CFM - Unit 5 Investment Decision

CORPORATE FINANCIAL MANAGEMENT (Fin. Ele.
UNIT 5: INVESTMENT DECISION
Top 9 Methods of Investment of

Surplus Funds | Working Capital
The following points highlight the top nine methods of

investment of surplus funds.
1. Treasury Bills:
The treasury bills are issued by RBI on behalf of the Central
Government. Earlier they were issued on the basis of tenders floated
regularly but now are available on tap system, i.e., on rates announced
by RBI every week. These bills are issued only in bearer form. Name of
the purchaser is not mentioned on the bills, rather they are easily
transferable from one investor to another.
No interest is paid on the bills but the return is the difference between
the purchase price and face (par) value of the bill. Since there is a
backing of the Central Government, these are risk free securities. A
very active secondary market exists for these bills so it has made them
highly liquid. Treasury bills are one of the popular marketable
securities even though the yield on them may be low.
2. Negotiable Certificates of Deposit (CD’s):

The money is deposited in a bank for a fixed period of time and
marketable receipt is issued. The receipt may be registered or bearer,
the latter facilitates transactions in the secondary market. The
denominations and maturity periods are decided as per the needs of
the investor.
On maturity the amount deposited and interests are paid. The CD’s
are different from the treasury bills which are issued on discount. The
short-term surplus funds can be used to earn interest in this method.
The investment is secure unless the bank fails, the chances of which
are remote.
3. Unit 1964 Scheme:

The Unit Trust of India’s unit 1964 scheme is very popular for making
short-term investments. It is an open ended scheme which allows
investors to withdraw their funds on a continuing basis. The units
have a face value of Rs10. The purchase and sale value of units is not
based on net assets value but it is determined administratively in such
a manner that they rise gradually over time.
The unit scheme offers a good avenue for investing short-

term funds and has the following advantages:
(i) The dividend income from unit received by companies is treated as
inter-corporate dividend, it qualifies for tax exemption up to 80 per
cent under Sec. 80M of the Income Tax Act. Many Companies
purchase cum-dividend units in May, collect dividend in July and then
sell the units.
(ii) The yield can be increased by a careful synchronizing of the

purchase and sale of units because the capital loss on sale of units
would qualify for a tax set-off, of which 80 per cent of the dividend
income would be tax free.
(iii) There is an active secondary- market for units, there will be no

liquidity problem.
4. Ready Forwards:
A commercial bank or some other organisation may enter into a ready
forward deal with a company willing to invest funds for a short period
of time. Under this system the bank sells and repurchases the same
security (that means that company purchases and sells securities in
turn) at predetermined prices.
The difference between the purchase and sale price is the income of
the company. Ready forwards are generally done in units, public
sector bonds or government securities. Ready forward deals are linked
with the position of the money market. The investor can hope to earn
more if money market is tight during busy season and at closing of the
year.
5. Badla Financing:
Badla financing is used in stock exchange transactions when a broker
wants to carry forward his transactions from one settlement period to
another. Badla financing is done through operators in stock exchange.
It is the financing of transactions of a broker who wants to carry
forward this deal to the other settlement period. The badla rates are
decided on the day of settlement.
Badla transaction is financed on the security of shares purchased

whose settlement is to be carried forward. Sometime this financing
facility may be extended for a particular share only. For example, a
company may provide badla finance to a broker X 10 crores for
purchasing ACC shares in forward market. Badla rates vary with
demand and supply position of funds.
Badla financing offers attractive interest rates. However, it becomes

risky if the broker defaults in his commitment. Even the wide
fluctuation in prices of shares may also affect the value of security.
An investor in this type of financing should be careful about

following things:
(i) The selection of a broker should be on the basis of reputation.
(ii) The shares with a sound intrinsic value should be selected.

(iii) The margin should be adequate.
(iv) The possession of securities should be taken.
6. Inter-Corporate Deposits:
These are short term deposits with other companies which attract a
good rate of return.
Inter-corporate deposits are of three types:

(i) Call Deposits:
It is a deposit which a lender can withdraw on one day’s notice. In
practice it takes three days to get this money. The rate of interest at
present is 14 per cent on these deposits.
(ii) Three Months Deposits:

These deposits are popular and are used by borrowers to tide over
short- term inadequacy of funds. The interest rate on such deposits is
influenced by bank overdraft interest rate and at present the
borrowing rate is 22 per cent per annum.
(iii) Six-month Deposits:

The lenders may not have surplus funds for a very long period. Six-
month period is normally the maximum which lenders may prefer.
The current interest rate on these deposits is 24 per cent per annum.
Since inter-corporate deposits are unsecured loans, the

creditworthiness of the borrower should be ascertained. Section 370
of the Company’s Act has placed certain restriction on inter-company
deposits, so these provisions should be adhered to, these provisions
are:
(a) A company cannot lend more than 10 per cent of its net worth
(equity plus free reserves) to any single company.
(b) The total lending of a company cannot exceed 30 per cent of its net
worth without the prior approval of the central government and a
special resolution should permit such a lending.
7. Bill Discounting:
A bill arises out of credit sales. The buyer will accept a bill drawn on
him by the seller. In order to raise funds the seller may get the bill
discounted with his bank. The bank will charge discount and release
the balance amount to the drawer. These bills normally do not exceed
90 days.
A company may also discount the bills as a bank does thus using its
surplus funds. The bill discounting is considered superior to inter-
corporate deposits.
The company should ensure that the discounted bills are:

(a) Trade bills (resulting from a trade transaction) and not
accommodation bills (helping each other),
(b) The bills backed by the letter of credit of a bank will be most secure
as these are guaranteed by the drawee’s bank.
8. Investment in Marketable Securities:

A firm has to maintain a reasonable balance of cash. This is necessary
because there is no perfect balancing of inflows and outflows of cash.
Sometimes more cash is received than required for quick payments.
Instead of keeping the surplus cash as idle, the firm tries to invest it in
marketable securities.
It will bring some income to the business. The cash surpluses will be
available during slack seasons and will be required when demand
picks up again. The investment of this cash in securities needs a
prudent and cautious approach. The selection of securities for
investment should be carefully made so that the amount is raised
quickly on demand.
In choosing among alternative securities, the firm should examine

three basic features of a security: safety, maturity and marketability.
The security element deals with the absence of any type of risk. The
securities with risk may give higher returns but these should be
avoided. There should not be any default in payment when the
securities are redeemed. The maturity periods will give higher returns.
The short- period securities will carry lower rates of interest but these
should be preferred. The surplus cash can be invested only for smaller
periods because the amount may be required for meeting operating
cash needs in the short periods.
The securities should have a ready market. These investments can be

made only in near cash securities. If the securities selected are such
which require some time for realisation then there may be payment
problems. So, the securities should have a ready market and may be
realizable in a very short period.
9. Money Market Mutual Funds (MMMF):

‘Money market mutual fund’ means a scheme of a mutual fund which
has been set up with the objective of investing exclusively in money
market instruments. These instruments include treasury bills, dated
Government securities with an expired maturity of upto one year, call
and notice money, commercial paper, commercial bills accepted by
banks and certificates of deposits.
Till recently, only commercial banks and public financial institutions

were allowed to set up MMMFs. But in November 1995, the
Government has permitted private sector mutual funds also to set up
money market mutual fund. MMMFs are wholesale markets for low
risk, high liquidity and short-term securities. The main feature of this
fund is the access to persons of small savings.
Centralization and Decentralization of

Cash Management
Centralization concentrates decisions into the hands of top

management. It is what we currently have to deal with when it comes
to our money. Our money, their rules? Most likely you have your
money in a bank. Banks are centralized, because they have
concentrated power, from top to bottom. People have been
conditioned to trust third-parties with their money and identity. We
open a bank account without any level of fear or understanding of what
we are really doing. We just trust it. We hand over our entire identity
and cash in trust that these third-parties will take care of it and not let
it leak to thieves (including governments). One central single entity to
tell me what I can or cannot do with my money, charging me horror
fees to transact this money. How did they convince us of this? For the
past 300 years it seemed to be a great solution as to the safety and
security of our finances, but things are changing, decentralization has
happened, not that it is a new thing it goes back hundreds of years, but
it is now growing unstoppably because…well… it makes sense. We do
not desire to drive you to put banks in the enemy category, no enemies,
just growth & different times, so instead we would like to have you
question and seek for transparency and understanding of why you
have made the choices you have made. Is it because you have been
conditioned to do it or do you know exactly where you are putting your
money? Why do we trust third-parties? Why have we decided that it
would be safer to put everyone’s cash into the hands of “one”?
Decentralized
As in opposed to centralized. Here you have: Spread power. No

concentration of power, consensus-based decisions.
A transfer of authority from central to local government.
Move departments of a large organization away from a single

administrative center to other locations, usually granting them some
degree of autonomy.
It is my money, I say how, when, to whom or to where I want to send

it, not out of rebellion or because it is the right thing.
Financing Short/Medium Term Cash Deficits
In cash and liquidity management the primary objective is always to minimise the cash deficits
that need financing. And when there are cash deficits, to minimise the overall cost of the
financing without placing unmanageable constraints on the company's liquidity or flexibility,
and without providing excessive security or collateral to the lender.
To minimise the overall cost of borrowing the corporate treasurer first needs to estimate the cash
deficits by amount location, duration and currency using comprehensive information on the
company's cash balances and forecast cash requirements. All financing decisions need be based
on the possible sources of finance, their current and forecast costs, associated terms and security
requirements, and their tax and accounting treatment.
Internal Financing
The first source of funding of cash deficits should always be internal financing using traditional
techniques, such as releasing working capital by extending payment terms and releasing trapped
cash in restricted currencies. Today credit is so limited that making inter-company loans within
business groups via the in-house bank is very attractive, even with the added tax implications.
External Financing
External short-term financing options include:
 Bank Overdraft facilities - the most flexible borrowing technique which gives
companies immediate access to funds within specified limits and at a predefined spread
over interbank rates. Overdrafts are mainly used to cover day-to-day gaps in companies
funding. But overdrafts are typically repayable on demand and so cannot be taken as a
committed source of liquidity.
 Short-Term Loans for a defined period - includes fixed rate bank loans or advance
facilities. Their main advantage is that these loans cannot be withdrawn immediately, but
can have complex documentation so there can be considerable break up costs if repaid
early. (For more details see Loan Finance.)
 Revolving Credit Facilities - offer some of the benefits of an overdraft and a term loan.
RCFs are mostly established for 3-5 years and allow companies to borrow up to a defined
amount provided all relevant documentation and warranties are complied with. Normally
the RCF can be repaid early with minimal break costs
 Money Market borrowing - some large companies will be able to use money market
lines with their relationship banks to borrow for a few days up to a month via the money
market
 Commercial Paper financing - CP or bonds are issued by companies at a discount to
their face value.
 Invoice Factoring/Invoice Discounting - the sale of receivables to a third can improve
cash flow by generating cash today in lieu of future sales receipts. (For more details
see Factoring/ Invoice Discounting / Dynamic Discounting.)
 Trade Finance - a wide range of trade finance services can be used to generate short-
term financing including Supply Chain Finance. (For more details see Supply Chain
Finance & Trade Finance.)
 Asset Based Financing including leasing, raising loans backed by inventory, real estate,
securitization, etc. can also be used to generate short-term finance.
Each company's combination of financing solutions they use will vary depending their treasury
policy and existing banking relationships.

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CORPORATE FINANCIAL MANAGEMENT (Fin. Ele.

UNIT 5: INVESTMENT DECISION

Top 9 Methods of Investment of

The following points highlight the top nine methods of

2. Negotiable Certificates of Deposit (CD’s):

3. Unit 1964 Scheme:

The unit scheme offers a good avenue for investing short-

(ii) The yield can be increased by a careful synchronizing of the

(iii) There is an active secondary- market for units, there will be no

Badla transaction is financed on the security of shares purchased

Badla financing offers attractive interest rates. However, it becomes

An investor in this type of financing should be careful about

(ii) The shares with a sound intrinsic value should be selected.

(iv) The possession of securities should be taken.

Inter-corporate deposits are of three types:

(ii) Three Months Deposits:

(iii) Six-month Deposits:

Since inter-corporate deposits are unsecured loans, the

The company should ensure that the discounted bills are:

8. Investment in Marketable Securities:

In choosing among alternative securities, the firm should examine

The securities should have a ready market. These investments can be

9. Money Market Mutual Funds (MMMF):

Till recently, only commercial banks and public financial institutions

Centralization and Decentralization of

Centralization concentrates decisions into the hands of top

As in opposed to centralized. Here you have: Spread power. No

A transfer of authority from central to local government.

Move departments of a large organization away from a single

It is my money, I say how, when, to whom or to where I want to send

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