Financial Management

FINANCIAL MANAGEMENT FINANCIAL MANAGEMENT

Course Code: 501 & 502Course Code: 501 & 502

Prof. Subir Sen – Faculty Member Prof. Subir Sen – Faculty Member ICFAIICFAIE-Mail:E-Mail: [email protected] / [email protected] / 9830697368

Ref:Ref: 1) Financial Management – 1) Financial Management – Prasanna ChandraPrasanna Chandra

2) Financial Management – 2) Financial Management – I. M. PandeyI. M. Pandey

3) Financial Management –3) Financial Management – Khan & Jain Khan & Jain

4) Financial Management – 4) Financial Management – James Van HorneJames Van Horne

5) Financial Institutions & Markets –5) Financial Institutions & Markets – L. M. Bhole L. M. Bhole

6) Indian Financial System –6) Indian Financial System – M. Y. Khan M. Y. Khan

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INTRODUCTIONINTRODUCTION

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WHAT IS FINANCIAL MANAGEMENT?WHAT IS FINANCIAL MANAGEMENT?

– Book Keeping –Book Keeping – It is the process of recording of It is the process of recording of financial information relating to business financial information relating to business operations in a systematic and orderly manner.operations in a systematic and orderly manner.

– Financial Accounting –Financial Accounting – It is the process of It is the process of identifying financial transactions, followed by identifying financial transactions, followed by condensation and classification, then subsequently condensation and classification, then subsequently summarizing and recording them with the summarizing and recording them with the objective of communicating them for analysis and objective of communicating them for analysis and interpretation.interpretation.

– Financial Management –Financial Management – It involves the It involves the presentation of accounting information in a way so presentation of accounting information in a way so as to assist the management in financial decision as to assist the management in financial decision making and enhancing shareholder value.making and enhancing shareholder value.

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OBJECTIVES OF FINANCIAL OBJECTIVES OF FINANCIAL ACCOUNTINGACCOUNTING

– To keep systematic records.To keep systematic records.– To protect business properties.To protect business properties.– To ascertain operational profit or loss.To ascertain operational profit or loss.– To assist in management decision making.To assist in management decision making.– To assess tax liability.To assess tax liability.– To furnish periodical government returns.To furnish periodical government returns.– To assess organizational health.To assess organizational health.– To prevent errors and fraud.To prevent errors and fraud.– To prevent asset – liability mismatch (ALM).To prevent asset – liability mismatch (ALM).

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USERS OF FINANCIAL INFORMATIONUSERS OF FINANCIAL INFORMATION

– Shareholders.Shareholders.– Managers.Managers.– Creditors.Creditors.– Investors & Prospective Investors.Investors & Prospective Investors.– Government.Government.– Employees.Employees.– Bankers.Bankers.– Local Bodies.Local Bodies.– Acquirers (i.e. Due Diligence Exercise).Acquirers (i.e. Due Diligence Exercise).– Court.Court.– General Public.General Public.

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ACCOUNTING Vs FINANCIAL ACCOUNTING Vs FINANCIAL MANAGEMENTMANAGEMENT

– Users of Information : External – InternalUsers of Information : External – Internal– Type of Analysis : Whole – PartType of Analysis : Whole – Part– Data Used : Raw Data – Semi finished DataData Used : Raw Data – Semi finished Data– Nature of Analysis : Historical – FuturisticNature of Analysis : Historical – Futuristic– Unit of Measurement : Quantitative – QualitativeUnit of Measurement : Quantitative – Qualitative– Periodicity : Long Term – Short TermPeriodicity : Long Term – Short Term– Precision : Very High – Low to MediumPrecision : Very High – Low to Medium– Nature : Objective – SubjectiveNature : Objective – Subjective– Legal Compulsion : Very High – LowLegal Compulsion : Very High – Low– Nature of Content : Low to Medium – Very HighNature of Content : Low to Medium – Very High

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IMPORTANT FINANCIAL DECISIONSIMPORTANT FINANCIAL DECISIONS

How to evaluate CAPEX decisions?How to evaluate CAPEX decisions? Where to park idle funds?Where to park idle funds? How many days inventory to carry?How many days inventory to carry? What should be its credit policy?What should be its credit policy? How should it raise long-term finance?How should it raise long-term finance? How much dividend to pay to shareholders?How much dividend to pay to shareholders? How to gauge and monitor performance?How to gauge and monitor performance?

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ROLE OF A FINANCIAL MANAGERROLE OF A FINANCIAL MANAGER

Financing / Mobilizing -Financing / Mobilizing -– Promoters ContributionPromoters Contribution– Public Issue, Rights Issue, Private PlacementPublic Issue, Rights Issue, Private Placement– Term Loans, Institutional FinanceTerm Loans, Institutional Finance– Overdraft, Cash CreditOverdraft, Cash Credit– Hire-Purchase / LeasingHire-Purchase / Leasing– Subsidies – Capital & RevenueSubsidies – Capital & Revenue– International Finance – GDR, ECB.International Finance – GDR, ECB.– Venture CapitalVenture Capital– Deferred PaymentDeferred Payment– Internal AccrualsInternal Accruals

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Investing / Deploying –Investing / Deploying –– Land & BuildingLand & Building– Plant & MachineryPlant & Machinery– Furniture & FixtureFurniture & Fixture– Shares, Bonds, Mutual Funds, DerivativesShares, Bonds, Mutual Funds, Derivatives– Dividend, Interest, TaxesDividend, Interest, Taxes– Working Capital – Inventory, DebtorsWorking Capital – Inventory, Debtors– Loan RepaymentLoan Repayment

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Planning & ControlPlanning & Control– Capital BudgetingCapital Budgeting– Treasury ManagementTreasury Management– Working Capital ManagementWorking Capital Management– Capital Structure PlanningCapital Structure Planning– Cost ControlCost Control– Forecasting & Budgeting Forecasting & Budgeting – Performance AnalysisPerformance Analysis– Internal AuditInternal Audit

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FINANCIAL MANAGEMENT FINANCIAL MANAGEMENT INTERFACEINTERFACE

Finance – MarketingFinance – Marketing– How much credit to extend to customers?How much credit to extend to customers?

Finance – ProductionFinance – Production– How many days inventory to keep?How many days inventory to keep?

Finance – Human ResourceFinance – Human Resource– How many new recruits to be made?How many new recruits to be made?

Finance – OperationsFinance – Operations– How should CAPEX decisions be evaluated?How should CAPEX decisions be evaluated?

Finance – Top ManagementFinance – Top Management– What is should be the pricing of an IPO?What is should be the pricing of an IPO?

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ENVIRONMENT OF CORPORATE ENVIRONMENT OF CORPORATE FINANCEFINANCE

Form of business organizationForm of business organization– Sole ProprietorshipSole Proprietorship– PartnershipPartnership– Company – Listed & UnlistedCompany – Listed & Unlisted

Regulatory FrameworkRegulatory Framework– Industrial (NIP) & Trade Policy (NTP)Industrial (NIP) & Trade Policy (NTP)– Foreign Exchange Management ActForeign Exchange Management Act– MRTP ActMRTP Act– Income Tax ActIncome Tax Act– Companies ActCompanies Act– SEBI ActSEBI Act

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ORGANISATIONAL FORM - CRITERIAORGANISATIONAL FORM - CRITERIA

Criteria for choosing an organizational form -Criteria for choosing an organizational form -– Initial set-up costsInitial set-up costs– Government strictures and regulationsGovernment strictures and regulations– Speedy decision makingSpeedy decision making– Fund raising capabilityFund raising capability– Degree of liability involvedDegree of liability involved– Life spanLife span– Extent and nature of taxationExtent and nature of taxation– Reputation and imageReputation and image– Public domain and secrecyPublic domain and secrecy

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FINANCIAL MARKETS FINANCIAL MARKETS

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INSTITUTIONSINSTITUTIONS

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FINANCIAL SYSTEMFINANCIAL SYSTEM

Producers

Government

Exports ImportsConsumers

Land + Labour + Capital +Technology

Rent + Wages + Profit +Royalty

Leakages = Savings

Injections = Investments

Leakages = Taxes Injections = Public Exp

Injections = Forex Leakages = Forex

Liquidity Crisis

Fiscal Crisis

BOP Crisis

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DEVELOPED FINANCIAL MARKETDEVELOPED FINANCIAL MARKET

– Economic & Industrial GrowthEconomic & Industrial Growth– Controlled Inflation – No Deficit FinancingControlled Inflation – No Deficit Financing– Stable Monetary PolicyStable Monetary Policy– Highly organized banking systemHighly organized banking system– Presence of Central BankPresence of Central Bank– Variety of Credit InstrumentsVariety of Credit Instruments– Rural market penetrationRural market penetration– Large number of intermediariesLarge number of intermediaries– Efficient price discovery mechanismEfficient price discovery mechanism– Size & Volumes (i.e. breadth & depth)Size & Volumes (i.e. breadth & depth)– Existence of Secondary MarketsExistence of Secondary Markets– Low Transaction Costs Low Transaction Costs

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FINANCIAL ASSETFINANCIAL ASSET

It refers to a claim on the repayment of a It refers to a claim on the repayment of a certain sum of money at the end of a maturity certain sum of money at the end of a maturity period.period. They can be either classified as They can be either classified as marketable or non-marketable. Marketability marketable or non-marketable. Marketability basically indicates that there is an basically indicates that there is an exit routeexit route prior to the maturity period. The categories of prior to the maturity period. The categories of financial assets listed in order of their financial assets listed in order of their marketability - marketability - – Equity Shares Equity Shares – Mutual FundsMutual Funds– DerivativesDerivatives– Debentures / BondsDebentures / Bonds– Govt. SecuritiesGovt. Securities

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FINANCIAL ASSET - FINANCIAL ASSET - CHARACTERISTICSCHARACTERISTICS

Continuous ready marketContinuous ready market Inter & Intra asset transferabilityInter & Intra asset transferability Easy liquidityEasy liquidity Security valueSecurity value Tax exemptionTax exemption Element of riskElement of risk Hedging optionsHedging options Low transaction costsLow transaction costs Streamlining returnsStreamlining returns Variety of durationsVariety of durations

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MONEY MARKETMONEY MARKET

The money market is the collective name The money market is the collective name given to institutions that deal in various grades given to institutions that deal in various grades of of near moneynear money. Though there is no strict . Though there is no strict definition of near money, for all practical definition of near money, for all practical purposes we take it at as one year. purposes we take it at as one year. – It deals with short-term financial assets with It deals with short-term financial assets with

a duration upto one year.a duration upto one year.– Exit route is nascent.Exit route is nascent.– No single homogeneous marketplace.No single homogeneous marketplace.– Intermediaries are absent.Intermediaries are absent.– Informal networks.Informal networks.– Low risk – Low return.Low risk – Low return.

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MONEY MARKET - INSTRUMENTSMONEY MARKET - INSTRUMENTS

Call Money MarketCall Money Market Commercial Bills MarketCommercial Bills Market Acceptance MarketAcceptance Market Treasury Bills MarketTreasury Bills Market Repurchase Agreements (Repo’s)Repurchase Agreements (Repo’s) Commercial PaperCommercial Paper Certificate of Deposit Certificate of Deposit Inter – Bank Participation CertificateInter – Bank Participation Certificate Inter – Corporate LoansInter – Corporate Loans MM Mutual FundsMM Mutual Funds

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CALL MONEY MARKETCALL MONEY MARKET

Call Money Market –Call Money Market – Extremely short term Extremely short term duration, usually less than duration, usually less than 1414 days. The loans days. The loans are repayable on demand either at option of the are repayable on demand either at option of the lender or borrower. The major players in this lender or borrower. The major players in this segment are – banks and stock brokers. It segment are – banks and stock brokers. It provides an equilibrium mechanism for balancing provides an equilibrium mechanism for balancing short term deficits and surpluses. short term deficits and surpluses. – Meet CRR or ALM criteria.Meet CRR or ALM criteria.– Sudden surge in demand-supply for funds.Sudden surge in demand-supply for funds.– Interest rates are very volatile, but negotiable.Interest rates are very volatile, but negotiable.– Minimum deal size is very high.Minimum deal size is very high.– Confidentiality is maintained.Confidentiality is maintained.– Credibility is very critical for dealings.Credibility is very critical for dealings.

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COMMERCIAL BILLSCOMMERCIAL BILLS

Commercial Bill –Commercial Bill – It is a document which arises It is a document which arises out of a genuine trade transaction on credit out of a genuine trade transaction on credit terms. The buyer accepts it by issuing a terms. The buyer accepts it by issuing a promissory note to pay the amount promissory note to pay the amount unconditionally on or before a specified date. unconditionally on or before a specified date. Its validity is usually between Its validity is usually between (30-120)(30-120) days. days. Types of commercial bills –Types of commercial bills –– Demand & Usance / TimeDemand & Usance / Time– Documentary & CleanDocumentary & Clean– Inland & Foreign (Letter of Credit)Inland & Foreign (Letter of Credit)– Supply & AccommodationSupply & Accommodation

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DISCOUNT & ACCEPTANCE MARKETDISCOUNT & ACCEPTANCE MARKET

Discount market refers to a market of short Discount market refers to a market of short term genuine trade bills, which are discounted term genuine trade bills, which are discounted by financial intermediaries, like commercial by financial intermediaries, like commercial banks. The seller gets immediate credit at a banks. The seller gets immediate credit at a discount ratediscount rate; whereas the buyer gets a ; whereas the buyer gets a convenient credit on the condition to pay on convenient credit on the condition to pay on the specified date.the specified date.– Large segment is in the unorganised sector.Large segment is in the unorganised sector.– Interest rates are stable, except in the Interest rates are stable, except in the

unorganised sector.unorganised sector.– Strong banking credibility is essential.Strong banking credibility is essential.– Collaterals are preferred.Collaterals are preferred.

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TREASURY BILLSTREASURY BILLS

Treasury bills are short term borrowings by the GoI Treasury bills are short term borrowings by the GoI through the RBI. It is a promissory note issued under through the RBI. It is a promissory note issued under a discount usually for a period not exceeding a year. a discount usually for a period not exceeding a year. – Ordinary TB are subscribed directly by the public.Ordinary TB are subscribed directly by the public.– Ad-hoc TB are meant for OMO (i.e. banks).Ad-hoc TB are meant for OMO (i.e. banks).– It acts as a benchmark for banks and institutions.It acts as a benchmark for banks and institutions.– Credit rating of such instruments is very high.Credit rating of such instruments is very high.– Discount rates usually vary between (6-8)%.Discount rates usually vary between (6-8)%.– Durations – 91/182/364 days.Durations – 91/182/364 days.– They are transferable and tax free.They are transferable and tax free.– Auctions are the preferred route.Auctions are the preferred route.

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REPURCHASE (REPO) AGREEMENTSREPURCHASE (REPO) AGREEMENTS

In a In a reporepo transaction, the lender parts with a transaction, the lender parts with a security security (usually a treasury bill)(usually a treasury bill) to a borrower to a borrower with an agreement to repurchase them at the with an agreement to repurchase them at the end of a fixed period at a specified price. The end of a fixed period at a specified price. The difference between the purchase price and the difference between the purchase price and the original price is the cost of the borrower, also original price is the cost of the borrower, also known as known as repo-raterepo-rate. The normal duration of a . The normal duration of a repo repo is usually between is usually between (3-7)(3-7) days. days.

In In reverse reporeverse repo a transaction is viewed from the a transaction is viewed from the point of view of supplier of funds. Thus whether point of view of supplier of funds. Thus whether a transaction is a a transaction is a reporepo or a or a reverse reporeverse repo depends largely on which party initiated the depends largely on which party initiated the transaction.transaction.

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COMMERCIAL PAPERCOMMERCIAL PAPER

A A commercial papercommercial paper is an unsecured promissory is an unsecured promissory note issued by a corporate, approved by the note issued by a corporate, approved by the RBIRBI, , to the general public to the general public (i.e. HNI)(i.e. HNI) at a discount rate at a discount rate with a duration not exceeding a year.with a duration not exceeding a year.– Securitisation – borrowing directly from the Securitisation – borrowing directly from the

public.public.– Minimising transaction costs.Minimising transaction costs.– Recent origin – 1990’s.Recent origin – 1990’s.– Can also have an interest bearing form.Can also have an interest bearing form.– No assets are pledged, unsecured.No assets are pledged, unsecured.– Merchant bankers are generally not involved.Merchant bankers are generally not involved.– Company’s earning power is the only Company’s earning power is the only

guarantee.guarantee.

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COMMERCIAL PAPER – RBI COMMERCIAL PAPER – RBI GUIDELINESGUIDELINES

A tangible net worth not less than Rs. 10cr.A tangible net worth not less than Rs. 10cr. A minimum current ratio of 1.33:1.A minimum current ratio of 1.33:1. A debt-service ratio not less than 2.A debt-service ratio not less than 2. Working capital limit exceeding Rs. 25cr.Working capital limit exceeding Rs. 25cr. Issue not exceeding 20% of Working Capital.Issue not exceeding 20% of Working Capital. Listing on at least one national level stock Listing on at least one national level stock

exchange.exchange. Minimum Rating of P2 from CRISIL.Minimum Rating of P2 from CRISIL. Minimum face value Rs. 25 lacs, lot size of 4 Minimum face value Rs. 25 lacs, lot size of 4

units.units. Maturity period (3-6) months.Maturity period (3-6) months. Competitive interest rates and flexible.Competitive interest rates and flexible. Underwriting not available.Underwriting not available.

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CERTIFICATE OF DEPOSITCERTIFICATE OF DEPOSIT

Certificate of DepositCertificate of Deposit is a short term deposit is a short term deposit instruments issued by banks and financial instruments issued by banks and financial institutions to raise large sums of money. institutions to raise large sums of money. – Intermediation with HNI’s.Intermediation with HNI’s.– Very nascent market in India.Very nascent market in India.– Document of title similar to time deposits.Document of title similar to time deposits.– Promissory note; partially secured.Promissory note; partially secured.– Issued at a discount to face value.Issued at a discount to face value.– Repayable on a fixed maturity date.Repayable on a fixed maturity date.– Subject to SLR and CRR norms.Subject to SLR and CRR norms.– Transferable by endorsement and delivery.Transferable by endorsement and delivery.

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CD – RBI GUIDELINESCD – RBI GUIDELINES

Normal face value in multiples of Rs. 5 lacs, Normal face value in multiples of Rs. 5 lacs, with a minimum lot size of 2 units.with a minimum lot size of 2 units.

Maturity period (3-12) months.Maturity period (3-12) months. Lock-in period 30 days.Lock-in period 30 days. Transferable after 30 days.Transferable after 30 days. Banks to maintain CRR & SLR on CD proceeds.Banks to maintain CRR & SLR on CD proceeds. No premature buy-back.No premature buy-back. Ceiling limit – 10% of aggregate deposits.Ceiling limit – 10% of aggregate deposits.

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INTER-BANK PARTICIPATIONINTER-BANK PARTICIPATION

IBPCIBPC enable commercial banks to fund their enable commercial banks to fund their short-term working capital needs from within the short-term working capital needs from within the periphery of the banking system.periphery of the banking system.– Introduced in 1970.Introduced in 1970.– Participation direct or indirect (re-discounting).Participation direct or indirect (re-discounting).– Period of participation period (90-180) days.Period of participation period (90-180) days.– Types of participation – with or without risk.Types of participation – with or without risk.– With risk – 90 days restriction.With risk – 90 days restriction.– Without risk – Subject to SLR and CRR norms.Without risk – Subject to SLR and CRR norms.– Banks classified (Health Code-1) permitted to Banks classified (Health Code-1) permitted to

issue with risk.issue with risk.

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INTER-CORPORATE LOANSINTER-CORPORATE LOANS

ICL ICL is an extremely short-term working capital is an extremely short-term working capital arrangement between two corporates under arrangement between two corporates under terms and conditions mutually agreed upon.terms and conditions mutually agreed upon.– Tenure seldom exceeds 7 days.Tenure seldom exceeds 7 days.– Interest rates are highly volatile.Interest rates are highly volatile.– No collaterals / pledges are involved.No collaterals / pledges are involved.– High degree of confidentiality is involved.High degree of confidentiality is involved.– Transaction size is large.Transaction size is large.– Call notice – Payable on demand.Call notice – Payable on demand.– Personal credibility is an important driver.Personal credibility is an important driver.

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MONEY MARKET MUTUAL FUNDSMONEY MARKET MUTUAL FUNDS

A A MMMFMMMF invests primarily in MM instruments of invests primarily in MM instruments of very high quality short-term maturities. It aims very high quality short-term maturities. It aims at bringing in the scope of MM instruments and at bringing in the scope of MM instruments and short-term surpluses within the ambit of retail short-term surpluses within the ambit of retail investors.investors.– A A MMFFMMFF is usually closed-ended.is usually closed-ended.– Earlier Earlier MMFS’sMMFS’s were governed by the RBI, but were governed by the RBI, but

w.e.f March 2007 they now come under the w.e.f March 2007 they now come under the ambit of SEBI.ambit of SEBI.

– Short-term lock-in period of Short-term lock-in period of (15–30)(15–30) days. days.– Minimum corpus of a MMMF is Minimum corpus of a MMMF is Rs.50Rs.50 crore. crore. – No No entryentry or or exitexit load. load. FixedFixed management fee. management fee.– No ceiling limits in investments.No ceiling limits in investments.

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FINANCIAL INTERMEDIARIESFINANCIAL INTERMEDIARIES

A financial intermediary is basically an A financial intermediary is basically an institution that lends liquidity to a financial institution that lends liquidity to a financial system, thereby facilitating a financial system, thereby facilitating a financial transaction. Intermediaries in the money transaction. Intermediaries in the money market –market –– Reserve Bank of IndiaReserve Bank of India– Commercial BanksCommercial Banks– Co-Operative BanksCo-Operative Banks– Post OfficesPost Offices– Central GovernmentCentral Government

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RBIRBI

It is the apex body responsible for guiding, It is the apex body responsible for guiding, monitoring, regulating, promoting, and monitoring, regulating, promoting, and controlling the Indian Financial System. Its controlling the Indian Financial System. Its functions include –functions include –– Issuing of currency.Issuing of currency.– Banker to the government.Banker to the government.– Bankers bank.Bankers bank.– The bank rate.The bank rate.– Open market operations (OMO).Open market operations (OMO).– Monitoring liquidity through CRR & SLR.Monitoring liquidity through CRR & SLR.– FOREX control.FOREX control.

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MONEY MARKET – SHORTCOMINGSMONEY MARKET – SHORTCOMINGS

Lack of coordination across institutions.Lack of coordination across institutions. Monopolistic market structures.Monopolistic market structures. Dominance of developmental institutions.Dominance of developmental institutions. Seasonal fluctuation in interest rates.Seasonal fluctuation in interest rates. Inactive and erratic transaction volumes.Inactive and erratic transaction volumes. Lack of secondary market.Lack of secondary market. High transaction costs.High transaction costs. Nascent hedging market.Nascent hedging market. Unscrupulous practices in unorganised sector.Unscrupulous practices in unorganised sector. Limited no. of intermediaries.Limited no. of intermediaries.

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MONEY MARKET – RECENT MONEY MARKET – RECENT DEVELOPMENTSDEVELOPMENTS

Integration of unorganised sector.Integration of unorganised sector. Increasing breadth and depth of the market.Increasing breadth and depth of the market. Introduction of innovative instruments.Introduction of innovative instruments. Interest rates have been made competitive.Interest rates have been made competitive. Transparency in offerings.Transparency in offerings. Exemption from stamp duties.Exemption from stamp duties. Increasing debt-based mutual funds.Increasing debt-based mutual funds. Importance of credit rating.Importance of credit rating. Stable monetary policy.Stable monetary policy. Establishment of DFHI.Establishment of DFHI.

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DISCOUNT & FINANCE HOUSE OF DISCOUNT & FINANCE HOUSE OF INDIAINDIA

DHFIDHFI commenced its operations in commenced its operations in 1988 1988 with with the objective to develop and stabilize a the objective to develop and stabilize a secondary MM. It was jointly promoted by the secondary MM. It was jointly promoted by the RBI, Commercial Banks & FI’s. It’s paid-up RBI, Commercial Banks & FI’s. It’s paid-up capital is capital is Rs.200 crRs.200 cr; and is entitled to borrow ; and is entitled to borrow upto 10 times its net worth. upto 10 times its net worth. – Discount, re-discount, buy, sell, acquire Discount, re-discount, buy, sell, acquire

money market instruments.money market instruments.– Buy-back arrangements of treasury bills.Buy-back arrangements of treasury bills.– Lend and borrow funds and MM instruments.Lend and borrow funds and MM instruments.– Support corporate, trusts for short-term Support corporate, trusts for short-term

capital shortages.capital shortages.– Market building & advisory role.Market building & advisory role.

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SOURCES & RAISING SOURCES & RAISING

OFOF

LONG TERM FINANCELONG TERM FINANCE

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MONEY MARKET Vs CAPITAL MONEY MARKET Vs CAPITAL MARKETMARKET

Term Period – Short Term Vs Medium to Long Term Period – Short Term Vs Medium to Long TermTerm

Requirements – Working Capital Vs Fixed CapitalRequirements – Working Capital Vs Fixed Capital Face Value – High Vs LowFace Value – High Vs Low Secondary Markets – No / Nascent Vs YesSecondary Markets – No / Nascent Vs Yes Intermediaries – No Vs YesIntermediaries – No Vs Yes Lot Size – Minimum Vs MaximumLot Size – Minimum Vs Maximum Apex Regulatory Body – RBI Vs SEBIApex Regulatory Body – RBI Vs SEBI Market Building – No Vs YesMarket Building – No Vs Yes Processing Period – Short Vs Medium to LongProcessing Period – Short Vs Medium to Long Contract – Informal Vs FormalContract – Informal Vs Formal Players – Corporates – IndividualsPlayers – Corporates – Individuals

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WHY LONG TERM FINANCE?WHY LONG TERM FINANCE?

Long term finance is required for expansion, Long term finance is required for expansion, modernisation, and diversification projects. The modernisation, and diversification projects. The duration of such projects usually range between duration of such projects usually range between (5-8) years. It comprises of –(5-8) years. It comprises of –– Project ImplementationProject Implementation– GestationGestation– Break-Even PointBreak-Even Point

They are usually characterised by huge They are usually characterised by huge investments, commitment of the top investments, commitment of the top management, and are irreversible. management, and are irreversible.

Using working capital to finance long-term Using working capital to finance long-term projects will lead to a asset – liability mismatch.projects will lead to a asset – liability mismatch.

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SOURCES OF LONG TERM FINANCESOURCES OF LONG TERM FINANCE

Capital –Capital –– Equity CapitalEquity Capital– Preference CapitalPreference Capital

Debt –Debt –– BondsBonds– DebenturesDebentures

Hybrid –Hybrid –– Partly & Fully Convertible DebenturesPartly & Fully Convertible Debentures– Secured Premium NotesSecured Premium Notes

Internal Accruals –Internal Accruals – Subsidies & Exemptions –Subsidies & Exemptions –

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PRIMARY MARKET - CLASSIFICATIONPRIMARY MARKET - CLASSIFICATION

Market where a firm goes to the investing Market where a firm goes to the investing public for the first time. Prior to an IPO stocks public for the first time. Prior to an IPO stocks are usually unlisted and closely held. are usually unlisted and closely held. (IPO).(IPO).

Market where a firm goes to the investing Market where a firm goes to the investing public at a time subsequent to its IPO for public at a time subsequent to its IPO for raising additional capital raising additional capital (SEO). (SEO). There are There are usually issued at a discount to the market usually issued at a discount to the market price.price.

Market where a firm goes to existing Market where a firm goes to existing shareholders at a time subsequent to its shareholders at a time subsequent to its commence of business for raising additional commence of business for raising additional capital, whose shares are already listed at any capital, whose shares are already listed at any recognised stock exchange recognised stock exchange (RO).(RO).

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SEBI GUIDELINES – PRIMARY SEBI GUIDELINES – PRIMARY MARKETMARKET

Maximum reservation available in case of an Maximum reservation available in case of an IPO –IPO –– Employees – 10%Employees – 10%– Mutual Funds – 20%Mutual Funds – 20%– Foreign Institutional Investors – 15%Foreign Institutional Investors – 15%– Financial Institutions – 20%Financial Institutions – 20%– Group Companies – 10%Group Companies – 10%

Reservations applicable for a maximum of any Reservations applicable for a maximum of any two of the above categories.two of the above categories.

Reservations are not available for the general Reservations are not available for the general public.public.

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PRIMARY MARKET - FUNCTIONSPRIMARY MARKET - FUNCTIONS

Origination –Origination – It refers to the work of systematic It refers to the work of systematic investigation, analysis and processing of data investigation, analysis and processing of data surrounding new projects. The basic services surrounding new projects. The basic services surrounding such information includes –surrounding such information includes –– Business Viability –Business Viability – Appropriateness of project Appropriateness of project

capacity, including target market share. capacity, including target market share. – Technical Feasibility –Technical Feasibility – Cost benefit analysis of Cost benefit analysis of

appropriate technologies.appropriate technologies.– Risk Analysis –Risk Analysis – Probability of failure of the Probability of failure of the

project on account of changes in critical project on account of changes in critical variables. Eg. economic risk, operational risk, variables. Eg. economic risk, operational risk, financial risk.financial risk.

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Advisory –Advisory – It refers to assessment of factors It refers to assessment of factors which may improve the quality of capital which may improve the quality of capital issues and ensure its success.issues and ensure its success.– Size of the IssueSize of the Issue– Type of InstrumentType of Instrument– Pricing of the IssuePricing of the Issue– Timing of the IssueTiming of the Issue– Structure of the IssueStructure of the Issue– Distribution of the IssueDistribution of the Issue– Market BuildingMarket Building

Such services are usually offered Merchant Such services are usually offered Merchant Bankers.Bankers.

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Underwriting –Underwriting – It refers to an pre-agreement It refers to an pre-agreement whereby the underwriter undertakes to whereby the underwriter undertakes to subscribe to a specified no. of units of a subscribe to a specified no. of units of a specific instrument of a specific issue in the specific instrument of a specific issue in the event of public not subscribing to the desired event of public not subscribing to the desired extent. It is therefore a specific guarantee for extent. It is therefore a specific guarantee for the marketability of the issue.the marketability of the issue.– Standing behind the issue.Standing behind the issue.– Consortium blocks.Consortium blocks.– Outright purchase.Outright purchase.

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NEW ISSUES MARKET - FUNCTIONSNEW ISSUES MARKET - FUNCTIONS

Distribution –Distribution – It is the function of sale of It is the function of sale of securities to ultimate investors. This service is securities to ultimate investors. This service is usually performed by Lead Managers who usually performed by Lead Managers who maintain direct contact with the investors. The maintain direct contact with the investors. The different methods of distribution are –different methods of distribution are –– Public Issue - ProspectusPublic Issue - Prospectus– Private Placement & Bought Out DealsPrivate Placement & Bought Out Deals– Rights IssueRights Issue– Book Building - Red Herring ProspectusBook Building - Red Herring Prospectus

4848

PUBLIC ISSUES – IPO and SEOPUBLIC ISSUES – IPO and SEO

The issuing company directly offers to the The issuing company directly offers to the general public a fixed no. of shares at a stated general public a fixed no. of shares at a stated price through a document called price through a document called prospectus.prospectus. Technically it is known as Technically it is known as invitation to an offerinvitation to an offer. . It contains -It contains -– Name & Address of the Company Name & Address of the Company – Issue Structure – Reservations, if anyIssue Structure – Reservations, if any– Existing & Proposed ActivitiesExisting & Proposed Activities– Factory Location, Names of DirectorsFactory Location, Names of Directors– Capital StructureCapital Structure– Subscription – Opening & Closing DatesSubscription – Opening & Closing Dates– Future Projections – Risk FactorsFuture Projections – Risk Factors

4949

SEBI GUIDELINES – PUBLIC ISSUESEBI GUIDELINES – PUBLIC ISSUE

Abridged prospectus with every application.Abridged prospectus with every application. Highlighting of risk factors.Highlighting of risk factors. Company’s management, history and businesses.Company’s management, history and businesses. Details of group companies.Details of group companies. Justification of premium (if any).Justification of premium (if any). Subscription period (3-10) working days.Subscription period (3-10) working days. At least 30 collection centres.At least 30 collection centres. No collection in cash.No collection in cash. A compliance report to be submitted within 45 A compliance report to be submitted within 45

days.days. Minimum application 100/500 depending on Minimum application 100/500 depending on

price.price.

5050

PRIVATE PLACEMENT & BODPRIVATE PLACEMENT & BOD

This method of sale consists of outright sale of This method of sale consists of outright sale of securities to an securities to an Investment BankerInvestment Banker. The . The transaction is usually carried out at a transaction is usually carried out at a negotiated price. The investment banker may negotiated price. The investment banker may offload the securities immediately or at an offload the securities immediately or at an opportune time. The difference is called the opportune time. The difference is called the spreadspread..– Suitable for small companies, minimum cost.Suitable for small companies, minimum cost.– Promoters diluting their stake to comply with Promoters diluting their stake to comply with

listing agreements.listing agreements.– Reduces the risk of timing of issue.Reduces the risk of timing of issue.– Market building is not required.Market building is not required.– Risk of take-over.Risk of take-over.

5151

RIGHTS OFFERINGRIGHTS OFFERING

It is a method a raising funds by an existing It is a method a raising funds by an existing listed company. It provides an option to an listed company. It provides an option to an existing shareholder to buy a specified no. of existing shareholder to buy a specified no. of units of a security at a predetermined price, units of a security at a predetermined price, within a specific time period. within a specific time period.

A company can come out withA company can come out with rights issuerights issue either aftereither after 2 years of incorporation or after2 years of incorporation or after 1 1 year of the previous issue, whichever is earlier.year of the previous issue, whichever is earlier.

A shareholder may reject the right, accept the A shareholder may reject the right, accept the right – partially or fully, or sell-off the right.right – partially or fully, or sell-off the right.

The ratio-of-rights can vary across different The ratio-of-rights can vary across different categories of shareholders, but at the same categories of shareholders, but at the same price.price.

5252

RIGHTS OFFERING - GUIDELINESRIGHTS OFFERING - GUIDELINES

The draft rights issue should contain all The draft rights issue should contain all information as listed in the prospectus U/S 81 of information as listed in the prospectus U/S 81 of the Companies, Act 1988.the Companies, Act 1988.

A rights issue is not required to be underwritten.A rights issue is not required to be underwritten. Any part of the issue remaining unsubscribed by Any part of the issue remaining unsubscribed by

the public has to taken over by the promoters.the public has to taken over by the promoters. It gives the promoters the scope to raise their It gives the promoters the scope to raise their

stakes.stakes. The cost of the issue is minimum.The cost of the issue is minimum. A rights offering has to be open for a minimum A rights offering has to be open for a minimum

duration ofduration of 45 days.45 days.

5353

BOOK BUILDING - 1995BOOK BUILDING - 1995

It is a process through which demand for the It is a process through which demand for the securities proposed to be issued is solicited and securities proposed to be issued is solicited and the price for such a security is assessed for the the price for such a security is assessed for the determination of the size of the issue through a determination of the size of the issue through a draft document draft document (Red Herring Prospectus)(Red Herring Prospectus). Book . Book building exercise is usually carried on through a building exercise is usually carried on through a price band price band (Floor & Ceiling Price)(Floor & Ceiling Price)..– Maximum permissible band width is 20%.Maximum permissible band width is 20%.– The exercise has to be open for (3-13) days.The exercise has to be open for (3-13) days.– Demand accessible on a continuous basis.Demand accessible on a continuous basis.– Fresh bid is permissible.Fresh bid is permissible.– Revision of band, prior to 3 days of close of Revision of band, prior to 3 days of close of

issue.issue.

5454

GREEN-SHOE OPTIONGREEN-SHOE OPTION

Green-Shoe option is a mechanism to bring Green-Shoe option is a mechanism to bring about stability in stock prices in the post – issue about stability in stock prices in the post – issue phase to generate shareholder confidence.phase to generate shareholder confidence.

A maximum of 15% the total issue size can A maximum of 15% the total issue size can used for this purpose.used for this purpose.

In this process a book – runner is appointed as In this process a book – runner is appointed as a stabilising agent.a stabilising agent.

His responsibility is to intervene in the His responsibility is to intervene in the secondary market, when the market price falls secondary market, when the market price falls below the issue price.below the issue price.

Such intervention can be carried out for a Such intervention can be carried out for a maximum period of 30 days.maximum period of 30 days.

5555

LISTING OF SECURITIESLISTING OF SECURITIES

Listing of securities mean that the securities are Listing of securities mean that the securities are admitted for official trading on a recognised admitted for official trading on a recognised stock exchange. SEBI makes listing agreement stock exchange. SEBI makes listing agreement prior to the equity offering mandatory. prior to the equity offering mandatory. Conditional listing is not permitted. Advantages Conditional listing is not permitted. Advantages of listing –of listing –– Ensures liquidity and continuous pricing.Ensures liquidity and continuous pricing.– Offers wide publicity.Offers wide publicity.– Transparency for shareholders.Transparency for shareholders.– Benchmarking against index or other stocks.Benchmarking against index or other stocks.– Facilitates pledging of securities.Facilitates pledging of securities.– Source for future rights offering.Source for future rights offering.

5656

LISTING PROCEDURELISTING PROCEDURE

The following documents are to be submitted to The following documents are to be submitted to CLA with prescribed format & fee, prior to entering CLA with prescribed format & fee, prior to entering into an agreement with a stock exchange –into an agreement with a stock exchange –– Brief history of operations.Brief history of operations.– Memorandum & Articles of Association.Memorandum & Articles of Association.– Prospectus & Underwriting Agreement.Prospectus & Underwriting Agreement.– Last 3 years audited balance sheet.Last 3 years audited balance sheet.– Capital structure, bonus, dividend.Capital structure, bonus, dividend.– Agreements with top managerial personnel.Agreements with top managerial personnel.– Nature of instrument.Nature of instrument.– Shareholding pattern, including top 10 Shareholding pattern, including top 10

promoters.promoters.

5757

LISTING – SEBI GUIDELINESLISTING – SEBI GUIDELINES

Listing conditions to be fulfilled by a company –Listing conditions to be fulfilled by a company –– Minimum issued capital Rs.Minimum issued capital Rs. 3 crores.3 crores.– Companies having more than Rs.Companies having more than Rs. 5 crore as 5 crore as

issued capital should go in for dual listing.issued capital should go in for dual listing.– At leastAt least 40%40% of each class of securities must of each class of securities must

be offered to the public.be offered to the public.– The issue to be advertised through at least 2 The issue to be advertised through at least 2

newspapers having national-level circulation, newspapers having national-level circulation, and 5 newspapers having regional-level and 5 newspapers having regional-level circulation.circulation.

– Listing norms should be complied within 30 Listing norms should be complied within 30 days from the closing of subscription .days from the closing of subscription .

5858

LISTING DRAWBACKSLISTING DRAWBACKS

Leads to speculation –Leads to speculation – May lead to May lead to manipulation of prices in a way as may be manipulation of prices in a way as may be detrimental to the interests of the company.detrimental to the interests of the company.

Discloses vital information to competitors –Discloses vital information to competitors – Information submitted for the purpose of Information submitted for the purpose of listing lies on public domain, hence may be listing lies on public domain, hence may be used by competitors to gain unfair advantage.used by competitors to gain unfair advantage.

Degrades company’s reputation –Degrades company’s reputation – Negative Negative information about companies gets easily information about companies gets easily percolated to the press.percolated to the press.

Fear of Takeover –Fear of Takeover – Vested interests wishing to Vested interests wishing to take-over from the current management can take-over from the current management can acquire shares from the market.acquire shares from the market.

5959

SHARE BUYBACK - 1988SHARE BUYBACK - 1988

Buyback is a process of cancellation of shares Buyback is a process of cancellation of shares out of free reserves to the extent of out of free reserves to the extent of 25%25% of of paid-up capital. It may lead to de-listing. It is paid-up capital. It may lead to de-listing. It is an exit route for cash-rich companies without an exit route for cash-rich companies without viable investment opportunities. viable investment opportunities.

Advantages –Advantages –– To prevent take-over bids.To prevent take-over bids.– Injecting leverage into the capital structure.Injecting leverage into the capital structure.– Reverse dilution of equity.Reverse dilution of equity.– Increase underlying share-value.Increase underlying share-value.– Minimise odd lots.Minimise odd lots.

6060

SEBI GUIDELINES – SHARES SEBI GUIDELINES – SHARES BUYBACKBUYBACK

Various modes of buyVarious modes of buy––back – tender, open offer, back – tender, open offer, Dutch auction, Repurchase odd lots, ESOP.Dutch auction, Repurchase odd lots, ESOP.– Tender Offer –Tender Offer – It is based on one fixed price. It is based on one fixed price.– Open Offer –Open Offer – It is based on ruling market price. It is based on ruling market price.– Dutch Auction –Dutch Auction – Shares offered at the lowest Shares offered at the lowest

price are given first priority. It is also known as price are given first priority. It is also known as reverse book–building.reverse book–building.

– Repurchase Odd Lots –Repurchase Odd Lots – Shareholders Shareholders possessing odd lots are given priority.possessing odd lots are given priority.

– ESOP –ESOP – The stock options given to employees The stock options given to employees are cancelled and bought back.are cancelled and bought back.

6161

SEBI GUIDELINES – SHARE BUYBACKSEBI GUIDELINES – SHARE BUYBACK

Prior SEBI approval.Prior SEBI approval. Special resolution needs to be passed by the Special resolution needs to be passed by the

board approving maximum price.board approving maximum price. Buyback through negotiated deals, spot Buyback through negotiated deals, spot

transactions and private placement not transactions and private placement not permissible.permissible.

Daily purchase details to be reported.Daily purchase details to be reported. Transaction based on immediate payment Transaction based on immediate payment

through Escrow Account.through Escrow Account. Buyback once announced cannot be Buyback once announced cannot be

withdrawn.withdrawn.

6262

SECONDARY MARKETSECONDARY MARKET

It is a physical or virtual market place where It is a physical or virtual market place where listed securities are traded through open–listed securities are traded through open–outcry system or through a secret–bidding outcry system or through a secret–bidding process. Its advantages –process. Its advantages –– Provides additional liquidity to securities.Provides additional liquidity to securities.– Marketability of long term funds.Marketability of long term funds.– Efficient flow of capital.Efficient flow of capital.– Benchmark for improved performance.Benchmark for improved performance.– Promotion of equity culture.Promotion of equity culture.– Barometers of the economy.Barometers of the economy.– Scope for diversification.Scope for diversification.

6363

PRIMARY VS SECONDARY MARKETPRIMARY VS SECONDARY MARKET

Status of Securities – New Vs ExistingStatus of Securities – New Vs Existing Existence – Virtual Vs Physical / On LineExistence – Virtual Vs Physical / On Line Structure & Set Up – No Vs YesStructure & Set Up – No Vs Yes Rules & Regulations – No Vs YesRules & Regulations – No Vs Yes Information – Ad-hoc Vs ContinuousInformation – Ad-hoc Vs Continuous Control – Decentralised Vs CentralisedControl – Decentralised Vs Centralised Purpose – Start Up Vs DiversificationPurpose – Start Up Vs Diversification Public Involvement – Direct Vs IndirectPublic Involvement – Direct Vs Indirect

6464

STOCK EXCHANGESTOCK EXCHANGE

Every stock exchange operating in India is Every stock exchange operating in India is recognised by the Central Government, set up recognised by the Central Government, set up under the under the Securities Contract Regulation Act, Securities Contract Regulation Act, 1956,1956, and duly approved by SEBI. and duly approved by SEBI.

A stock exchange applying for recognition has A stock exchange applying for recognition has to make an application to the Central Govt. in to make an application to the Central Govt. in the prescribed manner containing –the prescribed manner containing –– Organisation structure of the exchange.Organisation structure of the exchange.– A copy of the rules and regulations of the A copy of the rules and regulations of the

stock exchange.stock exchange.– Prescribed fees.Prescribed fees.

6565

FAQ’s – STOCK EXCHANGEFAQ’s – STOCK EXCHANGE

What is a stock exchange?What is a stock exchange?It is a market place where investments can be It is a market place where investments can be bought and sold.bought and sold.

Why were stock exchanges formed?Why were stock exchanges formed?To add liquidity to investments.To add liquidity to investments.

Why do people trade in a stock exchange?Why do people trade in a stock exchange?Because the buyer expects the prices will rise Because the buyer expects the prices will rise and the seller expects that prices will fall.and the seller expects that prices will fall.

Why are there differences in opinion?Why are there differences in opinion?Because markets are not perfect.Because markets are not perfect.

Which is the oldest stock exchange in India?Which is the oldest stock exchange in India?BSE. (circa 1875)BSE. (circa 1875)

6666

TYPES OF ORDERSTYPES OF ORDERS

Order –Order – An order is a requisition placed by an An order is a requisition placed by an investor to buy or sell a particular stock(s) for a investor to buy or sell a particular stock(s) for a certain consideration. However, prior to placing certain consideration. However, prior to placing any order, an investor is required to register any order, an investor is required to register himself with a broker.himself with a broker.

What are the various types of orders?What are the various types of orders?– Open OrderOpen Order– Market OrderMarket Order

(High)(High)– Span OrderSpan Order Confidence on the Broker Confidence on the Broker– Limit OrderLimit Order (Low)(Low)– Fixed Price OrderFixed Price Order

6767

TRADING SYSTEMTRADING SYSTEM

Earlier trading in stock exchanges was carried Earlier trading in stock exchanges was carried out through a out through a open–outcryopen–outcry system in the trading system in the trading ring. The system witnessed various limitations -ring. The system witnessed various limitations -– Lack of secrecy.Lack of secrecy.– Tackle unprecedented growth of the stock Tackle unprecedented growth of the stock

market.market.– Protection of investor’s interest.Protection of investor’s interest.– Scope for manipulations.Scope for manipulations.– Entry of FII’s.Entry of FII’s.

VSAT-network based trading system enable VSAT-network based trading system enable participants to view online information, login & participants to view online information, login & place requisitions, and execute deals. Automated place requisitions, and execute deals. Automated systems are either systems are either orderorder or or quotequote driven. driven.

6868

SETTLEMENT OF TRANSACTIONSSETTLEMENT OF TRANSACTIONS

Delivery –Delivery – It involves the handover of the stocks by It involves the handover of the stocks by the seller on due date for a consideration. Delivery the seller on due date for a consideration. Delivery is said to be bad if the seller fails to give delivery is said to be bad if the seller fails to give delivery on due date.on due date.

Settlement –Settlement – It is the process through which the It is the process through which the buyer fulfils his obligations against delivery of buyer fulfils his obligations against delivery of stocks. stocks.

Settlement Date –Settlement Date – It is the date announced by the It is the date announced by the stock exchange on which settlement has to be stock exchange on which settlement has to be made.made.

What are the various ways of settlement?What are the various ways of settlement?– Through payment or delivery.Through payment or delivery.– Through square-off.Through square-off.– Through carry–forward (i.e. badla).Through carry–forward (i.e. badla).

6969

SPECULATIONSPECULATION

What is speculation?What is speculation?– In the spot market, it involves taking exposure In the spot market, it involves taking exposure

in a financial asset, without having an in a financial asset, without having an intention to buy it. It is characterised by short intention to buy it. It is characterised by short term view, lack of funds, and/or malafide term view, lack of funds, and/or malafide intentions. In the futures market, it refers to intentions. In the futures market, it refers to an exposure in a derivative without basic an exposure in a derivative without basic exposure in the underlying instrument. exposure in the underlying instrument.

What are the benefits of speculation?What are the benefits of speculation?– Enhances liquidity of the market.Enhances liquidity of the market.

What are the drawbacks of speculation?What are the drawbacks of speculation?– Excessive volatility. Companies & genuine Excessive volatility. Companies & genuine

investors interests are harmed.investors interests are harmed.

7070

VOLATILITY & SPECULATIONVOLATILITY & SPECULATION

Speculation leads to volatility, but Speculation leads to volatility, but volatility is not always the result of volatility is not always the result of speculation. Major reasons for volatility –speculation. Major reasons for volatility –– Take over bid.Take over bid.– Insider trading.Insider trading.– Limited floating stock.Limited floating stock.– Multiple listing.Multiple listing.– Excess money supply.Excess money supply.– Low interest rates.Low interest rates.

7171

CONTROL OF SPECULATIONCONTROL OF SPECULATION

Measures adopted by the stock exchange -Measures adopted by the stock exchange -– Imposing or increasing margins.Imposing or increasing margins.– Reducing carry forward duration.Reducing carry forward duration.– Enhancing backwardation (i.e. badla) Enhancing backwardation (i.e. badla)

chargescharges– Transfer from Specified to Cash category.Transfer from Specified to Cash category.– Restriction on volumes.Restriction on volumes.– Price bands.Price bands.– Controlling settlement price.Controlling settlement price.– Suspension of trading.Suspension of trading.– De-listing.De-listing.

7272

SEBI – ACT, 1992.SEBI – ACT, 1992.

ObjectivesObjectives– To promote the interest of investors.To promote the interest of investors.– To regulate the securities market.To regulate the securities market.– To ensure efficient services by intermediaries.To ensure efficient services by intermediaries.

FunctionsFunctions– Regulation of stock exchanges, brokers, Regulation of stock exchanges, brokers,

mutual funds.mutual funds.– Prohibition of fraudulent and unfair practices.Prohibition of fraudulent and unfair practices.– Prevent insider trading, and substantial Prevent insider trading, and substantial

acquisition.acquisition.– Educate investors & intermediaries.Educate investors & intermediaries.– Promote research and code of conduct.Promote research and code of conduct.

7373

SEBI – ACT, 1992.SEBI – ACT, 1992.

Powers Powers – Power to call for returns from stock Power to call for returns from stock

exchanges.exchanges.– Power to grant registration to brokers.Power to grant registration to brokers.– Power to call for information from brokers.Power to call for information from brokers.– Power to direct enquiries and investigations.Power to direct enquiries and investigations.– Power to frame rules and regulations of Power to frame rules and regulations of

stock exchanges.stock exchanges.– Power to compel listing.Power to compel listing.– Power to levy fees on merchant banking Power to levy fees on merchant banking

activities.activities.– Power to grant recognition of new stock Power to grant recognition of new stock

exchanges.exchanges.

7474

CAPITAL MARKET - SHORTCOMINGSCAPITAL MARKET - SHORTCOMINGS

More of speculative trading than cash trading.More of speculative trading than cash trading. Prevalence of insider trading.Prevalence of insider trading. Lack of sufficient liquidity.Lack of sufficient liquidity. Scarcity of floating stocks.Scarcity of floating stocks. Lack of transparency and corporate Lack of transparency and corporate

governance.governance. Lack of professionalism.Lack of professionalism. Excessive volatility.Excessive volatility. Cumbersome settlement procedure.Cumbersome settlement procedure. Dominance by FII’s.Dominance by FII’s. Dominance by large-cap stocks.Dominance by large-cap stocks.

7575

RECENT DEVELOPMENTSRECENT DEVELOPMENTS

Regulation of intermediaries.Regulation of intermediaries. Prohibiting insider trading.Prohibiting insider trading. Standardisation of accounting practices.Standardisation of accounting practices. Encouraging market building activities.Encouraging market building activities. Electronic trading and depository system.Electronic trading and depository system. Fair pricing of odd-lots.Fair pricing of odd-lots. Protecting investors interest.Protecting investors interest. Free and fair pricing of securities.Free and fair pricing of securities. Trading in derivatives.Trading in derivatives. International issues and listing.International issues and listing.

7676

FINANCIAL INTERMEDIARIESFINANCIAL INTERMEDIARIES

Intermediaries in the capital market –Intermediaries in the capital market –– Financial Institutions – IFCI, IDBI, ICICIFinancial Institutions – IFCI, IDBI, ICICI– Insurance CompaniesInsurance Companies– Mutual FundsMutual Funds– Pension FundsPension Funds– FII’sFII’s– Agricultural Financing InstitutionsAgricultural Financing Institutions– Specialised Institutions – IRBI, EXIM BankSpecialised Institutions – IRBI, EXIM Bank– NBFCNBFC

Hire Purchase & LeasingHire Purchase & Leasing Finance & InvestmentFinance & Investment

7777

FOREX MARKETFOREX MARKET

Foreign exchange includes all deposits and Foreign exchange includes all deposits and credits which are drawn in a home currency, credits which are drawn in a home currency, but payable in a foreign currency. A foreign but payable in a foreign currency. A foreign currency can be quoted in two ways –currency can be quoted in two ways –– Direct Quote ($ 1 = Rs.42.00)Direct Quote ($ 1 = Rs.42.00)– Indirect Quote (Rs.100.00 = $ 2.38)Indirect Quote (Rs.100.00 = $ 2.38)

In the short run currency is quoted on the In the short run currency is quoted on the basis of basis of demand–supplydemand–supply; however in the long ; however in the long run it is quoted on the basis of run it is quoted on the basis of PPP TheoryPPP Theory..

Trading in FOREX can be done in the Trading in FOREX can be done in the spot spot marketmarket as well in the as well in the future marketfuture market..

7878

DERIVATIVES MARKETDERIVATIVES MARKET

A A derivativederivative is a financial instrument whose is a financial instrument whose value is derived from a another underlying value is derived from a another underlying instrument. instrument. The basic objective of of a The basic objective of of a derivative is to transfer known sources of risk.derivative is to transfer known sources of risk.

The act of investing in a derivative to protect The act of investing in a derivative to protect own position is known as own position is known as hedginghedging. Investing in . Investing in a derivative in isolation to make profit in price a derivative in isolation to make profit in price fluctuations is known as fluctuations is known as speculatingspeculating..

A derivative which gives the investor the right A derivative which gives the investor the right to buy is referred to as a to buy is referred to as a callcall; a derivative ; a derivative which gives the investor the right to sell is which gives the investor the right to sell is referred to as areferred to as a put put..

7979

DERIVATIVE STRATEGYDERIVATIVE STRATEGY

A buys A buys 100100 shares of XYZ @ shares of XYZ @ 150150 with the with the following expectation – a) following expectation – a) 200 (p=0.7)200 (p=0.7) b) b) 125 125 (p=0.3)(p=0.3). On the settlement date price falls to . On the settlement date price falls to 110110. Therefore A suffers a loss of . Therefore A suffers a loss of 40004000..

On the strike date if A had bought a On the strike date if A had bought a put optionput option of of 500500 shares of XYZ @ shares of XYZ @ 125125, which would of cost , which would of cost him @ him @ 22 (i.e. (i.e. 10001000), he would have made a profit ), he would have made a profit of of 25002500..

However, on the settlement date if the price However, on the settlement date if the price increased to increased to 180180, his profit would have been , his profit would have been reduced from reduced from 30003000 to to 20002000..

So a derivative transaction is basically a trade-So a derivative transaction is basically a trade-off between risk and return.off between risk and return.

8080

TIME VALUE OF MONEYTIME VALUE OF MONEY

8181

WHAT IS TIME VALUE OF MONEY?WHAT IS TIME VALUE OF MONEY?

Value of Money –Value of Money – Money does not have any Money does not have any inherent value. Therefore, money represents what inherent value. Therefore, money represents what it can buy (i.e. purchasing power). Value of money it can buy (i.e. purchasing power). Value of money is basically a function of – a)is basically a function of – a) interest ratesinterest rates b) b) inflation.inflation. The difference between the two is The difference between the two is technically called the technically called the spreadspread. (i.e. interest – . (i.e. interest – inflation)inflation)– Interest rates > the value of moneyInterest rates > the value of money– Inflation < the value of moneyInflation < the value of money

Therefore, if the spread is positive value increases Therefore, if the spread is positive value increases over time, decreases if the spread is negative.over time, decreases if the spread is negative.

If the spread is zero, value of money remains If the spread is zero, value of money remains constant.constant.

8282

TIME VALUE - CHARACTERISTICSTIME VALUE - CHARACTERISTICS

The value of money changes over time. Money The value of money changes over time. Money today is more valuable than money receivable today is more valuable than money receivable tomorrow. The logic –tomorrow. The logic –– Individuals in general, prefer current Individuals in general, prefer current

consumption over future consumption.consumption over future consumption.– In an inflationary period, purchasing power In an inflationary period, purchasing power

of money falls over time.of money falls over time.– Money can be employed effectively to Money can be employed effectively to

generate returns.generate returns. Therefore money over different time periods Therefore money over different time periods

cannot be evaluated without adjusting.cannot be evaluated without adjusting.

8383

COMPOUNDING & DISCOUNTINGCOMPOUNDING & DISCOUNTING

Compounding refers to a process of Compounding refers to a process of adjusting to find out the –adjusting to find out the –– future value of a single cash flowfuture value of a single cash flow– future value of an annuityfuture value of an annuity

Discounting refers to a process of Discounting refers to a process of adjusting to find out the –adjusting to find out the –– present value of a single cash flowpresent value of a single cash flow– present value of an annuitypresent value of an annuity

8484

PERIOD OF CASH FLOWSPERIOD OF CASH FLOWS

Annuity –Annuity – It refers to a series of constant cash It refers to a series of constant cash flows for a finite time span. (Eg. Recurring flows for a finite time span. (Eg. Recurring deposit, Equated Monthly Installments)deposit, Equated Monthly Installments)

Perpetuity –Perpetuity – It refers to a series of constant It refers to a series of constant cash flows for a infinite time span. (Eg. Pension cash flows for a infinite time span. (Eg. Pension Funds, Reverse Mortgage)Funds, Reverse Mortgage)

8585

RISK & RETURNRISK & RETURN

8686

WHY RISK & RETURN?WHY RISK & RETURN?

It is the most preferred and robust criteria for It is the most preferred and robust criteria for appraising investment in financial assets. Other appraising investment in financial assets. Other important criteria for appraising an investment –important criteria for appraising an investment –– Liquidity –Liquidity – The ease with which the investment The ease with which the investment

can be converted into cash.can be converted into cash.– Duration –Duration – It refers to the life of the investment; It refers to the life of the investment;

any deviation may lead to a AL mismatch.any deviation may lead to a AL mismatch.– Transaction Cost –Transaction Cost – The cost of entering and The cost of entering and

exiting an investment.exiting an investment.– Convenience –Convenience – It refers to the ease with which It refers to the ease with which

the implications can be understood by an the implications can be understood by an investor.investor.

– Tax – Tax – Shelter available as per IT laws.Shelter available as per IT laws.

8787

WHAT IS RETURN?WHAT IS RETURN?

Return –Return –– It is the excess value received by an It is the excess value received by an

investor for foregoing current consumption.investor for foregoing current consumption. What are the different sources of return –What are the different sources of return –

– Initial Return Initial Return – Periodical ReturnPeriodical Return– Terminal ReturnTerminal Return

8888

WHAT IS RISK?WHAT IS RISK?

Risk –Risk –– It is the probability that the desired return It is the probability that the desired return

may not be achieved.may not be achieved. What are the different sources of risk –What are the different sources of risk –

– Operational Risk -Operational Risk - Business Risk, Market Business Risk, Market Risk.Risk.

– Financial Risk -Financial Risk - Interest Rate Risk, Liquidity Interest Rate Risk, Liquidity RiskRiskDefault Risk.Default Risk.

– Economic Risk -Economic Risk - Currency Risk, Inflation Currency Risk, Inflation Risk.Risk.

8989

INVESTMENT CONCEPTSINVESTMENT CONCEPTS

Notion of ReturnNotion of Return– Stream of benefitsStream of benefits– Measure = Mean + IRRMeasure = Mean + IRR

Notion of RiskNotion of Risk– Volatility in returnVolatility in return– Measure = Standard Deviation + BetaMeasure = Standard Deviation + Beta

Low RiskLow Risk High RiskHigh Risk

9090

INVESTMENT CONCEPTSINVESTMENT CONCEPTS

Notion of PortfolioNotion of Portfolio– Return adds up, Risk does notReturn adds up, Risk does not

Notion of DominanceNotion of Dominance– If risk is constant, return is the dominant If risk is constant, return is the dominant

factorfactor– If return is constant, risk is the dominant If return is constant, risk is the dominant

factorfactor Notion of Trade-offNotion of Trade-off

– Risk exposure - VaRRisk exposure - VaR Notion of DiversificationNotion of Diversification

– Do not keep all your eggs in one basketDo not keep all your eggs in one basket

9191

RISK DIVERSIFICATIONRISK DIVERSIFICATION

Illustration:Illustration:Consider a hypothetical planet, in which a Consider a hypothetical planet, in which a given year is either under hot or cold wave, given year is either under hot or cold wave, either of which is equally likely to prevail. Let either of which is equally likely to prevail. Let us assume that there are two companies us assume that there are two companies constituting the entire market – coffee and ice-constituting the entire market – coffee and ice-cream. If the hot wave dominates the planet, cream. If the hot wave dominates the planet, the ice-cream company would register a return the ice-cream company would register a return of of 30%,30%, while the coffee company would while the coffee company would register a return of register a return of 10%.10%. If on the other hand, If on the other hand, cold wave dominates the planet, ice-cream cold wave dominates the planet, ice-cream company would register a return of company would register a return of 10%,10%, while while the coffee company would register a return of the coffee company would register a return of 30%.30%. What would be your investment strategy? What would be your investment strategy?

9292

Solution:Solution:

If we invested in only one of the two companies, If we invested in only one of the two companies, our expected return will be our expected return will be 20%,20%, with a possible with a possible risk of risk of 10%.10%. If, we split our investment between If, we split our investment between the two companies in equal proportion, half of the two companies in equal proportion, half of our investment will earn a return of our investment will earn a return of 30%,30%, while while the other half would earn the other half would earn 10%,10%, so our expected so our expected return would still be return would still be 20%.20%. But in the second But in the second instance there is no possibility of deviation of instance there is no possibility of deviation of returns. Diversification results in returns. Diversification results in 20%20% expected expected return without risk, whereas holding individual return without risk, whereas holding individual securities was yielding an expected return of securities was yielding an expected return of 20%20% with a risk factor of with a risk factor of 10%.10%.


9393


r= -1

Unsystematic Risk

Systematic Risk

Tota

l R

isk

(%)

No. of Securities

40

r=+1

r=0

Correlation: The Magical Factor

9494

MARKOWITZ PORTFOLIO THEORYMARKOWITZ PORTFOLIO THEORY

A portfolio theory is all about investing in a mix A portfolio theory is all about investing in a mix of securities that lies on the efficient frontier. of securities that lies on the efficient frontier. Harry M. MarkowitzHarry M. Markowitz in his pioneering study in in his pioneering study in 19501950 was the first to identify the benefits of was the first to identify the benefits of diversification. The theory he came up with is diversification. The theory he came up with is popularly known as the popularly known as the Mean-Variance CriteriaMean-Variance Criteria. . Assumptions: Assumptions: – Investor decisions are based on risk and Investor decisions are based on risk and

return.return.– Risk and return is linearly related.Risk and return is linearly related.– Investors are risk averse.Investors are risk averse.– Investors try to maximize return.Investors try to maximize return.– Investors have identical expectations.Investors have identical expectations.

9595

RISK OF A PORTFOLIORISK OF A PORTFOLIO

pp2 2 = = xx

22**xx

22 + + yy22

**yy22 + 2 + 2 xx**y y **xx**yy**xyxy

where – where –

pp22 = Variance of portfolio p (x, y) = Variance of portfolio p (x, y)

xx = % of investment in security x= % of investment in security x

yy = % of investment in security y = % of investment in security y

xx = Standard deviation of security x = Standard deviation of security x

yy = Standard deviation of security y = Standard deviation of security y

xyxy = Correlation between security (x, y) = Correlation between security (x, y)

xx**yy**xy = xy = xxyy = Covariance between (x, y) = Covariance between (x, y)

9696

CAPITAL ASSET PRICING MODELCAPITAL ASSET PRICING MODEL

The credit for developing The credit for developing CAPMCAPM, goes to , goes to William Sharpe for which he got the Nobel William Sharpe for which he got the Nobel Prize for Economics in 1990. The model was Prize for Economics in 1990. The model was later extended by Lintner and Mossin, they later extended by Lintner and Mossin, they renamed it as renamed it as Single Index Model. Single Index Model.

It is called the It is called the Single Index ModelSingle Index Model because it because it attempts to capture the return from a stock in attempts to capture the return from a stock in terms of the market (i.e. An Index).terms of the market (i.e. An Index).

The return varies according to the riskiness of The return varies according to the riskiness of the stock in terms of the market. Riskiness is the stock in terms of the market. Riskiness is measured in terms of measured in terms of beta.beta.

The basic contention is higher the risk (i.e. The basic contention is higher the risk (i.e. beta), higher is the return.beta), higher is the return.

9797

SECURITY MARKET LINE (SML)SECURITY MARKET LINE (SML)

According to CAPM in a well functioning market in According to CAPM in a well functioning market in which stocks are correctly priced, there should be which stocks are correctly priced, there should be relationship between risk and return of an relationship between risk and return of an individual stock. The relationship is given by –individual stock. The relationship is given by –

Expected Return = Risk free rate of return + Beta Expected Return = Risk free rate of return + Beta * *

(Expected market return – Risk (Expected market return – Risk free rate of return)free rate of return)

The excess of expected market return over risk The excess of expected market return over risk free rate of return is known as the free rate of return is known as the risk premium of risk premium of market.market.

CAPMCAPM therefore assumes a perfect market therefore assumes a perfect market condition and a linear relationship between risk condition and a linear relationship between risk and return.and return.

9898

EFFICIENT FRONTIEREFFICIENT FRONTIER

Any Portfolio lying on the Efficient Frontier Any Portfolio lying on the Efficient Frontier curve is called an Efficient Portfoliocurve is called an Efficient Portfolio

Risk PremiumRisk Premium

Inefficient Portfolio’sInefficient Portfolio’s

Risk (Beta)

Exp

ect

ed R

etu

rn (

IRR

)

Risk-Free Rate of Return

SML

9999

EFFICIENT MARKET THEORYEFFICIENT MARKET THEORY

The market takes to into account all relevant The market takes to into account all relevant facts relating to the financial performance of a facts relating to the financial performance of a firm in pricing a security. Characteristics –firm in pricing a security. Characteristics –– Large number of buyers and sellers.Large number of buyers and sellers.– Low transaction cost.Low transaction cost.– Investors to do not have an edge over Investors to do not have an edge over

information.information.– Established communication channels.Established communication channels.– Investors are rational and logical.Investors are rational and logical.– Significant volumes.Significant volumes.– Price takers and not price movers.Price takers and not price movers.

100100

MEASUREMENT OF RISKMEASUREMENT OF RISK

BetaBeta measures the volatility of a stock with measures the volatility of a stock with respect to the market. A beta of 1 implies that respect to the market. A beta of 1 implies that 10% change in the market will lead to a 10% 10% change in the market will lead to a 10% change in the stock price. A beta of 1.2 implies change in the stock price. A beta of 1.2 implies that 10% change in the market will lead to a 12 % that 10% change in the market will lead to a 12 % change in the stock price. change in the stock price. A beta of 0.8 implies that 10% change in the A beta of 0.8 implies that 10% change in the market will lead to a 8 % change in the stock market will lead to a 8 % change in the stock price. price.

Beta (Beta ()) = n = n xy – ( xy – (x * x * y) y) nnxx2 2 – (– (x)x)22

Statistically, Statistically, betabeta is the regression coefficient of is the regression coefficient of the stock price (the stock price (yy) on the market index () on the market index (xx))

Cov (x, y) Var (y)or

101101

SOME INDICATORSSOME INDICATORS

1)1) IRR Equation:IRR Equation: x – LRR = 0 – NPV (LRR) x – LRR = 0 – NPV (LRR) LRR – HRRLRR – HRR NPV (LRR) – NPV NPV (LRR) – NPV

(HRR)(HRR)where x = IRRwhere x = IRR

2) 2) Variance (Total Risk)Variance (Total Risk) = = xx2 2 – – x x 22

n n n n3)3) Correlation r =Correlation r = n nxy – (xy – (x x ** y)y)

{n{nxx22 – ( – (x)x)22} } ** {n{nyy22 – ( – (y)y)22}}4) 4) Systematic RiskSystematic Risk = Total Risk * r = Total Risk * r22

5) 5) Unsystematic RiskUnsystematic Risk = TR - SR = TR - SR

102102

VALUATION OF VALUATION OF SECURITIESSECURITIES

103103

VALUATION OF SECURITIESVALUATION OF SECURITIES

What is intrinsic value?What is intrinsic value?– Intrinsic Value = Present value of future benefit(s).Intrinsic Value = Present value of future benefit(s).

What is market value?What is market value?– Market Value = Price at which it was last Market Value = Price at which it was last

transacted.transacted. Since markets are inefficient (informational gaps) –Since markets are inefficient (informational gaps) –

– Intrinsic Value Intrinsic Value Market Value Market Value What should be your investment strategy?What should be your investment strategy?

– If Market Value < Intrinsic Value = Buy If Market Value < Intrinsic Value = Buy – If Market Value > Intrinsic Value = Sell If Market Value > Intrinsic Value = Sell – If Intrinsic Value = Market Value = HoldIf Intrinsic Value = Market Value = Hold

104104

SKILLS OF A SUCCESSFUL INVESTORSKILLS OF A SUCCESSFUL INVESTOR

Stock selection abilities –Stock selection abilities –– Strong knowledge of sectors.Strong knowledge of sectors.– Reading between the lines.Reading between the lines.– Strong analytical and forecasting skills.Strong analytical and forecasting skills.– Finding bargains.Finding bargains.

Market timing abilities –Market timing abilities –– Identifying trends and trends reversal.Identifying trends and trends reversal.– Feeling the pulse of the market.Feeling the pulse of the market.– Contrary thinking.Contrary thinking.

105105

BALANCING INVESTING SKILLSBALANCING INVESTING SKILLS

Market timing abilities

Sto

ck s

ele

ctio

n a

bili

ties

GoodGood Poor

Poor

ConcentratedPortfolio

Managed Beta

ConcentratedPortfolio

Constant Beta

DiversifiedPortfolio

Managed Beta

Diversified Portfolio

Constant Beta

106106

BOND VALUATIONBOND VALUATION

Bond –Bond – A bond (also known as a debenture) is a A bond (also known as a debenture) is a debt instrument containing an unconditional debt instrument containing an unconditional promise to pay interest at a certain rate of interest promise to pay interest at a certain rate of interest (also known as coupon rate) which is either fixed (also known as coupon rate) which is either fixed or floating and pay back the principal sum at the or floating and pay back the principal sum at the end of a duration, which is determined in advance.end of a duration, which is determined in advance.

Basic Bond Valuation Model -Basic Bond Valuation Model -V = V = I I + P+ P (1+k(1+kdd))n n (1+k(1+kdd))nn

where V=Intrinsic Value, I=Annual Interest where V=Intrinsic Value, I=Annual Interest PayablePayableP=Principal or Par Value, n=Maturity PeriodP=Principal or Par Value, n=Maturity Periodkkdd=Discounting Rate=Discounting Rate

107107

EQUITY VALUATIONEQUITY VALUATION

Equity –Equity – It denotes risk capital, with or without It denotes risk capital, with or without management control. Return on equity is management control. Return on equity is highly volatile and has the largest duration highly volatile and has the largest duration among all classes of financial assets.among all classes of financial assets.

Dividend Capitalisation Model –Dividend Capitalisation Model – It represents It represents present value of dividend streams coupled present value of dividend streams coupled with expected price.with expected price.

PP11 = D = D11

(k(kss – g) – g)

where P=Price, Dwhere P=Price, D11 = expected dividend (Rs) = expected dividend (Rs)

kkss=expected rate of return, g=growth rate in =expected rate of return, g=growth rate in dividend (constant)dividend (constant)

108108

ARBITRAGE PRICING MODELSARBITRAGE PRICING MODELS

Whitbeck-Kisor Model –Whitbeck-Kisor Model – Return is a function of Return is a function of multiple factors, not only risk.multiple factors, not only risk.

P/EP/E = = 7.2 7.2 (EPS%) + (EPS%) + 1.71.7 (DPS%) – (DPS%) – 0.8 0.8 (EPSσ)(EPSσ)– Growth in EPS is the most important factor Growth in EPS is the most important factor

that positively affects P/E.that positively affects P/E.– Dividend growth positively affects P/E in a Dividend growth positively affects P/E in a

small way.small way.– Volatility in EPS negatively affects P/E in a Volatility in EPS negatively affects P/E in a

very insignificant way.very insignificant way.

109109

COST OF CAPITALCOST OF CAPITAL

110110

MEANING OF COST OF CAPITALMEANING OF COST OF CAPITAL

Definition Definition – It is the minimum rate of return that – It is the minimum rate of return that a company must earn in order to satisfy the a company must earn in order to satisfy the contributories who have made investments in contributories who have made investments in parity with risk and tenure. It is the financial parity with risk and tenure. It is the financial yardstick against which discounting is done.yardstick against which discounting is done.

The cost of capital to a company is the The cost of capital to a company is the weighted average cost of all the individual weighted average cost of all the individual sources of finance which comprises –sources of finance which comprises –– Cost of debentures and term loansCost of debentures and term loans– Cost of preference sharesCost of preference shares– Cost of equity sharesCost of equity shares

111111

CAPITAL STRUCTURECAPITAL STRUCTURE

Definition Definition – It refers to a judicious mix of – It refers to a judicious mix of various long-term sources of finance deployed various long-term sources of finance deployed by a company. The broad objective is to by a company. The broad objective is to minimise the cost of capital and maximize minimise the cost of capital and maximize wealth of the shareholders. wealth of the shareholders.

Factors that affect capital structure decisions –Factors that affect capital structure decisions –– Cost of capital and tenureCost of capital and tenure– Expected cash inflows and outflowsExpected cash inflows and outflows– Nature of business, industry cycleNature of business, industry cycle– Dilution of controlDilution of control– Floating costs.Floating costs.– Risk attitude of the top managementRisk attitude of the top management– Flexibility and exit costsFlexibility and exit costs

112112

COST OF A SPECIFIC SOURCECOST OF A SPECIFIC SOURCE

It is measured as the rate of discount which It is measured as the rate of discount which equates the present value of the expected equates the present value of the expected payments to that source of finance with the payments to that source of finance with the net funds received from that source of finance.net funds received from that source of finance.

where P = net funds received from the sourcewhere P = net funds received from the source CCtt= expected payment to the source at the = expected payment to the source at the

end of year tend of year t

P = Σ Ct

(1+kd)t

t=1

n

113113

COST OF DEBTCOST OF DEBT

The cost of debt capital is measured as the The cost of debt capital is measured as the rate of discount which equates the present rate of discount which equates the present value of post-tax interest repayments with the value of post-tax interest repayments with the net proceeds of the debt issue.net proceeds of the debt issue.

The multiplication byThe multiplication by (1-t)(1-t),, wherewhere tt is the tax is the tax rate applicable to the firm, is necessary to rate applicable to the firm, is necessary to reflect the fact that the interest on debt is a reflect the fact that the interest on debt is a tax deductible expense. F represents the tax deductible expense. F represents the redemption value.redemption value.

P = Σ C(1-t) F (1+kd)t

(1+kd)n t=1

n

+

114114

COST OF DEBTCOST OF DEBT

For obtaining a quick estimate, which is fairly For obtaining a quick estimate, which is fairly close to the correct value, of the cost of debt, close to the correct value, of the cost of debt, the following approximation may also be used the following approximation may also be used ––

kkdd = C(1-t) + (F - P) = C(1-t) + (F - P)

nn

(F+P)/2(F+P)/2 It is based on amortisation of the cost of an It is based on amortisation of the cost of an

asset evenly over its effective life period (n).asset evenly over its effective life period (n).

*100

115115

COST OF PREFERENCE CAPITALCOST OF PREFERENCE CAPITAL

The cost of debt capital is measured as the The cost of debt capital is measured as the rate of discount which equates the present rate of discount which equates the present value of dividend (usually fixed) payments value of dividend (usually fixed) payments with the net proceeds of the capital issue.with the net proceeds of the capital issue.

where F represents the redemption value, and where F represents the redemption value, and D represents annualised dividend.D represents annualised dividend.

P = Σ D F (1+kd)t

(1+kd)n t=1

n

+

116116

COST OF EQUITY CAPITALCOST OF EQUITY CAPITAL

Equity capital of a firm is raised through raising Equity capital of a firm is raised through raising of external equity and retention of current of external equity and retention of current earnings. The rate of return expected by earnings. The rate of return expected by suppliers of debt and preference capital can be suppliers of debt and preference capital can be ascertained with a fair degree of certainty. ascertained with a fair degree of certainty.

However, the estimation of the return expected However, the estimation of the return expected by equity holders cannot be determined with by equity holders cannot be determined with near certainty. To cope with this several near certainty. To cope with this several approaches have been proposed. They are –approaches have been proposed. They are –

Dividend Capitalisation Approach, CAPM, Dividend Capitalisation Approach, CAPM, Realised Yield Approach, Bond Yield + Risk Realised Yield Approach, Bond Yield + Risk Premium Approach, P/E Approach.Premium Approach, P/E Approach.

117117

REALISED YIELD APPROACHREALISED YIELD APPROACH

According to this approach the yield According to this approach the yield (rate of (rate of return)return) earned by equity shareholders earned by equity shareholders historically is regarded as a close proxy of the historically is regarded as a close proxy of the return expected by them, which by proxy return expected by them, which by proxy represents its cost.represents its cost.

YYt t = D= Dtt + P + Pt t

P P t-1t-1

where –where –

YYt t == YieldYield

DDt t == Current Dividend (%)Current Dividend (%)

PPt t == Current Price Current Price

P P t-1 t-1 == Previous PricePrevious Price

- 1

118118

NET WEALTH CREATIONNET WEALTH CREATION

The following is referred to as wealth ratio –The following is referred to as wealth ratio –

WWt t = D= Dtt + P + Pt t

P P t-1t-1

Therefore, the yield for an n period is –Therefore, the yield for an n period is –

YYn n == (W(W11 * W * W22 * W * W33 * …… W * …… Wnn))1/n1/n – 1 – 1where –where –

WW11 = D = D11 + P + P11

PP00

WW22 = D = D22 + P + P22

PP11

119119

RISK PREMIUM APPROACHRISK PREMIUM APPROACH

According to this approach the ERR of equity According to this approach the ERR of equity investors of a firm equals – investors of a firm equals – – ERR = Yield on Lt bonds(%) + Risk ERR = Yield on Lt bonds(%) + Risk

Premium(%)Premium(%) The logic is equity investors should be The logic is equity investors should be

compensated for bearing additional risk. compensated for bearing additional risk. There is no foolproof way of assessing the There is no foolproof way of assessing the risk premium. It usually varies at risk premium. It usually varies at +x% (beta)+x% (beta) depending on the capital market. depending on the capital market.

Some analysts look at the operating and Some analysts look at the operating and financial leverage of the company and adjust financial leverage of the company and adjust the risk premium accordingly.the risk premium accordingly.– T. Leverage = O. Leverage * F. LeverageT. Leverage = O. Leverage * F. Leverage

120120

PRICE – EARNINGS RATIOPRICE – EARNINGS RATIO

The P/E ratio is an indication of the return The P/E ratio is an indication of the return expected by equity holders, where –expected by equity holders, where –

– P/EP/E00 = Market Price (P = Market Price (P00)) and and

EPSEPS00

– P/EP/E11 = Market Price (P = Market Price (P11))

EPSEPS11

– Average P/E = P/EAverage P/E = P/E0 0 ++ P/EP/E1 1 +……++……+ P/EP/Enn

nn This measure is quite accurate when pay-out This measure is quite accurate when pay-out

ratio is constant.ratio is constant.

121121

COST OF RETAINED EARNINGSCOST OF RETAINED EARNINGS

It is calculated as the post tax rate of return It is calculated as the post tax rate of return available to an investor. This means the available to an investor. This means the expected rate of return has to be adjusted for expected rate of return has to be adjusted for income tax and capital gains tax, where –income tax and capital gains tax, where –

kkrr = k = kss * (1-t * (1-tpp))

(1-t(1-tgg))

– kkr r = Cost of retained earnings= Cost of retained earnings

– kkss= Expected return of equity holders= Expected return of equity holders

– ttpp= Personal income tax rate= Personal income tax rate

– ttgg= Personal capital gains tax rate= Personal capital gains tax rate

122122

WEIGHTED AVERAGE COST OF WEIGHTED AVERAGE COST OF CAPITALCAPITAL

A firms cost of capital is the weighted average A firms cost of capital is the weighted average cost of various sources of long-term finance cost of various sources of long-term finance used by it. Suppose a firm uses equity costing used by it. Suppose a firm uses equity costing 16% and debt costing 9%. If the proportions in 16% and debt costing 9%. If the proportions in which equity and debt are used are which equity and debt are used are respectively 40% and 60%, the cost of capital respectively 40% and 60%, the cost of capital will be –will be –– Cost of Capital = 0.4*16% + 0.6*9%Cost of Capital = 0.4*16% + 0.6*9%

= 6.40% + 5.40%= 6.40% + 5.40%

= 11.80%= 11.80% Proportions may be based on book value or Proportions may be based on book value or

market value. market value.

123123

MARGINAL COST OF CAPITALMARGINAL COST OF CAPITAL

It is assumed that risk composition of new It is assumed that risk composition of new projects and financing mix remaining constant, projects and financing mix remaining constant, cost of capital remains unchanged. This cost of capital remains unchanged. This indicates that marginal cost of capital is zero, indicates that marginal cost of capital is zero, irrespective of the magnitude of financing. In irrespective of the magnitude of financing. In reality this is not so. Generally the weighted reality this is not so. Generally the weighted average cost of capital tends to rise as the average cost of capital tends to rise as the firm seeks more and more capital.firm seeks more and more capital.– Usually suppliers of capital wants to be Usually suppliers of capital wants to be

increasingly compensated for taking increasingly compensated for taking additional amounts of exposure.additional amounts of exposure.

– Marginal cost of capital is directly Marginal cost of capital is directly proportional to volume of finance.proportional to volume of finance.

124124

MARGINAL COST SCHEDULEMARGINAL COST SCHEDULEA

vera

ge C

ost

of

Cap

ital

Volume of Financing (Debt)

Marginal cost of capital Volume of financing

X%(X+1)%

(X+2)%

125125

CAPITAL EXPENDITURE DECISIONSCAPITAL EXPENDITURE DECISIONS

126126

CAPEX - CHARACTERISTICSCAPEX - CHARACTERISTICS

CAPEX is characterised by the following – CAPEX is characterised by the following – – These decisions involve large financial These decisions involve large financial

outlays.outlays.– They are irreversible in nature. Exit barrier They are irreversible in nature. Exit barrier

is very high.is very high.– They require full support and commitment They require full support and commitment

of the top management.of the top management.– They provide an array of choices, therefore, They provide an array of choices, therefore,

decisions are very critical and complex.decisions are very critical and complex.– They have the ability to make or destroy a They have the ability to make or destroy a

company.company.

127127

CAPEX APPRAISALCAPEX APPRAISAL

All costs and benefits are measured in terms of All costs and benefits are measured in terms of cash flows and not profits.cash flows and not profits.

They should be converted to net cash flows.They should be converted to net cash flows. Incremental approach should be followed.Incremental approach should be followed. Cost of long-term funds should not be Cost of long-term funds should not be

included.included. Sunk costs must be ignored.Sunk costs must be ignored. Opportunity costs associated with utilisation of Opportunity costs associated with utilisation of

resources should be taken into account.resources should be taken into account. Long term funds principle.Long term funds principle.

128128

APPRAISAL CRITERIAAPPRAISAL CRITERIA

Payback PeriodPayback Period Accounting Rate of ReturnAccounting Rate of Return Net Present ValueNet Present Value Cost Benefit RatioCost Benefit Ratio Internal Rate of ReturnInternal Rate of Return

129129

WORKING CAPITAL MANAGEMENT

WORKING CAPITALWORKING CAPITAL

Working capital primarily refers to the level of Working capital primarily refers to the level of liquidity in a business. Liquidity broadly refers liquidity in a business. Liquidity broadly refers to the investments in current assets; it normally to the investments in current assets; it normally has a duration not exceeding one year. It is has a duration not exceeding one year. It is considered the life-line of any business. considered the life-line of any business.

Excessive liquidity should be avoided because it Excessive liquidity should be avoided because it pulls down a firms profitability, as idle pulls down a firms profitability, as idle investment does not contribute to margins. investment does not contribute to margins.

On the other hand inadequate liquidity can On the other hand inadequate liquidity can impair the solvency of the business because of impair the solvency of the business because of its inability to meet short-term obligations, its inability to meet short-term obligations, thereby affecting its credit rating.thereby affecting its credit rating. 130130

WORKING CAPITAL - LEVELSWORKING CAPITAL - LEVELS

Gross Working Capital – Gross Working Capital – It refers to the firms It refers to the firms composite investment in current assets. It broadly composite investment in current assets. It broadly includes – inventory, debtors and cash.includes – inventory, debtors and cash.

Net Working Capital – Net Working Capital – It refers to the difference It refers to the difference between current assets and current liabilities. between current assets and current liabilities. Current liabilities includes the obligations of the Current liabilities includes the obligations of the business which are likely to mature within one year. business which are likely to mature within one year. It includes creditors and outstanding expenses. Net It includes creditors and outstanding expenses. Net working capital may be positive or negative, working capital may be positive or negative, however, a negative working capital need not however, a negative working capital need not always be associated with poor financials.always be associated with poor financials.

Critical Working Capital – Critical Working Capital – It includes hard core cash.It includes hard core cash.

131131

QUALITY OF WORKING CAPITALQUALITY OF WORKING CAPITAL

The quality of WC is equally important as its The quality of WC is equally important as its quantity. Quality of working capital implies quantity. Quality of working capital implies investment in current assets with an acceptable investment in current assets with an acceptable level of volatility. level of volatility.

A high level of volatility results in assets A high level of volatility results in assets becoming NPA becoming NPA (i.e. non-performing assets)(i.e. non-performing assets). An . An asset whose realisability extends beyond asset whose realisability extends beyond 66 months is said to non-performing.months is said to non-performing.

NPA’s severely impairs the quality of working NPA’s severely impairs the quality of working capital.capital.

A financial manager also needs to diligently A financial manager also needs to diligently apply the apply the Matching ConceptMatching Concept to maintain quality to maintain quality of WC.of WC.

132132

133133

MATCHING CONCEPTMATCHING CONCEPT

Temporary Current

Assets

Capacity / Production (Units)

Cap

ital Em

plo

yed

(R

s)

Permanent Current Assets

Fixed AssetsLong Term Financing

Short Term Financing

WORKING CAPITAL - CYCLEWORKING CAPITAL - CYCLE

134134

Raw Materials

Cash Creditors

Work – In Process

Finished Goods

Debtors

Overheads

WORKING CAPITAL - REQUIREMENTSWORKING CAPITAL - REQUIREMENTS

Nature of Business – Nature of Business – In a manufacturing business In a manufacturing business the requirements of WC are the maximum. Of its the requirements of WC are the maximum. Of its total investments approximately total investments approximately 1/31/3 of is blocked of is blocked in WC. in WC.

In a service business In a service business (i.e. telecom, banking, (i.e. telecom, banking, insurance, IT) insurance, IT) the requirements of WC is the requirements of WC is comparatively lesser than in manufacturing. comparatively lesser than in manufacturing. However, approximately However, approximately 2/32/3 total investments is total investments is blocked in WC. blocked in WC.

In a retail business, the requirements of WC is even In a retail business, the requirements of WC is even lesser than in service lesser than in service (except for organised sector)(except for organised sector). . However, However, approximately 90% total However, However, approximately 90% total investments is blocked in WC. investments is blocked in WC. 135135


Seasonality of Operations – Seasonality of Operations – Businesses which Businesses which are highly seasonal in nature are highly seasonal in nature (sales in certain (sales in certain periods differ significantly from other periods) periods differ significantly from other periods) require higher amounts of WC in peak months require higher amounts of WC in peak months rather than in slack month. Eg. air-conditioners, rather than in slack month. Eg. air-conditioners, soft-drinks.soft-drinks.

However, high volatility However, high volatility (measured in terms of (measured in terms of standard deviation)standard deviation) in sales should not be in sales should not be confused with seasonality. confused with seasonality.

Production Policy – Production Policy – A conservative management A conservative management may decide to maintain a higher level of WC may decide to maintain a higher level of WC than an aggressive one on the fear of losing than an aggressive one on the fear of losing customers.customers.

136136


Market Competition – Market Competition – It also partially depends on It also partially depends on the product-life cycle as the industry cycle in the product-life cycle as the industry cycle in which the firm is present. Different stages are which the firm is present. Different stages are obviously characterized by different levels of obviously characterized by different levels of competition. competition.

Higher levels of competition, irrespective of the Higher levels of competition, irrespective of the policy of the managements calls for higher levels policy of the managements calls for higher levels of WC, again on the fear of losing customers.of WC, again on the fear of losing customers.

As higher levels of competitions calls for higher As higher levels of competitions calls for higher investment in raw materials as well as finished investment in raw materials as well as finished goods and more credit being extended to goods and more credit being extended to customers. While creditors will demand advance customers. While creditors will demand advance payment against supplies.payment against supplies. 137137


Supply Conditions – Supply Conditions – Supply conditions also influences Supply conditions also influences requirements of WC. Supply conditions may include –requirements of WC. Supply conditions may include –

Promptness, order bookings and location of supplier.Promptness, order bookings and location of supplier. Seasonality of raw materials. Seasonality of raw materials. Attractive discounts / commissions against Attractive discounts / commissions against

purchasing in bulk.purchasing in bulk. Transporters arrangements Transporters arrangements (Eg. attractive rates – full (Eg. attractive rates – full

container bookings, uncertainty in transit time)container bookings, uncertainty in transit time).. Information on price hikes coming from formal as Information on price hikes coming from formal as

well as informal channels.well as informal channels. Government documentations – Government documentations – C form & Way BillC form & Way Bill..

138138

PERMANENT & FIXED WCPERMANENT & FIXED WC

Permanent WC is the minimum level of WC a Permanent WC is the minimum level of WC a firm should maintain a sufficient level of firm should maintain a sufficient level of current assets to ensure continuity in its current assets to ensure continuity in its business and pay its creditors on time.business and pay its creditors on time.

Permanent WC may be a constant or Permanent WC may be a constant or increasing function over time.increasing function over time.

WC going below the permanent level will lead WC going below the permanent level will lead to loss of market share, default in suppliers to loss of market share, default in suppliers payment, leading to loss of goodwill.payment, leading to loss of goodwill.

Variables WC represents the fluctuations in WC Variables WC represents the fluctuations in WC over and above the permanent level over and above the permanent level depending upon internal and external depending upon internal and external circumstances.circumstances.

139139

WORKING CAPITAL - FINANCINGWORKING CAPITAL - FINANCING

Working capital may be financed from the Working capital may be financed from the following one or more sources –following one or more sources –

Promoters – Promoters – This includes the investment made This includes the investment made by the promoters in the WC of the firm by the promoters in the WC of the firm (i.e. (i.e. inventory and debtors)inventory and debtors)..

Creditors – Creditors – This includes the raw-materials This includes the raw-materials supplied by creditors against deferred supplied by creditors against deferred payment.payment.

Bankers – Bankers – It extends credit against It extends credit against hypothecation of inventory hypothecation of inventory (i.e. overdraft) (i.e. overdraft) or or against discounting of billsagainst discounting of bills (i.e. cash credit). (i.e. cash credit).

Securitization – Securitization – Adding liquidity to a pool of Adding liquidity to a pool of book debts.book debts.

140140

141141141141

CONSERVATIVE FINANCINGCONSERVATIVE FINANCING

Temporary Current

Assets


Cap

ital Em

plo

yed

(R

s)




142142142142

AGGRESSIVE FINANCINGAGGRESSIVE FINANCING

Temporary Current

Assets


Cap

ital Em

plo

yed

(R

s)




YIELD CURVEYIELD CURVE

A firm has to make trade-off between following a A firm has to make trade-off between following a conservative or aggressive financing policy. The conservative or aggressive financing policy. The relationship between maturity of debt (i.e. relationship between maturity of debt (i.e. tenure) cost of capital is usually upward sloping. tenure) cost of capital is usually upward sloping. However, in the long-term it reaches a plateau. However, in the long-term it reaches a plateau.

According to the According to the liquidity preference theory liquidity preference theory the the tenure usually increases the risk involved tenure usually increases the risk involved (i.e. (i.e. uncertainty in forecasting long-term interests)uncertainty in forecasting long-term interests). . Therefore, the lender compensates the risk with Therefore, the lender compensates the risk with a higher interest rate.a higher interest rate.

This trade-off is guided by the following factors – This trade-off is guided by the following factors – a) cost of capital b) flexibility.a) cost of capital b) flexibility.

143143

INVENTORY MANAGEMENTINVENTORY MANAGEMENT

Inventory is the basic cornerstone of liquidity in a Inventory is the basic cornerstone of liquidity in a business. All the other components in WC business. All the other components in WC revolves around inventory. revolves around inventory. It has broadly three It has broadly three components –components –

Raw Materials – Raw Materials – These are the basic inputs that These are the basic inputs that goes into the manufacturing process.goes into the manufacturing process.

Work-In-Process –Work-In-Process – It refers to inventory in the It refers to inventory in the intermediary stage of production. It normally intermediary stage of production. It normally represents full absorption of raw materials and represents full absorption of raw materials and partial absorption of overheads partial absorption of overheads (i.e. usually 50%)(i.e. usually 50%)..

Finished Goods – Finished Goods – Items of production when they Items of production when they are ready for sale.are ready for sale.

Investment in inventory is next only to P&M.Investment in inventory is next only to P&M. 144144

INVENTORY DECISION MAKINGINVENTORY DECISION MAKING

Decisions revolving around inventory management – Decisions revolving around inventory management – – What should be the size of the order (EOQ)?What should be the size of the order (EOQ)?– When should the order be placed (safety stock)?When should the order be placed (safety stock)? The decisions revolves around three types of costs The decisions revolves around three types of costs

–– Ordering Cost – Ordering Cost – It includes requisitioning, It includes requisitioning,

expediting, transportation, and transfer costs.expediting, transportation, and transfer costs. Carrying Cost – Carrying Cost – It includes opportunity cost of It includes opportunity cost of

locked up inventory, storage, insurance and locked up inventory, storage, insurance and obsolescence. obsolescence.

Shortage Cost – Shortage Cost – It includes costs concomitant with It includes costs concomitant with cash purchase, production slowdown, loss of cash purchase, production slowdown, loss of market share.market share. 145145

ECONOMIC ORDER QUANTITYECONOMIC ORDER QUANTITY

Large orders reduces ordering costs but Large orders reduces ordering costs but increases carrying costs. Similarly, large increases carrying costs. Similarly, large safety stock reduces shortage costs but safety stock reduces shortage costs but increases carrying costs. Trade-off increases carrying costs. Trade-off assumptions –assumptions –

Short-term demand forecast is available.Short-term demand forecast is available. Production is uniform during the year.Production is uniform during the year. Stocks can be replenished immediately.Stocks can be replenished immediately. Inventory costs can be decomposed into – cost Inventory costs can be decomposed into – cost

of ordering and cost of carrying.of ordering and cost of carrying. Cost per order is constant, irrespective of size.Cost per order is constant, irrespective of size. Carrying cost is fully variable.Carrying cost is fully variable.

146146

147147147147147147

EOQ MODELEOQ MODEL

Order Size (Qty)

Cost

s(R

s)

Ordering Cost

Total Cost

Carrying Cost

EOQ

EOQ - DERIVATIONEOQ - DERIVATION

Total Cost = Ordering Cost + Carrying CostTotal Cost = Ordering Cost + Carrying Cost TC = (U/Q * F) + (Q/2 * P * C)TC = (U/Q * F) + (Q/2 * P * C)

where – where –

U = Annual Demand / UsageU = Annual Demand / Usage

Q = Order SizeQ = Order Size

F = Cost per OrderF = Cost per Order

C = % Carrying CostC = % Carrying Cost

P = Price per UnitP = Price per Unit

TC = Total CostTC = Total Cost

148148

Q = √ [(2 * F * U) / (P * C)]

QUANTITY DISCOUNTS & EOQQUANTITY DISCOUNTS & EOQ

The standard EOQ model assumes that price The standard EOQ model assumes that price per unit is constant irrespective of order size. per unit is constant irrespective of order size. However, in reality qty discounts are However, in reality qty discounts are associated with order size. This in principle associated with order size. This in principle violates the applicability of the EOQ model.violates the applicability of the EOQ model.

However, the EOQ model can still be adjusted However, the EOQ model can still be adjusted to determine the ordering qty. to determine the ordering qty. Steps –Steps –

Determine the order qty assuming no discount Determine the order qty assuming no discount is available. If change in profit is is available. If change in profit is (+)(+) then EOQ then EOQ needs to be upgraded to needs to be upgraded to Optimal Ordering Optimal Ordering QtyQty. However, If change in profit is . However, If change in profit is (-)(-) then then stick to stick to EOQEOQ.. 149149

DETERMINING CHANGE IN PROFIT - DETERMINING CHANGE IN PROFIT - ∆π∆π

∆∆π = [U*D + (U/Q* - U/Q’)*F] - π = [U*D + (U/Q* - U/Q’)*F] -

[Q’(P-D)*C/2 – Q*P*C/2] [Q’(P-D)*C/2 – Q*P*C/2] where – where –

U = Annual Demand / UsageU = Annual Demand / UsageQ = Order SizeQ = Order SizeF = Cost per OrderF = Cost per OrderC = % Carrying CostC = % Carrying CostP = Price per Unit without DiscountP = Price per Unit without DiscountD = Discount per Unit (Rs.)D = Discount per Unit (Rs.)Q* = EOQ assuming no qty discountQ* = EOQ assuming no qty discountQ’ = Minimum order qty to avail discountQ’ = Minimum order qty to avail discount

150150

ORDER POINTORDER POINT

The basic EOQ model assumes – stocks can be The basic EOQ model assumes – stocks can be replenished instantly. Therefore, the model replenished instantly. Therefore, the model assumes that orders be placed when inventory assumes that orders be placed when inventory level reaches zero. level reaches zero. However, this is not so reality. However, this is not so reality. Therefore, Therefore,

Order Point = Lead time (days) * Average daily Order Point = Lead time (days) * Average daily usage / consumption.usage / consumption.

A A safety stock safety stock is required since lead time as well is required since lead time as well as average consumption are both likely to vary. It as average consumption are both likely to vary. It provides protection against provides protection against stock-outstock-out. Put . Put differently, differently,

Adjusted Order Point Adjusted Order Point = Order point + Safety stock.= Order point + Safety stock.151151

SAFETY STOCKSAFETY STOCK

If the consumption / usage pattern only varies –If the consumption / usage pattern only varies – Safety stock = (Maximum – Average) Daily usage Safety stock = (Maximum – Average) Daily usage

* Lead time (days) * Lead time (days) If the consumption pattern as well as lead time If the consumption pattern as well as lead time

varies, a higher safety stock is required to varies, a higher safety stock is required to prevent a stock-out. prevent a stock-out. In such a case – In such a case –

Safety stock = (Maximum usage * Maximum lead Safety stock = (Maximum usage * Maximum lead time) – (Average usage * Average lead time)time) – (Average usage * Average lead time)

Stock out refers to a situation where the Stock out refers to a situation where the inventory level falls below the safety stockinventory level falls below the safety stock. Cost . Cost associated with it refers to opportunity loss and associated with it refers to opportunity loss and reputation.reputation.

152152

INVENTORY VALUATIONINVENTORY VALUATION

Inventory valuation is critical to the reflection of Inventory valuation is critical to the reflection of the financial position of the firm. the financial position of the firm. On one side it On one side it improves the current ratio, but on the other improves the current ratio, but on the other side it reduces profits (i.e. because of higher tax side it reduces profits (i.e. because of higher tax outflow)outflow). So a trade-off is very essential.. So a trade-off is very essential.

Raw materials are usually valued through – Raw materials are usually valued through – FIFO, LIFO or Weighted Average method.FIFO, LIFO or Weighted Average method.

Work-In-Process through Marginal or Absorption Work-In-Process through Marginal or Absorption Costing.Costing.

Finished Goods through BIN Cards.Finished Goods through BIN Cards. Selection of methodology is critical to valuation.Selection of methodology is critical to valuation.

153153

ABC ANALYSISABC ANALYSIS

In most organizations inventory follows the In most organizations inventory follows the Pareto’s (80:20) RulePareto’s (80:20) Rule. It explains that 20% of . It explains that 20% of the inventory units accounts for 80% of the the inventory units accounts for 80% of the inventory value. ABC analysis is based on this inventory value. ABC analysis is based on this empirical reality. empirical reality.

It classifies inventory into three broad It classifies inventory into three broad categories. A representing 15% of the items categories. A representing 15% of the items that accounts for 70% of the value.that accounts for 70% of the value.

B representing 30% of the items representing B representing 30% of the items representing 20% of the value.20% of the value.

C representing 55% of the items representing C representing 55% of the items representing 10% of the value.10% of the value.

The objective is to focus on A and ignore C.The objective is to focus on A and ignore C.154154

155155

ABC CLASSIFICATIONABC CLASSIFICATIONV

alu

e o

f In

ven

tory

A items

B items

C items

Suppose 15% of our items accounted for 70% of our sales.

They would be A items, managed most carefully.

100%

70%

Number of items

90%

15% 45% 100%

DEBTORS MANAGEMENTDEBTORS MANAGEMENT

While firms would like to sell on cash While firms would like to sell on cash (i.e. it (i.e. it minimizes investment in WC)minimizes investment in WC), but pressure from , but pressure from competition forces them to sell on credit competition forces them to sell on credit (i.e. (i.e. risk of losing market share)risk of losing market share). It has to make a . It has to make a trade-off between the two repelling forces.trade-off between the two repelling forces.

Normal credit usually ranges between Normal credit usually ranges between (15-60) (15-60) days and days and 9090 days in exceptional cases. days in exceptional cases.

Debts beyond Debts beyond 180180 days needs to classified days needs to classified separately in the Balance Sheet, and may be separately in the Balance Sheet, and may be qualified as qualified as NPA’sNPA’s..

Credit evaluation and monitoring Credit evaluation and monitoring is critical for is critical for successful management of WC successful management of WC (i.e. bad debts)(i.e. bad debts)..156156

CREDIT POLICY VARIABLES - ICREDIT POLICY VARIABLES - I

Credit Standards – Credit Standards – It revolves around a benchmark It revolves around a benchmark for accepting or rejecting an account for credit for accepting or rejecting an account for credit opening.opening.

At one end of the spectrum lies a choice At one end of the spectrum lies a choice not to not to extend any creditextend any credit, irrespective of the high credit , irrespective of the high credit rating. At the other end of the spectrum lies a rating. At the other end of the spectrum lies a choice choice to extend credit to extend credit to any customer to any customer irrespective of the low credit rating. irrespective of the low credit rating.

Between the two extremes lies several practical Between the two extremes lies several practical trade-offs based on credit evaluation bases –trade-offs based on credit evaluation bases –

Character, Capacity, Capital, Collateral, Character, Capacity, Capital, Collateral, Conditions.Conditions.

Type I & II Type I & II errors associated with credit evaluation.errors associated with credit evaluation.157157

CREDIT POLICY VARIABLES - IICREDIT POLICY VARIABLES - II

Credit Limit – Credit Limit – Credit limit refers to the maximum Credit limit refers to the maximum days /amountdays /amount outstanding to be provided to a outstanding to be provided to a customer customer one time/repeatone time/repeat, till when supplies will be , till when supplies will be made. made.

Cash Discount – Cash Discount – To induce customers to buy against To induce customers to buy against cash or make payment before scheduled tenure cash or make payment before scheduled tenure firms generally offer a cash discount to motivate firms generally offer a cash discount to motivate customers to make prompt payment. Liberalizing customers to make prompt payment. Liberalizing the cash discount means lesser investment in WC, the cash discount means lesser investment in WC, as well as squeezing of profit margins.as well as squeezing of profit margins.

Collection Effort – Collection Effort – It includes a slew of It includes a slew of comprehensive measures aimed at timely and comprehensive measures aimed at timely and speedy collection.speedy collection. 158158

CREDIT SCORINGCREDIT SCORING

Credit scoring Credit scoring (E.g. Fannie Mae) (E.g. Fannie Mae) is a method of is a method of credit evaluation which adds a degree of credit evaluation which adds a degree of objectivity to the objectivity to the 5C 5C method. method. It involves the It involves the following process –following process –

Identify the factors relevant for credit evaluation.Identify the factors relevant for credit evaluation. Assign weights to these factors based on relative Assign weights to these factors based on relative

importance.importance. Rate the customer on a relevant scale Rate the customer on a relevant scale (E.g. Likert)(E.g. Likert).. Find the factor score by multiplying the score with Find the factor score by multiplying the score with

the weight.the weight. Find the Find the Customer Rating IndexCustomer Rating Index, by adding all the , by adding all the

factor scores.factor scores. Classify the customer Classify the customer (i.e. the end objective)(i.e. the end objective).. 159159

160160160160160160160160

DISCRIMINANT ANALYSISDISCRIMINANT ANALYSIS

Return on Investment (Return)

Curr

en

t R

ati

o

(Ris

k)

+

o

++

+

+

+

+

+

+++

+

+

+

+ +

o

oo

o

o

o

ooo

o

o+

DAY’S SALES OUTSTANDING - DSODAY’S SALES OUTSTANDING - DSO

The DSO of a given company at a given time “t” The DSO of a given company at a given time “t” is defined as the ratio of debtors at that point of is defined as the ratio of debtors at that point of time with the average daily sales during the time with the average daily sales during the credit period.credit period.

The trend in The trend in DSODSO reflects how well the company reflects how well the company has managed the bargaining power of its has managed the bargaining power of its customers. The average customers. The average DSODSO when compared when compared with the credit norms of the company gives an with the credit norms of the company gives an indication of degree of slack in debtors indication of degree of slack in debtors management.management.

DSODSOtt = Average receivables at time “t” = Average receivables at time “t”

Average sales during the credit periodAverage sales during the credit period161161

CREDIT GRANTING DECISIONCREDIT GRANTING DECISION

To determine the credit worthiness of a one To determine the credit worthiness of a one time or repeat customer the following thumb time or repeat customer the following thumb rule based on expected profit may also be rule based on expected profit may also be applied – applied –

EEp p = p (r-c) – q*c= p (r-c) – q*c where -where - EEpp = Expected profit = Expected profit p = probability the customer pays his duesp = probability the customer pays his dues q = probability the customer defaultsq = probability the customer defaults r = expected revenuesr = expected revenues c = cost of production or goods soldc = cost of production or goods sold

162162

REPEAT ORDERREPEAT ORDER

A repeat order is normally accepted if the customer A repeat order is normally accepted if the customer does not default on the first orderdoes not default on the first order. However, once the . However, once the customer pays for the first order, the probability that customer pays for the first order, the probability that he would default on the second order would be lesser he would default on the second order would be lesser than the probability of default on the first order.than the probability of default on the first order.

EEp p = {p= {p11 (r (r11 – c – c11) – q*c) – q*c11} + p} + p11*{p*{p22*(r*(r22-c-c22) – q) – q22*c*c22}} where –where – pp11 = probability the customer pays his dues in order = probability the customer pays his dues in order11

pp22 = probability the customer pays his dues in order = probability the customer pays his dues in order22

qq11 = probability the customer defaults in order = probability the customer defaults in order11

qq2 2 = probability the customer defaults in order= probability the customer defaults in order22

163163

CONCEPT OF TREASURYCONCEPT OF TREASURY

Treasury includes cash and short-term Treasury includes cash and short-term money market instruments. money market instruments.

Cash is the focal point of fund flow in a Cash is the focal point of fund flow in a business. While the proportion of total assets business. While the proportion of total assets is very small is very small (i.e. 1-3) %(i.e. 1-3) %, its efficient , its efficient management is crucial for solvency. management is crucial for solvency.

A A cash-richcash-rich firm is better prepared to tap firm is better prepared to tap opportunities arising from fluctuations in opportunities arising from fluctuations in commodity prices, security prices, interest commodity prices, security prices, interest rates, and foreign exchange.rates, and foreign exchange.

However, it is the However, it is the most idle resource most idle resource of a firm of a firm and hence has an opportunity cost.and hence has an opportunity cost. 164164

TREASURY MANAGEMENTTREASURY MANAGEMENT

Successful treasury management has a direct impact Successful treasury management has a direct impact on profitability as well. It requires –on profitability as well. It requires –

Reliable forecasting and established reporting Reliable forecasting and established reporting systems.systems.

Improving cash collections and delaying disbursals.Improving cash collections and delaying disbursals. Achieve optimal utilization and conservation of funds.Achieve optimal utilization and conservation of funds. Float Float refers to the difference between book balance in refers to the difference between book balance in

bank ledger and actual funds available. bank ledger and actual funds available. Managing the Managing the float is critical for treasury management.float is critical for treasury management.

Electronic funds transfer Electronic funds transfer has considerably reduced has considerably reduced the cash holding requirement of most firms.the cash holding requirement of most firms.

165165

166166

CASH HOLDING MOTIVESCASH HOLDING MOTIVES

Transaction:Transaction: It emphasizes the need to It emphasizes the need to maintain the desired levels of cash to facilitate maintain the desired levels of cash to facilitate the smooth running of production and sales.the smooth running of production and sales.

Precautionary: Precautionary: It necessitates the holding of It necessitates the holding of cash to safeguard against fluctuations in lead cash to safeguard against fluctuations in lead time and consumption pattern. time and consumption pattern.

Speculative: Speculative: It influences the holding of cash It influences the holding of cash above the desired levels to take advantage of above the desired levels to take advantage of price fluctuations. However, as a standard price fluctuations. However, as a standard practice it is advisable to enforce suitable risk practice it is advisable to enforce suitable risk management practices management practices (i.e. derivatives) (i.e. derivatives) to to guard against downward risks.guard against downward risks.

OPTIMAL CASH HOLDINGOPTIMAL CASH HOLDING

Cash holding models attempts to answer the Cash holding models attempts to answer the following two questions – following two questions –

When should the transfers be effected between When should the transfers be effected between money market securities and cash?money market securities and cash?

What should be the magnitude of these transfers?What should be the magnitude of these transfers? If a firm maintains a small cash balance, it has to If a firm maintains a small cash balance, it has to

sell securities (and buy them later). This will lead sell securities (and buy them later). This will lead to high conversion costs, but low opportunity to high conversion costs, but low opportunity costs.costs.

If a firm maintains a large cash balance, its If a firm maintains a large cash balance, its conversion costs would be low, but opportunity conversion costs would be low, but opportunity costs will be comparatively higher.costs will be comparatively higher.

167167

168168168168168168168168

BAUMOL’S MODELBAUMOL’S MODEL

Conversion Size(Rs.)

Cost

s(R

s)

Conversion Cost

Total Cost

Opportunity Cost

Optimal Cash Balance

169169

EOQ - DERIVATIONEOQ - DERIVATION

Total Cost = Ordering Cost + Carrying CostTotal Cost = Ordering Cost + Carrying Cost TC = (U/Q * F) + (Q/2 * P * C)TC = (U/Q * F) + (Q/2 * P * C)

where – where –

U = Annual Demand / UsageU = Annual Demand / Usage

Q = Order SizeQ = Order Size

F = Cost per OrderF = Cost per Order

C = % Carrying CostC = % Carrying Cost

P = Price per UnitP = Price per Unit

TC = Total CostTC = Total Cost

169169

Q = √ [(2 * F * U) / (P * C)]

170170

QUANTITY DISCOUNTS & EOQQUANTITY DISCOUNTS & EOQ

The standard EOQ model assumes that price The standard EOQ model assumes that price per unit is constant irrespective of order size. per unit is constant irrespective of order size. However, in reality qty discounts are However, in reality qty discounts are associated with order size. This in principle associated with order size. This in principle violated the applicability of the EOQ model.violated the applicability of the EOQ model.

However, the EOQ model can still be adjusted However, the EOQ model can still be adjusted to determine the ordering qty. to determine the ordering qty. Steps –Steps –

Determine the order qty assuming no discount Determine the order qty assuming no discount is available. If change in profit is is available. If change in profit is (+)(+) then EOQ then EOQ needs to be upgraded to needs to be upgraded to optimal ordering qtyoptimal ordering qty. . However, If change in profit is However, If change in profit is (-)(-) then stick to then stick to EOQEOQ.. 170170

171171

DETERMINING CHANGE IN PROFIT - DETERMINING CHANGE IN PROFIT - ∆π∆π

∆∆π = [U*D + (U/Q* - U/Q’)*F] - π = [U*D + (U/Q* - U/Q’)*F] -

[Q’(P-D)*C/2 – [Q’(P-D)*C/2 – Q*P*C/2] Q*P*C/2]

where – where – U = Annual Demand / UsageU = Annual Demand / UsageQ = Order SizeQ = Order SizeF = Cost per OrderF = Cost per OrderC = % Carrying CostC = % Carrying CostP = Price per Unit without DiscountP = Price per Unit without DiscountD = Discount per Unit (Rs.)D = Discount per Unit (Rs.)Q* = EOQ assuming no qty discountQ* = EOQ assuming no qty discountQ’ = Minimum order qty to avail discountQ’ = Minimum order qty to avail discount

171171

MILLER & ORR MODELMILLER & ORR MODEL

Criticizing the completely deterministic Criticizing the completely deterministic assumptions of the assumptions of the Baumol’s ModelBaumol’s Model, the , the Miller & Miller & Orr Model Orr Model assumes that changes in cash balances assumes that changes in cash balances over a given period are over a given period are random in size as well as random in size as well as in directionin direction. As the no. of periods become . As the no. of periods become sufficiently large, cash balance changes form a sufficiently large, cash balance changes form a normal distributionnormal distribution. .

According to this model upward changes in cash According to this model upward changes in cash balance is allowed till it reaches an UL, then it is balance is allowed till it reaches an UL, then it is reduced to RP.reduced to RP.

Downward changes are permitted till it reaches a Downward changes are permitted till it reaches a LL, then it is increased to RP.LL, then it is increased to RP.

Determine UL & RP through Miller & Orr Model.Determine UL & RP through Miller & Orr Model.172172

173173

MILLER & ORR MODELMILLER & ORR MODEL

In the Miller & Orr Model the “Lower Control Limit” In the Miller & Orr Model the “Lower Control Limit” (LL) is set by the management based on its risk (LL) is set by the management based on its risk perspectives. The “Return Point” (RP) and “Upper perspectives. The “Return Point” (RP) and “Upper Control Limit” (UL) is calculated accordingly –Control Limit” (UL) is calculated accordingly –

RP = RP = 3 3 3 * b * σ3 * b * σ2 2 + LL + LL where – where –

4 * I4 * I

RP = Return PointRP = Return Point

b = Fixed Cost per Orderb = Fixed Cost per Order

I = Daily Interest on Marketable SecuritiesI = Daily Interest on Marketable Securities

σσ2 2 = Daily Cash Variance= Daily Cash Variance

UL = 3RP – 2LLUL = 3RP – 2LL173173

CASH BUDGETCASH BUDGET

A A cash budget cash budget is a summary statement of a is a summary statement of a firm’s expected cash inflows and outflows over firm’s expected cash inflows and outflows over a projected time period. a projected time period. Accruals are not taken Accruals are not taken into accountinto account..

It provides information on timing and It provides information on timing and magnitude of cash flows.magnitude of cash flows.

A series of cash forecasts leads to the A series of cash forecasts leads to the culmination of a cash budget.culmination of a cash budget.

A cash budget includes revenue as well as A cash budget includes revenue as well as capital transactions.capital transactions.

It is an important tool for treasury It is an important tool for treasury management and control.management and control.

174174

FINANCING CURRENT ASSETSFINANCING CURRENT ASSETS

During the normal course of business certain During the normal course of business certain sources for financing CA are spontaneous and sources for financing CA are spontaneous and accrue in the normal course of business –accrue in the normal course of business –

Trade Credit – Once the suppliers confidence in Trade Credit – Once the suppliers confidence in the firm is instilled it will offer generous credit to the firm is instilled it will offer generous credit to the extent of (30-90) days. On an average trade the extent of (30-90) days. On an average trade credit amounts to (40-50)% of total CL. credit amounts to (40-50)% of total CL.

Cost of trade credit needs to be weighed vis-à-vis Cost of trade credit needs to be weighed vis-à-vis the incentive sacrificed in the form of cash the incentive sacrificed in the form of cash discount.discount.

Financing may also be done through accrued Financing may also be done through accrued expenses – (electricity, salaries & wages) and / or expenses – (electricity, salaries & wages) and / or provisions – (dividends, taxes).provisions – (dividends, taxes).

175175

BANK FINANCINGBANK FINANCING

Bank financing for CA is generally guided by three Bank financing for CA is generally guided by three criteria – creditworthiness, collaterals, and margin criteria – creditworthiness, collaterals, and margin money. It can undertake the following forms –money. It can undertake the following forms –

Cash Credit – Cash Credit – It is a borrowing arrangement upto a It is a borrowing arrangement upto a preset limit against inventory and/or receivables. preset limit against inventory and/or receivables. Interest is charged only on the balance actually Interest is charged only on the balance actually utilized. In the event of default, risk is borne by the utilized. In the event of default, risk is borne by the borrower. It is payable on demand.borrower. It is payable on demand.

Overdraft –Overdraft – Overdraft is similar to C/C only that the Overdraft is similar to C/C only that the limit is offered against liquid financial assets. limit is offered against liquid financial assets. Interest in an O/D account is charged from the day Interest in an O/D account is charged from the day of disbursement, irrespective of utilization.of disbursement, irrespective of utilization.

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FACTORINGFACTORING

It is a transaction where firm sells of its It is a transaction where firm sells of its receivables to a financial institution (i.e. receivables to a financial institution (i.e. factor) with a objective of financing its current factor) with a objective of financing its current assets. In factoring the risk of default is borne assets. In factoring the risk of default is borne by the factor. by the factor. It has the following advantages - It has the following advantages -

Adds liquidity to the business.Adds liquidity to the business. Reduces the risk of NPA’s.Reduces the risk of NPA’s. Reduces cost of administration and Reduces cost of administration and

monitoring.monitoring. Outsourcing from experts in managing and Outsourcing from experts in managing and

collecting receivables.collecting receivables. Credit information and financial counseling.Credit information and financial counseling. 177177

TANDON COMMITTEE - 1975TANDON COMMITTEE - 1975

The The working capital gap (CA-CL) working capital gap (CA-CL) without any without any borrowing, should be partly funded through bank borrowing, should be partly funded through bank finance, rest through long-term borrowings and finance, rest through long-term borrowings and equity.equity.

Ascertaining Ascertaining Maximum Permissible Bank Maximum Permissible Bank Borrowing. Borrowing. The lower of the three is treated as The lower of the three is treated as MPBBMPBB..

a) 75% of working capital gap.a) 75% of working capital gap.

25% of total current assets from long-term 25% of total current assets from long-term sources. The balance is calculated as –sources. The balance is calculated as –

b) (0.75 * CA) – CL (without bank borrowings)b) (0.75 * CA) – CL (without bank borrowings) c) 0.75(CA – Core CA) – Current Liabilities.c) 0.75(CA – Core CA) – Current Liabilities. 178178

OTHER COMMITTEESOTHER COMMITTEES

Subsequently the Chore Committee came out Subsequently the Chore Committee came out with a report in 1979; Krishnaswamy Committee with a report in 1979; Krishnaswamy Committee in 1980; Marathe Committee in 1982; Kannan in 1980; Marathe Committee in 1982; Kannan Committee in 1997; Nayak Committee in 1991. Committee in 1997; Nayak Committee in 1991.

All the committees emphasized primarily on SME All the committees emphasized primarily on SME financing (i.e. inclusive growth).financing (i.e. inclusive growth).

Recommended periodical financial forecasts from Recommended periodical financial forecasts from the borrower (usually quarterly – Credit the borrower (usually quarterly – Credit Monitoring Arrangement - CMA Forms – I to VI). Monitoring Arrangement - CMA Forms – I to VI).

Facilitate simplified borrowing process –Facilitate simplified borrowing process – MPBB = 20% of Net Sales; Margin Requirement = MPBB = 20% of Net Sales; Margin Requirement =

5%5% 179179

COST ACCOUNTINGCOST ACCOUNTING

Cost accounting is that part of management Cost accounting is that part of management accounting which accounting which establishes budgets establishes budgets and and actual actual cost of operationscost of operations, , processesprocesses, , departmentsdepartments or or productproduct and the and the analysis of variancesanalysis of variances, , profitability profitability or social use of funds. Managers use cost or social use of funds. Managers use cost accounting to accounting to support decision making support decision making to reduce a to reduce a company's company's costscosts and improve its and improve its profitabilityprofitability. .

Cost accounting can be viewed as translating the Cost accounting can be viewed as translating the Supply Chain Supply Chain (the series of events in the (the series of events in the production process that, in concert, result in a production process that, in concert, result in a product) into financial values. product) into financial values. Applications - Applications - Product Costing, Operational Planning & Control, Product Costing, Operational Planning & Control, Key Decisions.Key Decisions.

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COSTINGCOSTING

As a form of management accounting, cost As a form of management accounting, cost accounting need not follow standards such as accounting need not follow standards such as GAAPGAAP, because its primary use is for , because its primary use is for internal internal managersmanagers, rather than external users, and what , rather than external users, and what to compute is decided pragmatically on the to compute is decided pragmatically on the managers requirements.managers requirements.

Costing refers to the processes and techniques Costing refers to the processes and techniques for ascertaining costs. The broad techniques are – for ascertaining costs. The broad techniques are –

Process Costing, Standard Costing, Marginal Process Costing, Standard Costing, Marginal Costing, Throughput Costing.Costing, Throughput Costing.

Cost audit is an audit of efficiency of the costing Cost audit is an audit of efficiency of the costing techniques while the work is in process.techniques while the work is in process.

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COSTING - TECHNIQUESCOSTING - TECHNIQUES

Process Costing Process Costing is a model that identifies is a model that identifies activities in an organization and activities in an organization and assignsassigns the cost the cost of each activity to products and services of each activity to products and services according to the according to the actual consumption actual consumption by each: by each: it it assigns indirect costs (overheads) into direct assigns indirect costs (overheads) into direct costscosts..

Standard costing Standard costing deals with deals with variance analysis variance analysis which breaks down the variation between actual which breaks down the variation between actual cost and standard costs into various components cost and standard costs into various components (volume, material cost, labor cost, etc.) so (volume, material cost, labor cost, etc.) so managers can understand managers can understand why costs were why costs were different from what was planneddifferent from what was planned and take and take appropriate action to correct the situation.appropriate action to correct the situation. 182182

COSTING - TECHNIQUESCOSTING - TECHNIQUES

Marginal Costing Marginal Costing deals with deals with decomposition of decomposition of costs into fixed and variable costs into fixed and variable components with components with the intention of identifying the the intention of identifying the break-even point break-even point (i.e. where costs equals revenue). Marginal costs (i.e. where costs equals revenue). Marginal costs refer to the incremental costs for producing one refer to the incremental costs for producing one additional unit of production. additional unit of production.

Throughput Costing Throughput Costing seeks to increase the seeks to increase the velocity or speed at which throughput velocity or speed at which throughput (T) (T) is is generated into products and services with generated into products and services with respect to an organization's constraint, whether respect to an organization's constraint, whether it is internal or external to the organization. it is internal or external to the organization. TT is is the rate at which the system produces the rate at which the system produces goal goal unitsunits. . 183183

COSTS - DEFINITIONCOSTS - DEFINITION

Cost Cost refers to an amount of expenditure refers to an amount of expenditure (actual or notional) incurred or attributable to (actual or notional) incurred or attributable to a specific thing or process a specific thing or process (CIMA)(CIMA). .

It is a sacrifice in monetary terms (i.e. It is a sacrifice in monetary terms (i.e. release of value) for the acquisition or release of value) for the acquisition or creation or value addition of economic creation or value addition of economic resources resources (ACC)(ACC)..

Costs can be classified in accordance with – Costs can be classified in accordance with – nature, elements, behaviour, function, nature, elements, behaviour, function, control, normality, or managerial decisions.control, normality, or managerial decisions.

Costs can be also classified depending on the Costs can be also classified depending on the specific circumstances.specific circumstances. 184184

CLASSIFICATION - NATURECLASSIFICATION - NATURE

Direct Cost – Direct Cost – It means a cost which can be It means a cost which can be conveniently identified with or allocated to a conveniently identified with or allocated to a particular particular cost centrecost centre. It is the smallest unit of . It is the smallest unit of an organization for which costs can be an organization for which costs can be ascertained separately. They are also known ascertained separately. They are also known as as responsibility centresresponsibility centres. .

Indirect Costs – Indirect Costs – It means a cost which cannot It means a cost which cannot be conveniently identified with or allocated to be conveniently identified with or allocated to a particular a particular cost centre; cost centre; it is incurred generally it is incurred generally or commonly for a no. of cost centres. or commonly for a no. of cost centres.

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CLASSIFICATION - ELEMENTSCLASSIFICATION - ELEMENTS

Material Cost – Material Cost – These are the These are the principal principal substances substances used in the manufacturing of a used in the manufacturing of a product or service. In the process they are product or service. In the process they are transformed into final products. transformed into final products.

Labour Cost – Labour Cost – It includes the It includes the physical and/or physical and/or mental effortsmental efforts of human beings expended in of human beings expended in the transformation of principal substances the transformation of principal substances into final products. into final products.

Overheads – Overheads – It is the cost of services It is the cost of services provided to provided to compliment compliment labourlabour costs in the costs in the transformation process and includes transformation process and includes notional notional costs costs as well.as well. 186186

Financial Management

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