1 FINANCIAL SERVICES INDUSTRY

The Financial services industry provides a plethora of opportunities for interested

individuals to work with people from varied backgrounds and in different settings. The
finance industry is multifaceted, offering a variety of positions catering to a number of
different skills and interests. A career in finance is not solely about money but does
depend heavily on it. This makes it quite challenging and at the same time interesting.
Despite the heavy ups and downs in the past, the industry has always remained a sought
after career option for MBA graduates

Broadly, the career opportunities can be grouped in the following categories –

• Investment Banking – Investment banks typically work with corporations,

governments, institutional investors and crazily rich individuals to help them multiply
their money and provide avenues for investments. The work revolves around mergers
and acquisitions for firms, raising money for companies, trading of stocks for rich
individuals as well as companies etc. This happens to be one of the most sought-after
roles post MBA owing to the huge pay-checks and lavish lifestyles. The “Bulge Bracket”
investment banks are-

• Corporate and Retail Banking – Corporate Banking caters to the banking needs
of corporate houses whereas, retail banking cater to the banking needs of the general
public. A career in this domain involves handling the cash dealings with traders and
businesses, devising strategies to help customers seize growth opportunities etc.

• Venture Capital/Private Equity– Venture Capitalists (VC) and Private Equity

(PE) firms help companies raise money in exchange for partial ownership of the firm.
The firm researches on the companies which are expected to show potential in the
future and make investments. The rise of start-ups has led to an unprecedented boom
in the PE/VC industry. The best finance minds from the top B- Schools across the
country are clawing for a spot in these tiny, highly profitable enterprises.

• Corporate Finance – Corporate Finance department of a firm looks after the

financial activities for the company. This involves making the decisions on how and
when to raise money, creating avenues so as to ensure maximum profitability for the
company, implement strategies to ensure optimum levels of inventory, manage
financial issues etc.

• Capital Markets- A career in the capital markets can be a roller coaster ride,
fuelled by the volatility and unpredictability of the financial markets. This role would
 involve using the excess cash with companies and wealthy individuals (clients) as well
as cash with the bank (proprietary trading) to invest in the financial markets to make
profits.

2 FINANCIAL STATEMENTS

2.1 Basic Accounting principles

These are called Generally Accepted Accounting Principles, or GAAP. Key GAAPs are:
 Going concern concept: This principle assumes that a business will go on, that is, it
will continue in the foreseeable future – it has no finite life. This principle is used to
project cash flows in the future.
 Legal entity concept: The business is an entity separate from owners; even if it’s a
small, one person business running out of home. Therefore the business accounts
are taken separate from the owners.
 Conservatism concept: It refers to the policy of 'playing safe'. As per this convention,
all prospective losses are taken into consideration but not all prospective profits. O
 Matching concept: The business must match the expenses incurred for a period, to
the income earned during that period.
 Cost concept: All assets are recorded on the books at purchase price (historical cost),
not market price, with some exceptions.

Cash vs. Accrual accounting

The cash basis of accounting recognizes revenues when cash is received, and expenses
when they are paid. This method does not recognize accounts receivable or accounts
payable. Under the accrual basis, revenues and expenses are recorded when they are
earned, regardless of when the money is actually received or paid. This method is more
commonly used than the cash method. Accrual basis gives a more realistic idea of
income and expenses during a period of time, therefore providing a long-term picture
of the business that cash accounting can’t provide.

2.2 Financial Statements

Balance sheet: The Balance Sheet presents the financial position of a company at a given
point in time. It is comprised of three parts: Assets, Liabilities, and Shareholder's Equity.
Assets are the economic resources of a company. They are the resources that the company
uses to operate its business and include Cash, Inventory, and Equipment. A company
normally obtains the resources it uses to operate its business by incurring debt, obtaining
new investors, or through operating earnings. The Liabilities section of the Balance Sheet
presents the debts of the company. Liabilities are the claims that creditors have on the
company's resources. The Equity section of the Balance Sheet presents the net worth of a
company, which equals the assets that the company owns less the debts it owes to
creditors. In other words, equity is comprised of the claims that investors have on the
company's resources after debt is paid off. The most important equation to remember is
that

Assets (A) = Liabilities (L) + Shareholder's Equity (SE)

To summarize, the Balance Sheet represents the economic resources of a business. One
side includes assets, the other includes liabilities (debt) and shareholder's equity, and Assets
= L+E. On the liability side, debts owed to creditors are more senior than the investments of
equity holders and are classified as Liabilities, while equity investments are accounted for in
the Equity section of the Balance Sheet.
Profit and loss/ income Statement: The Income Statement presents the results of operations
of a business over a specified period of time (e.g., one year, one quarter, one month) and is
composed of Revenues, Expenses and Net Income.

Revenue is a source of income that normally arises from the sale of goods or
services and is recorded when it is earned.

Expenses are the costs incurred by a business over a specified period of time
to generate the revenues earned during that same period of time. For example, in order for
a manufacturing company to sell a product, it must buy the materials it needs to make the
product. In addition, that same company must pay people to both make and sell the product.
These are all types of expenses that a company can incur during the normal operations of the
business. When a company incurs an expense outside of its normal operations, it is
considered a loss. Losses are expenses incurred as a result of one- time or incidental
transactions.

Assets vs. expenses: A purchase is considered an asset if it provides future economic benefit
to the company, while expenses only relate to the current period. For example, monthly
salaries paid to employees for services they already provided to the company would be
considered expenses. On the other hand, the purchase of a piece of manufacturing
equipment would be classified as an asset, as it will probably be used to manufacture a
product for more than one accounting period.

Net income: The Revenue a company earns, less its Expenses over a specified
period of time, equals its Net Income. A positive Net Income number indicates a profit, while
a negative Net Income number indicates that a company suffered a loss (called a "net loss").

Cash flow statement: The Statement of Cash Flows presents a detailed summary of all of the
cash inflows and outflows during the period and is divided into three sections based on three
types of activity:

Cash flows from operating activities: Includes the cash effects of transactions
involved in calculating net income.

Cash flows from investing activities: Basically, cash from non-operating

activities or activities outside the normal scope of business. This involves items classified as
assets in the Balance Sheet and includes the purchase and sale of equipment and
investments.
 Cash flows from financing activities: Involves items classified as liabilities and
equity in the Balance Sheet; it accounts for external activities that allow a firm to raise capital
and repay investors, such as issuing dividends, adding or changing loans or issuing more stock.

Linkages between the 3 financial statements

1. Balance sheet and Income Statement: The main link between the two statements is
that profits generated in the Income Statement get added to shareholder's equity on
the Balance Sheet as Retained Earnings. Also, debt on the Balance Sheet is used to
calculate interest expense in the Income Statement.
2. Balance sheet and Cash flow Statement: Cash balance in Balance Sheet is arrived
through net increase / decrease in cash, adjusted with beginning cash balance. Also,
Cash from Operations is derived using the changes in Balance Sheet accounts (such as
Accounts Payable, Accounts Receivable, etc.). The net increase in cash flow for the
prior year goes back onto the next year's Balance Sheet.
3. Income statement and Cash Flow Statement: The non-cash and non-operating items
in the Income Statement are adjusted to the net profit to arrive at the net cash flow
from operations.

2.3 General Financial Concepts

RATIO ANALYSIS

1. PROFITABILITY RATIOS

Gross Profit Margin: The gross profit margin looks at cost of goods sold as a percentage
of sales. This ratio looks at how well a company controls the cost of its inventory and
the manufacturing of its products and subsequently pass on the costs to its customers.
The larger the gross profit margin, the better for the company. The calculation is: Gross
Profit/Net Sales. Both terms of the equation come from the company's income
statement.
Operating Profit Margin: Operating profit is also known as EBIT and is found on the
company's income statement. EBIT is earnings before interest and taxes. The operating
profit margin looks at EBIT as a percentage of sales. The operating profit margin ratio is
a measure of overall operating efficiency, incorporating all of the expenses of ordinary,
daily business activity. The calculation is: EBIT/Net Sales. Both terms of the equation
come from the company's income statement.

Net Profit Margin: When doing a simple profitability ratio analysis, net profit margin is
the most often margin ratio used. The net profit margin shows how much of each sales
dollar shows up as net income after all expenses are paid. For example, if the net profit
margin is 5 percent, which means that 5 cents of every dollar are profit. The net profit
margin measures profitability after consideration of all expenses including taxes,
interest, and depreciation. The calculation is: Net Income/Net Sales. Both terms of the
equation come from the income statement.

Return on Assets (also called Return on Investment): The Return on Assets ratio is an
important profitability ratio because it measures the efficiency with which the company
is managing its investment in assets and using them to generate profit. It measures the
amount of profit earned relative to the firm's level of investment in total assets. The
 return on assets ratio is related to the asset management category of financial ratios. The
calculation for the return on assets ratio is: Net Income/Total Assets. Net Income is taken
from the income statement and total assets is taken from the balance sheet. The higher
the percentage, the better, because that means the company is doing a good job using
its assets to generate sales.

Return on Equity: The Return on Equity ratio measures the return on the money the
investors have put into the company. This is the ratio potential investors look at when
deciding whether or not to invest in the company. The calculation is: Net
Income/Stockholder's Equity. Net income comes from the income statement and
stockholder's equity comes from the balance sheet. In general, the higher the
percentage, the better, with some exceptions, as it shows that the company is doing a
good job using the investors' money.

2. LEVERAGE AND CAPITAL STRUCTURE RATIOS

In the financial world, leverage can be defined as the influence of fixed expenses over the
operating cash flow or earnings. Fixed expenses can be used as a lever to magnify the
operating cash flows and earnings. The term refers generally to circumstances, which
brings about an increase in income volatility. In business, leverage is the means of
increasing profits. It may be favourable or unfavourable. The leverage of a firm is
essentially related to a profit measure, which may be a return on investment or on
earnings before taxes.
Types of leverage

 Operating Leverage- It is defined as change in earnings before interest and taxes (EBIT)
due to change in sales. If all the costs of the product are variable, the expected
percentage change in the income before taxes will be equal to the percentage change in
sales. Operating leverage is concerned with the operation of any firm. The cost structure
of any firm gives rise to operating leverage because of the existence of fixed nature of
costs. This leverage relates to the sales and profit variations.

Operating leverage is the responsiveness of firm’s earnings before interest and taxes to
the changes in sales value. It refers to the sensitivity of operating profit before interest
and tax to the changes in quantity produced and sold. The firm’s operating leverage
would be higher if the firm has high quantum of fixed cost and low variable cost. The low
operating leverage represents the high variable cost and low fixed cost. If the operating
leverage of the firm is higher, the more its profits will vary with a given percentage in
sales. The operating leverage is an attribute of the firm’s business risk.

The operating leverage falls with the increase in sales beyond the firm’s break-even point.
A company with high proportion of fixed costs to total costs will have a high operating
leverage. A company with a high operating leverage will have higher break-even level. If
contribution to sales ratio of a firm is high, it can achieve higher profitability at maximum
operating level. In times of recession, the high operating leverage will act as a
disadvantage to the firm for the reason that lower level of operating profits due to higher
fixed costs.
 Degree of Operating Leverage

Degree of operating leverage is a relationship between the percentage changes in EBIT

with 1% change in sales. The ability of the firm to leverage the fixed costs to achieve more
than proportionate change in earnings is referred to as operating leverage.
The value of DOL is unique at each level of operation DOL is undefined at breakeven
point. Negative values of DOL signify that the firm is operating below breakeven point.
They do not signify the inverse relationship. While operating above the breakeven point,
the value of DOL declines and approaches 1 as the firm moves away from breakeven
point. This is because the fixed cost per unit decreases as the number of units’ increases.
017
 Financial Leverage- Financial leverage refers to the use of debt financing and the
resultant sensitivity of the earnings available to shareholders (EPS) by the substitution of
their capital with fixed charge finance. If the firm has no fixed financial charges, then any
change in the levels of EBIT will be transferred to shareholders as it is. The change in the
shareholders wealth would be identical to that of the change in EBIT. In such a case, all
the business risk is borne by the shareholders. However if some of the equity capital is
substituted by fixed charge capital, changes in earning per share will be larger as
compared to all equity financing option. Replacing equity with debt leaves the risk with
the remaining equity shareholders. Financial leverage indicates the effects on earnings
by rise of fixed costs funds.

It refers to the use of debt in the capital structure. Financial leverage arises when a firm
deploys debt funds with fixed charge. The higher the ratio, the lower the cushion for
paying interest on borrowings. A low ratio indicates a low interest outflow and
consequently lower borrowings. A high ratio is risky and constitutes a strain on profits.
This ratio is considered along with the operating ratio, gives a fair and accurate idea
about the firm’s earnings, its fixed costs and the interest expenses on long-term
borrowings. The financial leverage is an indicator of responsiveness of firm’s EPS to the
changes in its profit before interest and tax.

Degree of Financial Leverage (DFL)

Degree of Financial Leverage (DFL) is the percentage change in the Earning per share with
1% change in the EBIT level. The minimum value of DFL is 1.00. Just as fixed cost leverage
the EBIT for changes in sales, as underlined under the section on operating leverage, the
presence of a fixed charge in the financing of the firm leverage the EPS for a given change
in EBIT. This is called financial leverage. Use of debt causes fixed charges on the capital
by way of interest and since this fixed capital replaces more expensive equity, the
remaining equity earns a greater return. Degree of financial leverage (DFL) is defined as
highlighted in below.
DFL always has a value in excess of 1.0. The value of 1 signifies that entire funding is done
through equity. The firm has no interest burden. A DLF value less than 1 is possible when
the firm is unable to generate any income. The firm cannot meet its fixed operational
cost and EBIT is negative.

3. Debt-Equity Ratio

This ratio indicates the relationship between loan funds and net worth of the company,
which is known as ‘gearing’. If the proportion of debt to equity is low, a company is said
to be low-geared, and vice versa. A debt-equity ratio of 2:1 is the norm accepted by
financial institutions for financing of projects. Higher debt-equity ratio of 3:1 may be
permitted for highly capital intensive industries like petrochemicals, fertilizers, power
etc. The higher the gearing, the more is volatile the return to the shareholders. The use
of debt capital has direct implications for the profit accruing to the ordinary shareholders,
and expansion is often financed in this manner with the objective of increasing the
shareholders’ rate of return. This objective is achieved only if the rate of return earned
on the additional funds raised exceeds that payable to the providers of the loan. The
shareholders of a highly geared company reap disproportionate benefits when earnings
before interest and tax increase. This is because interest payable on a large proportion of
total finance remains unchanged. The converse is also true, and a highly geared company
is likely to find itself in severe financial difficulties if it suffers a succession of trading
losses. It is not possible to specify an optimal level of gearing for companies but, as a
general rule, gearing should be low in those industries where demand is volatile and
profits are subject to fluctuation. A debt-equity ratio which shows a declining trend over
the years is usually taken as a positive sign reflecting on increasing cash accrual and debt
repayment. The formula of the debt-equity ratio is highlighted in below:

4. SHAREHOLDERS EQUITY RATIO

It is assumed that larger the proportion of the shareholders’ equity, the stronger is the
financial position of the firm. This ratio will supplement the debt equity ratio. In this ratio,
the relationship is established between the shareholders’ fund and the total assets.
Shareholders fund represent equity and preference capital plus reserves and surplus less
accumulated losses. A reduction in shareholders’ equity signalling the over dependence
on outside sources for long term financial needs and this carries the risk of higher levels
of gearing. This ratio indicates the degree to which unsecured creditors are protected
against loss in the event of liquidation. The ratio is calculated as follows:

5. LONG TERM DEBT TO SHAREHOLDERS NET WORTH RATIO

The ratio compares long-term debt to the net worth of the firm i.e. the capital and free
reserves less intangible assets. This ratio is finer than the debt-equity ratio and includes
capital which is invested in fictitious assets like deferred expenditure and carried forward
losses. This ratio would be of more interest to the contributories of long term finance to
the firm, as the ratio gives factual idea of the assets available to meet the long-term
liabilities. The ratio is calculated as follows:

Capital Gearing Ratio

The fixed interest bearing funds include debentures, long-term loans and preference
share capital. The equity shareholders’ funds include equity share capital, reserves and
surplus. Capital gearing ratio indicates the degree of vulnerability of earnings available
for equity shareholders. This ratio signals the firm which is operating on trading on equity.
It also indicates the changes in benefits accruing to equity shareholders by changing the
levels of fixed interest bearing funds in the organization. The ratio is calculated as follows:

Fixed Assets to Long –Term Funds Ratio

This ratio indicates the proportion of long –term funds deployed in fixed assets. Fixed
assets represent the gross fixed assets minus depreciation provided on this till the date
of calculation.
Long –term funds include share capital, reserve and surplus and long-term loans. The
higher the ratio indicates the safer the funds available in case of liquidation. It also
indicates the proportion of long-term funds that is invested in working capital. The ratio
is expressed in below:

Debt Service Coverage Ratio (DSCR)

The ratio is the key indicator to the lender to assess the extent of ability of the borrower
to service the loan in regard to timely payment of interest and repayment of loan
instalment. It indicates whether the business is earning sufficient profits to pay not only
the interest charges, but also the instalments due of the principal amount. A ratio of 2 is
considered satisfactory by the financial institution. The greater debt service coverage
ratio indicates the better debt servicing capacity of the organization. The ratio is
calculated as:

Debt to Total Capital Ratio

The relationship between creditors fund and owner’s capital can also be expressed in
terms of another leverage ratio. This is the debt to total capital ratio. Here, the outsider’s
liabilities are related to the total capitalization of the firm and not merely to the
shareholders equity. It can be measured in the following way. Here, permanent capital
comprise of total debt capital, equity capital, preference capital and free reserve.

Interest Coverage Ratio

This is also known as time- interest- earned ratio. This ratio measures the debt servicing
capacity of a firm in so far as fixed interest on long term loan is concerned. It is
determined by dividing the operating profits or earnings before interest and taxes by the
fixed interest charges on loans. A very high ratio indicates that the firm is conservative in
using debt and a very low ratio indicates excessive use of debt. Further, it indicates how
many times a company can cover its current interest payments out of current profits. It
gives an indication of problem in servicing the debt. An interest cover of more than 7
times is regarded as safe and more than 3 times is desirable. An interest cover of 2 times
is considered reasonable by financial institutions.
Dividend Coverage Ratio

It measures the ability of a firm to pay dividend on preference shares which carry a stated
rate of return. This ratio is the ratio of net profits after taxes (EAT) and the amount of
preference dividend. Thus it is seen that although preference dividend is a fixed
obligation, the earnings taken into account are after taxes. This is because, unlike debt
on which interest is a charge on the profits of the firm, the preference dividend is treated
as an appropriation of profit. The ratio like the interest coverage ratio reveals the safety
margin available to the preference shareholders.

6. LIQUIDITY RATIOS

It is generally considered by analyst to determine the ability of firm to pay its short term
liabilities.
Current Ratio= (Current assets)/ (Current Liabilities)
Higher the ratio the more likely is that company will be able to pay its short term bills. A
current ratio of less than one means that the company has negative capital and is facing
a liquidity crisis.

Quick ratio= (Cash+ Marketable securities+ Receivables)/ (Current liabilities)

It is more stringent as it does not include the inventories and other such assets which
might not be liquid that easily. The higher the ratio, the more likely the company will be
able to pay its short term bills. Market securities are short term debt instruments
typically liquid and of good credit quality.

Cash Ratio = (Cash + Marketable securities)/ (Current liabilities)

It is the most conservative liquidity measure. These three just differentiate on basis of
assumed liquidity
Defensive interval ratio= (Cash+ Marketable securities+ Receivables)/ (Average daily
expenditure)

It tells about the average number of days cash expenditure the firm can pay with its
current liquid assets. Expenditure here includes cost of goods, Selling, general and
administrative and R and D cost.
Cash conversion cycle

Cash conversion cycle is the length of time it takes to turn the firm’s cash investment in
inventories back into cash, in form of collections from the sales of that inventory. High
 cash conversion cycle is undesirable. A high cash conversion cycle means that company
has an excessive amount of capital investment in the sales process.

Cash conversion cycle= (Days sale outstanding) + (Days of inventory on hand) - (number of
Days payable)

Days sale outstanding= Number of days it takes a company to collect its account
receivables.
Number of days payable= Average number of days a company takes to pay its supplier.
7. WORKING CAPITAL MANAGEMENT

Working capital is what remains on the balance sheet after the current liabilities are
subtracted from the current assets. It can be defined as - net working capital (current
assets - current liabilities) or gross working capital (current assets).
Working capital management involves the relationship between a firm's short term
assets and its short-term liabilities. The goal of working capital management is to ensure
that a firm is able to continue its operations and that it has sufficient ability to satisfy
both maturing short-term debt and upcoming operational expenses (maximize short-
term liquidity). The management of working capital involves managing inventories,
accounts receivable and payable, and cash.
Composition of working capital
Working Capital = Current Assets - Current Liabilities
- Current assets are cash, accounts receivable, short-term investments, and inventory

- If most of the value of current assets is in A/R and inventory, that may make the working
capital number look good, but to actually get at that working capital the entity would
have to collect on some accounts and/or sell some inventory -both of which can take
time.
- Management of working capital means managing different components of current
assets and current liabilities.

Management of Cash: Every enterprise irrespective of its scale requires certain amount
of cash to meet its day-to-day obligations. Hence, the enterprise needs to decide
carefully how much should be carried in cash. Management of cash aims at striking a fine
balance between two contradictory objectives of meeting the cash disbursement needs
and minimizing the amount locked up as cash balance. For this purpose, cash
management addresses to the following four problems:
Controlling the level of cash
Controlling inflows of cash
Controlling outflows of cash
Optimum use of surplus cash

Management of Inventory: Inventories refer to raw material, work-in-progress and

finished goods. These constitute a major portion, about 60% of total current assets. There
are three major motives for holding inventories in a firm, namely, transaction motive,
precautionary motive and speculative motive. But, holding inventories involves costs, i.e.
ordering costs and carrying costs. Hence, inventories need to be maintained at an
optimum size. Inventory management is a trade-off between cost of acquiring and cost
of holding inventories. Among various models evolved for managing inventories, the
commonly used model is Economic Ordering Quantity (EOQ) Model based on Baumol’s
cash management model. The other model of inventory management is ABC Analysis
also known as CTE i.e., Control by Importance and Exception. This method controls
expensive inventory items more closely than less expensive items.

Management of Accounts Receivable: The main objective of maintaining accounts

receivable are achieving growth in sales, increasing profits and meeting competition. Like
inventories, maintaining accounts receivable also involves certain costs such as capital
costs, administrative costs, collection costs and defaulting costs, i.e., bad debts. The size
of accounts receivable depends on the level of sales, credit policy, terms of trade,
efficiency of collection, etc. A larger size of accounts receivable increases profitability and
reduces liquidity and vice versa. Therefore, accounts receivable need to be maintained
at an optimum size. The optimum size of accounts receivable occurs at a point where
there is a “trade-off” between profitability and liquidity.

Management of Accounts Payable: Accounts payable are just reverse to accounts

receivable. Accounts payable emerge due to credit purchase. This refers to a loaning of
goods and inventories to the buyer. This is also called ‘buy-now, pay-later’. The
underlying objective of accounts payable is to slow down the payments process as much
as possible. But, it should be noted that the saving of interest cost should be offset against
loss of credit standing of the enterprise. The enterprise has, therefore, to ensure that the
payments to the creditors are made at the stipulated time periods after obtaining the
best credit terms possible. The salient points to be noted on effective management of
accounts payable are:
Obtain most favourable credit terms with the prevailing credit practice
Make payments on maturity or due dates
Keep good track record of past dealings with the suppliers
Avoid tendency to divert payables
Provide full information to the suppliers
Keep a constant check on incidence of delinquency

Negative working capital

Negative working capital is formed either when short term liabilities are used for long
term purposes or current assets faces a blow e.g. current liabilities or funds used for long
term assets, abnormal loss of inventory, bad debts, consistently selling goods at loss etc.
For working capital to go negative current assets must go below the current liabilities and
it can happen in following four situations.
 1. Abnormal Loss in Inventory: If there is a loss in inventory due to wastage of material, fire
in the store, theft, etc. or any such reason which will diminish the value of inventory in
the balance sheet will result in negative working capital. If the goods are lying in store for
long and company is not able to sell, the value will deteriorate.

2. Bad Debts: If a company faces a lot of bad debts, it can lead to Negative Working Capital.
It may be because of bad selection of customers, credit extension to customers with bad
credit records, excessively aggressive selling approach etc.
3. Goods Sold at Loss Consistently: If we are selling at negative margin, it will take current
assets below the current liabilities
4. Cash Used for Investing in Fixed Assets: Using cash from Retained Earnings to invest in
fixed assets or long term investments.

Is Negative Working Capital Good or Bad?

It will depend upon the reason due to which it is going negative. If the reason for NWC
going negative is abnormal inventory loss or high level of bad debts or consistently selling
goods at loss, then, negative working capital is a bad sign and company has all the
probabilities of facing financial distress or even bankruptcy. If the reason is investment
of extra available cash in Fixed Assets or Long Term Investments without disturbing the
operating cycle of the company, the negative working capital is a sign of efficient
management. Such situations appear for giant companies having muscle power of bulk
demand and who can command credit terms with the suppliers. Also, companies having
cash sales but credit purchase are able to create such a situation.
 Difference between Hedging, Speculation and Arbitrage

Hedging is an act of protecting or guarding the investment against an undesired price

movement. Suppose a long term investor owns a portfolio of stocks worth Rs 10 lacs. The
price movement of a stock is dependent both on the micro (profitability of the company,
its growth potential, business model, management competency etc.) and the macro
factors (GDP growth of the country, interest rates, overall state of economy etc.). Such
an investor can hedge his portfolio by selling Index Futures (like Nifty future) and thereby
removing the risk of macro variables from his portfolio.
Arbitrage involves the simultaneous buying and selling of an asset in order to profit from
small differences in price. Often, arbitrageurs buy stock on one market (for example, a
financial market in the United States like the NYSE) while simultaneously selling the same
stock on a different market (such as the London Stock Exchange). Since arbitrage involves
the simultaneous buying and selling of an asset, it is essentially a type of hedge and
involves limited risk, when executed properly. Arbitrageurs typically enter large positions
since they are attempting to profit from very small differences in price.
Speculation, on the other hand, is a type of financial strategy that involves a significant
amount of risk. Financial speculation can involve the trading of instruments such as
bonds, commodities, currencies and derivatives. Speculators attempt to profit from
rising and falling prices. A trader, for example, may open a long (buy) position in a stock
index futures contract with the expectation of profiting from rising prices. If the value of
 the index rises, the trader may close the trade for a profit. Conversely, if the value of the
index falls, the trade might be closed for a loss.

3 Banking
Measures to regulate banking in India

 SDR

Under Strategic Debt Restructuring (SDR) Scheme, banks who have given loans to a
corporate borrower gets the right to convert the full or part of their loans into equity
shares in the loan taken company. The SDR scheme which was introduced by the RBI in
June 2015 thus helps banks recover their loans by taking control of the distressed listed
companies.
The SDR initiative can be taken by the group of banks or JLF that have given loans to the
particular defaulted entity. The Joint Lender Forum (JLF) is a committee comprised of the
entire bankers who have given loans to a potentially stressed or stressed borrower. At
present, banks can form a JLF if the account by a borrower is classified as Special Mention
Account 2 (not paid any money back during the last 60 days).
The JLF/Corporate Debt Restructuring Cell (CDR) may consider the following options when
a loan is restructured:

 Possibility of transferring equity of the company by promoters to the lenders

 Promoters infusing more equity into their companies
 Transfer of the promoters’ holdings to a security trustee or an escrow arrangement
till turnaround of company.

At the time of initial restructuring, the JLF must incorporate an option to convert the
entire loan (including unpaid interest), or part thereof, into shares in the company in the
event the borrower is not able to achieve the ‘critical conditions’ as stipulated in the
restructuring package.
The decision on invoking the SDR by converting the whole or part of the loan into equity
shares should be taken by the JLF. The decision should be documented and approved by
the majority of the JLF members (minimum of 75% of creditors by value and 60% of
creditors by number). In order to achieve the change in ownership, the lenders under the
JLF should collectively become the majority shareholder by conversion of their dues from
the borrower into equity. After the conversion, all lenders under the JLF must collectively
hold 51% or more of the equity shares issued by the company.
The basic purpose of SDR is to ensure more stake of promoters in reviving stressed
accounts and providing banks with enhanced capabilities to initiate change of ownership,
where necessary, in accounts which fail to achieve the agreed critical conditions and
viability milestones. SDR cannot be used for any other reason.
 S4A
‘Scheme for Sustainable Structuring of Stressed Assets’ (S4A) as announced by RBI is
outlined to tackle the ‘problem loans’ of large projects at a sufficiently early stage and
protect the interest of lenders. The scheme is an optional framework under which the
liabilities of struggling company’s debt will be bifurcated into sustainable and
unsustainable portions. The banks shall then convert the unsustainable debt into equity
and sell this stake to a new owner who will have the advantage of getting to run the
business with more manageable sustainable debts. Instead of the earlier system of
leaving it to banks themselves, the entire exercise of credible resolution plan under S4A
is independently carried out by overseeing committee set up by Indian Banks Association
(IBA), in consultation with the RBI, in a transparent and prudent manner. By this exercise,
banks are put into a position to upgrade their loans with cleaning up of the large portion
of bad loans. Nevertheless, in this exercise, banks may have to take a haircut as the
market value of the stressed company might be less than the value of debt that is
converted into equity.
According to the guidelines, only the projects which have commenced commercial
operations are eligible for S4A scheme. The aggregate exposure of an enterprise like
Rupee loans, Foreign Currency loans, External Commercial Borrowings etc. (including
accrued interest) of all institutional lenders should be more than Rs.500 crore, to be
eligible for the scheme. The debt shall also meet the test of sustainability. The debt level
will be deemed as sustainable if an enterprise is in a position to service, its present
principal value of the funded and non- funded liabilities, over the same tenor as that of
the existing facilities, even if the future cash flows remain at their current level.
The ‘sustainable debt’ cannot be less than 50 percent of ‘current funded liabilities’ if an
enterprise is to be eligible for S4A. The assessment of debt will be done, through the
independent techno-economic viability (TEV) carried out by the experts of professional
agencies. The sustainable debt is referred as ‘Part A’ and the remaining portion of the
aggregate debt is treated as unsustainable debt which is referred as ‘part B’. At individual
bank level, the bifurcation into Part A and part B will be made in the proportion of Part A
to Part B at the aggregate level. The resolution plan shall be agreed upon by a minimum
of 75 percent of lenders by value and 50 percent of lenders by number in the
JLF/consortium/bank for implementation.
The S4A resolution envisages the ‘Part B’ portion of the debt to be converted into
equity/redeemable cumulative optionally convertible preference shares. In the cases
where the resolution plan does not involve the change in the promoter, banks may, at
their discretion, convert a portion of Part B into optionally convertible debentures which
will continue to be referred as Part B instruments. Further, the borrower is not eligible
for fresh moratorium on interest or principal repayment for servicing of Part A.
Management of the borrowing entity: The S4A post-resolution have two options to run
the management of the enterprise.

 The existing promoters continue to hold the management if they hold the majority
of the shares required to have control.

 If the existing promoter/s does not have the majority stake to have the control of the
enterprise; the existing promoter will be replaced with the new promoter/s. However,
in certain cases where the resolution does not contain a change in the promoter, the
 lenders may allow the existing promoter to operate and manage the company as the
minority owner.

ASSET QUALITY REVIEW

In January 2016, Raghuram Rajan, then governor of the Reserve Bank of India (RBI) asked
banks to clean up their books by March 2017. The RBI had undertaken an asset quality
review (AQR) of the sector in the second half of 2015 and found that banks were under-
reporting stressed assets. What followed was an effort to get banks to classify loans
appropriately, provide for them and move towards resolving the pile of bad loans that
had been allowed to lurk in undeclared corners of bank books.
Typically, Reserve Bank of India (RBI) inspectors check bank books every year as part of
its annual financial inspection (AFI) process. However, a special inspection was conducted
in 2015-16 in the August-November period. This was named as Asset Quality Review
(AQR). In a routine AFI, a small sample of loans is inspected to check if asset classification
was in line with the loan repayment and if banks have made provisions adequately.
However, in the AQR, the sample size was much bigger and in fact, most of the large
borrower accounts were inspected to check if classification was in line with prudential
norms. Some reports suggest that a list of close to 200 accounts was identified, which the
banks were asked to treat as non-performing. Banks were given two quarters, October-
December and January-March of 2016 to complete the asset classification.
The AQR created havoc on banks’ profit & loss accounts as many large lenders slipped
into losses in both the said quarters, which resulted in some of them reporting losses for
the full financial year. Record losses were posted in Q4 of FY16 by many large lenders like
Bank of Baroda (Rs.3,230 crore), Punjab National Bank (Rs.5,367 crore), IDBI Bank
(Rs.1,376 crore) – to name a few.
Almost all public sector banks were impacted, while the impact in the private sector was
limited to biggies such as ICICI Bank and Axis Bank. HDFC Bank – the second-largest
private sector lender – emerged unscathed from the crisis as its exposure to big-ticket
infrastructure projects was relatively small. Bad loans in the Indian banking system
jumped 80 per cent in FY16, according to RBI data, mainly on account of the AQR.
 Indradhanush plan

Mission Indradhanush is a 7 pronged plan launched by Government of India to resolve issues

faced by Public Sector banks. It aims to revamp their functioning to enable them to
compete with Private Sector banks. The 7 parts can be described as follows:

Appointments - separation of posts of CEO and MD to check excess concentration of

power and smoothen the functioning of banks; also induction of talent from private
sector ( recommendation of P J Nayak Committee)

Bank Boards Bureau - will replace the appointments board of PSBs. It will advise the banks
on how to raise funds and how to go ahead with mergers and acquisitions. It will also
hold bad assets of public sector banks and be a step into eventual transition of the bureau
into a bank holding company. The bureau will have three ex-officio members and three
expert members, in addition to the Chairman.
 Capitalisation- Capitalisation of the banks by inducing Rs 70,000 crore into the banks in
the next 4 years. Banks are in need of capitalisation due to high NPAs and due to need to
meet the new BASEL- III norms

De-stressing - Solve issues in the infrastructure sector to check the problem of stressed
assets in banks
Empowerment- Greater autonomy for banks; more flexibility for hiring manpower

Framework of accountability- The banks will be assessed on the basis of new key
performance indicators. These quantitative parameters such as NPA management,
return on capital, growth and diversification of business and financial inclusion as well as
qualitative parameters such as human resource initiatives and strategic steps to improve
assets quality.

Governance Reforms- GyanSangam conferences between government officials and

bankers for resolving issues in banking sector and chalking out future policy.

The Indian Government plans to come out with ‘Indradhanush 2.0’, a comprehensive plan for
recapitalisation of public sector lenders, with a view to make sure they remain solvent
and fully comply with the global capital adequacy norms, Basel-III.

‘Indradhanush 2.0’ will be finalised after completion of the asset quality review (AQR) by the
Reserve Bank of India (RBI), which is likely to be completed by March-end. The RBI had
embarked on the AQR exercise from December 2015 and asked banks to recognise some
top defaulting accounts as non-performing assets (NPAs) and make adequate provisions
for them. It has had a debilitating impact on banks’ numbers and their stocks.

Under Indradhanush roadmap announced in 2015, the government had announced to infuse
Rs70,000 crore in state-run banks over four years while they will have to raise a further
Rs1.1 trillion from the markets to meet their capital requirement in line with global risk
norms, known as Basel-III.

In line with the plan, public sector banks were given Rs25,000 crore in 2015-16, and similar
amount has been earmarked for the current fiscal. Besides, Rs10,000 crore each would
be infused in 2017-18 and 2018-19. The government has already announced fund
infusion of Rs22,915 crore, out of the Rs25,000 crore earmarked for 13 PSBs for the
current fiscal. Of this, 75% has already been released to them.

Balance sheets of banks

Commercial bank's balance sheet has two main sides i.e. the liabilities and the assets.
Bank's Liabilities-
o Share capital: the contribution which shareholders have contributed for starting the
bank
o Reserve funds: the money, which the bank has accumulated over the years from its
undistributed profits

o Deposits are the money owned by customers and therefore it is a liability of a bank o
Borrowings from central banks or reserve banks

o Others

Banks Assets: cash, money at short notice, bills and securities discounted, bank's
Investments,
loans sanctioned by the bank, etc.
o Bank's cash in hand, cash with other banks and cash with central bank (RBI)
o Money made available at short notice to other banks and financial institutions for a
very short period of 1-14 days
o loans and advances provided to its customers

Central Bank's Balance Sheet

Central bank assets:
o securities, mainly in the form of Treasuries
o foreign exchange reserves, which are mainly held in the form of foreign bonds

issued by foreign governments o loans to

commercial banks

Of these, the most important asset is securities, which the central bank uses to directly
control the supply of money in the country. In other countries, where exports are
important, such as China, federal exchange reserves may be the dominant asset.

Central bank liabilities:

o currency, which is held by the public federal government's bank account, which the
central bank uses to deposit its revenues, mostly in the form of tax revenues, into its
account, and paying its bills, mostly in electronic format
o Commercial bank accounts, otherwise known as reserves, where commercial banks keep
their deposits with the Fed. Vault cash, which is cash held in the banks' vaults, is also part
of the commercial banks' reserves, because the cash is used to service its customers.

Why are cash flow statements not used in banking analysis?

Cash flow statement is mandatory for all institutions according to Companies Act, 2013.
However, the banking regulations act (1949) decides banks final accounts- It specifies
that only balance sheet and income statement are mandatory for banks. Cash flows in
banks are useful for their own business decisions.

For an equity holder, cash flow statement is not needed for analysis as all the transactions
are made in terms of cash. Cash flows mainly consists of loans and deposits and those
transactions doesn't hold much value for banks itself.

The reason why bankers do not use the statements is that they do not consider the
information provided to be relevant. The results furthermore indicate that the cash flow
statements of banks are not used because the existing accounting standard does not
consider the credit creation function in banks. This is exemplified in the negative
operative cash flow during periods of lending growth.

Banks are different from other firms and hence, the reporting of banks’ cash flows functions
also differs because cash is their product and they create deposits on their balance sheet
when providing loans to their customers. The accounting transaction of lending does not
involve any prior funding or cash inflow, but occurs in the accounting system, creating
deposit as a liability and loan as an asset of the bank. These results contribute to the
debate needed in accounting and banking about useful cash flow statements for banks
and provide an overview to prepare new accounting regime.

How does a bank operate?

Banks take deposits from savers and pay interest on some of these accounts. They pass these
funds on to borrowers and receive interest on the loans. Their profits are derived from
the spread between the rate they pay for funds and the rate they receive from
borrowers. This ability to pool deposits from many sources that can be lent to many
different borrowers creates the flow of funds inherent in the banking system. By
managing this flow of funds, banks generate profits, acting as the intermediary of interest
paid and interest received, and taking on the risks of offering credit. Like any other
company, banks also have an equity capital but that is very small when compared to the
operating margins and depositor money.

The main functions of commercial banks can be divided under the following heads:
1. Accepting deposits: The most important function of commercial banks is to accept
deposits from the public. Various sections of society, according to their needs and
economic condition, deposit their savings with the banks.

2. Giving loans: The second important function of commercial banks is to advance loans to
its customers. Banks charge interest from the borrowers and this is the main source of
their income.
3. Overdraft: Banks advance loans to its customer’s up to a certain amount through over-
drafts, if there are no deposits in the current account. For this banks demand a security
from the customers and charge very high rate of interest.

4. Discounting of Bills of Exchange: This is the most prevalent and important method of
advancing loans to the traders for short-term purposes. Under this system, banks
advance loans to the traders and business firms by discounting their bills. In this way,
businessmen get loans on the basis of their bills of exchange before the time of their
maturity.

5. Investment of Funds: The banks invest their surplus funds in three types of securities-
Government securities, other approved securities and other securities. Government
securities include both, central and state governments, such as treasury bills, national
savings certificate etc.
6. Agency Functions: Banks function in the form of agents and representatives of their
customers. Customers give their consent for performing such functions.

BASEL norms and type of capital (Tier 1 and 2)

BASEL norms are a set of international banking regulations put forth by the Basel Committee
on Bank Supervision, which set out the minimum capital requirements of financial
institutions with the goal of minimizing credit risk.

Tier I capital is core capital, this includes equity capital and disclosed reserves. Equity capital
includes instruments that can't be redeemed at the option of the holder.

Tier 2 capital is supplementary bank capital that includes items such as revaluation reserves,
undisclosed reserves, hybrid instruments and subordinated term debt. Components of
Tier 2 Capital can be split into two levels: upper and lower. Upper Tier 2 maintains
characteristics of being perpetual, senior to preferred capital and equity; having
deferrable and cumulative coupons; and its interest and principal can be written down.
Lower Tier 2 is relatively cheap for banks to issue; has coupons not deferrable without
triggering default; and has subordinated debt with a maturity of a minimum of 10 years.

BASEL I
The first accord was the Basel I. It was issued in 1988 and focused mainly on credit risk by
creating a bank asset classification system. This classification system grouped a bank's
assets into five risk categories:
0% - cash, central bank and government debt and any OECD government debt
0%, 10%, 20% or 50% - public sector debt
20% - development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank
debt
(under one year maturity) and non-OECD public sector debt, cash in collection
50% - residential mortgages

100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and
equipment, capital instruments issued at other banks

The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-weighted
assets. For example, if a bank has risk-weighted assets of $100 million, it is required to
maintain capital of at least $8 million.

BASEL II

Basel II is the second of the Basel Committee on Bank Supervision's recommendations, and
unlike the first accord, Basel I, where focus was mainly on credit risk, the purpose of Basel
II was to create standards and regulations on how much capital financial institutions must
have put aside. Banks need to put aside capital to reduce the risks associated with its
investing and lending practices.

The guidelines were based on three parameters, which the committee calls it as pillars.

- Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy

requirement of 8% of risk assets

- Supervisory Review: According to this, banks were needed to develop and use better risk
management techniques in monitoring and managing all the three types of risks that a
bank faces, viz. credit, market and operational risks

- Market Discipline: This need increased disclosure requirements. Banks need to

mandatorily disclose their CAR, risk exposure, etc.

BASEL III

Post crisis, with a view to improving the quality and quantity of regulatory capital, it has been
decided that the predominant form of Tier 1 capital must be Common Equity; since it is
 critical that banks’ risk exposures are backed by high quality capital base. Non-equity Tier
1 and Tier 2 capital would continue to form part of regulatory capital subject to eligibility
criteria as laid down in Basel III. Accordingly, under revised guidelines (Basel III), total
regulatory capital will consist of the sum of the following categories:

1. Tier 1 Capital (going-concern capital)

a. Common Equity Tier 1
b. Additional Tier 1
2. Tier 2 Capital (gone-concern capital)

Limits and Minima

1. As a matter of prudence, it has been decided that scheduled commercial banks operating
in India shall maintain a minimum total capital (MTC) of 9% of total risk weighted assets
(RWAs) as against a MTC of 8% of RWAs as prescribed in Basel III

2. Common Equity Tier 1(CET1) capital must be at least 5.5% of risk weighted assets (RWAs)
i.e. for credit risk+ market risk + operational risk on an ongoing basis. Globally it is 4.5%
as per Basel III but RBI asks for an additional 1%.
3. Tier 1 capital must be at least 7% of RWAs on an ongoing basis. Thus, within the
minimum Tier
1 capital, Additional Tier 1 capital can be admitted maximum at 1.5% of RWAs.
4. Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 9% of RWAs on an
ongoing basis. Thus, within the minimum CRAR of 9%, Tier 2 capital can be admitted
maximum up to 2%.

5. If a bank has complied with the minimum Common Equity Tier 1 and Tier 1 capital ratios,
then the excess Additional Tier 1 capital can be admitted for compliance with the
minimum CRAR of 9% of RWAs

6. In addition to the minimum Common Equity Tier 1 capital of 5.5% of RWAs, banks are
also required to maintain a capital conservation buffer (CCB) of 2.5% of RWAs in the form
of Common Equity Tier 1 capital

7. For the purpose of reporting Tier 1 capital and CRAR, any excess Additional Tier 1 (AT1)
capital and Tier 2 (T2) capital will be recognised in the same proportion as that applicable
towards minimum capital requirements. This would mean that to admit any excess AT1
and T2 capital, the bank should have excess CET1 over and above 8% (5.5%+2.5%)

8. In cases where the a bank does not have minimum Common Equity Tier 1 + capital
conservation buffer of 2.5% of RWAs as required but, has excess Additional Tier 1 and /
or Tier 2 capital, no such excess capital can be reckoned towards computation and
reporting of Tier 1 capital and Total Capital

9. For the purpose of all prudential exposure limits linked to capital funds, the ‘capital funds’
will exclude the applicable capital conservation buffer and countercyclical capital buffer
as and when activated, but include Additional Tier 1 capital and Tier 2 capital which are
 supported by proportionate amount of Common Equity Tier 1 capital. Accordingly, capital
funds will be defined as [(Common Equity Tier 1 capital) + (Additional Tier 1 capital and
Tier 2 capital eligible forcomputing and reporting CRAR of the bank)]. It may be noted
that the term ‘Common Equity Tier 1 capital’ does not include capital conservation buffer
and countercyclical capital buffer.

Common Equity Tier 1 Capital

Elements of Common Equity Tier 1 Capital

(I) Common shares (paid-up equity capital) issued by the bank which meet the criteria for
classification as common shares for regulatory purposes
(ii) Stock surplus (share premium) resulting from the issue of common
shares; (iii) Statutory reserves;
(iv) Capital reserves representing surplus arising out of sale proceeds of assets
(v) Other disclosed free reserves, if any;
(vi) Balance in Profit & Loss Account at the end of the previous financial year.

Elements of Additional Tier 1 Capital

(i) Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the
regulatory requirements.
(ii) Stock surplus (share premium) resulting from the issue of instruments included in
Additional Tier 1 capital;
(iii) Debt capital instruments eligible for inclusion in Additional Tier 1 capital, which comply
with the regulatory requirements;
(iv) Any other type of instrument generally notified by the Reserve Bank from time to time
for inclusion in Additional Tier 1 capital;

(v) While calculating capital adequacy at the consolidated level, Additional Tier 1
instruments issued by consolidated subsidiaries of the bank and held by third parties
which meet the criteria for inclusion in Additional Tier 1 capital; and
(vi) Less: Regulatory adjustments / deductions applied in the calculation of Additional Tier 1
capital

Elements of Tier 2 Capital

(i) General Provisions and Loss Reserves
(ii) Debt Capital Instruments issued by the banks;

(iii) Preference Share Capital Instruments [Perpetual Cumulative Preference Shares (PCPS) /
Redeemable Non-Cumulative Preference Shares (RNCPS) / Redeemable Cumulative
Preference Shares (RCPS)] issued by the banks;
(iv) Stock surplus (share premium) resulting from the issue of instruments included in Tier 2
capital;

(v) While calculating capital adequacy at the consolidated level, Tier 2 capital instruments
issued by consolidated subsidiaries of the bank and held by third parties which meet the
criteria for inclusion in Tier 2 capital;
(vi) Revaluation reserves at a discount of 55%;

Banking ratios

As banks have very different operating structures than regular industrial companies,
investors have a different set of fundamental factors to consider, when evaluating
banks.

1. Loan/Deposit Ratio: helps assess a bank's liquidity, and by extension, the aggressiveness
of the bank's management. If the loan/deposit ratio is too high, the bank could be
vulnerable to any sudden adverse changes in its deposit base. Conversely, if the
Loan/deposit ratio is too low, the bank is holding on to unproductive capital and earning
less than it should.
2. Efficiency Ratio: Equivalent to a company's operating margin, in that it measures how
much the bank pays on operating expenses, like marketing and salaries. A lower ratio is
preferable.

3. Capital Ratios: Ratios that bank regulators and investors use to assess how risky a bank's
balance sheet is, and the degree to which the bank is vulnerable to an unexpected
increase in bad loans. A bank's Tier 1 capital ratio takes a bank's equity capital and
disclosed reserves and divides it by the bank's risk-weighted assets, (assets whose value
is reduced by certain statutory amounts, based upon its perceived riskiness).

4. Capital Adequacy Ratio: A measure of a bank’s capital. It is expressed as a percentage of

a bank’s risk weighted credit exposures. Also known as “Capital to Risk Weighted Assets
Ratio (CRAR).” Although not an especially popular ratio prior to the 2007/2008 credit
crisis, it does offer a good measure of the degree of loss a bank can withstand, before
wiping out shareholder equity. Capital ratios can be thought of as proxies for a bank’s
margin of error. Nowadays, capital ratios also play a larger role in determining whether
regulators will sign off on acquisitions and dividend payments.

CAMELS analysis
Camels approach is used to analyse bank risk. It is an international bank-rating system
where bank supervisory authorities rate institutions according to six factors.

C - Capital adequacy
A - Asset quality

M - Management quality
E - Earnings
L - Liquidity
S - Sensitivity to Market Risk

 Capital Adequacy: How much capital a bank should set aside as a proportion
of risky Assets. It helps to reduce the risk of default. Capital adequacy is measured by
the ratio of capital to risk-weighted assets (CRAR). A sound capital base strengthens
confidence of depositors

 Asset Quality: One of the indicators for asset quality is the ratio of non-
performing loans to total loans (GNPA). The gross non-performing loans to gross
advances ratio is more indicative of the quality of credit decisions made by bankers.
Higher GNPA is indicative of poor credit decision-making. Hence management must
follow four steps

– 1. Adopt effective policies before loans are made

– 2. Enforce those policies as the loans are made
– 3. Monitor the portfolio after the loans are made
– 4. Maintain an adequate Allowance for Loan and Lease Losses (ALLL)
 Management: To assess a bank’s management quality, it requires
professional judgment of a bank’s compliance to policies and procedures, aptitude for
risk-taking, development of strategic plans. The performance of the other five CAMELS
components will depend on the management quality. The ratio of non-interest
expenditures to total assets (MGNT) can be one of the measures to assess the working
of the management. This variable, which includes a variety of expenses, such as payroll,
workers compensation and training investment, reflects the management policy stance.
Another ratio helpful to judge management quality is Cost per unit of money lent which
is operating cost upon total money disbursed.

 Earnings: The quality and trend of earnings of an institution depend largely on how
well the management manages the assets and liabilities of the institution. An FI must
earn reasonable profit to support asset growth, build up adequate reserves and
enhance shareholders’ value. It can be measured as the return on asset ratio.

 Liquidity: An FI must always be liquid to meet depositors’ and creditors’ demand to

maintain public confidence. Cash maintained by the banks and balances with central
bank, to total asset ratio (LQD) is an indicator of banks liquidity. In general, banks with
a larger volume of liquid assets are perceived safe, since these assets would allow
banks to meet unexpected withdrawals.

o Sensitivity to market risk: The main concern for FIs is risk management. Reflects the
degree to which changes in interest rates, foreign exchange rates, commodity prices, or
equity prices can adversely affect a financial institution’s earnings. The major risks to be
examined include: (i) market risk; (ii) exchange risk; (iii) maturity risk; (iv) contingent risk.
• CRR, SLR, Repo and reverse repo

CASH RESERVE RATIO (CRR): It is the mandatory percentage of the amount of money in
deposits that the bank has to keep with the RBI. This Ratio secures solvency of the bank
and drains out the excessive money from the banks. The main purpose of CRR is to
protect the risk of the bank’s depositors to an extent and to ensure that a bank maintains
some funds in liquid form. It is used to meet the Net Demand and Time Liabilities. When
a bank's deposits increase by Rs100, and if the cash reserve ratio is 4%, the banks will
have to hold Rs 4 with RBI and the bank will be able to use only Rs 96 for investments and
lending, credit purpose. Therefore, higher the ratio, the lower is the amount that banks
will be able to use for lending and investment. This power of RBI to reduce the lendable
amount by increasing the CRR, makes it an instrument in the hands of a central bank
through which it can control the amount that banks lend. Thus, it is a tool used by RBI to
control liquidity in the banking system. Its other purpose is to adjust liquidity in the
system, the supply of money circulating in the economy. When there is excess money
supply in the market, RBI will increase the CRR to drain out the excess. Inversely if the
economy is falling short of liquidity, then RBI will decrease the CRR to release more funds
in the market. This is thus one of the instruments that the central bank uses to control
inflation. Present value of CRR: 4%

STATUTORY LIQUIDITY RATIO (SLR): Banks are required to invest a certain percentage of their
time and demand deposits in assets specified by RBI, including gold, government bonds
and securities. In monetary jargon, SLR is that percentage of net demand and time
liabilities (NDTL); in other words, Bank deposits that must be used to buy specified assets.
The SLR ratio of 22.5% which means that for every Rs.100 deposited in a bank, it has to
invest Rs.22.5 in any of the asset classes approved by the RBI. RBI wants banks to hold a
part of the money in near cash so that they can meet any unexpected demand from
depositors at short notice by selling the bonds. Present value of SLR: 20.5%

REPO RATE: Repo rate is the rate at which the central bank of a country (Reserve Bank of India
in case of India) lends money to commercial banks in the event of any shortfall of funds.
Repo rate is used by monetary authorities to control inflation. In the event of inflation,
central banks increase repo rate as this acts as a disincentive for banks to borrow from
the central bank. This ultimately reduces the money supply in the economy and thus
helps in arresting inflation. The central bank takes the contrary position in the event of a
fall in inflationary pressures. Repo and reverse repo rates form a part of the liquidity
adjustment facility. Present value of Repo Rate: 6.25%

REVERSE REPO RATE: Reverse repo rate is the rate at which the central bank of a country (RBI
in case of India) borrows money from commercial banks within the country. Reverse repo
rate is the rate at which the central bank of a country (Reserve Bank of India in case of
India) borrows money from commercial banks within the country. It is a monetary policy
instrument which can be used to control the money supply in the country. An increase in
 the reverse repo rate will decrease the money supply and vice-versa, other things
remaining constant. An

increase in reverse repo rate means that commercial banks will get more incentives to park
their funds with the RBI, thereby decreasing the supply of money in the market. Present
value of Reverse Repo Rate: 6%

Working of repo market

Repo (Repurchase Option) is a formal agreement between two counterparties where one
party sells securities to another party with the explicit intention of buying back the
securities at a later date. The Repo can be called a Sell-Buy transaction. The seller of the
securities agrees to buy back the securities from the buyer at a predetermined time and
rate. The rate at which the seller agrees to buy back the securities will include the interest
rate charged by the buyer for agreeing to buy the securities from the seller. Repo
transactions take place between the RBI and banks, RBI and primary dealers, banks to
banks, banks to other counterparties, primary dealers to primary dealers and primary
dealers to other counterparties.

The reason a seller wants to sell and buy back securities and paying interest on the transaction
is that the seller requires funds. The seller of securities can be called as the Repo
borrower as he receives funds for selling the securities. The buyer of the securities is the
Repo lender as he pays for the securities purchased.

The Repo rate is the rate of interest charged by the buyer of the securities to the seller of
securities. A Repo transaction has two legs. The first leg is the sale of securities by the
Repo borrower to the Repo lender. The second leg is the purchase of securities by the
Repo borrower from the Repo lender.

Example 1. Repo transaction in the market

A Repo transaction is the actual sale of securities by the Repo borrower to the Repo lender.
The securities sold could be government bonds, corporate bonds, treasury bills and other
money market instruments. Let us take the example of a Repo borrower selling
government bonds to the Repo lender. The Repo period is one day and the Repo rate is
7.50%.

The government bond sold by the Repo Borrower to the Repo Lender is the benchmark ten
year government bond the 8.15% 2022 government bond. The first leg settlement date
is 11th of March 2013 and the second leg settlement date is 12th of March 2013.
Details of 8.15% 2022 Government Bond

The 8.15% 2022 Government Bond matures on the 11th of June 2022 and pays semi-annual
interest on the 11th of June and 11th of December. The bond is trading at a price of Rs
101.93 that translates into a semi-annual yield of 7.85%. The last interest payment date
on the bond was 11th of December 2012 and the next interest payment date is the 11th
of June 2013.

The table below gives the first leg cash inflow and second leg cash outflow of the Repo
Borrower:

The cash inflow to the Repo Borrower in the first leg is calculated by adding accrued interest
to the price of the bond. The interest outgo for the Repo rate borrower in the second leg is
calculated by the Repo interest rate on the cash inflow. The Repo borrower pays interest on
the full sum of money received by him from the Repo lender.
 Repo transactions have also altered the policy toolbox of contemporary central banks.
Repos have overtaken the traditional outright sale and purchase of assets as monetary
policy instruments. Central banks use repos to meet banks’ demand for reserves and thus
influence interest rates on unsecured inter-bank money markets where they implement
monetary policy.
OPEN MARKET OPERATIONS BY RBI

Open market operations are conducted by the RBI by way of sale or purchase of government
securities (g-secs) to adjust money supply conditions. The central bank sells g-secs to suck out
liquidity from the system and buys back g-secs to infuse liquidity into the system. These
operations are often conducted on a day-to-day basis in a manner that balances inflation
while helping banks continue to lend. The RBI uses OMO along with other monetary policy
tools such as repo rate, cash reserve ratio and statutory liquidity ratio to adjust the quantum
and price of money in the system.
In India, liquidity conditions usually tighten during the second half of the financial year (mid-
October onwards). This happens because the pace of government expenditure usually slows
down, even as the onset of the festival season leads to a seasonal spike in currency demand.
Moreover, activities of foreign institutional investors, advance tax payments, etc. also cause
an ebb and flow of liquidity.
However, the RBI smoothens the availability of money through the year to make sure that
liquidity conditions don’t impact the ideal level of interest rates it would like to maintain in
the economy. Liquidity management is also essential so that banks and their borrowers don’t
face a cash crunch. The RBI buys g-secs if it thinks systemic liquidity needs a boost and
offloads them if it wants to mop up excess money.
The central bank’s signal that it will move to a ‘neutral’ liquidity stance from a ‘deficit’ stance,
hints at more liquidity in the system in future. This could arm banks with more funds for
lending, and lead to softer interest rates in the economy. This is good news for both
businesses as well as individuals.
However, large open market purchases by the RBI can give the government a helping hand in
its borrowing programme and are frowned upon for this reason. In April 2006, the RBI was
barred from subscribing to primary bond issues of the government. This was done to put an
end to the monetisation of debt by the Reserve Bank. However, that didn’t stop the process.
With rising fiscal deficit, the RBI has been criticised for accommodating larger government
debt by way of OMO.
o SARFAESI Act
SARFAESI stands for Securitization and Reconstruction of Financial Assets and Enforcement
of Security Interest Act. This Act covers the rights a lender has over the collateral, when a
secured loan defaults. ‘Reconstruction’ of an asset, is banker-speak for reworking the terms
of a loan to ensure that the money is repaid.
The SARFAESI Act in case of default, covers features such as:
 1. Securitization: Issuing securities – financial instruments – against the recovered assets. It
can be done only by specific registered entities called an asset reconstruction company
or securitization company.

2. Guidelines for Asset Reconstruction: It covers how a defaulting business should be

managed or controlled to ensure repayment. Payments can be rescheduled, and secured
collateral repossessed.
3. No court intervention needed: One of the main features of this Act is, the lender can
take over the collateral without court intervention, which was not possible earlier.

NPAs

The reported numbers show that gross NPAs across listed banks including the consolidated bad
bank loans declared by SBI stood at 7.7 lakh crore at the end of March 2017. Excluding SBI
associates for the purposes of comparison, gross NPAs stood at 7.11 lakh crore at the end of
FY 17, compared to 5.70 lakh crore at the end of FY 16, an increase of about 25% in aggregate
terms.
An NPA is a ‘Non Performing Asset’. Lenders must ‘provision’ for NPAs, which means they must
keep aside a certain portion of their income to provide for the losses against these NPAs.

For a bank, a loan becomes an NPA after 90 days ‘past due’ or overdue; for an NBFC, 180 days
after repayment is due and hasn’t been made. A Non Performing asset (NPA) is a loan or an
advance where:
p respect
interest of
and/ or instalment
a term loan of principal remain overdue for a period of more than 90 days in
q the account remains ‘out of order’ , in respect of an Overdraft/Cash Credit (OD/CC)

r the bill remains overdue for a period of more than 90 days in the case of bills purchased and
discounted,

s the instalment of principal or interest thereon remains overdue for two crop seasons for short
duration crops,

t the instalment of principal or interest thereon remains overdue for one crop season for long
duration crops
The two ways in which NPA’s can be removed are by Income recognition and Write off. Banks
are required to classify nonperforming assets further into the following three categories
based on the period for which the asset has remained nonperforming and the realisability of
the dues:

a. Substandard Assets- A substandard asset would be one, which has remained NPA
for a period less than or equal to 12 months. In such cases, the current net worth of the
borrower/ guarantor or the current market value of the security charged is not enough to
ensure recovery of the dues to the banks in full. In other words, such an asset will have well
defined credit weaknesses that jeopardise the liquidation of the debt and are characterised
by the distinct possibility that the banks will sustain some loss, if deficiencies are not
corrected.
b. Doubtful Assets- An asset would be classified as doubtful if it has remained in the
substandard category for a period of 12 months. A loan classified as doubtful has all the
weaknesses inherent in assets that were classified as substandard, with the added
characteristic that the weaknesses make collection or liquidation in full, – on the basis of
currently known facts, conditions and values – highly questionable and improbable.
c. Loss Assets- A loss asset is one where loss has been identified by the bank or
internal or external auditors or the RBI inspection but the amount has not been written off
wholly. In other words, such an asset is considered uncollectible and of such little value that
its continuance as a bankable asset is not warranted although there may be some salvage or
recovery value.

NBFCs

Non Banking Finance Companies (NBFCs) are financial institutions that provide services,
similar to banks, but they do not hold a banking license. The main difference is that NBFCs
cannot accept deposits repayable on demand. Classification if NBFCs:

1. Asset Finance Company (AFC): An AFC is an NBFC, whose principal business is the
financing of physical assets. This includes financing of automobiles, tractors, lathe
machines, generator sets, earth moving and material handling equipment and general
purpose industrial machines. Examples of AFCs are Infrastructure Finance Limited,
Diganta Finance etc.
An AFC may be either
 Giving loans to businesses for purchasing the physical assets – tractors, machinery
etc.
 Leasing these assets to businesses

2. Investment Company (IC): This is an NBFC whose primary business is purchase and sale
of securities (financial instruments, such as stocks and bonds). A mutual fund would come
under this category. Examples of an Investment Company (IC) are Motilal Oswal, UTI
Mutual Fund etc.

3. Loan Company (LC): Loan Company (LC) means any NBFC whose principal business is that
of providing finance, by giving loans or advances. It does not include leasing or hire
purchase. Example of a Loan Company (LC) is Tata Capital Limited.
NBFCs can be further classified into those taking deposits or those not taking deposits. Only
those NBFCs can take deposits, that
- Hold a valid certificate of registration with authorization to accept public deposits.
- Have minimum stipulated Net Owned Funds (NOF – i.e. owners’ funds)

- Comply with RBI directions such as investing part of the funds in liquid assets, maintain
reserves, rating etc. issued by the bank.

The three key differences between a bank and NBFC are:

 An NBFC cannot accept deposits which are repayable on demand. Some can accept
fixed-term deposits
  Any deposits accepted by NBFCs (these will be of fixed maturity as explained above)
are not insured

 Only banks can participate in the payment system; hence NBFCs cannot issue
cheque books to their customers

4 Corporate Finance

4.1 Time Value of Money

The time value of money (TVM) is the idea that money available at the present time is worth
more than the same amount in the future due to its potential earning capacity. Conversely,
the sum of money received in future is less valuable that it is today. Since a rupee received
today has more value, rational investors would prefer current receipt to future receipts. The
time value of money can also be referred to as time preference for money. The main reason
for this is to be found in the reinvestment opportunities for funds which are received early.
The funds so invested will earn a rate of return; this would not be possible if the funds are
received at a later time.
Compounding techniques:

The most fundamental TVM formula takes into account the following variables:
FV = Future value of money
PV = Present value of money
i = interest rate
n = number of years
FV = PV x (1 + i)n
The term (1+i)n is called FVIF (Future Value Interest factor) whose values at different rates
for different time periods are provided in the FVIF Table.
For example, assume a sum of $10,000 is invested for one year at 10% interest. The future
value of that money is:

FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000

An Annuity is a stream of equal annual cash flows. Annuities involve calculations based upon
the regular periodic contribution or receipt of a fixed sum of money. Future Value of an
annuity is provided by the following formula:
Here, the annual amount is multiplied by the appropriate FVIFA (Future Value Interest factor
for Annuity), whose calculations are available in the FVIFA Table.

Present Value or discounting technique:

The concept of present value is the exact opposite of that of compound value. While in the
latter approach money invested now appreciates in value because compound interest is
added, in the former approach, money is received at some future date and will be worth less
because the corresponding interest is lost during the period. Present Value is the current
value of a future amount.

The formula for calculating the present value of a single sum is as follows:

PVIF (Present Value Interest Factor) is the multiplier used to calculate at a specified discount
rate the present value of an amount to be received in a future period. PVIF Tables give present
value of one rupee for various combinations of i and n.
Present Value of Annuity is calculated by the following formula:

PVIFA (Present Value Interest Factor for Annuity) is the multiplier to calculate the present
value of an annuity at a specified discount rate over a given period of time. PVIFA Table
provides annuity discount factor for Re. 1 for a wide range of i and n.

4.2 Capital Budgeting

The term “capital budgeting” is used to describe how managers plan significant outlays on
projects that have long-term implications such as the purchase of new equipment and the
introduction of new products. Managers must carefully select those projects that promise the
greatest future return. How well managers make these capital budgeting decisions is a critical
factor in the long run profitability of the company.

What types of business decisions require capital budgeting analysis?

Business decisions that require capital budgeting analysis are decisions that involve in outlay
now in order to obtain some return in the future. This return may be in the form of increased
revenue or reduced costs. Typical capital budgeting decisions include:

 Cost reduction decisions- Should new equipment be purchased to reduce costs?

 Expansion decisions- Should a new plan, warehouse, or other facility be acquired to
increase capacity and sales?
 Equipment selection decision- Which of several available machines should be the
most cost effective to purchase?
 Lease or buy decisions- Should new equipment be leased or purchased?
 Equipment replacement decisions- Should old equipment be replaced now or later?
In capital budgeting decisions, the focus is on cash flows and not on accounting net income.
The reason is that accounting net income is based on accruals that ignore the timing of cash
flows into and out of an organization. From a capital budgeting standpoint, the timing of cash
flows is important, since a dollar received today is more valuable than a dollar received in the
future. Therefore, even though accounting net income is useful for many things, it is not
ordinarily used in discounted cash flow analysis.
Typical cash out flows:

Most projects will have an immediate cash outflows in the form of an initial investment or
other assets. Any salvage value realized from the sale of the old equipment can be recognized
as a cash inflow or as a reduction in the required investment. In addition, some projects
require that a company expand its working capital. When a company takes on a new project,
the balances in the current assets will often increase. For example, opening a new
Nordstrom’s department store would require additional cash in sales registers, increased
accounts receivable for new customers, and more inventory to stock the shelves. These
additional working capital needs should be treated as part of the initial investment in a
project. Also, many projects require periodic outlays for repairs and maintenance and for
additional operating costs. These should all be treated as cash outflows for capital budgeting
purposes.

Typical cash inflows:

On the cash inflow side, a project will normally either increase revenues or reduce costs.
Either way, the amount involved should be treated as a cash inflow for capital budgeting
purposes. Notice that so far as cash flows are concerned, a reduction in costs is equivalent to
an increase in revenues. Cash inflows are also frequently realized from salvage of equipment
when a project ends, although the company may actually have to pay to dispose of some low
– value or hazardous items. In addition, any working capital that was tied up in the project
can be released for use elsewhere at the end of the project and should be treated as a cash
inflow at that time.
Capital Budgeting techniques
Payback Period
The payback period is the length of time that it takes for a project to recoup its initial cost out
of the cash receipts that it generates. This period is also referred to as “the time that it takes
for an investment to pay for itself.” The basic premise of the payback method is that the more
quickly the cost of an investment can be recovered, the more desirable is the investment. The
payback period is expressed in years. When the net annual cash inflow is the same every year,
the following formula can be used to calculate the payback period.

Payback period = Investment required / Net annual cash inflow*

*If new equipment is replacing old equipment, this becomes incremental net annual cash
inflow.
To illustrate the payback method, consider the following example:

York Company needs a new milling machine. The company is considering two machines.
Machine A and machine B. Machine A costs $15,000 and will reduce operating cost by $5,000
per year. Machine B costs only $12,000 but will also reduce operating costs by $5,000 per
year. Calculate payback period and determine which machine should be purchased.
Machine A payback period = $15,000 / $5,000 = 3.0 years
Machine B payback period = $12,000 / $5,000 = 2.4 years
According to payback calculations, York Company should purchase machine B, since it has
shorter payback period than machine A.
Evaluation of the payback period method:
The payback method is not a true measure of the profitability of an investment. Rather, it
simply tells the manager how many years will be required to recover the original investment.
Unfortunately, a shorter payback period does not always mean that one investment is more
desirable than another.
To illustrate, consider the two machines used in the example above. Since machine B has a
shorter payback period than machine A, it appears that machine B is more desirable than
machine A. But if we add one more piece of information, this illusion quickly disappears.
Machine A has a project 10-years life, and machine B has a projected 5 years life. It would
take two purchases of machine B to provide the same length of service as would be provided
by a single purchase of machine A. Under these circumstances, machine A would be a much
better investment than machine B, even though machine B has a shorter payback period.
Unfortunately, the payback method has no inherent mechanism for highlighting differences
in useful life between investments. Such differences can be very important, and relying on
payback alone may result in incorrect decisions.

Another criticism of payback method is that it does not consider the time value of money. A
cash inflow to be received several years in the future is weighed equally with a cash inflow to
be received right now. To illustrate, assume that for an investment of $8,000 you can
purchase either of the two following streams of cash inflows.
On the other hand, under certain conditions the payback method can be very useful. For one
thing, it can help identify which investment proposals are in the “ballpark.” That is, it can be
used as a screening tool to help answer the question, “Should I consider this proposal
further?” If a proposal does not provide a payback within some specified period, then there
may be no need to consider it further. In addition, the payback period is often of great
importance to new firms that are “cash poor.” When a firm is cash poor, a project with a short
payback period but a low rate of return might be preferred over another project with a high
rate of return but a long payback period. The reason is that the company may simply need a
faster return of its cash investment. And finally, the payback method is sometimes used in
industries where products become obsolete very rapidly – such as consumer electronics.
Since products may last only a year or two, the payback period on investments must be very
short.

4.3 Net Present Value (NPV)

Under the net present value method, the present value of a project’s cash inflows is
compared to the present value of the project’s cash outflows. The difference between the
present values of these cash flows is called “the net present value”. This net present value
determines whether or not the project is an acceptable investment.
A positive net present value indicates that the projected earnings generated by a project or
investment (in present dollars) exceeds the anticipated costs (also in present dollars).
Generally, an investment with a positive NPV will be a profitable one and one with a negative
NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which
dictates that the only investments that should be made are those with positive NPV values.
To illustrate, assume we are asked to use the NPV approach to choose between two projects,
and our company's weighted average cost of capital (WACC) is 8%. Project A costs $7 million
in upfront costs, and will generate $3 million in annual income starting three years from now
and continuing for a five-year period (i.e. years 3 to 7). Project B costs $2.5 million upfront
and $2 million in each of the next three years (years 1 to 3). It generates no annual income
but will be sold six years from now for a sales price of $16 million.
For each project, find NPV = (PV inflows) - (PV outflows).
Project A: The present value of the outflows is equal to the current cost of $7 million. The
inflows can be viewed as an annuity with the first payment in three years, or an ordinary
annuity at t = 2 since ordinary annuities always start the first cash flow one period away.
PV annuity factor for r = .08, N = 5: (1 - (1/ (1 + r)N)/r = (1 - (1/(1.08)5)/.08 = (1 -
(1/(1.469328)/.08 = (1 - (1/(1.469328)/.08 = (0.319417)/.08 = 3.99271
Multiplying by the annuity payment of $3 million, the value of the inflows at t = 2 is ($3
million)*(3.99271) = $11.978 million.
Discounting back two periods, PV inflows = ($11.978)/(1.08)2 = $10.269 million.
NPV (Project A) = ($10.269 million) - ($7 million) = $3.269 million
Project B: The inflow is the present value of a lump sum, the sales price in six years
discounted to the present: $16 million/(1.08)6 = $10.083 million.
Cash outflow is the sum of the upfront cost and the discounted costs from years 1 to 3. We
first solve for the costs in years 1 to 3, which fit the definition of an annuity.
PV annuity factor for r = .08, N = 3: (1 - (1/(1.08)3)/.08 = (1 - (1/(1.259712)/.08 =
(0.206168)/.08
= 2.577097. PV of the annuity = ($2 million)*(2.577097) = $5.154

million. PV of outflows = ($2.5 million) + ($5.154 million) = $7.654

million.

NPV of Project B = ($10.083 million) - ($7.654 million) = $2.429 million

Applying the NPV rule, we choose Project A, which has the larger NPV: $3.269 million versus
$2.429 million.
One primary issue with gauging an investment’s profitability with NPV is that NPV relies
heavily upon multiple assumptions and estimates, so there can be substantial room for error.
Estimated factors include investment costs, discount rate and projected returns. A project
may often require unforeseen expenditures to get off the ground or may require additional
expenditure at the project’s end.
Additionally, discount rates and cash inflow estimates may not inherently account for risk
associated with the project and may assume the maximum possible cash inflows over an
investment period. This may occur as a means of artificially increasing investor confidence. As
such, these factors may need to be adjusted to account for unexpected costs or losses or for
overly optimistic cash inflow projections.

4.4 Internal rate of Return (IRR)

The internal rate of return (IRR) is the rate of return promised by an investment project over
its useful life. It is some time referred to simply as “yield on project”. The internal rate of
return is computed by finding the discount rate that equates the present value of a project’s
cash out flow with the present value of its cash inflow In other words, the internal rate of
return is that discount rate that will cause the net present value of a project to be equal to
zero.
EXAMPLE:
A school is considering the purchase of a large tractor-pulled lawn mower. At present, the
lawn is moved using a small hand pushed gas mower. The large tractor-pulled mower will cost
$ 16,950 and will have a useful life of 10 years. It will have only a negligible scrap value, which
can be ignored. The tractor-pulled mower will do the job much more quickly than the old
mower and would result in a labour savings of $ 3,000 per year.
The simplest and most direct approach to compute the internal rate of return when the net
cash inflow is the same every year is to divide the investment in the project by the expected
net annual cash inflow. This computation will yield a factor from which the internal rate of
return can be determined.

The formula or equation is as follows:

[Factor of internal rate of return = Investment required / Net annual cash inflow] (1)

The factor derived from formula (1) is then located in the present value tables to see what
rate of return it represents. Using formula (1) and the data for school’s proposed project:
Investment required / Net annual cash inflow
= $16,950 / $3,000
= 5.650

Thus, the discount factor that will equate a series of $ 3,000 cash inflows with a present
investment of $16,950. Now we need to find this factor in the table to see what rate of return
it represents. If we scan along the 10-period line, we find that a factor of 5.650 represents a
12% rate of return. We can verify this by computing the project’s net present value using a
12% discount rate.
Notice that using a 12% discount rate equates the present value of the annual cash inflows
with the present value of the investment required in the project, leaving a zero net present
value. The 12% rate therefore represents the internal rate of return promised by the project.
Salvage value and other cash flows:

The technique just demonstrated works very well if a project’s cash flow s are identical every
year. But what if they are not? For example, what if a project will have some salvage value at
the end of its life in addition to the annual cash inflows? Under these circumstances, a trial
and error process may be used to find the rate of return that will equate the cash inflow with
the cash outflows. The trial and error process can be carried out by hand; however, computer
software programs such as spreadsheets can perform the necessary computations in
seconds. In short, erratic or uneven cash flows should not prevent a manager from
determining a project’s internal rate of return.
Once the internal rate of return has been computed it is compared to the company’s required
rate of return. The required rate of return is the minimum rate of return that an investment
project must yield to be acceptable. If the internal rate of return is equal to or greater than
the required rate of return, than the project is acceptable. If it is less than the required rate
of return, then the project is rejected. Quite often the company’s cost of capital is used as the
required rate of return. The reasoning is that if a project cannot provide a rate of return at
least as greater as the cost of the funds invested in it, then it is not profitable.
Cost of capital as a screening tool:

The cost of capital often operates as a screening device, helping the manager screen out
undesirable investment projects. This screening is accomplished in different ways, depending
on whether the company is using the internal rate of return method or the net present value
method in its capital budgeting analysis.

When the internal rate of return method is used, the cost of capital is used as the hurdle rate
that a project must clear for acceptance. If the internal rate of return of a project is not great
enough to clear the cost of capital hurdle, then the project is ordinarily rejected.

When the net present value method is used, the cost of capital is the discount rate used to
compute the net present value of a proposed project. Any project yielding a negative net
present value is rejected unless other factors are significant enough to require its acceptance.

4.5 NPV vs. IRR

Each of the two rules used for making capital-budgeting decisions has its strengths and
weaknesses. The NPV rule chooses a project in terms of net dollars or net financial impact on
the company, so it can be easier to use when allocating capital.
However, it requires an assumed discount rate, and also assumes that this percentage rate
will be stable over the life of the project, and that cash inflows can be reinvested at the same
discount rate. In the real world, those assumptions can break down, particularly in periods
when interest rates are fluctuating. The appeal of the IRR rule is that a discount rate need not
be assumed, as the worthiness of the investment is purely a function of the internal inflows
and outflows of that particular investment. However, IRR does not assess the financial impact
on a firm; it only requires meeting a minimum return rate.
All other things being equal, using internal rate of return (IRR) and net present value (NPV)
measurements to evaluate projects often results in the same findings. However, there are a
number of projects for which using IRR is not as effective as using NPV to discount cash flows.
IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate
every investment.
Although using one discount rate simplifies matters, there are a number of situations that
cause problems for IRR. Without modification, IRR does not account for changing discount
rates, so it's just not adequate for longer-term projects with discount rates that are expected
to vary. Another type of project for which a basic IRR calculation is ineffective is a project with
a mixture of multiple positive and negative cash flows. If market conditions change over the
years, such projects can have two or more IRRs. The advantage to using the NPV method here
is that NPV can handle multiple discount rates without any problems. Each cash flow can be
discounted separately from the others. Another situation that causes problems for users of
the IRR method is when the discount rate of a project is not known.

4.6 Discount rate

In general, a dollar today is worth more than a dollar tomorrow for two simple reasons. First,
a dollar today can be invested at a risk-free interest rate (think savings account or U.S.
government bonds), and can earn a return. A dollar tomorrow is worth less because it has
missed out on the interest you would have earned on that dollar had you invested it today.
Second, inflation diminishes the buying power of future money.
A discount rate is the rate you choose to discount the future value of your money. A discount
rate can be understood as the expected return from a project that matches the risk profile of
the project in which you'd invest your money.

Note: The discount rate is different than the opportunity cost of the money. Opportunity cost
is a measure of the opportunity lost. Discount rate is a measure of the risk. These are two
separate concepts.

4.7 Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model, or (CAPM) is a model used to calculate the expected return on
investment, also referred to as expected return on equity. It is a linear model with one
independent variable, Beta. Beta represents relative volatility of the given investment with
respect to the market. For example, if the Beta of an investment is I, the returns on the
investment (stock/bond/portfolio) vary identically with the market returns.
A Beta less than 1, like 0.5, means the investment is less volatile than the market. So if the
Dow Jones Industrial Average goes up or down 20 percent the next day, a less volatile stock
(i.e., Beta < 1) would be expected to go up or down 10 percent. A Beta of greater than 1, like
1.5, means the investment is more volatile than the market. A company in a volatile industry
(think Internet Company) would be expected to have a Beta greater than 1. A company whose
value does not vary much, like an electric utility, would be expected to have a Beta under 1.
Mathematically, CAPM is calculated as:
re = Discount rate for an all-equity firm
rf = Risk-free rate (The Treasury bill rate for the period the cash projections are being
considered. For example, if we are considering a 10-year period, then the risk-free rate
is the rate for the 10-year U.S. Treasury note.)
rm – rf = Excess market return ß =
Equity Beta
Types of risk
The systematic risk is a result of external and uncontrollable variables, which are not industry
or security specific and affects the entire market leading to the fluctuation in prices of all the
securities. Systematic risk cannot be eliminated by diversification of portfolio. It is divided into
three categories that are explained as under:

Interest risk: Risk caused by the fluctuation in the rate or interest from time to
time and affects interest-bearing securities like bonds and debentures.

Inflation risk: Alternatively known as purchasing power risk as it adversely

affects the purchasing power of an individual. Such risk arises due to a rise in the cost
of production, the rise in wages, etc.

Market risk: The risk influences the prices of a share, i.e. the prices will rise or
fall consistently over a period along with other shares of the market.
On the other hand, unsystematic risk refers to the risk which emerges out of controlled and
known variables that are industry or security specific. Diversification proves helpful in
avoiding unsystematic risk. It has been divided into two category business risk and financial
risk, explained as under:

Business risk: Risk inherent to the securities, is the company may or may not perform
well. The risk when a company performs below average is known as a business risk. There
are some factors that cause business risks like changes in government policies, the rise in
competition, change in consumer taste and preferences, development of substitute
products, technological changes, etc.

Valuation techniques overview

Discounted Cash Flow (DCF)
Discounted cash flow (DCF) analysis is a method of valuing the intrinsic value of a company
(or asset). In simple terms, discounted cash flow tries to work out the value today, based on
projections of all of the cash that it could make available to investors in the future. It is
described as "discounted" cash flow because of the principle of "time value of money" (i.e.
cash in the future is worth less than cash today).
The advantage of DCF analysis is that it produces the closest thing to an intrinsic stock value
- relative valuation metrics such as price-earnings (P/E) or EV/EBITDA ratios aren't very useful
if an entire sector or market is overvalued. In addition, the DCF method is forward-looking
and depends more on future expectations than historical results. The method is also based
on free cash flow (FCF), which is less subject to manipulation than some other figures and
ratios calculated out of the income statement or balance sheet.
The steps involved are as follows:
A. Estimate Cash flows

Free Cash Flow to the Firm (FCFF) is the cash available to bond holders and stock holders
after all expense and investments have taken place.

B. Estimate Growth Profile (1 stage, 2 stage, etc.) & Growth Rates

C. Calculate Discount Rate
D. Calculate the Terminal Value
E. Calculate fair value of company and its equity

Sum Of The Parts Analysis (SOTP)

Sum-of-the-parts ("SOTP") or "break-up" analysis provides a range of values for a company's
equity by summing the value of its individual business segments to arrive at the total
enterprise value (EV). Equity value is then calculated by deducting net debt and other non-
operating adjustments.
For a company with different business segments, each segment is valued using ranges of
trading and transaction multiples appropriate for that particular segment. Relevant multiples
used for valuation, depending on the individual segment's growth and profitability, may
include revenue, EBITDA, EBIT, and net income. A DCF analysis for certain segments may also
be a useful tool when forecasted segment results are available or estimable.
SOTP analysis is used to value a company with business segments in different industries that
have different valuation characteristics. Below are two situations in which a SOTP analysis
would be useful:
 Defending a company that is trading at a discount to the sum of its parts from a hostile
takeover

 Restructuring a company to unlock the value of a business segment that is not getting
credit for its value through a spin-off, split-off, tracking stock, or equity (IPO) carve-out

Asset Based Approach

An asset-based approach is a type of business valuation that focuses on a company's net asset
value (NAV), or the fair-market value of its total assets minus its total liabilities, to determine
what it would cost to recreate the business. Adjustments are made to the company’s
historical balance sheet in order to present each asset and liability item at its respective fair
market value. Examples of potential normalizing adjustments include:
 Adjusting fixed assets to their respective fair market values
 Reducing accounts receivable for potential uncollectable balances if an allowance for
doubtful accounts has not been established or if it is not sufficient to cover the potentially
uncollectable amount
 Reflecting any unrecorded liabilities such as potential legal settlements or judgments.

Consideration of the Adjusted Net Asset Method is typically most appropriate when:
 Valuing a holding company or a capital-intensive company
 Losses are continually generated by the business
 Valuation methodologies based on a company’s net income or cash flow levels indicate
a value lower than its adjusted net asset value

Comparable approach
There are two primary comparable approaches. Trading comparables is the most common
and looks at market comparables for a firm and its peers. Common market multiples include
the following: enterprise value to sales (EV/S), enterprise multiple, price to earnings (P/E),
price to book (P/B) and price to free cash flow (P/FCF). The specific ratio to be used depends
on the objective of the valuation. The valuation could be designed to estimate the value of
the operation of the business or the value of the equity of the business.
When calculating the value of the operation the most commonly used ratio is the EBITDA
multiple, which is the ratio of EBITDA (Earnings Before Interest Taxes Depreciation and
Amortization) to the Enterprise Value (equity value plus Net Debt). When valuing the equity
of a company, the most widely used multiple is the Price Earnings Ratio (PE) of stocks in a
similar industry, which is the ratio of Stock price to Earnings per Share of any public company.
The second comparables approach; transaction comparables, looks at market transactions
where similar firms, or at least similar divisions, have been bought out or acquired by other
rivals, private equity firms or other classes of large, deep-pocketed investors. Using this
approach, an investor can get a feel for the value of the equity being valued. Combined with
using market statistics to compare a firm to key rivals, multiples can be estimated to come to
a reasonable estimate of the value for a firm.
It can be difficult to find truly comparable companies and transactions to value an equity.
Additionally, using trailing and forward multiples can make a big difference in an analysis. If a
firm is growing rapidly, a historical valuation will not be overly accurate. What matters most
in valuation is making a reasonable estimate of future market multiples. If profits are
projected to grow faster than rivals, the value should be higher.

Mutual funds

A mutual fund is an investment vehicle made up of a pool of funds collected from many
investors for the purpose of investing in securities such as stocks, bonds, money market
instruments and similar assets. Mutual funds are operated by money managers, who invest
the fund's capital and attempt to produce capital gains and income for the fund's investors.
A mutual fund's portfolio is structured and maintained to match the investment objectives
stated in its prospectus. They give small investors access to professionally managed,
diversified portfolios of equities, bonds and other securities.
Investors typically earn a return from a mutual fund in three ways:
 Income is earned from dividends on stocks and interest on bonds held in the fund’s
portfolio.
A fund pays out nearly all of the income it receives over the year to fund owners in the
form of a distribution. Funds often give investors a choice either to receive a check for
distributions or to reinvest the earnings and get more shares
 If the fund sells securities that have increased in price, the fund has a capital gain. Most
funds also pass on these gains to investors in a distribution.
 If fund holdings increase in price but are not sold by the fund manager, the fund's
shares increase in price. The investor can then sell mutual fund shares for a profit in the
market.
Advantages of mutual funds:
 Professional Management – The primary advantage of funds is not having to
pick stocks and manage investments. Instead, a professional investment manager
takes care of all of this using careful research and skilful trading.
 Diversification- By owning shares in a mutual fund instead of owning
individual stocks or bonds, investor’s risk is spread out across many different
holdings.
  Economies of Scale – Because a mutual fund buys and sells large amounts of
securities at a time, its transaction costs are lower than what an individual would pay
for securities transactions.

 Variety- Mutual funds today exist with any number of various asset classes or
strategies. This allows investors to gain exposure to not only stocks and bonds but also
commodities, foreign assets, and real estate through specialized mutual funds.

Disadvantages of mutual funds:

 Active Management- Actively managed funds incur higher fees, but increasingly passive
index funds have gained popularity. These funds track an index such as the S&P 500 and
are much less costly to hold.
 Costs and fees- Since fees vary widely from fund to fund, failing to pay attention to the
fees can have negative long-term consequences. Actively managed funds incur
transaction costs that accumulate over each year.
 Dilution- Because mutual funds can have small holdings in many different companies, high
returns from a few investments often don't make much difference on the overall return.
Dilution is also the result of a successful fund growing too big.

Hedge funds

Hedge funds are alternative investments using pooled funds that employ numerous different
strategies to earn active return, or alpha, for their investors. Hedge funds may be aggressively
managed or make use of derivatives and leverage in both domestic and international markets
with the goal of generating high returns. It is important to note that hedge funds are generally
only accessible to accredited investors as they require less SEC regulations than other funds.

One aspect that has set the hedge fund industry apart is the fact that hedge funds face less
regulation than mutual funds and other investment vehicles.
Investors in hedge funds have to meet certain net worth requirements to invest in them - net
worth exceeding $1 million excluding their primary residence. Instead of charging an expense
ratio only, hedge funds charge both an expense ratio and a performance fee. This fee
structure is known as "Two and Twenty"—a 2% asset management fee and then a 20% cut of
any gains generated.
Exchange Traded Funds (ETFs)

An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity,
bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a
common stock on a stock exchange. ETFs experience price changes throughout the day as
they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual
fund shares, making them an attractive alternative for individual investors. Because it trades
like a stock, an ETF does not have its net asset value (NAV) calculated once at the end of every
day like a mutual fund does.
An ETF is a type of fund which owns the underlying assets (shares of stock, bonds, oil futures,
gold bars, foreign currency, etc.) and divides ownership of those assets into shares. The actual
investment vehicle structure (such as a corporation or investment trust) will vary by country,
and within one country there can be multiple structures that co-exist. Shareholders do not
directly own or have any direct claim to the underlying investments in the fund; rather they
indirectly own these assets. ETF shareholders are entitled to a proportion of the profits, such
as earned interest or dividends paid, and they may get a residual value in case the fund is
liquidated. The ownership of the fund can easily be bought, sold or transferred in much the
same was as shares of stock, since ETF shares are traded on public stock exchanges.

By owning an ETF, investors get the diversification of an index fund as well as the ability to
sell short, buy on margin and purchase as little as one share (there are no minimum deposit
requirements). Another advantage is that the expense ratios for most ETFs are lower than
those of the average mutual fund. When buying and selling ETFs, you have to pay the same
commission to your broker that you'd pay on any regular order.

Differences between FII and FDI

 Both 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.
 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.
 While 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.

5 Capital Markets and Financial Instruments

 1. Equity

Equity or Stock is a share in the ownership of a company, a claim on the company's assets
and earnings. As one acquires more stock, one’s ownership stake in the company becomes
greater. Stockholders are entitled to a share of the company's earnings as well as any voting
rights attached. Shareholder are entitled to a portion of the company's profits and have a
claim on assets. Profits are sometimes paid out in the form of dividends. And there is no
obligation to pay out dividends even for those firms that have traditionally given them.
Without dividends, an investor can make money on a stock only through its appreciation in
the open market. A shareholder’s claim on assets is only relevant if a company goes bankrupt
i.e. they have a residual claim over the assets.

There are two main types of stocks: common stock and preferred stock.

Common Stock: When people talk about stocks they are usually referring to this
type. In fact, the majority of stock is issued is in this form. Common shares represent
ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote
per share to elect the board members, who oversee the major decisions made by
management. Over the long term, common stock, by means of capital growth, yields higher
returns than almost every other investment. This higher return comes at a cost since common
stocks entail the most risk. If a company goes bankrupt and liquidates, the common
shareholders will not receive money until the creditors, bondholders and preferred
shareholders are paid.

Preferred Stock: Preferred stock represents some degree of ownership in a

company but usually doesn't come with the same voting rights. (This may vary depending on
the company.) With preferred shares, investors are usually guaranteed a fixed dividend
forever. This is different than common stock, which has variable dividends that are never
guaranteed. Another advantage is that in the event of liquidation, preferred shareholders are
paid off before the common shareholder (but still after debt holders). Preferred stock may
also be callable, meaning that the company has the option to purchase the shares from
shareholders at any time for any reason (usually for a premium). Some people consider
preferred stock to be more like debt than equity. A good way to think of these kinds of shares
is to see them as being in between bonds and common shares.

How do Stock Price Change

Stock prices change every day as a result of market forces. By this we mean that share prices
change because of supply and demand. If more people want to buy a stock (demand) than
sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock
than buy it, there would be greater supply than demand, and the price would fall.

Understanding supply and demand is easy. What is difficult to comprehend is what makes
people like a particular stock and dislike another stock. This comes down to figuring out what
news is positive for a company and what news is negative. The principal theory is that the
price movement of a stock indicates what investors feel a company is worth. Don't equate a
company's value with the stock price. The value of a company is its market capitalization,
which is the stock price multiplied by the number of shares outstanding.
For example, a company that trades at Rs 100 per share and has 1 million shares outstanding
has a lesser value than a company that trades at Rs 50 that has 5 million shares outstanding
(Rs 100 x 1 million = Rs 100 million while Rs 50 x 5 million = Rs 250 million). To further
complicate things, the price of a stock doesn't only reflect a company's current value, it also
reflects the growth that investors expect in the future.

The important things to grasp about this subject are the following:
At the most fundamental level, supply and demand in the market determines
stock price
Price times the number of shares outstanding (market capitalization) is the value
of a company. Comparing just the share price of two companies is meaningless
Theoretically, earnings are what affect investors' valuation of a company, but
there are other indicators that investors use to predict stock price. Remember, it is investors'
sentiments, attitudes and expectations that ultimately affect stock prices
There are many theories that try to explain the way stock prices move the way
they do.
Unfortunately, there is no one theory that can explain everything .

Equity Markets

A bull market is when everything in the economy is great, people are finding jobs, Gross
Domestic Product (GDP) is growing, and stocks are rising. Picking stocks during a bull market
is easier because everything is going up. Bull markets cannot last forever though, and
sometimes they can lead to dangerous situations if stocks become overvalued. If a person is
optimistic and believes that stocks will go up, he or she is called a "bull" and is said to have a
"bullish outlook".

A bear market is when the economy is bad, recession is looming and stock prices are falling.
Bear markets make it tough for investors to pick profitable stocks. One solution to this is to
make money when stocks are falling using a technique called short selling. Another strategy
is to wait on the sidelines until you feel that the bear market is nearing its end, only starting
to buy in anticipation of a bull market. If a person is pessimistic, believing that stocks are going
to drop, he or she is called a "bear" and said to have a "bearish outlook".

Active and passive investing

Active investing, as its name implies, takes a hands-on approach and requires that someone
act in the role of portfolio manager. The goal of active money management is to beat the
stock market’s average returns and take full advantage of short-term price fluctuations. It
involves a much deeper analysis and the expertise to know when to pivot into or out of a
particular stock, bond or any asset.
Advantages to active investing:

Flexibility – Active managers aren't required to follow a specific index. They can buy those
"diamond in the rough" stocks they believe they've found.

Hedging – Active managers can also hedge their bets using various techniques such as short
sales or put options, and they're able to exit specific stocks or sectors when the risks become
too big.

Tax management – Even though this strategy could trigger a capital gains tax, advisors can
tailor tax management strategies to individual investors, such as by selling investments that
are losing money to offset the taxes on the big winners.
But active strategies have these shortcomings:

Very expensive –Thomson Reuters Lipper pegs the average expense ratio at 1.4% for an
actively managed equity fund, compared to only 0.6% for the average passive equity fund. All
those fees over decades of investing can kill returns.

Active risk – Active managers are free to buy any investment they think would bring high
returns, which is great when the analysts are right but terrible when they're wrong.

Passive investors limit the amount of buying and selling within their portfolios, making this a
very cost-effective way to invest. The strategy requires a buy and hold mentality. That means
resisting the temptation to react or anticipate the stock market’s every next move. The prime
example of a passive approach is to buy an index fund that follows one of the major indices
like the S&P 500 or Dow Jones. Whenever these indices switch up their constituents, the index
funds that follow them automatically switch up their holdings by selling the stock that’s
leaving and buying the stock that’s becoming part of the index.

Some of the key benefits of passive investing are:

Ultra-low fees – There's nobody picking stocks, so oversight is much less expensive. Passive
funds simply follow the index they use as their benchmark.

Transparency – It's always clear which assets are in an index fund.

Tax efficiency – Their buy and hold strategy doesn't typically result in a massive capital gains
tax for the year.

Proponents of active investing would say that passive strategies have these weaknesses:
Too limited – Passive funds are limited to a specific index or predetermined set of investments
with little to no variance; thus, investors are locked into those holdings, no matter what
happens in the market.

Small returns – By definition, passive funds will pretty much never beat the market, even
during times of turmoil, as their core holdings are locked in to track the market.

Technical and fundamental analysis

Technical analysis involves looking at charts and patterns associated with a stock's historical
price movements to try to profit from predictable patterns, regardless of fundamentals such
as revenue growth or expense trends. While many on Wall Street look down upon technical
analysis (and it is rarely taught at business schools), some Wall Street traders still rely on it or
use it in conjunction with fundamental analysis to decide whether and when to buy and sell.

In contrast, fundamental analysis of a stock (or other security) involves using financial analysis
to analyse the company's underlying business, such as sales growth, its balance sheet, etc. (its
"fundamentals") to decide whether and when to buy and sell.

Indicators to pick a stock

P E ratio= Market price per share/Earnings per share

This ratio is used to know if the stock price is overvalued or undervalued. High ratio
indicates that the stock is expensive. This is generally used to compare companies in the
same industry. Dividend yield= Dividend/Share price

This is a financial ratio that indicates how much the shareholders are paid in the form of
dividend
for a specific amount invested.
EPS- Earnings per share= (Profit-dividend on preferred stock)/No of shares outstanding

Earnings per share is a measurement of company’s profit per outstanding share. EBIT - EPS
analysis is considered very important to determine the firm’s capital structure that maximises
earnings per share over the expected range of earnings before interest and tax.
Valuation of shares
Zero growth model

The zero-growth model assumes that the dividend always stays the same, the stock price
would be equal to the annual dividends divided by the required rate of return. This is basically
the same formula used to calculate the value of a perpetuity, which is a bond that never
matures, and can be used to price preferred stock, which pays a dividend that is a specified
percentage of its par value. A stock based on the zero-growth model can still change in price
if the capitalization rate changes.
 Gordon model

The constant-growth DDM (aka Gordon Growth model) assumes that dividends grow by a
specific percentage each year, and is usually denoted as g, and the capitalization rate is
denoted by k. The constant-growth model is often used to value stocks of mature
companies that have increased the dividend steadily over the years. Although the annual
increase is not always the same, the constant-growth model can be used to approximate an
intrinsic value of the stock using the average of the dividend growth and projecting that
average to future dividend increases.

Note that if both the capitalization rate and dividend growth rate remains the same every
year, then the denominator doesn't change, so the stock's intrinsic value will increase
annually by the percentage of the dividend increase. In other words, both the stock price and
the dividend amount will increase by the constant-growth factor, g.

Multi stage growth model

Variable-growth rate models (aka multi-stage growth models) can take many forms, even
assuming the growth rate is different for every year. However, the most common form is one
that assumes 2 different rates of growth: an initial high rate of growth and a sustainable,
steady rate of growth. Basically, the constant-growth rate model is extended, with each phase
of growth calculated using the constant-growth method, but using 2 different growth rates of
the 2 phrases. The present values of each stage are added together to derive the intrinsic
value of the stock. Sometimes, even the capitalization rate, or the required rate of return,
may be varied if changes in the rate are projected.
Minority interest

A minority interest, which is also referred to as non-controlling interest (NCI), is ownership of

less than 50% of a company's equity by an investor or another company. Minority interest
shows up as a noncurrent liability on the balance sheet of companies with a majority interest
in a company, representing the proportion of its subsidiaries owned by minority
shareholders.
Dividends

Dividends are paid to many shareholders of common stock (and preferred stock). However,
the directors cannot pay any dividends to the common stock shareholders until they have
paid all outstanding dividends to the preferred stockholders. The incentive for company
directors to issue dividends is that companies in industries that are particularly dividend
sensitive have better market valuations if they regularly issue dividends. Issuing regular
dividends is a signal to the market that the company is doing well.

Stock splits

As a company grows in value, it sometimes splits its stock so that the price does not become
absurdly high. This enables the company to maintain the liquidity of the stock. If The Coca-
Cola Company had never split its stock, the price of one share bought when the company's
stock was first offered would be worth millions of dollars. If that were the case, buying and
selling one share would be a very crucial decision. This would adversely affect a stock's
liquidity (that is, its ability to be freely traded on the market). In theory, splitting the stock
neither creates nor destroys value. However, splitting the stock is generally received as a
positive signal to the market; therefore, the share price typically rises when a stock split is
announced.

Stock buybacks

Often when a company has announced that it will buy back its own stock, it is usually followed
by an increase in the stock price. The reason behind the price increase is fairly complex, and
involves three major reasons.

The first has to do with the influence of earnings per share on market valuation. Many
investors believe that if a company buys back shares, and the number of outstanding shares
decreases, the company's earnings per share goes up. If the P/E (price to earnings-per-share
ratio) stays stable, investors reason, the price should go up. Thus investors drive the stock
price up in anticipation of increased earnings per share.
The second reason has to do with the signalling effect. This reason is simple to understand,
and largely explains why a company buys back stock. No one understands the health of the
company better than its senior managers. No one is in a better position to judge what will
happen to the future performance of the company. So if a company decides to buy back stock
(i.e., decides to invest in its own stock), these managers must believe that the stock price is
undervalued and will rise. This is the signal company management sends to the market, and
the market pushes the stock up in anticipation.

The third reason the stock price goes up after a buyback can be understood in terms of the
debt tax shield (a concept used in valuation methods). When a company buys back stock, its
net debt goes up (net debt = debt - cash). Thus the debt tax shield associated with the
company goes up and the valuation rises.

Basic and diluted EPS

Earnings per share (EPS) and diluted EPS are profitability measures used in fundamental
analysis of companies. EPS only takes into account a company's common shares, whereas
diluted EPS take into account all convertible securities.

EPS measures the amount of a company's profit on a per share basis. Unlike diluted EPS, basic
EPS does not take into account any dilutive effects that convertible securities have on its EPS.
The formula to calculate a company's basic EPS is its net income less any preferred dividends
divided by the weighted average number of common shares outstanding.
Conversely, diluted EPS is a metric used in fundamental analysis to gauge a company's quality
of earnings per share, assuming all convertible securities are exercised. Convertible securities
includes all outstanding convertible preferred shares, convertible debt, equity options,
mainly employee-based options, and warrants.

The formula used to calculate a company's diluted EPS is a company's net income less
preferred dividends divided by the weighted average number of shares outstanding plus
impact of convertible preferred shares, impact of options, warrants and other dilutive
securities. Generally, if a company has convertible securities, the diluted EPS is less than its
basic EPS.

2. Debt

Bonds - A debt investment in which an investor loans money to an entity (corporate or

governmental) that borrows the funds for a defined period of time at a fixed interest rate.
Features of Bonds –
 Principal - Nominal, principal, par or face amount — the amount on which the issuer
pays interest, and which, most commonly, has to be repaid at the end of the term. Some
structured bonds can have a redemption amount which is different from the face amount and
can be linked to performance of particular assets such as a stock or commodity index, foreign
exchange rate or a fund. This can result in an investor receiving less or more than his original
investment at maturity.
Maturity - The issuer has to repay the nominal amount on the Maturity date. The
maturity can be any length of time, some bonds have been issued with maturities of up to
one hundred years, and some do not mature at all. In the market for U.S. Treasury securities,
there are three groups of bond maturities:
Bills - debt securities maturing in less than one year. Notes - debt
securities maturing in one to 10 years. Bonds - debt securities
maturing in more than 10 years.
Coupon - The coupon is the interest rate that the issuer pays to the bond holders.
Usually this rate is fixed throughout the life of the bond. It can also vary with a money market
index, such as LIBOR, or it can be even more exotic.
Types of Coupon –
1. Fixed rate bond- It is a type of debt instrument bond with a fixed coupon
(interest) rate, payable at specified dates before bond maturity.

2. Zero coupon bond- Zero coupon bonds are bonds that do not pay interest
during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount
from their face value, which is the amount a bond will be worth when it "matures" or becomes
due. When a zero coupon bond matures, the investor will receive one lump sum equal to the
initial investment plus the imputed interest.

3. Floating rate notes (FRNs) - FRNs are a medium-term instrument similar in

structure to straight bonds but for the interest base and interest rate calculations. The coupon
rate is reset at specified regular intervals, normally 3 months, 6 months, or one year. The
coupon comprises a money market rate (e.g. The London Interbank Offered Rate for 6-month
deposits, or LIBOR) plus a margin, which reflects the creditworthiness of the issuer. FRNs
usually carry a prepayment option for the issuer. Issuers like FRNs because they combine the
lower pricing of a bank loan and larger maturities than the straight bond market. Investors
are attracted to FRNs because the periodic resetting of the coupon offers the strongest
protection of capital. Reverse Floating Rate -A bond or other debt security with a variable
coupon rate that changes in inverse proportion to some benchmark rate. For example, an
inverse floating- rate note may be linked to LIBOR; as the LIBOR decreases, the coupon rate
increases and vice versa. An inverse floating-rate note allows a bondholder to benefit from
declining interest rates. It is also called an inverse floater.

Types of Bonds

1. Government Bonds (Treasuries) - Treasuries are different from all other types of
bonds, because they are issued by the government, and are therefore considered stable in
value and virtually free of credit risk. For this reason, the yields of all other types of bonds are
compared to the yield on a treasury bond with the same maturity.

2. Agency Bonds (Agencies) - Agency bonds are bonds issued by institutions that were
originally created by the US Government to perform important functions such as fostering
home ownership, and providing student loans. The primary government agencies are Fannie
Mae, Freddie Mac, Ginnie Mae and Sallie Mae. While these agencies technically operate in a
similar manner to a corporation, they are thought to be implicitly backed by the US
government.

3. Municipal Bonds (Munis) – State and local governments often borrow money by
issuing bonds, similar to the US Government, but on a smaller scale. Municipal bonds fund a
wide variety of projects and government functions ranging from police and fire departments
to bridges and toll roads. Municipal bonds are popular among individual investors because
they provide tax advantages that other types of bonds do not.

4. Corporate Bonds (Corporates) - And last but certainly not least are corporations, who
often choose the bond market as a way of raising capital to fund improvement in their
businesses. A corporation can issue bonds for many reasons, including paying dividends to
shareholders, purchasing another company, funding an operating loss, or expansion.

5. High-yield bonds (junk bonds) are bonds that are rated below investment grade by
the credit rating agencies. As these bonds are more risky than investment grade bonds,
investors expect to earn a higher yield.

6. Convertible bonds let a bondholder exchange a bond to a number of shares of the

issuer's common stock. These are known as hybrid securities, because they combine equity
and debt features.

7. Inflation-indexed bonds (linkers) (US) or Index-linked bond (UK), in which the

principal amount and the interest payments are indexed to inflation.

8. Asset-backed securities are bonds whose interest and principal payments are backed
by underlying cash flows from other assets. Examples of asset-backed securities are
mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and
collateralized debt obligations (CDOs).

Yield to Maturity

The yield to maturity (YTM), book yield or redemption yield of a bond or other fixed-interest
security, such as gilts, is the internal rate of return (IRR, overall interest rate) earned by an
investor who buys the bond today at the market price, assuming that the bond will be held
until maturity, and that all coupon and principal payments will be made on schedule. Yield to
maturity is the discount rate at which the sum of all future cash flows from the bond (coupons
and principal) is equal to the price of the bond. As some bonds have different characteristics,
there are some variants of YTM:
Yield to call (YTC): when a bond is callable (can be repurchased by the issuer before the
maturity), the market looks also to the Yield to call, which is the same calculation of the YTM,
but assumes that the bond will be called, so the cash flow is shortened.
Yield to put (YTP): same as yield to call, but when the bond holder has the option to sell the
bond back to the issuer at a fixed price on specified date.

Coupon Rate vs. YTM

If a bond's coupon rate is less than its YTM, then the bond is selling at a discount
If a bond's coupon rate is more than its YTM, then the bond is selling at a premium
If a bond's coupon rate is equal to its YTM, then the bond is selling at par

Pricing of debentures/bonds

The price of a bond is the net present value of all future cash flows expected from that
bond. The bond price depends on the interest rate. If the interest rate is higher, the bond
price is lower and vice versa.

Here:
r = Discount rate
t= Interval (for example, 6 months)
T = Total payments

Relation between Price, yields and prevailing interest rates

Bond price and yield are inversely related. That is, if a bond's price rises, it's yield falls, and
vice versa. Simply put, current yield = interest paid annually / market price * 100%.

When inflation does up, interest rates rise. And when interest rates rise, bond prices fall.
Therefore, when inflation goes up, bond prices fall.

In general, a positive economic event (such as a decrease in unemployment, greater

consumer confidence, higher personal income, etc.) drives up inflation over the long term
(because there are more people working, there is more money to be spent), which drives up
interest rates, which causes a decrease in bond prices.

The following table summarizes this relationship with a variety of economic events:
 Capital Markets
Primary Markets

A primary market issues new securities on an exchange for companies, governments and
other groups to obtain financing through debt-based or equity-based securities. Primary
markets are facilitated by underwriting groups consisting of investment banks that set a
beginning price range for a given security and oversee its sale to investors. Once the initial
sale is complete, further trading is conducted on the secondary market, where the bulk of
exchange trading occurs each day.

Companies and government entities sell new issues of common and preferred stock,
corporate bonds, and government bonds, notes, and bills on the primary market to fund
business improvements or expand operations. Although an investment bank may set the
securities' initial price and receive a fee for facilitating sales, most of the funding goes to the
issuer. Investors typically pay less for securities on the primary market than on the secondary
market.

Public Offer

An Initial Public Offering (IPO) is the first time that the stock of a private company is offered
to the public. IPOs are often issued by smaller, younger companies seeking capital to expand,
but they can also be done by large privately owned companies looking to become publicly
traded. In an IPO, the issuer obtains the assistance of an underwriting firm, which helps
determine what type of security to issue, the best offering price, the amount of shares to be
issued and the time to bring it to market.

A Follow-on Public Offer (FPO) is an issuing of shares to investors by a public company that is
already listed on an exchange. An FPO is essentially a stock issue of supplementary shares
made by a company that is already publicly listed and has gone through the IPO process. FPOs
are popular methods for companies to raise additional equity capital in the capital markets
through a stock issue.
There are two main types of follow-on public offers. The first type is dilutive to investors, as
the company’s Board of Directors agrees to increase the share float level. This type of follow-
on public offering seeks to raise money to pay debt or expand the business. This increases the
number of shares outstanding.

The other type of follow-on public offer is non-dilutive. This approach is used when directors
or large shareholders sell privately held shares. This is non-dilutive, as no additional shares
are sold. This method is commonly referred to as a secondary market offering. There is no
benefit to this method for the company or current shareholders.

Private Placement

A private placement is the sale of securities to a relatively small number of select investors as
a way of raising capital. Investors involved in private placements are usually large banks,
mutual funds, insurance companies and pension funds. A private placement is different from
a public issue, in which securities are made available for sale on the open market to any type
of investor. A formal prospectus is not necessary for a private placement, and the participants
in a private placement are usually large, sophisticated investors such as investment banks,
investment funds and insurance companies.

Secondary markets

A market where investors purchase securities or assets from other investors, rather than from
issuing companies themselves. The national exchanges - such as the Bombay Stock Exchange
and the National Stock Exchange are secondary markets. Diverse roles played by stock
exchanges include, generation of initial capital required for starting a business, channelizing
savings for further investment, facilitating growth of a company, redistributing funds of the
company and creating investment opportunities for small investors.

A newly issued IPO will be considered a primary market trade when the shares are first
purchased by investors directly from the underwriting investment bank; after that any shares
traded will be on the secondary market, between investors themselves. In the primary market
prices are often set beforehand, whereas in the secondary market only basic forces like supply
and demand determine the price of the security. Most stocks are traded on exchanges, which
are places where buyers and sellers meet and decide on a price. Some exchanges are physical
locations where transactions are carried out on a trading floor. The other type of exchange is
virtual, composed of a network of computers where trades are made electronically.

A private investor needs to use a stock broker to buy and sell shares on the Stock market.
There are three types of services offered by a stockbroker:

Discretionary services
This gives the broker or investment manager complete authority to buy and sell shares for
you without obtaining your prior approval. This will be in the context of a carefully-designed
brief, a clear framework for your portfolio manager to use when making transactions on your
behalf. The advantage is that your manager can therefore act instantly on changes in the
market, rather than spending valuable time trying to contact you. You will receive a contract
note every time a transaction is made and detailed reports will be sent to you regularly.

Advisory services

Instead of managing the portfolio without consulting you, your investment manager will
suggest courses of action which you may or may not choose to take. As well as verbal or
written advice, you may receive regular newsletters which review the market. A second kind
of advisory service gives you access to this advice, but still allows you to control your own
portfolio and manage your own bargains. Essentially you simply call your professional and ask
whether he or she shares your view on whether you should buy or sell a particular share.

Execution only

Execution only services are generally the cheapest as they do not require advice or
management - you simply tell your stockbroker to buy and sell shares for you. Because of the
increasing knowledge of investors and the wider access to these services the use of execution
only stockbrokers has increased dramatically over recent years. Most execution only brokers
allow trading over the telephone or over the internet.

Over-The-Counter (OTC)

A security traded in some context other than on a formal exchange such as the NYSE, TSX,
AMEX, etc. The phrase "Over-The-Counter" can be used to refer to stocks that trade via a
dealer network as opposed to on a centralized exchange. It also refers to debt securities and
other financial instruments such as derivatives, which are traded through a dealer network.

Over-The-Counter (OTC) or off-exchange trading is done directly between two parties,

without any supervision of an exchange. It is contrasted with exchange trading, which occurs
via exchanges. A stock exchange has the benefit of facilitating liquidity, mitigates all credit
risk concerning the default of one party in the transaction, provides transparency, and
maintains the current market price. In an OTC trade, the price is not necessarily published for
the public.

OTC trading, as well as exchange trading, occurs with commodities, financial instruments
(including stocks), and derivatives of such. Products traded on the exchange must be well
standardized. This means that exchanged deliverables match a narrow range of quantity,
quality, and identity which is defined by the exchange and identical to all transactions of that
product. This is necessary for there to be transparency in trading. The OTC market does not
have this limitation. In general, the reason for which a stock is traded over-the-counter is
usually because the company is small, making it unable to meet exchange listing
requirements. Also known as "unlisted stock", these securities are traded by broker-dealers
who negotiate directly with one another over computer networks and by phone.
GDR, ADR, IDR

A Global Depositary Receipt (GDR) is a bank certificate issued in more than one country for
shares in a foreign company. The shares are held by a foreign branch of an international bank.
The shares trade as domestic shares but are offered for sale globally through the various bank
branches. A GDR is a financial instrument used by private markets to raise capital
denominated in either U.S. dollars or euros. GDRs may be traded in multiple markets,
generally referred to as capital markets, as they are considered to be negotiable certificates.
Capital markets are used to facilitate the trade of long-term debt instruments, primarily for
the purpose of generating capital. GDR transactions in the international market tend to have
lower associated costs than some other mechanisms that can be used to trade in foreign
securities.

Introduced to the financial markets in 1927, an American Depositary Receipt (ADR) is a stock
that trades in the United States but represents a specified number of shares in a foreign
corporation. ADRs are bought and sold on American markets just like regular stocks, and are
issued/sponsored in the U.S. by a bank or brokerage. ADRs were introduced as a result of the
complexities involved in buying shares in foreign countries and the difficulties associated with
trading at different prices and currency values. For this reason, U.S. banks simply purchase a
bulk lot of shares from the company, bundle the shares into groups, and reissues them on
either the New York Stock Exchange (NYSE), American Stock Exchange (AMEX) or the Nasdaq.
In return, the foreign company must provide detailed financial information to the sponsor
bank. The depositary bank sets the ratio of U.S. ADRs per home-country share. This ratio can
be anything less than or greater than 1. This is done because the banks wish to price an ADR
high enough to show substantial value, yet low enough to make it affordable for individual
investors.

Indian Depository Receipt (IDR) is a financial instrument denominated in Indian Rupees in the
form of a depository receipt. The IDR is a specific Indian version of the similar global
depository receipts. It is created by a Domestic Depository (custodian of securities
registered with the Securities and Exchange Board of India) against the underlying equity
of issuing company to enable foreign companies to raise funds from the Indian securities
Markets. The foreign company IDRs will deposit shares to an Indian depository. The
depository would issue receipts to investors in India against these shares. The benefit of
the underlying shares (like bonus, dividends etc.) would accrue to the depository receipt
holders in India.

Market Participants

Issuer: Any corporate or government entity that issues a fixed income security is termed as
an issuer. While selecting a debt instrument, the investor should primarily consider the
 stability of the issuer, since this assures repayment of the principal. In the Indian context,
instruments issued by the Central or State governments are far more stable than those
issued by any corporate. E.g. - RBI

Investor: The investor in the market is one who buys the debt that is being issued in the
market. They basically include every group or organization as well as any type of investor,
including the individual. Governments play one of the largest roles in the market because
they borrow and lend money to other governments and banks.

Intermediaries: There are two types of transactions in the market:

Direct transactions between wholesale market participants. This does not include any
intermediary; and Broker intermediated transactions i.e. where brokers undertake
dealings for banks, institutions or other entities.

An intermediary is an entity that acts as the middleman between two parties in a financial
transaction. While a commercial bank is a typical financial intermediary, this category
also includes other financial institutions such as investment banks, insurance companies,
broker-dealers, mutual funds and pension fund.

Regulators: The debt market is regulated by either central bank or government exchange
board. The issue & trade of securities in India are regulated by either RBI or SEBI.
Government securities and bonds, instruments issued by banks and financial institutions
are regulated by RBI while issues of non-government securities (i.e. issue by corporates)
are regulated by SEBI.

Credit rating agency: A credit rating agency is a company that assigns credit ratings, which
rate a debtor's ability to pay back debt by making timely interest payments and the
likelihood of default. An agency may rate the creditworthiness of issuers of debt
obligations, of debt instruments, and in some cases, of the servicers of the underlying
debt, but not of individual consumers. The debt instruments rated by CRAs include
government bonds, corporate bonds, CDs, municipal bonds, preferred stock, and
collateralized securities, such as mortgage-backed securities and collateralized debt
obligations.

A credit rating facilitates the trading of securities on a secondary market. It affects the interest
rate that a security pays out, with higher ratings leading to lower interest rates. Individual
consumers are rated for creditworthiness not by credit rating agencies but by credit
bureaus (also called consumer reporting agencies or credit reference agencies), which
issue credit scores.
 Debt Instruments
o Government Securities

A Government Security is a bond (or debt obligation) issued by a government authority, with
a promise of repayment upon maturity that is backed by said government. A government
security may be issued by the government itself or by one of the government agencies.
These securities are considered low-risk, since they are backed by the taxing power of
the government. Government securities are usually used to raise funds that pay for the
government's various expenses, including those related to infrastructure development
projects.

Such securities are short term (usually called treasury bills, with original maturities of less
than one year) or long term (usually called Government bonds or dated securities with
original maturity of one year or more). In India, the Central Government issues both,
treasury bills and bonds or dated securities while the State Governments issue only bonds
or dated securities, which are called the State Development Loans (SDLs). Government
securities carry practically no risk of default and, hence, are called risk-free gilt-edged
instruments. Government of India also issues savings instruments (Savings Bonds,
National Saving Certificates (NSCs), etc.) or special securities (oil bonds, Food Corporation
of India bonds, fertiliser bonds, power bonds, etc.). They are, usually not fully tradable
and are, therefore, not eligible to be SLR securities.

1. Treasury bills: Treasury bills or T-bills, which are money market instruments, are short
term debt instruments issued by the Government of India and are presently issued in
three tenors, namely, 91 day, 182 day and 364 day. Treasury bills are zero coupon
securities and pay no interest. They are issued at a discount and redeemed at the face
value at maturity. For example, a 91 day Treasury bill of Rs.100/-(face value) may be
issued at say Rs. 98.20, that is, at a discount of say, Rs.1.80 and would be redeemed at
the face value of Rs.100/-. The return to the investors is the difference between the
maturity value or the face value and the issue price. The Reserve Bank of India conducts
auctions usually every Wednesday to issue T-bills. Payments for the T-bills purchased are
made on the following Friday. The Reserve Bank releases an annual calendar of T-bill
issuances for a financial year in the last week of March of the previous financial year. The
Reserve Bank of India announces the issue details of T-bills through a press release every
week.

2. Cash Management Bills (CMBs): Government of India, in consultation with the Reserve
Bank of India, has decided to issue a new short-term instrument, known as Cash
Management Bills (CMBs), to meet the temporary mismatches in the cash flow of the
Government. The CMBs have the generic character of T-bills but are issued for maturities
less than 91 days. Like T-bills, they are also issued at a discount and redeemed at face
value at maturity. The tenure, notified amount and date of issue of the CMBs depends
upon the temporary cash requirement of the Government. The announcement of their
auction is made by Reserve Bank of India through a Press Release which will be issued
one day prior to the date of auction. The settlement of the auction is on T+1 basis. The
 non-competitive bidding scheme has not been extended to the CMBs. However, these
instruments are tradable and qualify for ready forward facility. Investment in CMBs is also
reckoned as an eligible investment in Government securities by banks for SLR purpose.
First set of CMBs were issued on May 12, 2010.

3. State Development Loans (SDLs): State Governments also raise loans from the market.
SDLs are dated securities issued through an auction similar to the auctions conducted for
dated securities issued by the Central Government (see question 3 below). Interest is
serviced at half-yearly intervals and the principal is repaid on the maturity date. Like
dated securities issued by the Central Government, SDLs issued by the State
Governments qualify for SLR. They are also eligible as collaterals for borrowing through
market repo as well as borrowing by eligible entities from the RBI under the Liquidity
Adjustment Facility (LAF).

4. Commercial Mortgage Backed Securities (CMBS): They are a type of mortgage-backed

security backed by commercial mortgages rather than residential real estate. CMBS tend
to be more complex and volatile than residential mortgage-backed securities due to the
unique nature of the underlying property assets.

A commercial mortgage-backed security (CMBS) is a type of fixed-income security that is

collateralized by commercial real estate loans. In essence, CMBS are created when a bank
takes a group of loans on its books, bundles them together, and sells them in securitized
form as a series of bonds. Each series will typically be organized in "tranches" from the
senior - or highest-rated, lowest-risk issue - to the highest-risk, lowest-rated issue. The
senior issue is first in line to receive principal and interest payments, while the most
junior issues will be the first to take a loss if a borrower defaults. Investors choose which
issue they invest in based on their desired yield and capacity for risk.

This process of loan securitization is useful in many ways: it enables banks to make more
loans, it provides institutional investors with a higher-yielding alternative to government
bonds, and it makes it easier for commercial borrowers to gain access to funds.

The risk of individual issues can vary based on the strength of the property market in the
specific area where the loans were originated, as well as by the date of issuance. For
instance, commercial mortgage-backed securities issued during a market peak or a time
in which underwriting standards were more relaxed would be seen as having higher risk.
CMBS can also be negatively affected by weakness in the real estate market, which was
the case during 2009. CMBS lending dried up in the wake of the financial crisis of 2008,
but it gradually came back as market conditions improved. Post-crisis CMBS tend to be
larger and characterized by more stringent underwriting standards.

5. Dated Government securities: Dated Government securities are long term securities and
carry a fixed or floating coupon (interest rate) which is paid on the face value, payable at
fixed time periods (usually half-yearly). The tenor of dated securities can be up to 30
years. The Public Debt Office (PDO) of the RBI acts as the registry/ depository of
 government securities and deals with the issue, interest payment and repayment of
principal at maturity. The details of all the dated securities issued by the Government of
India are available on the RBI website at
http://www.rbi.org.in/Scripts/financialmarketswatch.aspx. Just as in the case of Treasury
Bills, dated securities of both, Government of India and State Governments, are issued
by Reserve Bank through auctions. The Reserve Bank announces the auctions a week in
advance through press releases. Government Security auctions are also announced
through advertisements in major dailies.
Instruments:

Fixed Rate Bonds – These are bonds on which the coupon rate is fixed for the entire life
of the bond. Most Government bonds are issued as fixed rate bonds.

Floating Rate Bonds – Floating Rate Bonds are securities which do not have a fixed coupon
rate. The coupon is re-set at pre-announced intervals (say, every six months or one year)
by adding a spread over a base rate. In the case of most floating rate bonds issued by the
Government of India so far, the base rate is the weighted average cut-off yield of the last
three 364- day Treasury Bill auctions preceding the coupon re-set date and the spread is
decided through the auction.

Zero Coupon Bonds – Zero coupon bonds are bonds with no coupon payments. Like
Treasury Bills, they are issued at a discount to the face value. The Government of India
issued such securities in the nineties, it has not issued zero coupon bond after that.

Capital Indexed Bonds – These are bonds, the principal of which is linked to an accepted
index of inflation with a view to protecting the holder from inflation. The government is
currently working on a fresh issuance of Inflation Indexed Bonds wherein payment of
both, the coupon and the principal on the bonds, will be linked to an Inflation Index
(Wholesale Price Index). In the proposed structure, the principal will be indexed and the
coupon will be calculated on the indexed principal. In order to provide the holders
protection against actual inflation, the final WPI will be used for indexation.

Bonds with Call/ Put Options – Bonds can also be issued with features of optionality
wherein the issuer can have the option to buy-back (call option) or the investor can have
the option to sell the bond (put option) to the issuer during the currency of the bond.

Special Securities - In addition to Treasury Bills and dated securities issued by the
Government of India under the market borrowing programme, the Government of India
also issues, from time to time, special securities to entities like Oil Marketing Companies,
Fertilizer Companies, the FoodCorporation of India, etc. as compensation to these
companies in lieu of cash subsidies. These securities are usually long dated securities
carrying coupon with a spread of about 20-25 basis points over the yield of the dated
securities of comparable maturity. These securities are, however, not eligible SLR
securities but are eligible as collateral for market repo transactions. The beneficiary oil
marketing companies may divest these securities in the secondary market to banks,
insurance companies / Primary Dealers, etc., for raising cash.

Steps are being taken to introduce new types of instruments like STRIPS (Separate Trading of
Registered Interest and Principal of Securities). Accordingly, guidelines for stripping and
reconstitution of Government securities have been issued. STRIPS are instruments
wherein each cash flow of the fixed coupon security is converted into a separate tradable
 Zero Coupon Bond and traded. For example, when Rs.100 of the 8.24%GS2018 is
stripped, each cash flow of coupon (Rs.4.12 each half year) will become coupon STRIP
and the principal payment (Rs.100 at maturity) will become a principal STRIP. These cash
flows are traded separately as independent securities in the secondary market. STRIPS in
Government securities will ensure availability of sovereign zero coupon bonds, which will
facilitate the development of a market determined zero coupon yield curve (ZCYC).
STRIPS will also provide institutional investors with an additional instrument for their
asset- liability management. Further, as STRIPS have zero reinvestment risk, being zero
coupon bonds, they can be attractive to retail/non-institutional investors. The process of
stripping/reconstitution of Government securities is carried out at RBI, Public Debt Office
(PDO) in the PDO-NDS (Negotiated Dealing System) at the option of the holder at any
time from the date of issuance of a Government security till its maturity. Minimum
amount of securities that needs to be submitted for stripping/reconstitution will be Rs. 1
crore (Face Value) and multiples thereof.

o Corporate Debt Instruments

1. Certificate of Deposit: A certificate of deposit is a promissory note issued by a bank. It is

a time deposit that restricts holders from withdrawing funds on demand. Although it is
still possible to withdraw the money, this action will often incur a penalty. CDs are
generally issued by commercial banks. The term of a CD generally ranges from one month
to five years.

2. Inter- Corporate Deposits: Inter-company deposit is the deposit made by a company

that has surplus funds, to another company for a maximum of 6 months. It is a source
of short-term financing. Such deposits are of three types:

Call Deposit: Such a type of deposit is withdrawn by the lender by giving a notice of one
day. However, in practice, a lender has to wait for at least 3 days.

Three-month Deposit: As the name suggests, such type of a deposit provides funds for
three months to meet up short-term cash inadequacy
Six-month Deposit: The lending company provides funds to another company for
a period of six months

Advantages of Inter-company deposits:

Surplus funds can be effectively utilized by the lender company

Such deposits are secured in nature
Inter-corporate deposits can be easily procured
Disadvantages of Inter-company Deposits: A company cannot lend more than 10 per cent of
its net worth to a single company and cannot lend beyond 30 per cent of its net worth
in total
 The market for such source of financing is not structure

3. Call Money: Call money is short-term finance repayable on demand, with a maturity
period of one to fifteen days, used for inter-bank transactions. The money that is lent for
one day in this market is known as "call money" and, if it exceeds one day, is referred to
as "notice money." Commercial banks have to maintain a minimum cash balance known
as the cash reserve ratio. The Reserve Bank of India changes the cash ratio from time to
time.

Call money is a method by which banks lend to each other to be able to maintain the
cash reserve ratio. The interest rate paid on call money is known as the call rate. It is a
highly volatile rate that varies from day to day and sometimes even from hour to hour.
There is an inverse relationship between call rates and other short-term money market
instruments such as certificates of deposit and commercial paper. A rise in call money
rates makes other sources of finance, such as commercial paper and certificates of
deposit, cheaper in comparison for banks to raise funds from these sources.

4. CBLO: It was in the year 2002-03 that the RBI first time came up with the term CBLO
(Collateralized Borrowing & Lending Obligation). Similar to Repo, an organization with
surplus funds can lend out its money in the market to other organizations in need of funds
with collateral in place. While call money market caters to the need of banks and primary
dealers, CBLO lends out to mutual funds, insurance & financial companies etc. in addition
to primary dealers and banks mostly. The only difference is that CBLO involves collateral.
Interested parties are required to open Constituent SGL (CSGL) Account with Clearing
Corporation of India Limited (CCIL) for depositing securities as collateral.

Types of CBLO:

 CBLO Normal Market: It facilitates borrowing and lending by members on an

online basis
 CBLO Auction Market: It facilitates borrowing and lending by members through
submission of bids and offers
Features:

 This RBI approved Money Market instrument is backed by Gilts as collateral

 It creates an obligation to repay the borrowed money along with interest on a fixed
date. Also it provides a right to the lender to receive money lent with interest on a
fixed future date

 CBLO is tradable and CCIL acts counterparty to transaction

 It is traded on screen that provides right amount of anonymity to a trade for counter
parties
  CBLO membership is usually extended to REPO eligible entities as per the guidelines
laid down by the RBI. CBLO Membership is granted to Negotiated Dealing System
(NDS) Members and non NDS MembersCapital structure

Refers to the percentage of capital (money) at work in a business by type or the

composition of debt and equity capital that comprise a firm’s financing its assets. The
capital structure decision affects financial risk and, hence, the value of the company.

Equity Capital: Refers to money put up and owned by the shareholders (owners). Typically,
equity capital consists of two types:

• Contributed capital: Money that was originally invested in the business in exchange for
shares of stock or ownership
• Retained earnings: Represents accumulated profits from past years

Debt Capital: Refers to borrowed money that is at work in the business. Different types of
debt capital include short term bonds, long term bonds, commercial paper, etc.

Optimal Capital Structure

The best debt-to-equity ratio for a firm that maximizes its value. The optimal capital structure
for a company is one which offers a balance between the ideal debt-to-equity range and
minimizes the firm's cost of capital. The optimal capital structure of a company cannot
be determined as it depends on the following:

• The business risk of the company

• The tax situation of the company
• The degree to which the company’s assets are tangible
• The company’s corporate governance
• The transparency of the financial information

Debt vs. Equity

Advantages to equity financing:

 Less risky than a loan as it doesn’t have to be paid back

 Investors take a long-term view, and most don't expect a return on their investment
immediately

Disadvantages to equity financing:

 It may require returns that could be higher than the rates of interest on bank loans
 Investors may interfere in big (or even routine) decision making
  In the case of irreconcilable disagreements with investors, may need to cash in
portion of the business and allow the investors to run the company

Advantages to debt financing:

 The bank or lending institution has no ownership in the business
 The business relationship ends once the money is paid back
 The interest on the loan is tax deductible
 Loans can be short term or long term
 Principal and interest are known figures you can plan in a budget

Disadvantages to debt financing:

 Money must paid back within a fixed amount of time
 May have trouble paying back loan in case of problems with cash flow
 Too much debt is seen as “high risk” by potential investors which may limit ability to
raise capital by equity financing in the future
 Assets of the business can be held as collateral to the lender. And the owner of the
company is often required to personally guarantee repayment of the loan

Derivatives

A derivative is an instrument whose value is derived from the value of one or more
underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks
indices, etc. The various types of derivatives are described below:

Forwards

A forward contract is a customized contract between two parties, where settlement

takes place on a specific date in future at a price agreed today. The main features of
forward contracts are

They are bilateral contracts and hence exposed to counter-party risk

Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality
The contract price is generally not available in public domain
The contract has to be settled by delivery of the asset on expiration date

In case the party wishes to reverse the contract, it has to compulsorily go to the same
counter party, which being in a monopoly situation can command the price it wants
Futures

Futures are exchange-traded contracts to sell or buy financial instruments or physical

commodities for a future delivery at an agreed price. There is an agreement to buy or
sell a specified quantity of financial instrument commodity in a designated future
month at a price agreed upon by the buyer and seller. To make trading possible, BSE
specifies certain standardized features of the contract.

A margin in the futures market is the amount of cash an investor must put up to open
an account to start trading. This cash amount is the initial margin requirement. It acts as
a down payment on the underlying asset and helps ensure that both parties fulfil their
obligations. Both buyers and sellers must put up payments.

Initial Margin- This is the initial amount of cash that must be deposited in the account
to start trading contracts. It acts as a down payment for the delivery of the contract and
ensures that the parties honour their obligations.

Maintenance Margin- This is the balance a trader must maintain in his or her account as
the balance changes due to price fluctuations. It is some fraction - perhaps 75% - of
initial margin for a position. If the balance in the trader's account drops below this
margin, the trader is required to deposit enough funds or securities to bring the account
back up to the initial margin requirement. Such a demand is referred to as a margin call.

Options

Options are basically the financial instruments that give the buyers the right to buy or
sell the underlying security within a point of time in the future for a price, which is fixed
at the time when the option is bought. The stock option buyers are called the holders
and sellers are called writers in option trading terminology.

The call in option trading gives the owner of option a right but not an obligation to buy
an underlying security within the specified time while the put gives the owner a right
but not the obligation to sell the underlying asset within the specified time at a pre-
fixed price.

The value of a stock option contract is determined by five factors – the strike price,
price of the stock, the expiration date, the cumulative cost that is required to hold a
position in the stock and the estimated future volatility of the stock price. The strike
price is referred to the price for which an option stock can be bought or sold. For calls,
the stock price must go above the strike price while for puts the stock price should be
below the strike price.
Swaps

Swap is a derivative where the two parties agree to exchange one stream of cash flow
with another while the streams are called the legs of the swap. The two commonly used
swaps are INTEREST RATE SWAPS and CURRENCY SWAPS. Interest rate swaps entail
swapping only the interest between the parties and currency swaps entail swapping
both the principal and interest between the parties.

Efficient market hypothesis

In the early 1960s, Nobel Prize winning economist Eugene Fama put forth the theory of
efficient markets, which continues to garner acceptance throughout the field of finance.

Fundamental to Fama’s theory are inherently efficient markets, rational expectations

and security prices reflecting all available information. The logic behind this is
characterized by a random walk, where all subsequent price changes reflect a random
departure from previous prices. According to the EMH, stocks always trade at their fair
value on stock exchanges, making it impossible for investors to either purchase
undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to
outperform the overall market through expert stock selection or market timing, and the
only way an investor can possibly obtain higher returns is by purchasing riskier
investments.

Strong form efficiency is where all information, public, personal and confidential, is
reflected in share prices. Therefore investors are unable to achieve a competitive
advantage and deters insider trading. This degree of market efficiency implies that
above average return cannot be achieved regardless of an investor’s access to
information.

To a lesser degree, semi-strong efficiency proposes that share prices are a reflection of
publicly available information. Since market prices already reflect public information,
investors are unable to gain abnormal returns.

In its last degree, weak form efficiency claims all previous stock prices are a reflection of
today’s price. Therefore, technical analysis is not a practical tool to predict future price
movements.

If all the assumptions about efficient markets had held, then the housing bubble and
subsequent crash would not have occurred. Yet, efficiency failed to explain market
anomalies, including speculative bubbles and excess volatility. As the housing bubble
reached its peak and investors continued to pour funds into subprime mortgages,
irrational behaviour began to precede the markets. Contrary to rational expectations,
investors acted irrationally in favour of potential arbitrage opportunities. Yet an
efficient market would have automatically adjusted asset prices to rational levels.

Besides its failure to address financial downturns, the theory itself has often been
contested. In theory, each individual is able to access and analyse information at the
 same pace. However, with the growing number of information channels, including
social media and the internet, even the most involved investors are unable to monitor
every piece of information. With that being said, investment decisions tend to be
influenced more so by emotions rather than rationality.

Regulators, Clearing Corporation and Depositories RBI – Reserve Banks of India:

Reserve Bank of India is the apex monetary Institution of India. It was established on
April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934.
Though originally privately owned, since nationalization in 1949, the Reserve Bank is
fully owned by the Government of India. RBI is the financial regulator of all the financial
institutions like public sector banks, private sector banks, RRBs, Cooperative banks and
all type of NBFCs etc. RBI is the banker to the banks and banker to the government of
India. It decides the policy rates which influence the growth and inflation in the country.

SEBI – Securities and Exchange Board of India:

Apart from RBI, SEBI also forms a major part under the financial body of India. It is a
regulator associated with the security markets in Indian Territory. Established in the
year 1988, the SEBI Act came into power in the year 1992, 12th April. There are three
groups, which fall under its supervision; investors, the security issuers and market
intermediaries. It directs the capital market and money market to work in the interest
of general public. SEBI also regulates the foreign investments in Indian firms and
businesses.

IRDA- Insurance Regulatory and Development Authority

The Insurance Regulatory and Development Authority (IRDA) is a national agency of the
Government of India and is based in Hyderabad (Andhra Pradesh). It was formed by an
Act of Indian Parliament known as IRDA Act 1999, which was amended in 2002 to
incorporate some emerging requirements. Mission of IRDA as stated in the act is "to
protect the interests of the policyholders, to regulate, promote and ensure orderly
growth of the insurance industry and for matters connected therewith or incidental
thereto."

CCIL- Clearing Corporation of India

The Clearing Corporation of India Ltd. (CCIL) was set up in April, 2001 to provide
guaranteed clearing and settlement functions for transactions in Money, G-Secs,
Foreign Exchange and Derivative markets. The introduction of guaranteed clearing and
settlement led to significant improvement in the market efficiency, transparency,
liquidity and risk management/measurement practices in these market along with
added benefits like reduced settlement and operational risk, savings on settlement
costs, etc. CCIL also provides non-guaranteed settlement for Rupee interest rate
derivatives and cross currency transactions through the CLS Bank.
FIMMDA- Fixed Income Money Market and Derivatives

The Fixed Income Money Market and Derivatives Association of India (FIMMDA), an
association of Scheduled Commercial Banks, Public Financial Institutions, Primary
Dealers and
Insurance Companies was incorporated as a Company under section 25 of the
Companies Act, 1956 on June 3rd, 1998. FIMMDA is a voluntary market body for the
bond, money and derivatives markets. FIMMDA has members representing all major
institutional segments of the market. The membership includes Nationalized Banks such
as State Bank of India, its associate banks and other nationalized banks; Private sector
banks, Foreign Banks, Financial institutions, Insurance Companies and all Primary
Dealers.

NSDL- National Securities Depositories Ltd

NSDL, the first and largest depository in India was established in August 1996. Using
innovative and flexible technology systems, NSDL works to support the investors and
brokers in the capital market of the country. NSDL aims at ensuring the safety and
soundness of Indian marketplaces by developing settlement solutions that increase
efficiency, minimise risk and reduce costs. In the depository system, securities are held
in depository accounts, which is more or less similar to holding funds in bank accounts.
Transfer of ownership of securities is done through simple account transfers. This
method does away with all the risks and hassles normally associated with paperwork.
Consequently, the cost of transacting in a depository environment is considerably lower
as compared to transacting in certificates.

CDSL- Central Depository Services Ltd.

CDSL was initially promoted by BSE Ltd. which has thereafter divested its stake to leading
banks as "Sponsors" of CDSL. CDSL was set up with the objective of providing convenient,
dependable and secure depository services at affordable cost to all market participants.
CDSL facilitates holding of securities in electronic form and enables security transactions, off
market transfer and pledge through book entry. It also offers other online services such as
e-voting, e-locker etc. All leading stock exchanges like the BSE Ltd, National Stock Exchange
and Metropolitan Stock Exchange of India have established connectivity with CDSL.

Currencies

These three factors - interest rates, inflation, and the principle of capital market
equilibrium - govern the valuation of various currencies. Because the U.S. dollar is
generally considered the world's most stable currency, it is the widely accepted basis
for foreign exchange valuation. Other currencies that are considered stable are the
Japanese yen and the Euro. The relative movements of these currencies, as well as
others, are monitored daily.
Influence of inflation on Foreign exchange

If the inflation in the foreign country goes up relative to the home currency, the foreign
currency devalues or weakens relative to the home currency.

Influence of interest rates on foreign exchange

The higher interest rates that can be earned tend to attract foreign investment,
increasing the demand for and value of the country's currency. Conversely, lower
interest rates tend to be unattractive for foreign investment and decrease the
currency's relative value. When interest rates in a country rise, investments held in that
country's currency (for example, bank deposits, bonds, CDs, etc.) will earn a higher rate
of return. Therefore, when a country's interest rates rise, money and investments will
tend to flow to that country, diving up the value of its currency. (The reverse is true
when a country's interest rates fall).

Effect of exchange rates on interest rates and inflation

A weak dollar means that the prices of imported goods will rise when measured in U.S.
dollars (i.e., it will take more dollars to buy the same good). When the prices of
imported goods rise, this contributes to higher inflation, which also raises interest rates.
Conversely, a strong dollar means that the prices of imported goods will fall, which will
lower inflation (which will lower interest rates). The following table summarizes the
relationship between interest rates, inflation, and exchange rates:

Fixed and floating exchange rate mechanisms

An exchange rate is the rate at which one currency can be exchanged for another. In
other words, it is the value of another country's currency compared to that of another.
There are two ways the price of a currency can be determined against another. A fixed,
or pegged, rate is a rate the government (central bank) sets and maintains as the official
exchange rate. A set price will be determined against a major world currency (usually
the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of
currencies). In order to maintain the local exchange rate, the central bank buys and sells
its own currency on the foreign exchange market in return for the currency to which it
is pegged.

If, for example, it is determined that the value of a single unit of local currency is equal
to US$3, the central bank will have to ensure that it can supply the market with those
dollars. In order to maintain the rate, the central bank must keep a high level of foreign
reserves. This ensures an appropriate money supply, appropriate fluctuations in the
market (inflation/deflation) and ultimately, the exchange rate. The central bank can also
adjust the official exchange rate when necessary.

The reasons to peg a currency are linked to stability. Especially in today's developing
nations, a country may decide to peg its currency to create a stable atmosphere for
foreign investment. With a peg, the investor will always know what his or her
investment's value is, and therefore will not have to worry about daily fluctuations. A
pegged currency can also help to lower inflation rates and generate demand, which
results from greater confidence in the stability of the currency. Fixed regimes, however,
can often lead to severe financial crises, since a peg is difficult to maintain in the long
run. This was seen in the Mexican (1995), Asian (1997) and Russian (1997) financial
crises: an attempt to maintain a high value of the local currency to the peg resulted in
the currencies eventually becoming overvalued.

Unlike the fixed rate, a floating exchange rate is determined by the private market
through supply and demand. A floating rate is often termed "self-correcting," as any
differences in supply and demand will automatically be corrected in the market. Look at
this simplified model: if demand for a currency is low, its value will decrease, thus
making imported goods more expensive and stimulating demand for local goods and
services. This in turn will generate more jobs, causing an auto-correction in the market.
A floating exchange rate is constantly changing. In a floating regime, the central bank
may also intervene when it is necessary to ensure stability and to avoid inflation.
However, it is less often that the central bank of a floating regime will interfere.