FINANCIAL MANAGEMENT

Course Code: 501 & 502

Prof. Subir Sen – Faculty Member
ICFAI
E-Mail: subir@ibsindia.org / 9830697368
Ref: 1) Financial Management – Prasanna Chandra
2) Financial Management – I. M. Pandey
3) Financial Management – Khan & Jain
4) Financial Management – James Van Horne
5) Financial Institutions & Markets – L. M. Bhole
6) Indian Financial System – M. Y. Khan
INTRODUCTION

2
 WHAT IS FINANCIAL MANAGEMENT?

– Book Keeping – It is the process of recording of financial

information relating to business operations in a
systematic and orderly manner.
– Financial Accounting – It is the process of identifying
financial transactions, followed by condensation and
classification, then subsequently summarizing and
recording them with the objective of communicating
them for analysis and interpretation.
– Financial Management – It involves the presentation of
accounting information in a way so as to assist the
management in financial decision making and
enhancing shareholder value.

3
OBJECTIVES OF FINANCIAL
ACCOUNTING

– To keep systematic records.

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

4
USERS OF FINANCIAL INFORMATION

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

5
ACCOUNTING Vs FINANCIAL
MANAGEMENT

– Users of Information : External – Internal

– Type of Analysis : Whole – Part
– Data Used : Raw Data – Semi finished Data
– Nature of Analysis : Historical – Futuristic
– Unit of Measurement : Quantitative – Qualitative
– Periodicity : Long Term – Short Term
– Precision : Very High – Low to Medium
– Nature : Objective – Subjective
– Legal Compulsion : Very High – Low
– Nature of Content : Low to Medium – Very High
6
 IMPORTANT FINANCIAL DECISIONS

 How to evaluate CAPEX decisions?

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

7
 ROLE OF A FINANCIAL MANAGER

 Financing / Mobilizing -
– Promoters Contribution
– Public Issue, Rights Issue, Private Placement
– Term Loans, Institutional Finance
– Overdraft, Cash Credit
– Hire-Purchase / Leasing
– Subsidies – Capital & Revenue
– International Finance – GDR, ECB.
– Venture Capital
– Deferred Payment
– Internal Accruals 8
ROLE OF A FINANCIAL MANAGER

 Investing / Deploying –
– Land & Building
– Plant & Machinery
– Furniture & Fixture
– Shares, Bonds, Mutual Funds, Derivatives
– Dividend, Interest, Taxes
– Working Capital – Inventory, Debtors
– Loan Repayment

9
 ROLE OF A FINANCIAL MANAGER

 Planning & Control

– Capital Budgeting
– Treasury Management
– Working Capital Management
– Capital Structure Planning
– Cost Control
– Forecasting & Budgeting
– Performance Analysis
– Internal Audit

10
 FINANCIAL MANAGEMENT
INTERFACE

 Finance – Marketing
– How much credit to extend to customers?
 Finance – Production
– How many days inventory to keep?
 Finance – Human Resource
– How many new recruits to be made?
 Finance – Operations
– How should CAPEX decisions be evaluated?
 Finance – Top Management
– What is should be the pricing of an IPO?
11
 ENVIRONMENT OF CORPORATE
FINANCE

 Form of business organization

– Sole Proprietorship
– Partnership
– Company – Listed & Unlisted
 Regulatory Framework
– Industrial (NIP) & Trade Policy (NTP)
– Foreign Exchange Management Act
– MRTP Act
– Income Tax Act
– Companies Act
– SEBI Act 12
 ORGANISATIONAL FORM - CRITERIA

 Criteria for choosing an organizational form -

– Initial set-up costs
– Government strictures and regulations
– Speedy decision making
– Fund raising capability
– Degree of liability involved
– Life span
– Extent and nature of taxation
– Reputation and image
– Public domain and secrecy 13
FINANCIAL MARKETS
&
INSTITUTIONS

14
 FINANCIAL SYSTEM

Leakages = Taxes Government Injections = Public Exp

Fiscal Crisis Rent + Wages + Profit +Royalty

Leakages = Savings Liquidity Crisis

Consumers Producers
Exports Imports
Injections =
Investments
Land + Labour + Capital +Technology

Injections = Forex Leakages = Forex BOP Crisis15

DEVELOPED FINANCIAL MARKET

– Economic & Industrial Growth

– Controlled Inflation – No Deficit Financing
– Stable Monetary Policy
– Highly organized banking system
– Presence of Central Bank
– Variety of Credit Instruments
– Rural market penetration
– Large number of intermediaries
– Efficient price discovery mechanism
– Size & Volumes (i.e. breadth & depth)
– Existence of Secondary Markets
– Low Transaction Costs 16
 FINANCIAL ASSET

 It refers to a claim on the repayment of a certain

sum of money at the end of a maturity period. They
can be either classified as marketable or non-
marketable. Marketability basically indicates that
there is an exit route prior to the maturity period.
The categories of financial assets listed in order of
their marketability -
– Equity Shares
– Mutual Funds
– Derivatives
– Debentures / Bonds
– Govt. Securities
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FINANCIAL ASSET -
CHARACTERISTICS

 Continuous ready market

 Inter & Intra asset transferability
 Easy liquidity
 Security value
 Tax exemption
 Element of risk
 Hedging options
 Low transaction costs
 Streamlining returns
 Variety of durations
18
 MONEY MARKET

 The money market is the collective name given

to institutions that deal in various grades of
near money. Though there is no strict definition
of near money, for all practical purposes we
take it at as one year.
– It deals with short-term financial assets with
a duration upto one year.
– Exit route is nascent.
– No single homogeneous marketplace.
– Intermediaries are absent.
– Informal networks.
– Low risk – Low return. 19
MONEY MARKET - INSTRUMENTS

 Call Money Market

 Commercial Bills Market
 Acceptance Market
 Treasury Bills Market
 Repurchase Agreements (Repo’s)
 Commercial Paper
 Certificate of Deposit
 Inter – Bank Participation Certificate
 Inter – Corporate Loans
 MM Mutual Funds
20
 CALL MONEY MARKET

 Call Money Market – Extremely short term duration,

usually less than 14 days. The loans are repayable on
demand either at option of the lender or borrower.
The major players in this segment are – banks and
stock brokers. It provides an equilibrium mechanism
for balancing short term deficits and surpluses.
– Meet CRR or ALM criteria.
– Sudden surge in demand-supply for funds.
– Interest rates are very volatile, but negotiable.
– Minimum deal size is very high.
– Confidentiality is maintained.
– Credibility is very critical for dealings.
21
 COMMERCIAL BILLS

 Commercial Bill – It is a document which arises

out of a genuine trade transaction on credit
terms. The buyer accepts it by issuing a
promissory note to pay the amount
unconditionally on or before a specified date. Its
validity is usually between (30-120) days. Types
of commercial bills –
– Demand & Usance / Time
– Documentary & Clean
– Inland & Foreign (Letter of Credit)
– Supply & Accommodation
22
 DISCOUNT & ACCEPTANCE MARKET

 Discount market refers to a market of short term

genuine trade bills, which are discounted by
financial intermediaries, like commercial banks.
The seller gets immediate credit at a discount
rate; whereas the buyer gets a convenient credit
on the condition to pay on the specified date.
– Large segment is in the unorganised sector.
– Interest rates are stable, except in the
unorganised sector.
– Strong banking credibility is essential.
– Collaterals are preferred.
23
 TREASURY BILLS

 Treasury bills are short term borrowings by the GoI through

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

24
 REPURCHASE (REPO) AGREEMENTS

 In a repo transaction, the lender parts with a security

(usually a treasury bill) to a borrower with an agreement
to repurchase them at the end of a fixed period at a
specified price. The difference between the purchase
price and the original price is the cost of the borrower,
also known as repo-rate. The normal duration of a repo
is usually between (3-7) days.
 In reverse repo a transaction is viewed from the point of
view of supplier of funds. Thus whether a transaction is
a repo or a reverse repo depends largely on which party
initiated the transaction.

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 COMMERCIAL PAPER

 A commercial paper is an unsecured promissory note

issued by a corporate, approved by the RBI, to the
general public (i.e. HNI) at a discount rate with a
duration not exceeding a year.
– Securitisation – borrowing directly from the public.
– Minimising transaction costs.
– Recent origin – 1990’s.
– Can also have an interest bearing form.
– No assets are pledged, unsecured.
– Merchant bankers are generally not involved.
– Company’s earning power is the only guarantee.

26
COMMERCIAL PAPER – RBI
GUIDELINES

 A tangible net worth not less than Rs. 10cr.

 A minimum current ratio of 1.33:1.
 A debt-service ratio not less than 2.
 Working capital limit exceeding Rs. 25cr.
 Issue not exceeding 20% of Working Capital.
 Listing on at least one national level stock exchange.
 Minimum Rating of P2 from CRISIL.
 Minimum face value Rs. 25 lacs, lot size of 4 units.
 Maturity period (3-6) months.
 Competitive interest rates and flexible.
 Underwriting not available.
27
 CERTIFICATE OF DEPOSIT

 Certificate of Deposit is a short term deposit instruments issued

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

28
 CD – RBI GUIDELINES

 Normal face value in multiples of Rs. 5 lacs,

with a minimum lot size of 2 units.
 Maturity period (3-12) months.
 Lock-in period 30 days.
 Transferable after 30 days.
 Banks to maintain CRR & SLR on CD proceeds.
 No premature buy-back.
 Ceiling limit – 10% of aggregate deposits.

29
 INTER-BANK PARTICIPATION

 IBPC enable commercial banks to fund their short-term working

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

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 INTER-CORPORATE LOANS

 ICL is an extremely short-term working capital

arrangement between two corporates under terms
and conditions mutually agreed upon.
– Tenure seldom exceeds 7 days.
– Interest rates are highly volatile.
– No collaterals / pledges are involved.
– High degree of confidentiality is involved.
– Transaction size is large.
– Call notice – Payable on demand.
– Personal credibility is an important driver.
31
 MONEY MARKET MUTUAL FUNDS

 A MMMF invests primarily in MM instruments of

very high quality short-term maturities. It aims
at bringing in the scope of MM instruments and
short-term surpluses within the ambit of retail
investors.
– A MMFF is usually closed-ended.
– Earlier MMFS’s were governed by the RBI, but
w.e.f March 2007 they now come under the
ambit of SEBI.
– Short-term lock-in period of (15–30) days.
– Minimum corpus of a MMMF is Rs.50 crore.
– No entry or exit load. Fixed management fee. 32

– No ceiling limits in investments.

 FINANCIAL INTERMEDIARIES

 A financial intermediary is basically an

institution that lends liquidity to a financial
system, thereby facilitating a financial
transaction. Intermediaries in the money
market –
– Reserve Bank of India
– Commercial Banks
– Co-Operative Banks
– Post Offices
– Central Government
33
 RBI

 It is the apex body responsible for guiding,

monitoring, regulating, promoting, and controlling
the Indian Financial System. Its functions include –
– Issuing of currency.
– Banker to the government.
– Bankers bank.
– The bank rate.
– Open market operations (OMO).
– Monitoring liquidity through CRR & SLR.
– FOREX control.
34
MONEY MARKET – SHORTCOMINGS

 Lack of coordination across institutions.

 Monopolistic market structures.
 Dominance of developmental institutions.
 Seasonal fluctuation in interest rates.
 Inactive and erratic transaction volumes.
 Lack of secondary market.
 High transaction costs.
 Nascent hedging market.
 Unscrupulous practices in unorganised sector.
 Limited no. of intermediaries.
35
MONEY MARKET – RECENT
DEVELOPMENTS

 Integration of unorganised sector.

 Increasing breadth and depth of the market.
 Introduction of innovative instruments.
 Interest rates have been made competitive.
 Transparency in offerings.
 Exemption from stamp duties.
 Increasing debt-based mutual funds.
 Importance of credit rating.
 Stable monetary policy.
 Establishment of DFHI.
36
 DISCOUNT & FINANCE HOUSE OF
INDIA

 DHFI commenced its operations in 1988 with the

objective to develop and stabilize a secondary
MM. It was jointly promoted by the RBI,
Commercial Banks & FI’s. It’s paid-up capital is
Rs.200 cr; and is entitled to borrow upto 10 times
its net worth.
– Discount, re-discount, buy, sell, acquire money
market instruments.
– Buy-back arrangements of treasury bills.
– Lend and borrow funds and MM instruments.
– Support corporate, trusts for short-term capital
shortages.
37
– Market building & advisory role.
SOURCES & RAISING
OF
LONG TERM FINANCE

38
 MONEY MARKET Vs CAPITAL
MARKET

 Term Period – Short Term Vs Medium to Long Term

 Requirements – Working Capital Vs Fixed Capital
 Face Value – High Vs Low
 Secondary Markets – No / Nascent Vs Yes
 Intermediaries – No Vs Yes
 Lot Size – Minimum Vs Maximum
 Apex Regulatory Body – RBI Vs SEBI
 Market Building – No Vs Yes
 Processing Period – Short Vs Medium to Long
 Contract – Informal Vs Formal
 Players – Corporates – Individuals
39
 WHY LONG TERM FINANCE?

 Long term finance is required for expansion,

modernisation, and diversification projects. The
duration of such projects usually range between (5-8)
years. It comprises of –
– Project Implementation
– Gestation
– Break-Even Point
 They are usually characterised by huge investments,
commitment of the top management, and are
irreversible.
 Using working capital to finance long-term projects will
lead to a asset – liability mismatch.
40
 SOURCES OF LONG TERM FINANCE

 Capital –
– Equity Capital
– Preference Capital
 Debt –
– Bonds
– Debentures
 Hybrid –
– Partly & Fully Convertible Debentures
– Secured Premium Notes
 Internal Accruals –
 Subsidies & Exemptions –
41
PRIMARY MARKET - CLASSIFICATION

 Market where a firm goes to the investing public

for the first time. Prior to an IPO stocks are
usually unlisted and closely held. (IPO).
 Market where a firm goes to the investing public
at a time subsequent to its IPO for raising
additional capital (SEO). There are usually
issued at a discount to the market price.
 Market where a firm goes to existing
shareholders at a time subsequent to its
commence of business for raising additional
capital, whose shares are already listed at any
recognised stock exchange (RO). 42
 SEBI GUIDELINES – PRIMARY
MARKET

 Maximum reservation available in case of an IPO –

– Employees – 10%
– Mutual Funds – 20%
– Foreign Institutional Investors – 15%
– Financial Institutions – 20%
– Group Companies – 10%
 Reservations applicable for a maximum of any two
of the above categories.
 Reservations are not available for the general
public.

43
 PRIMARY MARKET - FUNCTIONS

 Origination – It refers to the work of systematic

investigation, analysis and processing of data
surrounding new projects. The basic services
surrounding such information includes –
– Business Viability – Appropriateness of project
capacity, including target market share.
– Technical Feasibility – Cost benefit analysis of
appropriate technologies.
– Risk Analysis – Probability of failure of the project on
account of changes in critical variables. Eg.
economic risk, operational risk, financial risk.

44
PRIMARY MARKET - FUNCTIONS

 Advisory – It refers to assessment of factors which

may improve the quality of capital issues and
ensure its success.
– Size of the Issue
– Type of Instrument
– Pricing of the Issue
– Timing of the Issue
– Structure of the Issue
– Distribution of the Issue
– Market Building
 Such services are usually offered Merchant
Bankers.
45
PRIMARY MARKET - FUNCTIONS

 Underwriting – It refers to an pre-agreement

whereby the underwriter undertakes to
subscribe to a specified no. of units of a
specific instrument of a specific issue in the
event of public not subscribing to the desired
extent. It is therefore a specific guarantee for
the marketability of the issue.
– Standing behind the issue.
– Consortium blocks.
– Outright purchase.
46
 NEW ISSUES MARKET - FUNCTIONS

 Distribution – It is the function of sale of

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

47
 PUBLIC ISSUES – IPO and SEO

 The issuing company directly offers to the

general public a fixed no. of shares at a stated
price through a document called prospectus.
Technically it is known as invitation to an offer.
It contains -
– Name & Address of the Company
– Issue Structure – Reservations, if any
– Existing & Proposed Activities
– Factory Location, Names of Directors
– Capital Structure
– Subscription – Opening & Closing Dates 48

– Future Projections – Risk Factors

SEBI GUIDELINES – PUBLIC ISSUE

 Abridged prospectus with every application.

 Highlighting of risk factors.
 Company’s management, history and businesses.
 Details of group companies.
 Justification of premium (if any).
 Subscription period (3-10) working days.
 At least 30 collection centres.
 No collection in cash.
 A compliance report to be submitted within 45 days.
 Minimum application 100/500 depending on price.
49
 PRIVATE PLACEMENT & BOD

 This method of sale consists of outright sale of

securities to an Investment Banker. The transaction is
usually carried out at a negotiated price. The
investment banker may offload the securities
immediately or at an opportune time. The difference
is called the spread.
– Suitable for small companies, minimum cost.
– Promoters diluting their stake to comply with
listing agreements.
– Reduces the risk of timing of issue.
– Market building is not required.
– Risk of take-over.
50
 RIGHTS OFFERING

 It is a method a raising funds by an existing listed

company. It provides an option to an existing
shareholder to buy a specified no. of units of a
security at a predetermined price, within a
specific time period.
 A company can come out with rights issue either
after 2 years of incorporation or after 1 year of
the previous issue, whichever is earlier.
 A shareholder may reject the right, accept the
right – partially or fully, or sell-off the right.
 The ratio-of-rights can vary across different
categories of shareholders, but at the same price.
51
 RIGHTS OFFERING - GUIDELINES

 The draft rights issue should contain all information as

listed in the prospectus U/S 81 of the Companies, Act
1988.
 A rights issue is not required to be underwritten.
 Any part of the issue remaining unsubscribed by the
public has to taken over by the promoters.
 It gives the promoters the scope to raise their stakes.
 The cost of the issue is minimum.
 A rights offering has to be open for a minimum duration
of 45 days.

52
 BOOK BUILDING - 1995

 It is a process through which demand for the securities

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

53
 GREEN-SHOE OPTION

 Green-Shoe option is a mechanism to bring about

stability in stock prices in the post – issue phase to
generate shareholder confidence.
 A maximum of 15% the total issue size can used
for this purpose.
 In this process a book – runner is appointed as a
stabilising agent.
 His responsibility is to intervene in the secondary
market, when the market price falls below the
issue price.
 Such intervention can be carried out for a
maximum period of 30 days.
54
 LISTING OF SECURITIES

 Listing of securities mean that the securities are

admitted for official trading on a recognised stock
exchange. SEBI makes listing agreement prior to
the equity offering mandatory. Conditional listing is
not permitted. Advantages of listing –
– Ensures liquidity and continuous pricing.
– Offers wide publicity.
– Transparency for shareholders.
– Benchmarking against index or other stocks.
– Facilitates pledging of securities.
– Source for future rights offering.
55
 LISTING PROCEDURE

 The following documents are to be submitted to CLA

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

56
 LISTING – SEBI GUIDELINES

 Listing conditions to be fulfilled by a company –

– Minimum issued capital Rs. 3 crores.
– Companies having more than Rs. 5 crore as issued capital
should go in for dual listing.
– At least 40% of each class of securities must be offered to the
public.
– The issue to be advertised through at least 2 newspapers
having national-level circulation, and 5 newspapers having
regional-level circulation.
– Listing norms should be complied within 30 days from the
closing of subscription .

57
 LISTING DRAWBACKS

 Leads to speculation – May lead to manipulation

of prices in a way as may be detrimental to the
interests of the company.
 Discloses vital information to competitors –
Information submitted for the purpose of listing
lies on public domain, hence may be used by
competitors to gain unfair advantage.
 Degrades company’s reputation – Negative
information about companies gets easily
percolated to the press.
 Fear of Takeover – Vested interests wishing to
take-over from the current management can
acquire shares from the market.
58
 SHARE BUYBACK - 1988

 Buyback is a process of cancellation of shares

out of free reserves to the extent of 25% of
paid-up capital. It may lead to de-listing. It is
an exit route for cash-rich companies without
viable investment opportunities.
 Advantages –
– To prevent take-over bids.
– Injecting leverage into the capital structure.
– Reverse dilution of equity.
– Increase underlying share-value.
– Minimise odd lots. 59
 SEBI GUIDELINES – SHARES
BUYBACK

 Various modes of buy–back – tender, open offer, Dutch

auction, Repurchase odd lots, ESOP.
– Tender Offer – It is based on one fixed price.
– Open Offer – It is based on ruling market price.
– Dutch Auction – Shares offered at the lowest price are given
first priority. It is also known as reverse book–building.
– Repurchase Odd Lots – Shareholders possessing odd lots
are given priority.
– ESOP – The stock options given to employees are cancelled
and bought back.

60
 SEBI GUIDELINES – SHARE BUYBACK

 Prior SEBI approval.

 Special resolution needs to be passed by the
board approving maximum price.
 Buyback through negotiated deals, spot
transactions and private placement not
permissible.
 Daily purchase details to be reported.
 Transaction based on immediate payment
through Escrow Account.
 Buyback once announced cannot be
withdrawn. 61
 SECONDARY MARKET

 It is a physical or virtual market place where listed

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

62
PRIMARY VS SECONDARY MARKET

 Status of Securities – New Vs Existing

 Existence – Virtual Vs Physical / On Line
 Structure & Set Up – No Vs Yes
 Rules & Regulations – No Vs Yes
 Information – Ad-hoc Vs Continuous
 Control – Decentralised Vs Centralised
 Purpose – Start Up Vs Diversification
 Public Involvement – Direct Vs Indirect

63
 STOCK EXCHANGE

 Every stock exchange operating in India is

recognised by the Central Government, set up
under the Securities Contract Regulation Act,
1956, and duly approved by SEBI.
 A stock exchange applying for recognition has to
make an application to the Central Govt. in the
prescribed manner containing –
– Organisation structure of the exchange.
– A copy of the rules and regulations of the stock
exchange.
– Prescribed fees.
64
 FAQ’s – STOCK EXCHANGE

 What is a stock exchange?

It is a market place where investments can be
bought and sold.
 Why were stock exchanges formed?
To add liquidity to investments.
 Why do people trade in a stock exchange?
Because the buyer expects the prices will rise and
the seller expects that prices will fall.
 Why are there differences in opinion?
Because markets are not perfect.
 Which is the oldest stock exchange in India?
BSE. (circa 1875)
65
 TYPES OF ORDERS

 Order – An order is a requisition placed by an investor to

buy or sell a particular stock(s) for a certain
consideration. However, prior to placing any order, an
investor is required to register himself with a broker.
 What are the various types of orders?
– Open Order
– Market Order (High)
– Span Order Confidence on the Broker
– Limit Order (Low)
– Fixed Price Order

66
 TRADING SYSTEM

 Earlier trading in stock exchanges was carried out

through a open–outcry system in the trading ring. The
system witnessed various limitations -
– Lack of secrecy.
– Tackle unprecedented growth of the stock market.
– Protection of investor’s interest.
– Scope for manipulations.
– Entry of FII’s.
 VSAT-network based trading system enable participants
to view online information, login & place requisitions,
and execute deals. Automated systems are either order
or quote driven.

67
 SETTLEMENT OF TRANSACTIONS

 Delivery – It involves the handover of the stocks by the

seller on due date for a consideration. Delivery is said to
be bad if the seller fails to give delivery on due date.
 Settlement – It is the process through which the buyer
fulfils his obligations against delivery of stocks.
 Settlement Date – It is the date announced by the stock
exchange on which settlement has to be made.
 What are the various ways of settlement?
– Through payment or delivery.
– Through square-off.
– Through carry–forward (i.e. badla).

68
 SPECULATION

 What is speculation?
– In the spot market, it involves taking exposure in a
financial asset, without having an intention to buy it.
It is characterised by short term view, lack of funds,
and/or malafide intentions. In the futures market, it
refers to an exposure in a derivative without basic
exposure in the underlying instrument.
 What are the benefits of speculation?
– Enhances liquidity of the market.
 What are the drawbacks of speculation?
– Excessive volatility. Companies & genuine investors
interests are harmed.
69
VOLATILITY & SPECULATION

 Speculation leads to volatility, but

volatility is not always the result of
speculation. Major reasons for volatility –
– Take over bid.
– Insider trading.
– Limited floating stock.
– Multiple listing.
– Excess money supply.
– Low interest rates.
70
CONTROL OF SPECULATION

 Measures adopted by the stock exchange -

– Imposing or increasing margins.
– Reducing carry forward duration.
– Enhancing backwardation (i.e. badla)
charges
– Transfer from Specified to Cash category.
– Restriction on volumes.
– Price bands.
– Controlling settlement price.
– Suspension of trading.
– De-listing. 71
 SEBI – ACT, 1992.

 Objectives
– To promote the interest of investors.
– To regulate the securities market.
– To ensure efficient services by intermediaries.
 Functions
– Regulation of stock exchanges, brokers, mutual funds.
– Prohibition of fraudulent and unfair practices.
– Prevent insider trading, and substantial acquisition.
– Educate investors & intermediaries.
– Promote research and code of conduct.

72
 SEBI – ACT, 1992.

 Powers
– Power to call for returns from stock exchanges.
– Power to grant registration to brokers.
– Power to call for information from brokers.
– Power to direct enquiries and investigations.
– Power to frame rules and regulations of stock
exchanges.
– Power to compel listing.
– Power to levy fees on merchant banking activities.
– Power to grant recognition of new stock exchanges.

73
CAPITAL MARKET - SHORTCOMINGS

 More of speculative trading than cash trading.

 Prevalence of insider trading.
 Lack of sufficient liquidity.
 Scarcity of floating stocks.
 Lack of transparency and corporate governance.
 Lack of professionalism.
 Excessive volatility.
 Cumbersome settlement procedure.
 Dominance by FII’s.
 Dominance by large-cap stocks.
74
RECENT DEVELOPMENTS

 Regulation of intermediaries.
 Prohibiting insider trading.
 Standardisation of accounting practices.
 Encouraging market building activities.
 Electronic trading and depository system.
 Fair pricing of odd-lots.
 Protecting investors interest.
 Free and fair pricing of securities.
 Trading in derivatives.
 International issues and listing.
75
 FINANCIAL INTERMEDIARIES

 Intermediaries in the capital market –

– Financial Institutions – IFCI, IDBI, ICICI
– Insurance Companies
– Mutual Funds
– Pension Funds
– FII’s
– Agricultural Financing Institutions
– Specialised Institutions – IRBI, EXIM Bank
– NBFC
 Hire Purchase & Leasing

 Finance & Investment

76
 FOREX MARKET

 Foreign exchange includes all deposits and

credits which are drawn in a home currency, but
payable in a foreign currency. A foreign
currency can be quoted in two ways –
– Direct Quote ($ 1 = Rs.42.00)
– Indirect Quote (Rs.100.00 = $ 2.38)
 In the short run currency is quoted on the basis
of demand–supply; however in the long run it is
quoted on the basis of PPP Theory.
 Trading in FOREX can be done in the spot
market as well in the future market.
77
 DERIVATIVES MARKET

 A derivative is a financial instrument whose

value is derived from a another underlying
instrument. The basic objective of of a
derivative is to transfer known sources of risk.
 The act of investing in a derivative to protect
own position is known as hedging. Investing in
a derivative in isolation to make profit in price
fluctuations is known as speculating.
 A derivative which gives the investor the right
to buy is referred to as a call; a derivative
which gives the investor the right to sell is
referred to as a put.
78
 DERIVATIVE STRATEGY

 A buys 100 shares of XYZ @ 150 with the following

expectation – a) 200 (p=0.7) b) 125 (p=0.3). On
the settlement date price falls to 110. Therefore A
suffers a loss of 4000.
 On the strike date if A had bought a put option of
500 shares of XYZ @ 125, which would of cost him
@ 2 (i.e. 1000), he would have made a profit of
2500.
 However, on the settlement date if the price
increased to 180, his profit would have been
reduced from 3000 to 2000.
 So a derivative transaction is basically a trade-off
79
between risk and return.
TIME VALUE OF MONEY

80
WHAT IS TIME VALUE OF MONEY?

 Value of Money – Money does not have any inherent

value. Therefore, money represents what it can buy
(i.e. purchasing power). Value of money is basically a
function of – a) interest rates b) inflation. The
difference between the two is technically called the
spread. (i.e. interest – inflation)
– Interest rates > the value of money
– Inflation < the value of money
 Therefore, if the spread is positive value increases
over time, decreases if the spread is negative.
 If the spread is zero, value of money remains constant.

81
 TIME VALUE - CHARACTERISTICS

 The value of money changes over time. Money today

is more valuable than money receivable tomorrow.
The logic –
– Individuals in general, prefer current consumption
over future consumption.
– In an inflationary period, purchasing power of
money falls over time.
– Money can be employed effectively to generate
returns.
 Therefore money over different time periods cannot
be evaluated without adjusting.

82
COMPOUNDING & DISCOUNTING

 Compounding refers to a process of

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

83
PERIOD OF CASH FLOWS

 Annuity – It refers to a series of constant cash

flows for a finite time span. (Eg. Recurring
deposit, Equated Monthly Installments)
 Perpetuity – It refers to a series of constant
cash flows for a infinite time span. (Eg. Pension
Funds, Reverse Mortgage)

84
RISK & RETURN

85
 WHY RISK & RETURN?

 It is the most preferred and robust criteria for appraising

investment in financial assets. Other important criteria for
appraising an investment –
– Liquidity – The ease with which the investment can
be converted into cash.
– Duration – It refers to the life of the investment; any
deviation may lead to a AL mismatch.
– Transaction Cost – The cost of entering and exiting
an investment.
– Convenience – It refers to the ease with which the
implications can be understood by an investor.
– Tax – Shelter available as per IT laws.
86
WHAT IS RETURN?

 Return –
– It is the excess value received by an
investor for foregoing current consumption.
 What are the different sources of return –
– Initial Return
– Periodical Return
– Terminal Return

87
WHAT IS RISK?

 Risk –
– It is the probability that the desired return
may not be achieved.
 What are the different sources of risk –
– Operational Risk - Business Risk, Market Risk.
– Financial Risk - Interest Rate Risk, Liquidity
Risk
Default Risk.
– Economic Risk - Currency Risk, Inflation Risk.

88
 INVESTMENT CONCEPTS

 Notion of Return
– Stream of benefits
– Measure = Mean + IRR
 Notion of Risk
– Volatility in return
– Measure = Standard Deviation + Beta

Low Risk High Risk

89
INVESTMENT CONCEPTS

 Notion of Portfolio
– Return adds up, Risk does not
 Notion of Dominance
– If risk is constant, return is the dominant factor
– If return is constant, risk is the dominant factor
 Notion of Trade-off
– Risk exposure - VaR
 Notion of Diversification
– Do not keep all your eggs in one basket

90
 RISK DIVERSIFICATION

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

91
 RISK DIVERSIFICATION

 Solution:
If we invested in only one of the two companies,
our expected return will be 20%, with a possible
risk of 10%. If, we split our investment between
the two companies in equal proportion, half of
our investment will earn a return of 30%, while
the other half would earn 10%, so our expected
return would still be 20%. But in the second
instance there is no possibility of deviation of
returns. Diversification results in 20% expected
return without risk, whereas holding individual
securities was yielding an expected return of
20% with a risk factor of 10%. 92
RISK DIVERSIFICATION

Correlation: The Magical Factor

r=+1
Total Risk (%)

Unsystematic Risk

r=0

r= -1 Systematic
Risk
40

No. of 93
Securities
MARKOWITZ PORTFOLIO THEORY

 A portfolio theory is all about investing in a mix of

securities that lies on the efficient frontier. Harry
M. Markowitz in his pioneering study in 1950 was
the first to identify the benefits of diversification.
The theory he came up with is popularly known as
the Mean-Variance Criteria. Assumptions:
– Investor decisions are based on risk and return.
– Risk and return is linearly related.
– Investors are risk averse.
– Investors try to maximize return.
– Investors have identical expectations.
94
RISK OF A PORTFOLIO

σ p2 = ω x2*σ x
2
+ ω y2*σ y
2
+ 2 ω x* ω y
*σ x*σ y*ρ xy

where–

σ p
2 =Varianceof portfoliop(x, y)

ω x =%ofinvestmentinsecurityx
ω y =%ofinvestmentinsecurityy
σ x =Standarddeviationof securityx 95

σ
CAPITAL ASSET PRICING MODEL

 The credit for developing CAPM, goes to

William Sharpe for which he got the Nobel
Prize for Economics in 1990. The model was
later extended by Lintner and Mossin, they
renamed it as Single Index Model.
 It is called the Single Index Model because it
attempts to capture the return from a stock in
terms of the market (i.e. An Index).
 The return varies according to the riskiness of
the stock in terms of the market. Riskiness is
measured in terms of beta.
 The basic contention is higher the risk (i.e.
beta), higher is the return. 96
 SECURITY MARKET LINE (SML)

 According to CAPM in a well functioning market in which stocks

are correctly priced, there should be relationship between risk
and return of an individual stock. The relationship is given by –
 Expected Return = Risk free rate of return + Beta *
(Expected market return – Risk free rate of return)
 The excess of expected market return over risk free rate of
return is known as the risk premium of market.
 CAPM therefore assumes a perfect market condition and a
linear relationship between risk and return.

97
 EFFICIENT FRONTIER

 Any Portfolio lying on the Efficient Frontier

curve is called an Efficient Portfolio
SML
Expected Return (IRR)

Risk Premium

Inefficient Portfolio’s
Risk-Free Rate of Return

Risk 98
EFFICIENT MARKET THEORY

 The market takes to into account all relevant facts

relating to the financial performance of a firm in
pricing a security. Characteristics –
– Large number of buyers and sellers.
– Low transaction cost.
– Investors to do not have an edge over
information.
– Established communication channels.
– Investors are rational and logical.
– Significant volumes.
– Price takers and not price movers. 99
MEASUREMENT OF RISK

Beta measures the volatility of a stock with respect to

the market. A beta of 1 implies that 10% change in the
market will lead to a 10% change in the stock price. A
beta of 1.2 implies that 10% change in the market will
lead to a 12 % change in the stock price.
A beta of 0.8 implies that 10% change in the market will
lead to a 8 % change in the stock price.
Beta (β ) = nΣ xy – (Σ x * Σ y)
nΣ x2 – (Σ x)2
Cov (x,
Statistically, beta is the regression coefficient of y)
the
or Var (y)
stock price (y) on the market index (x)

100
 SOME INDICATORS

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

LRR – HRR NPV (LRR) – NPV (HRR)
where x = IRR
2) Variance (Total Risk) = Σ x2 – Σ x 2
n n
3) Correlation r = nΣ xy – (Σ x * Σ y)
√ {nΣ x2 – (Σ x)2} * √ {nΣ y2 – (Σ y)2}
4) Systematic Risk = Total Risk * r2
5) Unsystematic Risk = TR - SR

101
VALUATION OF
SECURITIES

102
VALUATION OF SECURITIES

 What is intrinsic value?

– Intrinsic Value = Present value of future benefit(s).
 What is market value?
– Market Value = Price at which it was last transacted.
 Since markets are inefficient (informational gaps) –
– Intrinsic Value ≠ Market Value
 What should be your investment strategy?
– If Market Value < Intrinsic Value = Buy
– If Market Value > Intrinsic Value = Sell
– If Intrinsic Value = Market Value = Hold

103
SKILLS OF A SUCCESSFUL INVESTOR

 Stock selection abilities –

– Strong knowledge of sectors.
– Reading between the lines.
– Strong analytical and forecasting skills.
– Finding bargains.
 Market timing abilities –
– Identifying trends and trends reversal.
– Feeling the pulse of the market.
– Contrary thinking.

104
BALANCING INVESTING SKILLS

Market timing abilities

Good Poor
Stock selection abilities

Concentrated Concentrated
Good

Portfolio Portfolio
Managed Beta Constant Beta

Diversified Diversified
Poor

Portfolio Portfolio
Managed Beta Constant Beta
105
 BOND VALUATION

 Bond – A bond (also known as a debenture) is a debt

instrument containing an unconditional promise to
pay interest at a certain rate of interest (also known
as coupon rate) which is either fixed or floating and
pay back the principal sum at the end of a duration,
which is determined in advance.
 Basic Bond Valuation Model -
V=Σ I + P
(1+kd)n (1+kd)n

where V=Intrinsic Value, I=Annual Interest Payable

P=Principal or Par Value, n=Maturity Period
kd=Discounting Rate
106
EQUITY VALUATION

 Equity – It denotes risk capital, with or without

management control. Return on equity is
highly volatile and has the largest duration
among all classes of financial assets.
 Dividend Capitalisation Model – It represents
present value of dividend streams coupled
with expected price.
P1 = D1
(ks – g)
where P=Price, D1 = expected dividend (Rs)
ks=expected rate of return, g=growth rate in
dividend (constant) 107
 ARBITRAGE PRICING MODELS

 Whitbeck-Kisor Model – Return is a function of

multiple factors, not only risk.
 P/E = 7.2 (EPS%) + 1.7 (DPS%) – 0.8 (EPSσ)
– Growth in EPS is the most important factor
that positively affects P/E.
– Dividend growth positively affects P/E in a
small way.
– Volatility in EPS negatively affects P/E in a
very insignificant way.

108
COST OF CAPITAL

109
MEANING OF COST OF CAPITAL

 Definition – It is the minimum rate of return that

a company must earn in order to satisfy the
contributories who have made investments in
parity with risk and tenure. It is the financial
yardstick against which discounting is done.
 The cost of capital to a company is the
weighted average cost of all the individual
sources of finance which comprises –
– Cost of debentures and term loans
– Cost of preference shares
– Cost of equity shares 110
 CAPITAL STRUCTURE

 Definition – It refers to a judicious mix of various

long-term sources of finance deployed by a
company. The broad objective is to minimise the
cost of capital and maximize wealth of the
shareholders.
 Factors that affect capital structure decisions –
– Cost of capital and tenure
– Expected cash inflows and outflows
– Nature of business, industry cycle
– Dilution of control
– Floating costs.
– Risk attitude of the top management
– Flexibility and exit costs 111
 COST OF A SPECIFIC SOURCE

 It is measured as the rate of discount which

equates the present value of the expected
payments to that source of finance with the
net funds received from that source of finance.
n
P=Σ
t=1
Ct
(1+kd)t
 where P = net funds received from the source
 Ct= expected payment to the source at the
end of year t

112
 COST OF DEBT

 The cost of debt capital is measured as the

rate of discount which equates the present
value of post-tax interest repayments with the
net proceeds of the debt issue.
n
P=Σ C(1-t) F
+
t=1
(1+kd)t (1+kd)n
 The multiplication by (1-t), where t is the tax
rate applicable to the firm, is necessary to
reflect the fact that the interest on debt is a
tax deductible expense. F represents the
redemption value.
113
 COST OF DEBT

 For obtaining a quick estimate, which is fairly

close to the correct value, of the cost of debt,
the following approximation may also be used
–

 kd = C(1-t) + (F - P)
*100
n
(F+P)/2
 It is based on amortisation of the cost of an
asset evenly over its effective life period (n).
114
 COST OF PREFERENCE CAPITAL

 The cost of debt capital is measured as the

rate of discount which equates the present
value of dividend (usually fixed) payments
with the netn proceeds of the capital issue.
P=Σ D F
+
t=1
(1+kd)t (1+kd)n

 where F represents the redemption value, and

D represents annualised dividend.

115
 COST OF EQUITY CAPITAL

 Equity capital of a firm is raised through raising

of external equity and retention of current
earnings. The rate of return expected by
suppliers of debt and preference capital can be
ascertained with a fair degree of certainty.
 However, the estimation of the return expected
by equity holders cannot be determined with
near certainty. To cope with this several
approaches have been proposed. They are –
 Dividend Capitalisation Approach, CAPM, Realised
Yield Approach, Bond Yield + Risk Premium
Approach, P/E Approach. 116
 REALISED YIELD APPROACH

 According to this approach the yield (rate of return)

earned by equity shareholders historically is
regarded as a close proxy of the return expected by
them, which by proxy represents its cost.
Yt = D t + P t
P t-1 -1
where –
Yt = Yield
Dt = Current Dividend (%)
Pt = Current Price
P t-1 = Previous Price
117
 NET WEALTH CREATION

 The following is referred to as wealth ratio –

Wt = Dt + Pt
P t-1
 Therefore, the yield for an n period is –
Yn = (W1 * W2 * W3 * …… Wn)1/n – 1
where –
W1 = D1 + P1
P0
W2 = D2 + P2
P1
118
RISK PREMIUM APPROACH

 According to this approach the ERR of equity

investors of a firm equals –
– ERR = Yield on Lt bonds(%) + Risk
Premium(%)
 The logic is equity investors should be
compensated for bearing additional risk. There
is no foolproof way of assessing the risk
premium. It usually varies at +x% (beta)
depending on the capital market.
 Some analysts look at the operating and
financial leverage of the company and adjust
the risk premium accordingly.
– T. Leverage = O. Leverage * F. Leverage 119
 PRICE – EARNINGS RATIO

 The P/E ratio is an indication of the return expected

by equity holders, where –
– P/E0 = Market Price (P0) and
EPS0
– P/E1 = Market Price (P1)
EPS1
– Average P/E = P/E0 + P/E1 +……+ P/En
n
 This measure is quite accurate when pay-out ratio
is constant.
120
 COST OF RETAINED EARNINGS

 It is calculated as the post tax rate of return available to

an investor. This means the expected rate of return has
to be adjusted for income tax and capital gains tax,
where –
 kr = ks * (1-tp)

(1-tg)
– kr = Cost of retained earnings
– ks= Expected return of equity holders
– tp= Personal income tax rate
– tg= Personal capital gains tax rate

121
 WEIGHTED AVERAGE COST OF
CAPITAL

 A firms cost of capital is the weighted average

cost of various sources of long-term finance
used by it. Suppose a firm uses equity costing
16% and debt costing 9%. If the proportions in
which equity and debt are used are respectively
40% and 60%, the cost of capital will be –
– Cost of Capital = 0.4*16% + 0.6*9%
= 6.40% + 5.40%
= 11.80%
 Proportions may be based on book value or
market value.
122
MARGINAL COST OF CAPITAL

 It is assumed that risk composition of new

projects and financing mix remaining constant,
cost of capital remains unchanged. This
indicates that marginal cost of capital is zero,
irrespective of the magnitude of financing. In
reality this is not so. Generally the weighted
average cost of capital tends to rise as the firm
seeks more and more capital.
– Usually suppliers of capital wants to be
increasingly compensated for taking
additional amounts of exposure.
– Marginal cost of capital is directly 123
proportional to volume of finance.
MARGINAL COST SCHEDULE
Average Cost of Capital

Marginal cost of capital Volume of financing

(X+2)%
(X+1)%
X%

Volume of Financing (Debt) 124

CAPITAL EXPENDITURE DECISIONS

125
 CAPEX - CHARACTERISTICS

 CAPEX is characterised by the following –

– These decisions involve large financial
outlays.
– They are irreversible in nature. Exit barrier
is very high.
– They require full support and commitment
of the top management.
– They provide an array of choices, therefore,
decisions are very critical and complex.
– They have the ability to make or destroy a
company. 126
CAPEX APPRAISAL

 All costs and benefits are measured in terms of

cash flows and not profits.
 They should be converted to net cash flows.
 Incremental approach should be followed.
 Cost of long-term funds should not be
included.
 Sunk costs must be ignored.
 Opportunity costs associated with utilisation of
resources should be taken into account.
 Long term funds principle.
127
APPRAISAL CRITERIA

 Payback Period
 Accounting Rate of Return
 Net Present Value
 Cost Benefit Ratio
 Internal Rate of Return

128
WORKING CAPITAL
MANAGEMENT

129
WORKING CAPITAL

 Working capital primarily refers to the level of

liquidity in a business. Liquidity broadly refers to
the investments in current assets; it normally has a
duration not exceeding one year. It is considered
the life-line of any business.
 Excessive liquidity should be avoided because it
pulls down a firms profitability, as idle investment
does not contribute to margins.
 On the other hand inadequate liquidity can impair
the solvency of the business because of its inability
to meet short-term obligations, thereby affecting its
credit rating.
130
WORKING CAPITAL - LEVELS

 Gross Working Capital – It refers to the firms composite

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

131
QUALITY OF WORKING CAPITAL

 The quality of WC is equally important as its

quantity. Quality of working capital implies
investment in current assets with an acceptable
level of volatility.
 A high level of volatility results in assets
becoming NPA (i.e. non-performing assets). An
asset whose realisability extends beyond 6
months is said to non-performing.
 NPA’s severely impairs the quality of working
capital.
 A financial manager also needs to diligently apply
the Matching Concept to maintain quality of WC.
132
 MATCHING CONCEPT

C u rre nt Short
p or a ry
Tem Term
Assets Financin
g
Capital Employed

t A s s ets
C u rren
ma ne nt
Per
Long
ss e ts
A Term
Fixed
(Rs)

Financin
g

133
Capacity / Production (Units)
WORKING CAPITAL - CYCLE

Cash Creditor
s

Raw
Materials
Overhead
s
Work – In
Process

Debtors Finished
Goods 134
WORKING CAPITAL - REQUIREMENTS

 Nature of Business – In a manufacturing business the

requirements of WC are the maximum. Of its total
investments approximately 1/3 of is blocked in WC.
 In a service business (i.e. telecom, banking, insurance,
IT) the requirements of WC is comparatively lesser than
in manufacturing. However, approximately 2/3 total
investments is blocked in WC.
 In a retail business, the requirements of WC is even
lesser than in service (except for organised sector).
However, However, approximately 90% total
investments is blocked in WC.

135
WORKING CAPITAL - REQUIREMENTS

 Seasonality of Operations – Businesses which are highly

seasonal in nature (sales in certain periods differ
significantly from other periods) require higher amounts of
WC in peak months rather than in slack month. Eg. air-
conditioners, soft-drinks.
 However, high volatility (measured in terms of standard
deviation) in sales should not be confused with seasonality.
 Production Policy – A conservative management may
decide to maintain a higher level of WC than an aggressive
one on the fear of losing customers.

136
WORKING CAPITAL - REQUIREMENTS

 Market Competition – It also partially depends on the

product-life cycle as the industry cycle in which the
firm is present. Different stages are obviously
characterized by different levels of competition.
 Higher levels of competition, irrespective of the policy
of the managements calls for higher levels of WC,
again on the fear of losing customers.
 As higher levels of competitions calls for higher
investment in raw materials as well as finished goods
and more credit being extended to customers. While
creditors will demand advance payment against
supplies.

137
WORKING CAPITAL - REQUIREMENTS

 Supply Conditions – Supply conditions also influences requirements

of WC. Supply conditions may include –
 Promptness, order bookings and location of supplier.
 Seasonality of raw materials.
 Attractive discounts / commissions against purchasing in bulk.
 Transporters arrangements (Eg. attractive rates – full container
bookings, uncertainty in transit time).
 Information on price hikes coming from formal as well as informal
channels.
 Government documentations – C form & Way Bill.

138
PERMANENT & FIXED WC

 Permanent WC is the minimum level of WC a firm

should maintain a sufficient level of current assets
to ensure continuity in its business and pay its
creditors on time.
 Permanent WC may be a constant or increasing
function over time.
 WC going below the permanent level will lead to
loss of market share, default in suppliers
payment, leading to loss of goodwill.
 Variables WC represents the fluctuations in WC
over and above the permanent level depending
upon internal and external circumstances.
139
WORKING CAPITAL - FINANCING

 Working capital may be financed from the

following one or more sources –
 Promoters – This includes the investment made
by the promoters in the WC of the firm (i.e.
inventory and debtors).
 Creditors – This includes the raw-materials
supplied by creditors against deferred payment.
 Bankers – It extends credit against
hypothecation of inventory (i.e. overdraft) or
against discounting of bills (i.e. cash credit).
 Securitization – Adding liquidity to a pool of
book debts. 140
 CONSERVATIVE FINANCING

C u rre nt Short
p or a ry Term
Tem
Assets Financin
g
Capital Employed

t A s s ets
C u rren
ma ne nt
Per
Long
ss e ts
A Term
Fixed
(Rs)

Financin
g

141
Capacity / Production (Units)
 AGGRESSIVE FINANCING

u rre n t Short
r a ry C
o
Temp Term
Assets Financin
e ts g
Capital Employed

nt As s
C u rr e
a ne nt
Perm
Long
A ss ets Term
Fixed
(Rs)

Financin
g

142
Capacity / Production (Units)
YIELD CURVE

 A firm has to make trade-off between following a

conservative or aggressive financing policy. The
relationship between maturity of debt (i.e. tenure) cost
of capital is usually upward sloping. However, in the
long-term it reaches a plateau.
 According to the liquidity preference theory the tenure
usually increases the risk involved (i.e. uncertainty in
forecasting long-term interests). Therefore, the lender
compensates the risk with a higher interest rate.
 This trade-off is guided by the following factors – a)
cost of capital b) flexibility.

143
INVENTORY MANAGEMENT

 Inventory is the basic cornerstone of liquidity in a

business. All the other components in WC revolves
around inventory. It has broadly three components –
 Raw Materials – These are the basic inputs that goes
into the manufacturing process.
 Work-In-Process – It refers to inventory in the
intermediary stage of production. It normally
represents full absorption of raw materials and
partial absorption of overheads (i.e. usually 50%).
 Finished Goods – Items of production when they are
ready for sale.
 Investment in inventory is next only to P&M.
144
INVENTORY DECISION MAKING

 Decisions revolving around inventory management –

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

 Ordering Cost – It includes requisitioning, expediting,

transportation, and transfer costs.
 Carrying Cost – It includes opportunity cost of locked up
inventory, storage, insurance and obsolescence.
 Shortage Cost – It includes costs concomitant with cash
purchase, production slowdown, loss of market share.

145
ECONOMIC ORDER QUANTITY

 Large orders reduces ordering costs but increases

carrying costs. Similarly, large safety stock reduces
shortage costs but increases carrying costs. Trade-
off assumptions –
 Short-term demand forecast is available.
 Production is uniform during the year.
 Stocks can be replenished immediately.
 Inventory costs can be decomposed into – cost of
ordering and cost of carrying.
 Cost per order is constant, irrespective of size.
 Carrying cost is fully variable.
146
 EOQ MODEL

Total Cost
Costs(Rs

Carrying Cost
)

Ordering Cost

EOQ
147
Order Size (Qty)
EOQ - DERIVATION

 Total Cost = Ordering Cost + Carrying Cost

 TC = (U/Q * F) + (Q/2 * P * C)
where –
U = Annual Demand / Usage
Q = Order Size
F = Cost per Order
C = % Carrying Cost
P = Price per Unit
TC = Total Cost Q = √ [(2 * F * U) / (P * C)]
148
QUANTITY DISCOUNTS & EOQ

 The standard EOQ model assumes that price per

unit is constant irrespective of order size. However,
in reality qty discounts are associated with order
size. This in principle violates the applicability of
the EOQ model.
 However, the EOQ model can still be adjusted to
determine the ordering qty. Steps –
 Determine the order qty assuming no discount is
available. If change in profit is (+) then EOQ needs
to be upgraded to Optimal Ordering Qty. However,
If change in profit is (-) then stick to EOQ.

149
DETERMINING CHANGE IN PROFIT -
∆π

∆π = [U*D + (U/Q* - U/Q’)*F] -

[Q’(P-D)*C/2 – Q*P*C/2]
where –
U = Annual Demand / Usage
Q = Order Size
F = Cost per Order
C = % Carrying Cost
P = Price per Unit without Discount
D = Discount per Unit (Rs.)
Q* = EOQ assuming no qty discount
Q’ = Minimum order qty to avail discount

150
ORDER POINT

 The basic EOQ model assumes – stocks can be replenished

instantly. Therefore, the model assumes that orders be
placed when inventory level reaches zero. However, this is
not so reality. Therefore,
 Order Point = Lead time (days) * Average daily usage /
consumption.
 A safety stock is required since lead time as well as average
consumption are both likely to vary. It provides protection
against stock-out. Put differently,
 Adjusted Order Point = Order point + Safety stock.

151
SAFETY STOCK

 If the consumption / usage pattern only varies –

 Safety stock = (Maximum – Average) Daily usage *
Lead time (days)
 If the consumption pattern as well as lead time
varies, a higher safety stock is required to prevent a
stock-out. In such a case –
 Safety stock = (Maximum usage * Maximum lead
time) – (Average usage * Average lead time)
 Stock out refers to a situation where the inventory
level falls below the safety stock. Cost associated
with it refers to opportunity loss and reputation.

152
INVENTORY VALUATION

 Inventory valuation is critical to the reflection of

the financial position of the firm. On one side it
improves the current ratio, but on the other side it
reduces profits (i.e. because of higher tax outflow).
So a trade-off is very essential.
 Raw materials are usually valued through – FIFO,
LIFO or Weighted Average method.
 Work-In-Process through Marginal or Absorption
Costing.
 Finished Goods through BIN Cards.
 Selection of methodology is critical to valuation.

153
ABC ANALYSIS

 In most organizations inventory follows the

Pareto’s (80:20) Rule. It explains that 20% of the
inventory units accounts for 80% of the
inventory value. ABC analysis is based on this
empirical reality.
 It classifies inventory into three broad
categories. A representing 15% of the items that
accounts for 70% of the value.
 B representing 30% of the items representing
20% of the value.
 C representing 55% of the items representing
10% of the value.
 The objective is to focus on A and ignore C. 154
 ABC CLASSIFICATION

100% Suppose 15% of

Value of Inventory

our items
90%
accounted for
70% 70% of our sales.
They would be A
items, managed
most carefully.

Number of
15% 45% 100% items

A B C
items items items
155
DEBTORS MANAGEMENT

 While firms would like to sell on cash (i.e. it

minimizes investment in WC), but pressure from
competition forces them to sell on credit (i.e.
risk of losing market share). It has to make a
trade-off between the two repelling forces.
 Normal credit usually ranges between (15-60)
days and 90 days in exceptional cases.
 Debts beyond 180 days needs to classified
separately in the Balance Sheet, and may be
qualified as NPA’s.
 Credit evaluation and monitoring is critical for
successful management of WC (i.e. bad debts)156.
CREDIT POLICY VARIABLES - I

 Credit Standards – It revolves around a benchmark for accepting

or rejecting an account for credit opening.
 At one end of the spectrum lies a choice not to extend any
credit, irrespective of the high credit rating. At the other end of
the spectrum lies a choice to extend credit to any customer
irrespective of the low credit rating.
 Between the two extremes lies several practical trade-offs based
on credit evaluation bases –
 Character, Capacity, Capital, Collateral, Conditions.
 Type I & II errors associated with credit evaluation.

157
CREDIT POLICY VARIABLES - II

 Credit Limit – Credit limit refers to the maximum days

/amount outstanding to be provided to a customer one
time/repeat, till when supplies will be made.
 Cash Discount – To induce customers to buy against cash or
make payment before scheduled tenure firms generally
offer a cash discount to motivate customers to make
prompt payment. Liberalizing the cash discount means
lesser investment in WC, as well as squeezing of profit
margins.
 Collection Effort – It includes a slew of comprehensive
measures aimed at timely and speedy collection.

158
CREDIT SCORING

 Credit scoring (E.g. Fannie Mae) is a method of credit

evaluation which adds a degree of objectivity to the 5C
method. It involves the following process –
 Identify the factors relevant for credit evaluation.
 Assign weights to these factors based on relative
importance.
 Rate the customer on a relevant scale (E.g. Likert).
 Find the factor score by multiplying the score with the
weight.
 Find the Customer Rating Index, by adding all the factor
scores.
 Classify the customer (i.e. the end objective).

159
 DISCRIMINANT ANALYSIS

+
+ +
+ +
+ + o +
Current Ratio

o + +
+
(Risk)

o
o + o
+
o + + +
o o +
o o
o o

160
Return on Investment
DAY’S SALES OUTSTANDING - DSO

 The DSO of a given company at a given time “t” is

defined as the ratio of debtors at that point of time
with the average daily sales during the credit period.
 The trend in DSO reflects how well the company has
managed the bargaining power of its customers. The
average DSO when compared with the credit norms of
the company gives an indication of degree of slack in
debtors management.
 DSOt = Average receivables at time “t”
Average sales during the credit period

161
CREDIT GRANTING DECISION

 To determine the credit worthiness of a one

time or repeat customer the following thumb
rule based on expected profit may also be
applied –
 Ep = p (r-c) – q*c

 where -
 Ep = Expected profit
 p = probability the customer pays his dues
 q = probability the customer defaults
 r = expected revenues
 c = cost of production or goods sold 162
REPEAT ORDER

 A repeat order is normally accepted if the customer

does not default on the first order. However, once the
customer pays for the first order, the probability that
he would default on the second order would be lesser
than the probability of default on the first order.
 Ep = {p1 (r1 – c1) – q*c1} + p1*{p2*(r2-c2) – q2*c2}
 where –
 p1 = probability the customer pays his dues in order1
 p2 = probability the customer pays his dues in order2
 q1 = probability the customer defaults in order1
 q2 = probability the customer defaults in order2
163
CONCEPT OF TREASURY

 Treasury includes cash and short-term

money market instruments.
 Cash is the focal point of fund flow in a
business. While the proportion of total assets
is very small (i.e. 1-3) %, its efficient
management is crucial for solvency.
 A cash-rich firm is better prepared to tap
opportunities arising from fluctuations in
commodity prices, security prices, interest
rates, and foreign exchange.
 However, it is the most idle resource of a firm
and hence has an opportunity cost. 164
TREASURY MANAGEMENT

 Successful treasury management has a direct impact on

profitability as well. It requires –
 Reliable forecasting and established reporting systems.
 Improving cash collections and delaying disbursals.
 Achieve optimal utilization and conservation of funds.
 Float refers to the difference between book balance in bank ledger
and actual funds available. Managing the float is critical for
treasury management.
 Electronic funds transfer has considerably reduced the cash
holding requirement of most firms.

165
CASH HOLDING MOTIVES

 Transaction: It emphasizes the need to maintain

the desired levels of cash to facilitate the
smooth running of production and sales.
 Precautionary: It necessitates the holding of
cash to safeguard against fluctuations in lead
time and consumption pattern.
 Speculative: It influences the holding of cash
above the desired levels to take advantage of
price fluctuations. However, as a standard
practice it is advisable to enforce suitable risk
management practices (i.e. derivatives) to
guard against downward risks. 166
OPTIMAL CASH HOLDING

 Cash holding models attempts to answer the following

two questions –
 When should the transfers be effected between money
market securities and cash?
 What should be the magnitude of these transfers?
 If a firm maintains a small cash balance, it has to sell
securities (and buy them later). This will lead to high
conversion costs, but low opportunity costs.
 If a firm maintains a large cash balance, its conversion
costs would be low, but opportunity costs will be
comparatively higher.

167
 BAUMOL’S MODEL

Total Cost
Costs(Rs

Opportunity Cost
)

Conversion Cost

Optimal Cash Balance

168
Conversion Size(Rs.)
EOQ - DERIVATION

 Total Cost = Ordering Cost + Carrying Cost

 TC = (U/Q * F) + (Q/2 * P * C)
where –
U = Annual Demand / Usage
Q = Order Size
F = Cost per Order
C = % Carrying Cost
P = Price per Unit
TC = Total Cost Q = √ [(2 * F * U) / (P * C)]
169
QUANTITY DISCOUNTS & EOQ

 The standard EOQ model assumes that price

per unit is constant irrespective of order size.
However, in reality qty discounts are
associated with order size. This in principle
violated the applicability of the EOQ model.
 However, the EOQ model can still be adjusted
to determine the ordering qty. Steps –
 Determine the order qty assuming no discount
is available. If change in profit is (+) then EOQ
needs to be upgraded to optimal ordering qty.
However, If change in profit is (-) then stick170to
EOQ.
170
DETERMINING CHANGE IN PROFIT -
∆π

∆π = [U*D + (U/Q* - U/Q’)*F] -

[Q’(P-D)*C/2 –
Q*P*C/2]
where –
U = Annual Demand / Usage
Q = Order Size
F = Cost per Order
C = % Carrying Cost
P = Price per Unit without Discount
D = Discount per Unit (Rs.) 171
171
Q* = EOQ assuming no qty discount
MILLER & ORR MODEL

 Criticizing the completely deterministic assumptions

of the Baumol’s Model, the Miller & Orr Model
assumes that changes in cash balances over a given
period are random in size as well as in direction. As
the no. of periods become sufficiently large, cash
balance changes form a normal distribution.
 According to this model upward changes in cash
balance is allowed till it reaches an UL, then it is
reduced to RP.
 Downward changes are permitted till it reaches a
LL, then it is increased to RP.
 Determine UL & RP through Miller & Orr Model.
172
MILLER & ORR MODEL

 In the Miller & Orr Model the “Lower Control Limit” (LL) is
set by the management based on its risk perspectives. The
“Return Point” (RP) and “Upper Control Limit” (UL) is
calculated accordingly –
 RP = 3 3 * b * σ2 + LL where –
4*I
RP = Return Point
b = Fixed Cost per Order
I = Daily Interest on Marketable Securities
σ2 = Daily Cash Variance
UL = 3RP – 2LL

173
CASH BUDGET

 A cash budget is a summary statement of a

firm’s expected cash inflows and outflows over a
projected time period. Accruals are not taken
into account.
 It provides information on timing and magnitude
of cash flows.
 A series of cash forecasts leads to the
culmination of a cash budget.
 A cash budget includes revenue as well as
capital transactions.
 It is an important tool for treasury management
and control. 174
FINANCING CURRENT ASSETS

 During the normal course of business certain

sources for financing CA are spontaneous and
accrue in the normal course of business –
 Trade Credit – Once the suppliers confidence in the
firm is instilled it will offer generous credit to the
extent of (30-90) days. On an average trade credit
amounts to (40-50)% of total CL.
 Cost of trade credit needs to be weighed vis-à-vis
the incentive sacrificed in the form of cash discount.
 Financing may also be done through accrued
expenses – (electricity, salaries & wages) and / or
provisions – (dividends, taxes).
175
BANK FINANCING

 Bank financing for CA is generally guided by three criteria

– creditworthiness, collaterals, and margin money. It can
undertake the following forms –
 Cash Credit – It is a borrowing arrangement upto a preset
limit against inventory and/or receivables. Interest is
charged only on the balance actually utilized. In the
event of default, risk is borne by the borrower. It is
payable on demand.
 Overdraft – Overdraft is similar to C/C only that the limit
is offered against liquid financial assets. Interest in an
O/D account is charged from the day of disbursement,
irrespective of utilization.

176
FACTORING

 It is a transaction where firm sells of its receivables

to a financial institution (i.e. factor) with a objective
of financing its current assets. In factoring the risk of
default is borne by the factor. It has the following
advantages -
 Adds liquidity to the business.
 Reduces the risk of NPA’s.
 Reduces cost of administration and monitoring.
 Outsourcing from experts in managing and
collecting receivables.
 Credit information and financial counseling.

177
177
TANDON COMMITTEE - 1975

 The working capital gap (CA-CL) without any borrowing,

should be partly funded through bank finance, rest
through long-term borrowings and equity.
 Ascertaining Maximum Permissible Bank Borrowing. The
lower of the three is treated as MPBB.
 a) 75% of working capital gap.
25% of total current assets from long-term sources. The
balance is calculated as –
 b) (0.75 * CA) – CL (without bank borrowings)
 c) 0.75(CA – Core CA) – Current Liabilities.

178
OTHER COMMITTEES

 Subsequently the Chore Committee came out with a

report in 1979; Krishnaswamy Committee in 1980;
Marathe Committee in 1982; Kannan Committee in
1997; Nayak Committee in 1991.
 All the committees emphasized primarily on SME
financing (i.e. inclusive growth).
 Recommended periodical financial forecasts from the
borrower (usually quarterly – Credit Monitoring
Arrangement - CMA Forms – I to VI).
 Facilitate simplified borrowing process –
 MPBB = 20% of Net Sales; Margin Requirement = 5%

179
COST ACCOUNTING

 Cost accounting is that part of management accounting

which establishes budgets and actual cost of operations,
processes, departments or product and the analysis of
variances, profitability or social use of funds. Managers
use cost accounting to support decision making to reduce
a company's costs and improve its profitability.
 Cost accounting can be viewed as translating the Supply
Chain (the series of events in the production process that,
in concert, result in a product) into financial values.
Applications - Product Costing, Operational Planning &
Control, Key Decisions.

180
COSTING

 As a form of management accounting, cost accounting

need not follow standards such as GAAP, because its
primary use is for internal managers, rather than
external users, and what to compute is decided
pragmatically on the managers requirements.
 Costing refers to the processes and techniques for
ascertaining costs. The broad techniques are –
 Process Costing, Standard Costing, Marginal Costing,
Throughput Costing.
 Cost audit is an audit of efficiency of the costing
techniques while the work is in process.

181
COSTING - TECHNIQUES

 Process Costing is a model that identifies activities in an

organization and assigns the cost of each activity to products
and services according to the actual consumption by each: it
assigns indirect costs (overheads) into direct costs.
 Standard costing deals with variance analysis which breaks
down the variation between actual cost and standard costs into
various components (volume, material cost, labor cost, etc.) so
managers can understand why costs were different from what
was planned and take appropriate action to correct the
situation.

182
COSTING - TECHNIQUES

 Marginal Costing deals with decomposition of costs

into fixed and variable components with the intention
of identifying the break-even point (i.e. where costs
equals revenue). Marginal costs refer to the
incremental costs for producing one additional unit
of production.
 Throughput Costing seeks to increase the velocity or
speed at which throughput (T) is generated into
products and services with respect to an
organization's constraint, whether it is internal or
external to the organization. T is the rate at which
the system produces goal units.

183
COSTS - DEFINITION

 Cost refers to an amount of expenditure

(actual or notional) incurred or attributable to
a specific thing or process (CIMA).
 It is a sacrifice in monetary terms (i.e. release
of value) for the acquisition or creation or
value addition of economic resources (ACC).
 Costs can be classified in accordance with –
nature, elements, behaviour, function, control,
normality, or managerial decisions.
 Costs can be also classified depending on the
specific circumstances.
184
CLASSIFICATION - NATURE

 Direct Cost – It means a cost which can be

conveniently identified with or allocated to a
particular cost centre. It is the smallest unit of
an organization for which costs can be
ascertained separately. They are also known
as responsibility centres.
 Indirect Costs – It means a cost which cannot
be conveniently identified with or allocated to
a particular cost centre; it is incurred generally
or commonly for a no. of cost centres.

185
CLASSIFICATION - ELEMENTS

 Material Cost – These are the principal substances

used in the manufacturing of a product or service.
In the process they are transformed into final
products.
 Labour Cost – It includes the physical and/or
mental efforts of human beings expended in the
transformation of principal substances into final
products.
 Overheads – It is the cost of services provided to
compliment labour costs in the transformation
process and includes notional costs as well.

186