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What is business?
What is 'Finance'
Finance describes the management, creation and study of money, banking, credit,
investments, assets and liabilities that make up financial systems, as well as the study of
those financial instruments. Some people prefer to divide finance into three distinct
categories: public finance, corporate finance and personal finance. Additionally, the study
of behavioral finance aims to learn about the more "human" side of a science considered by
most to be highly mathematical.
financial resources
The money available to a business for spending in the form of cash, liquid securities and credit lines.
Before going into business, an entrepreneur needs to secure sufficient financial resources in order to
be able to operate efficiently and sufficiently well to promote success.
Pre-emption right
From Wikipedia, the free encyclopedia
WHAT IT IS:
Preemptive rights are a clause in an option, security or merger agreement that gives
the investor the right to maintain his or her percentage ownership of a company by
buying a proportionate number of shares of any future issue of the securit
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2. Return on Investment:
The most important criteria to decide the investment proposal is rate of return
it will be able to bring back for the company in the form of income for, e.g., if
project A is bringing 10% return and project is bringing 15% return then we
should prefer project B.
3. Risk Involved:
With every investment proposal, there is some degree of risk is also involved.
The company must try to calculate the risk involved in every proposal and
should prefer the investment proposal with moderate degree of risk only.
4. Investment Criteria:
Along with return, risk, cash flow there are various other criteria which help in
selecting an investment proposal such as availability of labour, technologies,
input, machinery, etc.
The finance manager must compare all the available alternatives very
carefully and then only decide where to invest the most scarce resources of
the firm, i.e., finance.
Investment decisions are considered very important decisions because of
following reasons:
(i) They are long term decisions and therefore are irreversible; means once
taken cannot be changed.
(ii) Involve huge amount of funds.
(iii) Affect the future earning capacity of the company.
3. Risk Involved:
The fixed capital decisions involve huge funds and also big risk because the
return comes in long run and company has to bear the risk for a long period of
time till the returns start coming.
4. Irreversible Decision:
Capital budgeting decisions cannot be reversed or changed overnight. As
these decisions involve huge funds and heavy cost and going back or
reversing the decision may result in heavy loss and wastage of funds. So
these decisions must be taken after careful planning and evaluation of all the
effects of that decision because adverse consequences may be very heavy.
C. Financing Decision:
The second important decision which finance manager has to take is deciding
source of finance. A company can raise finance from various sources such as
1. Cost:
The cost of raising finance from various sources is different and finance
managers always prefer the source with minimum cost.
2. Risk:
More risk is associated with borrowed fund as compared to owners fund
securities. Finance manager compares the risk with the cost involved and
prefers securities with moderate risk factor.
4. Control Considerations:
If existing shareholders want to retain the complete control of business then
they prefer borrowed fund securities to raise further fund. On the other hand if
they do not mind to lose the control then they may go for owners fund
securities.
5. Floatation Cost:
It refers to cost involved in issue of securities such as brokers commission,
underwriters fees, expenses on prospectus, etc. Firm prefers securities which
involve least floatation cost.
D. Dividend Decision:
This decision is concerned with distribution of surplus funds. The profit of the
firm is distributed among various parties such as creditors, employees,
debenture holders, shareholders, etc.
Payment of interest to creditors, debenture holders, etc. is a fixed liability of
the company, so what company or finance manager has to decide is what to
do with the residual or left over profit of the company.
The surplus profit is either distributed to equity shareholders in the form of
dividend or kept aside in the form of retained earnings. Under dividend
decision the finance manager decides how much to be distributed in the form
of dividend and how much to keep aside as retained earnings.
To take this decision finance manager keeps in mind the growth plans and
investment opportunities.
If more investment opportunities are available and company has growth plans
then more is kept aside as retained earnings and less is given in the form of
dividend, but if company wants to satisfy its shareholders and has less growth
plans, then more is given in the form of dividend and less is kept aside as
retained earnings.
1. Earning:
Dividends are paid out of current and previous years earnings. If there are
more earnings then company declares high rate of dividend whereas during
low earning period the rate of dividend is also low.
2. Stability of Earnings:
Companies having stable or smooth earnings prefer to give high rate of
dividend whereas companies with unstable earnings prefer to give low rate of
earnings.
4. Growth Opportunities:
If a company has a number of investment plans then it should reinvest the
earnings of the company. As to invest in investment projects, company has
two options: one to raise additional capital or invest its retained earnings. The
retained earnings are cheaper source as they do not involve floatation cost
and any legal formalities.
If companies have no investment or growth plans then it would be better to
distribute more in the form of dividend. Generally mature companies declare
more dividends whereas growing companies keep aside more retained
earnings.
5. Stability of Dividend:
Some companies follow a stable dividend policy as it has better impact on
shareholder and improves the reputation of company in the share market. The
stable dividend policy satisfies the investor. Even big companies and financial
institutions prefer to invest in a company with regular and stable dividend
policy.
Financial Institutions
Financial Markets
Financial Institutions
Financial institutions facilitate smooth working of the financial system by making investors and
borrowers meet. They mobilize the savings of investors either directly or indirectly via financial
markets, by making use of different financial instruments as well as in the process using the services
of numerous financial services providers. They could be categorized into Regulatory, Intermediaries,
Non-intermediaries and Others. They offer services to organizations looking for advises on different
problems including restructuring to diversification strategies. They offer complete array of services to
the organizations who want to raise funds from the markets and take care of financial assets for
example deposits, securities, loans, etc.
Financial Markets
A financial market is the place where financial assets are created or transferred. It can be broadly
categorized into money markets and capital markets. Money market handles short-term financial
assets (less than a year) whereas capital markets take care of those financial assets that have
maturity period of more than a year. The key functions are:
1.
2.
3.
Assist
in
Serve
creation
as
Help
and
intermediaries
achieve
allocation
for
balanced
of
credit
mobilization
economic
and
liquidity.
of
savings.
growth.
One more classification is possible: primary markets and secondary markets. Primary markets
handles new issue of securities in contrast secondary markets take care of securities that are
presently available in the stock market.
Financial markets catch the attention of investors and make it possible for companies to finance their
operations and attain growth. Money markets make it possible for businesses to gain access to
funds on a short term basis, while capital markets allow businesses to gain long-term funding to aid
expansion. Without
financial
markets,
borrowers
would
have
problems
finding
lenders.
Intermediaries like banks assist in this procedure. Banks take deposits from investors and lend
money from this pool of deposited money to people who need loan. Banks commonly provide money
in the form of loans.
Financial Instruments
This is an important component of financial system. The products which are traded in a financial
market are financial assets, securities or other type of financial instruments. There is a wide range of
securities in the markets since the needs of investors and credit seekers are different. They indicate
a claim on the settlement of principal down the road or payment of a regular amount by means of
interest or dividend. Equity shares, debentures, bonds, etc are some examples.
Financial Services
Financial services consist of services provided by Asset Management and Liability Management
Companies. They help to get the necessary funds and also make sure that they are efficiently
deployed. They assist to determine the financing combination and extend their professional services
upto the stage of servicing of lenders. They help with borrowing, selling and purchasing securities,
lending and investing, making and allowing payments and settlements and taking care of risk
exposures in financial markets. These range from the leasing companies, mutual fund houses,
merchant bankers, portfolio managers, bill discounting and acceptance houses. The financial
services sector offers a number of professional services like credit rating, venture capital financing,
mutual funds, merchant banking, depository services, book building, etc. Financial institutions and
financial markets help in the working of the financial system by means of financial instruments. To be
able to carry out the jobs given, they need several services of financial nature. Therefore, Financial
services are considered as the 4th major component of the financial system.
Money
Money is understood to be anything that is accepted for payment of products and services or for the
repayment of debt. It is a medium of exchange and acts as a store of value.
Dervative:
A derivative is a contract between two or more parties whose value is based on an agreedupon underlying financial asset, index or security. Common underlying instruments include:
bonds, commodities, currencies, interest rates, market indexes and stocks.
Futures contracts, forward contracts, options, swaps and warrants are common derivatives.
A futures contract, for example, is a derivative because its value is affected by the
performance of the underlying contract. Similarly, a stock option is a derivative because its
value is "derived" from that of the underlying stock.
Derivatives are used for speculating and hedging purposes. Speculators seek to profit from
changing prices in the underlying asset, index or security. For example, a trader may
attempt to profit from an anticipated drop in an index's price by selling (or going "short") the
related futures contract. Derivatives used as a hedge allow the risks associated with the
underlying asset's price to be transferred between the parties involved in the contract.
For example, commodity derivatives are used by farmers and millers to provide a degree of
"insurance." The farmer enters the contract to lock in an acceptable price for the commodity;
the miller enters the contract to lock in a guaranteed supply of the commodity. Although both
the farmer and the miller have reduced risk by hedging, both remain exposed to the risks
that prices will change. For example, while the farmer locks in a specified price for the
commodity, prices could rise (due to, for instance, reduced supply because of weatherrelated events) and the farmer will end up losing any additional income that could have been
earned. Likewise, prices for the commodity could drop and the miller will have to pay more
for the commodity than he otherwise would have.
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One of the key features of financial markets are extreme volatility. Prices of
foreign currencies, petroleum and other commodities, equity shares and
instruments fluctuate all the time, and poses a significant risk to those whose
businesses are linked to such fluctuating prices . To reduce this risk, modern
finance provides a method called hedging. Derivatives are widely used for
hedging. Of course, some people use it to speculate as well although in India
such speculation is prohibited.
Derivatives are products whose val ue is derived from one or more basic
variables called underlying assets or
base
are financial security such as an option or future whose value is derived in part
from the value and characteristics of another an underlying asset. The primary
objectives of any investor are to bring an element of certainty to returns and
minimise risks. Derivatives are contracts that originated from the need to limit
risk. For a better conceptual understanding of different kind of derivatives, you
can see this link.
Derivative contracts can be standardized and traded on the stock exchange.
Such derivatives are called exchange-traded derivatives. Or they can be
customised as per the needs of the user by negotiating with the other party
involved. Such derivatives are called over-the-counter (OTC) derivatives.
A Derivative includes :
(a) a security derived from a debt instrument, share, loan, whether secured or
unsecured, risk instrument or contract for differences or any other form of
security ;
(b) a contract which derives its value from the prices, or index of prices, of
underlying securities.
Advantages of Derivatives:
1. They help in transferring risks from risk adverse people to risk oriented
people.
2. They help in the discovery of future as well as current prices.
3. They catalyze entrepreneurial activity.
4. They increase the volume traded in markets because of participation of
risk adverse people in greater numbers.
5. They increase savings and investment in the long run.
Types of Derivative Instruments:
Derivative contracts are of several types. The most common types are forwards,
futures, options and swap.
Forward Contracts
A forward contract is an agreement between two parties a buyer and a seller
to purchase or sell something at a later date at a price agreed upon today.
Forward contracts, sometimes called forward commitments , are very common
in everyone life. Any type of contractual agreement that calls for the future
purchase of a good or service at a price agreed upon today and without the
right of cancellation is a forward contract.
Future Contracts
A futures contract is an agreement between two parties a buyer and a seller
to buy or sell something at a future date. The contact trades on a futures
exchange and is subject to a daily settlement procedure. Future contracts
evolved out of forward contracts and possess many of the same characteristics.
Unlike forward contracts, futures contracts trade on organized exchanges, called
future markets. Future contacts also differ from forward contacts in that they
are subject to a daily settlement procedure. In the daily settlement, investors
who incur losses pay them every day to investors who make profits.
Options Contracts
Options are of two types calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price
on or before a given future date. Puts give the buyer the right, but not the
obligation to sell a given quantity of the underlying asset at a given price on or
before a given date.
Swaps
Swaps are private agreements between two parties to exchange cash flows in
the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are interest rate
swaps and currency swaps.
1. Interest rate swaps: These involve swapping only the interest
related cash flows between the parties in the same currency.
2. Currency swaps: These entail swapping both principal and interest
between the parties, with the cash flows in one direction being in a
different currency than those in the opposite direction.
Futures contracts are highly standardized whereas the terms of each forward
contract can be privately negotiated.
Counterparty risk
In any agreement between two parties, there is always a risk that one side will renege on
the terms of the agreement. Participants may be unwilling or unable to follow through the
transaction at the time of settlement. This risk is known as counterparty risk.
In a futures contract, the exchange clearing house itself acts as the counterparty to both
parties in the contract. To further reduce credit risk, all futures positions are marked-tomarket daily, with marginsrequired to be posted and maintained by all participants at all
times. All this measures ensures virtually zero counterparty risk in a futures trade.
Forward contracts, on the other hand, do not have such mechanisms in place. Since
forwards are only settled at the time of delivery, the profit or loss on a forward contract is
only realized at the time of settlement, so the credit exposure can keep increasing. Hence, a
loss resulting from a default is much greater for participants in a forward contract.
A fixed interest rate is an interest rate on a liability, such as a loan or mortgage, that remains
the same either for the entire term of the loan or for part of the term. A fixed interest rate is
attractive to borrowers who do not want their interest rates to rise over the term of their
loans, increasing their interest expenses.
While fixed interest rates stay fixed or set, variable interest rates vary or adjust. For
example, if a borrower takes out an adjustable rate mortgage (ARM), he typically receives
an introductory rate for a set period of time, often for one, three or five years. After that
point, the rate adjusts on a periodic basis, as outlined in the mortgage agreement.
To illustrate, imagine the bank gives the borrower a 3.5% introductory rate on a $300,000
30-year mortgage with a 5/1 ARM. During the first five years of the loan his monthly
payments are $1,347. However, when the rate adjusts, it increases or decreases based on
the interest rate set by the Federal Reserve or another benchmark index. If the rate adjusts
to 6%, for example, the borrower's payments increase to $1,799. In contrast, if the rate falls
to 3%, the monthly payments fall to $1,265. Conversely, if the 3.5% rate is fixed, the
borrower faces the exact same $1,347 payment every month for 30 years.
(1) Pledge is used when the lender (pledgee) takes actual possession of
assets (i.e. certificates, goods ). Such securities or goods are movable
securities. In this case the pledgee retains the possession of the goods until
the pledgor (i.e. borrower) repays the entire debt amount. In case there is
default by the borrower, the pledgee has a right to sell the goods in his
possession and adjust its proceeds towards the amount due (i.e. principal
and interest amount). Some examples of pledge are Gold /Jewellery Loans,
Advance against goods,/stock, Advances against National Saving
Certificates etc.
possession of the security and then sell the same. The best example of this
type of arrangement are Car Loans. In this case Car / Vehicle remains with
the borrower but the same is hypothecated to the bank / financer. In case
the borrower, defaults, banks take possession of the vehicle after giving
notice and then sell the same and credit the proceeds to the loan account.
Other examples of these hypothecation are loans against stock and debtors.
[Sometimes, borrowers cheat the banker by partly selling goods
hypothecated to bank and not keeping the desired amount of stock of
goods. In such cases, if bank feels that borrower is trying to cheat, then it
can convert hypothecation to pledge i.e. it takes over possession of the
goods and keeps the same under lock and key of the bank].