Full Final IFP Reference 2007

COPYRIGHT 2007 i-flex Solutions Ltd (For internal use only)

i-flex- FP -02.01


Enriching Learning The software industry is a dynamic and evolving area. At i-flex, we understand that we can retain the competitive edge only by providing excellent training to our employees in the domain function. The major activities of the training function are:

To provide the necessary infrastructure for facilitating the learning process.

Our programs focus on the latest developments in areas relevant to the business.

To provide quality learning intervention by following a system to evaluate the performance in measurable terms and use the same to continuously enhance and develop the training function, making us, a Learning Organization

It has been our constant endeavor to offer specialized courses to augment the domain focus. In order to facilitate this, we encourage you to gain knowledge so that you can appreciate the businesses that you are developing applications for. The iflex Finance Professional ( FP) lays the foundation for you on Finance and different Banking services. About this program. This three day program is designed to expose you to the very basic of Finance and Banking services. The program will help your understanding those financial terminologies that will make your work much easier and interesting. This Program will enable you to improve clarity in communication with our customers. The Program leads to an internal certification which will be awarded on the completion of the required assessments. About the book We take pride to state that this manual has been completely designed and developed in-house by the Training team in collaboration with our functional experts. The content has been developed to act as your reference through-out the program and also serve as a guide for you in future. We wish you all the very best!

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Preface Friends, Deep Domain Expertise is a key differentiator in our PrimeSourcing services business, which helps us to add value and reduce risk while managing mission-critical customer engagements. As part of our goal to continuously strengthen this differentiator, we created PrimeUniversity, the virtual learning environment, in the year 2005. Since the launch over a year ago, we have successfully offered a variety of courses ranging from foundation level to advance level certification courses. We are now pleased to share with you the i-flex Finance Professional ( FP), which is an improved and enhanced version of our hugely successful Finance Foundation Program. FP has been entirely designed and developed in-house by our own domain and training experts, from PrimeSourcing and the Training Group. This program is already being delivered as part of the induction for all employees who join PrimeSourcing, with mandatory evaluation process at the end of the program.

I am confident the FP series of programs launched & managed under the aegis of PrimeUniversity, will go a long way in helping each one of you get closer to achieving the deep domain expertise at individual as well as the organization level.

All the very best,

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Acknowledgments

We would like to thank the following people for their valuable contribution In putting together this material

R Ganesh

Chandan Mohanty

Adwait Mulay

Mohammed Mohiyuddin Khan

K T Ponnamma

Hemant Kharadkar

Sonali Bhattacharjee

Ruchi Chaurey

Janani Chandramoulisekar

Avinash Kumar Yadav

Vijay Krishnamurthy

Anilkumar Narendula

Rajaram Bhandarkar

Samir Zaveri

Vinayak Pai

Sujith Nair

Avinash Thakur

Jyoti Pednekar

Nityanand Bhangale


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1. THEORY OF INVESTMENT MODULE 1 3 2. CORPORATE FINANCE MODULE 2 ..29 3. FINANCIAL MARKETS & MARKET PARTICIPANTS I MODULE 3 ..51 4. FINANCIAL MARKETS & MARKET PARTICIPANTS II MODULE 4 ..83 5. FINANCIAL ACCOUNTING MODULE 5 ..109 6. BFSI DOMAIN MODULE 6 ..145 7. BFSI TECHNOLOGY MODULE 7 ..179


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Theory of Investment Module 1

TABLE OF CONTENTS

1 SAVINGS AND ACCUMULATION OF SAVINGS 7 1.1. Why are Savings Important.. 7 1.2. Types of Savings 7

2 INVESTMENT AVENUES... 8 2.1. What is Investment 8 2.2. Investment Avenues.. 8 2.3. How is it possible to maximize savings.. 9 2.4. Accumulation of savings... 9

3 CALCULATING RETURNS 10 3.1. Return on Assets... 10 3.2. Return on Investment 10

4 INVESTMENT STRATEGIES. 12 4.1. Investment Strategies... 12 4.2. Speculation. 12

5 LIQUIDITY. 13 5.1. What is Liquidity. 13 5.2. Liquidity Risk.. 13

6 INTEREST. 14 6.1. Simple Interest... 14 6.2. Compound Interest... 14

7 TIME VALUE OF MONEY.. 16 7.1. Future Value.. 16 7.2. Present Value. 16 7.3. Annuity. 16 7.3.1. Ordinary Annuity........................ 17 7.3.2. Annuity Due . 17 7.4. Net Present Value (NPV) . 18 7.5. Internal Rate of Return (IRR) .. 18

8 INFLATION 19 8.1. Inflation ..................... 19 8.2. Factors ... 19

9 RISK & RETURNS .. 20 9.1. Risk . 20 9.2. Relationship between Risk & Returns .. 20 9.3. Types of Risk 20 9.4. Types of Risk in Connection with Investments 21 9.4.1. Types of Non-Operational Risks . 21

10 FINANCIAL PLANNING 22 10.1. What is Financial Planning . 22


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10.2. Steps in Financial Planning 22

11 INSURANCE . 24 11.1. What is Insurance ... 24 11.2. Principles of Insurance .. 24 11.3. Types of Insurance Available Worldwide 25 11.4. Classifications of Insurance Companies . 26

12 BIBLIOGRAPHY & REFERENCES . 27


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Chapter 1

Savings & Accumulation of Savings

When we talk about investments, the first thing that comes to mind is MONEY!!!

To make any kind of investments, the major requirement is money. Where does this money come from?

Money can come from the following sources:

Borrowings, inheritances, winnings and income.

The most regular source of money is income. But all that is income cannot be used for investment. A portion of what is left over after meeting day-to-day expenses can be utilized for investments.

This portion of excess income over expenditure is termed as Savings

1.1 Why are savings important?

Life is unpredictable and so we need to plan for the future. Moreover, the source of your income may not remain constant or it may not remain permanent. In order to have a resource that you can depend during such occurrences, it is necessary to get into the habit of saving money.

Savings also enable you to upgrade your lifestyle and standard of living, buy comforts and luxuries, and help you to enjoy life without cutting down on your day-to-day expenses.

1.2 Types of Savings

Savings can be of three types: short-term, medium-term and long-term.

Short-term savings refer to savings that you might make and use up for your annual holiday, or for the purchase of home appliances. Short-term generally refers to a period not exceeding one year.

Medium-term savings might be those that can be used for occasions in the family, childrens education, purchase of a larger house, etc. Medium-term usually refers to a period greater than one year, but not exceeding five years.

Long-term savings typically refer to retirement savings. Usually, long-term refers to an investment horizon exceeding five years.


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Chapter 2

Investment Avenues

2.1 What is investment?

Investment is the deployment of savings for earning higher returns thereon.

The purchasing power of money decreases due to inflation. It is therefore necessary to generate returns which are higher than the rate of inflation by a wide margin. Only then is real capital appreciation possible.

Moreover, higher returns mean that you can achieve your targets sooner and start living a better life earlier.

Investments can be classified as: Short-term, medium term and long term investments depending upon the duration for which they are held.

They can also be classified as investments held for trading and permanent investments.

2.2 Investment Avenues:

Savings can be channelised into investments in any of the following ways:

Ploughing cash back into business: This will result in a growth in business, and consequently a growth in profits.

Fixed deposits: Savings can be deployed into fixed deposits with banks or companies. This is a safe form of investment, but the returns are low.

Mutual funds: These are an indirect method of investment in the equity, debt and derivative markets. They are supposed to bear lower risk as compared to direct investment in the markets, and if used wisely and well, can help build capital over a period of time. Mutual funds are usually well-structured, transparent and regulated.

Hedge funds: These are the instruments of investment of the rich people, with the minimum investment generally being one million dollars and multiples. Hedge funds are not highly regulated, but they can generate very high returns. Very risky.

Investment in the markets: Savings can be invested directly in various markets like equity, bonds, commodities, derivatives, and currencies. Usually considered as high risk, but can generate very high returns too. Most markets nowadays are well-structured, transparent and regulated.

Property: Purchase of house-property, holiday homes, timeshares, land (residential, agricultural or industrial).

Other fixed assets: Machinery for production, vehicles, etc are some examples of fixed assets.

Precious metals: Investment in gold, silver, platinum, precious stones, either made independently or in the form of jewelry.

High end investments: Antiques, art (paintings, sculptures, etc.), watches, limited editions, collections of rare items (stamps, coins, pens, etc.) very expensive. Done as a hobby, but can generate exceptional returns.


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Compulsory investments: For salaried persons, a part of the income every year is generally invested into compulsory investments like Provident Fund, Pension Fund, PPF, Postal Savings, Life and Medical Insurance, etc. This is done to lower the income-tax outgo for the individual, and results in long-term savings.

2.3 How is it possible to maximize savings?

Some simple rules, if followed, can help in maximizing savings.

Follow financial prudence.

Live within your means.

Avoid taking excessive risks for marginally incremental gains.

Do not buy what you cannot afford.

Be disciplined with your savings, and save regularly.

2.4 Accumulation of Savings

Some of the end uses of savings are:

Channelisation into investments.

Expending of savings for education, purchase of assets, etc.

For use in emergencies.


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Chapter 3

Calculating Returns

3.1 Return on Assets

ROA means the total net earnings or income generated by investment in the asset concerned. This includes capital gain (or loss) as well as income that the asset has generated, like rent (hire charges) or dividend (or interest earned).

ROA also sometimes referred as Return on Investment (ROI) is calculated as: ROA = Income generated from the asset + Capital Gain (or loss)

Earnings on assets refer to the income that the asset generates on a regular basis. This can be hire charges or rent if the asset is rented or leased out or it can be interest or dividend if the money is invested in any of the avenues mentioned chapter 2.

It also refers to regular income being generated from business.

3.2 Return on Investment

A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio on a per annum basis.

ROI (%) = Profits/Investment

ROI (%) = (Annual income) + (Selling price Purchase Price)

Purchase price

= Current yield + Capital gain or loss

Comparing Investment

Various investments of a similar nature can be evaluated by comparing their ROIs. An investment is profitable if it has a positive ROI. If an investment does not have a positive ROI (when there is a loss on investment), or if there are other opportunities with a higher ROI, then the investment should be not be undertaken.

The calculation for ROI can be modified to suit the situation -it all depends on what is included as returns and costs. The term in the broadest sense just attempts to measure the profitability of an investment and, as such, there is no one "right" calculation. For example, a marketer may compare two different products by dividing the revenue that each product has generated by its respective expenses. A financial analyst, however, may compare the same two products using an entirely different ROI calculation, perhaps by dividing the net income of an investment by the total value of all resources that have been employed to make and sell the product.

Consider an asset purchased for Rs. 5,00,000 and leased out at Rs. 10,000 per month for one year. The asset is sold after one year to fetch Rs. 4,80,000. The ROI in this case would work out to be:


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ROI = Income generated + Capital gains

ROI = 1,20,000 + (-20,000) = Rs. 1,00,000

ROI (%) = 1,00,000/5,00,000 = 20.00%

Rita sells her investment in Excellent Products Ltd. at Rs. 375 per share after holding it for exactly 1 year. Assuming that she has received a dividend of Rs. 10 per share during the year and her ROI is 10%, what is the price at which she bought the shares?


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Chapter 4

Investment Strategies

4.1 Investment Strategies:

Where investment with specific goals in mind is required, one size fits all strategy does not work. Individuals need to plan their investment strategies in accordance with their age, income, savings, financial goals, etc.

A younger person has a longer investment horizon and a longer time period in which to save and accumulate capital. Moreover, he may have less responsibilities, and so may be able to save more, as well as take more risks.

Conversely, a middle-aged person has a slightly shorter investment horizon to save and accumulate capital. He may also have additional family responsibilities, and may not be able to save more, in spite of having a larger income. He would also prefer not to take high risks with the capital that he has accumulated so far.

On the other hand, a person who is nearing retirement will prefer very low risk investments, and his prime concern is the preservation of the accumulated corpus. High returns are not very important. Such a person will prefer bonds or fixed deposits, where the initial capital is definitely preserved.

An indicative risk-return chart is given below:

Age Risk taking ability Possible investment avenues Below 30 years High All avenues. Equity (upto 80%) 30 to 45 years Moderate Balanced funds, some equity (upto 40%) Above 45 years Low Bonds, FDs, Liquid funds, Postal Savings,

only bluechip equity (upto 20%) 4.2 Speculation:

Speculation involves the buying, holding, and selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives or any valuable financial instrument to profit from fluctuations in its price as opposed to buying it for use or for income via methods such as dividends or interest.

It is the art of investment for generating very high returns in a very short time period by taking advantage of market imperfections. Speculation is a very high risk investment avenue, where a person can lose not only his initial investment, but multiples of the amount investment!!!

Speculative purchasing can create inflationary pressure, causing particular prices to increase above their "true value" (real value - adjusted for inflation) simply because the speculative purchasing artificially increases the demand. Speculative selling can also have the opposite effect, causing prices to artificially decrease below their "true value" in a similar fashion. In various situations price rises due to speculative purchasing cause further speculative purchasing in the hope that the price will continue to rise. This creates a positive feedback loop in which prices rise dramatically above the underlying "value" or "worth" of the items. This is known as an economic bubble. Such a period of increasing speculative purchasing is typically followed by one of speculative selling in which the price falls significantly, in extreme cases this may lead to crashes. Overall, the participation of speculators in financial markets tends to be accompanied by significant increase in short term market volatility.


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Chapter 5

Liquidity

5.1 What is Liquidity?

Liquidity is the ability to meet all financial obligations arising in the short term (a period less than one year).

Being liquid or having sufficient liquidity is a good sign of financial strength, and it allows you to take advantage of opportunities that might arise unexpectedly.

Liquidity ensures that you are able to meet your financial obligations on time, which is a very important business ethic, and has a direct impact on your creditworthiness and market standing.

The liquidity of an asset refers to how quickly the concerned asset can be sold to fetch a reasonable price in the market.

The liquidity of an asset depends upon the conditions prevailing in the market, and the demand/supply for the asset.

A booming market will have high demand, whereas in a recessionary period, demand drops even for some necessities.

A commonly available item will not command a big premium, nor a big discount. But a rare item may command a premium; conversely, there may not be many buyers for the same at times.

Liquidity includes both the ability to turn an asset into cash and to do so without being required to significantly reduce the price below its current level.

5.2 Liquidity risk

Refers to the inability to meet financial commitments due to liquidity constraints. It may also refer to the inability to liquidate an investment to meet the same commitments. Liquidity risk has to be seen in conjunction with many other factors such as opportunity cost and the disadvantages or consequences of defaulting on commitments.

Opportunity cost is the cost of the opportunity lost by choosing one option against another.

For example, if you are expecting to gain Rs. 1,00,000 by choosing one investment, but you do not have the capital to undertake the investment. To raise the capital required, if you sell another investment at a loss of Rs. 50,000 the net gain would be only Rs. 50,000. You have to analyze whether it is worth the trouble of going through all this effort for the return likely.

Liquidity risk may also refer to the scenario when your investments (shares, bonds) in a certain company may become unsaleable due to the impact of negative news or sentiments concerning that particular company. It may also happen due to a downgrade in the credit rating of the company.

The price of a companys shares or bonds might fall due to a downgrade in the credit rating. Consequently, there might not be enough buyers for the securities in the market, or the buyers might demand much lower prices as compensation for the risk premium.


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Chapter 6

Interest

Interest: Interest is the rent that is paid for using borrowed money.

Risk-free interest rate

The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no risk.

Though a truly "risk-free" asset exists only in theory, in practice most professionals and academics use rates of short- term government securities. These securities are considered to be risk-free because the likelihood of a government defaulting is extremely low, and because the short maturity of the bill protects the investor from interest-rate risk that is present in all fixed rate bonds (if interest rates go up soon after the bill is purchased, the investor will miss out on a fairly small amount of interest before the bill matures and can be reinvested at the new interest rate).

Since this interest rate can be obtained with no risk, it is implied that any additional risk taken by an investor should be rewarded with an interest rate higher than the risk-free rate.

6.1 Simple Interest

The amount of Simple Interest paid each year is a fixed percentage of the Principal Amount only. The rate of interest is applied ONLY to the initial Principal, even in the subsequent years.

Simple Interest (I) = Principal (P) x Rate of Interest per Period (R) x Number of Periods (N).

I = P x R x N (if R is expressed as a fraction)

I = P x R x N (if R is %) 100

Amount = Principal + Interest

In practice, Simple Interest is rarely used for deposits held for more than one year.

6.2 Compound Interest

The interest rate is applied to the original Principal AND any interest accrued on the Principal (and not withdrawn). Thus, the Principal with the Accrued Interest for the first Period together become the Principal for the next Period, and the interest is calculated on this higher base.

A = P [1+(R/100)]N

For example, if Rs. 1,00,000 is left on deposit to earn a rate = 6% compounded annually, at the end three years, the deposit will be worth:

A = 1,00,000 x [1+(6/100)]3 = 1,19,101.60

As before, the Rate of Interest is usually per annum, and the periods are years. If the frequency of Compounding is higher, i.e., if interest is calculated and compounded for shorter time periods, then the formula becomes:


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A = P [1+(R/t x 100)](Nxt)

For semi-annual compounding, t will take a value of 2, for quarterly compounding t will take a value of 4, and so on.

Compounding the above example on a monthly basis, we will get:

A = 1,00,000 x [1+(6/12 x 1/100)](3 x 12) = 1,19,668.05

All other things being equal, compound interest has a larger effect as the time period increases and as the interest rate increases.

A higher frequency of compounding (t) results in the interest being calculated more frequently. The limiting case of this is called continuous compounding where interest is credited on a continuous basis.

The distinction is like the difference between getting water from a hand pump and getting water from a faucet. With the hand pump, the water flow is broken. With the faucet, it is continuous. The faucet does not necessarily deliver water any faster than the pump. It just delivers it continuously.

With continuous compounding, at any time t, the value of a deposit is given by

A = P x e (R x t)

Were R is the continuously compounded interest rate and e =2.71828183

For example, if Rs. 1,00,000 is left on deposit to earn a rate = 6% continuously compounded interest, at the end three years, the deposit will be worth

A = 1,00,000 x e (6/100) x 3 = 1,19,721.74

Interest is rarely compounded continuously in practice. Continuous compounding is more of a theoretical notion. It is used frequently in theoretical finance because it simplifies many calculations.

A Comparison of the final amounts using different methods of calculation of interest is given below:

Method of Calculation Simple Interest

Compounded Annually

Compounded Monthly

Continuously Compounded

Amount (Rs.) 1,18,000.00 1,19,101.60 1,19,668.05 1,19,721.74

Problem: Calculate the Simple Interest and Compound Interest for the following scenario:

Principal: Rs. 3,75,000

Rate of Interest: 7.25% per annum.

Period: 5 years.

For compound interest calculations, calculate for monthly, quarterly and half-yearly compounding.


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Chapter 7

Time Value of Money

Time Value of money: Money has value. The time at which it is received or paid also adds or detracts from its value, as the case may be. Money also has opportunity cost associated with it. An amount of Money today is more valuable than the same amount of Money at a future date. The relationship between the values of Money at different points in time can be found using Time Value of Money calculations.

7.1 Future Value

This is simply the amount to which a sum of money invested today will grow at a given rate of appreciation. Future value is the same as compounding, and the formula is:

FV = PV (1+r)n

Here, r is the rate at which the initial amount appreciates and n is the period in years.

Future Value is very similar to Compound Interest that we have looked at earlier.

Consider a sum of Rs. 2,00,000 which is invested to earn a rate of 11% per annum for 5 years. The FV (at the end of five years) in this case would work out to be

FV = 2,00,000*(1+0.11)^5

FV = Rs.3,37,011.63

7.2 Present Value

This is the value today, assigned to an amount of money due at a date in future. This is done by using estimates of the rate of return over the concerned period.

If future value is compounding, present value is discounting, or exactly the reverse. The above formula is used to calculate the present value as:

PV = FV/(1+r)n

If we try and discount the above FV using the same discount factors, the PV (today) of Rs. 3,37,011.63 five years hence at 11% per annum would be:

PV = 3,37,011.63 / (1+0.11)^5

PV = Rs. 2,00,000.00

7.3 Annuity

Annuities are a series of fixed amounts (paid or received) at a specified frequency over the course of a fixed period of time. The most common payment frequencies are yearly (once a year), semi-annually (twice a year), quarterly (four times a year) and monthly (once a month). There are two basic types of annuities: ordinary annuities and annuities due. Annuities are used in insurance policies, pension schemes, recurring deposits, etc.


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7.3.1 Ordinary Annuity

Payments are made (or received) at the end of each period. For example, straight bonds usually pay coupon payments at the end of every six months until the bond's maturity date.

For an ordinary annuity, the PV (which is the sum of the PVs of each installment of the annuity taken separately) is calculated as:

PV = P*[{1-(1+r)-n}/r]

Where P is each installment, r is the rate of appreciation and n is the number of installments to be paid (or received).

Lets try and find out the PV of an ordinary annuity.

Frequency = yearly Installment = Rs. 1,000 Term = 5 years Interest rate = 6%

PV = 1,000*[{1-(1+0.06)^-5}/0.06]

PV = 1000*(0.25274/0.06)

PV = Rs. 4,212.33

What this means is that instead of paying (or receiving) the sum of Rs. 1,000 at the end of every year for five years, one can pay (or receive) an amount of Rs. 4,212.33 today, if the prevailing rate of interest is 6% per annum.

For an ordinary annuity, the FV is calculated as:

FV = P*[{(1+r)n 1}/r]

If we try to calculate the FV for the above annuity, we get:

FV = 1,000*[{(1+0.06)^5 1}/0.06]

FV = 1,000*(0.33823/0.06)

FV = 5,637.09

This means that a sum of Rs. 1,000 paid (or received) at the end of every year for five years will accumulate to Rs. 5,637.09 at the end of five years, if the prevailing rate of interest is 6% per annum.

7.3.2 Annuity Due

Payments are made (or received) at the beginning of each period. Rent is an example of annuity due. You are usually required to pay rent when you first move in at the beginning of the month, and then on the first of each month thereafter.

The formulae for the PV and FV of an annuity due are slightly different. Any handbook on Financial Management can be referred to for the same.


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7.4 Net Present Value (NPV)

The NPV of a project is the arithmetic sum of the present values of all cash flows associated with that project. Here, outflows are taken as negative and inflows are taken as positive.

The discount rate used for present valuing the cash flows is generally a reflection of the prevailing interest rates as well as the risks associated with the project.

NPV is used to evaluate projects and projects having a higher NPV are preferred over those having a lower NPV. Projects with negative NPV are generally not thought to be viable.

Formulae and examples have been dealt with in detail elsewhere in this program, and hence are not reproduced here.

7.5 Internal Rate of Return (IRR)

The IRR of a project is that rate of discounting which makes its NPV equal to zero. IRR is that rate of discounting at which the NPV of the outflows equals the NPV of the inflows.

IRR is also used to evaluate projects and projects having a higher IRR are preferred over those having a lower IRR.

Formulae and examples have been dealt with in detail elsewhere in this program, and hence are not reproduced here.


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Chapter 8

Inflation

8.1 Inflation

Inflation is the rate of increase in the generic price level of all goods and services, which results in a decrease in the purchasing power of money. (This should not be confused with increases in the prices of specific goods relative to the prices of other goods.)

Inflation is usually measured as a percentage increase in the Consumer Price Index (CPI) or the Wholesale Price Index (WPI). This percentage increase is calculated every week, and gives us the change in the index over that of the previous year. Inflation is measured in percentage per year.

The Wholesale Price Index (WPI) and Consumer Price Index (CPI) are indices made up of a basket of commodities in a fixed ratio. The composition and weights are generally not known to the public.

8.2 Factors

Inflation is dependent on some factors, and at the same time, it influences those factors too. There exists a cyclical relationship between interest rates and inflation.

Other factors are rising costs, rising demand, reducing supply, interest rates, changes in monetary policy, etc.


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Chapter 9

Risk & Returns

9.1 Risk

Risk is the degree of uncertainty regarding the rate of return on and/or the principal value of an investment. It usually refers to an event having an adverse impact on the returns or profitability from an investment or project.

A measurable possibility of losing capital (or not gaining value). The chance that invested capital will drop in value can be caused by many factors including but not restricted to inflation, interest rates, default, politics, liquidity, call provisions, etc.

9.2 Relationship between Risk and Returns

First is the principle that risk and return are directly related. The greater the risk that an investment may lose money, the greater its potential for providing a substantial return. By the same rule, the smaller the risk an investment poses, the smaller the potential return it will provide.

A startup business could become bankrupt, or it could become a blue-chip company. If you invest in the stock of this company, you could lose everything or make a fortune. In contrast, a blue chip company is less likely to go bankrupt, but youre also less likely to get rich by buying stock in company with millions of shareholders.

The second principle is that if you can get a better-than-average return on an investment with less risk, you may be willing to sacrifice potentially greater return to avoid greater risk. Thats sometimes the case when interest rates go up. Investors pull their money out of stocks, which are more risky, and put it in bonds, which are less risky, because theyre not giving up much in the way of potential return and theyre gaining more safety.

The third principle is that you can balance risk and return in your overall portfolio by making investments along the spectrum of risk, from the most to the least. Diversifying your portfolio in this way means that some of your investments have the potential to provide strong returns while others ensure that part of your principal is secure.

9.3 Types of Risk

There are two basic types of risk are:

Market or Systematic Risk: A risk that influences a large number of assets or investments. An example is political events. It is virtually impossible to protect yourself against this type of risk if you are restricted to a single market.

Unique or Specific Risk: It is the risk that affects a very small number of assets or investments, or is specific to a particular asset or investment. An example is news that affects a specific stock such as a sudden strike by employees.

Diversification is the only way to protect your investments from unsystematic risk.


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9.4 Specific types of risk in connection with investments

Operational Risk: Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.

Operational risk includes legal risk, but excludes strategic risk: i.e. the risk of a loss arising from a poor strategic business decision. It also excludes reputational risk (damage to an organization through loss of its reputation or standing).

Non-operational Risk: Non-operational risk would refer to all other risks such as credit (or default) risk, market risk, liquidity risk, country risk (may be political or currency risk), catastrophe risk, interest rate risk, etc.

9.4.1 Types of Non operational risks

Credit or Default Risk: This is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bond's within their portfolio. Government bonds, especially those issued by the Federal government, have the least amount of default risk and least amount of returns while corporate bonds tend to have the highest amount of default risk but also the higher interest rates. Bonds with lower chances of default are considered to be investment grade, and bonds with higher chances of default are considered to be junk bonds. Bond rating services, such as Moody's, allows investors to determine which bonds are investment-grade, and which bonds are junk.

Country Risk: This refers to the risk that a country won't be able to honor its financial commitments. When a country defaults it can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit.

Foreign Exchange or Currency Risk: When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well. Foreign exchange risk applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you are a resident of America and invest in some Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the American dollar.

Interest Rate Risk: A rise in interest rates during the term of your debt securities hurts the performance of stocks and bonds.

Political Risk: This represents the financial risk that a country's government will suddenly change its policies. This is a major reason that second and third world countries lack foreign investment.

Market Risk: This is the most familiar of all risks. It's the day to day fluctuations in a stocks price. It is also referred to as volatility. Market risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear marketvolatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behavior, or temperament, of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance it can go dramatically either way.


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Chapter 10

Financial Planning

10.1 Financial Planning

Financial Planning is the organization of financial affairs so as to achieve specific goals or objectives, keeping in mind the age, risk and returns profile etc. For an individual, it is the process of process of meeting his (or her) lifes goals through the proper management of finances. These can include buying a home, saving for childs education, marriages, planning for retirement or estate planning, as well as unexpected emergencies.

10.2 Steps in Financial Planning

Budgeting, saving, investing, reviewing, retirement allocation, insurance allocation, contingency planning and taxes.

Some steps for financial planning:

Set measurable goals.

Understand the effect your financial decisions have on other financial issues.

Re-evaluate your financial plan periodically.

Start now dont assume financial planning is for when you get older.

Start with what youve got dont assume financial planning is only for the wealthy.

Take charge you are in control of the financial planning process.

Look at the big picture financial planning is more than just retirement planning or tax-planning.

Dont confuse financial planning with investing.

Dont expect unrealistic returns on investments.

Dont wait until a money crisis to begin financial planning.


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Case Study: Consider a young man who wants to plan his finances:

Married, spouse working, no children. Combined earnings Rs. 45,000 per month Expenses Rs. 25,000 per month (including compulsory savings) Savings Rs. 20,000 per month How to plan for the future? Age: 27 years. Income growth > Expense growth Retire at 55 years.

How would you plan?

There is no fixed solution here; no right solution and no wrong solution either. What can be done is:

Net investible amount is Rs. 2,40,000 per annum.

65% can be invested in equities, either directly, or through SIP in a mutual fund. Break-up of 50% in medium-term assets and 15% in long-term assets (retirement planning)

He can go in for a high risk sectoral fund or an index fund (for the 50%) and a blue-chip equity fund (for the balance 15%)

20% can be deployed towards life insurance, either a unit-linked plan or a whole-life plan which offers maximum term coverage along with good returns and tax benefits.

The balance 15% can be put in a bank, on short term deposit, renewed fortnightly, or else put in a liquid fund. This will take care of liquidity and emergencies, if any.

This can be continued for the next 2 to 3 years, and reviewed.


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Chapter 11

Insurance

11.1 What is Insurance?

Insurance is a form of risk management primarily used to hedge against the risk of potential loss.

It is defined as the equitable transfer of the risk of a potential loss, from one entity to another, in exchange for a reasonable fee and duty of care.

11.2 Principles of insurance

The timing or occurrence of the loss must be uncertain.

The rate of losses must be relatively predictable: In order to set premiums (charges) insurers must be able to estimate them accurately. If the coverage is unique, the insured will pay a correspondingly higher premium.

The losses must be predictable on a macro level: Insurers need to know how much they would be required to pay when the insured-for event occurs. Most types of insurance have maximum levels of payouts, but not all do, notably health insurance.

The loss must be significant.

The loss must not be catastrophic: If the insurer is insolvent, it will be unable to pay the insured.

Indemnification

An entity seeking to transfer risk (an individual, corporation, or association of any type) becomes the 'insured' party once risk is assumed by an 'insurer', the insuring party, by means of a contract, defined as an insurance 'policy'.

This legal contract sets out terms and conditions specifying the amount of coverage (compensation) to be rendered to the insured, by the insurer upon assumption of risk, in the event of a loss, and all the specific perils covered against (indemnified), for the term of the contract.

When insured parties experience a loss for a specified peril, the coverage entitles the policyholder to make a 'claim' against the insurer for the amount of loss as specified by the policy contract.

The fee paid by the insured to the insurer for assuming the risk is called the 'premium'.

Insurance premiums from many clients are used to fund accounts set aside for later payment of claims - in theory for a relatively few claimants - and for overhead costs. So long as an insurer maintains adequate funds set aside for anticipated losses, the remaining margin becomes their profit.


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11.3 Types of insurances available worldwide:

Any risk that can be quantified probably has a type of insurance to protect it. Among the different types of insurance are:

Automobile Insurance: may cover both legal liability claims against the driver and loss of or damage to the vehicle itself.

Casualty Insurance insures against accidents, not necessarily tied to any specific property.

Credit Insurance pays some or all of a loan back when certain things happen to the borrower such as unemployment, disability, or death.

Financial loss Insurance protects individuals and companies against various financial risks. For example, a business might purchase cover to protect it from loss of sales if a fire in a factory prevented it from carrying out its business for a time. Insurance might also cover failure of a creditor to pay money it owes to the insured.

Health Insurance covers medical bills incurred because of sickness or accidents.

Liability Insurance covers legal claims against the insured. For example, a housing insurance policy provides the insured with protection in the event of a claim brought by someone who slips and falls on the property, and brings a lawsuit for her injuries. Similarly, a doctor may purchase liability insurance to cover any legal claims against him if his negligence (carelessness) in treating a patient caused the patient injury and/or monetary harm. The protection offered by a liability insurance policy is two-fold: a legal defense in the event of a lawsuit commenced against the policyholder, plus indemnification (payment on behalf of the insured) with respect to a settlement or court verdict.

Life Insurance provides a cash benefit to a decedent's family or other designated beneficiary, and may specifically provide for burial and other final expenses.

How it works: The investible part of the contribution grows to a corpus which is usually returned with all accrued bonuses to the person insured on maturity.

The risk cover portion ensures that the nominees of the insured person get the full value of the insurance sum assured in the case of unforeseen occurrences.

It is possible to have adequate life insurance at an affordable rate if one starts early in life.

Annuities provide a stream of payments and are generally classified as insurance because they are issued by insurance companies and regulated as insurance. Annuities and pensions that pay a benefit for life are sometimes regarded as insurance against the possibility that a retiree will outlive his or her financial resources. In that sense, they are the complement of life insurance.

Total Permanent Disability Insurance provides benefits when a person is permanently disabled and can no longer work in their profession, often taken as an adjunct to life insurance.

Locked Funds Insurance is a little known hybrid insurance policy jointly issued by governments and banks. It is used to protect public funds from tamper by unauthorized parties.

Marine Insurance covers the loss or damage of goods at sea. Marine insurance typically compensates the owner of merchandise for losses sustained from fire, shipwreck, etc., but excludes losses that can be recovered from the carrier.


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Nuclear Incident Insurance: covers against damages resulting from an incident involving radioactive materials is generally arranged at the national level.

Political Risk Insurance can be taken out by businesses with operations in countries in which there is a risk that revolution or other political conditions will result in a loss.

Professional Indemnity Insurance is normally a mandatory requirement for professional practitioners such as Architects, Lawyers, Doctors and Accountants to provide insurance cover against potential negligence claims. Non licensed professionals may also purchase malpractice insurance; it is commonly called Errors and Omissions Insurance and covers a service provider for claims made against them that arise out of the performance of specified professional services. For instance, a web site designer can obtain E&O insurance to cover them for certain claims made by third parties that arise out of negligent performance of web site development services.

Property Insurance provides protection against risks to property, such as fire, theft or weather damage. This includes specialized forms of insurance such as fire insurance, flood insurance, earthquake insurance, home insurance, inland marine insurance or boiler insurance.

Terrorism Insurance: as the name suggests, provides for loss of business or property in incidents occurring from terrorism.

Title Insurance provides a guarantee that title to real property is vested in the purchaser and/or mortgagee, free and clear of liens or encumbrances. It is usually issued in conjunction with a search of the public records done at the time of a real estate transaction.

Travel Insurance is an insurance cover taken by those who travel abroad, which covers certain losses such as medical expenses and theft.

Workers' Compensation Insurance replaces all or part of a worker's wages lost and accompanying medical expense incurred due to a job-related injury.

11.4 Classification of Insurance Companies

Insurance companies may be classified as

Life insurance companies: who sell life insurance, annuities and pension products.

Non-life or general insurance companies: who sell other types of insurance.

The distinction between the two types of company is that life business is very long term in nature coverage for life assurance or a pension can cover risks over many decades. By contrast, non-life insurance cover usually covers a shorter period, such as one year.

Reinsurance companies are insurance companies that sell policies to other insurance companies, allowing them to reduce their risks and protect themselves from very large losses. The reinsurance market is dominated by a few very large companies, with huge reserves.


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Bibliography and References

Books

Financial Management Theory & Practice by Prasanna Chandra

Principles of Corporate Finance by Brealey & Myers

Essentials of Investment by Bodie, Kane & Marcus

Websites

http://www.investopedia.com/

http://www.wikipedia.org/

http://www.finpipe.com/

http://www.finance-glossary.com/


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Corporate Finance Module 2

TABLE OF CONTENTS

1 FORMS OF BUSINESS ENTERPRISE 33

1.1. Sole Proprietorship .. 33 1.2. Partnership .... 33 1.3. Private Limited Company 33 1.4. Public Limited Company . 33 1.5. Co-operative Society 34 1.6. Features of a Corporate Body 34

2 RAISING FINANCIAL RESOURCES .. 35 2.1. Equity Capital ... 35

2.1.1 Companys Perspective 35 2.1.2 Shareholders Perspective 35 2.1.3 Raising Equity Capital ... 36

2.2. Preference Shares ..................... 36 2.2.1 Types of Preference Shares ................... 36

2.3. Debenture Capital ................... 37 2.3.1 Companys Perspective 37 2.3.2 Investors Perspective 38

2.4. Term Loan ..... 38 2.5. External Commercial Borrowing (ECB) . 38 2.6. Internal Sources of Finance ...................... 38

2.6.1 Working Capital Management.. 39

3 CAPITAL STRUCTURE . 42 3.1. Introduction 42 3.2. Capital Structure Impact .. 42 3.3. Factory Affecting Capital Structure 43

4 COST OF CAPITAL 44 4.1. Introduction 44 4.2. Weighted Average Cost of Capital (WACC) 44 4.3. Calculating WACC ... 44

5 CAPITAL BUDGETING . 46 5.1. Introduction 46 5.2. Methods .................... 46

5.2.1 Net Present Value .. 46 5.2.2 Internal Rate of Return (IRR) ... 47 5.2.3 Payback Period (PP) . 49

6 BIBLIOGRAPHY & REFERENCES . 50


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Chapter 1

Forms of Business Enterprises

The financial decision of a firm is influenced by legal form of its organization, the regulatory framework governing it and the tax law applicable to it. Hence it is very important for us to know and understand different forms of business

Following are the important forms of business organizations

Sole Proprietorship

Partnership

Private Limited Company

Public Limited Company

Cooperative Society

1.1 Sole Proprietorship

A sole proprietorship is a business that is owned by one individual. It is the simplest form of business organisation to start and maintain. The business has no separate status apart from the owner. Owner undertakes the risks of the business for all assets owned, whether used in the business or personally owned. He realises all the profits, bears all the losses and incur all the Liabilities of the business. Income earned by sole proprietorship is taxable under personal income tax. There is no separate firm tax.

1.2 Partnership

A partnership firm is business firm owned by two or more persons who agreed to share profits of the business. There must be an agreement entered in to orally or in writing by persons desire specifying capital contribution, profit sharing, rights, duties and liabilities to form a partnership. The business must be carried on by all the partners or by any of them acting for all of them. As partnership firm involve two or more people can benefit from expertise of the partners, but the life of partnership firm is rather limited as withdrawal, conflict or death of any of the partners may result in dissolution of the partnership firm.

The Partnership Act does not put any restrictions on maximum number of partners. However, section 11 of Companies Act prohibits partnership consisting of more than 20 members, unless it is registered as a company.

1.3 Private Limited Company

A private limited company can be formed with minimum of two and Maximum of fifty people subscribing to its share capital. Shares of Private limited company are not freely transferable.

1.4 Public Limited Company

A public limited company is a corporate body that has a Minimum of seven share holders and does not limit the number of share holders. It issues securities through IPO and which are traded at the exchange. Ownership of the company represented by equity shares is easily transferable. All Public


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Limited companies need to make disclosure of accounting, financial and other important information.

1. 5 Cooperative Society

A cooperative society may be defined as a Society which has its objective the promotion of economic interests of its members in accordance with cooperative principles. While there is no maximum limit for membership a minimum of ten members are required to form a Cooperative society. Member of a cooperative society have right of only one vote, irrespective of the number of shares held of any denomination.

1.6 Features of a Corporate Body

Corporate form of business organisation (whether it is a Private company or a Public Company) has following salient features

Distinct Legal Entity: A company is a distinct legal entity separate from its owners.

It can own assets, incur liability, enter in to contract, sue and can be sued by others.

As company is a separate legal entity there is always a distinction between company and its owners.

Limited Liability: Unlike in a partnership or sole proprietorship, members of a corporation hold no liability for the corporation's debts and obligations, As a result their "limited" potential losses cannot exceed the amount which they contributed to the corporation as dues or paid for shares

Perpetual Lifetime: The assets and structure of the corporation exist beyond the lifetime of any of its members or agents.


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Chapter 2

Raising Financial Resources

Companies require funds for two important reasons. To invest in capital assets this also referred as capital investment and to manage working capital finance.

Capital investment require generally require large funds and benefit of capital investment is enjoyed over longer period of time. Investment bank executing the ambitious plan of computerization of its operations or a commercial bank setting up a retail branches are some of the examples.

To meet the day to day fund requirement for expenses like salaries, wages, raw material etc this is termed as working capital finance, generally short term in nature.

Sources of Long term funds

Equity Capital

Preference Capital

Internal Sources of Finance

Debenture Capital

Term Loan

External Commercial Borrowing

2.1 Equity Capital

2.1.1 Company's Perspective

Equity capital represents ownership capital as equity share holders collectively own the company. Equity capital is permanent in nature. As long as company continues to be in existence company need not repay capital to its equity share holders, hence no liability for repayment.

It also does not involve any fixed obligation for repayment of dividend. Equity share holders are entitled to dividend that is declared by the board of directors. Dividend decision is the prerogative of the board of directors and equity share holders cannot challenge their decision.

Cost of equity capital is high, usually the highest. The rate of return required by equity share holders is generally higher than rate of return required by other investors.

Issuance of additional equity shares may lead to dilution of management control as every new share holder will have voting rights proportion to number of shares issued to the new share holder.

2.1.2 Equity Capital - Shareholder's Perspective

Equity share holders as owners of the company elect the board of directors of the company and have the right to vote on every resolution placed before the company. Board of directors in turn, selects the management which controls the operations of the firm.


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The liability of equity share holders is limited to the extent of their capital contributions. In the event of liquidation they can loose only to the extent of share capital contributed by them.

As equity share investors have residual claim to the income of the firm, income left after satisfying the claims of all other investors belong to the equity share holders. They can expect returns in terms of dividend income and capital gains, which can be very high.

But equity share holders also face the risk of not only zero return on their investment but also capital loss.

Equity shares are traded at the stock exchange hence can be bought or sold at the exchange they are comparatively very liquid.

2.1.3 Raising Equity Capital

Initial Public Offer (IPO) is a most important way of raising equity capital. This is the first sale of stock by a company to the public. Both institutional investors and retail investors can participate in IPO.

Private placements This involves selling securities to small group of investors. Less regulated as no public offering is involved hence easier to raise funds.

Rights Issue This is a method of raising further funds from existing share / debenture holders

Companies can access global capital Markets through issue of GDR, ADR

American Depository Receipt (ADR) American Depository Receipt is a Negotiable certificate issued by US bank which represents specified number of shares of an underlying company. ADRs listed in a American stock exchange.

Global depository Receipt (GDR) - Global Depository Receipt is a Negotiable certificate issued by an international bank which represents specified number of shares of an underlying company. GDRs listed in a American or European stock exchange

Foreign Currency Convertible Bonds Issued to foreign investors in foreign currency and convertible into ordinary shares of the issuing company in any manner, either in whole, or in part, on the basis of any equity related warrants attached to debt instruments

2.2 Preference Capital

It represents hybrid form of financing with some features of equity and some attributes of debenture. It resembles equity in the following ways. Preference dividend is payable only out of distributable profits and it is not a tax deductible expense and like debenture rate of dividend is fixed and no voting rights to preference share holders under normal circumstances.

2.2.1 Types of preference shares

Cumulative Preference Shares: Preference shares may be cumulative or Non-cumulative with respect to dividends. Unpaid dividend on cumulative preference shares are carried forward and payable when the dividend is resumed.

Perpetual Preference Shares: A perpetual preference shares has no maturity period.


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Where as Redeemable Preference Shares has a limited life after which it is suppose to be retired. Most preference issues are redeemable.

Callable Preference Shares: The terms of preference shares may contain a call feature by which issuing company enjoys the right to call the preference shares, wholly or partly at a certain price.

Convertible Preference Shares: Preference shares may some times be convertible in to equity shares. The holders of convertible preference shares enjoy the option of converting preference shares in to equity shares at a predetermined ratio.

Participating Preference Shares: Preference shares which entitle preference share holders to participate in surplus profits and residual assets in the event of liquidation according to a specific formula are called Participating Preference Shares.

Example

Raj buys 10,000 equity shares of XYZ co at Rs. 200 also buys 5,000 pref shares at Rs.101 on 01-Jan-2005.He sells equity shares on 31-dec-2005 at Rs.250. Brokerage paid is 1% each.

XYZ co has issued 1000000 equity shares @ FV of Rs.10 and 10000Pref shares @ FV of Rs.100 What is his voting rights as on 30-jun-2005? What is his return on Investment?

Solution.

As preference shares under normal circumstances not eligible for voting rights,

We calculate voting rights only on the basis of his equity shares holding as on 30-jun-2005

Raj has 10,000 shares as on 30th June he has 1% voting rights. (10000/1000000)

Solution.

To calculate return,

Cost of Acquisition of shares is 10000 x 200 = 2000000 + brokerage 20000(2000000 x.01) = 2020000

Sale proceeds = 10000 x 250 = 2500000 brokerage25000 - 2475000

Profit = 455000.

Return = 22.52%

2.3 Debenture capital

2.3.1 Companys Perspective

Debentures are instruments for raising long term debt capital. Debenture holders are creditors of the company. Company has an obligation to pay the interest and principal at specified times.

Cost of debt capital represented by debenture capital is lower than the cost of preference or equity capital. Interest on debenture is also tax deductible and hence effective post tax cost of debenture is lower. As Debenture holders are not entitled to vote debenture financing does not result in dilution of control.


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Fixed monitory burden associated with debenture financing irrespective of changes in price level has appeal to many companies.

2.3.2 Investor's Perspective

Debenture holders earn stable rate of return to a larger extent even if there is a fluctuation in companys profits. Debenture holders have higher order of priority over equity share holders in the event of Liquidation .Interest on debenture is fully taxable and debenture share holders do not carry right to vote.

2.4 Term Loans

Represents source of debt finance which is generally repayable in more than one year.

Term loans are generally employed to finance acquisition of fixed assets and working capital margin. Interest on term loan is definite obligation that is payable irrespective of the financial situation of the firm.

2.5 External Commercial Borrowing

ECBs occupy a very important position as a source of funds for Corporate.

ECBs include

Commercial bank loans;

Buyer's credit

Supplier's credit

Securitised instruments (Floating Rates Notes and Fixed Rate Bonds).

Credit from official export credit agencies.

Borrowings from Multilateral Financial Institutions such as International Finance Corporation, ADB, AFIC, CDC. Etc

As repayment needs to be done in borrowed currency exchange rate risk exists for all the ECBs.

2.6 Internal Sources of Finance

Internal sources are often preferable to a firm as they will usually be cheaper and perhaps easier to arrange.

Depreciation charges and retained earning represents internal sources of finance.

Although depreciation charges are debited from profit and loss account it does not represent actual cash out flow. Retained earning represents part of profits which are not distributed as dividend and which remains with the corporate is used to fund expansion plans.

Working Capital Finance

Equity: New businesses rely on equity funds for short-term working capital needs.

Trade Credit :A company's open account arrangements with its vendor


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Factoring: Factoring is another resource for short-term working capital financing. Once you have filled an order, a factoring company buys your account receivable and then handles the collection.

Line of Credit: A line of credit allows you to borrow funds for short-term needs when they arise. The funds are repaid once you collect the accounts receivable that resulted from the short-term sales peak.

Commercial Paper: An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities

Letter of Credit :A letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount

2.6.1 Working Capital Management

Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities

It ensures that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses.

The management of working capital involves managing inventories, accounts receivable and payable, and cash

In the management of working capital two important characteristics of current assets must be borne in mind. 1. Short Life span 2. Swift transformation into other forms of asset.

Each current asset is swiftly transformed in to other asset forms within a short period of time. Cash is used for acquiring raw materials, raw materials through various stages of work in progress converted in to finished goods. When finished goods are sold on credit are converted in to accounts receivables and finally accounts receivables on realisation generate cash.

Cash flows in a cycle into, around and out of a business. It is the business's life blood and every manager's primary task is to help keep it flowing and to use the cashflow to generate profits. If a business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn't generate surpluses, the business will eventually run out of cash and expire

The faster a business expands, the more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right within business. Good management of working capital will generate cash will help improve profits and reduce risks. Bear in mind that the cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm's total profits.

There are two elements in the business cycle that absorb cash - Inventory (stocks and work-in-progress) and Receivables (debtors owing you money). The main sources of cash are Payables (your creditors) and Equity and Loans.

Each component of working capital (namely inventory, receivables and payables) has two dimensions ........ TIME ......... and MONEY. When it comes to managing working capital - TIME IS MONEY. If you can get money to move faster around the cycle (e.g. collect monies due from debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory levels relative to sales), the business will generate more cash or it will need to borrow less money to fund working capital. As a consequence, you could reduce the cost of bank interest or you'll have additional free money available to support additional sales growth or investment. Similarly, if you can negotiate


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improved terms with suppliers e.g. get longer credit or an increased credit limit, you effectively create free finance to help fund future sales.

If you ....... Then ...... Collect receivables (debtors)

faster You release cash from the cycle

Collect receivables (debtors) slower

Your receivables soak up cash

Get better credit (in terms of duration or amount) from suppliers

You increase your cash resources

Shift inventory (stocks) faster You free up cash

Move inventory (stocks) slower You consume more cash

It can be tempting to pay cash, if available, for fixed assets e.g. computers, plant, vehicles etc. If you do pay cash, remember that this is now longer available for working capital. Therefore, if cash is tight, consider other ways of financing capital investment - loans, equity, leasing etc. Similarly, if you pay dividends or increase drawings, these are cash outflows and, like water flowing down a plug hole, they remove liquidity from the business


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Following are the important terms of Payment

Cash Terms: When goods are sold on cash terms the payment is received either before the goods are shipped or when the goods are delivered.

Open Account: This happens when the seller first ships the goods and then sends the invoice. Credit terms are stated in the invoice which is acknowledged by the buyer.

Consignment: The consignment means the transfer of possession of merchandise from the owner to another person who sells it as the sales agent of the owner

Draft: A draft represents an unconditional order issued by the seller asking the buyer to pay on demand (demand draft) or at a certain future date (Time draft)

Letter of Credit (L C): A letter of credit is issued by a bank on behalf of its customer (buyer) to the seller. As per this document bank agrees to honour draft drawn on it for the supplies made to the customer if the seller fulfills the condition laid down in LC.

LC virtually eliminates credit risk, if the bank has a good standing. It reduces uncertainty as the seller knows the conditions that should be fulfilled to receive payment. It also offers safety to the buyer who wants to ensure that payment is made only in conformity with the conditions of LC


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Chapter 3

Capital Structure

3.1 Introduction

A firm can finance operations through common and preferred stock, with retained earnings, or with debt. Usually a firm will use a combination of these financing instruments.

The proportion of short and long-term debt is considered when analyzing capital structure. And, when people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk.

Capital structure explains the proportion of equity and debt capital. Since, the objective of financial management is to maximize the shareholder wealth, the proportion of the debt and equity capital in the capital structure is decided accordingly. The key issue in the capital structure decision is: what is the relationship between capital structure and cost of capital? Since, the value of a firm is maximized when the cost of capital is minimized and vice versa.

3.2 Capital Structure - Impact

The following example describes how capital structure impacts the shareholders wealth as the companys revenue change.

Company A with 1,000,000 equity capital of Rs. 10/- each

Company B with 500,000 equity capital of Rs. 10/- each and 12% 500,000 debentures of Rs. 10/- each

Tax rates applicable: 50%, both the companies have same earnings

Company A Company B PBIT 1,000,000 1,200,000 1,000,000 1,200,000

Interest Nil Nil 600,000 600,000 PBT 1,000,000 1,200,000 400,000 600,000 Tax 500,000 600,000 200,000 300,000 PAT 500,000 600,000 200,000 300,000 EPS 0.5 0.6 0.4 0.6

Company A Company B

PBIT 3,000,000 4,000,000 3,000,000 4,000,000 Interest Nil Nil 600,000 600,000

PBT 3,000,000 4,000,000 2,400,000 3,400,000 Tax 1,500,000 2,000,000 1,200,000 1,700,000 PAT 1,500,000 2,000,000 1,200,000 1,700,000 EPS 1.5 2 2.4 3.4


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The capital structure concerns the proportion of capital that is obtained through debt and equity. There are tradeoffs involved: using debt capital increases the risk associated with the firm's earnings, which tends to decrease the firm's stock prices. At the same time, however, debt can lead to a higher expected rate of return, which tends to increase a firm's stock price. "The optimal capital structure is the one that strikes a balance between risk and return and thereby maximizes the price of the stock and simultaneously minimizes the cost of capital."

3.3 Factors Affecting Capital Structure

Capital structure decisions depend upon several factors. One is the firm's business riskthe risk pertaining to the line of business in which the company is involved. Firms in risky industries, such as high technology, have lower optimal debt levels than other firms. Another factor in determining capital structure involves a firm's tax position. Since the interest paid on debt is tax deductible, using debt tends to be more advantageous for companies that are subject to a high tax rate and are not able to shelter much of their income from taxation.

A third important factor is a firm's financial flexibility, or its ability to raise capital under less than ideal conditions. Companies that are able to maintain a strong balance sheet will generally be able to obtain funds under more reasonable terms than other companies during an economic downturn. In general, companies that tend to have stable sales levels, assets that make good collateral for loans, and a high growth rate can use debt more heavily than other companies. On the other hand, companies that have conservative management, high profitability, or poor credit ratings may wish to rely on equity capital instead.


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Chapter 4

Cost of Capital

4.1 Introduction

Cost of Capital is the required return necessary to make a capital budgeting project worthwhile, such as building a new factory. Cost of capital would include the cost of debt and the cost of equity.

The Cost of Capital for any investment, whether for an entire company or for a project, is the rate of return capital providers would expect to receive if they would invest their capital elsewhere. In other words, the cost of capital is an opportunity cost.

The Cost of Capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if they invested their money someplace else with similar risk.

"Capital is a necessary factor of production and, like any other factor, it has a cost". In the case of debt capital, the cost is the interest rate that the firm must pay in order to borrow funds. For equity capital, the cost is the returns that must be paid to investors in the form of dividends and capital gains. Since the amount of capital available is often limited, it is allocated among various businesses on the basis of price.

For a proper analysis of capital expenditure decisions, which are the most important decisions taken by a company, an estimate of the cost of capital is required. Several other decisions like leasing, long-term financing, and working capital policy require estimates of cost of capital. In order to maximize the value of the company, costs of all inputs must be minimized and in this context the firm should be able to measure the cost of capital.

For an investment to be worthwhile the return on capital must be greater than the cost of capital. Companies create value for shareholders by earning a return on the invested capital that is above the cost of capital.

The cost of capital is also used for Capital Budgeting purposes. Under the Net Present Value Method (NPV), the cost of capital is used as the Discount Rate to calculate the present value of future cash inflows. Under the Internal Rate of Return Method (IRR), it is used to make an accept-or-reject decision by comparing the cost of capital with the internal rate of return on a given project. A project is accepted when the internal rate exceeds the cost of capital.

4.2 Weighted Average Cost of Capital (WACC)

WACC (Weighted Average Cost of Capital) is an expression of this cost and is used to see if certain intended investments or strategies or projects or purchases are worthwhile to undertake.

WACC is expressed as a percentage, like interest. So for example if a company works with a WACC of 12%, than this means that only (and all) investments should be made that give a return higher than the WACC of 12%.

4.3 Calculating WACC

The easy part of WACC is the debt part of it. In most cases it is clear how much a company has to pay their bankers or bondholders for debt finance. More elusive however, is the cost of equity


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finance. Normally the cost of equity finance is higher than the cost of debt finance, because the cost of equity involves a risk premium. Calculating the risk premium is one thing that makes calculating WACC complicated.

Another important complication is which mix of debt and equity should be used to maximize shareholder value (This is what Weighted means in WACC).

Finally, the corporate tax is also important, as interest payments are generally tax-deductible.

Formula:

WACC = Proportion of Equity * Cost of equity + Proportion of Debt * Cost of debt (1-Tax)

Proportion of Equity is derived from Equity / Total Financing** Proportion of Debt is derived from Debt / Total Financing

** Total financing consists of sum of the market values of debt and equity finance.

Example: Suppose XYZ company has the following costs and values:

Market value of Debt: Rs. 300,000,000 Market value of Equity: Rs. 400,000,000 Cost of debt: 8% Cost of equity: 18% Tax: 35%

WACC = [(400/700) * 18%] + [(300/700) * 8% (1-35%)] = 12.5%


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Chapter 5

Capital Budgeting

5.1 Introduction

Capital Budgeting is a process of determining investment in a project / asset that is expected to produce a cash inflow over a period of time.

5.2 Methods

Popular capital budgeting methods are

Net Present Value (NPV)

Internal Rate of Return (IRR)

Pay back period

5.2.1 Net Present Value:

The Net Present Value (NPV) of an investment (project) is the difference between the sum of the discounted cash flows which are expected from the investment and the amount which is initially invested. It is a traditional valuation method for a project used in the Discounted Cash Flow measurement methodology, whereby the following steps are undertaken:

Calculation of expected fresh cash flows per year that result out of the investment

Subtract / discount for the cost of capital (an interest rate to adjust for time and risk)

Subtract the initial investments

The intermediate result is called: Present value

The end result is NPV

So NPV is an amount that expresses how much value an investment will result in. This is done by measuring all cash flows over time back towards the current point in present time. If the NPV method results in a positive amount, the project should be undertaken.

In other words, NPV of a project is equal to the sum of the present values of the all the cash flows associated with it.

C 0 C1 Cn n C t NPV = --------- + --------- + + ------- = --------- (1+r)0 (1+r) (1+r)n t=0 (1+r)t

C = cash flow n = Life of the project r = discount rate


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For Example:

ABC Co invested in a project which has following cash flows. Cost of capital is 12%

Year Cash Flow 0 -100000 1 50000 2 50000 3 40000 NPV = - 100000 50000 50000 40000 --------- + --------- + --------- + ---------- = 12,973.76 (1.12)0 (1.12)1 (1.12)2 (1.12)3

5.2.2 Internal Rate of Return (IRR):

The IRR is the discount rate that results in a net present value of zero for a series of future cash flows. It is a Discounted Cash Flow approach to valuation and investing just as Net Present Value. Both IRR and NPV are widely used to decide which investments to undertake and which investments not to make.

NPV is expressed in monetary units and IRR is expressed as a percentage.

In other words, Internal Rate of Return is the discount rate which makes its Net present value of all cash flows equal to zero.

IRR can be calculated for the earlier example as follows:

50000 50000 40000 100000 = --------- + --------- + ------------ = 19.69% (1+ r)1 (1+r)2 (1+r)3

Advantages and disadvantages of IRR and NPV

In practice, the IRR method is more popular than the NPV approach. The reason may be that the IRR is straightforward, but it uses cash flows and recognizes the time value of money, like the NPV. In other words, while the IRR method is easy and understandable, it does not have the drawbacks of the ARR and the payback period, both of which ignore the time value of money.

The main problem with the IRR method is that it often gives unrealistic rates of return. Suppose the cutoff rate is 11% and the IRR is calculated as 40%. Does this mean that the management should immediately accept the project because its IRR is 40%. The answer is no! An IRR of 40% assumes that a firm has the opportunity to reinvest future cash flows at 40%. If past experience and the economy indicate that 40% is an unrealistic rate for future reinvestments, an IRR of 40% is suspect. Simply speaking, an IRR of 40% is too good to be true! So unless the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a yardstick to accept or reject a project.

Another problem with the IRR method is that it may give different rates of return. Suppose there are two discount rates (two IRRs) that make the present value equal to the initial investment. In this case, which rate should be used for comparison with the cutoff rate? The purpose of this question is not to resolve the cases where there are different IRRs. The purpose is to let you know that the IRR method, despite its popularity in the business world, entails more problems than a practitioner may think.


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Why the NPV and IRR sometimes select different projects

When comparing two projects, the use of the NPV and the IRR methods may give different results. A project selected according to the NPV may be rejected if the IRR method is used.

Suppose there are two alternative projects, X and Y. The initial investment in each project is $2,500. Project X will provide annual cash flows of $500 for the next 10 years. Project Y has annual cash flows of $100, $200, $300, $400, $500, $600, $700, $800, $900, and $1,000 in the same period.

Using the trial and error method explained before, you find that the IRR of Project X is 17% and the IRR of Project Y is around 13%. If you use the IRR, Project X should be preferred because its IRR is 4% more than the IRR of Project Y. But what happens to your decision if the NPV method is used? The answer is that the decision will change depending on the discount rate you use. For instance, at a 5% discount rate, Project Y has a higher NPV than X does. But at a discount rate of 8%, Project X is preferred because of a higher NPV.

The purpose of this numerical example is to illustrate an important distinction: The use of the IRR always leads to the selection of the same project, whereas project selection using the NPV method depends on the discount rate chosen.

Project size and life

There are reasons why the NPV and the IRR are sometimes in conflict: the size and life of the project being studied are the most common ones. A 10-year project with an initial investment of $100,000 can hardly be compared with a small 3-year project costing $10,000. Actually, the large project could be thought of as ten small projects. So if you insist on using the IRR and the NPV methods to compare a big, long-term project with a small, short-term project, dont be surprised if you get different selection results. (See the equivalent annual annuity discussed later for a good way to compare projects with unequal lives.)

Different cash flows

Furthermore, even two projects of the same length may have different patterns

Documents

Full Final IFP Reference 2007