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IPCC FM THEORY

CA IPCC Inputs for exams

FM Theory
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1. Do not leave any topic as the paper will cover the entire syllabus and almost no choices 2. Please go through the class notes first.. . Please go through the !"P prescribed for your attempt# and your previous attempt# as sometimes the exam problem is one of the !"P $uestions. %. &our answer to the problem should include as many wor'ing notes as possible. (. "heory $uestions will be very simple and straight forward and please don)t ignore theory and the *isc. topics. It will help in scoring and also clearing the exams. +. "ime will be a constraint so plan your time well in advance ,. -eep practicing the problems during your preparations. It will give you momentum and will let you 'now which problem will ta'e how much time in exams. .. /hile preparing for exam note down all the formulae in a sheet and 0ust before entering the exam revise the formulae for an hour. It will really help you in solving problems $uic'ly and ensure that you are not stuc' mid way. 1. "ry to go through the past $uestion papers and solve them and the feel of the type of $uestions as'ed in the exams.

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ca.kesav@gmai .com!"h#$%&''(%()& FM Theory
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1. BASIC CONCEPT OF F.M

(1) FUNCTIONS OF FINANCE MANAGER Answer: The finance manager occupies an important position in the organisational structure. Earlier his role was just confined to raising of funds from a number of sources. Today his functions are multidimensional. The functions performed by today's finance managers are as below: Forecasting the financia re!"ire#ent: A financial manager has to make an estimate and forecast accordingly the financial requirements of the firm. $ anning: A finance manager has to plan out how the funds will be procured and how the acquired funds will be allocated. $roc"re#ent of f"n%: A finance manager has to select the best source of finance from a large number of options a ailable. The finance manager's decisions regarding the selection of source is influenced by the need! purpose! object and the cost in ol ed. In&est#ent'A ocation of f"n%: A finance manager has also to in est or allocate funds in best possible ways. "n doing so a finance manager can not but ignore the principles of safety profitability and liquidity. Maintaining (ro(er i!"i%it): A finance manager plays an important role in maintaining proper liquidity. #e determines the need for liquid asset and then arrange them in such a way that there is no scarcity of funds. Cash #anage#ent: A finance manager has also to manage the cash in an efficient way. $ash is to be managed in such a way that neither there is scarcity of it nor does it remains idle earning no return on it. *i&i%en% %ecision: A finance manager has also to decide whether or not to declare a di idend. "f di idends are to be declared! then what amount is to be paid to the shareholder and what amount is to be retained in the business. E&a "ation of financia (erfor#ance: A finance manager has to implement a system of financial control to e aluate the financial performance of arious units and then take correcti e measures where er needed. Financia negotiations: "n order to procure and in est funds! a finance manager has to negotiate with the arious financial institutions! banks! public depositors in a meticulous way. To ens"re (ro(er "se of s"r( "s: A finance manager has to see to the proper use of surplus fund. This is necessary for e%pansion and di ersification plan and also for protecting the interest of share holders.

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Inter,re ationshi( -etween in&est#ent. financing an% %i&i%en% %ecisions/ Answer: The basic finance function includes:&i' "n estment decision! &ii' (inancing decision! &iii' )i idend decision. All the abo e three decisions are inter-related because the ultimate aim of all these is wealth ma%imisation. *oreo er! they influence each other in one way or the other (or e.g. "n estment decision should be backed up by finance for which financing decisions are to be taken. The financing decision in turn influences and is influenced by di idend decision. +et us e%amine the three decisions in relation to their inter-relationship. In&est#ent *ecision: The funds once procured ha e to be allocated to the arious projects. This requires proper in estment decision. The in estment decisions are taken after careful analysis of arious projects through capital budgeting , risk analysis. -nly those proposals are e%cepted which yields a reasonable return on the capital employed. Financing *ecision: There are arious sources of funds. A finance manager has to select the best source of finance from a large number of options a ailable. The financing decision regarding selection of source and internal financing depends upon the need! purpose! object and the cost in ol ed . The finance manager has also to maintain a proper balance between long term , short term loan. #e has also to ensure a proper mi% of loans fund and owner's funds which will yield ma%imum return to the shareholders *i&i%en% *ecision: A finance manager has also to decide whether or not to declare di idend. "f di idends are to be declared then what portion is to be paid to the shareholder and what portion is to be retained in the business. Thus! we see that in estment! financing and di idend decisions are all interrelated. (0) *ifferentiate -etween Financia Manage#ent an% Financia Acco"nting/ Answer: *ecision,#a1ing: The chief focus of (inancial Accounting is to collect data and present the data while (inancial *anagement's primary responsibility relates to financial planning! controlling and decisionmaking. Treat#ent of f"n%s: "n (inancial Accounting! the measurement of funds is based on the accrual principle of funds! in financial management is based on cash flows. The re enues are recognised only when cash is actually recei ed &i.e. cash inflow' and e%penses are recognised on actual payment &i.e. cash outflow'.

(2)

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*isting"ish -etween the fo owing: (i) $rofit #a3i#isation &s 4ea th #a3i#isation o-5ecti&e of the fir#/ (or) Two -asic f"nctions of finance #anage#ent Answer: .rofit *a%imi/ation ersus 0ealth *a%imi/ation .rinciple of the (irm (inancial management is basically concerned with procurement and use of funds. "n the light of these! the main objecti es of financial management are:1. .rofit *a%imisation. 2. 0ealth *a%imisation. 1/ $rofit Ma3i#isation: .rofit *a%imisation is the main objecti e of business because: &i' .rofit acts as a measure of efficiency and &ii' "t ser es as a protection against risk. Agree#ents in fa&o"r of (rofit #a3i#isation: &i' 0hen profit earning is the main aim of business the ultimate objecti e should be profit ma%imisation! &ii' (uture is uncertain. A firm should earn more and more profit to meet the future contingencies. &iii' The main source of finance for growth of a business is profit. #ence! profits ma%imisation is required. &i ' .rofit ma%imisation is justified on the grounds of rationality as profits act as a measure of efficiency and economic prosperity. Arg"#ents against (rofit #a3i#isation : &i' "t leads to e%ploitation of workers and consumers &ii' "t ignores the risk factors associated with profit. &iii' .rofit in itself is a ague concept and means differently to different people. "t is a narrow concept at the cost of social and moral obligations. Thus! profit ma%imisation as an objecti e of financial management has been considered inadequate. +/ 4ea th Ma3i#isation: 4ea th #a3i#isation is considered as the appropriate objecti e of an enterprise. 0hen the firms ma%imises the stock holder's wealth! the indi idual stockholder can use this wealth to ma%imise his indi idual utility. 0ealth ma%imisation is the single substitute for a stock holder's utility. A stoc1 ho %er6s wea th is shown -): Stoc1 ho %er6s wea th 3 4o. of shares owned % $urrent stock price per share #igher the stock price per share! the greater will be the stock holder's wealth the greater will be the stock price per share. *a%imum 5tility *a%imum stock holder's wealth *a%imum stock price per share Arg"#ents in fa&o"r of wea th #a3i#isation: &i' )ue to wealth ma%imisation! the short term money lenders get their payments in time. &ii' The long time lenders too get a fi%ed rate of interest on their in estments!

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&iii' The employees share in the wealth gets increased! &i ' The arious resources are put to economical and efficient use. Arg"#ent against wea th #a3i#isation: &i' "t is socially undesirable. &ii' "t is not a descripti e idea. &iii' -nly stock holders wealth ma%imisation does not lead to firm's wealth ma%imisation. &i ' The objecti e of wealth ma%imisation is endangered when ownership and management are separated. "nspite of the arguments against wealth ma%imisation! it is the most appropriati e objecti e of a firm. (7) *isc"ss the changing scenario of Financia Manage#ent in In%ia/ Answer: *odern financial management has come a long way from traditional corporate finance. As the economy is opening up and global resources are being tapped! the opportunities a ailable to a finance manager ha e no limits. (inancial management is passing through an era of e%perimentation and e%citement as a large part 6f finance acti ities are carried out today. A few instances of these are mentioned as below: "nterest rate freed from regulation treasury operation therefore ha e to be more sophisticated as interest rates are fluctuating. The rupee has become fully con ertible. -ptimum debt equity mi% is possible. *aintaining share prices is crucial. The di idend policies and bonus policies formed by finance managers ha e a direct bearing on the share prices. 7hare buy backs and re erse hook building. 8aising resources globally through A)879:)87 8isk *anagement due to introduction of option and future trading. (ree pricing and book building for ".-s! seasoned equity offering. Treasury management. (8) E3( ain the two -asic f"nctions of Financia Manage#ent/ Answer: The two basic aspects of ..*. are: 1. .rocurement of funds 2. Effecti e use of these funds 1/ $roc"re#ent of f"n%: .rocurement of funds includes: "dentification of sources of finance )etermination of finance mi% 8aising of funds )i ision of profit 8etention of profit There are arious so"rces of (roc"re#ent of funds such as:

FM Theory

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7hare capital! debentures! bank! financial institution! A)8! :)8! ()"! (ll etc. E ery source has an element of risk! cost and control attached with it. 0hate er be the source! the cost of the fund should be at the minimum! balancing the risk and the control function. +/ Effecti&e "se of f"n%: The funds once procured cannot be left to remain idle. The funds are to be in ested in such a way that the business yields ma%imum return along with maintaining its sol ency. Thus the effecti e use of the funds would require that adequate funds should be maintained to meet the working capital requirement and a oiding the blockage of funds in in entories book debts! cash etc. (9) State the ro e of a Chief Financia Officer/ Answer: The chief financial officer of an organisation plays an important role in the company's goals! policies and financial success. #is responsibilities include: Financia Ana )sis an% $ anning: )etermining the proper amount of funds to employ in the firm. In&est#ent *ecisions: The efficient allocation of funds to specific assets. Financing an% Ca(ita Str"ct"re *ecisions: 8aising funds on fa ourable terms as possible. *anagement of (inancial 8esources such as working capital. Ris1 Manage#ent: .rotecting assets.

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2. TIME VALUE OF MONEY

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E3( ain the re e&ance of ti#e &a "e of #one) in financia %ecisions/ Time alue of money means that worth of a rupee recei ed today is different from the worth of a rupee to be recei ed tomorrow or in future! The preference of money now! as compared to future money is known as time preference for money. A rupee today is more aluable than a rupee after a year due to se eral reasons like: Ris1:, There is uncertainly about the receipt of money in future. Inf ation:, "n an inflationary period! a rupee today represents a greater real purchasing power than a rupee a year later. $reference for (resent cons"#(tion: , *ost of the persons , companies in general prefer current consumption to future consumption. In&est#ent o((ort"nities:, *any persons and the companies ha e a preference for present money as there are many opportunities of in estment a ailable for earning additional cash flow. Ca(ita ;"%geting:- 0hile arri ing at capital budgeting decisions time alue of money is one or utmost important option. "n this type of decision money is in ested today but return is realised o er a long period of time. #ence to arri e at a correct decision we need to consider time alue of money.

3. CASH & FUN S FLO!

(1) *isting"ish -etween F"n% F ow State#ent an% Cash F ow State#ent/ ;asis 1. -bject 2. 7cope Cash F ow State#ent "t indicates change in cash position "ts co erage is narrow confined only to cash. F"n% F ow State#ent "t indicates change in working capital "ts co erage is wide confined to working capital.
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;. -pening , closing "t is always prepared by balance opening cash balance and closing cash balance <. Adjustment )ue weightage is gi en to outstanding and prepaid income and e%penses. =. .reparation of 4o need to prepare schedule schedule of change of change in working capital in working capital 6. "ncrease or 4ot shown. decrease in working cap-ital >. $alculation :ash generated from operation is calculated. ?. Analysis Essential for short term financial analysis. -pening , closing cash balances are not required. 4o adjustment is needed for outstanding and prepaid e%penses "t is necessary to prepare the schedule of change in working capital. Always shown. (und generated from operation is calculated. Essential for long term financial analysis.

(+) *isc"ss the co#(osition of Ret"rn on E!"it) (ROE) "sing the *"$ont #o%e / Answer: Co#(osition of Ret"rn on E!"it) "sing the *"$ont Mo%e There are three components in the computation of return on equity using the traditional )u.ont model - the net profit margin! asset turno er! and the equity multiplier. @y e%amining each input indi idually! the sources of a company's return on equity can be disco ered and compared to its competitors (i) Net $rofit Margin: The net profit margin is simply the after-ta% profit a company generates for each rupee of re enue. 4et profit margin 3 4et "ncome A 8e enue 4et profit margin is a safety cushionB the lower the margin! lesser the room for error. (ii) Asset T"rno&er: The asset turno er ratio is a measures of how effecti ely a company con erts its assets into sales. "t is calculated as follows: Asset Turno er 3 8e enue A Assets The asset turno er ratio tends to be in ersely related to the net profit marginB i.e.! the higher the net profit margin! the lower the asset turno er. (iii) E!"it) M" ti( ier: "t is possible for a company with terrible sales and margins to take on e%cessi e debt and artificially increase its return on equity. The equity multiplier! a measure of financial le erage! allows the in estor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows: Equity *ultiplier 3 Assets A 7hareholders' Equity Co#("tation of Ret"rn on E!"it) To calculate the return on equity using the )u.ont model! simply multiply the three components &net profit margin! asset turno er! and equity multiplier.' 8eturn on Equity 3 4et profit margin % Asset turno er % Equity multiplier (0)

FM Theory

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E3( ain -rief ) the i#itations of Financia ratios/ Answer: The limitations of 8A are as below: Conce(t of I%ea Ratio: The concept of ideal ratio is ague and there is no uniformity as to what an ideal ratio is. Thin ine of %ifference -etween goo% an% -a% ratio: The line of difference between good and bad ratio is so thin that they are hardly separable. Financia ratios are not in%e(en%ent: The (8's cannot be considered in isolation. They are inter related but not independent. Thus! decision taken on the basis of one ratio may not be correct. Mis ea%ing: Carious firms may follow different accounting policies. "n such case ratio companies of may be misleading. I#(act of Seasona Factor: 7easonal factor brings boom or recession. 8atios may indicate different results during different periods. I#(act of Inf ation: 5nder the impact of inflation! the ratios might not present a true picture. $ro%"ct ine %i&ersification: )ue to product line di ersification! the o erall position of the firm may differ from position of indi idual product line.

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". COST OF CAPITAL & CAPITAL ST#UCTU#E

(1) 7tate three assumptions of *odigliani and *iller approach to $ost of $apital Answer: The Theor): (ranco *odigliani and *eron # *iller de eloped a hypothesis which is actually an e%tension of net operating income approach. EAccording to the theory! in

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absence of corporate ta%! cost of capital and the market alue of equity share is independent to the changes in capital structure or degree of le erage.E E3( anation : The *-* hypothesis ga e two propositions! which are as follows : $ro(osition I: The market alue of the firm &C' and the cost of capital &ko' are independent of its capital structure. $ro(osition II: The firm's cost of equity increase to offset the use by cheaper debt capital. "n other words! the firms use of debt increases its cost of equity as well. Ass"#(tions: The in estors are free to buy and sell the securities is the securities are traded in perfect market... The e%pectations of in estors are same and homogenous. The firms can be classified into homogeneorisk class. The di idend pay out ratio is 1FFG There are no corporate ta%es. (+) *isc"ss the #a5or consi%erations in Ca(ita str"ct"re ( anning/ Answer: The major considerations in $apital 7tructure .lanning are: &1' 8isk &2' $ost of capital &;' $ontrol (1) Ris1 : Ris1 is a situation wherein the possibility of happening or nonhappening of an e ent can be measured. 0ith reference to capital structure planning! risk may be defined as the ariability in the actual return from an in estment and the estimated return as forecasted at the time of capital structure planning. 0hile designing the capital structure the firm tries to keep the risk at minimum. (+) Cost of Ca(ita : The cost of ca(ita is the minimum rate of return that a firm must earn on its in estment to satisfy its arious in estor $ost is thus! an important consideration in capital structure planning. (0) Contro : The decisions relating to capital structure are taken after keeping the contro factor in mind. (or e.g. when equity shares are issued the company automatically dilutes its controlling. (0) *i&i%en% (rice a((roach: This approach emphasi/es on di idend e%pected by an in estor from a particular share to determines its cost. $ost of ordinary share is calculated on the basis of the present alues of the e%pected future stream of di idendB where as Earning (rice a((roach: 5nder this approach cost of ordinary share capital would be based on e%pected ratio of earning of a company. This approach is similar to di idend price approach! only it seeks to nullify the effect of changes in di idend policy. (2) O$TIMUM CA$ITA< STRUCTURE Answer:

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$apital structure is optimum when the alue of the firm is ma%imum and cost of capital &debits , equity' is minimum and so market price per share is ma%imum. 0hich .leads to the ma%imisation of the alue of the firm. -ptimum $apital 7tructure deals with the issue of right mi% of debt and equity in the long -term capital structure of a firm. According to this: "f a company takes on debt! the alue of the firm increases upon a certain point. @eyond that alue of the firm will start to decrease. "f the company is unable to pay the debt within the specified period then it will affect the goodwill of the company in the market. #ence! company should select it appropriate capital structure with due consideration of all factors An o(ti#a ca(ita str"ct"re sho" % (ossess the fo owing feat"res: *a%imisation of profitability : by using le erage minimum cost. (le%ibility: structure should be fle%ible so that company may be able to raise fund or reduce fund whene er it is required. $ontrol: "t should reduce the risk of dilution of control. 7ol ency : E%cessi e debt may threat the sol ency of the company. (7) Ass"#(tions of Net O(erating Inco#e a((roach (NOI) Answer: The Theor): According to the net operating income approach! the market alue of the firm depends upon the net operating profit or E@"T and the 0A$$. The financing mi% or capital structure is irrele ant and does not affect the alue of the firm. E3( anation: The market alue of the firm is not affected by the capital structure changes. (or a gi en alue of E@"T! the alue of firm remains same irrespecti e of the capital composition. "t howe er depends upon the 0A$$.
Gra(hica Re(resentation:

Net o(erationa Inco#e A((roach/ According to the figure! Hd , kF are constant for all le erages. As the le erage increases! k e also increases. @ut the increase in ke is such that the o erall alue of the firm remains same. Conc "sion: As per 4o. 1 approach! kF is constant9Therefore! there is no optimal capital structure. "nstead! e ery capital structure is an optimal one. Ass"#(tions: the 0A$$ remains constant for all le erage. kd is always less than He ke increases as le erage increases.

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kd is constant there are no corporate ta%es. (8) 4eighte% a&erage cost of Ca(ita Answer: Co#("tation of o&era cost of ca(ita of a fir# in&o &es: 1. $omputation of weighted a erage cost of capital 2. $omputation of cost of specific source of finance. 1/ Co#("tation of 4eighte% A&erage Cost of Ca(ita (4ACC): 0eighted a erage cost of capital is the a erage cost of the costs of arious sources of financing. 0eighted a erage cost of capital is also known as composite cost of capital! o erall cost of capital or a erage cost of capital. -nce the specific cost of indi idual sources of finance is determined! we can compute the weighted a erage costs of capital by putting weights to the specific costs of capital in proportion to the. Carious sources of firm to the total. The weights may be gi en either by using the book alue of the source or market alue of the sources.
4ACC = ($ro(ortion of E!"it) 3 Cost of E!"it)) > ($ro(ortion of $reference > Cost of $reference) > ($ro(ortion of *e-t 3 Cost of *e-t)

(or the abo e formula! we consider some assumptions in order to simplify , make it calculati e. These are: &i' 4e consi%er on ) three t)(es of ca(ita : Equity! non-con ertible , noncancellable preference shares and non-con ertible , non-cancellable debts so! we ha e to ignore other forms of capital. because cost of these forms of capital is ery difficult to calculate due to its comple%ities. :enerally! such types of financing co ers a minor part only! so it should be e%cluded as it cannot make any material difference! &ii' *e-ts inc "%e: +ong term debts as well as short terms debts &i.e. working capital loan! commercial papers etc.' &iii' Non,interest: @earing liabilities such as trade creditors are not included in the calculation of 0A$$. This is done to ensure the consistency in reality. 7uch type of securities ha e cost but such costs are indirectly reflected in the price paid by " the co. at the time of getting the goods , ser ices. (9) Financia -rea1,e&en an% E;IT, E$S in%ifference ana )sis/ Answer: Financia ;rea1,e&en an% E;IT,E$S In%ifference Ana )sis (inancial break-e en point is the minimum le el of E@"T needed to satisfy all the fi%ed financial charges i.e. interest and preference di idend. "t denotes the le el of E@"T for which firm's E.7 equals /ero. "f the E@"T is less than the financial breake en point! Then the E.7 will be negati e but if the e%pected le el of E@"T is more than the breake en point then more fi%ed costs financing instruments can be taken in the capital structure! otherwise! equity would be preferred. E@"T-E.7 analysis is a ital tool for designing the optimal capital structure of a firm. The objecti e of this analysis is to find the E@"T le el that will equate E.7 regardless of the financing plan chosen.

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&E@"T-"1'&1-T' 3 &E@"T-12'&1-T' E1 E2 0here! E@"T 3 "ndifference point E1 3 4umber of equity shares in Alternati e 1 E2 3 4umber of equity shares in Alternati e 2 "1 3 "nterest charges in Alternati e 1 12 3 "nterest charges in Alternati e 2 T 3 Ta%-rate Alternati e 13 All equity finance Alternati e 23 )ebt-equity finance.

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$. BUSINESS #IS%, FINANCIAL #IS% &LEVE#AGE

(1) *ifference -etween ;"siness ris1 an% Financia ris1/ Answer: ;"siness Ris1: "t refers to the risk associated with the firm's operations. "t is uncertainty about the future operating income. That is! how well can the operating income be predicted I "t can be measured by standard de iation of basic earning power ratio. Financia Ris1: "t refers to the additional risk placed on firm's shareholders as a result of debt used in financing. $ompanies that issue more debt instruments would ha e higher financial risk than companies financed mostly

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by equity. (inancial risk can be measured by ratios such as firm's financial le erage multiplier! total debt to assets ratio etc. (+) <e&erage% ease/ 5nder a le erage lease transaction! the leasing company &called the equity participation' and a lender &called the loan participant' jointly fund the in estment in the asset to be leased to the lessee. "n this form of lease agreement! the lessor undertakes to finance only a part of the money required to purchase the asset. The major part of the finance is arranged with a financier to whom the title deeds for the asset as well as the lease retails are assigned. There are usually three parties in ol ed! the lessor! the lessee and the financier. The lease agreement is between the lessee and lessor as in any other case. @ut it is supplemented by another separate agreement between the lesser and the financier who agrees to pro ide a major part say ?FG of the money required. 7uch lease agreement which will enable the lessor to undertake an e%pand olume of lease business with a limited amount of capital and hence it is named le erage leasing. (0) O(erating <e&erage an% Financia <e&erage O(erating e&erage is defined as the JfirmKs ability to use fi%ed operating costs to magnify effects of changes in sales on its earnings before interest and ta%es.L 0hen there is an increase or decrease in sales le el the E@"T also changes. The effect of change in sales on the le el o f E@"T is measured by operating le erage. -perating le erage occurs when a firm has fi%ed costs which must be met regardless of olume of sales. 0hen the firm has fi%ed costs! the percentage change in profits due to change in sales le el is greater than the percentage change in sales. 0hereas! Financia e&erage is defined as Jthe ability of a firm to use fi%ed financial charges to magnify the effects of changes in E@"T9-perating profits! on the firmKs earnings per shareL. The financia e&erage occurs when a firmKs capital structure contains obligation of fi%ed financial charges e.g. interest on debentures! di idend on preference shares etc. along with ownerKs equity to enhance earnings of equity shareholders. The fi%ed financial charges do not ary with the operating profits or E@"T. They are fi%ed and are to be paid irrespecti e of le el of operating profits or E@"T. (2) C ose% An% O(en En%e% <ease C ose en%e% ease "n the closed ended lease! the asset gets transferred to the lessor at the end! and the risk of obsolescence! residual alue etc. remain with the lessor being the legal owner of the asset. "t is also known as Etrue leaseL! Ewalkaway leaseE or Enet lease.E

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@ecause the lessee has no obligation to purchase the leased asset upon lease e%piration! that person does not ha e to worry about whether the asset will depreciate more than e%pected throughout the course of the lease. 7o! it is argued that the closed-end leases are better for the a erage person. -pen ended lease in the open ended lease! the lease has the option of purchasing the asset at the end of lease. "t is also known as Efinance lease.E (or e%ample! suppose your lease payments are based on the assumption that a <F!FFF new car will be worth only 2F!FFF at the end of your lease agreement. "f the car turns out to be worth only ?!FFF! you must compensate the lessor &the company who leased the car to you' for the lost 12!FFF since your lease payment was calculated on the basis of the car ha ing a sal age alue of 2F!FFF.

CHAPTE# &' TYPES OF FINANCING

(1) 4rite short notes on the fo owing: Co##ercia (a(er (IM$) Answer: Co##ercia $a(er: A commercial paper is an instrument meant for financing working capital requirement. "t represents short term unsecured promissory notes issued by firms which enjoy a fairly high credit rating. 7uch a promissory note is negotiable by endorsement and deli ery and is issued at a discount on face alue. The feat"res of a co##ercia (a(er are: "t is a short term instrument for financing the working capital requirement. "t represents a promissory note! which is negotiable by endorsement and deli ery. "t is a certificate! which acts as an e idence for unsecured corporate debt of short term maturity. The maturity period of commercial paper usually ranges between MF to ;6F days.

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"t is issued at a discount and is redeemed at face alue. "t is issued directly by the firm to the in estors or through banks. 5nder it the issuer promises to pay the buyer some fi%ed amount on some future date. 4o asset is pledged against the promise. (+) 4rite notes on (i) ?ent"re ca(ita financing (IM$) (ii) See% ca(ita assistance/ Answer: (i) ?ent"re ca(ita financing: , The term 6?ent"re ca(ita 6 refers to capital in estment made in a business or indi idual enterprise! which carries elements of risks and insecurity and the probability of business ha/ards. $apital "n estment may assume the form of either equity or debt or both as a deri ati e instrument. The risk associated with the enterprise could be so high as to entail total loss or be so insignificant as to lead to high gains. The European enture capital association describes enture capital as risk finance for entreprenurial growth oriented companies. "t is an in estment for the medium or long term seeking to ma%imise the return. Centure capital! thus! implies an in estment in the form of equity for high risk projects with the e%pectation of higher profits. The in estments are made through pri ate placement with the e%pectation of risk of total loss or huge returns. #igh technology industry is more attracti e to enture capital financing due to the high profit potential. The main object of in esting equity is to get high capital profit at saturation stage. "n a broad sense! under enture capital financing! enture capitalist makes in estment to purchase debt or equity from ine%perienced enterprenures! who undertake highly risky entures with potential of success (ii) See% ca(ita assistance:, (IM$) The seed capital assistance scheme is designed by the ")@" for professionally or technically qualified enterprenure. The project cost should not e%ceed 2 crores. The ma%imum assistance under this scheme will be :&a' =FG of the promoters required contribution! or &b' 1= lacs! which e er is lower. The assistance is initially interest free but carries a ser ice charge of 1G p.a. for the 1st fi e years and at increasing rate thereafter. The repayment schedule is fi%ed depending upon the repaying capacity of the unit with an initial moratorium of upto = years (0) 4rite short notes on the fo owing: (i) *e-t Sec"ritisation (OR) 4hat Is %e-t Sec"ritisation@ E3( ain the -asic %e-t sec"ritisation (rocess/ (IM$) (ii) ;ri%ge Finance/ Answer: (i) *e-t Sec"ritisation:, *e-t sec"ritisation is a method of recycling of funds. "t is a process whereby loans and other recei ables are under written

FM Theory

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and sold in form of asset. "t is thus a process of transforming the assets of a lending institution into negotiable instrument for generation of funds. $rocess of %e-t sec"ritisation: The (rocess of %e-t sec"ritisation is as fo ows:, 1. The loans are segregated into relati ely homogeneous pools. 2. The basis of pool is the type of credit! maturity pattern! interest rate! risk etc. ;. The asset pools are then transferred to a trustee. <. The trustee then issues securities which are purchased by in estors =. 7uch securities &asset pool' are sold on the undertaking without recourse to seller. F"nction of %e-t sec"ritisation: "t is a method of recycling of funds. "t is especially beneficial to financial intermediaries to support the lending olumes. The basic debt securitisation process can be classified in the following three functions: 1/ The origination f"nction: 0hene er a bank! financial institution! leasing company! #ire .urchase $ompany! credit card company! housing finance company etc. lends money &whether directly of indirectly' to a borrower! there comes into e%istence an asset in the books of bank. This creation of financial asset is called the origination function. +/ The (oo ing f"nction: 7imilar loans or recei ables are clubbed together to create an underlying pool of assets. This pool is transferred in fa our of a 7.C &7pecial .urpose Cehicle'! which acts as a trustee for the in estor. This pooling of assets is 7.C's portfolio is called the pooling function. 0/ The sec"ritisation f"nction: -nce the assets are transferred! 7.C issue its securities &$alled .ass through certificates' to the in estor. This issue of securities is called the securiti/ation function. "n this way we see that con ersion of debts to securities is known as debt securitisation. Fo owing are the &ario"s (arties in&o &e% in the (rocess of asset sec"ritiAation: 1. -riginator is an entity that owns the financial assets proposed to be securitised and initiates the process of securitisation in respect of such assets. 2. 7pecial .urpose Entity &7.E' is an entity which acquires the financial assets under securitisation and normally holds them till maturity. 7.E is an independent entity! usually constituted as a trust though it may be constituted in other forms! for e%ample! as a limited company formed with small capital for the specific purpose of funding the transaction by issue of .T$s or debt securities. The purpose of forming 7.E is insol ency remote. ;. "n estor is the person who finances the acquisition of the securitised assets or of beneficial interest therein by subscribing to .T$s and 9or debt securities issued by an 7.E. The in estors interest in this type of securities are generally institutional in estors like mutual funds! insurance companies etc. A%&antages of %e-t sec"ritisation: 1. "t con erts the debt into securities. 2. "t con erts the illiquid asset into liquid ones.

FM Theory

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;. The assets are shifted from the balance sheet! gi ing the borrower an opportunity of balance sheet funding. <. "t thus helps in better balance sheet management. =. "t enhances the borrower's credit rating. 6. "t opens up new in estment a enues. >. The securities are tied up in definite asset. (ii) ;ri%ge Finance: , ;ri%ge finance is a short-term loan taken by a firm from commercial banks to disperse loans sanctioned by financial institutions. I#(ortance or Nee% for ;ri%ge finance: @ridge finance as the name suggests bridges the time gap between the date of sanctioning of a term loan and its disbursement. The reason for such delay is due to procedure formalities. 7uch delays result in cost o er run of the project. Thus! to a oid such cost o er runs! firms approach commercial banks for short term loans for a period for which delay may occur. $haracteristics of @ridge (inance: 1. "t is short-term loan. 2. "t bridges the gap between the date of sanctioning the loan and the final disbursement of loan. ;. The rate of interest on such loan is usually high. <. These loans are usually repaid as and when term loans are disbursed. A%&antage: 1. "t helps in a oiding the cost o er runs. 2. 7uch loans are useful to implement the projects on time. *isa%&antage: 1. The rate of interest on such loans is ery high. (2) 4rite a short note on B*ee( *isco"nt ;on%sB/ Answer: *ee( *isco"nt ;on%s: *ee( %isco"nt -on%s are a form of /ero interest bonds. These bonds are sold at a discounted alue and an maturity face alue is paid to the in estor such bonds! there is no interest payout during lock in period. 0hen such bonds are sold in the stock market! the difference realised between face alue and market price is the capital gain ")@" was the first to issue deep discount bonds in "ndia in Nanuary 1MM2. (7) 4rite a note on ?ent"re Ca(ita Financing/ Answer: Centure capital refers to financial in estment in a highly risky project with the objecti e of earning a high rate of return. Thus! enture capital financing means financing of high risk projects promoted by new! ine%perienced entrepreneurs who ha e e%cellent business ideas! but does not ha e a financial backing. Feat"res of ?ent"re Ca(ita Financing: 1. Equity participation by the enture capitalist.

FM Theory

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2. "t is a long term financing for a period between = to 1F years ;. The enture capitalist not only in est but also participate in the management of the enture capital undertaking. Metho%s of ?ent"re Ca(ita Financing: 1/ E!"it) financing: 5sually enture capital financing takes form of equity financing as equity financing is a long term financing. +/ Inco#e Note: "t is a type of financing in which the entrepreneur has to pay both interest and royalty on sales but at a low rate. $rocess of ?ent"re Ca(ita Financing: A Centure $apitalist &the financer' in ests in equity or debt of a enture capital undertaking &entrepreneurs'.
Venture Capitalist Venture Capital assistance Invests Venture Capital Undertaking

(8) *isc"ss the e igi-i it) criteria for iss"e of co##ercia (a(er/ Answer: Eligibility criteria issue of commercial paper:The issue of commercial paper is subject to the nature and conditions stipulated by 8@" from time to time. The broad condition are: (1) <isting: The issuing company should be listed in atleast one recognised stock e%change. #owe er! rela%ation from this rule is gi en to closely held companies ,public sector companies. (+) Cre%it Rating: The issuing company should obtain the necessary credit rating from agencies like "$8A! $8"7"+ etc. Application to 8@" for appro al should be made within 2 months of obtaining the rating. (0) Stan%ar% Asset: "n addition to credit rating! the issuing company should be classified as Estandard assetsE by bankers9lending financial institutions. (2) Net worth: The issues should ha e a minimum tangible net worth of = crores as per-recent audited balance sheet!
where Net worth = $ai% "( ca(ita > Free reser&es ,Acc"#" ate% osses C fictitio"s assets

(7) 4or1ing ca(ita : The fund based 0$ limit should be ma%imum of = crores (8) C"rrent Ratio: The minimum current ratio should be 1.;;:1 (9) Iss"e E3(enses: All issue e%penses like dealers fee! credit rating! agency fee etc. shall be borne by the issue company. (9) E3( ain the ter# 6$ o"ghing -ac1 of $rofits6/ (IM$) Answer: $ o"ghing -ac1 of (rofit is an internal source of finance. "t is a phenomenon under which the company does not distribute all the profit earned but retains a part of it! which is re-in ested in the business for its de elopment. "t is thus known as 8etained Earning. Characteristics: 1. "t is a technique of self-financing. 2. "t is a source of finance which contributes towards the fi%ed as well as working capital needs of the company.

FM Theory

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;. 5nder this phenomenon! a part of the total profit is transferred to arious reser es such as general reser e! reser e for repair and renewal! secret reser es etc. <. The funds so created entails almost no risk and the control of the owners is also not diluted. A%&antages: 1/ Econo#ica #etho% of financing: 7ince the company does not depend upon e%ternal sources ploughing back of profit or retained earning acts as! an economical methods of financing. +/ De (s the co#(an) to fo ow sta- e %i&i%en% (o ic): The retained earning helps the company to pay di idend regularly. This enhances the credit worthiness of the company. 0/ It acts as a shoc1 a-sor-ent: A company with large reser es can withstand the shocks of trade cycle and the uncertainty of market with ease. 2/ F e3i- e financia str"ct"re: "t allows the financial structure to remain fle%ible. 7/ Se f,%e(en%ent: "t makes the company self dependent. "t need not depend on outsiders for its financial needs. *isa%&antages: 1/ O&er Ca(ita isation: E%cessi e ploughing back of profit may lead to o er capitalisation. +/ Mis"se of retaine% earning: The retained earning may be misused by in esting in non-profitable areas. 0/ Uncontro a- e growth: 0ith the help of retained earning! the company may e%pand to an e%tent beyond control. 2/ *issatisfaction a#ong shareho %ers: E%cessi e retention of profit may lead to high dissatisfaction among shareholders (E) E3( ain the conce(t of e&erage% ease/ Answer: 5nder a le erage lease transaction! the leasing company &called the equity participation' and a lender &called the loan participant' jointly fund the in estment in the asset to be leased to the lessee. "n this form of lease agreement! the lessor undertakes to finance only a part of the money required to purchase the asset. The major part of the finance is arranged with a financier to whom the title deeds for the asset as well as the lease retails are assigned. There are usually three parties in ol ed! the lessor! the lessee and the financier. The lease agreement is between the lessee and lessor as in any other case. @ut it is supplemented by another separate agreement between the lesser and the financier who agrees to pro ide a major part say ?FG of the money required. 7uch lease agreement which will enable the lessor to undertake an e%pand olume of lease business with a limited amount of capital and hence it is named le erage leasing. (F) *isc"ss the feat"res of %ee( %isco"nt -on%s/ Answer:

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A %ee( %isco"nt -on% does not carry any coupon rate but is issued at a steep discount o er its face alue. "t is also known as '/ero interest &coupon' bond' or just a '/ero'. "n "ndia! ")@" has first time issued *ee( *isco"nt ;on% in 1MM6. 0hich has a face alue of 2!FF!FFF and a maturity period of 2= years The bonds were issued at =;FF. The unique benefit of ))@ is the elimination of in estment risk. "t allows an in estor to lock in the yield to maturity or keep on withdrawing from the scheme periodically after fi e years by returning the certificate. A%&antages: The main ad antage of ))@ is that the difference between the sale price and original cost of acquisition will be treated as capital gain! if the in estor sells the bonds on stock e%change. The ))@ is safe! solid and liquid instrument. "n estors can take ad antage of these new instruments in balancing their mi% of securities to minimise risks and ma%imise returns. *isa%&antages: The main disad antage of deep discount bonds is that they entail a huge payment at maturity. The issuer may e%perience difficulty in arranging for such a large payment and hence in estors may be e%posed to higher risk. (1G) *isc"ss the feat"res of Sec"re% $re#i"# Notes (S$Ns)/ Answer: Sec"re% (re#i"# 4otes is issued along with a detachable warrant and is redeemable after a notified period of say A to > or ? years The con ersion of detachable warrant into equity shares will ha e to be done within time period notified by the company. "n simple language S$N is a /ero interest bond! issued at par! redeemable gradually at a premium and a warrant is also attached with. S$N was issued during August! 1MM2 by TISCO <t%. following were the features of S$N: - (ace alue of one note was ;FF and this were issued at par - "t was redeemable in four equal installments of 1=F each 6 totaling 6FF' at the end of <th to >lh year. - -ut of each repayment of 1=F! >= was to be considered as repayment of principal and >= was to be considered as capital gain. There was a warrant attached with this S$N! which entitles e ery S$N holder to get one equity share of the company at a price of 1FF each at the end of first year. (11) E3( ain the conce(t of c ose% an% o(en en%e% ease. Answer: $lose ended lease "n the closed ended lease! the asset gets transferred to the lessor at the end! and the risk of obsolescence! residual alue etc. remain with the lessor being the legal owner of the asset. "t is also known as Etrue leaseL! Ewalkaway leaseE or Enet lease.E @ecause the lessee has no obligation to purchase the leased asset upon lease e%piration! that person does not ha e to worry about whether the asset

FM Theory

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will depreciate more than e%pected throughout the course of the lease. 7o! it is argued that the closed-end leases are better for the a erage person. -pen ended lease in the open ended lease! the lease has the option of purchasing the asset at the end of lease. "t is also known as Efinance lease.E (or e3a#( e! suppose your lease payments are based on the assumption that a <F!FFF new car will be worth only 2F!FFF at the end of your lease agreement. "f the car turns out to be worth only ?!FFF! you must compensate the lessor &the company who leased the car to you' for the lost 12!FFF since your lease payment was calculated on the basis of the car ha ing a sal age alue of 2F!FFF. (1+) *isc"ss the a%&antages of (reference share ca(ita as an instr"#ent of raising f"n%s/ Meaning: As the name suggests! .reference shares are the shares which enjoys certain preferential rights o er the equity shareholders in regards to:1. .ayment of di idend at a fi%ed rate. 2. 8epayment of capital on the winding up of the company. Characteristics: (1) C ai#s on Inco#e: The preference shares ha e prior claim on income &di idend' o er equity shares. The rate of di idend is fi%ed irrespecti e of the profit earned. (+) C ai# on Asset: "n the e ent of winding up! the preference shareholders ha e a right to claim settlement from the asset. (0) Re%ee#a- e an% con&erti- e: The preference shares are redeemable and can be con erted to equity shares e en. (2) Contro s: 5nder ordinary! conditions the preference shares do not ha e oting rights! howe er they can ote on resolutions which are directly attached to their rights. (7) D)-ri% for#s of financing: .reference shares possess dual characteristics- that of debt and equity. "t is a debt because it carries a fi%ed rate of di idend and a priority o er equity shares holders "t is equity because the di idend is payable only out of distributable profit and is not deductible as an e%pense while determining ta% liability. A%&antage: "t pro ides a long term capital to the company. There is no dilution of E.7. As it bears a fi%ed charge! there is a le eraging ad antage "t can be redeemed after a specified time period. "t does not carry oting rights hence! there is no dilution of control. "t enhance the credit worthiness of the company. (10) *isc"ss the -enefits to the originator of *e-t Sec"ritisation Answer: ;enefits to the Originator of *e-it Sec"ritiAation The -enefits to the originator of %e-t sec"ritiAation are as fo ows:

FM Theory

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The assets are shifted off the balance sheet! thus gi ing the originator recourse to off balance sheet funding. "t con erts illiquid assets to liquid portfolio. "t facilitates better balance sheet management as assets are transferred off balance sheet facilitating satisfaction of capital adequacy norms. The originator's credit rating enhances.

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CHAPTE# &( INTE#NATIONAL FINANCING

(1' E"ro Con&erti- e ;on%s E"ro Con&erti- e ;on%s: "t is a Euro @ond with the characteristics of con ertibility attached to it. "t gi es the bond holders an option to con ert them into equity shares at premium. These bonds carry a fi%ed rate of interest and may include a call option of a put option. 5nder call option! the issuing company has the option to buy or call the bonds prior to maturity date for its redemption. 5nder a .ut -ption the holder has the option to .ut9sell his bonds to the issuing company at a predetermined date , price. (+) 4rite short notes on the fo owing: (a) A#erican *e(ositor) Recei(ts &s/ G o-a *e(ositor) Recei(ts/ (IM$) ;asis of G*R A*R *ifference 1. *eaning The depository receipts in The depository receipts in the 57 the world market is called market is called A)8 :)8. 2. Coting 8ight :)8's do not ha e oting A)8's may be with or without oting rights. rights. ;. 7cope :)8's are traded world A)8's are traded only in 57. wide.

FM Theory

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<. .reference :)8's are more preferred A)8's pro ide certain stringent rules due to their easy operation. to be followed which makes them less preferred. =. $ost The cost in ol ed in The cost in ol ed in operation of A)8 in ol ed operation of :)8 is less is comparati ely high due to than that of A)8. formalities to be fulfilled under 57 :AA. , 7E$. (0) A#erican *e(ositor) Recei(ts Answer: A#erican %e(ositor) recei(t:, )eposit receipt issued by an "ndian company in 57A is known as American depository receipt &A)8s'. 7uch receipt ha e to be issued in accordance with the pro isions stipulated by the security and e%change commission of 57A. An A)8 is generally created by the deposit of the securities of an outsider company with a custodian bank in the country of incorporation of issuing company. The custodian bank informs the depository in 57A that the A)8s can be issued. A)8s are dollar denominated and are traded in the same way as are security of 5.7. company. A)8s can be traded either by trading e%isting A)8s or purchasing the shares in the issuer's home market and ha ing new A)8s created! based upon a ailability and market conditions. 0hen trading in e%isting A)8s! the trade is e%ecuted on the secondary market on the 4ew Oork 7tock E%change through )epository Trust $ompany &)T$' without in ol ement from foreign brokers or custodians. (2) *e-t Sec"ritisation an% ;ri%ge Finance *e-t Sec"ritisation: )ebt securitisation is a method of recycling of funds. "t is a process whereby loans and other recei ables are under written and sold in form of asset. "t is thus a process of transforming the assets of a lending institution into negotiable instrument for generation of funds. .rocess of debt securitisation: The process of debt securitisation is as follows:1. The loans are segregated into relati ely homogeneous pools. 2. The basis of pool is the type of credit! maturity pattern! interest rate! risk etc. ;. The asset pools are then transferred to a trustee. <. The trustee then issues securities which are purchased by in estors =. 7uch securities &asset pool' are sold on the undertaking without recourse to seller. ;ri%ge Finance: ;ri%ge finance is a short-term loan taken by a firm from commercial banks to disperse loans sanctioned by financial institutions. I#(ortance or Nee% for ;ri%ge finance: @ridge finance as the name suggests bridge the time gap between the date of sanctioning of a term loan and its disbursement. The reason for such delay is due to procedure formalities. 7uch delays result in cost o er run of the project.

FM Theory

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Thus! to a oid such cost o er runs! firms approach commercial banks for short term loans for a period for which delay may occur. Characteristics of ;ri%ge Finance: "t is short-term loan. "t bridges the gap between the date of sanctioning the loan and the final disbursement of loan. The rate of interest on such loan is usually high. These loans are usually repaid as and when term loans are disbursed. (7) G o-a *e(ositor) Recei(ts an% A#erican *e(ositor) Recei(ts/ Answer: G o-a *e(ositor) Recei(ts (G*Rs) an% A#erican *e(ositor) Recei(ts (A*Rs) G o-a *e(ositor) Recei(ts are negotiable certificates held in the bank of one country representing a specific number of shares of a stock traded on the e%change of another country. These financial instruments are used by companies to raise capital in either dollars or Euros. These are mainly traded in European countries and particularly in +ondon. A#erican *e(ositor) Recei(ts! whereas on the other hand! are basically negotiable certificates denominated in 57 dollars that represent a non-57 company's publicly traded local currency equity shares. These are created when the local currency shares of "ndian $ompany are deli ered to the depository's local custodian bank! against which the depository bank issues )epository 8eceipts in 57 dollars These are deposited in a custodial account in the 57. 7uch receipts! ha e to be issued in accordance with the pro isions stipulated by the 7E$. (8) E3( ain the conce(t of In%ian %e(ositor) recei(ts/ Answer: The )epartment of $ompany Affairs &)$A' has notified the $ompanies &"ssue of "ndian )epository 8eceipts' 8ules! 2FF< &the ")8 8ules'. These rules pa e the way for foreign companies to raise funds in "ndia by means of issue of depository receipts! against their underlying equity shares. Although the concept of ")8s was mooted by the )$A as early as in 1MM>! when the $ompanies @ill 1MM> introduced this concept for the first time! it did not find place in the actual amendments introduced in the $ompanies Act 1M=6! in 1MMM. The concept of an ")8 can be understood as a mirror image of the familiar A)8s9:) "n an ")8! foreign companies issue shares to an "ndian )epository! which would! in turn! issue )epository 8eceipts to in estors in "ndia. The )epository 8eceipts would be listed on stock e%changes in "ndia and would be freely transferable. The actual shares underlying the ") would be

FM Theory

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held by an - erseas $ustodian! which shall authorise the "ndian )epository to issue the ") The - erseas $ustodian is required to be a foreign bank ha ing a place of business in "ndia and needs appro al from the (inance *inistry for acting as a custodian while the "ndia )epository needs to be registered with 7E@". (9) E3( ain -rief ) the feat"res of E3terna Co##ercia ;orrowings/ (EC;) Answer: E3terna Co##ercia ;orrowings (EC;): EC;s refer to commercial loans &in the form of bank loans! buyers credit! suppliers credit! securitised instruments &e.g. floating rate notes and fi%ed rate bonds' a ailed from non resident lenders with minimum a erage maturity of ; years @orrowers can raise E$@s through internationally recognised sources like &i' international banks! &ii' international capital markets &iii' multilateral financial institutions such as the "($! A)@ etc! &i ' e%port credit agencies & ' suppliers of equipment! & i' foreign collaborators and & ii' foreign equity holders E%ternal $ommercial @orrowings can be accessed under two routes i/ &i' Automatic route &ii' Appro al route. 5nder the Automatic route there is no need to take the 8@"9:o ernment appro al whereas such appro al is necessary under the Appro al route. $ompany's registered under the $ompanies Act and 4:-s engaged in micro i finance acti ities are eligible for the Automatic 8oute where as (inancial "nstitutions and @anks dealing e%clusi ely in infrastructure or e%port finance and the ones which had participated in the te%tile and steel sector restructuring packages as appro ed by the go ernment are required to take the Appro al 8oute. &?' Na#e the &ario"s financia instr"#ents %ea t with in the internationa #ar1et/ Answer: 7ome of the arious financial instruments dealt with in the international market are discussed below: 1/ E"ro Iss"e : An Euro issue is a issue listed on a foreign stock e%change. "t is an instrument which raises foreign currency in the international market! through the issue of: &i' )epository 8eceipts-A)8 , :)8 &ii' (oreign $urrency con ertible bonds +/ E"ro ;on%s: Euro bonds are long term loans raised by entities enjoying an e%cellent credit rating. These bonds are issued for a period ranging between ; to 2F years 0/ Foreign ;on%s: (oreign @onds are debt instrument denominated in a currency which is foreign to the borrower and is sold in the country of that currency. 2/ F" ) De%ge% ;on%s: (ully hedged bonds are the foreign bonds de oid of the risk of currency fluctuation. "t eliminates the risk by selling the entire streams of principal and interest payment in forward market.

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7/ F oating Rate Note: The floating 8ate 4otes pro ide foreign currency at a rate lower than foreign loans. They are issued for a period upto > years The interest rates are adjusted to reflect the pre ailing e%change rate. 8/ E"ro Co##ercia $a(er: Euro commercial papers are promissory notes with a maturity period of less than one year. These are unsecured instruments issued by a corporate body. The main in estors are banks insurance companies! fund managers etc. 9/ Foreign C"rrenc) o(tion: (oreign currency option is a right to buy or sell a sum of foreign currency at a predetermined rate on a future date. E/ Foreign C"rrenc) F"t"res: A foreign currency future is a right to by or sell a sum of foreign currency at a fi%ed e%change rate on a specific future date. "t is an alternati e to forward contract for hedging of e%change risk.

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). CAPITAL BU GETING & INVESTMENT ECISIONS

(1) Net $resent &a "e an% Interna Rate of Ret"rn Answer: 4.C and "88 *ethod differ in the following ways : &1' 5nder 4.C! projects with positi e 4.C are accepted. 5nder "88! projects whose "88 is more than the cost of project are accepted. &2' 4.C measures both quality and scale of in estment. "88 measures only quality of in estment. &;' 4.C pro ides an absolute measure in quantitati e terms. "88 .ro ides a relati e measure in percentage. &<' 5nder 4.C! cash flows are re-in ested at the rate of cost of capital. 5nder "88! cash flows are re-in ested at the rate of "88. (+) Socia Cost ;enefit Ana )sis Answer: 4eed for 7ocial $ost @enefit Analysis:

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The market price which is used to measure cost , benefit in a project does not represent social alues due to imperfections in market. *onetary cost , benefit analysis fails to consider the e%ternal positi e and negati e effects of a project. Ta%es and subsidies are transfer payments and therefore are not rele ant in national economic profitability analysis. The SC;A is essential for measuring the redistribution effect of benefit of a project! as benefit going to economically weaker section is more important than one going to economically fairer section. *erit wants are important appraisal criteria for SC;A. (0) Conce(t of %isco"nte% (a)-ac1 (erio%/ Answer: $oncept of )iscounted .ayback .eriod .ayback period is time taken to reco er the original in estment from project cash flows. "t is also termed as break e en period. The focus of the analysis is on liquidity aspect and it suffers from the limitation of ignoring time alue of money and profitability. )iscounted payback period considers present alue of cash flows! discounted at company's cost of capital to estimate breake en period i.e. it is that period in which future discounted cash flows equal the initial outflow. The shorter the period! better it is. "t also ignores post discounted payback period cash flows. "t takes care of the time alue of money. (2) *esira-i it) factor/ Answer: "n certain cases we ha e to compare a number of proposals each in ol ing different amount of cash inflows. -ne of the methods of comparing such proposals is to work out! what is known as the ')esirability (actorE or '.rofitability "nde%'. "n general terms! a project is acceptable if the .rofitability "nde% is greater than 1. *athematically! )esirability (actor3 7um of )iscounted $ash inflows . "nitial $ash -utlay or Total )iscounted $ash outflows DDDDDDDDDDDDDD

FM Theory

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*. T#EASU#Y & CASH MANAGEMENT

(1) *ifferent 1in%s of f oat with reference to #anage#ent of cash Answer: The term 'float' denotes a delay or lag between two e ents. 0hen a firm recei es a cheque! there is usually a time gap between the time the cheque is written and when it is cleared. This time gap is known as '(loat.' "n the conte%t of cash management the term float is usually used for the following delays:
Despatch of finished Goods to Custo er Billing Float Preparation of Bill or Invoice Mailing Float !eceipt of invoice "# custo er Credit Period Pa# ent of a ount due under the invoice Mailing Float !eceipt of Cheque $"# the %eller& Cheque Processing Float Deposit of Cheque in to Bank Banking Processing Float. Credit of Cheque "# Bank

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Meas"res are a%o(te% to Re%"ce &ario"s F oats in #anage#ent of Cash: F oat @illing float *ailing float &"n oice from seller to customer' *ailing float &$heque from customer' $heque processing float! @anking processing float Meas"res "mmediate preparation of bill right on the ery date of dispatch of finished goods. 7ending the in oice by faster means. $oncentration @anking , +ock @o% 7ystem (+) En"#erate the acti&ities which are co&ere% -) Treas"r) Manage#ent/ Answer: Treasury )epartment conducts efficient 'management of liquidity and financial risk is business. Earlier it was iewed as a peripheral acti ity conducted by back-office! but today it plays a ery ital role in corporate management. The #a5or f"nctions of treas"r) %e(art#ent are as fo ows: 1. 7etting up of corporate financial objecti e: &i' (inancial and treasury policies! &ii' (inancial and treasury systems! &iii' (inancial aims and strategies. 2. $orporate (inance : &i' Equity capital management! &ii' .roject finance! &iii' Noint entures. &i ' @usiness acquisition. & ' @usiness sales! & i' Equity capital management. ;. +iquidity *anagement: &i' 0orking capital management! &ii' *oney management! &iii' *oney transmission management! &i ' @anking relationships and arrangements. <. (unding *anagement: &i' 7ourcess of fund. &ii' (unding policies! &iii' Types of funds! &i ' (unding procedures. =. $urrency *anagement: &i' E%posure policies and procedures. &ii' E%change regulations. &iii' E%change dealings. 6. -ther: &i' 8isk management. &ii' "nsurance management. &iii' $orporate transaction.

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CA Kesav
(0) For#s of ;an1 Cre%it The -an1 cre%it wi genera ) -e in the fo owing for#s: Cash Cre%it: This facility will be gi en by the banker to the customers by gi ing certain amount of credit facility on continuous basis. The borrower will not be allowed to e%ceed the limits sanctioned by the bank. ;an1 O&er%raft: "t is a short-term borrowing facility made a ailable to the companies in case of urgent need of funds. The banks will impose limits on the amount they can lend. 0hen the borrowed funds are no longer required they can quickly and easily be repaid. The banks issue o erdrafts with a right to call them in at short notice. ;i s *isco"nting: The company which sells goods on credit! will normally draw a bill on the buyer who will accept it and sends it to the seller of goods. The seller! in turn discounts the bill with his banker. The banker will generally earmark the discounting bill limit. ;i s Acce(tance: To obtain finance under this type of arrangement a company draws a bill of e%change on bank. The bank accepts the bill thereby promising to pay out the amount of the bill at some specified future date. <ine of Cre%it: +ine of $redit is a commitment by a bank to lend a certain amount of funds on demand specifying the ma%imum amount. <etter of Cre%it: "t is an arrangement by which the issuing bank on the instructions of a customer or on its own behalf undertakes to pay or accept or negotiate or authori/es another bank to do so against stipulated documents subject to compliance with specified terms and conditions. ;an1 G"arantees: @ank guarantee is one of the facilities that the commercial banks e%tend on behalf of their clients in fa our of third parties who will be the beneficiaries of the guarantees.

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1+. MANAGEMENT OF #ECEIVABLES

(1) Factoring/ (i) Factoring: (actoring is an arrangement between a firm and a financial institution under which the firm called the borrower recei es ad ances against its recei ables from the financial institution called the factor. "n factoring! recei ables are generally sold to the factor. who charges commission and bears the credit risk associated with the recei ables. "t is not just a single ser ice but in ol es pro isions of specialised ser ices relating to: 1. credit in estigation. 2. sales ledger management. ;. purchase of debts. <. collection of debts. =. credit protection. 6. .ro ision of finance against recei ables and risk bearing! etc. The borrower selects arious combinations of these functions and makes arrangement with the factor accordingly. The operation of factoring is ery simple and operates in the following way: 1. The borrower enters into an agreement with the factor on suitable terms and conditions. 2. The factor then selects the account of the customer that would be handled by it. ;. The borrower sells his account recei able to the factor. <. The factor pro ide ad ance against the account recei ables after deducting its commission and fees. =. The borrower forwards collection from the customers to the factor and settles the ad ances recei ed along with interest on ad ances. 6. "f pro ided in the agreement! the factor pro ides for the following allied ser ices. &i' $redit in estigation. &ii' $ollection of debt. &iii' 7ales ledger management. &i ' $redit protection. & ' .ro ision of finance against recei ables. Note: The operation of factoring in "ndia is with recourse i.e. in case of default by the customer the risk is borne by borrower and not the factor The -enefits of factoring are as fo ows : 1. The recei ables gets easily con erted into cash. 2. "t ensures a definite pattern of cash inflows from credit sales. ;. "t eliminates the need for the credit and collection department and in this way reduces the cost. <. "t pro ides fle%ibility to the borrower as he is ensured of the debt return. =. 5nlike an unsecured loan! compensating balances are not required in this case.

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1. (actoring may be considered as a sign of financial weakness. 2. The cost of factoring sometimes tends to be higher than the cost of other forms of short term borrowing. ;. 0hile e aluating the credit worthiness of a customer by a factor! it may o er look the sales growth aspect. (+) I#(ortance of 6Cre%it,rating6/ Answer: After drawing up the credit policy! a firm has to e aluate the credit worthiness of the indi idual customer and also the possibility of bad debt. $redit analysis determines the degree of risk associated with the capacity of the customer to borrow and his ability and willingness to pay. (or this! firm has to ascertain the credit rating of prospecti e customers Cre%it Rating: $redit rating is to rate the arious debtors who seek credit facility. $redit rating implies taking decisions regarding indi idual debtors so as to ascertain the quantum of credit and the credit period. This would further in ol e :1. $ollection of information about the debtor. 2. )ecision Tree analysis of credit granting. Co ection of infor#ation a-o"t the %e-tor: The arious sources of information are:(i) $ast Recor%s: .ast records of e%isting customers pro e to be a aluable source of information to find out the credit risk in ol ed! (ii) Sa es #an6s Re(ort: Cery often the firms depend and decide the credit worthiness of a customer on the basis of the sales man's report. The sales man ascertains the potential of the customers and reports accordingly! (iii) ;an1 References: 7ometimes the banks pro ide the required information about the customer and decision is taken after analysing such information! (i&) Tra%e References: "nformation about the customer is also collected from the persons referred by the customer himself. 7uch persons gi ing rele ant information about the customer are the trade references. (&) Cre%it ;"rea" Re(orts: 5seful and authentic credit information is also pro ided by credit bureaus of specific industries. (&i) $"- ishe% Financia Re(orts: The financials reports i.e. balance sheet! profit , loss A9c and others when e%amined can gi e aluable information about credit worthiness of a customer. (&ii) <ist of Go&ern#ent S"(( iers: "f a customer's name appears in the list of :o ernment appro ed suppliers in agencies like ):7 , ) or any other reputed agency! it pro es the credit worthiness of the customer. (&iii) *ecision tree ana )sis of cre%it granting: -nce all the credit information about the customer &both e%isting and prospecti e' is gathered! it has to be thoroughly analysed to arri e at a decision relating to: &a' 0hether or not to grant credit. &b' "f credit is to be granted! then on what terms and conditions.

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The fi&e 6C6s of cre%it which (ro&i%e a fra#ewor1 for e&a "ating a c"sto#er are: $haracter. $apacity. $apital. $ollateral. $ondition. (0) $rinci( es of BTra%ing on e!"it)B/ Answer: The term 'equity' refers to the ownership or 'stock' of a company and 'trading' means 'taking ad antage of. #ence! the term 'trading on equity' means taking ad antage of equity share capital to borrow funds on reasonable basis. "t refers to the additional profit which equity shares make at the e%pense of other forms to securities. This concept is based on the theory that there is a difference among the rates of return on the arious types of securities issued by the company. 0hen the 8eturn on "n estment &8-"' is more than the interest rate then financial le erage works in fa our of equity shareholder and 8eturn on Equity &8-E' will be e en more then 8-". The policy of trading on equity is followed by a company for the following three purpose:&i' To retain full control o er the business. &ii' To increase the rate of .di idend on equity shares. &iii' To achie e control on more financial resources by taking ma%imum loan9 debt on the basis of minimum owned or equity share capital. For e3a#( e the $apital employed is 2!FF!FFF! debt equity ratio is 1:1! interest rate is 1FG and E@"T is ;F!FFF. #ere 8-" is 1=G &;FFFF 9 2FFFFF' which is more than interest rate of 1FG. This e%cess return of =G &1=-1F' will go to equity shareholders and &8-E' will be 2FG &2FFFF91FFFFF'. This e%cess return earned by equity shareholder due to fa ourable financialle erage position is termed as trading on equity. (2) Acco"nts recei&a- e s)ste#s/ Answer: *anual systems of recording the transactions and managing recei ables are cumbersome and costly. The automated recei able management systems automatically update all the accounting records affected by a transaction. This system allows the application and tracking of recei ables and collections to store important information for an unlimited number of

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CA Kesav
customers and transactions! and accommodate efficient processing of customer payments and adjustments. (7) Factoring an% ;i s %isco"nting ;asis of Factoring *ifference *eaning "t is management of book @ank debt .arties (actors! clients! debtors Also known as "n oice (actoring Applicable Act 4o specific Act

;i *isco"nting "t is borrowing from commercial )rawer! drawee and payee "n oice )iscounting 4egotiable "nstruments Act

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