowed to be on the board of directors who have a say in the company’s policies. What it that makes stock prices rise and fall is. – The company’s stock prices are dependent on how well the company is doing in the market. The better the company’s position in the market – the higher is the amount of people who are willing to invest in its stock – and hence higher is the price of the stocks. On the contrary if a company is suffering severe losses and not faring well in the market- there would be less number of people who want a piece of ownership (stock) of that company- and hence lesser the prices of the stocks.


There are several other factors, which are instrumental in deciding the rise or fall of share prices. These factors are as follows:

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Investor participation: This refers to the number of investors who are interesting in buying stocks of the company or the number of investors who are already stockholders of the company. Gross earnings of the company: This refers to the success of the company in terms of its turnover and profit numbers. Company Image: This refers to the general image of the company in the market with regards to its financial position, profits and also its core values. General Market Sentiment: This refers to the general trends in the market which can hamper or enhance the company’s position. Overall condition of the U.S. and world economies: The world economies including the US economy are all inter-dependent on each other in some way and hence have an effect on the share pricing. Different Types of Orders in the Stock Market

There are 3 basic orders that can be given by traders. These are Market Orders, Limit Orders and Stop Orders which are basically the opposite of Limit Orders. Knowing these three types of orders is vital in ensuring you can open and close positions profitably. Market Order - Basic Trade A market order is where a trader purchases or sells their security at the best market price available. There are two variations on the market order. The Market on Open Order means that the trade must be done during the opening range of trading prices. So the highest price for selling and lowest price for buying. The Market on Close order is done within minutes of the market closing. This is done at whatever price is available at the time. Limit Order - Buying at a Lower Price/Selling at a Higher Price Limit orders involve setting the entry or exit price and then aiming to buy below the limit or sell above it. You can set two conditions on this, one is "Good for A Day" and the other is "Good till Cancelled." Both of which are self-explanatory. They of course can be changed any time before execution. Reaching these limits/targets is not always possible and sometimes the orders do not go through. Limit orders are very common for online traders. Stop Orders Stop orders are used for both opening and closing positions. They are the opposite of Limit Orders. In a limit order the case was that when a price rose to a certain level a sell order was given, in this case a buy signal is given and vice-versa for when the price drops. In the case of a sell stop, it is done so buyers can cut their losses when a share price falls too low. A "Buy stop" is more common and is put into place if the share price is predicted to

break through its peak level and head to a new high. There are down sides and risks associated with both types of stop orders though and should be made with careful scrutiny. Traders should be sure their technical analysis are correct in predicting breakthroughs in share prices in the risk of buying high and selling low. Traders can also use "guaranteed stops" to protect their position. This is a stop guaranteed by the broker and is ideal if the share takes a sharp sudden turn. The variations in the three orders require traders to be well aware of their options when trading. Studying the stock and predicting the trend accurately is very important. Stop buys are ideal for securities you expect to break through upwards. Stop sells are for shaky markets that may turn any time. Limit orders are for conservative stocks that are fluctuating. Short notes Stock: A type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings. Stock refers to a share in the profit. Stock trading involves 'buying into ownership' of a company. Stock is also referred to as equity or shares. Investor: An investor is the owner of a particular company's stock. He has 'claim', in however small a proportion, to all company assets. The investor shares the company's earnings. What Is A Stock Market? This is an organized set-up with a regulatory body and the members who trade in shares are registered with the stock market and regulatory body SEBI. Stock markets exist in different cities all over the world with each market having a different set of "listed" shares. Thus, the shares listed in the Bombay Stock Exchange (BSE) will be different from those in the Delhi Stock Exchange (DSE), because a company may not want to be listed in a particular stock exchange or may not fit the eligibility requirements of the particular exchange. The stock market is also called the secondary market as it involves trading between two investors. What is a share? A Share or stock is a document issued by a company, which entitles its holder to be one of the owners of the company. A share is directly issued by a company through IPO or can be purchased from the stock market. By owning a share you can earn a portion of the company's profit called dividend. Also, by buying and selling the shares you get capital gain. So, your return is the dividend plus the capital gain. However, you also run a risk of making a capital loss if you have sold the share at a price below your buying price.

What is a company? A company basically means a group of persons associated together for achieving some objectives. The term company means a company formed and registered under the Indian Companies Act 1956. As company is a voluntary association of persons its capital is divisible into parts which are known as shares with limited liabilities. A company exists only in contemplation of law and it has no physical existence. What is the difference between debt and equity? Debt Debt instruments don’t give ownership rights to holders. Interest is payable. Interest is legal obligation to pay. Debt holders get preference in case of dissolution of company. Interest not paid is carried forward. Equity Equity instruments entitle the holders to own part of the business. Dividend is payable. Dividend is not legally necessary. Equity holders are paid only after all other obligations are met. Dividend can’t be carried forward.

What Are The Advantages And Disadvantages Of Stock Market? Stock market is a best place to make money in no time for those who are expert in stock markets. It takes a "day-trading" approach to the market and has made a little rather large return. With the market so unstable, it is the best chance to make money. The advantage is that there is big potential if you do some research and pay close attention to the market changing conditions. The biggest disadvantage is that if you are new to this world then you might lose half, or more of your investment in an hour or so. In both the case, it is all about being patient and waiting for the right conditions for your investment to realize a return. Stock certificate: The stock certificate represents the stock purchased and defines the return on investment. Offline, the certificate is a fancy document, while online it is a display available at a click on the mouse. How Does The Stock Market Work? The stock market works like any other market in the world. Most stock markets in the world are regulated by the Government in some way or the other. Governments apply regulations so that no individual or group of individuals can manipulate the stock market at the expense of the

general public. Companies are allowed to list their stocks on the stock market. The stock market is a place where these stocks are traded. People can buy and sell them. But the people who are allowed to execute the trade are called brokers. They act as intermediaries between the buyers and the sellers. Most stock markets in the world have a T+2 settlement period. This means that someone purchasing shares will actually get possession of them two days after the trade is made. Stock markets are also used to trade other instruments apart from stocks i.e. Futures, options and derivatives. What Are The Features Of Stock Market? In a stock market, every investor knows how he should sell or buy a share to his benefit and all the people participating have access to the same information. No operator can influence the price of the securities. The stock market is considered to be a free market because it is administered by a limited company and the government only does the supervision for the market to perform better. The market is efficient as all the new information quickly affects the market and causes changes in the price of the securities. The public has the right to know the trading and bidding going on in the market. Dividend: This is a distribution of the owned portion of a company's earnings. It is commonly quoted in terms of a currency amount per share. There are two main types of stock:
1. Common. 2. Preferred.

Common stock: Common stock represents ownership in a company and claim on a portion of profits. It yields higher returns in the long run. Common stock usually entitles the owner to vote at shareholders' meetings and to receive dividends. Preferred stock: It guarantees a fixed dividend forever. In event of liquidation, preferred stock continues to be paid off.

Preferred stock generally does not have voting rights, but has a higher claim on assets and earnings than the common shares. For example, owners of preferred stock receive dividends before common shareholders and have priority in the event that a company goes bankrupt and is liquidated. The role of the stock exchange:     Corporate governance Creates investment opportunities for small investors Government raises capital for development projects Barometer of the economy

Advantages & disadvantages of stock market account Advantages:
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Potential for high investment returns Tax-free investment options Long-term investment possible Flexible investment options Government monitored 'safer' stakeholder options

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Money must often be left untouched long-term May be minimum deposit requirements May be high charges which reduce earnings from investment returns No guarantee of returns Risk of losing your money Advantages & disadvantages of investing in stock market

Stock market investing can offer an excellent way to build long term wealth over time. Of course, there are risks as well as rewards to investing in the stock market, and those risks and rewards are as follows: Advantages-:

Stock Market investments offer benefits like easy liquidity, flexibility of amounts invested/disinvested, reasonable returns and a regulatory framework to safeguard your rights. Opportunity to get more returns on investment comparing with Bank FD, Postal Saving etc.


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Investment is not blocked for specific time limit .If the market value of your shares increased you sell it within a short period. (Bank FD can be withdrawn only after maturity otherwise interest is deducted.) Liquidity- The volume of transactions in share market is very high and in case of A group, B1 group the shares are easily traded. Opportunity of growth of investment by dividend, bonus issue, right issue, stock split etc. If you have a deep study of market trends and have a good confidence you can earn while market is growing as well as it is sleeping.

Disadvantages Stocks are volatile investments. The price of a single stock can vary quite widely from day to day, and the factors that cause these price fluctuations are beyond the control of the investor.  Risk Factor is the major disadvantage because there are many factors which affect the market such as Govt.Policies, any natural disaster, political issues etc so there is no assurance of growth of investment.  In case of certain small cap. A company there is a very high risk of investment.  Many times the new comers and also the experienced traders also depend upon the Tips which may be cause to loss.  As investors near retirement, the amount of stocks in the portfolio should be reduced. Investors who are close to retirement age can no longer afford to take chances with their money, and that means moving a significant portion of their retirement funds to safer and more stable investments. Keeping in to mind all these merits as well as demerits one should enter into market with deep study and strong confidence. A long term investor who invests carefully always gains success in market.

Leasing is an important source of equipment financing. Lease financing is a commercial arrangement, whereby an equipment owner or manufacturer conveys to the equipment user the right to use the equipment in return for a rental. However, the really big financings of aircraft and power plants are longterm. In lease financing, the lessee agrees to pay the lessor periodically for economic use of the lessor's asset. Because of this contractual obligation, leasing is regarded as a method of financing similar to borrowing. Leasing can involve the direct acquisition of an asset under a lease, a sale and leaseback arrangement whereby the firm sells an asset it owns and leases it back from the buyer, or a leveraged lease.

History and development of leasing The history of leasing dates back to 200BC when Sumerians leased goods. Romans had developed a full body law relating to lease for movable and immovable property. However the modern concept of leasing appeared for the first time in 1877 when the Bell Telephone Company began renting telephones in USA. In 1832, Cottrell and Leonard leased academic caps, grown and hoods. Subsequently, during 1930s the Railway Industry used leasing service for its rolling stock needs. In the post war period, the American Air Lines leased their jet engines for most of the new aircrafts. This development ignited immediate popularity for the lease and generated growth of leasing industry. The concept of financial leasing was pioneered in India during 1973. The First Company was set up by the Chidambaram group in 1973 in Madras. The company undertook leasing of industrial equipment as its main activity. The Twentieth century Leasing Company Limited was established in 1979. By 1981, four finance companies joined the fray. The performance of First Leasing Company Limited and the Twentieth Century Leasing Company Limited motivated others to enter the leasing industry. In 1980s financial institutions made entry into leasing business. Industrial Credit and Investment Corporation was the first all India financial institution to offer leasing in 1983. Entry of commercial banks into leasing was facilitated by an amendment of Banking Regulation Act, 1949. State Bank of India was the first commercial bank to set up a leasing subsidiary, SBI capital market, in October 1986. Can Bank Financial Services Ltd., BOB Financial Service Ltd., and PNB Financial Services Limited followed suit. Industrial Finance Corporation’s Merchant Banking division started financing leasing companies as well as equipment leasing and financial services. There was thus virtual explosion in the number of leasing companies rising to about 400 companies in 1990. In the subsequent years, the adverse trends in capital market and other factors led to a situation where apart from the institutional lessors, there were hardly 20 to 25 private leasing companies who were active in the field. The total volume of leasing business companies was Rs.5000 crores in 1993 and it is expected to cross Rs.10, 000 crores by March 1995. Elements or essentials in lease structure This is an explanation of the elements in a lease - the parties, asset, rentals, residual value, etc. This section would also elaborate the unique features of a lease as different from a regular financing transaction. 1. The transaction: The transaction of lease is generically an asset-renting transaction. Difference between lease and a loan is in a loan money is lent out; in a lease the asset is lent out.

2. Parties to a lease: There are two parties to a lease: the owner and the user, called the lessor and the lessee. The lessor is the person who owns the asset and gives it on lease. The lessee takes the asset on lease and uses it for the period of the lease. Anyone can be a lessor, and any one can be a lessee, subject to usual conditions as to competence to contract, or holding of properties. Technically, in order to be a lessor, one does not have to own the asset: one has to have the right to use the asset. Thus, a lessee can be a lessor for a sub-lessee, unless the parent lessor has restricted the right to sub-lease. 3. The leased asset: The subject of a lease is the asset, article or property to be leased. The asset may be anything - an automobile, or aircraft, or machine, or consumer durable, or land, or building, or a factory. Only tangible assets can be leased - one cannot contemplate the leasing of the intangible assets, since one of the essential elements of a lease is handing over of possession, along with the right to use. Hence, intangible assets are assigned, whereas tangible assets may be leased. leasing will have the following limitations: 1. What cannot be owned cannot be leased. Thus, human resources cannot be "leased". 2. While lease of movable properties can be affected by mere delivery, immovable property is incapable of deliveries in physical sense. Most countries have specific laws relating to transactions in immovable properties: if such law provides a particular procedure for a lease of immovable or real estate, such procedure should be complied with. For example, in Anglo-Saxon legal systems (UK, Australia, India, Pakistan, etc.), transactions in real estate are not valid unless they are effected by registered conveyance. This would apply to lease of land and buildings, and permanent attachments to land. 3. A lease is structurally a rental for the lease period: with the understanding that the asset will be returned to the lessor after the period. Thus, the asset must be capable of re-delivery: it must be durable (at least during the lease period), identifiable and severable. The existence of the leased asset is an essential element of a lease transaction - the asset must exist at the beginning of the lease, during the lease and at the end of the lease term. Non-existence of the asset, for whatever reason, will be fatal to the lease. 4. Lease period:


The term of lease, or lease period, is the period for which the agreement of lease shall be in operation. As an essential element in a lease is redelivery of the asset by the lessee at the end of the lease period, it is necessary to have a certain period of lease. During this certain period, the lessee may be given a right of cancellation, and beyond this period, the lessee may be given a right of renewal, but essentially, a lease should not amount to a sale: that is, the asset being given permanently to the lessee. In financial leases, is common to differentiate between the primary lease period and the secondary lease period. The former would be the period over which the lessor intends recovering his investment; the latter intended to allow the lessee to exhaust a substantial part of the remaining asset value. The primary period is normally non-cancelable, and the secondary period is normally cancelable. 5. Lease rentals: The lease rentals represent the consideration for the lease transaction. This is what the Lessee pays to the Lessor. If it is a financial lease transaction, the rentals will simply be the recovery of the lessor's principal, and a certain rate of return on outstanding principal. In other words, the rentals can be seen as bundled principal repayment and interest. If it is an operating lease transaction, the rentals might include several elements depending upon the costs and risks borne by the Lessor, such as:     Interest on the lessor's investment. If the lessor is bearing any repairs, insurance, maintenance or operation costs, them charges for such cost. Depreciation in the asset. Servicing charges or packaging charges for providing a package of the above service.

6. Residual value: Put simply, "residual value" means the value of the leased equipment at the end of the lease term. If the lease contains a buyout option with the lessee, residual value would mostly mean the value at which a lessee will be allowed to buy the equipment. If there is no embedded purchase option, residual value might mean the value that the lessee or someone else assures will be the minimum value of the equipment at the end of the lease term. This is typical in case of financial leases where the lessor cannot grant a buyout option to the lessee; for the lessor to protect himself against asset-based risks, he would take an assured residual value commitment either from the lessee himself or from a third party, typically an insurance company.

The residual value might also the value that the lessor assures to pay-back to the lessee in case the lessee returns the asset to the lessor: that is, it might be the value the lessor assures as the minimum value of the equipment. Such a lease, obviously an operating lease because the lessor is taking a risk on asset values, is a full payout lease, but the lessor agrees to refund the guaranteed value on the lessee returning the equipment at the end of the lease term. 7. End-of-term options: The options allowed to the lessee at the end of the primary lease period are called End-of-term options. Essentially, one, or more, of the following options will be given to the lessee at the end of the lease term:

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Option to buy (buyout option) at a bargain price or nominal value (typical in a hire-purchase transaction), called bargain buyout option Option to buy at a fair market value or fixed, but substantial value Option to renew the lease at nominal rentals, called bargain renewal option Option to renew the lease at fair market rentals or substantial rentals Option to return the equipment

In any lease, which option will be suitable depends on the nature of the lease transaction, as also the applicable regulations. For example, in a full payout financial lease, the lessor would have recovered the whole or substantially the whole of his investment during the primary lease period. Therefore, it is quite natural that the lessee should be allowed to exhaust the whole of the remaining value of the equipment. Regulation permitting, the lessor provide the lessee a bargain purchase option to allow the lessee to complete the purchase of the equipment. Buyout option may characterize the lease as hire-purchase: However, in many jurisdictions, it is the existence of such buyout option that demarcates between lease and hire-purchase transaction. If the lessor is interested to structure the lease as a lease and not hire-purchase, he would be advised not to provide any buyout option, but instead, to allow the lessee to renew the lease to continue the use of the asset. In essence, a renewal option achieves the same purpose as a purchase, but the lessor retains his ownership as also his reversionary interest in the equipment. Fair market value options, either for purchase of equipment, or for renewal, are typical of operating leases, but are really speaking no more than assuring to the lessee a continued use of the equipment. If equipment has to be bought at its prevailing market value, it can be bought from the market rather than from the lessor - therefore, the fair market value option carries no value for the lessee.


8. Upfront payments: Lessors may require one or more of the following upfront, that is, instant Payments from a lessee:  Initial lease rental or initial hire or down payment  Advance lease rental  Security deposit  Initial fees Margins in leases are taken as initial rental: The initial lease rent or initial hire (the word hire is more common in case of hire-purchase transactions) is a surrogate for a margin or borrower contribution in case of loan transactions. Note that given the nature of a lease or hire-purchase as asset-renting transaction, it is not possible to expect a lessee's contribution to asset cost as such. Hence, the down payment or first lease rent serves the purpose of a margin. Between advance lease rent and initial lease rent - the difference is only technical. The whole of the initial lease rental is supposed to be appropriated to income on the date of its receipt, whereas advance rental is still an advance - normally an advance against the last few rentals. Therefore, the advance rental will remain as a deposit with the lessor to be adjusted against the last few rentals. The security deposit is a proper deposit to secure against the lessee's commitments under the contract - it is generally intended to be refunded at the end of the lease contract. Types of leasing

Finance lease: A lease is defined as finance lease if it transfers a substantial part of the risks and rewards associated with ownership from the lessor to the lessee. According to the International Accounting Standards Committee (IASC), there is a transfer of a substantial part of the ownership-related risks and rewards if:


i. The lease transfers ownership of the asset to the lessee by the end of the lease term; (or) ii. The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair market value at the date the option becomes exercisable and, at the inception of the lease, it is reasonably certain that the option will be exercised; (or) iii. The lease term is for a major part of the useful life of the asset. The title may or may not eventually be transferred; (or) iv. The present value of the minimum lease payments (See Glossary) is greater than or substantially equal to the fair market value of the asset at the inception of the lease. The title may or may not eventually be transferred. The aforesaid criteria are largely based on the criteria evolved by the Financial Accounting Standards Board (FASS) of USA. The FASS has in fact defined certain cut-off points for criteria (iii) and (iv). According to the FASS definition of a finance lease, if the lease term exceeds 75 percent of the useful life of the asset or if the present value of the minimum lease payments exceeds 90 percent of the fair market value of the asset at the inception of the lease, the lease will be classified as a 'finance lease' Financial leases are "loan look-alike": However, financial leases, though being leases by structure, are financings by contrivance. To achieve the financing purpose, the leasing structure here tries to eliminate the substantive differences between leasing and plain financings. As you might notice, in the above example, the lessee has been put virtually in the position of an asset owner - he has the right to use the asset for 5 years, with a power to extend the lease period for another 5 years. The primary and secondary lease period: The first 5 years are called the primary lease period and the extended period is called the secondary lease period. The lease is noncancelable during the primary lease period - that is, the lessee cannot return the asset and not pay balance of the lessor's rentals. For the secondary period, the lessee will have no incentive of returning the asset, as what the lessee has to pay is nominal, whereas the asset might still carry substantial value. Thus, the asset will be enjoyed by the lessee virtually for the whole of its economic life. Full payout lease: The lessor too has no significant risk/reward other than that of a virtual money-lender: he would continue getting the lease rentals for the primary

period which will fully-payout the lessor's investment in the lease as also give him his desired return on investment, irrespective of the state, value or utility of the asset. If the lessee performs as per agreement, the lessor would get no more, and no less, than such pre-fixed return on investment. The IRR: Incidentally, in the present example, the lessor gets a return of 12.98% this is equivalent to the rate of interest in case of loans. As this rate is not explicit, but implicit in the rate of rentals, the rate is implicit rate of return or IRR. Features of financial leases: The above discussion leads to the following features of financial leases: Financial leases allow the asset to be virtually exhausted by the same lessee. Financial leases put the lessee in the position of a virtual owner. The lessor takes no asset-based risks or asset-based rewards. He only takes financial risks and financial rewards, and that is why the name financial leases. The lease is non-cancelable, meaning the lessee cannot return the asset and not pay the whole of the lessor's investment. In this sense, they are full-payout, meaning the full repayment of the lessor's investment is assured. As the lessor generally would not take any position other than that of a financier, he would not provide any services relating to the asset. As such, the lease is net lease. The risk the lessor takes is not asset-based risk but lessee-based risk. The value of the asset is important only from the viewpoint of security of the lessor's investment. In financial leases, the lessor's payback period, viz., primary lease period is followed by an extended period to allow exhaustion of asset value by the lessee, called secondary lease period. As the renewal is at a token rental, this option is called bargain renewal option. Alternatively, if the regulations permit, the lessee may be given a purchase option at a nominal price, called bargain buyout or purchase option. In financial leases, the lessor's rate of return is fixed: it is not upon the asset-value, performance, or any other extraneous fixed lease rentals give rise to an ascertainable rate of investment, called implicit rate of return. Financial leases are different but substantively similar to secured loans. dependant costs. The return on technically


Financial leases and Hire-purchase: In some countries, distinction is made between lease and hire-purchase transactions. A hire-purchase transaction is usually defined as one where the hirer (user) has, at the end of the fixed term of hire, an option to buy the asset at a token value. In other words, financial leases with a bargain buyout option at the end of the term can be called a hire-purchase transaction. Hire-purchase is decisively a financial lease transaction, but in some cases, it is necessary to provide the cancellation option in hire-purchase transactions by statute: that is, the hirer has to be provided with the option of returning the asset and walking out from the deal. If such an option is embedded, hire-purchase becomes significantly different from a financial lease: the risk of obsolescence gets shifted to the hire-vendor. If the asset were to become obsolete during the pendency of the hire term, the hirer may off-hire the asset and closes the contract, leaving the owner with less than a full-payout. Hire-purchase is of British origin - the device originated much before leases became popular, and spread to countries which were then British dominions. The device is still popular in Britain, Australia, New Zealand, India, Pakistan, etc. Most of these countries have enacted, in line with United Kingdom, specific laws dealing with hire-purchase transactions. Difference between lease financing and hire purchase BASIS Meaning LEASE FINANCING A Lease transaction is a commercial arrangement, whereby an equipment owner or manufacturer Conveys to the equipment user the right to use the equipment in return for a rental. HIRE PURCHASE Hire purchase is type of installment credit under which the hire purchaser agrees to take the goods on hire at a stated rental, which is inclusive of the repayment of principal as well as interest, with an option to purchase. Option is provided to the hirer (user). Only interest element Included in the hire Purchase, installments are revenue expenditure by nature. Hire purchase installments comprise of three elements

Option To User No option is provided to the lessee (user) to purchase the goods. Nature Of Lease rentals paid by the Expenditure lessee are entirely revenue expenditure of lessee. s Component Lease rentals comprise of two elements (1) finance

charge and (2) capital recovery. Depreciation Lessee is not entitled to claim depreciation tax shield. Lessee can charge the entire lease payments for tax purposes. Thus, he/she saves tax on lease payments. Once the hirer has paid all installments, he becomes owner of the asset and can claim salvage value.

(1) normal trading profit (2) finance charge (3) recovery of cost of goods/assets. Hire is entitled to claim depreciation tax shield Include interest and repayment of principal. Hire get tax benefits only on interest. Lessee does not become owner of the asset. Therefore, he has no claim over the asset’s salvage value.


Salvage value

Good Reasons for Leasing If leasing is a good choice, it will probably be because one or more of the following are true: 1. Taxes may be reduced by leasing. 2. The lease contract may reduce certain types of uncertainty that might otherwise decrease the value of the firm. 3. Transactions costs may be lower for a lease contract than for buying the asset. 4. Leasing may require fewer (if any) restrictive covenants than secured borrowing. 5. Leasing may encumber fewer assets than secured borrowing Differences between Finance and Operating Leases Financial Lease 1. Risks and rewards of ownership are transferred to, and borne by, the lessee. This includes the risks of accidental ruin or damage of the asset (although these risks may be insured or otherwise assigned). Thus damage that renders an asset unusable does not exempt the lessee from financial liabilities before the lessor.

Operating Lease 1. Economic ownership with all Corresponding rights and responsibilities are borne by the lessor. The lessor buys insurance and undertake responsibility for Maintenance. 2. The goal of the lessee is usage of

2. The goal of the lessee is either to acquire the asset or at least use the asset for most of its economic life. As such, the lessee will aim to cover all or most of the full cost of the asset During the lease term and therefore is likely to assume the title for the asset at the end of the lease term. The lessee may gain the title for the asset Earlier, but not before the full cost of the asset has been paid off. 3. The lessor retains legal ownership for the duration of the lease term, though the lessee may or may not buy out the leased asset at the end of The lease, with the lessor charging only a nominal fee for the transfer of asset to the lessee. 4. The lessee chooses the supplier of the asset and applies to the lessor for funding. This is significant because the leasing company that funds the Transaction should not be liable for the asset quality, technical characteristics, and completeness, even though it retains the legal ownership of the asset. The lessee will also generally retain some rights With respect to the supplier, as if it had purchase asset directly.

the leased asset for a specific temporary need, and hence the operating lease contract covers only the short-term use of the Asset. Further, the duration of an operating lease is usually much shorter than the useful life of the Asset. 3. It is not the lessee’s intention to Acquire the asset, and lease payments are determined accordingly. In addition, an asset under an operating lease may Subsequently be rented out. 4. The present value of all lease Payments are significantly less than the full asset price.

Types of Lease Contracts


Virtually all lease financing arrangements fall into one of three types: a sale and leaseback, the direct acquisition of an asset under a lease, and leveraged leasing.
1. Sale and Leaseback: Under a sale and leaseback arrangement, a firm

sells an asset to another party, and this party leases it back to the firm. Usually, the asset is sold at approximately its market value. The company receives the sales price in cash and the economic use of the asset during the basic lease period. In turn, it contracts to make periodic lease payments and gives up title to the asset. As a result, the lessor realizes any residual value the asset might have at the end of the lease period, whereas before, this value would have been realized by the firm. Lessors engaged in a sale and leaseback arrangement include insurance companies, other institutional investors, finance companies, and independent leasing companies.
2. Direct Leasing: Under direct leasing, a company acquires the use of

an asset it did not own previously. A firm may lease an asset from the manufacturer: IBM leases computers; Xerox leases copiers. Indeed many capital goods are available today on a lease-financed basis. The major lessors are manufacturers, finance companies, banks, independent leasing companies, special-purpose leasing companies such as Polaris Aircraft Leasing, and partnerships. For leasing arrangements involving all but manufacturers, the vendor sells the asset to the lessor, who in turn, leases it to the lessee.
3. Leveraged leasing: A special form of leasing sometimes is used in

financing assets requiring large capital outlays. It is known as leveraged leasing. In contrast to the two parties involved in the forms of leasing previously described, there are three parties involved in leveraged leasing: (1) the lessee; (2) the lessor, or equity participant; and (3) the lender. From the standpoint of the lessee, there is no difference between a leveraged lease and any other of type of lease. The lessee contracts to make periodic payments over the basic lease period and, in return, is entitled to the use of the asset over that period of time. The role of the lessor, however, is changed. The lessor acquires the asset in keeping with the terms of the lease arrangement and finances the acquisition in part by an equity investment of, say, 20 percent (hence the name equity participant). The remaining 80 percent is provided by a long-term lender or lenders. The loan is usually secured by a mortgage on the asset, as well as by the assignment of the lease and lease payments. The lessor is the borrower. Valuing Financial Leases


Organizations and individuals are after be sided by the choice between leasing and buying an asset. Note that there was been a pride decision by an organization by the individual to acquire the asset. So the choice of which vs. why is actually financial decision. That arises once an Investment decision is been made. That is by Decision analysis depends and determining the value of a lease.  The Value of a financial lease is far for Compare financing provided by lease to financing provided by equivalent loan. We compare this financing and that financing because Leasing is commitment for fixed payments similar to debt. Because the financial markets consider these financing to be part of overall debt financing .The comparison of this and that financing is done by discovering lease cash flows Discount lease cash flows at net after-tax (and other subsidies) interest rate firm would pay on equivalent loan.

We calculate net present value of lease NPV = Initial Financing Provided + (LCF)/(1-r) Where LCF= + Lease payment Tax shield of lease pmt Depn tax shield lost

SHORT ANSWERS Lease LEASE is a contract between a lessor, the owner of the asset, and a lessee, the user of the asset. A lease may be defined as a contract whereby the owner of an asset grants to another party the exclusive right to use the asset without actually receiving ownership title, for an agreed period of time in return for the periodic payment of pre-determined rentals (normally spread of the lease period). The former is called ‘lessor’ and the latter ‘lessee’. The lessee acquires most of the economic values associated with the asset without acquiring title. Lease rate (rental payment)


The periodic rental payment to a lessor for the use of assets. Others may define lease rate as the implicit interest rate in minimum lease payments. Lessor The party to a lease agreement who has legal or tax title to the equipment, grants the lessee the right to use the equipment for the lease term, and is entitled to the rentals. Lessee The user of the equipment being leased. Hire purchase It is type of installment credit in which goods are purchased on installments, whereby ownership is transferred on the payment of last installment. It is popular in automobile sector.

Difference between HIRE PURCHASE and INSTALLMENT CREDIT Under hire purchase ownership is transfer on the payment of last installment, but in installment credit ownership is transfer by paying 1st installment. Advantages and disadvantages of Leasing: Advantages of leasing to the lessee:  Avoidance of initial cash outlay  easy source of finance  enhanced liquidity  shifting the risk of obsolescence  lesser administrative and Maintenance costs Limitations of leasing for the lessee:  higher cost  loss of moratorium period  loss of ownership incentives  loss of salvage value of the asset  penalties’ on termination of lease  no alteration or change in asset Advantages of leasing to the lessor:  higher profits  tax benefits  quick returns  increased sales Limitations for the Lessor:  high risk of obsolescence  competitive market  price level changes  management of cash flows

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increased cost due to loss of User benefits long-term investment

Leveraged lease In this type of lease, the lessor provides an equity portion (usually 20 to 40 percent) of the equipment cost and lenders provide the balance on a nonrecourse debt basis. The lessor receives the tax benefits of ownership. Open-end lease A conditional sale lease in which the lessee guarantees that the lessor will realize a minimum value from the sale of the asset at the end of the lease. Operating lease Any lease that is not a capital lease. These are generally used for short term leases of equipment. The lessee can acquire the use of equipment for just a fraction of the useful life of the asset. Additional services such as maintenance and insurance may be provided by the lessor. Residual value The value of an asset at the conclusion of a lease. Sale-leaseback An arrangement whereby equipment is purchased by a lessor from the company owning and using it. The lessor then becomes the owner and leases it back to the original owner, who continues to use the equipment. Sales-type lease A lease by a lessor who is the manufacturer or dealer, in which the lease meets the definitional criteria of a capital lease or direct financing lease. Tax lease A lease wherein the lessor recognizes the tax incentives provided by the tax laws for investment and ownership of equipment. Generally, the lease rate factor on tax leases is reduced to reflect the lessor's recognition of this tax incentive. Vendor leasing A working relationship between a financing source and a vendor to provide financing to stimulate the vendor's sales. The financing source offers leases or conditional sales contracts to the vendor's customers. The vendor leasing firm substitutes as the captive finance company of a manufacturer or distributor through the extension of leasing to customers, provisions of credit checking, and performance of collections and operational administration. Also known as lease asset servicing or vendor program. Capital lease Type of lease classified and accounted for by a lessee as a purchase and by the lessor as a sale or financing, if it meets any one of the following criteria: (a) the lessor transfers ownership to the lessee at the end of the lease

term; (b) the lease contains an option to purchase the asset at a bargain price; (c) the lease term is equal to 75 percent or more of the estimated economic life of the property (exceptions for used property leased toward the end of its useful life); or (d) the present value of minimum lease rental payments is equal to 90 percent or more of the fair market value of the leased asset less related investment tax credits retained by the lessor. (Also see finance lease.) Certificate of acceptance (Delivery and Acceptance) A document whereby the lessee acknowledges that the equipment to be leased has been delivered, is acceptable, and has been manufactured or constructed according to specifications Direct financing lease (direct lease) Direct lease is a lease under which a lessor owns/acquires the assets that are leased to a given lessee. A direct lease can be of two types: bipartite and tripartite lease. Bipartite Lease There are two parties in this lease transaction, namely, 1) The equipment supplier-cum-lessor and 2) The lessee. Such a lease is typically structured as an operating lease with inbuilt facilities like up gradation of the equipment (Upgrade lease), addition to the original equipment configuration and so on. Tripartite Lease Such a lease involves three different parties in the lease agreement: 1) The equipment supplier, 2) The lessor and 3) The lessee. Economic life (useful life) The period of time during which an asset will have economic value and be usable. Effective lease rate The effective rate (to the lessee) of cash flows resulting from a lease transaction. To compare this rate with a loan interest rate, a company must include in the cash flows any effect the transactions have on federal tax liabilities. First amendment lease The first amendment lease gives the lessee a purchase option at one or more defined points with a requirement that the lessee renew or continue the lease if the purchase option is not exercised. The option price is usually either a fixed price intended to approximate fair market value or is defined as fair market value determined by lessee appraisal and subject to a floor to insure that the lessor's residual position will be covered if the purchase option is exercised. If the purchase option is not exercised, then the lease is automatically renewed for a fixed term (typically 12 or 24 months) at a

fixed rental intended to approximate fair rental value, which will further reduce the lessor's end-of-term residual position. The lessee is not permitted to return the equipment on the option exercise date. If the lease is automatically renewed, then at the expiration of that initial renewal term, the lessee typically has the right either to return the equipment without penalty or to renew or purchase at fair market value. Typically, a finance lease is a full-payout, no cancellable agreement, in which the lessee is responsible for maintenance, taxes, and insurance. Full payout lease A lease in which the lessor recovers, through the lease payments, all costs incurred in the lease plus an acceptable rate of return, without any reliance upon the leased equipment's future residual value. Why Lease is not popular in Asian countries, like India? Because of psychological reasons, people prefer to own assets rather than taking it on lease.

Mutual Funds: It is a form of collective investment. A mutual fund collects money from many investors and invests such pooled fund in share market. Income is received in the form of capital gains, interests or dividends on securities. Players in Mutual Funds 1. Sponsor – Runs the show, akin the promoters of a Company. The SEBI (Mutual Funds) Regulations, 1996, defines sponsor as any person who, acting alone or in combination with another body corporate, establishes a mutual fund. The sponsor forms the Trust and appoints the board of trustees, appoints the AMC as the fund managers and may also appoint custodian to hold the fund assets. As per the SEBI (Mutual Fund) Regulations, 1996, sponsor makes an application for registration of the mutual fund and contributes atleast 40% of the net worth of the asset management company. The sponsor must comply with the eligibility criteria without which the Board may reject the application. Eligibility criteria for grant of certificate of registration are that the sponsor should a) Have a sound track record and general reputation of fairness and integrity in all his business transactions. b) The applicant is a fit and proper person c) In the case of an existing mutual fund, such fund is in the form of a trust and the trust deed has been approved by the Board; d) The sponsor has contributed or contributes at least 40% to the net worth of the asset management company: e) The sponsor or any of its directors or the principal officer to be employed by the mutual fund should not have been guilty of fraud or


has not been convicted of an offence involving moral turpitude or has not been found guilty of any economic offence; f) Appointment of trustees to act as trustees for the mutual fund in accordance with the provisions of the regulations; g) Appointment of asset management company to manage the mutual fund and operate the scheme of such funds in accordance with the provisions of these regulations; h) Appointment of custodian in order to keep custody of the securities or gold and gold related instrument or other assets of the mutual fund held in terms of these regulations, and provide such other custodial services as may be authorised by the trustees Sound track record here means: a) Be carrying on business in financial services for a period of not less than five years; and b) The net worth is positive in all the immediately preceding five years; and c) The net worth in the immediately preceding year is more than the capital contribution of the sponsor in the asset management company; and d) The sponsor has profits after providing for depreciation, interest and tax in three out of the immediately preceding five years, including the fifth year 2. Asset Management Company – AMC acts as an investment manager of the Trust. AMC’s float and manage different investment schemes in the name of the Trust. Restrictions on AMC are: • Not act as a trustee of any mutual fund • Not undertake any activity conflicting with the activities of the mutual fund • AMC shall not invest in any of its schemes unless intention to invest has been made in the offer document Obligations of AMCs are:  AMC shall not carry transactions with any broker whether associated with sponsor or not; for average of 5% or more; with exceptions  Ensure regulatory compliances & approvals when required  Liable to mutual funds for the acts of omission & commission  Details of directors, their interest in other companies; changes in interest to be submitted to the trustees  Fund manager to ensure that the funds of the scheme are invested to meet the objectives of the scheme  Due diligence and care in all investment decisions  AMC shall not utilize the services of any sponsor or its associates etc

AMCs to make half yearly disclosures for: • • • • Underwriting obligations Devolvement Subscriptions in the schemes lead managed by associates Subscriptions to debt/ equity issues where sponsors/associates acted as arranger/ lead manager

3. Trustee – Trustees hold unit holders’ money in fiduciary capacity. Two thirds of the trustees shall be independent persons and shall not be associated with sponsors in any manner. The Eligibility Criteria for a trustee and the rights and obligations of the trustees as stated in the SEBI (Mutual Fund) Regulations, 1996 are as follows: Eligibility criteria for being a trustee: No person shall be eligible to be appointed as a trustee unless— (a) he is a person of ability, integrity and standing; and (b) has not been found guilty of moral turpitude; and (c) has not been convicted of any economic offence or violation of any securities laws; (d) Have furnished particulars as specified in Form C. (e) No asset management company and no director (including independent director), officer or employee of an asset management company shall be eligible to be appointed as a trustee of any mutual fund (f) No person who is appointed as a trustee of a mutual fund shall be eligible to be appointed as a trustee of any other mutual fund. (g) Two-thirds of the trustees shall be independent persons and shall not be associated with the sponsors or be associated with them in any manner whatsoever. (h) In case a company is appointed as a trustee then its directors can act as trustees of any other trust provided that the object of the trust is not in conflict with the object of the mutual fund. Benefits of investing in mutual funds
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Diversification – As discussed above, the portfolio is diversified, so it reduces the risk Professionally managed – These funds are managed by skilled professionals, with experience and expertise Administrative Advantage – Mutual Funds offer services in demat mode, so it saves time investor’s time and risk of delay in share transfer etc Higher Returns – Returns are usually higher than other avenues of investment


At relatively low cost – Mutual funds cannot increase the charge beyond 2.5%, any cost over and above the prescribed limit is borne by the Asset Management Company (AMC) Liquidity – In case of an open ended funds, liquidity is provided by direct sales or repurchase by the Mutual Funds and in case of close ended funds, liquidity is provided by listing of the units on Stock Exchange (terms explained later) Transparency – Mutual Funds are regulated by SEBI and have to disclose the portfolio on a half yearly basis. NAVs are calculated on daily basis in case of open ended funds and published in newspapers for investors’ knowledge Flexibility – Some Mutual funds provide investors the flexibility of switching from one scheme to other without any load Mutual funds offer the benefit of investing in the portfolio of your choice depending upon the risk/ return you want out of our investments Drawbacks of investments in Mutual Funds

No guarantee on returns – the returns on Mutual Funds investments are not guaranteed. There may be such situation where the proportionate increase in the value of the mutual fund may be the same or less than what an investor would have received had he invested in risk free securities. Sometimes Mutual Funds may depreciate in value as well Diversification – Diversification reduces risks, but too much of diversification can effect returns as well Fund Selection – It the premises for investments are not proper Cost Factor – The cost payable to the fund managers may not be related to the performance of the fund. In this case the cost factor would be a drawback for the investors Brief process of functioning of the mutual funds

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The process of registering/ functioning of mutual funds are: 1. A sponsor has to make an application in Form A along with the requisite fees to the Board (SEBI). Grant of certificate of registration is given by the Board in Form B. Thereafter each mutual fund must pay an annual service fee, in case of failure to pay the annual fee, the Board may not permit the mutual fund to launch any scheme 2. Mutual Fund has to be established in the form of a Trust and the deed has to be registered under the Indian Registration Act, 1908, the deed being duly executed by the sponsor in the name of the trustees as mentioned in the deed


a) The purpose of the trust deed is to safeguard interest of the unit

holders and thus states the rights, obligations and liabilities of the trust in relation to the mutual fund or the unit holders. b) The contents of the trust deed will broadly include the following clauses: a. Unit holders would have beneficial interest in the trust property to the extent of individual holdings in the respective schemes. b. Liabilities & duties of the trustees, right to appoint/ dismiss asset management company iii. Right to forbid the mutual funds from making investments which are detrimental to the interests of the unit holders. c. Minimum number of trustees, trusteeship fees, removal of members, number of meetings, quorum for the meeting etc. d. Disclosures of particulars of interests of the trustees in other companies, institution, financial intermediary or anybody corporate. c) Appointed trustees need to furnish their details in Form C to the Board – approval of the Board is must for the appointment of Trustees d) The trustees and/ or the sponsors appoint the Asset Management Company. The trustees and AMC with the prior approval of the Board enter into an investment management agreement (Clauses of the investment management agreement are mentioned in the Fourth Schedule of the Regulation). Application Form D to be submitted to the Board for appointment of AMC 3. Scheme to be launched with the approval of the trustees and offer document filed with the Board. Offer document disclosures will include: a. Adequate information to enable investors make investment decisions b. Application form for investing in units to contain the information memorandum c. Mention of prior in-principle approval of stock exchanges, if listing of units to be carried out 4. Advertisement of each scheme to disclose the investment objective of the scheme 5. Once units sold, there are restrictions on investments specified in the Regulations 6. Valuations of the investments in the portfolio are carried out regularly and published 7. Liquidity options are provided both in case of open ended and close ended schemes Evaluating Performance of Mutual Funds Net Asset Value is the amount a unit holder would receive if the mutual fund were wound Up, it is also called the mutual fund’s calling card. Since the unit holders are part owners of the assets and liabilities of the mutual fund, NAV is the net


value of all assets and liabilities, i.e. the market value of total assets and market value of total liabilities. What is the peculiar to NAV is: • NAV changes daily • NAV is computed as a value per unit holding • Returns to the investor are determined by Cost of Mutual Fund and Net Asset Value Computation of NAV: NAV = Net assets of the scheme Number of units outstanding Where; Net assets of the scheme = Market value of investments + receivables + other accrued income + other assets – Accrued expenses – other payables – other liabilities Classification of Mutual Funds
1. On the basis of Function – Mutual Funds can be divided into  Open Ended Scheme – In such schemes investors can make an

entry or exit in the fund anytime. The capital of the fund is unlimited and the redemption period is undefined Close Ended Scheme – In this case the investor can buy the units only during Initial Public Offer or after the units have been listed. The scheme has limited life and at the end of the period the corpus is liquidated. Investors can exit the scheme by a) selling shares in the stock market, b) expiry of the scheme and c) during repurchase period. Difference between Open ended and Close ended Scheme Close Ended Scheme 1. Fixed Corpus: no new units can be offered time 2. beyond the limit Variable Corpus due to ongoing purchase and redemption Open Ended Scheme

Listed on the stock exchange for buying and selling, other than equity linked savings

No listing; transaction done directly with the fund


scheme 3. Two values are available NAV and market trading price 4. Mostly liquid Highly liquid One price available – NAV

2. On the basis of Portfolio
1. Equity – Funds that invest in equity stocks. Depending on the kind of

investor and his risk appetite, the funds are of the following types  growth funds – for long term investors looking for long term capital appreciation  aggressive funds – for investors looking for super normal profits, investments are in start-ups, IPOs, speculative shares  Income Funds – for investors looking for safe stocks with high cash dividends  Balance Funds – mix of growth and income funds 2. Debt  Bond funds – investments are in fixed income securities  Gilt funds – investments in G-secs 3. Special Funds  Index funds – investments in stock index, the benefit of investing in index funds is that the investor is immune to the upward and downward movement of a particular stock/ script.  International Funds – Mutual Fund locate in India, raising money in India for investments to be made globally  Offshore funds – Mutual Fund located in India, raises money globally to be invested in India  Sector Funds – investing in a particular industry
3. On the basis of Ownership

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Public Sector Mutual Funds – sponsored by a company of public sector Private Sector Mutual Funds – sponsored by company of private sector Foreign Mutual Funds – sponsored by foreign companies operating in India Types of Mutual Funds

1. Balanced Funds – A portfolio which has strategic allocation of debt

and equity

2. Equity diversified funds – As the name suggests the portfolio has

wide array of stocks. There are many types of equity dividend funds: • Flexicap/ Multicap funds – the fund is diversified, with defined minimum and maximum level of exposure to each of the market caps • Contra Fund – it is for those investors who want the fund to perform in all types of market environments. • Index Fund – fund that tracks the performance of the benchmark market index. • Dividend Yield Fund – as the name suggests the fund invests in shares of companies having high dividend yield. These stocks are generally less volatile and offer potential for good capital appreciation.

Equity Linked Tax Savings Scheme (ELSS) – this fund gives investors the option to save taxes under section 80C of the Income Tax Act. The fund has a minimum lock in of 3 years, it helps investors avoid problems of investing lump sum amount and also helps one get the benefit of averaging. particular sector to let investors reap benefit of seasonal returns and industry cycles. These would be riskier than diversified portfolios as they bear a greater risk of a particular sector turning out to be non performing.

4. Sector Funds – as the name suggests, the fund invests in a

5. Thematic Funds – The fund managers invest in a particular sector or

industry which is likely to outperform, based on their assessment or industry analysis. The research and analysis.
6. Arbitrage Funds – these funds provide safety, liquidity, better

returns and tax benefits as these funds include mix of derivatives and equity. These funds provide better returns than a typical debt instrument and lower volatility than equity
7. Hedge Funds – There are no hedge funds in India but they are

private investment vehicles and are lightly regulated investment funds. The concept is later explained in details.

Cash Funds – As the name suggests these funds offer higher liquidity and lower volatility as the portfolio includes debt and money market instruments.



Exchange Traded Funds – these funds are listed on the stock exchange and their prices are linked to the underlying index. The concept has been explained in detail later. Factors to be considered for selecting Mutual Fund

• Past performance – The past performance of the mutual fund can be adjudged by growth of the NAV during the referral period. Growth is evaluated in the following manner: Growth = (NAV1 – NAV0) + D1/ NAV0 • Timing – timing for investments made by the mutual fund is critical for maximizing returns, for instance investing in the bullish or bearish market may be vital for the investment and performance of the mutual fund • Size of fund – larger the size of the fund, greater would be the risk as there would be more products to be monitored. Small sized funds may not give the much expected return or growth. So investors should be very careful will selecting the fund to invest in. • Age of fund – Longevity of the fund would indicated how seasoned the player is in the market and expertise. • Fund Manager – He is the fulcrum of the fund, the investors should also have an idea whose hands their money rests in. • Expense Ratio – Though there is an upper ceiling imposed on the expenses by the regulators. Lower the expenses higher would be the return • PE Ratio – The weighted average PE of the stocks in the portfolio can be used to measure the risk levels of the fund • Portfolio turnover – This again is crucial to the return bearing capacity of the fund. High turnover would have greater cost implications, whereas low turnover would mean that the fund manager is not using the market options to the hilt. Short answers Money Market Mutual Funds (MMMFs) – These are funds that invest in money market instruments. The purpose of such funds was to enable the individual investors to gain from investments in money market instruments which would have not been possible otherwise for individuals to invest in. MMMFs have a minimum lock-in period. These can be set up by scheduled commercial banks, public financial institutions or their subsidiaries and can be both open ended or close ended schemes. Banks can also set up ‘inhouse’ MMMFs wherein the assets and liabilities would be ring fenced or allocated to a separate entity, such as a trust. The units of MMMFs can be

issued to individuals only. Non-resident Indian individuals may subscribe provided the capital and the dividend would be non-repartiable. MMMFs are free to determine the investment by a single investor. Prior compulsory authorization from RBI is required before setting up MMMFs. Issue or transfer of units would attract stamp duty. Switching of assets between schemes can be done at market rate and based upon conscious investment decisions. Exchange Traded Funds (ETFs) – They are hybrid products with features of an index fund. These funds are listed on the stock exchange and their prices are linked to the underlying index. Exchange traded funds trade like a stock. Unlike mutual funds which have their Net Asset Value (NAV) calculated at the end of each trading day, an exchange traded funds price changes throughout the day with variation in demand and supply. These exchange traded funds can be traded like stocks. ETFs provide the diversification of index funds and flexibility of a stock. Expense ratio of ETFs is lower than that of an average mutual fund. Hedge Funds - Hedge funds are private pooled investment limited partnerships which fall outside many of the rules and regulations governing mutual funds. Hedge funds therefore can invest in a variety of securities on a leveraged basis. The term hedge fund refers not so much to the hedging techniques hedge funds may employ as it does to their status as private investment partnerships. These funds are exempted from many of the rules and regulations governing mutual funds. Hedge funds are not required to meet disclosure requirements and are prohibited from public advertising and soliciting investors directly or through a registered broker-dealer. They provide flexibility in their investment options. Hedge funds can use short selling, leverage and derivatives. This enables them to deliver non-market correlated returns. They also provide a wide dispersion in investment returns, volatility and risk.

Introduction to venture capital Venture capital is an age old concept but the venture capital market has developed in the recent decades. The term venture capital denotes the act of investment in the areas of high risk, in order to get some high returns. The developments in the venture capital market have taken place in the US markets mainly. The market of venture capital, in the past, was disconnected and may be identified as an individualized to some extent. In the recent times only, the market has been shaped and the market became matured. Venture capital markets are like boons for Those who wants to set up new business. At the same time, if an existing business wants to develop, the venture capitalists are there to provide financial assistance. These capitalists have their own business interest behind the assistance. These

people want to have a share of the huge profits by the business in the future. Because of this, only those businesses are selected which are supposed to develop rapidly in the future. For the purpose, the venture capitalists have their own team of people to identify the appropriate opportunities. The modern concept of venture capital should be grateful to General Doriot because he was the person who founded the American Research and Development Fund. This was done to provide financial assistance to the activities of developing new technologies in the US universities. At the same time, the commercial use and financial benefits from such technologies were also considered seriously. With the commercial success of the concept of venture capital, big players entered the venture capital market of United States of America. The giant companies like Xerox and General Electric played a major role in expanding the venture capital market. The entry of these companies in this market encouraged with separate divisions to deal in the market, encouraged many others. Because of these situations, the venture capital market was expanded beyond the territories of US and within a short period, it gained ground globally. Venture capital: Venture capital means funds made available for startup firms and small businesses with exceptional growth potential. Venture capital is money provided by professionals who alongside management invest in young, rapidly growing companies that have the potential to develop into significant economic contributors. The most flexible definition of Venture capital is: “The support by investors of entrepreneurial talent with finance and business skills to exploit market opportunities and thus obtain capital gains.” Features of Venture Capital
1. High Risk:

By definition the Venture capital financing is highly risky and chances of failure are high as it provides long term startup capital to high risk-high reward ventures. Venture capital assumes four types of risks, these are:
    Management risk - Inability of management teams to work together. Market risk Product risk - Product may fail in the market. - Product may not be commercially viable.

Operation risk - Operations may not be cost effective resulting in increased cost decreased gross margins. 109

2. High Tech: As opportunities in the low technology area tend to be few

of lower order, and hi-tech projects generally offer higher returns than projects in more traditional areas, venture capital investments are made in high tech. areas using new technologies or producing innovative goods by using new technology. Not just high technology, any high risk ventures where the entrepreneur has conviction but little capital gets venture finance. Venture capital is available for expansion of existing business or diversification to a high risk area. Thus technology financing had never been the primary objective but incidental to venture capital.
3. Equity Participation & Capital Gains:

Investments are generally in equity and quasi equity participation through direct purchase of shares, options, convertible debentures where the debt holder has the option to convert the loan instruments into stock of the borrower or a debt with warrants to equity investment. The funds in the form of equity help to raise term loans that are cheaper source of funds. In the early stage of business, because dividends can be delayed, equity investment implies that investors bear the risk of venture and would earn a return commensurate with success in the form of capital gains.
4. Participation in Management:

Venture capital provides value addition by managerial support, monitoring and follow up assistance. It monitors physical and financial progress as well as market development initiative. It helps by identifying key resource person. They want one seat on the company’s board of directors and involvement, for better or worse, in the major decision affecting the direction of company. This is a unique philosophy of “hands on management” where Venture capitalist acts as complementary to the entrepreneurs. Based upon the experience other companies, a venture capitalist advise the promoters on project planning, monitoring, financial management, including working capital and public issue. Venture capital investor cannot interfere in day today management of the enterprise but keeps a close contact with the promoters or entrepreneurs to protect his investment.

Length of Investment: Venture capitalist help companies grow, but they eventually seek to exit the investment in three to seven years. An early stage investment may take seven to ten years to mature, while most of the later stage investment takes only a few years. The process of having significant returns takes several years and calls on the capacity and talent of venture capitalist and entrepreneurs to reach fruition.



Illiquid Investment: Venture capital investments are illiquid, that is, not subject to repayment on demand or following a repayment schedule. Investors seek return ultimately by means of capital gains when the investment is sold at market place. The investment is realized only on enlistment of security or it is lost if enterprise is liquidated for unsuccessful working. It may take several years before the first investment starts to locked for seven to ten years. Venture capitalist understands this illiquidity and factors this in his investment decisions. DIFFERENCE BETWEEN VENTURE CAPITAL & OTHER FUNDS

Venture Capital Vs Development Funds: Venture capital differs from Development funds as latter means putting up of industries without much consideration of use of new technology or new entrepreneurial venture but having a focus on underdeveloped areas (locations). In majority of cases it is in the form of loan capital and proportion of equity is very thin. Development finance is security oriented and liquidity prone. The criteria for investment are proven track record of company and its promoters, and sufficient cash generation to provide for returns (principal and interest). The development bank safeguards its interest through collateral. They have no say in working of the enterprise except safeguarding their interest by having a nominee director. They do not play any active role in the enterprise except ensuring flow of information and proper management information system, regular board meetings, adherence to statutory requirements for effective management control where as Venture capitalist remain interested if the overall management of the project o account of high risk involved I the project till its completion, entering into production and making available proper exit route for liquidation of the investment. As against this fixed payments in the form of installment of principal and interest are to be made to development banks. Venture Capital Vs Seed Capital & Risk Capital: It is difficult to make a distinction between venture capital, seed capital, and risk capital as the latter two form part of broader meaning of Venture capital. Difference between them arises on account of application of funds and terms and conditions applicable. The seed capital and risk funds in India are being provided basically to arrange promoter’s contribution to the project. The objective is to provide finance and encourage professionals to become promoters of industrial projects. The seed capital is provided to

conventional projects on the consideration of low risk and security and use conventional techniques for appraisal. Seed capital is normally in the form of low interest deferred loan as against equity investment by Venture capital. Unlike Venture capital, Seed capital providers neither provide any value addition nor participate in the management of the project. Unlike Venture capital Seed capital provider is satisfied with low risk-normal returns and lacks any flexibility in its approach. Risk capital is also provided to established companies for adapting new technologies. Herein the approach is not business oriented but developmental. As a result on one hand the success rate of units assisted by Seed capital/Risk Finance has been lower than those provided with venture capital. On the other hand the return to the seed/risk capital financier had been very low as compared to venture capitalist. Seed Capital Scheme Basis Beneficiaries Income or aid Very small entrepreneurs Rs. 15 Lac (Max) Normal 20 percent Nil Nil Sell back to promoters Owner funds Not done Nil Not good Venture capital Scheme Commercial viability Medium and large entrepreneurs are also covered Up to 40 percent of promoters’ equity Skilled and specialized 30 percent plus Highly flexible Multiple ways Several ,including Public offer Outside contribution allowed Possible Exempted Very satisfactory

Size of assistance Appraisal process Estimates returns Flexibility Value addition Exit option Funding sources Syndication Tax concession Success rate


Table: Difference between Seed Capital Scheme and Venture capital Scheme Venture Capital Vs Bought Out Deals: The important difference between the Venture capital and bought out deals is that bought-outs are not based upon high risk- high reward principal. Further unlike Venture capital they do not provide equity finance at different stages of the enterprise. However both have a common expectation of capital gains yet their objectives and intents are totally different. THE VENTURE CAPITAL SPECTRUM The growth of an enterprise follows a life cycle as shown in the diagram below. The requirements of funds vary with the life cycle stage of the enterprise. Even before a business plan is prepared the entrepreneur invests his time and resources in surveying the market, finding and understanding the target customers and their needs. At the seed stage the entrepreneur continue to fund the venture with his own or family funds. At this stage the funds are needed to solicit the consultant’s services in formulation of business plans, meeting potential customers and technology partners. Next the funds would be required for development of the product/process and producing prototypes, hiring key people and building up the managerial team. This is followed by funds for assembling the manufacturing and marketing facilities in that order. Finally the funds are needed to expand the business and attaint the critical mass for profit generation. Venture capitalists cater to the needs of the entrepreneurs at different stages of their enterprises. Depending upon the stage they finance, venture capitalists are called angel investors, venture capitalist or private equity supplier/investor.


Venture capital was started as early stage financing of relatively small but rapidly growing companies. However various reasons forced venture capitalists to be more and more involved in expansion financing to support the development of existing portfolio companies. With increasing demand of capital from newer business, Venture capitalists began to operate across a broader spectrum of investment interest. This diversity of opportunities enabled Venture capitalists to balance their activities in term of time involvement, risk acceptance and reward potential, while providing on going assistance to developing business. Different venture capital firms have different attributes and aptitudes for different types of Venture capital investments. Hence there are different stages of entry for different Venture capitalists and they can identify and differentiate between types of Venture capital investments, each appropriate for the given stage of the investee company, These are:1. Early Stage Finance  Seed Capital  Startup Capital  Early/First Stage Capital  Later/Third Stage Capital 2. Later Stage Finance  Expansion/Development Stage Capital  Replacement Finance  Management Buy Out and Buy ins  Turnarounds  Mezzanine/Bridge Finance Not all business firms pass through each of these stages in a sequential manner. For instance seed capital is normally not required by service based ventures. It applies largely to manufacturing or research based activities. Similarly second round finance does not always follow early stage finance. If the business grows successfully it is likely to develop sufficient cash to fund its own growth, so does not require venture capital for growth. The table below shows risk perception and time orientation for different stages of venture capital financing. Financing Stage Period (funds locked in years) 7-10 Risk perception Extreme Activity to be financed

Early stage finance Seed

For supporting a concept or idea or R & D for product


development Start up 5-9 Very high Initializing operations or developing prototypes Start commercial production and marketing Expand market & growing working capital need Market expansion, acquisition & product development for profit making company Acquisition financing Turning around a sick company Facilitating public issue

First stage



Second stage


Sufficiently high Medium

Later stage finance


Buy out-in Turnaround Mezzanine

1-3 3-5 1-3

Medium Medium to high Low

Table: Venture Capital- Financing Stages 1. Seed Capital: It is an idea or concept as opposed to a business. European Venture capital association defines seed capital as “The financing of the initial product development or capital provided to an entrepreneur to prove the feasibility of a project and to qualify for startup capital”. 2. Startup Capital: It is stage 2 in the venture capital cycle and is distinguishable from seed capital investments. An entrepreneur often needs finance when the business is just starting. The startup stage involves starting a new business. Here in the entrepreneur has moved closer towards establishment of a going concern. Here in the business concept has been fully investigated and the business risk now becomes that of turning the concept into product. Startup capital is defined as: “Capital needed to finance the product development, initial marketing and establishment of product facility. “

3. Early Stage Finance: It is also called first stage capital is provided to entrepreneur who has a proven product, to start commercial production and marketing, not covering market expansion, de-risking and acquisition costs. At this stage the company passed into early success stage of its life cycle. A proven management team is put into this stage, a product is established and an identifiable market is being targeted. British Venture Capital Association has vividly defined early stage finance as: “Finance provided to companies that have completed the product development stage and require further funds to initiate commercial manufacturing and sales but may not be generating profits.” 4 .Second Stage Finance: It is the capital provided for marketing and meeting the growing working capital needs of an enterprise that has commenced the production but does not have positive cash flows sufficient to take care of its growing needs. Second stage finance, the second trench of Early State Finance is also referred to as follow on finance and can be defined as the provision of capital to the firm which has previously been in receipt of external capital but whose financial needs have subsequently exploded. This may be second or even third injection of capital. 5. Later Stage Finance It is called third stage capital is provided to an enterprise that has established commercial production and basic marketing set-up, typically for market expansion, acquisition, product development etc. It is provided for market expansion of the enterprise. VENTURE CAPITAL INVESTMENT PROCESS Venture capital investment process is different from normal project financing. In order to understand the investment process a review of the available literature on venture capital finance is carried out. Tyebjee and Bruno in 1984 gave a model of venture capital investment activity which with some variations is commonly used presently. As per this model this activity is a five step process as follows:    Deal Organization Screening Evaluation or due Diligence

 

Deal Structuring Post Investment Activity and Exit

Figure: Venture Capital Investment Process

Deal origination: In generating a deal flow, the VC investor creates a pipeline of deals or investment opportunities that he would consider for investing in. Deal may originate in various ways. Referral system, active search system, and intermediaries. Referral system is an important source of deals. Deals may be referred to VCFs by their parent organisaions, trade partners, industry associations, friends etc. Another deal flow is active search through networks, trade fairs, conferences, seminars, foreign visits etc. Intermediaries is used by venture capitalists in developed countries like USA, is certain intermediaries who match VCFs and the potential entrepreneurs. Screening: VCFs, before going for an in-depth analysis, carry out initial screening of all projects on the basis of some broad criteria. For example, the screening process may limit projects to areas in which the venture capitalist is familiar in terms of technology, or product, or market scope. The size of investment, geographical location and stage of financing could also be used as the broad screening criteria. Due Diligence: Due diligence is the industry jargon for all the activities that are associated with evaluating an investment proposal. The venture capitalists evaluate

the quality of entrepreneur before appraising the characteristics of the product, market or technology. Most venture capitalists ask for a business plan to make an assessment of the possible risk and return on the venture. Business plan contains detailed information about the proposed venture. The evaluation of ventures by VCFs in India includes; Preliminary evaluation: The applicant required to provide a brief profile of the proposed venture to establish prima facie eligibility. Detailed evaluation: Once the preliminary evaluation is over, the proposal is evaluated in greater detail. VCFs in India expect the entrepreneur to have:Integrity, long-term vision, urge to grow, managerial skills, commercial orientation. VCFs in India also make the risk analysis of the proposed projects which includes: Product risk, Market risk, Technological risk and Entrepreneurial risk. The final decision is taken in terms of the expected risk-return trade-off as shown in Figure. Deal Structuring: In this process, the venture capitalist and the venture company negotiate the terms of the deals, that is, the amount, form and price of the investment. This process is termed as deal structuring. The agreement also include the venture capitalist's right to control the venture company and to change its management if needed, buyback arrangements, acquisition, making initial public offerings (IPOs), etc. Earned out arrangements specify the entrepreneur's equity share and the objectives to be achieved. Post Investment Activities: Once the deal has been structured and agreement finalised, the venture capitalist generally assumes the role of a partner and collaborator. He also gets involved in shaping of the direction of the venture. The degree of the venture capitalist's involvement depends on his policy. It may not, however, be desirable for a venture capitalist to get involved in the day-to-day operation of the venture. If a financial or managerial crisis occurs, the venture capitalist may intervene, and even install a new management team. Exit: Venture capitalists generally want to cash-out their gains in five to ten years after the initial investment. They play a positive role in directing the company towards particular exit routes. A venture may exit in one of the following ways: There are four ways for a venture capitalist to exit its investment:  Initial Public Offer (IPO)  Acquisition by another company  Re-purchase of venture capitalists share by the investee company  Purchase of venture capitalists share by a third party

PLAYERS IN VENTURE CAPITAL INDUSTRY: There are following groups of players: • • Angels and angel clubs Venture Capital funds  Small  Medium  Large Corporate venture funds Financial service venture groups

• •

Figure: players in venture capital industry

1. Angels and angel clubs Angels are wealthy individuals who invest directly into companies. They can form angel clubs to coordinate and bundle their activities. Besides the money, angels often provide their personal knowledge, experience and contacts to support their investees. With average deals sizes from USD 100,000 to USD 500,000 they finance companies in their early stages. Examples for angel clubs are · Media Club, Dinner Club, · Angel’s Forum 2. Small and Upstart Venture Capital Funds These are smaller Venture Capital Companies that mostly provide seed and start-up capital. The so called "Boutique firms" are often specialized in certain industries or market segments. Their capitalization is about USD 20

to USD 50 million (is this deals size or total money under management or money under management per fund?). As for the small and medium Venture Capital funds strong competition will clear the marketplace. There will be mergers and acquisitions leading to a concentration of capital. Funds specialized in different business areas will form strategic partnerships. Only the more successful funds will be able to attract new money. Examples are • • • Artemis Comaford Abbell Venture Fund Acacia Venture Partners

3. Medium Venture Funds The medium venture funds finance all stages after seed stage and operate in all business segments. They provide money for deals up to USD 250 million. Single funds have up to USD 5 billion under management. An example is Accel Partners 4. Large Venture Funds As the medium funds, large funds operate in all business sectors and provide all types of capital for companies after seed stage. They often operate internationally and finance deals up to USD 500 million The large funds will try to improve their position by mergers and acquisitions with other funds to improve size, reputation and their financial muscle. In addition they will to diversify. Possible areas to enter are other financial services by means of M&As with financial services corporations and the consulting business. For the latter one the funds have a rich resource of expertise and contacts in house. In a declining market for their core activity and with lots of tumbling companies out there is no reason why Venture Capital funds should offer advice and consulting only to their investees. Examples are: • • • AIG American International Group Cap Vest Man 3i

5. Corporate Venture Funds These Venture Capital funds are set up and owned by technology companies. Their aim is to widen the parent company's technology base in an win-win-situation for both, the investor and the investee. In general,

corporate funds invest in growing or maturing companies, often when the investee wishes to make additional investments in echnology or product development. The average deals size is between USD 2 million and USD 5 million. The large funds will try to improve their position by mergers and acquisitions with other funds to improve size, reputation and their financial muscle. In addition they will to diversify. Possible areas to enter are other financial services by means of M&As with financial services corporations and the consulting business. For the latter one the funds have a rich resource of expertise and contacts in house. In a declining market for their core activity and with lots of tumbling companies out there is no reason why Venture Capital funds should offer advice and consulting only to their investees. Examples are: • • • • Oracle Adobe Dell Kyocera

As an example, Adobe systems launched a $40m venture fund in 1994 to invest in companies strategic to its core business, such as Cascade Systems Inc and Lantana Research Corporation. - has been successfully boosting demand for its core products, so that Adobe recently launched a second $40m fund. 6. Financial funds: A solution for financial funds could be a shift to a higher securisation of Venture Capital activities. That means that the parent companies shift the risk to their customers by creating new products such as stakes in an Venture Capital fund. However, the success of such products will depend on the overall climate and expectations in the economy. As long as the sown turn continues without any sign of recovery customers might prefer less risky alternatives. Methods of Venture Financing Venture capital is typically available in three forms in India, they are:
1. Equity:

All VCFs in India provide equity but generally their contribution does not exceed 49 percent of the total equity capital. Thus, the effective control and majority ownership of the firm remains


with the entrepreneur. They buy shares of an enterprise with an intention to ultimately sell them off to make capital gains. 2. Conditional Loan: It is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. In India, VCFs charge royalty ranging between 2 to 15 percent; actual rate depends on other factors of the venture such as gestation period, cost-flow patterns, riskiness and other factors of the enterprise. 3. Income Note: It is a hybrid security which combines the features of both conventional loan and conditional loan. The entrepreneur has to pay both interest and royalty on sales, but at substantially low rates. 4. Other Financing Methods: A few venture capitalists, particularly in the private sector, have started introducing innovative financial securities like participating debentures, introduced by TCFC is an example.

Funding Options Venture capital firms usually focus their funding by geographic location, industry or stage. Stages of a company's growth are delineated in a number of ways, but some of the most common are: Seed financing Ranging from $50,000 to $500,000, these funds are to help the entrepreneurs prove that an invention or concept works. The money usually pays for product development and market research. Start-up financing The usual range is $50,000 to $1 million for initial marketing and product production. First or Early Stage Usually $500,000 to $15 million for helping the enterprise at the point it has completed its product, but has little or no revenue. Second or Later Stage The usual range is between $2 million and $15 million for a firm with product and revenues, and which may have already taken other institutional money. Third or Mezzanine Stage The usual range is between $2 million and $20 million for a profitable company looking to make a major expansion leading to an IPO within 3 to 18 months. Bridge An investment of $2 to $20 million made only 3 - 12 months before an IPO.

Finding Venture Capital Venture capital firms can be found worldwide. The National Venture Capital Association provides a wide variety of resources for finding venture capital firms. Venture capital can also be found through bankers, insurance companies, and business associations. The internet is becoming a popular venue for finding venture capital. There are a number of sites devoted to capital searches. Internet venture capitalists see the internet not only as a vehicle in making their job easier with the use of such methods as evaluating an email submission of the executive summary for an entrepreneurial venture, but also as a source of new venture capital opportunities. While there is more venture capital available than there has ever been, a major portion of that money goes to technology-related businesses. Health care, also, has been well-funded traditionally. Seeking venture capital can be a soul-searing experience that can be as time consuming as the entrepreneurial venture itself. However, with the right match, it can also be one of the most rewarding relationships both financially and inspirationally that you find in establishing your venture. Venture Capital Advantages  It injects long term equity finance which provides a solid capital base for future growth. The venture capitalist is a business partner, sharing both the risks and rewards. Venture capitalists are rewarded by business success and the capital gain. The venture capitalist is able to provide practical advice and assistance to the company based on past experience with other companies which were in similar situations. The venture capitalist also has a network of contacts in many areas that can add value to the company. The venture capitalist may be capable of providing additional rounds of funding should it be required to finance growth. Venture capitalists are experienced in the process of preparing a company for an initial public offering (IPO) of its shares onto the stock exchanges or overseas stock exchange such as NASDAQ. They can also facilitate a trade sale. Risk in each stage

Financial Stage

Period (Funds locked years) 7-10

Risk Perceptio in n

Activity to be financed

Seed Money


For supporting a concept or idea or R&D for product development Initializing operations or developing prototypes Start commercials production and marketing Expand market and growing working capital need

Start Up


Very High

First Stage



Second Stage


Sufficientl y high

Third Stage



Market expansion, acquisition & product development for profit making company Facilitating public issue

Fourth Stage



Venture capital Characteristics      Long time horizon Lack of liquidity High risk Equity participation Participation in management

Short answers: 1. Reasons for which active Venture Capital Industry is important for India include:
 

Innovation: needs risk capital in a largely regulated, conservative, legacy financial system Job creation: large pool of skilled graduates in the first and second tier cities

 

Patient capital: Not flighty, unlike FIIs Creating new industry clusters: Media, Retail, Call Centers and back office processing, trickling down to organized effort of support services like office services, catering, and transportation.

2. Definition of Venture Capital Fund : The Venture Capital Fund is now defined as a fund established in the form of a Trust, a company including a body corporate and registered with SEBI which: A. Has a dedicated pool of capital; B. Raised in the manner specified under the regulations; and C. To invest in venture capital undertakings in accordance with the regulations." 3. Definition of Venture Capital Undertaking: Venture Capital Undertaking means a domestic company:a. India

Whose shares are not listed on a recognized stock exchange in

Which is engaged in business including providing services, production or manufacture of articles or things, or does not include such activities or sectors which are specified in the negative list by the Board with the approval of the Central Government by notification in the Official Gazette in this behalf? The negative list includes real estate, non-banking financial services, gold financing, activities not permitted under the Industrial Policy of the Government of India. 4. Minimum contribution and fund size: the minimum investment in a Venture Capital Fund from any investor will not be less than Rs. 5 lacs and the minimum corpus of the fund before the fund can start activities shall be at least Rs. 5 crores. 5. Investment Criteria: The earlier investment criteria have been substituted by new investment criteria which has the following requirements: Disclosure of investment strategy; maximum investment in single venture capital undertaking not to exceed 25% of the corpus of the fund;  Investment in the associated companies not permitted;  At least 75% of the investible funds to be invested in unlisted equity shares or equity linked instruments.  Not more than 25% of the investible funds may be invested by way of:
 


a. b.

Subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed subject to lock-in period of one year; Debt or debt instrument of a venture capital undertaking in which the venture capital fund has already made an investment by way of equity.

It has also been provided that Venture Capital Fund seeking to avail benefit under the relevant provisions of the Income Tax Act will be required to divest from the investment within a period of one year from the listing of the Venture Capital Undertaking. 6. Disclosure and Information to Investors: In order to simplify and expedite the process of fund raising, the requirement of filing the Placement memorandum with SEBI is dispensed with and instead the fund will be required to submit a copy of Placement Memorandum/ copy of contribution agreement entered with the investors along with the details of the fund raised for information to SEBI. Further, the contents of the Placement Memorandum are strengthened to provide adequate disclosure and information to investors. SEBI will also prescribe suitable reporting requirement from the fund on their investment activity. 7. QIB status for Venture Capital Funds: The venture capital funds will be eligible to participate in the IPO through book building route as Qualified Institutional Buyer subject to compliance with the SEBI (Venture Capital Fund) Regulations. 8. Relaxation in Takeover Code: The acquisition of shares by the company or any of the promoters from the Venture Capital Fund under the terms of agreement shall be treated on the same footing as that of acquisition of shares by promoters/companies from the state level financial institutions and shall be exempt from making an open offer to other shareholders. 9. Investments by Mutual Funds in Venture Capital Funds: In order to increase the resources for domestic venture capital funds, mutual funds are permitted to invest upto 5% of its corpus in the case of open ended schemes and up to 10% of its corpus in the case of close ended schemes. Apart from raising the resources for Venture Capital Funds this would provide an opportunity to small investors to participate in Venture Capital activities through mutual funds. 10. Government of India Guidelines: The Government of India (MOF) Guidelines for Overseas Venture Capital Investment in India dated September 20, 1995 will be repealed by the MOF on notification of SEBI Venture Capital Fund Regulations.


11. Advantages of financing by venture capital:

 

It injects long term equity finance which provides a solid capital base for future growth. The venture capitalist is a business partner, sharing both the risks and rewards. Venture capitalists are rewarded by business success and the capital gain. The venture capitalist is able to provide practical advice and assistance to the company based on past experience with other companies which were in similar situations. The venture capitalist also has a network of contacts in many areas that can add value to the company, such as in recruiting key personnel, providing contacts in international markets, introductions to strategic partners, and if needed co-investments with other venture capital firms when additional rounds of financing are required. The venture capitalist may be capable of providing additional rounds of funding should it be required to finance growth.

A derivative is a financial product, the value of which is derived from the value of underlying asset. Derivatives were created to help banks, investors and corporations, to manage risk. So, for stock derivatives, the price of the shares of a particular company is the underlying. For an index derivative, the value of the index is the underlying. And for a crude oil derivative, the price of crude oil is the underlying. When the price of the underlying changes, the value of the derivative based on it also changes. Of course, the price also depends on the demand and supply for that derivative, but the primary driver of the price of a derivative is the price of the underlying. Types of Derivatives • Forwards • Futures • Options • Swaps 1. Forwards: A forward contract is 'an agreement to buy or sell an asset for a predetermined, fixed price, at a certain time or date in the future'. The only difference between a normal spot transaction and a forward transaction is the time span between the contract and its fulfillment. While spot is an immediate, present tense contract, a forward is a later date or future tense contract that is just being finalized today. Forwards contracts are over-the-counter contracts that usually trade on commodities. There is no monetary transaction to the contract when it is first negotiated and money only changes hands on contract maturity.

Forwards are not options, they are obligations and should be considered as a “cash transaction.”
E xchange Traded D erivatives "Forwards "

7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Interest-R ate F utures S tock-Index F utures Types C urrency F utures

Billions of $

Amount in

Over-The-Counter Derivatives "Forwards "
Interest-R ate C ontracts 28%

Example: An agreement on Monday to buy a book,Currency Contracts from a bookstore on (Fin 374c) Friday for $1000.00. On Friday, you return 72% the bookstore and take to delivery of the book and pay the $1000.00. The contract is actually the agreement. 2. Futures: This is a derivative contract in which the quantity, rate and date of a future purchase is agreed upon today for a given asset. At this pre-decided date, the buyer of the futures contract gets the delivery of the pre-decided quantity of the given asset at the pre-decided price. Similarly, the seller of the futures contract gives the delivery of the pre-decided quantity of the given asset at the pre-decided price. In a futures contract, both the buyer and seller are bound to honor their commitment – the buyer has to take delivery, and the seller has to make delivery according to the terms of the contract. Thus, even if the price of the asset goes down, the buyer has to get the asset from the seller at the pre-decided price. And even if the price goes up, the seller has to give the seller at the pre-decided price. Cost: There is no upfront cost involved in the purchase of a futures contract, apart from brokerage. Example: 1 A sells the futures contract of Reliance Industries stock to B. Quantity is 200 shares, price is Rs. 3200 and the expiry date is 3 months away.


Now, after 3 months, irrespective of the market price of the stock of Reliance Industries, A would deliver 200 shares of Reliance Industries to B at Rs. 3200. Example: 2 On Monday we enter into a futures contract to buy our book on Friday. We are required to place a deposit for the book of 50% ($500.00). We are told that if the book appreciates in value we may be required to increase the deposit. If the book depreciates in value, we may take back some of the money. Wednesday the book goes to $1500.00. We must deposit another $250.00. On Thursday the book drops to $750.00. We can collect $375.00. On Friday the book value is $800.00, therefore we owe $425.00 on the remaining balance. 3. Options: An option gives the buyer the right, but not the obligation, to buy or sell something at a predefined price, until a specific date. This option normally costs a fraction of the cost of the asset. An OPTION is the right, not the obligation to buy or sell an underlying instrument. There are many types of Options to name a few: collar, cylinder, fence, mini-max, zero-cost tunnel and straddle. These are all newer forms of options. The two basic options are: 1.Tradedoption 2. Put option Exchange Call Derivatives "Options"
Individual Stock Options Types Stock-Index Options Currency Options Interest-Rate Options 0 500 1,000 1,500 2,000 2,500 3,000 3,500

In Billions of $

Over-The-Counter Derivitaves "Options"
O C TC urrency O ptions 29%

O Interest-R TC ate O ptions 71%

As the name suggests, here, the buyer has an option to take delivery of the asset, and not the obligation. Thus, if the market price of the asset goes up, and buyer of an option would exercise the option and get profits. But if the market price of the asset goes down, the buyer of the option would not exercise it, and would allow the option to lapse.

Thus, Options are more flexible for the buyers compared to futures. But the seller of the option has the obligation to deliver the assets if the buyer chooses to exercise the option. In case of options, the pre-decided price for the exchange of asset is called the Strike Price. One thing to remember though is that in reality, not many people actually exercise their options – people do not actually exchange the asset at the time of exercise. Since the options are traded in the market, instead of exercising them, the buyers just sell them in the market. The logic behind this – when an option is in the money (that is, when it becomes profitable for the buyer), its option premium or the price goes up. So, one can sell it and make profit instead of exercising it. This is easier, and therefore is done by most people. American and European Options: The options are of two types – American and European. In American options, the option can be exercised any time up to the settlement date. In European options, the option can be exercised only on the settlement date. Thus, American options are much more flexible (I am introducing this here just as a concept – in India, only American options are traded). Cost: There is a cost involved for options – the buyer of the option has to pay the seller an Option Premium, which is the fee the option seller (also called the Option Writer) gets in return for the one-sided guarantee he extends to the buyer. Since the option writer assumes the risk of the price movement, this fee is well justified. Example: A writes the option of Reliance Industries stock to B. Quantity is 200 shares, strike price is Rs. 3200 and the expiry date is 3 months away. The option premium is Rs. 25. Now, during these 3 months, say the price of Reliance Industries stock goes up to Rs. 3400. In this case, B would exercise the option, and would get the shares at Rs. 3200 from A. Thus, B would make a profit of Rs. 3400 – Rs. 3200 – Rs. 25 (Option premium) = Rs. 175. Similarly, A would make a loss of Rs. 175. But if the price of Reliance Industries stock remains less than Rs. 3200 for the 3 month duration, B would not exercise the option. In this case, the option buyer B would make a loss equal to the option premium – Rs. 25 in this case, and the option writer would make a profit equal to the option premium – Rs. 25. Options are basically of two types. 1. Call option 2. Put option

A call option gives the option buyer the right but not the obligation to buy a certain asset from the call option writer, by a certain date and for a certain price, known as the strike price. Since a call option is the 'right but

not the obligation' to buy an asset, it is obvious that the call option will only be exercised if the strike price is lower than the going market price for the underlying asset at that certain time in the future. Calls: Long a call: Person buys the right (a contract) to buy an asset at a cretin price. They feel that the price in the future will exceed the strike price. This is a bullish position. Short a Call: Person sells the right (a contract) to someone that allows them to buy an asset at a cretin price. The writer feels that the asset will devalue over the time period of the contract. This person is bearish on that asset. A put option gives the option buyer the right but not the obligation to sell a certain asset at an agreed price (strike price) by a certain date in the future. In a put option, the option will thus, only be exercised if the strike price is higher than the going market price at that specific point of time in the future. Inexperienced options expire once their time duration ends and it is only the premium paid for buying the option that exchanges hands between the two parties. Puts: Long a Put: Buy the right to sell an asset at a pre-determined price. You feel that the asset will devalue over the time of the contract. Therefore you can sell the asset at a higher price than is the current market value. This is a bearish position. Short a Put: Sell the right to someone else. This will allow them to sell the asset at a specific price. They feel the price will go down and you do not. This is a bullish position.

4. Swaps: A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond. Types of swaps: Interest Rate Swaps, Currency Swaps, Commodity Swaps, Equity Swaps
Over-The-Counter Derivatives "Swaps"
Currency Sw aps 12%

Interest-Rate Sw aps 88%

Uses • • •

of swap: To smooth out interest rate payments in a cyclic environment. To secure and level out future interest payments. To secure foreign currency for loans when you are a visitor in that country and it would be too difficult to secure credit or the cost is prohibitive.

Plain vanilla Interest rate swaps: The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties. Uses of Interest Rate Swap: • Converting a liability from – fixed rate to floating rate – floating rate to fixed rate • Converting an investment from – fixed rate to floating rate – floating rate to fixed rate Currency swaps: The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated. Currency swaps have two main uses: To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan).


To hedge against (reduce exposure to) exchange rate fluctuations.

Use of Derivatives The primary use of a derivative is to hedge risk (also called Hedging). When you buy a derivative, you are making a provision that makes your cash flows more certain or that limits your losses. (I would write another article to illustrate these using calculations). For example, say you are an exporter, and your earnings are in dollars. Now, you would receive your payment of $15000 after six months. But since you spend in Rupees, you would also like to keep track of your earnings in Rupees. The value of dollars after six months would decide your actual earning in rupees. Since that is not known right now, it brings uncertainty to your earnings too. Derivatives can be helpful in such a scenario. You can buy Dollar – Rupee futures contract of $15000 with the rate of Rs. 39.5 for a dollar, and with a validity of 6 months. Thus, you would be certain about your earnings after 6 months – whether the rate after 6 months is Rs. 37 or Rs. 41, you would get Rs. 39.5 for every dollar. For a business, this kind of certainty in cash flows and earnings can be a very big relief! Hedging is the primary use of derivatives. But in the market, apart from hedgers, we also have many participants that use derivatives just for investments – people who want to make profits out of the price movement of derivatives – just like stocks. The presence of such participants is not bad, because they provide liquidity and depth to the derivatives market. Why Derivative is needed? They take a lot of risk out of doing business, by spreading that risk to many other people, for a fee. Businesses in this country would be very unstable if they weren’t allowed to stabilize their raw material and currency risks. Look at South West Airline’s as an example. South West, during the period when gas cost $4 a gallon, saw their profits sore because they had established derivative’s that allowed them to buy fuel for $50 a barrel. Without those derivative’s they would have been in the same shape as many other airlines. That definitely would have cost them a loss in profits, but also a loss in jobs. Derivatives exist for one reason. They are the cheapest way for a company to protect themselves from normally unforeseen risks.

Uses of Derivatives in Investment Finance Below are some of the uses of derivatives like futures and options

Derivatives are very good risk management tools and are mainly used to hedge risks that a trader is routinely exposed to. Derivative instruments offer the trader, the option of passing on some of the risk that he's bearing over to another party. He either takes on another risk in return or makes cash payment in exchange for the risk transfer. Derivative instruments like forwards and futures play a key role in giving directions to the market prices of the future. Forwards and futures prices are good reflectors of the price directions as well as the expected change in the future prices of the underlying asset. Derivatives offer the traders an option to change the nature of their liabilities and exchange the risks associated with some of their unwanted liabilities with some more bearable ones. Derivatives can be used to make arbitrage profits. Arbitrage profit opportunities are those opportunities that allow for riskless, zero net investment profits, by capitalizing on price differentials on the same commodity in different markets. The intention is to buy low and sell high in two different markets and pocket the differential profits. Derivatives allow for large portfolio position changes without incurring the buying and selling transaction costs. Differences between future and options Future contract Option contract 1. An option gives the buyer the right, but not the obligation to buy (or sell) a certain asset at a specific price at any time during the life of the contract.

1. A futures contract gives the buyer the obligation to purchase a specific asset, and the seller to sell and deliver that asset at a specific future date, unless the holder's position is closed prior to expiration.

2. An investor can enter into a 2. An options position does require futures contract with no upfront the payment of a premium. cost. 3. The underlying position is much 3. The underlying position is much larger for futures contracts. small. 4.Gains on futures positions are automatically 'marked to market' daily, meaning the change in the value of the positions is attributed to the futures accounts of the parties at the end of every trading day - but a 4. The gain on a option can be realized in the following three ways: exercising the option when it is deep in the money, going to the market and taking the opposite position, or waiting until expiry and


futures contract holder can realize collecting the difference between the gains also by going to the market asset price and the strike price. and taking the opposite position. Understanding Derivatives: Futures and Options Granted that mastering derivatives can make you a millionaire overnight, but it is good to understand them first. Research them and you will find a very grim picture, more houses have been broken with derivatives than have been built. Lack of knowledge coupled with greed turn derivatives into your worst possible nightmare. Derivatives are a boon for the hedgers but not always so for the arbitrageurs and speculators. Let us have a brief look as to why.  Certain exotic derivatives like Cacall, Caput, Barrier options, etc. lure investors with the greed of returns but what happens many a times is that traders fail to see the complexity involved in them. Not understanding how the derivative works and investing large sums of money in them blindly is a folly. For many derivatives, small changes in the underlying asset can swing your fortunes from millionaire to bankrupt within seconds. Be careful and ask all the right questions before you bring out the cash. Since most derivatives involve the play of big money with very little in the way of initial investment, most people fail to foresee the impact they can have on their total funds. Even though you have just invested $100, the position that you had taken in the market was on $10000 shares. Marginal swings in the value of these shares can leave you with the outcome – 'Investment - $100 and Total Loss $ 100, 000'. For many, what they invest in derivatives are their savings so you can only imagine the impact. Many investors fail to understand that investing in the derivatives market means indulging in a kind of leveraging. How else did you think it possible that just investing $10 should help you take positions worth $1000. Think about it and you'll know why so many have gone down while betting on derivatives. You'll know then, why all derivatives traders haven't mastered the art yet and become overnight millionaires. When investing in derivatives, be aware of the risk that you are taking on with that kind of leverage. When derivatives are used for hedging, they perform exceptionally well but when used for speculation, it is not prudent to rely too heavily on them. These are extremely powerful instruments and though, 'no guts no glory' does summarize the 'higher risk, higher potential return' mantra of investment finance, having open positions in derivatives is never prudent. Many an investor have fallen to greed in the derivatives market, for everyone else, it is a risk management boon.


Inflation is defined as a sustained increase in the general level of prices. Basically, the purchasing power of our currency declines. Inflation expectations impact not only a project's required return but also the projected cash flows. Inflation also impacts a firm's stock and bond values because interest rates are directly affected by inflation expectations. As a result, understanding inflation is critical to managing a firm's financial resources and directly impacts financial decision-making. INFLATION AND DECISION MAKING The term inflation refers to rise in general (on an average basis) price level of goods and services in the economy, i.e., fall in purchasing power of money. Financial Management is the process of financial decision-making. There are three categories of financial decisions: (i) financing decisions, (ii) investment decisions, and (iii) dividend decisions. During inflationary conditions, the financial decisions should be influenced by the impact of the declining purchasing power of money on the company. The single most important maxim of financial management that influences every decision is: Time eats money. This maxim holds good even in the absence of inflation (because of cost of capital), it gains extra strength during the inflationary conditions. The finance manager should consider the following points while taking such decisions during the inflationary conditions: Basis of Decision-making The profits reported by the historical accounting are inflated. Hence, such profits should not be the basis for decision-making. Pricing Decisions: The pricing policies undergo a dramatic transformation during inflation. Prices must be revised frequently and sharply to accurately reflect the impact of inflation. Investment Decisions (i) Capital expenditure decisions: Capital budgeting is one of the major tools which helps financial managers in evaluating investment proposals. Capital budgeting decisions are seriously distorted by inflation. Inflation affects two aspects of capital budgeting: (a) Projected cash flows, and (b) Discounting rate. Inflation will change the projected cash flows, i.e., in case of inflation (which was not considered at the time of making projections about future cash flows) the cash flows would be different than these would have in the absence of inflation. Inflation also affects interest rates and this in turn may change the cost of capital. Also, the investor should get the returns only in real terms, otherwise he may not get what he expects or he may even suffer loss (in terms of purchasing power of money). (ii) Working capital: In the time of rising prices, a firm needs more funds to finance working capital. Hence, it should be planned properly.


Financing Decisions The finance manager should consider inflation while making financing decisions. Loans may be taken on fixed rate basis (and not on the basis of floating rate as floating rate rises in case of inflation). He should note that the stock market may become an uncertain source of capital. Shareholders will expect real rate of return (in the form of dividend as well as capital appreciation) on their investments otherwise the share prices may go down in the share market. Dividend Decisions Cash position becomes a very important determinant of dividend payment as during inflationary conditions generally companies face the shortage of cash. Besides, the finance manager should see that the dividend decision is based on real profit (calculated on the basis of inflation adjustment, after providing depreciation on replacement cost basis) otherwise the company would be consuming its capital. Other Points (i) Make absolutely certain that all the managers under-stand time value of money. (ii) Develop an appropriate inflationary adjustment for capital replacement or capital will disappear. (iii) Anticipate that the purchasing department will assume a more important role in the long-run survival of the firm. (iv) Develop methods for estimating rate of inflation. (v) Anticipate difficulty in maintaining capital expenditure programs INVENTORY CONDITIONS MANAGEMENT UNDER INFLATIONARY

The term ‘inflation’ refers to rise in general (on an average basis) price level of goods and services in the economy .i.e. fall in purchasing power of money. It creates a number of uncertainties because of rising prices in raw materials, semi-finished and finished goods. Inflation also muddies inventory planning; The management should consider the following points for effective management of inventories under the inflationary conditions: (i) EOQ: We use inventory carrying cost to determine how much inventory we will keep on-hand. Inflation affects the EOQ model by increasing carrying costs (because the inflation pushes up the interest rate ) (C) which results in a small EOQ level. This small quantity is misleading and results in increase in inventory related costs. Hence, to calculate the optimum order size, cost to carry should be reduced by inflation’s impact on interest cost. To understand this let’s have an example:  Cost per unit Rs.5. Cost to order Rs.100 per order. Annual demand 10,000 units. Cost to carry 12% p.a. of cost of inventory carried (this


is made of 10% interest cost and 2 % storage etc cost). Cost to carry per unit p.a. = Re.0.60. Now suppose inflation is there and data is: Cost per unit Rs. 6, cost to order Rs.110 per order, Cost to carry 14% (including 11.50 % interest cost and 2.50 % other cost like storage etc. Now for the purpose of calculation of EOQ, cost to carry should be taken as 12.50% of Rs.6. (otherwise the inflation’s impacted on cost to carry per unit be considered twice; once as increased price and other time as increased % of cost to carry)

(ii) NIFO as the basis of valuation of inventory: NIFO assumes that the inventory we sell is purchased at the time of its sale. Generally, this inventory costs more than earlier layers of inventory. As a result, ending inventory is smaller than it otherwise would be. Since ending inventory is smaller, COGS is higher. (COGS is calculated on the basis of replacement cost) Higher COGS means reporting the lower profit, this helps in lower dividend, higher retained profit for replacement of assets and maintaining the capital intact. (iii) Ideally, the inventory-sales ratio should be kept as low as feasible so as to minimize the cost of storage and the cost of money tied up in inventory. But As these prices rise, purchasing managers naturally tempted to buying for forward requirements.. The purchasing manager of course realizes that his cost of storage and tied up money will thereby go up. But he may hold that these costs are more than offset by being able to obtain inventory at lower prices than he could later. Such decisions, for buying for future requirements should be taken after considering the both (i) possible further price movements and (ii) cost to carry including the cost of obsolescence. IMPACT OF MANAGEMENT INFLATION ON WORKING CAPITAL

The term inflation refers to rise in general (on an average basis) price level of goods and services in the economy, i.e., fall in purchasing power of money. Working Capital is the money used to make goods and attract sales. During the period of rising prices, a firm needs more funds to finance working capital. Hence, it should be planned properly. Not under-standing the impact of inflation on working capital has been the cause of many business failures. Cost of financing the working rises because of increase in interest rates. Cash should never be allowed to remain idle (Time eats value of money, i.e., on one hand the company suffers loss of interest and on the other purchasing power of wealth kept as cash declines). Good cash management can provide a major source of profit, while poor cash management can destroy a company in a short time. Inventory valuation should be based on NIFO (next in first out). Impact of inflation on working capital can be explained as follows:

Cost of financing working capital increase because of rise in interest rates.  Working capital required for carrying inventories increases.  Requirement of working capital for debtors is influenced by ability to increase the selling price. If selling prices can be increased in the proportion of cost of sales, external working capital to finance the sales is not required. The requirement of additional working capital for sales will be met from increase in profit (in nominal terms).  Increase in selling price may result in decrease in demand and this may result in reduced profit and in turn reduced cash flows; the result may be increase in raising of working capital from external sources. To successfully meet the challenge of inflation, the management should take following steps:  Try to reduce the working capital cycle  The shareholders may be rewarded through issuance of bonus shares  Inflation-Related Problems (i) Difficulty in forecasting the future rates of inflation which is quite essential for monetary and fiscal monitoring and cannot simply be avoided. (ii) Difficulty of predicting demand and other factors which may be affected by the level of inflation. Inflation seems to intensity economic uncertainty, which is the reason why Governments seem so eager to try to solve the inflation problem. This tends to make forecasts even more difficult to make than they would otherwise be. (iii) Problems with carrying out the analysis. A decision needs to be made as to whether to express forecast cash flows in ‘real’ terms (“constant money”) or in ‘money’ (or ‘nominal’) terms. Real, in this context refers to expression of future cash flows in terms of $ of today’s purchasing power. Money in this context, means the number of $ which are forecasted to be paid and received at various futures times. Inflation and capital budgeting Inflation is a concept which each one of us is not only aware but is also experiencing. The impact of inflation is erosion of the purchasing power of money over a period of time. It is explained in the chapter 1 of this book that financial management is basically concerned with the proper management of finance. This requires finance manager to take certain decisions. Even though it is beyond the scope of the finance manager to control inflation, he, however, tries to measure the impact of inflation on his decisions so as to re-orient various financial management policies according to the fast changing circumstances Some of the prominent areas which are affected by inflation and are required to be re-oriented are dividend payout policy, capital restricting, depreciation policy, profit planning,

working capital and tax planning. Inflation, thus, greatly affects the financial affairs and planning of the firm. Impact of inflation on capital budgeting decisions In general, an inflationary economy distorts capital budgeting decisions. For one thing, depreciation charges are based on historical cost rather than replacement costs. As income grows with inflation, an increasing portion is taxed, with the result that real cash flows do not keep up with inflation. Illustration Of Impact Of Inflation On Capital Budgeting Decision An investment proposal for the installation of a machine for an amount of . 24 million $ is under consideration. It is assumed that no inflation is expected to occur. It is also assumed that the useful life of the machine is 5 years at the end of which there is no scrap value. Depreciation is to be charged straight line-basis, tax rate is 30% and the cost of capital of the firm is 10%. You are required to advise as to whether the machine should be installed or not, if the yearly cash flows are (1) $ 65000, (2) $ 70000 (3) $ 75000 (4) $80000 (5) $ 85000 at the end of each year. Solution The following cash flows are expected to be generated during the period of useful life of machine. Year Cash Depreciation Profit Cash Savings tax inflow $ $ $ $ (1) (2) (5) (6) (3+6) = 7 1 11900 2 15400 3 18900 4 22400 5 25900 94500 65000 59900 70000 63400 75000 66900 80000 70400 85000 73900 48000 48000 48000 48000 48000 Profit before tax $ (3) 17000 22000 27000 32000 37000 135000 Tax @ 30% $ (4) 5100 6600 8100 9600 11100 40500 after

375000 240000 334500

By substituting the cash flows in the equation we get the following result: NPV = -240000 + (59900/1.10 + 63400/(1.10)2 = 66900/(1.10)4 + 70400/ (1.10)4 + 73900/(1.10)5) = -240000 + (54455 + 52397+ 50263 + 48084 + 45886) = -240000 + (251085) = + 11085 Recommendation: In view of positive NPV the proposal is acceptable and therefore the machine may be installed Note : In the aforesaid illustration, depreciation has been deducted from cash inflows to arrive at taxable income. The tax has been calculated @ 30% and in the Profit after tax (PAT), we have added depreciation to ascertain the amount of yearly cash flows after tax. These are the figures relevant for appraising a project. The aforesaid illustration recommends for the installation of the machine since the Net Present Value is positive assuming a non-inflationary scenario. However, if we consider a situation in which inflation rate is at 15% per annum and cash savings are also expected to grow at the same rate, the after tax cash inflows will be as follows: Illustration Of Impact Of Inflation On Capital Budgeting Decision Part.. 2 Year Cash Depreciation Profit Cash Savings tax inflow $ $ $ $ (1) (2) (3) (6) (3+6) = 7 1 74750 48000 18725 66725 2 92575 48000 31202 79202 3 114066 48000 46246 94246 4 139921 48000 64345 112345 5 170965 48000 86075 134075 105684 592277 246593 486593 Profit before tax $ (4) 26750 44575 66066 91921 122965 Tax @ 30% $ (5) 8025 13373 19820 27576 36890 352277 after



The cash savings in column-2 have been calculated @ 15% compound inflation p.a. as follows: 1st Year = 1.15 2nd year = (1.15)2 3rd Year = (1.15)3 4th year = (1.15)4 5th year = (1.15)5 X X X X X $ 65000 $ 70000 $ 75000 $ 80000 $ 85000 = = = = = $ 74750 $ 92575 $ 114066 $ 139921 $ 170965

A look on Table 2 shows that the cash savings (Column 2) have grown at a compound inflation rate of 15% p.a. over a period of five years. However, depreciation remains constant at $ 48000 p.a. and does not keep pace with replacement cost. As a consequence thereof, the taxable income (Column 4) has increase by 4.6 times whereas cash savings (Column 2) have gone up only by 2.28 tunes and cash flows (Column 7) have just doubled during the same period. This shows that the growing income is being increasingly taxed, with the result that real cash flows do not keep up with inflation and there is every likelihood that the project may result into negative return, thus loss of opportunity. This contention is proved by referring to Table (Column 7) which shows cash flows (PAT + Depreciation) are larger than the cash flows shown in Table 1. However, if they are deflated by the rate of inflation to find out the real cash flows as opposed to nominal cash flows at 0 year, we get the following real cash inflows. Formula for deflation = Index Number at the beginning/Index Number at the the end X Cash inflows Viz = 100/115 $66725 = $58022 and so on. Alternatively this may also be calculated if money cash flows set out in Table – 2 (Column – 7) can be restated as current purchasing power equivalents as follows: End of year End of year End of year End of year End of year 1 2 3 4 5 $66725/1.15 $ 79202/(1.15)2 $ 94246/(1.15)3 $ 112345/(1.15)4 $ 134075/(1.15)5 = = = = = 58022 59888 61968 64234 66671

By substituting the figures in the equation, we get the following result. NPV = $ (58022/1.10 + 59888/(1.10)2 + 61968/(1.10)3 + 64234/(1.10)4 + 66671/(1.10)5) - $ 240000


NPV = $ (52747 + 49494 + 46557 + 43876 + 41400) - $ 240000 NPV = $ (234074 ) - $ (240000) NPV = -$5926

Hence under inflationary conditions, the same proposal is not acceptable in view of negative net present value (NPV) despite the fact that cash saving have grown at a compound inflation rate of 15% p.a. and we have used the same discount rate (10%) without undertaking inflation adjustment. However, if the 10% opportunity cost of capital (discount rate) of the firm is adjusted by a 15 per cent compound rate of inflation, it automatically gives a negative rate of return i.e. (-43 percent) and the project will automatically be rejected outright. Thus under inflationary conditions, there is every likelihood of capital budgeting decisions being distorted. For example, in 1974 there was a political storm in Ireland over the Government’s acquisition of a stake in Bulla mines. The price paid by the Government reflected an assessment of 8 million and others though that it was as high as 104 million. Although these valuations used different cash flow projections, a significant part of the difference in views seemed to reflect confusion about real and nominal discount rates while appraising projects under inflationary conditions. In summary, because inflation can have major effects on business, it is critically important, and it must be recognized and dealt with. The most effective way to deal with inflation is to build it into each cash flow element, using the best available information about how each element will be affected. Since one cannot estimate future inflation rates with precision, errors are bound to be made. Therefore, inflation adds to uncertainty, riskiness, and complexity to capital budgeting. Fortunately, computers and spread-sheet models are available to help in inflation analysis, thus, in practice; the mechanics of inflation adjustments are not difficult.

What is a multinational corporation?  A multinational corporation (MNC) or transnational corporation (TNC), also called multinational enterprise (MNE), is a corporation or enterprise that manages production or delivers services in more than one country. It can also be referred to as an international corporation.  A corporation that operates in two or more countries.  Decision making within the corporation may be centralized in the home country, or may be decentralized across the countries the corporation does business in.  The first modern MNC is generally thought to be the Dutch East India Company, established in 1602. Very large multinationals have budgets that exceed some national GDPs. Multinational

corporations can have a powerful influence in local economies as well as the world economy and play an important role in international relations and globalization.














SOME MULTINATIONAL CORPORATIONS  ABB (Asea Brown Boveri)  ABN-Amro  Adidas ltd.  Aditya Birla Group  IBM  ICICI Bank  Infosys Ltd.  General Electric Company  General Motors  Google Inc.  Parker Hannifin  PepsiCo Inc.  Procter & Gamble Co.  Proton  Honda Motor Co. Ltd.  Sony Corporation  Tata Group  Toyota Motor Corporation  Unilever  Nike Inc.  Nokia Corporation  Ford Motor Company ADVANTAGES:  MNCs can help to reduce poverty.  They can bring money into a country through employment and investment.  Three quarters of international investment in developing countries is from MNCs and private sources.  They can create jobs and raise labor standards.  They can pass on expertise in their field.  They work to equalize the cost of factors of production around the world.  MNCs help increase competition & break domestic monopolies. DISADVANTAGES:  The MNC can be guilty of pollution or human rights abuse (e.g. by sourcing products from factories where child labor is used or by forbidding its workers to join trade unions).  The finance brought into a country by an MNC may be badly managed by that country’s government.  Multinationals create false needs in consumers and have had a long history of interference in the policies of sovereign nation states.  MNCs may destroy competition & acquire monopoly powers.


 The transfer pricing enables MNCs to avoid taxes by manipulating prices on intra-company transactions. Duties of MNCs  MNCs have an obligation towards employers, customers, governments, suppliers and communities as well as towards shareholders. This is known as Corporate Social Responsibility (CSR).  Most agree that CSR includes a duty to behave honestly, legally and with integrity, not to be corrupt but to deal fairly and obey the host country’s laws.  Some MNCs would say that no more than this bare minimum can be expected of them. They would argue that the cost of CSR could eat into their profits and push them out of business.

International Financial Institutions
Definition International Financial Institutions (IFIs) refers to financial institutions that have been established (or chartered) by more than one country and hence are subject to international Law. Types of IFIs  Bretton Woods institutions  Regional development banks  Bilateral development banks  Other regional financial institutions Bretton Woods institutions The best-known IFIs were established after World War II to assist in the reconstruction of Europe and provide mechanisms for international cooperation in managing the global Financial system. Examples: They include the World Bank, the IMF, the International Finance Corporation, and other members of the World Bank Group. Regional development banks The regional development banks consist of several regional institutions that have functions similar to the World Bank group's activities, but with particular focus on a specific region. Shareholders usually consist of the regional countries plus the major donor countries. Examples: The best-known of these regional banks cover regions that roughly correspond to United Nations regional groupings, including the Inter-American Development Bank (which works in the Americas, but primarily for development in Latin America and the Caribbean); the Asian Development Bank; the African Development Bank; and the European Bank for Reconstruction and Development.

Bilateral development banks Bilateral development banks are financial institutions set up by individual contries to finance development projects in developing countries and emerging markets. Examples: include the Netherlands Development Finance Company FMO and the German Development Bank DEG. Other regional financial institutions Several regional groupings of countries have established international financial institutions to finance various projects or activities in areas of mutual interest. Examples: The largest and most important of these is the European Investment Bank, an institution established by the members of the European Union. Other examples include the Black Sea Development Bank, the International Investment Bank (established by the countries of the former Soviet Union and Eastern Europe), the Islamic Development Bank and the Nordic Investment Bank. Examples of IFIs  International Monetary Fund  World Bank Group  Asian Development Bank  African Development Bank  Inter-American Development Bank  Islamic Development Bank Need for the IFIs After the Great Depression in the 1930s there was a need for an organization to create a System for exchange rate stability. Countries’ economies were adversely affected by WWII. There was a need for reconstruction in well-developed nations. And also need for development in the lesser developed nations. The World Bank and the International Monetary Fund were created in the aftermath of World War II, to direct investments to the neediest countries of the world, the Bank, and to ensure international monetary cooperation, the Fund. However, these International Financial Institutions (IFIs) have changed their roles over the last few decades, becoming international advocates of controversial economic policies in developing countries. The governance of the Bank and the Fund is severely skewed towards rich countries which dominate decision-making in these institutions.



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