Financial Management I

10MBAPF204 Semester II

FINANCIAL MANAGEMENT

UNIT – I

FINANCIAL MANAGEMENT

Financial Management is that managerial activity which is concerned with the planning and controlling of the firm’s financial resources. It was a branch of economics till 1890 and as a separate discipline, it is of recent origin.

The subject of financial management is of immense interest to both academicians and practicing managers. It is of great interest to academicians because the subject is still developing and there are still certain areas where controversies exist for which no unanimous solutions have been reached as yet.

Practicing managers are interested in this subject because among the most crucial decisions of the firm are those which relate to finance and an understanding of the theory of financial management provides them with conceptual and analytical insights to make those decisions skillfully.

OBJECTIVES OF FINANCE

The management of finance is to achieve financial objectives. The following are the main objectives of finance

To create wealth for business To generate cash To provide adequate return of investment (bearing in mind the risk of business and

the resources invested) To ensure that sufficient fund is provided at right time to meet the needs of the

business

SCOPE OF FINANCE:What is finance? What are a firm’s financial activities? How are they related to the firm’s other activities? Firms create manufacturing capacities for production of goods; some provide services to customers. They sell their goods or services to earn profit. They raise funds to acquire manufacturing and other facilities. Thus, the three most important activities of a business firm are:

Production Marketing Finance

A firm secures whatever capital it needs and employs it (finance activity) in activities, which generate returns on invested capital (production and marketing activities).

FINANCE FUNCTIONS

It may be difficult to separate the finance functions from production, marketing and other functions, but the functions themselves can be readily identified. The functions of raising funds, investing them in assets and distributing returns earned from assets to shareholders are respectively know as financing decision, investment decision and dividend decision.

A firm attempts to balance cash inflows and outflows while performing these functions. This is called liquidity decision and we may add it to the list of important finance decisions or functions. Thus finance functions or decisions are divided into long-term and short-term decision.s

Long-term financial decisions: Long-term asset-mix or investment decision Capital-mix or financing decision Profit allocation or dividend decision

Short-term financial decisions: Short-term asset-mix or liquidity decision

A firm performs finance functions simultaneously and continuously in the normal course of the business. They do not necessarily occur in a sequence. Finance functions call for skilful planning, control and execution of a firm’s activities.

Let us note at the outset that shareholders are made better-off by a financial decision that increases the value of their shares. Thus, while performing the finance functions, the financial managers should strive to maximize the market value of shares.

Long-term Finance Decisions: The long-term finance functions or decisions have a longer time horizon, generally grater than a year. They may affect the firm’s performance and value in the long run. They also relate to the firm’s strategy and generally involve senior management in taking the final decision.

Investment Decisions: A firm’s investment decisions involve capital expenditures. They are therefore referred as capital budgeting decisions. There is a broad agreement that the correct cut-off rate or the required rate of return on investments is the opportunity cost of capital. The opportunity cost of capital is the expected rate of return that an investor could earn by investing his or her money in financial assets of equivalent risk.

Financing Decisions: A financing decision is the second important function to be performed by the financial manager. He or she must decide when, where from and how to acquire funds to meet the firm’s investment needs. The mix of debt and equity is known as the firm’s capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm.

Dividend Decisions: A dividend decision is the third major financial decision. The financial manager must decide whether the firm should distribute all profits or retain them or distribute a portion and retain the balance. The proportion of profits distributed as divided is called the dividend-payout ratio and the retained portion of profits is known as the retention ratio.

Short-term Finance Decisions: The short-term finance functions or decisions involve a period of less than one year. These decisions are needed for managing the firm’s day-to-day fund requirements. Generally, they relate to the management of current assets and current liabilities, short-term borrowings and investment of surplus cash for short periods.

Liquidity Decision: Investment in current assets affects the firm’s profitability and liquidity. Management of current assets that affects a firm liquidity is yet another important finance function. A proper trade-off must be achieved between profitability and liquidity. The profitability-liquidity trade-off requires that the financial manger should develop sound techniques of managing current assets.

RISK RETURN RELATIONSHIP

Financial decisions incur different degree of risk. Your decision to invest the money in government bonds has less risk as interest rate is known and the risk of default is very less. On the other hand, you would incur more risk if you decide to invest the money in shares, as return is not certain. However, you can expect a lower return from government bond and higher from shares. Risk and expected return move in tandem; the greater the risk, the greater the expected return. The following figure shows this risk-return relationship.

Risk-return relationship

Risk

An overview of financial management

Trade-off

Financial decisions of the firm are guided by the risk-return trade-off. These decisions are interrelated and jointly affect the market value of its shares by influencing return and risk of the firm. The relationship between return and risk can be simply expressed as follows:

Return= Risk-free rate + Risk premium

Risk-free rate is a rate obtainable from a default-risk free government security. An investor assuming risk from her investment requires risk premium above the risk-free rate. Risk-free rate is a compensation for time and risk premium for risk. Higher the risk of action, higher will be the risk premium leading to higher required return on that action.

A proper balance between return and risk should be maintained to maximize the market value of a firm’s shares. Such balance is called risk-return trade-off and every financial decision involves this trade-off. The interrelation between market value, financial decisions and risk-return trade-off is depicted in the above figure. It also gives an overview of the functions of financial management.

The financial manager in a bid to maximize shareholder’s wealth should strive to maximize returns in relation to the gain risk; he or she should seek courses of actions that avoid unnecessary risks. To ensure maximum return, funds flowing in and out of the firm should be constantly monitored to assure that they are safeguarded and properly utilized. The financial reporting system must be designed to provide timely and accurate picture of the firm’s activities.

Financial Management

Maximization of Share Value

Financial Decision

Investment Decisions

Liquidity Management

Financing Decisions

Dividend Decisions

Return Risk

BETA

Beta is a measure of a security’s future risk. But investors do not have future data to estimate beta. What they have is past data about the share prices and the market portfolio. They can only estimate beta based on historical data. Investors can use historical beta as the measure of future risk only if it is stable over time. Most research has shown that the betas of individual securities are not stable over time. This implies that historical betas are poor indicators of the future risk of securities.

The risk of a portfolio of securities is measured by its variance and standard deviation. The variance of a portfolio is the sum of

The variances of individual securities and (the square of) their respective weights,

The covariance (that is, the correlation coefficient between securities times their standard deviations) of securities and twice the product of their respective weights.

In a well diversified portfolio the weights of individual securities would be very small and therefore the variances of individual securities would be quite insignificant and its magnitude would depend on the correlation coefficients between the securities.

The covariance will be negative if all securities in the portfolio are negatively correlated. In practice securities may have some correlation because they all have a tendency to move with the market. The logic introduces the concepts of diversifiable risk and non-diversifiable risk. The unique or the unsystematic risk of a security can be diversified when it is combined with other securities to form a well diversified portfolio.

On the other hand, the market or the systematic risk of the security cannot be diversified because like other securities it also moves with the market.

DIRECT METHOD:How is the systemic risk of a security measured? The beta is also the measure of systematic risk and it is the ratio of covariance between market return and the security’s return to the market return variance:

Βj = = Covj,m = σj σm Covj,m = σj x Covj,m σ2 σm x σm σm

Estimation of Beta:The following table shows the percentage returns on the market, represented by the BSE Sensex (Sentivity Index) and the share of the Jaya Infotech Limited for recent five years:

Returns on Sensex and Jaya InfotechYear Market Return Jaya Infotech R m (%) R j (%) 1 18.60 23.46 2 −16.50 −36.13 3 63.83 52.64 4 −20.65 −7.29 5 −17.87 −12.95

The Beta can be calculated by the following steps:1. Calculate the average return on market (Sensex) and Jaya’s share (column 2 and 3).2. Calculate deviations of returns on market from the average return (column 4)3. Calculate deviations of returns on Jaya’s share from the average return (column 5)4. Multiply deviations of market returns and deviations of Jaya’s return (column 6).

Take the sum and divide by 5 (number of observations) to get covariance.

Covm,j = 4666.30 = 933.265

5. Calculate the squared deviations of the market returns (column 7). Take the sum and divide by 5 to find the variance of market return.

σm = 5288.23 = 1057.655

6. Divide the covariance of market and Jaya by the market variance to get beta.

βj = Covj,m = 933.26 = 0.88 σ2

m 1057.65

7. The intercept term is given by the following formula: αj = rj−βj x rm rj represents average return on investment j

rm represents average market return.

8. Thus, the characteristic line of Jaya Infotech is: rj = −0.89 + 0.88 rm

Beta Calculation for Jaya Infotech Limited

-------------------------------------------------------------------------------------------------------------(rm− rm)

xYear rm rj (rm− rm) (rj− rj) (rj− rJ) (rm− rm)2

------------------------------------------------------------------------------------------------------------- 1 18.60 23.46 13.11 19.51 255.91 171.98 2 −16.50 −36.13 −21.98 −40.08 880.83 483.08 3 63.83 52.64 58.35 48.69 2841.35 3404.85 4 −20.65 −7.29 −26.13 −11.24 293.64 682.96 5 −17.87 −12.95 −23.35 −16.90 394.57 545.35 rm rj Sum = Sum =

= 5.48 = 3.95 4666.30 5288.23

THE MARKET MODEL:Yet another procedure for calculating beta is the use of the market or index model. In the market, we regress returns on a security against returns of the market index. The market model is given by the following equations

rj = α + βj rm + ej where, Rj is the expected return on security j, Rm is the expected market return,

α is intercept, βj is slope of the regressionej is the error term (with zero mean and constant standard deviation)

The slope, βj of the regression measures the variability of the security’s returns relative to the market returns and it is the security’s beta. As discussed earlier, beta is the ratio of the covariance between the security returns and the market returns to the variance of the market returns.

You may note that α indicates the return of the security when the market return is zero. It could be interpreted as return on the security on account of unsystematic risk. Over a long period of time α should become zero, given the randomness of unsystematic risks.

We can plot the observed returns on market and Jaya’s share and fit a regression line as shown in the below figure. The fitted line is given by equation: r j = α + βj rm + ej , The regression line of the market model is called the characteristic line.

Notice that in the above figure, the estimation of regression equation is also shown. The value of a is −0.89 and the value of β is 0.88. How do we get these estimates? The table calculated below gives relevant numbers to estimate the regression equation.

Estimates for Regression Equation-------------------------------------------------------------------------------------------------------------Year rm (X) rj(Y) XY X2 Y2

------------------------------------------------------------------------------------------------------------- 1 18.60 23.46 436.30 345.88 550.37

2 −16.50 −36.13 595.99 272.10 1305.38 3 63.83 52.64 3360.26 4074.86 2770.97 4 −20.65 −7.29 150.54 426.42 53.14 5 −17.87 −12.95 231.41 319.31 167.70Sum SX = SY = SXY = SX2 = SY2 = 27.42 19.73 4774.49 5438.58 4847.56

Average X= Y= 5.48 3.95

The value of β and α in the regression equation are given by the following equations.

β = NΣXY − (ΣX) (ΣY)NΣX2 − (ΣX)2

βj = (5) (4774.49) − (27.42) (19.73)(5) (5438.58) − (27.42)2

= 23872.45 − 541.00 = 23331.45 = 0.88 27192.90 − 751.86 26441.04

Alhpa = α = Y − βX= αj = 3.95 − (0.88) (5.48) = −0.89

We can also calculate the correlation between return on market and Jaya’s share as follows.

…….. P.No.118-119

Coefficient of correlation = NΣXY − (ΣX) (ΣY) [{(NΣY2 ) − (ΣY)2 } {(NΣX2 ) − (ΣX)2 }]½ Corj,m = ________(5) (4774.49) − (27.42) (19.73) [{(5)(4847.56) − (19.73)2 } {((5)(5438.58) − (27.42)2 }]½

= ________23872.45 − 541.00 [(24237.80 − 389.27) (27192.90 − 751.86)]½

= 23331.45 / 25111.35 = 0.93

The squared correlation coefficient or R-square is called the coefficient of determination.

Coefficient of determination = r2 = (Corj,m)2 = (0.93)2 = 0.86

The R-square indicates the extent to which the market model explains a security’s returns. In the above example, the market is able to explain 86 percent of Jaya Infotech’s share return.

Beta Estimation in PracticeIn practice, the market portfolio is approximated by a well diversified share price index. We have several price indices available in India. For example, these indices are:

(a) Bombay Stock Exchange’s Sensitivity Index (Sensex)(b) Bombay Stock Exchange’s National Index(c) National Stock Exchange’s Nifty(d) Economic Times Share Price Index(e) Financial Express Share Price Index

Notice that these indices include only shares of companies. In theory, the market portfolio should include all risky assets–shares, bonds, gold, silver, real estate, art objects, etc.

In computing beta by regression, we need data on returns on market index and the security for which beta is estimated over a period of time. There is no theoretically determined time period and time intervals may vary. The returns may be measured on a daily, weekly or monthly basis. One should have sufficient number of observations over a reasonable length of time. A number of agencies providing the beta values, in developed countries like the USA and the UK, use monthly returns for five-year periods for estimating beta.

The return on a share and market index may be calculated as total return; that is, dividend yield plus capital gain:

Current Dividend + Share price in the beginning – Share price at the endRate of return = Share price in the beginning

= Dividend yield + Capital gain/loss

Dt + (Pt −Pt-1) = Dt + Pt −1 r = Pt-1 Pt-1 Pt-1

In practice, one may use capital gains/loss or price returns (i.e. Pt / Pt-1 −1) rather than total returns to estimate beta of a company’s share. A further medication may be made in calculating the return. We may calculate the compounded rate of return as shown below:

Rj = In (Pt − Pt-1) = In (Pt / Pt-1 −1)

The advantage of the above equation is that it is not influenced by extreme observations.

Summaries of Regression Parameters for HUL Vs Market Returns

Alpha (intercept) −0.8770Standard error of alpha 1.0801Beta 0.6621Standard error of beta 0.1455Correlation 0.5130Coefficient of determination 0.2631F-statistic 20.713Significance 0.0000

Market HULAverage monthly return 2.9957 1.1055Variance of returns 46.9270 78.1804Covariance 30.5534

N.B: By giving input of the above particulars in SPSS we can get the beta and regression observations. The graphical figures can be seen in Page No.120

……………P.No.120

There are many important parameters in a regression shown above. We summarize the statistics of regression parameters for one of the companies, via. HUL., the parameters are explained in the above details.

Beta (slope) HUL has a beta of 0.66 based on the monthly returns during April 2003 to March 2008. A beta of less than 1 means that HUL’s returns are less volatile than the market (Sensex) returns.

Alpha (intercept) The intercept is −0.887. HUL has negative 0.9% return (Rh) when the market return is zero. HUL’s beta (Bh) is 0.66 If the monthly market return (Rm) is expected to be 1 percent, HUL’s expected monthly return is −0.23 percent:

Rh = α + βRm = −0.887 + 0.66 * 1 = −0.227 Coefficient of correlation (Cor) The coefficient of correlation is 0.51. The positive

correlation indicates that when the market return goes up, HUL’s return also goes up. Coefficient of determination (Cor2) The squared coefficient of correlation or the

coefficient of determination (Cor2) is 0.26 (or26%). It indicates the percentage of the variance of HUL’s returns, explained by the changes in the market returns. Thus, the market explains 26 percent of HUL’s risk (variance of returns). The 74 percent unexplained variance is the firm-specific variance. The HUL’s systematic and non-systematic risks are as follows:

Total risk = Security variance = Systematic risk + Unsystematic risk

Systematic risk = Cor2 * security variance= 0.26 * 78.1804 = 20.33

Unsystematic risk = (1−Cor2) * security variance= (1−0.26) * 78.1804 = 57.85

Variance and covariance: Variance of the security is a measure of total risk. The variance of HUL’s returns is 78.1804 and the market return is 46.9270. The covariance of the HUL returns and the market returns is 30.5534. HUL’s beta can also be calculated as follows:

Standard error of beta: Standard error of beta coefficient is 0.1455. It indicates the extent of error in the estimation of beta. The confidence level of the estimated value is measured plus or minus two standard errors. Thus HUL’s beta has a confidence range between 0.37 [i.e.0.66 − (2 * 0.1455)] and 0.95 [i.e.0.66 + (2 * 0.1455)] and there is 95 percent probability that it would range within these intervals.

Betas for the Sensex CompaniesThe BSE’s sensitivity index includes 30 highly traded shares. In the table shown here, the information on beta and other parameters are provided for these companies. These estimates are based on daily returns for one year. You may note that Jaiprakash Associates has the highest beta of 2.28 and Gujarat Ambuja Cement the lowest beta of 0.37.

Name of Company Beta Values R 2 1. A.C.C. 0.79 0.302. Jaiprakash Associates 2.28 0.143. Bharati Televentures 0.79 0.344. BHEL 1.12 0.525. CIPLA Limited 0.46 0.186. DLF Ltd 1.58 0.547. Grasim Ind. 0.77 0.468. Gujarat Ambuja Cement 0.37 0.169. HDFC 1.02 0.46

10. HDFC Bank 0.99 0.5111. HINDALCO 1.23 0.4912. Hindustan Lever 0.54 0.2213. ICICI Bank 1.26 0.6414. Infosys Technologies 0.71 0.3215. ITC Ltd 0.66 0.3116. Larsen & Toubro 1.11 0.5517. Mahindra & Mahindra 0.73 0.3418. Maruti Udyog Ltd 0.65 0.2919. National Thermal Power 1.18 0.5520. ONGC 1.06 0.5821. Ranbaxy Lab. 0.63 0.3022. Reliance 1.17 0.7623. Reliance Comm. 1.19 0.6024. Reliance Energy 1.66 0.5025. Satyam Computer 0.68 0.2526. State Bank of India 1.03 0.5427. Tata Consultancy 0.70 0.3428. Tata Motors 0.77 0.4529. Tata Steel 1.13 0.4830. Wipro Ltd 0.76 0.35

Does Beta Remain Stable Over Time?Betas may not remain stable for a company over time even if a company stays in the same industry. There could be several reasons for this. Over time, a company may witness changes in its product mix, technology, competition or market share. In India, many industrial sectors are witnessing changes in competition and market composition due to the government policy of reforms and deregulation. This is expected to affect the betas of many companies.

Determinants of BetaThe Beta is the ratio of covariance between returns on market and a security to variance of the market returns. But what drives the variance and covariance? The variance and covariance and therefore, Beta depend on three fundamental factors: the nature of business, the operating leverage and the financial leverage.

Nature of Business: All economies go through business cycles. Firms behave differently within a business cycle. The earnings of some companies fluctuate more with the business cycles.

Operating Leverage: Operating leverage refers to the use of fixed costs. The degree of operating leverage is defined as the change in a company’s earnings before interest and tax, due to change in sales. Companies with higher degrees of operating leverage have high betas.

Financial Leverage: Financial leverage refers to debt in a firm’s capital structure. Firms with debt in the capital structure are called levered firms. The degree of financial leverage is defined as the change in a company’s profit after tax due to change in its EBIT. Since financial leverage increases the firm’s (financial) risk, it will increase the equity beta of the firm.

Asset Beta and Equity BetaAssets of a levered firm are financed by debt and equity. Therefore, the asset beta should be the weighted average of the equity beta and the debt beta:

Asset beta = Equity beta * Weight of equity * Debt beta * Weight of debt

βA = βE * Equity / Equity +Debt + βD * Debt / Equity + Debt

It may be noted that for an unlevered (all-equity) firm, the asset beta and the equity beta would be the same. Debt is less risky than equity. Hence the beta of debt will be lower than the equity beta. In case of the risk-free debt, beta will be zero. If we make the assumption that the beta of debt is zero, then the beta of the assets can be given as follows:

βA = βE * Equity / Equity + Debt

For a levered firm, the proportion of equity will be less than 1. Therefore, the beta of asset will be less than the beta of equity. The beta of equity for a levered firm can be given as follows:

ΒE = βA [ 1+ Debt / Equity (1−T]

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CAPM and the Opportunity Cost of Equity Capital: Shareholders supply capital to a firm. In return, they expect to receive dividends. They can also realize cash by selling their shares. The firm has discretion to retain entire or a part of profits. If dividends were distributed to shareholders, they would have an opportunity to invest cash so received in securities in the capital markets and earn a return. When the firm retains profits, there is loss of opportunity for which shareholders need to be compensated. The expected rate of return from a security of equivalent risk in the capital market is the cost of the lost opportunity. Shareholders require the firm to at least earn this rate of their capita invested in projects. From the firm’s point of view, the expected rate of return from a security of equivalent risk is the cost of equity.

The expected rate of rate of return or the cost of equity in CAPM is given by the following equation: Rj = Ke = Rf + (Rm – Rf)βE

We need the following information to estimate a firm’s cost of equity: The risk-free rate The market premium The beta of the firm’s share

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TIME VALUE OF MONEY

Most financial decisions, such as the purchase of assets or procurement of funds, affect the firm’s cash flows in different time periods. For example, if a fixed asset is purchased it will require an immediate cash outlay and will generate cash inflows during many future periods. Similarly, if the firm borrows funds from a bank or from any other source, it receives cash now and commits an obligation to pay cash for interest and repay principal in future periods.

The firm may also raise funds by issuing equity shares. The firm’s cash balance will increase at the time shares are issued, but as the firm pays dividends in future the outflow of cash will occur.

The recognition of the time value of money and risk is extremely vital in financial decision-making. If the timing and risk of cash flows is not considered the firm may make decisions that may allow it to miss its objective of maximizing the owners’ welfare. The welfare of owners would be maximized when wealth or net present value is created from making a financial decision. What is net present value? How is it computed?

Time Preference for MoneyIf an individual behaves rationally, he or she would not value the opportunity to receive a specific amount of money now, equally with the opportunity to have the same amount at some future date. Most individuals value the opportunity to receive money now higher than waiting for one or more periods to receive the same amount.

Time Preference of Money or Time Value of Money (TVM) is an individual’s preference for possession of a given amount of money now, rather than the same amount at some future time.

Three reasons may be attributed to the individual’s time preference for money.

Risk Preference for consumption Investment opportunities

We live under risk or uncertainty. As an individual is not certain about future cash receipts, he or she prefers receiving cash now. Most people have subjective preference for present consumption over future consumption of goods. Most individuals prefer present cash to future cash because of the available investment opportunities to which they can put present cash to earn additional cash. Certain statistical tools such as probability theory or decision tree could be used to handle the uncertainty associated with cash flows.

Required Rate of ReturnThe time preference for money is generally expressed by an interest rate. This rate will be positive even in the absence of any risk. It may therefore be called the risk free rate.

For instance, if time preference rate is 5 percent, it implies that an investor can forego the opportunity of receiving Rs.100 if he is offered Rs.105 after one year (i.e. Rs.100 which he could have received now plus the interest which he could earn in a year by investing Rs.100 at 5 percent).

Thus, the individual is indifferent between Rs.100 and Rs.105 a year from now as he considers these two amount equivalent in value. In reality, an investor will be exposed to some degree of

risk. Therefore, he would require a rate of return, called risk premium from the investment, which compensates him for both time and risk. The required rate of return will be calculated as:

Required Rate of Return = Risk-free rate + Risk premium

The risk-free rate compensates for time while risk premium compensates for risk. The required rate of return may also be called the opportunity cost of capital of comparable risk. It is called so because the investor could invest his money in assets or securities of equivalent risk. Like individuals firms also have required rates of return and use them in evaluating the desirability of alternative financial decisions.

How does knowledge of the required rate of return (or simply called the interest rate) help an individual or a firm in making investment decision? It permits the individual or the firm to convert different cash flows occurring at different times to amounts of equivalent value in the present, that is, a common point of reference.

For example, assume an individual with a required interest rate of 10 percent. If she is offered Rs.115.50 one year from now in exchange for Rs.100 which she should give up today, should she accept the offer?

The answer in this particular case is that she should accept the offer. When her interest rate is 10 percent, this implies that she is indifferent between any amount today and 110 percent of that amount one year hence. She would obviously favour more than 110 percent of the amount (i.e. more than Rs.110 in the example) one year from now; but if the amount offered one year from now were less than 110 percent of the immediate payment, she would retain the immediate payment. She would accept Rs.115.50 after a year since it is more than 110 percent of rs.100, which she is required to sacrifice today.

We can ask a different question. Between what amount today and Rs.115.50 one year from now would our investor be indifferent? The answer is that amount of which Rs.115.50 is exactly 110 percent. Dividing Rs.115.50 by 110 percent or 1.10, we get: Rs.115.50 / 1.10 = Rs.105

This amount is larger than what the investor has been asked to give up today. She would therefore, accept the offer.

This simple example illustrates two most coomon methods of adjusting cash flows for time value of money: compounding – the process of calculating future values of cash flows and discounting – the process of calculating present values of cash flow.

FUTURE VALUEAs seen above the logic for deciding cash flows that is separated by a period, such as one year. But most investment decisions involve more than one period. To solve such multi-period investment decisions, we simply need to extend the logic developed above.

Let us assume that an investor requires 10 percent interest rate to make him different to cash flows one year apart. The question is how should he arrive at comparative values of cash flows that are separated by two, three or any number of years?

Once the investor has determined his interest rate, say, 10 percent, he would like to receive at least Rs.1.10 after one year or 110 percent of the original investment of Re 1 today. A

two year period is two successive one-year periods. When the investor invested Re1 for one year, he must have received Rs.1.10 back at the end of that year in exchange for the original Re1. If the total amount so receive (Rs.1.10) were reinvested, the investor would expect 1.10 percent of that amount, or rs.1.21 = Re1 * 1.10 * 1.10 at the end pf the second year.

Notice that for any time after the first year, he will insist on receiving interest on the first year’s interest as well as interest on the original amount (principal).

Compound interest is the interest that is received on the original amount (principal) as well as on any interest earned but not withdrawn during earlier periods. Compounding is the process of finding the future values of cash flows by applying the concept of compound interest.

Simple interest is the interest that is calculated only on the original amount (principal) and thus, no compounding of interest takes place.

Future Value of a Single Cash FlowFuture Value of a Single Cash FlowSuppose your father gave you Rs.100 on your eighteenth birthday. You deposited this amount in a bank at 10 percent rate of interest for one year. How much future sum would you receive after one year? You would receive Rs.110:

Fn = P (1 +i)n Future sum = Principal + Interest = 100 + (0.10 *100) = 100 * (1.10) = Rs.110

What would be the future sum if you deposited Rs.100 for two years? You would now receive interest on interest earned after one year:

Future sum = 100 * 1.10 * 1.10 = Rs.121

You could similarly calculate future sum for any number of years. We can express this procedure of calculating compound or future value in formal terms.

Future Value of an AnnuityAnnuity is a fixed payment (or receipt) each year for a specified number of years. If you rent a flat and promise to make a series of payment over an agreed period, you have created an annuity. The equal-installment loans from the house financing companies or employers are common examples of annuities. The compound value of an annuity cannot be computed directly from the previous equation as shown above. The computations can be expressed as follows:

F4 = A(1+i)3 + A(1+i)2 + A(1+i) + A

For example, a constant sum of Re1 is deposited in a savings account at the end of each year for four years at 6 percent interest. This implies that Re1 deposited at the end of the first year grow for 3 years, Re1 at the end of second year for 2 years, Re1 at the end of the third year for 1 year and Re1 at the end of the fourth year will not yield any interest.

Using the concept of the compound value of a lump sum, we can compute the value of annuity. The compound value of

Re1 deposited in the first year will be: 1*1.063 = 1.191Re1 deposited in the second year will be: 1*1.062 = 1.124Re1 deposited in the third year will be: 1*1.061 = 1.060Re1 deposited at the end of fourth year will be: 1 = 1.000 Total = 4.375

This is the compound value of an annuity of Re1 for four years at 6 percent rate of interest. It can be seen that for a given interest rate, the compound value increases over a period.

In the above equation A is the annuity. We can extend the same for n periods and rewrite it as follows:

Fn = A [(1+i)n – 1 / i]

The term within brackets is the compound value factor for an annuity of Re1 which we shall refer as CVFA.

Consider an example:

Suppose Rs.100 is deposited at the end of each of the next three years at 10 percent interest rate. With a scientific calculator, the compound value, using the above equation can be calculated as follows: F = 100 [(1.10)3– 1/ 0.10] = 100 * 3.31 =Rs.331

Sinking FundSinking fund is a fund which is created out of fixed payments each period to accumulate to a future sum after a specified period. For example, companies generally create sinking funds to retire bonds (debentures) on maturity.

Suppose we want to accumulate Rs.21,875 at the end of four years from now. How much should we deposit each year at an interest rate of 6% so that it grows to Rs.21875 at the end of fourth year? As calculated and shown below the answer is Rs.5000 each year.

The problem posed is the reversal of the situation in the calculation given below. We are given the future amount and we have to calculate the annual payments.

The factors used to calculate the annuity for a given future sum is called the sinking fund factor (SFF). SFF ranges between zero and 1.0. It is equal to the reciprocal of the compound value factor for an annuity. In the calculation given below, the reciprocal of CVFA of 4.3746 is ¼.3746 = 0.2286

Calculation of Annuity of a Future Value (Sinking Fund)

PMT (RATE, NPER, PV, FV, TYPE)

Fn = A*CVFAni

A= Fn*1/CVFAni

A= Fn*1/SFF

The formula for sinking fund can be written as follows as well:

Sinking fund (annuity) = Future Value Compound value factor of an annuity of Re1

A= Fn[i/(1+i)n − 1]

From the above equation we obtain the following result: A = 21875* 1/4.375 = 21875*0.2286 = Rs.5000

The sinking fund factor is useful in determining the annual amount to be put in a fund to repay bonds or debentures at the end of a specified period.

PRESENT VALUEWe have so far studied how compounding technique can be used for adjusting for the time value of money. It increases an investor’s analytical power to compare cash flows that are separated by more than one period, given the interest rate per period. With the compound technique, the amount of present cash can be converted into an amount of cash equivalent value in future.

However, it is a common practice to translate future cash flows into their present values. Present value of a future cash flow (inflow or outflow) is the amount of current cash that is of equivalent value to the decision maker. Discounting is the process of determining present values of a series of future cash flows. The compound interest rate used for discounting cash flows is also called the discount rate.

Present Value of a Single Cash FlowAs we have seen earlier that an investor with an interest rate i, of say, 10 percent per year, would remain indifferent between Re1 now and Re1*1.101 = Rs1.10 one year from now and Re1*1.102

= Rs1.21 after two years and Re1*1.103 = Rs1.33 after 3 years.

We can say that, given 10 percent interest rate, the present value of Rs.1.10 after one year is Re1; of Rs.1.21 after two years is Re1,,,,

Assuming a 10 percent interest rate, we know that an amount sacrificed in the beginning of the year will grow to 110 percent or 1.10 after a year. Thus the amount to be sacrificed today would be: 1/1.10 = Rs.0.909. In other words, at a 10 percent rate, Re1 to be received after a year is 110 percent of Re0.909 sacrificed now. Stated differently, Re0.909 deposited now at 10 percent rate of interest will grow to Re1 after one year. If Re1 is received after two years, then the amount needed to be sacrificed today would be 1/1.102 = Rs.0.826.

How can we express the present value calculations formally? Let I represent the interest rate per period, n the number of periods, F the future value (or cash flow) and P the present value (cash flow). We know the future value after one year, F1 (viz., present value (principal) plus interest), will be F1 = P(1+i)

The present value, P will be = P = F1 / (1+i)1

The future value after two years is = F2 = P(1+i)2

The present value, P will be = P = F2 / (1+i)2

The present values can be worked out for any combination number of years and interest rate. The following general formula can be employed to calculated the present value of a lump sum to be received after some future periods:

P = Fn / (1+i)n = Fn [(1+i)−n ]

P = Fn / (1+i)n

The term in parentheses is the discount factor or present value factor (PVF) and it is always less than 1.0 for positive I, indicating that a future amount has a smaller present value. We can rewrite Equation as follows: Present value = Future value*Present value factor of Re1

PV = Fn * PVFni

PVFni is he present value factor for n periods at i rate of interest. When we want to calculate the present value factor, we can use a scientific calculator. Alternatively we can use of a table of pre-calculated present value factors. Simply, to find out the present value of future amount, find out the present value factor (PVF) for given n and I from the calculated table and multiply by the future amount.

For example, an investor wants to find out the present value of Rs.50000 to be received after 15 years. The interest rate is 9 percent. First, we will find out the present value factor from the calculated table as 0.275 and multiply by Rs.50000; we obtain Rs.13750 as the present value.

PV = 50000*PVF15 = 50000*0.275 = Rs.13750

Present Value of AnnuityAn investor may have an opportunity of receiving an annuity – a constant periodic amount – for a certain specified number of years. We will have to find out the present value of the annual amount every year and will have to aggregate all the present values to get the total present value of the annuity.

For example, an investor, who has a required interest rate as 10 percent per year, may have an opportunity to receive an annuity of Rs.1 for four years. The present value of Rs.1 received after one year is , P = 1/(1.10) = Rs.0.909, after two years, P = 1/(1.10)2 = Rs.0.826, after 3 years, P = 1/(1.10)3 = Rs.0.751 and after four years, P = 1/(1.10)4 = Rs.0.683. Thus the total present value of an annuity of Rs.1 for four years is Rs.3.169 as shown below.

P = [1/(1.10) + 1/(1.10)2 +1/(1.10)3 + 1/(1.10)4 ]

= [0.909 + 0.826 + 0.751 + 0.683 = Rs.3.169

The computation of the present value of an annuity can be written in the following general form:

P = A[1/i − 1/i (1+i)n ]

The term within parentheses of above equation is the present value factor of an annuity of Rs.1, which we would call PVFA and it is a sum of single-payment present value factors.

For example, assume that a person receives an annuity of Rs.5000 for four years. If the rate of interest is 10 percent, the present value of Rs.5000 annuity is calculated as follows:

P = A[1/i − 1/i (1+i)n ]

P = 5000 [1/0.10 − 1/0.10 (1.10)4 ] = 5000 * (10 − 6.830) = 5000 * 3.170 = Rs.15,850

It can be realized that the present value calculations of an annuity for a long period would be extremely cumbersome without a scientific calculator. We can use the table of pre-calculated present values of an annuity of given present value of annuity of Rs.1 for numerous combinations of time periods and rates of interest.

We can also calculate the present value factor of an annuity of Rs.1 for n periods at i rate of interest, by the formula and using the table (factor) value as shown below:

PV = 5000 * (PVFA4,0.10) = 5000 * 3.170 = Rs.15,850

Capital Recovery and Loan AmortizationIf we make an investment today for a given period of time at a specified rate of interest, we may like to know the annual income. Capital recovery is the annuity of an investment made today, for a specified period of time, at a given rate of interest.

The reciprocal of the present value annuity factor is called the capital recovery factor (CRF).

P = A * PVFAn,i

A = P [1/ PVFAn,i]

The term with bracket may be referred to as the capital recovery factor (CRF). Thus,

Sinking fund = Present value * Capital recovery (annuity) recovery factor of Rs.1

A = P * CRFn,i

For example, you plan to invest Rs.10000 today for a period of four years. If your interest rate is 10% how much income per year should your receive to recover your investment? Using the equation the problem can be solved as follows:

A = P * CRFn, = P * i(1+i)n ------------- (1+i)n − 1

1 ------------------- = P 1 1 --- − -------- i i(1+i)n

* Where the term in parenthesis is CFTni or 1/PVFAni

Suppose you plan to invest Rs.10000 today for period of four years. If your interest rate is 10 percent, how much income per year should you receive to recover your investment? Using the above equation, the problem can be solved as follows:

1 --------------------------

A = 10000 1 1 ------- − -------------

0.10 0.10(1.10)4

= 10000 [1/3.170] = 10000 * 0.3155 = Rs.3,155

It would be thus clear, that the term 0.3155 is the capital recovery factor and it is reciprocal of the present value factor of an annuity of Rs.1. The annuity is found out by multiplying the amount of investment by CRF.

Capital recovery factor helps in the preparation of a loan amortization schedule or loan repayment schedule.

Loan Amortization: ProblemSuppose you have borrowed a 3-year loan of Rs.10000 at 9% rate of interest, from your employer to buy a motorcycle. If your employer requires three equal end-of-year repayments, then what will be the annual installment? Also prepare loan amortization schedule for three years.

Solution: The annual installment will be as follows:

P = A * PVFAn,i

10000 = A * PVFAn,i

10000 = A * 2.531

A = 10000 / 2.531 = Rs.3,951

By paying Rs.3,951 each year for three years, you shall completely pay-off your loan with 9 percent interest. This can be observed from the loan-amortization schedule given below.

Loan Amortization ScheduleEnd of Year Payment Interest Principal Outstanding Repayment Balance

0 - - - 100001 3951 900 3051 69492 3951 625 3326 36233 3951 326 3625* 0

______________________________________________________________________________* Rounding off error.

Present Value of PerpetuityPerpetuity is an annuity that occurs indefinitely. Perpetuities are not very common in financial decision-making. But one can find a few examples. For instance, in case of irredeemable preference shares (i.e., preference shares without a maturity), the company is expected to pay preference dividend perpetually. By definition, in a perpetuity period, n, is so large (mathematically n approaches infinity, ∞) that the expression (1+i)n in Equation tends to become zero and the formula for a perpetuity simply becomes as follows:

Present value of perpetuity = Perpetuity / Interest rate

P = A / i

To take an example, let us assume that an investor expects a perpetual sum of Rs.500 annually from his investment. What is the present value of this perpetuity if interest rate is 10 percent? Applying the above equation:

P = A / i = 500 / 0.10 = Rs.5000

Present Value of an Uneven Cash FlowInvestments made by a firm do not frequently yield constant periodic cash flows (annuity). In most instances the firm receives a stream of even cash flows. Thus the present value factors for an annuity, as given in the calculated table cannot be used. The procedure is to calculate the present value of each cash flow (using the calculated table) and aggregate all present values.

Problem: Consider than an investor has an opportunity of receiving Rs.1000, Rs.1500, Rs.800, Rs.1100 and Rs.400 respectively at the end of one through five years. Find out the present value of this stream of uneven cash flows. If the investor’s required interest is 8 percent, what will be the present cash flow?

Solution: The present value is calculated as follows:

Present value = 1000 + 1500 + 800 + 1100 + 400 (1.08) (1.08)2 (1.08)3 (1.08)4 (1.08)5 The complication of solving this equation can be resolved by using the calculated table. We can find out the appropriate present value factors (PVFs) either from the calculated table or by using calculator land multiplying them by respective amount. The present value calculation will be as follows:

PV = 1000 * PVF1.08 + 1500 * PVF2.08 + 800 * PVF3.08 + 1100 * PVF4.08 + 400 * PVF5.08

= 1000*0.926 + 1500*0.857 + 800*0.794 + 1100*0.735 + 400*0.681

= Rs.3,927.60_________________________________

The following equation can be used to calculate the present value of uneven cash flows:

P = A1 / (1+i) + A2 / (1+i)2 + A3 / (1+i)3 + ……… An (1+i)n n

= ∑ At / (1+i)t t = 1

In the above equation ‘t’ indicates number of years, extending from one year to ‘n’ years. In operational terms the same can be written as follows:

P = A1 * PVF1i + A2 * PVF2i + A3 * PVF3i + …………. + An * PVFni ___________________________________

Present Value of Growing AnnuityIn financial decision-making there are number of situations where cash flows may grow at a constant rate. For example, in the case of companies, dividends are expected to grow at a constant rate. Assume that to finance your post-graduate studies in an evening college, you under take a part-time job for 5 years. Your employer fixes an annual salary of Rs.1000 with the provision that you will get annual increment at the rate of 10 percent. It means that you shall get the following amounts from year 1 through year 5.

End of year Amount of Salary ( Rs. ) 1 1000 = 1000 * 1.100 1000 2 1000*1.10 = 1000 * 1.101 1100 3 1100*1.10 = 1000 * 1.102 1210 4 1210*1.10 = 1000 * 1.103 1331 5 1331*1.10 = 1000 * 1.104 1464

If your required rated of return is 12 percent, you can use the present value factor@12% from the calculated table to obtain the present value for your salary.

Table of Present Value of a Growing AnnuityYear End Amount of Salary (Rs.) PVF@12% PV of Salary (Rs.) 1 1000 0.893 893 2 1100 0.797 877 3 1210 0.712 862 4 1331 0.636 847 5 1464 0.567 830 6105 4309

Problem: A company paid a dividend of Rs.60 last year. The dividend stream commencing from year one is expected to grow at 10 percent per annum for 15 years and then end. If the discount rate is 21 percent, what is the present value of the expected series?

Solution: There is a long way to solve this problem. You may first calculate the series of dividends over 15 years. Note that the first annuity (dividend) in year 1 will be: 60*1.10 = Rs.66. Similarly, dividends for other years can be calculated. Once the dividends have been worked out, you can find their present value using the 21 percent discount rate.

There is a short cut to solve the problem. You can use Equation to find the present value of the series of dividends as follows:

P = A 1+g n ------ 1− 1+i i – g

= 66 ----------- 1 − 1.10 15 0.21-0.10 1.21

= 600 * (1-0.90915 ) = 600 * 0.7606 = Rs.456.36________________________________Yet another alternative is to use Equation as shown below:

i * i – g = 0.11 = 0.10 P = 66 / 1.10 [(1 / 0.10 – 1 / 0.10(1.10)15 ] i + g 1.10

= 60 * 7.606 = Rs.456.36__________________________________Present Value of Growing PerpetuitiesConstantly growing perpetuities are annuities growing indefinitely. How can we value a constantly growing perpetuity? Suppose dividends of Rs.66 after year one as mentioned in previous problem are expected to grow at 10 percent indefinitely. The discount rate is 21 percent. The present value of dividends will be as follows:

P = 66 + 66(1.10) + 66(1.10) 2 + …… + 66(1.10) n–1 1.21 (1.21)2 (1.21)3 (1.21)n In mathematical term, we may say that in Equation n – the symbol for the number of years – is not finite and that it extends to infinity (∞). Then the calculation of the present value of a constantly growing perpetuity is given by a simple formula as follows:

P = A / i–g

Thus if the dividend of Rs.66 in year 1 were expected to grow perpetually, the present value would be: P = 66 / 0.21 – 0.10 = 66 / 0.11 = Rs.600

VALUE OF AN ANNUITY DUEThe concepts of compound value and present value of an annuity discussed earlier are based on the assumption that series of cash flows occur at the end of the period. In practice, cash flows could take place at the beginning of the period. When you buy a fridge on an installment basis, the dealer requires you to make the first payment immediately (viz., beginning of the first period) and subsequent installments in the beginning of the each period. It is common in lease of hire purchase contracts that lease or hire purchase payments are required to be make in the beginning of each period.

Lease is a contract to pay lease rentals (payments) for the use of an asset. Hire purchase contract involves regular payments (installments) for acquiring (owning)

an asset. Annuity due is a series of fixed receipts or payments starting at the beginning of each

period for a specified number of periods.

Future Value of an Annuity DueHow can we compute the compound value of an annuity due? Suppose you deposit Rs.1in a savings account at the beginning of each year for 4 years to earn 6 percent interest, how much will be compound value at the end of 4 years? You may recall that when deposit of Rs.1 made at

the end of each year, the compound value at the end of 4 years will be Rs.4.375 as seen earlier. However, Rs.1 deposited in the beginning of each year 1 through year 4 will earn interest respectively for 4 years, 3 years, 2 years and 1 year.

F = 1*1.064 + 1*1.063 + 1*1.062 + 1*1.061

= 1.262 + 1.191 + 1.124 + 1.06

= Rs.4.637

You can see that the compound value of an annuity due is more than an annuity because it earns extra interest for one year. If you multiply the compound value of an annuity by (1+ i), you would get the compound value of annuity due.

The formula for the compound value of an annuity due is as follows:

Future value of an annuity due = Future value of an annuity * (1+i)

= A * CVFAn,I * (1+i)

= A [(1+i) n −1 ] (1+i) 1 Thus the compound value of Rs.1 deposited at the beginning of each year for 4 year is:

1 * 4.375 * 1.06 = Rs.4.637The compound value annuity factors in the calculated table should be multiplied by (1+i) to obtain relevant factors for an annuity due.

Present Value of an Annuity DueLet us consider a 4-year annuity of Rs.1 each year, the interest rate being 10 percent. L What is the present value of this annuity if each payment is made at the beginning of the year?

You may recall that when payments of Rs.1 are made at the end of each year, then the present value of the annuity is Rs.3.169 as seen earlier. Note that if the first payment is made immediately, then its present value would be the same (i.e. Rs.1) and each year’s cash payment will be discounted by one year less. This implies that the present value of an annuity due would be higher than the present value of an annuity. Thus, the present value of the series of Rs.1 payments starting at the beginning of a period is,

PV = 1 + 1 + 1 + 1 (1.10)0 (1.10)1 (1.10)2 (1.10)3

= 1 + 0.909 + 0.826 + 0.751 = Rs.3.487

The formula for the present value of an annuity due is:

Present value of an annuity due = Present value of an annuity * (1+i)

P = A [(1 / i) – (1 / i(1+i)n ] (1+i)

= A * PVFAn,I * (1+i)

You can see that the present value of an annuity due is more than of annuity by the factor of (1+i). If you multiply the present value of an annuity by (1+i), you would get the present value of an annuity due. Applying the above equation the present value (annuity factors) of Rs.1 paid at the beginning of each year for 4 years is : 1 * 3.170 * 1.10 = Rs.3.487

MULTI-PERIOD COMPOUNDINGWe have assumed in the previous calculations so far that cash flows occurred once a year. In practice, cash flows could occur more than once a year. For example, banks may pay interest on savings account quarterly. On bonds or debentures and public deposits, companies may pay interest semi-annually. Similarly, financial institutions may require corporate borrowers to pay interest quarterly or half-yearly.

The interest rate is usually specified on an annual basis, in a long agreement or security (such as bonds) and is known as the nominal rate of interest. If compounding is done more than once a year, the actual annualized rate of interest would be higher than the nominal interest rate and it is called the effective interest rate.

For example, suppose you invest Rs.100 now in a bank, interest rate being 10 percent a year and that the bank will compound interest semi-annually. How much amount will you get after a year? The bank will calculate interest on your deposit of Rs.100 for first six months at 10 percent and add this interest to your principal. On this total amount accumulated at the end of first six months, you will again receive interest for next six months at 10 percent. Thus, the amount of interest for first six months will be calculated as:

Interest = Rs.100 * 10% *½ = Rs.5

and the outstanding amount at the beginning of the second six month period will be Rs.100 + Rs.5 =Rs.105. Now you will earn interest on Rs.105. The interest on Rs.105 for next six months will be as:

Interest = Rs.105 * 10% *½ = Rs.5.25

Thus you will accumulate Rs.100 + Rs.5 + Rs.5.25 = Rs.110.25 at the end of a year. If the interest were compounded annually, you will have received Rs.100 + 10% = Rs.110. You will get still higher amount if the compounding is done quarterly or monthly.

What effective annual interest rate did you earn on your deposit of Rs.100? On an annual basis, you earned Rs.10.25 on your deposit of Rs.100; so the effective interest rate (EIR) is:

EIR = 5 + 5.25 / 100 = 10.25%

This implies that Rs.100 compounded annually at 10.25 percent or Rs.100 compounded annually at 10 percent will accumulate to the same amount.

EIR in the above example can also be found out using the following equation:

EIR = [1+i/m]nm – 1

= [1+i/2]1*2 – 1 = [1+0.10/2]2 – 1

= 1.1025 – 1 = 0.1025 or 10.25%

Notice that annual interest rate, I, has been divided by 2 to find out semi-annual interest rate since we want to compound interest twice and since there are two compounding periods in one year, the term )1+i/2) has been squared. If the compounding is done quarterly, the annual interest rate, i, will be divided by four and there will be four compounding periods in one year. Problem:You can get an annual rate of interest of 13 percent on a public deposit with a company. What is the effective rate of interest if the compounding is done (a) half-yearly, (b) quarterly, (c) monthly and (d) weekly? Calculate EIR.

Solution:The general formula for calculating EIR can be written in the following general form:

EIR = [1+i/m]nm – 1 where ‘i’ is the annual nominal rate of interest, ‘n’ the number of years and ‘m’ the number of compounding per year.

In annual compounding, m = 1, in monthly compounding, m = 12 and in weekly compounding m = 52.

Effective Interest Rate (EIR)(a) EIR = [1+0.13/2]1*2 – 1 = (1.065)2 – 1 = 1.1342 – 1 = 0.1342 or 13.42%

(b) EIR = [1+0.13/4]1*4 – 1 = (1.0325)4 – 1 = 1.1365 – 1 = 0.1365 or 13.65%

(c) EIR = [1+0.13/12]1*12 – 1= (1.01083)12 – 1 = 1.1380 – 1 = 0.1380 or 13.80%

(a) EIR = [1+0.13/52]1*52 – 1= (1.0025)52 – 1 = 1.1386 – 1 = 0.1386 or 13.86%

______________________________________

The concept developed in the above equation can be used to accomplish the multi-period compounding or discounting for any number of years. For example if a company pay 15% interest, compound quarterly on a 3-year public deposit of Rs.1000, then the total amount compounded after 3 years will be:

F3 = 100 *[1+0.15/4]3*4 = 1000*(1.0375)12 = 1000*1.555 = Rs.1555

We can use the above equation for computing the compounded value of a sum in case of the multi period compounding:

Fn = P[1+i/m]n*m

Fn is the future value, P the cash flow today, ‘i’ the annual rate of interest, ‘n’ is the number of years and ‘m’ is the number of compounding per year. The compound value of an annuity in case of the multi period compounding is given as below:

Fn = A[(1+ i / m ] n*m – 1 ] i/mThe logic developed above can be extended to compute the preset value of sum or an annuity in case of the multi-period compounding. The discount rate will be i/m and the time horizon will be equal n*m.

Problem: (Multi-period Compounding)Find out the compound value of Rs.1000, interest rate being 12 percent per annum if compounded annually, semi-annually, quarterly and monthly for 2 years.Annual compounding

Fn = 1000[1+0.12/1]2*1 = 1000(1.12)2 = 1000*1.254 = Rs.1254

Half-yearly compounding

Fn = 1000[1+0.12/2]2*2 = 1000(1.06)4 = 1000*1.262 = Rs.1262 Quarterly compounding

Fn = 1000[1+0.12/4]2*4 = 1000(1.03)8 = 1000*1.267 = Rs.1267 Monthly compounding

Fn = 1000[1+0.12/12]2*12 = 1000(1.01)24 = 1000*1.270 = Rs.1270

Continuous Compounding Sometimes compounding may be done continuously. For example, banks may pay interest continuously; they call it daily compounding. The continuous compounding function takes the form of the following formula:

Fn = P*eim = P*ex

In the above equation x= interest rate i multiplied by the number of years n and e is equal to 2.7183 (as per the calculated table) or you can also use scientific calculator for this purpose.

In the previous problem if the compounding is done continuously, then the compound value will be: Fn = 1000*e(0.12*2) = P*e0.24

= 1000*2.71830.24 = 1000*1.2713 = Rs.1271.30

The above equation (Fn = P*eim = P*ex ) can be transformed into a formula for calculating present value under continuous compounding.

P = Fn/ein = Fn*e−i*n

Thus, if Rs.1271.30 is due in 2 years, discount rate being 12 percent, then the present value of this future sum is:

P = 12713.30 / 1.2713 = Rs.1000

NET PRESENT VALUEThe firm’s financial objective should be to maximize the shareholder’s wealth. Wealth is defined as net present value. Net present value (NPV) of financial decision is the difference between the present value of cash inflows and the present value of cash outflows.

Suppose you have Rs.200,000. You want to invest this money in land, which can fetch you Rs.245,000 after one year when you sell it. You should undertake this investment if the present value of the expected Rs.245,000 after a year is greater than the investment outlay of Rs.200,000 today. You can put your money to alternate uses.

For example, you can invest Rs.200,000 in units (say, Unit Trust of India sells ‘units’ and invests money in securities of companies on behalf of investors) and earn 15% dividend a year. How much should you invest in units to obtain Rs.245,000 after a year?

In other words, if your opportunity cost of capital is 15%, which is the present value of Rs.245,000 if you invest in land? By applying the present value formula:

PV = A*PVFAn,I

= 245,000*(PVF1,0.15) = 245,000*0.870 = Rs.213,150

The land is worth Rs.213,150 today, but that does not mean that your wealth will increase by Rs.213,150. You will have to commit Rs.200,000 and therefore, the net increase in your wealth or net present value is Rs.213,150 − Rs.200,000 = Rs.13,150. It is worth investing in land.

The general formula for calculating NPV can be written as: NPV = C1 + C2 + . . . . . + Cn − C0

(1+k) (1+k)2 (1+k)n

n

NPV = ∑ Ct − C0 Ct is cash inflow in period t, t=1 (1+k)t C0 is cash outflow today, k is the opportunity cost of capital and t is the time period

Note that the opportunity cost of capital is 15 percent because it is the return foregone by investing in land rather than investing in securities (units), assuming risk is the same. The opportunity cost of capital is used as a discount rate.

Present Value and Rate of ReturnYou may be frequently reading advertisement in newspapers: deposit say Rs.1000 today and get twice the amount in 7 years; or pay us Rs.100 a year for 10 years and we will pay you Rs.100 a year thereafter in perpetuity.

A company or financial institution may offer you bond or debenture for a current price lower than its face value and repayable in the future at the face value, but without and interest (coupon). A bond that pays some specified amount in future (without periodic interest) in exchange for the current price today is called a zero-interest bond or zero-coupon bond. In such situations, you would be interested to know what rate of interest the advertiser is offering. You can use the concept of present value to find out the rate of return or yield of these offers.

For example, a bank offers you to deposit Rs.100 and promises to pay Rs.112 after one year. What rate of interest would you earn? The answer is 12 percent:

100*(1+i) = 112

100 = 112 / (1+i)

(1+i) = 112 / 100

i = 112 / 100 – 1 = 0.12 or 12%

Problem:What rate of interest would you earn if you deposit Rs.1000 today and receive Rs.1762 at the end of five years?

Or

For the deposit of Rs.1000 the return would be Rs.1762 which to be received at the end of fifth year.

Solution: 1000 = 1762 / (1+i)5 = 1762*(PVF5i)

* PVF5i = 1000 / 1762 = 0.576 (use scientific calculator or calculated table value)

1000 = 1762 / (1+i)5

(1+i)5 = 1762/1000

i = (1762/1000)1/5 – 1

= 1.7621/5 – 1

i = 1.12 – 1 = 0.12 or 12%

Let us take an example of an annuity. Assume you borrow Rs.70000 from the Housing Development Finance Corporation (HDFC) to buy a flat in Ahmedabad. You are required to mortgage the flat and pay Rs.11,396.93 annually for a period of 15 years. What interest rate would you be paying? You may note that Rs.70,000 is the present value of a fifteen-year annuity of Rs.11,396.93. That is,

70000 = 11396.93*PVAF15,i

PVAF15,I = 70000 / 11396.93 = 6.142

If you look across the calculated table value in the book, the 15-year row and interest rate columns until you get the value 6.142. You will find this value in the 14 percent column. Thus HDFC is charging 14 percent interest from you.

Finding the rate of return for an uneven series of cash flows is a bit difficult. By practice and using trial and error method you can find it.

Problem: (Calculating Rate of Return)Suppose your friend wants to borrow from you Rs.1600 today and would return to you Rs.700, Rs.600 and Rs.500 in year 1 through year 3 as principal plus interest What rate of return would you earn?

You should recognize that you earn that rate of return at which the present value of Rs.700, Rs.600 and Rs.500 received, respectively, after one, two and three is Rs.1600. Suppose (arbitrarily) this rate is 8 percent. When you calculate the present value of the cash flows at 8 percent you get the following amount:

Cash Flow PV of Cash Flow Year (Rs.) PVF at 8% (Rs.) 1 700 0.926 648.20 2 600 0.857 514.20 3 500 0.794 397.00

1559.40

Since the present value at 8 percent is less than Rs.1600, it implies that your friend is allowing you a lower rate of return; so you try 6 percent. You obtain the following results:

Year Cash Flow PVF PV of Cash Flow (Rs.) at 6% (Rs.)

1 700 0.943 660.00 2 600 0.890 534.00 3 500 0.840 420.00

1614.00 The present value at 6% is slightly more than Rs.1600; it means that your friend is offering you approximately 6 percent interest. In fact, the actual rate would be a little higher than 6 percent. At 7 percent, the present value of cash flows is Rs.1586. You can interpolate as follows to calculate the actual rate.

= 6% +(7% − 6%) * (1614 – 1600) (1614 – 1586)

= 6 % + 1% * 14/28 = 6% +0.5% = 6.5%

At 6.5% percent rate of return, present value of Rs.700, Rs.600 and Rs.500 occurring respectively in year once through three is equal to Rs.1600:

= (Rs.700 / 1.065) + (Rs.600 / 1.0652 ) + (Rs.500 / 1.0653 )

= (700*0.939)+ (600*0.883)+ (500*0.828) = Rs.1600

The rate of return of an investment is called internal rate of return (IRR) or yield since it depends exclusively on the cash flows of the investment. Once you have understood the logic of the calculation of the internal rate of return, you can use a scientific calculator or Excel to find it.

RESERVE BANK OF INDIA (Central Banking)

The pattern of central banking in India was based on the Bank of England. England had a highly developed banking system in which the functioning of the central bank as a banker’s bank and their regulation of money supply set the pattern. The effectiveness of open market operations however depends on the member banks’ dependence on the central bank. The central bank plays an advisory role and renders technical services in the field of foreign exchange, foster the growth of a sound financial system and acts as a banker to government.Instruments of Monetary ControlOne of the most important functions of a central bank is monetary management – regulation of the quantity of money and the supply and availability of credit for industry, business and trade. The central bank relies on two types of instruments: direct and indirect. The direct instrument of monetary control is reserve requirements, administered interest rate and credit controls; and the indirect of control is open market operations.

Money SupplyThe total expansion of money supply depends on the creation of high-powered money (reserve base) and the multiplier action upon it. The components of the reserve money are currency with the public, other deposits with the RBI and bankers’ deposits with the RBI. Reserve requirements consists of cash reserve ratio and statutory liquidity ratio. The impact of any change in reserve ratios on money supply depends on the ratio of bank reserves to total reserves which is defined as the currency with the public and bank reserves.

Open Market OperationsOpen market operations can be continuous and flexible in influencing bank reserves. Till the initiation of several measures to promote primary and secondary markets in government securities since 1992-93, the market was quite narrow. There was no choice of amount. The amount was determined by the budgetary requirements. As a corollary to the financial liberalization measures, the development of money market and securities market promoted new market arena by way of introducing of new instruments, auction system of government securities.

Bank Rate or Discount RateBank rate has been defined in Section 49 of the Reserve Bank of India Act, 1934 as the standard rate at which the bank is prepared to buy or rediscount bills of exchange or other commercial papers eligible to purchase under the Act. It is the rate at which the central bank lends funds as a

‘lender of last resort’ to banks against approved securities, purchases, discounts eligible bills of exchange. Its effectiveness depends on the dependence of commercial banks on the central bank for a additional resources.

Selective Credit ControlsSelective credit controls are concerned with distribution and direction of available credit supplies. The instruments used are minimum margin of lending against specific securities, ceiling on the amount of credit for specific purposes and discriminatory or differential rates of interest for some sectors of credit or borrowers.

RESERVE BANK OF INDIAThe Reserve Bank of India was established on April 1, 1935, under the Reserve Bank of India Act, 1934. The Bank’s share capital was Rs.5 crores. In the terms of the Reserve Bank (Transfer to Public Ownership) Act, 1948, the entire share capital was deemed to be transferred to the Central Government. The Reserve Bank entered upon its career as a state-owned institution from January 1, 1949. The Act of 1948 empowered the Central Government to issue such directions to the Bank as it might, after the consultation with the Governor of Bank, consider necessary in the public interest.

Main Functions of the BankThe main functions of the Bank are to act s the note-issuing authority, Banker’s Bank, Banker to the government and to promote the growth of the economy with the framework of the general economic policy of the government. The Reserve Bank of India is the controller of foreign exchange. It is the watchdog of the entire financial system. The Bank is the sponsor bank of a wide variety of top-ranking banks and institutions such as SBI, IDBI, NABARD and NHB. The Bank sits on the board of all banks and it counsels the Central and State governments and all public sector institutions on monetary and money matters.

Money Supply MeasuresAs per the recommendations of the Working Group of Money Supply (1997) four monetary aggregates are complied on the basis of the balance sheet of the banking sector in conformity with the norms in terms of liquidity. Mo (monetary base) (weekly) M1 (narrow money) M2& M3 (broad money) (fortnightly)

Further three liquidity aggregates in order of progress viz., L1, L2 and L3 (quarterly) are computed incorporating deposits with post office savings banks, term deposits, term borrowings and certificates of deposits of term lending institutions (FIs) and public deposits of NBFCs on an aggregation basis.

Issue of CurrencyThe Reserve Bank is the sole authority for the issue of currency in India. Rupee coins/notes and subsidiary coins are issued by the Government of India but they are put into circulation only through the Reserve Bank. Currency notes are legal tender in payment or on account, without limit. One rupee notes and coins are legal tender for unlimited amounts, fifty paise coins for a sum not exceeding ten rupees and smaller coins for any sum not exceeding one rupee.

The Act permits the issue of notes in the denominations of rupees two, five, ten, twenty, fifty, hundred, five hundred, one thousand, five thousand and ten thousand. At present denominations up to Rs.1000 are being used.

The affairs of the bank relating to note issue and its general banking business are conducted through two separate departments: the Issue and Banking Department.

The Issue Department is liable for the aggregate value of currency notes of Government of India and the currency notes of the Reserve Bank in circulation and it maintains eligible assets for equivalent value.

The Banking Department produces the expansion and contraction of currency in circulation. Cash deposits and withdrawals by scheduled banks are handled by the Banking Department.

In practice, the distinction between the Issue Department and the Banking Department has little economic significance, since there are frequent shifts between the assets of the two departments.

Banker to GovernmentThe Reserve Bank is the banker to the Government of India statutorily and to State Governments by virtue of agreements entered into with them. The Bank accepts money on deposit, withdrawal of funds by cheques, receipt and collection of payments to the Government and transfer of funds by various means throughout India. The terms and conditions on which the Bank acts as a banker to the Central and State Governments are set out in separate agreements which the Bank has entered into with them. It acts as a principal and as an agent in securities market.

Ways and Means AdvancesUnder the agreement between Government of India and the RBI (March 26, 1997) the Bank will provide Ways and Means Advances (WMA) to the Government as and when required at an interest rate mutually agreed from time to time. These advances will have to be repaid within three months. When 75% of the agreed level of Ways and Means Advances is utilized, the RBI will trigger fresh floatation of government securities.

Public DebtPublic debt management policy determines the composition of debt while the size of the debt is determined by budgetary requirement. The introduction of the auction system for treasury bills and securities has let the interest rate to be market-determined. While the institutions, banks, LIC and PFs have to statutorily buy government securities, the interest rate on their holdings is market-determined.

The Reserve Bank manages the pubic debt and issues new loans on behalf of the Central Government and State Governments. With a view to activate internal debt management policy and for more effective conduct of monetary policy the coupon rate raised to near market rates, new instruments were introduced and borrowing was made auction based. The debt stability condition which should suggest that the output growth rate should exceed the interest rate should be met to achieve fiscal sustainability.

Nominal RateInflation reduces the real value of debt. The impact on yield depends on how it is reflected in higher nominal rates of interest. The 91-day treasury bill on an auction basis was introduced in 1993 with a predetermined amount with RBI support at the cut-off yield.

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RESERVE BANK OF INDIA BALANCE SHEET AS ON JUNE 30, 2000

(Rs.Crores)Issue Department

Liabilities 1999-2000 Assets 1999-2000Notes held in the Gold coins & Bullion Banking Department 15 a) Held in India 10,761Notes in circulation 2,01,486 b) Held outside India - 2,01,501 Foreign securities 86,700 Total 97,461 Rupee coin 115 Government of India Rupee securities 1,03,925 Internal bills of exchange and other commercial papers - ________ _______Total Liabilities 2,01,501 Total Assets 2,01,501__________________________________________________________________________

Banking DepartmentLiabilities 1999-2000 Assets 1999-2000Capital paid-up 5 Notes 15 Reserve fund 6500 Rupee coins -National industrial credit Small coins - (long-term operations fund) 4,633 Bills purchased National housing credit & discounted (long-term operations fund) 883 a) Internal - b) External - c) Govt. treasury bills -Deposits a) Government Balances held abroad 32,372 i) Central Govt. 100 Investments 79,728 ii) State Govt. 41 Loans & Advances to i) Central Govt. 5,298 ii) State Govt. 2,386 b) Banks Loans & Advances to i) Scheduled commercial i) Scheduled commercial banks 60,854 banks 8,712 ii) Scheduled state ii) Scheduled cooperative banks 845 cooperative banks 215 iii) Other scheduled iii) NABARD 5,104 cooperative banks 1,625 iv) Others 5,187 iv) Non-scheduled state cooperative banks 52 Loans & Advances to v) Other banks 658 i) Industrial Development Bank of India 1,740 c) Others 16,470 ii) Export Import Bank

Bills payable 744 of India 697 Other liabilities 65,069 iii) Industrial Reconstn. Bank of India 170 iv) Others 2,005 Loans & Advances and Investment from National Housing Credit (Long-term Operations fund) - Loans & Advances to National Housing bank 875 Other assets 13,972 ------------- ------------- 1,58,481 1,58,481 ------------ -------------

Maturity PatternThere has also been a shortening of maturity structure during 1991-98. The outstanding market loans under five-years maturity have gone up from 8.6% in 1991 to 41% in 1998, As against this, the longer loans of over 10-year maturity have declined from 85.8$ to 18.2%. The maturity structure of debt has significantly shifted in favour of medium and short-term borrowings. Irrespective of expectations about interest rate changes, excessive maturities at the short end have to be avoided since it would lead to bunching of redemption and roll-over problems.

Ownership of SecuritiesThe ownership of government securities continues to be skewed in favour of captive investors with commercial banks and insurance companies holding the largest share. The share of ownership of commercial banks between 1991 and 1995 has gone up from 59.4 percent to 75.5 percent but has declined to 63% in 1997 and insurance companies, from 12.3% in 1991 to 18% in 1998. The investor base has expanded to certain extent with finance companies, corporates and financial institutions investing in government securities.

Secondary Debt MarketDebt management policy can be effective if there is secondary market with depth. The move to market-related rates of interest is likely to strengthen the development of the secondary market. This enables the primary and secondary markets to give effective signals to each other. The development of the debt segment in the National Stock Exchange and duplication of transactions recorded by the Reserve Bank under the Subsidiary Ledger Account (SGL) has imparted a greater element of transparency.

Liquidity of securities should improve with the setting up of the Securities Trading Corporation of India (STCI) along with the existing Discount and Finance House of India (DFHI) and the holding of government securities would become attractive.

REPOsREPO and reverse REPO operated by RBI in dated government securities and Treasury bills (except 14 days) helps banks to manage their liquidity as well as undertake switch to maximize the return. REPOs are also used to signal changes in interest rates. REPOs bridge securities nd banking business.

A REPO is the purchase of one loan against the sale of another. They involve the sale of securities against cash with a future buy back agreement. There are no restrictions on the tenor of REPOs. They are well established in US and spread to Euro market in the second half of 1980s to meet the trading demand from dealers and small commercial banks with limited access to international inter-bank funding. REPOs are a substitute for traditional inter-bank credit.

REPOs are part of open market operations undertaken to influence short-term liquidity. The bank maintains separate lists for purchase and sale transactions with reference to its stock securities and the dates of maturity of the different loans.______________________________________________A Repurchase agreement, also known as a Repo or Sale and Repurchase Agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price will be greater than the original sale price, the difference effectively representing interest, sometimes called the repo rate. The party who originally buys the securities effectively acts as a lender. The original seller is effectively acting as a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest.

A repo is equivalent to a cash transaction combined with a forward contract. The cash transaction results in transfer of money to the borrower in exchange for legal transfer of the security to the lender, while the forward contract ensures repayment of the loan to the lender and return of the collateral of the borrower. The difference between the forward price and the spot price is effectively the interest on the loan while the settlement date of the forward contract is the maturity date of the loan.

_____________________________________________

Reverse REPOsIn order to activate the REPOs market so that it serves as an equilibrating force between the money market and the securities market, REPO and reverse REPO transactions among select institutions have been allowed since April 1997 in respect of all dated Central Government securities besides Treasury Bills of all maturities. Reverse REPOs ease undue pressure on overnight call money rates.

Interbank REPOsCommercial banks and select entities can conduct REPO transactions in PSU bonds and private corporate debt securities. These transactions provide liquidity support to the debt market. The system of Delivery versus Payment (DVP) was introduced in April 1999 as a regulatory safeguard.

It may be noted that according to the international accounting practices the funds advanced by the purchaser of a security under a firm repurchase agreement are generally treated as collateralized loan and the underlying security is maintained on the balance sheet of the seller.

Liquidity Adjustment Facility (LAF)Liquidity Adjustment Facility (LAF) is operated by RBI through REPOs and reverse REPOs in order to set a corridor for money market rates. This is pursuant to the recommendations of the Committee on Banking Sector Reforms. The funds made available by RBI through LAF would primarily meet the day to day liquidity mismatches in the system and not the normal financing requirements of eligible institutions.

RESERVE REQUIREMENTS

Cash Reserve RatioThe variation of reserve requirement changes the amount of cash reserve of banks and affects their credit creating capacity. The requirements may be stipulated as a proportion of aggregate outstanding deposits or on the increment after a base date. Reserve Bank regulates the liquidity of the banking system through two complementary methods.

(i) Cash Reserve Ratio (CRR) (ii) Statutory Liquidity Ratio

The Cash Reserve Ratio (CRR) involves deposit of cash by the bank with the Reserve Bank of a proportion of its deposits. The cash reserve ratio could be varied between 3 percent to 15 percent of their total demand and time liabilities.

The Statutory Liquidity Ratio involves the maintenance by the bank of a proportion of its deposit liabilities in the form of specified liquid assets. Under Banking Regulation Act, 1962, banks have to maintain a minimum liquid asset of 25 percent of their demand and time liabilities in India.

Selective Credit ControlsSelective credit controls are the most widely used qualitative controls to regulate the distribution or direction of bank resources to particular sectors of the economy in accordance with policy objectives. In India, the objective of selective credit control is to prevent speculative holding with the help of bank credit of certain essential commodities like food grains, sugar, cotton and basic raw materials and thereby checking an undue rise in their price.

The main instruments of selective credit control are minimum margin for lending against selected commodities, ceilings on the levels of credit and charging a minimum rate of interest on advances against specified commodities. Selective credit controls have been dispensed with as a part of banking sector reforms.

Advances to Priority SectorSocial control over banks initiated in 1969 introduced reforms to correct the functioning of banking system and to promote purposeful distribution of bank credit. It was found that for various historical reasons, the bulk of bank advances was directed to the large and medium scale industries and big and established houses while agriculture, small scale industries and exports which were emerging priority sectors did not receive adequate attention.

Private sector lending was stipulated at one-third of the outstanding credit by March 1979 and 40 percent by 1985. The major portion of advances to the priority sector was to agriculture followed by small scale industrial units.

Supervision SystemThe Board for Financial Supervision (BFS) under the chairmanship of the Governor of the Reserve Bank became functional on November 1994, with a Deputy Governor as Vice-Chairman and six other members. An advisory council was also constituted. The BFS was set up to ensure implementation of regulations in the areas of credit management, asset classification, income recognition, and capital adequacy and treasury operations of commercial banks.

CAMEL

The Padmanabhan Working Group recommended the adoption of six rating factors for Indian Banks, viz. CAMEL and Systems (CAMELs) and four rating factors for foreign banks, capital adequacy, asset quality, compliance and systems (CACS).

CAMEL refers to a system of bank rating initially introduced in the US as an effective supplement to bank supervision. It refers to five key criteria, such as Capital adequacy - C Asset quality - A Management - M Earnings - E Liquidity - L

against each of which a bank’s financial health is evaluated on a scale of 1 to 5 with 1 as the highest rating and 5 as the lowest.

Bank with composite CAMEL ratings of 1 and 2 are deemed to be sound and generally permitted to operate without any restrictions. Banks that receive CAMEL ratings of 4 or 5 are designated as problem banks to be subjected to close surveillance and regulatory restrictions.

Autonomy for Central BankAutonomy for Central Bank is a crucial issue. The Reserve Bank of India Act does not assure autonomy to the bank. It is true that the Central Bank can only be independent within the government but not from the government.

In USA there are adequate safeguards to ensure that the Federal Reserve is not compelled to act against its own judgment. In India there have been historic accords limiting the access of government to RBI but they are breached in practice, RBI should not be involved in underwriting government securities. It acts as a principal and as an agent in the securities market. The dual role of RBI as an issuer and regulator of debt gives rise to conflict of policies of debt management and monetary policy.

In the context of globalization of the financial system Reserve Bank needs autonomy to define benchmarks or anchors such as inflation and money supply to guide policy and use its judgment to assess the impact of the ever changing financial environment on the design and implementation of policy. Reform of the banning system is not complete unless it includes the Central Bank.

Monetary Policy in IndiaThe objectives of monetary policy are price stability and growth. RBI also attempts to maintain orderly conditions in the foreign exchange market and curb establishing and self fulfilling speculative activities.

Monetary policy is implemented with the help of an intermediate target which the bank could influence. Central banks depending upon their institutional and financial structure and the level of maturity of markets use three types of nominal anchors or targets to serve as guide posts in the conduct or monetary policy.

Reforms in the government securities market which ensured market related interest rates provided some of the basic conditions for developing a secondary market. The bank rate since April 1997 is used as a reference rate and signaling device by RBI to reflect the stance of monetary policy. Liquidity is augmented through Liquidity Adjustment Facility (LAF) and export credit refinance to banks and liquidity support to primary dealers.

The rate of interest and the amount are varied in the LAF to respond to day-to-day liquidity conditions in the system. LAF is not meant for funding financial requirements of eligible institutions. It would impart greater degree of stability to the short-term money market rates and facilitate the emergence of a short-term rupee yield curve.

COMMERCIAL BANKING

Commercial banks provide securities related services. Commercial banks in India have set up subsidiaries to provide capital market related services, advice on portfolio management or investment counseling.

Banks are financial firms and depend on economies of size and gains arising from internalizing certain activities rather than relying on market transactions. Banks provide packages of financial services which individuals find too costly to search out, produce and monitor by them. Banking system evolved to meet the demands of the constituents, vested interests and regulations governing their establishment. The British system evolved around central banking system with a central bank and clearing banks with a large network of offices regulated by the central bank while the German one evolved out of an identification of interest of finance, industry and government to provide multiple services to constituents. The US system however was set apart by the dominance of the unit banks, the role played by an activity inter bank market in deposits and reserve and the cooperative lending practices.

Role of ExchangeGlobal markets are integrated by the exchanges which link up across borders. This results in reduction of costs, lower trading fee and longer trading hours. SIMEX and Chicago Mercantile Exchange, Eurex with DTB and SOFFEX and EUREX and CBOT are now connected. Exchanges are also relaxing membership criteria to expand participation by including off site members.

The Singapore International Monetary Exchange (SIMEX) Eurex is one of the world’s leading derivatives exchanges, providing European featuring

open and low-cost electronic access globally. Eurex was established in 1998 with the merger of Deutsche Terminbörse (DTB, the German derivatives exchange)

SOFFEX (Swiss Options and Financial Futures). The Chicago Board of Trade (CBOT), established in 1848 which is the world’s oldest

futures and options exchange.

Branch Vs Unit Banking System

Unit banking consists of provision of banking services by a single institution. The size as well as area of operation is small and far more limited than under branch banking. However the unit bank may have branches within a strictly limited area. The choice of location of a branch was subject to approval in India by the central bank, the Reserve Bank of India. The advantage of unit banking is adoption to local conditions which facilitates the mobilization of deposits and deploying them for local needs (agriculture, small scale industrial units and agro-industrial units.

Branch banking consists of conducting banking operations at two or more centers by a bank from one location called head office. The branches may be located in the same city, state or across other states in the nation or overseas.

Retail Vs Wholesale BankingRetail banking refers to the mobilization of deposits from individuals and lending to small business and in retail loan markets. Retail banking consists of large volumes of low value transactions. On the other hand, whole sale banking refers to dealing with large customers’ often multinational companies, governments or government enterprises. Wholesale banks deal in large valued transactions, usually in small volumes.

Characteristics of Commercial BanksAmong the financial institutions the role of commercial banks is unique. Bank demand deposit liabilities. Commercial banks are the primary vehicle through which credit and monetary policies are transmitted to the economy. The nature of lending and investing by commercial banks is multi-functional. They deal in a wide variety of assets and accommodate different types of borrowers.

Further, the operations of commercial banks are highly flexible since they provide facilities for financing different types of borrowers which enables them to channel funds according to specified priorities and purposes.

The Banking Regulation Act, 1949, defines banking as accepting for the purposes of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdrawals on demand by cheque, draft or order otherwise.

Functions of Commercial Bank To change cash for bank deposits and bank deposits for cash To transfer bank deposits between individuals and / or companies To exchange deposits for bills of exchange, government bonds, the secured and unsecured

promises of trade and industrial units. To underwrite capital issues. They are also allowed to invest 5% of their incremental

deposit liabilities in shares and debentures in the primary and secondary markets.

Payment SystemsCommercial banks are institutions which combine various types of transactions services with financial intermediation. Banks provide three types of transactions to convert deposits into notes and coins to enable holders of deposits to undertake transactions in cash. Bank deposits are used as a means of settling debts. Banks exchange cash and deposits from one currency into cash and deposits of another currency.

Commercial banks are at the very center of the payment systems. Bank money constitutes 38 percent of the money supply of the Indian economy. An efficient payment system is vital to a

stable and growing economy and the banks role is important.

In advanced economies commercials banks are also at the heart of the electronic payment system which is replacing paper based payment methods. In USA electronic payments between commercial banks are done through ‘Fedwire’ which is a wholesale wire transfer system operated by the Federal Reserve System.

Commercial banks undertake the important process of financial intermediation whereby the funds or savings of the surplus sectors are channeled to deficit sectors. Commercial banks along with other financial institutions channel the funds or surplus economic units to those wanting to spend on real capital investments. Deposits of commercial banks can be of any denominations which have the characteristics of low risk and high liquidity. The small deposits are put together to make large loans.

Credit Analysis: Traditional TechniqueFor banks the traditional activity was balance sheet lending and the risk management technique was credit analysis. Bank always managed assets and liabilities and took decisions on liabilities they were able to create and the assets they would acquire. Variations in interest rate usually followed changes in the discount rate of the Central Bank and the type and terms of loans were subject to official constraints, notable on pricing.

Banks in the process of providing financial services assume various kinds of risks, credit, interest rate, currency, liquidity and operational risks.

Types of RiskBanks have to manage four types of risk to earn profits for maximizing shareholder wealth.

Credit risk: This risk arises when a bank cannot get back the money from loan or investment. Credit risk is the risk of losing money when loans default.

Interest risk: This risk arises when the market value of a bank asset, loan or security falls when interest rates rise. Interest rate risk management may be approached either by on-balance adjustment or off-balance sheet adjustment or a combination of both.

Liquidity risk: This risk arises when the bank s unable to meet the demands of depositors and needs of borrowers by turning assets into cash or borrow funds when needed with minimal loss. Liquidity risk refers to the bank’s ability to meet its cash obligations to depositors and borrowers.

Operational risk: This risk arises out of inability to control operating expenses, especially non interest expenses such as salaries and wages. In view of the phenomenal increase in the volume of financial transactions, proper systems for measurement, monitoring and control of operation risk should be set up. Suitable methodologies for estimating and maintaining economic capital should be developed.

Foreign Exchange RiskForeign exchange risk arises out of the fluctuations in value of assets, liabilities, income or expenditure when unanticipated changes in exchange rates occur. An open foreign exchange position implies a foreign exchange risk.

Assets and Liabilities of Scheduled Commercial Banks as on March 31, 2000 (Specimen)

Liabilities Rs. Crores % Assets Rs. Crores `Rs.%1 Capital 18447 1.66 Cash and balances 85371 7.692 Reserves & surplus 43834 3.95 with RBI Balance with banks 81019 7.30 and money at call and short notice3 Deposits 900307 81.08 Investments 413871 37.27 Demand 129339 11.65 Government 288178 25.95 Savings 188483 16.97 securities Term 582485 52.46 Other approved 25243 2.27 Non approved 100450 9.054 Borrowings 45350 4.09 Loans and adv. 443469 39.945 Other 102420 9.22 Bills purchased 43051 3.88 liabilities and and discounted provisions Cash credit and 241596 21.76(Unclassified over drafts liabilities to Term loans 158822 14.30banking systems Fixed assets 15480 1.39and participation Other assets 71158 6.41certificates issued by SCBs)Total Liabilities 1110368 100.00 Total assets 11110368 100.00

SEBI – SECURITIES AND EXCHANGE BOARD OF INDIA

Securities and Exchange Board of India (SEBI):The establishment of the Securities and Exchange Board of India (SEBI), on the lines of the Securities and Investment Board of the UK, is a major development in the Indian capital market. SEBI, which was established on the 12th April 1988, is required to take a holistic view of the Indian securities markets. SEBI is required to regulate and promote the securities market by:

Providing fair dealing in the issues of securities and ensuring a market place where funds can be raised at a relatively low cost;

Providing a degree of protection to the investors and safeguard their rights and interests so that there is a steady flow of savings into the market;

Regulating and developing a code of conduct and fair practices by intermediaries in the capital market like brokers and merchant banks with a view to make them competitive and professional.

The Securities and Exchange Board Act, 1992, provides for the establishment of a board to protect the interest of investors in securities and to promote the development and regulation of securities market. The Board consists of a Chairman, two members from the Government of

India, Ministry of Law and Finance, one member from the RBI and two other members. The head office of the SEBI is in Bombay.

The Securities and Exchange Board of India (frequently abbreviated SEBI) is the regulator for the securities market in India. It was formed officially by the Government of India in 1992 with SEBI Act 1992 being passed by the Indian Parliament. Chaired by C B Bhave, SEBI is headquartered in the popular business district of Bandra-Kurla complex in Mumbai, and has Northern, Eastern, Southern and Western regional offices in New Delhi, Kolkata, Chennai and Ahmedabad.

Functions of the Board (SEBI)The Board may provide the following functions:

Regulating business in stock exchanges and any other securities market Registering and regulating the working of stockbrokers, sub-brokers, share transfer agents,

bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisors and other intermediaries associated with securities market.

Registering and regulating the working of depositories, custodians of securities, FIIs credit rating agencies.

Registering and regulating the working of venture capital funds an collective investment schemes, including mutual funds.

Promoting and regulating Self-Regulatory Organizations (SROs) Prohibiting fraudulent and unfair trade practices relating to securities market Prohibiting insider trading in securities Regulating substantial acquisition of shares and takeover of companies Calling for information from undertaking inspection, conducting inquiries and audits of

the stock exchanges, mutual funds, intermediaries and self-regulatory organizations in the securities market

Levying fees and other charges for carrying out its work.

PRIMARY MARKET Primary capital market is a conduit for the sale of new securities. Listed (existing or new) companies may make the public issues of shares. The initial public offerings (IPOs) are the public issues of securities by new companies for the first time. In the IPOs or public offerings, made by the established companies, securities are sold to the public – all individuals and institutional investors.

Private corporate sector did not show much enthusiasm to offer capital to the public till 1980, because of the following factors:

Small size of the operations and narrow capital base Availability of loan capital on easy terms from the term-lending institutions Fear of losing control over the company Highly regulated environment

The decades of 80s, however, witnessed a sea change in the funds mobilization efforts of companies through public issued of equity and debt, encouraged by the deregulation of capital markets and other economic reforms. As a result, the annual funds mobilization in the new issues

market, which was only to the tune of about Rs.700 million in 60s and Rs.900 million in 70s and increased substantially during the 80s. The funds mobilized in 1990-91 were 3.3 percent of gross domestic savings (GDS) and 10.5 percent in 1994-95 and much higher in 2006-07.

Financial Instruments:Equity and debt are the two basic instruments of raising capital from the primary market. Equity was more important source of capital market until 1995-96. The share of equity in funds mobilization through public issues was 72 percent in 1995-96, which declined to 15 percent in 1998-99. After showing an increase in 1999-00 and 2000-01, the share of equity has dropped to about 17 percent in 2002-03 and picked up substantially afterwards.

Companies, in practice, offer a number of variations of equity and debt securities. They include:

Ordinary shares: Ordinary (equity) shares represent the ownership position in a company. The holders of the equity shares are the owners of the company and they provide permanent capital. The have voting rights and receive dividends at the discretion of the board of directors.

Preference shares: The holders of the preference shares have a preference over the equity in the event of the liquidation of the company. The preference dividend rate is fixed and known and is payable before paying dividend on the ordinary share capital.

Companies in India can issue redeemable preference shares; but they cannot issue irredeemable preference shares. A preference share may also provide for the accumulation of dividend. It is called a cumulative preference share. Companies in India now hardly issue preference shares.

Debentures: Debentures represent long-term debt given by the holders of debentures to the company. Debentures may be secured or unsecured. Secured debentures are also known as bonds. The rate of interest on debentures is specified and interest charges are treated deductible expenses in the hands of the company.

Straight debentures, without a conversion feature, are called non-convertible debentures (NCDs). Debentures may be issued without an interest rate. They are called zero-interest debentures. Such debentures are issued at a price much lower than their face value. Hence they are also called deep-discount debentures/bonds.

Convertible debentures: A debenture may be issued with the feature of being convertible into equity shares after a specified period of time at a given price. Thus a convertible debenture (CDs) will have features of a debenture as well as equity.

Warrants: A company may issue equity shares or debentures attached with warrants. Warrants entitle an investor to buy equity shares after a specified time period at a given price.

Cumulative convertible preference shares: CCPS is an instrument giving regular returns, at say, 10 percent, during the gestation period from three to five years and equity benefits thereafter. In India, the Government introduced CCPS in 1984. However, it has failed to catch the investors’ interest mainly because the rate of return was considered too low in the initial years and the provision for conversion into equity was also unattractive, if the company failed to perform well.

Derivative securities: Securities with options to buy or sell are called derivative securities. CDs, CCPSs and warrants are example of derivative securities.

Borrowings from financial institutions in India, besides issuing debentures, companies raise debt capital through borrowings from the financial institutions and banks. Banks are the important source of working capital for companies.

Pricing of New Issues: Until 1992, the Controller of Capital Issues (CCI) used to decide the prices of securities to be offered to the public. CCI does not exist now and it has been replaced by SEBI. Companies in India can freely price share issues, subject to the SEBI guidelines.

Book Building and Price Discovery: In the case of normal public issue, the price is fixed and known in advance. At the close of subscription, the company knows the number of shares applied for. Book building is an alternative to the traditional fixed-price method of security issue. In the book building the issue price is not fixed. Book building is a process of offering securities at various bid prices from investors.

SECONDARY MARKET Secondary capital markets deal in the second-hand issued securities. Stock exchanges are secondary markets where buyers and sellers trade in already issued securities. A stock exchange provides the following useful economic functions.

Help in determining fair prices based on demand and supply forces and all-available information.

Providing easy marketability and liquidity for investors Facilitation in capital allocations in primary markets through price signaling Enabling investors to adjusting portfolios of securities

India is one of the oldest stock markets in Asia, viz., the Bombay Stock Exchange (BSE). L BSE was established in 1875. Later on, may more stock exchanges were established in other Indian cities like Ahmedabad, Calcutta, Madras, Kanpur etc. Until the 80s, there were eight stock exchanges in India; the number has now increased to 23.

However in the terms of business activities, the two most prominent all-India stock exchanges are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). NSE was set up in June 1994. It started the screen-based trading in India which has been now adopted by BSE and other stock exchanges as well.

The relatively high level of issued capital required for a company to be eligible to be listed in a stock exchange, prompted the Government of India to grant recognition to the Over-the-Counter Exchange of India (OTCEI), which was promoted by Unit Trust of India, Industrial Credit and Investment Corporation of India Ltd. and others. OTCEI is also a screen-based market.

The Securities Contract (Regulation) Act 1956 was the first all-India legislation regulating the stock exchanges in the country. Now Security Exchange Board of India (SEBI) regulates the operations of the primary and secondary markets in India.

Derivatives Market:Derivatives are securities derived from other securities (called underlying securities) like equity, debt, or any other type of security. They also include contracts that derive their values from

prices or index of prices. In India, the OTC derivatives are not allowed; the legal derivatives must trade on recognized stock exchanges only.

Derivatives trading in India started in June 2000, with SEBI approving trading in index future contracts, based on BSE’s Sensex index and NSE’s S&P CNX Nifty index. Trading derivatives mostly takes place in NSE, accounting for the large volume share of the contracts and traded value.

Trading and Settlement:Investors can carry out their operations (buying and selling of securities) through brokers and sub-brokers. A broker is an enrolled member of a stock exchange who is authorized to the stock exchange trade. He or she is registered with SEBI. Sub-brokers are affiliated to the members (brokers) of the stock exchange and registered with SEBI as sub-brokers.

Investors can hold and trade in securities in dematerialized form.

Dematerialization of shares: Dematerialization is a process of changing paper certificates of securities into electronic form and recording in computers by a depository. A depository holds shares in dematerialization (demat) form, maintains ownership records and also facilitates transfer of ownership. All transactions take place through computers without paper work.

An investor may hold shares in physical or demat form but he or she can trade and settle deals in most shares easily in demat form. In India, there are two depositories – NSDL and CDSL, who compete with each other.

Dematerialization of shares in India was introduced in 1998. Within three years, a very high level of dematerialization was achieved. Now almost 100 percent trades are settled in demat form. The growth of dematerialization in India has been the fastest in emerging capital markets and most developed markets.

The following features may be observed about dematerialization: Fall in settlement and other charges No stamp duty Depository facility has affected changes in the stock market microstructure Breadth and depth of investment culture has further got extended to interior areas of the

country faster Explicit transaction cost has been falling Increased growth in turnover

Trading: Buying and selling of shares is an agreement between the broker/sub-broker and the client (investor) once he or she has filled in a client registration. The broker charges a fee, which is between 0.50 percent and 1 percent of the value of transaction, for executing the transaction in the stock exchanges. Sub-brokers cannot charge commission more than 1 percent.

Stock exchanges have a scheduled pay-in day and pay-out day. The pay-in day is the day when the broker makes payment or delivery of securities to the exchange. The pay-out day is the day when the exchange makes payment or delivery of securities to the broker.

Circuit breaker: Extreme volatility in the stock market is not considered healthy. The circuit breaker or price bands system helps to control the extreme volatility. From 2nd July 2001, SEBI

move to a system of index-based circuit breaker system market-wide. The system applied when the market moves in either direction by either direction by specified circuit breakers (limits). The three stages of the market movement are 10 percent, 15 percent and 20 percent. Whenever these limits are breached, depending on the extent of breach, the stock exchange authorities will halt the market for a specified period.

These circuit breakers bring about a coordinated trading halt in all equity and equity derivatives market across the country and the movement of either BSE Sensex or the NSE S&P CNX Nifty, whichever is breached earlier, triggers the market-wide circuit breakers.

SEBI GUIDELINES FOR TAKEOVERSThe salient features of some of the important guidelines are as follows:

Disclosure of share acquisition/holding: Any person who acquires 5 percent or 10 percent or 14 percent shares or voting rights of the target company should disclose his holdings at every stage to the target company and the Stock Exchanges within 2 days of acquisition or receipt of intimation of allotment of shares.

Any person who holds more than 15 percent but less than 75 percent shares or voting rights of target company, and who purchases or sells shares aggregating to 2 percent or more shall within 2 days disclose such purchase or sale along with aggregate of his shareholding to the target company and the Stock Exchanges.

Any person who holds more than 15 percent shares or voting rights of the target company and a promoter and person having control over the target company, shall within 21 days from the financial year ending 31st March as well as the record date fixed for the purchase of dividend declaration, disclose every year his aggregate shareholding to the target company.

Public announcement and open offer: An acquirer who intends to acquire shares which along with his existing shareholding would entitle him to exercise 15 percent or more voting rights, can acquire such additional shares only after making a public announcement to acquire at least additional 20 percent of the voting capital of target company from the shareholders through an open offer.

An acquirer who hold 15 percent or more but less than 75 percent of shares or voting rights of a target company can acquire such additional shares as would entitle him to exercise more than 5 percent of the voting rights in any financial year ending 31st March only after making a public announcement to acquire at least an additional 20 percent shares of the target company from the shareholders through an open offer.

An acquirer, who holds 75 percent shares or voting rights of a target company, can acquire further shares or voting rights only after making a public announcement to acquire at least additional 20 percent shares of target company from the shareholders through an open offer.

Offer price: The acquirer is required to ensure that all the relevant parameters are taken into consideration while determining the offer price and that justification for the same is disclosed in the letter of offer.

Disclosure: The offer should disclose the detailed terms of the offer, identity of the offerer, details of the offerer’s existing holdings in the offeree company etc. and the information should be made available to all the shareholders at the same time and in the same manner.

Offer document: The offer document should contain the offer’s financial information, its intention to continue the offeree company’s business and to make major change and long-term commercial justification for the offer.

MUTU AL FUNDS

Mutual funds are financial intermediaries which collect the savings of investors and invest them in a large and well diversified portfolio of securities such as money market instruments, corporate and Government bonds and equity shares of joint stock companies. Mutual funds are conceived as institutions for providing small investors with avenue of investment in the capital market.

The advantages for the investors are reduction in risk, expert professional management, and diversified portfolio, liquidity of investment and tax benefits. By pooling their assets through mutual funds, investors achieve economies of scale. The interest of the investors is protected by the SEBI which acts a watch dog. Mutual funds are governed by the SEBI (Mutual Funds) Regulations, 1993.

Mutual Funds in IndiaThe first mutual fund to be set up was the Unit Trust of India in 1964 under an Act of parliament. During the years 1987-1992, seven new mutual funds were established in the public sector. In 1993, the government changed its policy to allow the entry of private corporate and foreign institutional investors into the mutual fund segment. By the end of March 2000, apart from UTI there were 36 mutual funds, 9 in the public sector and 27 in the private sector.Objectives of Mutual FundsMutual funds have specific investment objectives, w3hich are state in their prospectus. The main objectives are growth, growth-income, balanced income and industry specific funds.

Growth funds strive for large capital gains, while growth-income funds seek both dividend income and capital gains from the common stocks.

The balanced fund generally holds a portfolio of diversified common stocks, preferred stocks and bonds with the hope of realizing capital gains, dividend and interest income, while at the same time, conserving the principal.

Income funds concentrate heavily on high interest and high dividend yielding securities.

In general growth funds seem to have the highest risk, balanced funds, the lowest risk and income growth funds and intermediate risk.

Benefits of Mutual Funds

Tax shelter is the most important advantages, the mutual funds industry enjoys in India. A mutual fund, set up by a public sector bank or a financial institution or one that is authorized by the SEBI is exempted from tax, under Section 10 (23D) of IT Act, provided it distributes 90 percent of its profits.

As compared to direct investment, mutual funds offer firstly, reduced risk and diversified investment. Mutual funds help small investors in reducing risk by diversification, economies of scale in transaction cost and professional portfolio management. Mutual funds offer revolving type of investments. Automatic reinvestment of dividends and capital gains provide tax relief to the members. Selection and timing of investment are undertaken by mutual funds.

Types of Mutual FundsTwo major fund categories of mutual funds are closed-end funds and the open-end funds. Open-end funds are commonly referred to as the mutual funds. Mutual funds can be further classified into equity funds, growth funds, income funds, real estate funds, offshore funds, leveraged funds and hedge funds. Such schemes are listed on the stock exchanges for dealings in the secondary market.

Closed-end FundsClosed-end fund Investment Company cannot sell share units after its initial offering. Its growth in terms of the number of share is limited. The shares of the closed-end funds are not redeemable at their NAV as in the case of open-end funds. One the other hand, these shares are traded in the secondary market on a stock exchange.

Open-end FundsThe open-end mutual funds are characterized by the continual selling and redeeming of shares. Mutual funds do not have a fixed capitalization. It sells its shares to the investing public, whenever it can, at their NAV and stands ready to repurchase the same, directly from the investing public, at the net asset value per share.

Return from Mutual FundsInvestors in mutual funds obtain return in the form of dividends, capital gains and appreciation in NAV. The dividend income of a mutual fund company from its investment in shares, both equity and preference are passed on to the unit holders. All income received by investors from mutual funds is exempt from tax. Mutual fund unit holders or owners also get benefits of capital gains which are realized and distributed to them in cash or kind. The increase or decrease in the NAV is the result of unrealized gains or losses on the portfolio holdings of the mutual fund.

Mutual fund Holder’s AccountThere are three types of accounts offered by most of the mutual funds. The investors select the type that matches their objectives. The various accounts are:

Regular Account: An investor is permitted to purchase any number of shares of the mutual fund, at any time he chooses. An investor is paid the dividend either monthly or quarterly or half-yearly as he chooses as per the scheme.

Accumulation Account: An investor is allowed to open an account, with a very small initial investment and continuous adding to the funds, periodically. Accumulation account may be voluntary or contractual.

Withdrawal Account: Under this plan, the individual investor can withdraw the amount of funds on a regular basis, which suits elderly people to supplement their pension benefits.

A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors and invests typically in investment securities (stocks, bonds, short-term money market instruments, other mutual funds, other securities, and/or commodities such as precious metals). The mutual fund will have a fund manager that trades (buys and sells) the fund's investments in accordance with the fund's investment objective.

In the U.S., a fund registered with the Securities and Exchange Commission (SEC) under both SEC and Internal Revenue Service (IRS) rules must distribute nearly all of its net income and net realized gains from the sale of securities (if any) to its investors at least annually. Most funds are overseen by a board of directors or trustees (if the U.S. fund is organized as a trust as they commonly are) which is charged with ensuring the fund is managed appropriately by its investment adviser and other service organizations and vendors, all in the best interests of the fund's investors.

Expenses and Expense Ratios

Mutual funds bear expenses similar to other companies. The fee structure of a mutual fund can be divided into two or three main components: management fee, non-management expense, and 12b-1/non-12b-1 fees. All expenses are expressed as a percentage of the average daily net assets of the fund.

FOREIGN INSTITUTIONAL INVESTORS (FII)

Government of India through Guidelines issued on September 14, 1992 has allowed reputed Foreign Institutional Investors (FIIs) including pension funds, mutual funds, asset management companies, investment trusts, nominee companies and incorporated or institutional portfolio mangers to invest in the Indian capital market, subject to the condition that they register with the SEBI and obtain RBI’s approval under FERA (Foreign Exchange Regulation Act).

FIIs Investment in Government Securities: SEBI has permitted the FIIs to invest in Government dated securities, within the framework of guidelines on FII investment in debt instruments for 100 percents debt funds, subject to an annual capital on such investment within the overall limit of external commercial borrowings for the year.

FIIs are allowed to setup 100 percent debt funds. FIIs will be allowed to invest in dated securities of all maturities of both Central and State Government, but not in Treasury Bills. RBI clarified that the FII can operate both in the primary and secondary markets. The transactions will be governed by the RBIx delivery versus payment systems. The entry of FIIs into gilts trading will add depth to the securities market and push th eyields downwards, since their entry will push up demand.

Foreign Brokers

To facilitate operations of FIIs and encourage investment, foreign brokers registered with the SEBI are allowed to assist registered FIIs in their dealings in securities. As registered FIIs are familiar with their own brokers, it is expected that this step will help the FIIs to deal more easily in our markets.

The guidelines stipulated that the foreign broker will be allowed to assist and operate only on behalf of the registered FII and will not act as the principal. RBI gives the necessary permission to the foreign broker to pen a foreign currency denominated bank account and a rupee account with a designated bank branch. He has to bring inward remittances in foreign currency.

The foreign brokers can tap global sources of finance and brokering houses tend to be giant corporations. They have also been able to attract the management of Euro business because of their capability and on the whole, they are making good money. Foreign Brokers:

Institutional investors are organizations which pool large sums of money and invest those sums in securities, real property and other investment assets. They can also include operating companies which decide to invest its profits to some degree in these types of assets.

Types of typical investors include banks, insurance companies, retirement or pension funds, hedge funds, investment advisors and mutual funds. Their role in the economy is to act as highly specialized investors on behalf of others. For instance, an ordinary person will have a pension from his employer. The employer gives that person's pension contributions to a fund. The fund will buy shares in a company, or some other financial product. Funds are useful because they will hold a broad portfolio of investments in many companies. This spreads risk, so if one company fails, it will be only a small part of the whole fund's investment.

Institutional investors will have a lot of influence in the management of corporations because they will be entitled to exercise the voting rights in a company. They can actively engage in corporate governance. Furthermore, because institutional investors have the freedom to buy and sell shares, they can play a large part in which companies stay solvent, and which go under. Influencing the conduct of listed companies, and providing them with capital are all part of the job of investment management.

Because of their sophistication, institutional investors may often participate in private placements of securities, in which certain aspects of the securities laws may be inapplicable. For example, in the United States, a private placement under Rule 506 of Regulation D may be made to an "accredited investor" without registering the offering of securities with the Securities and Exchange Commission. In essence institutional investor, an accredited investor is defined in the rule as:

a bank, insurance company, registered investment company (generally speaking, a mutual fund), business development company, or small business investment company;

an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;

a charitable organization, corporation, or partnership with assets exceeding $5 million; a director, executive officer, or general partner of the company selling the securities; a business in which all the equity owners are accredited investors; a natural person who has individual net worth, or joint net worth with the person’s spouse,

that exceeds $1 million at the time of the purchase; a natural person with income exceeding $200,000 in each of the two most recent years or

joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or

a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

Economic theory

By definition, institutional investors are opposed to individual actors on the financial markets. This specificity has majors consequences in the eyes of economic theory.

Institutional investors as financial intermediariesNumerous institutional investors act as intermediaries between lenders and borrowers. As such they have a critical importance in the functioning of the financial markets. Economies of scale and scope imply that they increase returns on investments and diminish the cost of capital for entrepreneurs. Acting as savings pools, they also play a critical role in guarantying a sufficient diversification of the individual investors’ portfolios. Their greater ability to monitor corporate behaviour as well to select investor’s profiles implies that they help diminish agency costs

Institutional investor types

Pension fund Mutual fund Investment trust Unit trust and Unit Investment Trust Investment banking Hedge fund Sovereign wealth fund Endowment fund Private equity firms Insurance companies

Globalization of financial markets

Institutional investors have played a major role in the emergence of truly global money flows, notably through their large-scale cross-border investments, channelling the excess liquidities of pension funds of G8 and OPEC countries towards both Western bourses and emerging markets, contributing to the development of a truly integrated and thus more efficient global financial sphere.

When considered from a strictly local standpoint, institutional investors are sometimes called foreign institutional investors (FIIs). This expression is mostly used in emerging markets such as Malaysia and India.

In countries like India, statutory agencies like SEBI have prescribed norms to register FIIs and also to regulate such investments flowing in through FIIs. In 2008, FIIs represented the largest institution investment category, with an estimated US$ 751.14 billion.

Since the mid-1970s, it has been argued that geographic diversification would generate superior risk-adjusted returns for long-term global investors by reducing overall portfolio risk while capturing some of the higher rates of returns offered by the emerging markets of Asia and Latin America.

Regional

In various countries different types of institutional investors may be more important. In oil-exporting countries sovereign wealth funds are very important, while in developed countries, pension funds may be more important.

CanadaIn Canada, both pension funds and government funds are powerful investors in the market with hundreds of billions of dollars in assets in an economy of only around one trillion dollars- some think-tanks such as the CEE Council have argued that this constitutes a long-term competitive advantage for the Canadian economy. The most important Canadian institutional investors are:

Caisse de dépôt et placement du Québec (C$237.3 billion [2007]) Canada Pension Plan (C$116.6 Billion [2007]) Ontario Teachers' Pension Plan (C$106 billion [2006]) British Columbia Investment Management (C$83.4 billion [2007]) Alberta Investment Management (C$73.3 billion [2007])

United KingdomIn the UK, institutional investors may play a major role in economic affairs, and are highly concentrated in the City of London's square mile. Their wealth accounts for around two thirds of the equity in public listed companies. For any given company, the largest 25 investors would have be able to muster over half of the votes

The major investor associations are:

Investment Management Association Association of British Insurers National Association of Pension Funds The Association of Investment Trust Companies

The IMA, ABI, NAPF, and AITC, plus the British Merchant Banking and Securities House Association are also represented by the Institutional Shareholder Committee.

SEBI (FIIs) REGULATION, 1995The regulations stipulate that foreign institutional investors have to be registered with the SEBI and obtain a certificate from the SEBI. For the purpose of grant of the certificate the following particulars are taken into account by SEBI.

(a) The applicant’s track record, professional competence, financial soundness, experience, general reputation of fairness and integrity

(b) Whether the applicant is regulated by appropriate foreign regulatory authority.(c) Whether the applicant has been granted permission by the RBI under Foreign Exchange

Regulation Act, for making investment in India as a foreign institutional investor.

(d) Where the applicant is (i) an institution established or incorporated outside India as a pension fund,,

mutual fund or investment trust; or(ii) an asset management company or nominee company or bank or institutional

port-folio manager, established or incorporated outside India and proposing to make investment in India on behalf of broad based funds; or

(iii) a trustee or power of attorney holder established or incorporated outside India and proposing to make investment in India on behalf of broad-based funds.

The certificate is granted in form “B” subject to payment of prescribed fees which is valid for 5 years and can be renewed thereafter. Provision is also made for registration of sub-accounts on whose behalf FII proposes to make the investment in India. The purchase of shares of each company should not be more than 10 percent of the total issued capital of the company.

The investment by foreign institutional investor is also subject to GOI guidelines. The general obligations and responsibilities of FIIs include appointment of a domestic custodian.

FOREIGN DIRECT INVESTMENT

It has to be recognized that the transfer of technology, export promotion and access to foreign exchange can be achieved only by greater reliance on market mechanism. Trader and Foreign Investments are the two instruments that integrate domestic economy with the international markets. With greater reliance on market mechanism, barriers to trade and foreign direct investments can be lowered.The foreign investment inflows have been meeting more than half of the financing needs on India’s external account. The spurt in direct foreign investment to US$2,133 million in 1995-96 constituted 77.6 percent of the net inflow of portfolio investments and emerged as an important item of the capital account.

Policy for Foreign Direct InvestmentPolicy towards foreign investment was liberalized in 1991 to permit automatic approval of a foreign investment up to 57 percent equity in 34 industries. The Foreign Investment Promotion Board (FIPB) was set up to process applications in case not covered by automatic approval. The FIPB was reconstituted in July 22, 1996 and the Foreign Investment Promotion Council was set up to promote Foreign Direct Investment (FDI) in India. During 1992-93, several additional measures were taken to encourage investment flows, direct foreign investment, portfolio investment, NRI investment and deposits and investment in global depository receipts.

__________________________________Non Resident Indians (NRI)Non-resident Indian (NRI) deposits have been a major source of external financing, especially since the mid-eighties. The deposit schemes can be put into two broad categories: (i) deposits denominated in Indian rupees and (ii) foreign currency denominated deposits.

A part of the increase in the NRI deposits during the eighties could be attributed to genuine savings of the Indians working abroad while the surge over the latter half of the eighties was partly due to interest rate differential over the prevailing international interest rates.

At the same time provision of foreign exchange guarantee by the Reserve Bank of India / Government of India provided incentives to non-residents to hold deposits mainly in the form of foreign currency denominated deposits. In the recent period, the policy with respect to non-resident deposit scheme has been to retain the attractiveness of these schemes and maintain capital flows from abroad while at the same time bringing down the effective cost of borrowing in terms of interest outgo and the cost to macroeconomic management.______________________________________

Role of Foreign InvestmentForeign investment flows supplement domestic efforts in augmenting investments in the economy. In respect of approval procedures regarding foreign direct investment (FDI), a transparent framework is followed under which all sectors, except agriculture and plantation, have been opened with full repatriation benefits to foreign investors. Free operation of market forces should be permitted in the market for land by amending/scraping Urban Land Ceiling Act which is a major obstacle for new investment. Where the domestic industry is flourishing, FDI will participate.

DIFFERENCE BETWEEN FII & FDIBoth FDI and FII is related to investment in a foreign country. FDI or Foreign Direct Investment is an investment that a parent company makes in a foreign country. On the contrary, FII or Foreign Institutional Investor is an investment made by an investor in the markets of a foreign nation.

In FII, the companies only need to get registered in the stock exchange to make investments. But FDI is quite different from it as they invest in a foreign nation.

The Foreign Institutional Investor is also known as hot money as the investors have the liberty to sell it and take it back. But in Foreign Direct Investment, this is not possible. In simple words, FII can enter the stock market easily and also withdraw from it easily. But FDI cannot enter and exit that easily. This difference is what makes nations to choose FDI’s more than then FIIs.

FDI is more preferred to the FII as they are considered to be the most beneficial kind of foreign investment for the whole economy.

Foreign Direct Investment only targets a specific enterprise. It aims to increase the enterprises capacity or productivity or change its management control. In an FDI, the capital inflow is translated into additional production. The FII investment flows only into the secondary market. It helps in increasing capital availability in general rather than enhancing the capital of a specific enterprise.

The Foreign Direct Investment is considered to be more stable than Foreign Institutional Investor. FDI not only brings in capital but also helps in good governance practises and better management skills and even technology transfer. Though the Foreign Institutional Investor helps in promoting good governance and improving accounting, it does not come out with any other benefits of the FDI.

FII Vs FDIWhile the FDI flows into the primary market, the FII flows into secondary market. While FIIs are short-term investments, the FDI’s are long term.

FDI is an investment that a parent company makes in a foreign country. On the contrary, FII is an investment made by an investor in the markets of a foreign nation.

FII can enter the stock market easily and also withdraw from it easily. But FDI cannot enter and exit that easily.

Foreign Direct Investment targets a specific enterprise. The FII increasing capital availability in general.

The Foreign Direct Investment is considered to be more stable than Foreign Institutional Investor